It was the best of times; it was the worst of times.
Of course, I stole the line, but that’s the whole point of the Investment Advisory, isn’t it? To comb through what the world’s best investors are buying and steal their very best ideas. On other occasions, we steal the lede from long-dead English literary legends.
The Best of Times
When it comes to the economy, in many ways, it is the best of times.
The consumer remains strong, and we continue getting surprise after surprise on the retail sales front. I know we keep hearing all these scary stories about how high consumer debt levels are right now, but consumer’s debt service payments are the lowest they have been since they started being tracked back in 1981.
Second-quarter earnings comparisons will most likely turn out to be the best that has ever been (or will be in terms of percentage gains).
The economy has been so strong that we are seeing the Fed prepare to end the purchasing of mortgage backed and Treasury securities as soon as next month. There is talk of an interest rate hike next year as well.
The Worst of Times
It is the worst of times as well.
With rates so low and valuations so high, it is very tough to see how traditional stocks and bonds do well over the next 7 to 10 years.
If you need to earn 15–20% a year or more on your money, you better think twice before buying an index fund or owning the current market darlings.
We are really beginning to see inflation rear its ugly head, and hear the higher ups admit that it’s not all that “transitory” after all.
I was in Costco (COST) last week and saw something I have never seen before… empty shelves. And not one or two empty spaces mind you, but lots of them.
On my way home, I stopped at Rural King (a slightly downscale version of Tractor Supply) to pick up some fire ant bait. Not only did they have shortages (including ant bait dammit), but they had signs on the doors announcing that they were hiring (no experience required), at $14-$18 an hour to start.
That is wage inflation. It is not transitory. It is pure inflation.
Eventually, some of the supply chain issues will get fixed and pricing pressures will abate, but some of the inflationary pressure will be sticky.
The natural gas shortage could become a huge problem as well.
No matter which way you slice it, between power generation, feedstock, chemicals, and other natural gas based products used to build damn near everything, natural gas is here to stay.
And with way too many oil and gas producers in the U.S. spending more time worrying about their ESG scores and how to meet their arbitrarily assigned climate control goals, production will continue to fall by the wayside.
The energy story is not going away anytime soon and it may get worse. Patrick Pouyanné, chief executive at France’s TotalEnergies, said in a recent conference:
“If we stop investing in 2020, we leave all these resources in the ground, and then the price will rocket to the roof. And even in developed countries, it will be a big issue.”
Moody’s has weighed in with an estimate that spending on exploration and production (E&P) will have to increase by as much as 54% over the next few years to head off a supply shock.
Remember all those zero-net emission plans governments were adopting all over the world? Pretty much all of them called for lowered E&P spending immediately.
Simply put, the energy issues are inflationary and not even close to transitory.
What do we do as investors?
Now that we have covered the bad times (wage, price, and energy inflation), let’s take a look at how we can take advantage of this as investors.
1. Own energy infrastructure
As energy prices continue to rise, owning energy infrastructure is a solid idea that will produce tons of cash flow.
For example, in the Investment Advisory, we own shares in a company that is combining with one of the largest private equity firms in the world. The company aims to consolidate the fractured oil and gas market in the United States and should provide massive profits.
2. Own banks
In addition to the ongoing consolidation wave which I have covered many times, banks will see earnings rise sharply as inflation pushes interest rates higher.
3. Follow the disruption
Continued inflation and rising rates should also give us some periods of severe disruption where we can follow activists and private equity investors into companies with a high probability of outsized returns at lower valuations.
4. Invest in Real Estate
Select pockets of the real estate market should also respond well to inflationary pressures. With REIT valuations stretched though, I prefer to wait for those disruption pockets that allow us to buy at lower valuations. But, I am, as Michael Milken used to say, “highly confident” we will get these opportunities.
We have had massive institutional and retail flows into REITs since the lows in March of 2020. But rising rates are going to irrationally push investors out of the REIT sector and bring pricing down to the bargain levels where we like to get involved. Stay tuned.
5. Small Cap Value
Historically when we see high inflation, small-cap value stocks do very well. Investors should focus on small cap companies that are trading for less than book value as cash delivered today is worth more than cash delayed. Smaller companies trading at low multiples of free cash flow will do much better than large growth companies that are losing money in hopes of profits down the road.
As always, I will be aggressively tracking SEC filings to uncover special situations that are not dependent on market movements.
We will continue to find ways to hedge off-market risk when volatility is spiking lower, and insurance is cheap.
It is the best of times. The economy is strong, and third-quarter earnings should be good. M&A activity is brisk, especially in banks, and M&A has always been a great exit strategy for me and my readers.
The worst of times could be right over the hill as economic growth slows and earnings comparisons get tougher even as inflation rates rise.
We are prepared to profit in both conditions.