Client Investment Letter April 2021

“Inflation is the process that enables you to live in a more expensive neighborhood without going to the trouble of moving.” – A.W. Claussen

During the first quarter, stocks continued their march to all-time highs as vaccine rollouts and declining case and hospitalization rates bring some version of “normal” in sight. It’s a race against time to get enough people vaccinated before the more-contagious variants become widespread and people simply tire of adhering to Covid precautions. While the U.S. trends are promising, Brazil, India and much of Europe are lagging far behind on inoculations and, in some cases, are moving back to lockdowns. Beyond impacting sales of multinationals and curbing U.S. exports, because the world is so interconnected, we can’t declare victory until much of the global population is vaccinated.

To fight the economic fallout of the virus, the Treasury and Fed continue to dole out a seemingly endless amount of fiscal and monetary stimulus.

Lawmakers passed a $1.9 trillion stimulus package in March, bringing the government’s total support to $5.3 trillion since the start of the pandemic. With the ink barely dry, there’s already talk about plans to spend trillions more on infrastructure, partially financed with tax hikes. With rates virtually at zero, the Fed continues to buy bonds at a rate of $120 billion per month and has now expanded its balance sheet to a whopping $7.8 trillion to maintain smooth market functioning and accommodative financial conditions. The Fed expects to keep rates at zero through 2023.

Trillions upon trillions of dollars of support – while vital through the peak of the pandemic – does have its consequences. Cheap, easy credit has allowed many companies to cling to life instead of restructuring through bankruptcy. It creates moral hazard, which incentivizes excessive risk taking. We’re seeing speculative manias in pockets of the market, a common side effect of an easy Fed. Margin debt is at an all-time high, as investors hope to benefit from the upside of leverage without concern about its perils. On that note, this quarter we witnessed two epic margin calls, or forced liquidations, within months of one another as a couple of multi-billion-dollar hedge fund managers were forced to lock-in heavy losses.

The aggressive policy response that persists even as the recovery gains steam also stews concern about inflation. Commodity prices from crude, copper and aluminum to lumber, coffee and corn are up sharply. Global supply chains are strained; freight costs are rising. Housing in many global cities seems to be overheating. After decades of globalization lowered costs, new nationalistic policies to secure supply chains could eventually lead to higher prices. The Fed is now content to let inflation overshoot its 2% target; it may just get what it wants. In fact, the bond market has begun to price in higher inflation, with 10-year Treasury yields hitting 1.75% after the starting the year at 0.92%. Market-based measures of expected inflation are over 2.50%, the highest since 2008. If inflation does take hold it will be bad for stock prices as earnings multiples will fall, but it will be devastating for long term bonds, securities many investors rely on for “safe” returns.

Uncertainty is causing a rolling rotation between growth and value, stay-at-home and reopening, and a tug-of-war between crowded hedge fund positioning and retail driven momentum trading mania. How do all these cross currents impact our investment process?

We continue to stick to the same disciplined process that has served us well over time. We strive to buy high-quality, well-managed companies at fair prices and to remain concentrated in our best ideas. We prefer secular growth stories that are leaders in an inherently attractive industry that generate strong free cash flow and have fortress balance sheets. Over the past year, we bought several high quality but beaten-up stocks that we expect will benefit from the reopening. Yet we still retain ample cash to put to work should opportunities arise.

We added to our energy exposure in January, when we initiated a new position in Black Stone Minerals (“BSM”), one of the largest owners and managers of oil and natural gas mineral interests in the U.S. BSM’s large, diversified asset base across all of the major onshore producing basins, with minimal operating costs or capital requirements, allows the majority of cash flow to be distributed to shareholders. Growth comes through active management and expanding the company’s asset base through acquisitions of additional mineral and royalty interests. The board and management own nearly 25% of the company so they have every incentive to maximize this growth.

The energy transition to zero-carbon has caused some traditional energy companies to be overlooked, left for dead. This evolution will play out over many decades, though, and in the interim the production of oil and natural gas will continue to fulfill the bulk of our energy needs. We’re content to have exposure to this out-of-favor sector on the front end of a demand surge as the country reopens, and we’re especially happy to collect BSM’s 8% annual dividend in a world where income opportunities are scarce. In fact, we believe there’s upside to the dividend as the company re-aligns its payout with higher commodity prices and cash flow.

Your portfolio had a strong first quarter, and we believe it is well positioned. As the world recovers and the virus moves into the rearview mirror, we look forward to better days ahead. In the meantime, we hope you stay healthy and enjoy this beautiful spring weather. Everyone in our office has now been vaccinated, so we’d love to see you in person but would be happy to connect via Zoom as well.

Penn Davis McFarland, Inc.
April 2021