What About the Dufresnes?
<August 24, 2022>
Born in 1968, Mitch Hedberg was an American stand-up comedian known for his dry humor and stoner demeanor. Like most great comedians, Mitch’s delivery was as good as his material. While reading his jokes doesn’t serve him justice, classics include: “I used to do drugs. I still do, but I used to too.” “Rice is great if you're really hungry and want to eat two thousand of something.” And, “You're supposed to yell 'fore,' but I was way too busy mumbling, 'There ain't no way that's gonna hit him.'"
One of my favorite Mitch Hedberg jokes is a little longer, but worthwhile!
"When you go to a restaurant and it's busy, they start a waiting list. They start calling out names. They say ‘Dufresne, party of two. Dufresne, party of two.’ And if no one answers they'll say their name again. ‘Dufresne, party of two, Dufresne, party of two.’ If no one answers they'll just go right on to the next name. ‘Bush, party of three.’ Yeah, but what happened to the Dufresnes? No one seems to give a s#*t. Who can eat at a time like this? People are missing! You f#&%@s are selfish. The Dufresnes are in someone's trunk right now with duct tape over their mouths. And they're hungry! That's a double whammy. We need help. Bush, search party of three! You can eat once you find the Dufresnes.”
Similar to the Dufresnes, investor concern regarding inflation has recently gone missing. With the price of oil declining and inflation comparisons becoming easier (up against high 2021 numbers), recent government reports indicate inflation is moderating. The eager adoption of the “peak inflation” narrative and resulting rally in risk assets has been impressive.
As investors celebrate, few seem overly concerned about the significant amount of purchasing power that has been lost over the past two years. To borrow from Mitch Hedberg, “Peak Inflation, party of three. Yeah, but what happened to Purchasing Power? No one seems to give a s#*t. Who can celebrate at a time like this? Purchasing Power has gone missing!”
A dollar two years ago (July 2020) is currently only worth $0.87, adjusted for inflation. That’s a tremendous amount of purchasing power (and savings!) that has gone missing in a short period. Will it ever return? Barring a sharp decline in demand, we don’t think so. In fact, we believe consumers will continue to lose purchasing power, even if the year-over-year rate of inflation continues to moderate in upcoming months. Meanwhile, investors seem content ignoring all of the accumulated inflation, as long as the Federal Reserve continues to do what it does best—backstop asset prices with accommodative policy shifts, negative real interest rates, and when necessary, additional rounds of quantitative easing (QE).
We’ve been reporting on inflation since the inception of Palm Valley Capital. In May 2019, we wrote an article debunking the popular inflation is dead myth. We noted that while many in the media and Wall Street were proclaiming the death of inflation, evidence was building that prices were in fact rising. In later posts (Loose Teeth and Tangible Assets, Buy Things, The Fed’s Labor Trap, and The Inflation Headshake), we continued to site specific examples of rising inflation and how it conflicted with the “inflation is dead,” and eventually, the “inflation is transitory” narratives. With much of our small cap universe reporting noticeable cost and price increases, we never subscribed to the popular deflationary themes.
Although our views on inflation have differed from the consensus over the past several years, we are currently in agreement—slightly. Based on our bottom-up analysis, cost pressures appear to be moderating for some businesses and in certain categories. Along with the price of oil, some material costs have in fact moderated or declined. And while the labor market remains very tight, several companies have communicated that they are beginning to see an increase in labor availability.
As a reminder, we view the economy through the eyes of business. As bottom-up economists, we collect data and commentary from the hundreds of small cap companies we analyze to help us better understand where we are in the profit and economic cycle. Below are some company-specific examples that point to moderating cost and labor pressures.
Gencor Industries (GENC): “Steel prices remained at record high levels in the quarter but showed signs of moderating.”
Sonoco Products (SON): “We're beginning to see improvements in truck and driver availability as well as some moderating diesel costs.”
Hubbell Inc. (HUBB): “While material inflation is showing signs of easing, non-material inflation and supply chain headwinds persist.”
Lennar Corp. (LEN): “Material costs were lower due to the lower priced lumber from starts in the second half of last year.”
Fastenal Company (FAST): “Hiring remains challenging. However, our trends and applications received have improved.”
Although there are some signs of costs moderating, in most cases, we are not seeing large declines. In fact, most businesses continue to report that costs, including labor, are increasing and remain a significant challenge. As costs rise in aggregate, additional prices increases are being implemented, with many increases likely to be felt well into 2023. Further, in several industries, the capital expenditures needed to increase supply and replace aging equipment have been restrained due to the rising cost of investment and shortage of parts and labor. In summary, as many structural issues related to higher costs and supply remain, without a sharp decline in economic activity, we do not expect inflation to decrease meaningfully in the near term.
Coterra Energy (CTRA): “Inflation continues to be a headwind…it is hard to point to any significant item that has not seen some level of price increase.”
Sherwin-Williams (SHW): “While some key feedstocks have come down sequentially, the issue is timing as resins, solvents and other key inputs are taking longer to reflect this trend than anticipated. Additionally, the rest of the cost basket remained highly elevated, including labor, transportation, fuel and other costs.”
J.B. Hunt (JBHT): “Inflationary cost pressures on tires, parts, maintenance, technicians are meaningful. And the higher frequency of repairs as a result of an aging fleet is also impacting the utilization of our tractor equipment.”
Church & Dwight (CHD): “Through mid-2022, we have already announced price increases covering 80% of our global portfolio. And we did a second round of price increases in laundry and litter that just hit the shelves. But at the same time, cost inflation continues to climb.”
Scotts Miracle-Gro (SMG): “As we go into next year, we're taking more pricing. We're also expecting to see more cost increases, even though the costs have come down recently, our average costs for next year are still planned to be above the costs that we've experienced this year…”
Lassonde Industries (LAS.TO): “Our second-quarter results reflect persisting inflationary pressures on transportation and input costs, partially offset by selling price adjustments…certain capital expenditures will be deferred to the first half of 2023…current market conditions are making access to certain resources and equipment more difficult."
Oil-Dri (ODC): “Global supply chain challenges coupled with rampant inflation have resulted in fixed asset replacement costs that are nearly double their historic acquisition costs…we will be announcing product-specific price increases to incorporate these rapidly rising capital improvement costs. These pricing measures are a response to substantial inflation on commodities, transportation, labor, and other manufacturing costs.”
Woodward (WWD): What we'll see in January of 2023 is the indices-based pricing increases that will be based on 2022 inflation which I think, everyone is aware, has been significantly higher than any preceding year in any last few decades. So that's one price realization that we will see.
And while the price of oil has declined (natural gas certainly hasn't), we do not believe energy prices were allowed to remain high enough for long enough to materially improve supply. We question if investors fully appreciate the amount of underinvestment that’s occurred in the industry since 2014. It’s been a very difficult period, especially for energy service companies that now find themselves short of equipment and experienced labor. And with oil prices declining, uncertainty related to the industry’s future cash flows has increased. Considering many banks and investors have pulled away from lending to the energy industry, any threat to internally generated cash flow will directly influence the amount of capital available to increase supply. This is particularly relevant given the industry’s newly found discipline of investing within internally generated cash flow and with the cost to find and develop new reserves rising sharply.
Patterson-UTI Energy (PTEN): “…the industry supply remains constrained. We expect the strong market for our services to continue, and we anticipate further improvements in pricing and activity. The availability of fully crewed super-spec rigs is almost nonexistent as few customers are willing to give up rigs.”
Halliburton (HAL): “On the industry side, despite high commodity prices, operators remain disciplined because of investor return requirements, public ESG commitments and regulatory pressure. In response, service companies invested for returns and did not overbuild. In short, this cycle has been nothing like prior cycles. This means any economic slowdown will not solve the structural oil undersupply problem.”
“As for the overall market, I believe it will be all but sold out for the second half of the year due to service company discipline, long lead times for new fleets and supply chain bottlenecks for consumables. And the tightness around oil supply is not something that's resolved quickly after seven, eight years of underinvestment.”
Coterra Energy (CTRA): “Long-term underinvestment in our sector, combined with the rebound in demand, has created a shortage of oil and natural gas and the impacts of which have ricocheted around the world."
Helmerich & Payne (HP): “It's encouraging to see capital discipline in our industry. And when combined with the supply chain and labor constraints, we expect this could put a damper on the industry's ability to reactivate idle super-spec rigs…this will likely perpetuate the supply-demand tightness.”
Cullen/Frost Bankers (CFR): “I was glad to see the great work of our energy team rationalizing [reducing] our concentration in our energy portfolio. Energy loans represented 5.9% of loans at the end of the second quarter, and I'm happy to declare that we've reached mid-single digits.”
And finally, while investors appear comfortable dismissing the significant amount of inflation that has been created over the past two years, the consumer is not and continues to suffer. There is building evidence of demand destruction and increasing pressure on consumer spending and corporate profitability.
The Children's Place (PLCE): “The decrease in net sales compared to Q2 2021 was primarily due to the impact of a slowdown in consumer demand resulting from the unprecedented inflation impacting our customer…”
Kohl’s (KSS): “A weakening macro environment, high inflation and dampened consumer spending are having broad implications across much of retail, especially in discretionary categories. Second quarter comparable sales declined 7.7%...it became increasingly clear that inflationary pressures were beginning to impact our customer spending, especially our middle-income customers.”
Ross Stores (ROST): As noted in today's press release, we are disappointed with our sales results, which were impacted by the mounting inflationary pressures our customers faced as well as an increasingly promotional retail environment. We are facing a very difficult and uncertain macroeconomic environment that we expect will continue to strain our customers' discretionary spending.
Big Lots (BIG): “It's clear that the lower-income customer has been directly impacted by all-time high gas prices and is worried about ongoing inflation. Consumer confidence is at a low while real disposable income is declining, and consumer balance sheets have depleted as stimulus recedes into the rearview mirror.”
Carter’s (CRI): “In May and June, the trend in our retail sales weakened. It is increasingly clear that the strength of the market has changed since the beginning of the year. The post-pandemic optimism we all experienced last year has been disrupted…media reports highlighted the new and heavy burden on consumers weighed down by the surge in gas prices, a 41-year high in inflation affecting food prices, shortages of baby formula and rising interest rates.”
La-Z-Boy (LZB): “As far as the consumer, the entire industry over the last three, four months is certainly seeing a slowdown in traffic. And I think there's a couple of things driving that. Overall, consumer sentiment, no doubt, is challenged.”
While we were not surprised by the sharp rise in inflation over the past two years, we were surprised by the response from investors and policy makers. Most stunning was how long it took for the “data-dependent” Federal Reserve to acknowledge and react to inflation. We were also mystified by the fleeting lack of concern displayed by investors considering how threatening inflation can be to the Fed’s ability to backstop asset prices. While asset prices declined for most of 2022, the consequences to date have been less severe than we’d expect from such an important and large miscalculation. And finally, we were surprised the Federal Reserve did not lose more credibility. Given the market’s positive response to “peak inflation,” it appears that all has been forgotten and forgiven, as if the risk of inflation and future policy errors have been permanently put to rest (again).
Our memory is not as short, and we are not as forgiving. As the Federal Reserve sat on its hands trying to convince everyone, including themselves, that inflation was transitory, the U.S. consumer suffered a tremendous amount of lost purchasing power. Based on our bottom-up analysis of hundreds of small cap businesses, accumulated inflation continues to impair real incomes, consumer spending, and capital investment. While year-over-year increases in inflation may be moderating, cumulative inflation and diminished purchasing power remain a threat to profits, asset valuations, and the much-anticipated shift in Fed policy. As such, we have not reduced our valuation standards, or required rates of return, by assuming the numerous risks stemming from inflation have been eliminated.
Dufresne, party of two. Dufresne, party of two. Like the Dufresnes, concerns related to inflation and lost purchasing power have gone missing. While investors have moved on to the next party, until our bottom-up indicators suggest otherwise, we believe the risk associated with accumulated inflation remains elevated. Similar to “inflation is dead” and “inflation is transitory,” we believe “peak inflation” is just another one of Wall Street’s self-serving narratives being used to dismiss risk and encourage overpaying.
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