Client Investment Letter April 2022

“He who wishes to fight must first count the cost.” – Sun Tzu

It was an eventful quarter, to say the least, with two wars breaking out: a war in Eastern Europe and a “monetary war” here at home against overheating inflation.

Russia’s invasion of Ukraine brought to the forefront geopolitical risk, the fragility of supply chains and the West’s overreliance on adversaries for key natural resources. Commodity prices were already moving higher before war broke out due to strong post-pandemic demand, but the supply shock from sanctions, boycotts and retaliatory export bans have sent everything from crude oil and natural gas to grains and industrial metals to the moon. According to Bank of America, commodity prices are on course for their best year since 1915.

There’s a full-blown energy crisis underway in Europe, where bad energy policies have led the continent to become far too dependent on Russian oil and natural gas. With the disruption of grain and fertilizer trade, food costs are set to soar. Russian and Ukrainian exports are at risk for wheat, barley, corn, sunflower oil, and other foods that account for more than 10% of all calories traded globally, according to Bloomberg, and a much higher percentage in North Africa and the Middle East, which could lead to severe humanitarian suffering and, ultimately, social unrest.

Apart from the tragic human element of Putin’s aggression, the events over the past month have redrawn political and economic alliances and put an end to the peace dividend that fostered decades of pro-growth globalization. Energy and food security and military readiness have become new priorities after years of complacency. Onshoring, de-globalization and a splintering between the Eastern and Western worlds are longer-term potential outcomes we are keeping a close eye on. Also on our radar is the U.S. relationship with China, which could be at an important inflection point as China maintains its diplomatic and economic relationship with Russia and thus might have an increasingly strained relationship with the West.

The second war – an economic one – started here in mid-March, with the Federal Reserve taking on the sinister effects of inflation with the first interest rate hike since 2018. After letting inflation run hot, initially brushing it off as only transitory, the Fed is now embarking on a more aggressive cycle of interest-rate hikes and the start of the roll-off of the central bank’s $8.5 trillion balance sheet in the battle to tame the highest inflation since the 1980s. Inflation was elevated coming out of the pandemic, but sanctions against the eleventh largest economy in the world have sent it soaring. The Fed, already behind the curve, now has a difficult choice to make: defeat inflation by uncompromisingly tightening monetary policy but choking economic growth in the process and risking a recession; or allow potentially destabilizing inflation to run high and risk losing control of it altogether.

Despite the Fed’s sudden determination to fight skyrocketing inflation, changes in monetary policy have a lagged impact on economic growth, and we do not expect a disorderly tightening of financial conditions. We also clearly recall December 2018, when the market balked at Chairman Powell’s hawkishness and he quickly reversed course, cutting rates instead by the summer. Likewise, we believe the Fed will ultimately de-escalate and continue to support stock prices; in fact, the market is already pricing in multiple rate cuts in 2023 and 2024. Every tightening cycle since the early 1980s, the peak in the Fed Funds rate has been lower than the previous peak, and we do not believe the Fed will be able to raise it above the 2018 high of 2.50% this time either, which stocks should be able to absorb. It’s also unlikely that the Fed’s bloated balance sheet will ever be completely unwound. After all, it’s still sitting on many trillions of dollars of assets from the last crisis in 2008, some 14 years ago.

So, what does this mean to our investment strategy and your portfolio?

We continue to believe that equities with valuation support look attractive relative to other asset classes. Bonds, by contrast, are historically unappealing in an inflationary environment; despite their sharp selloff during the first quarter, yields appear poised to continue higher. Not all stocks are created equal, though, and after more than a decade of bananas Fed policy elevated pretty much everything, we believe going forward stock selection will be rewarded over passive indexing. As an example, rising interest rates during the quarter triggered a sharp rotation out of richly valued, non-profitable tech stocks where future earnings potential lies far into the future. Many of these former highfliers are down 50-80% from their highs as the downward pull from a fast-rising discount rate is inescapable for these expensive securities. Fortunately, this is not an area we traffic in.

We continue to focus on high-quality companies with strong free cash flow generation and fortress balance sheets that are reasonably valued. Oftentimes a short-term market overreaction or controversy which we believe is unwarranted provides us an entry point. We believe that the companies you own will be able to navigate the current environment just fine. Many of your holdings have the pricing power to offset higher raw material costs or directly benefit from high energy prices.

We have a number of portfolio updates to discuss this quarter.

First, in January, Activision agreed to be acquired by Microsoft for $95 a share in cash. Prior to the deal announcement, the stock was trading at $65, under pressure from allegations of sexual harassment and misconduct at the company and an attempt to cancel long-time CEO Bobby Kotick. Despite the $95 all-cash offer, the stock has been trading in the low-$80s, an unusually wide discount due to perceived risk that the deal will be blocked by the Federal Trade Commission. We believe the deal will close by next summer, as it’s hard to argue that the takeover will harm competition. If it is blocked, though, Microsoft will pay Activision a reverse termination fee of between $2 billion and $3 billion and, over time, we will likely retain more upside value (recall the stock was over $100 in early 2021). Either way, the big gain in Activision was a welcome contributor to our first quarter performance.

Second, we added a new company to your portfolio. We have been interested in the secular theme of digital payments for years, and finally got an opportunity to establish a position in the industry leader, PayPal. Though we’ve long admired the company and count ourselves among the millions of users of its PayPal and Venmo products, the persistently rich valuation in excess of 30x earnings always kept us watching from the sidelines. A combination of factors gave us an entry in February: a broad-based rotation out of high-multiple technology as 10-year interest rates topped 2% for the first time in years, and a modest fourth-quarter earnings disappointment where the company added fewer net new customer accounts than expected and management walked backed its medium-term aspirational goal of 750 million accounts.

We believe the company’s strategy pivot to focus on customer engagement makes sense and should increase total payment volume per user over time. More users do not necessarily equate to more revenue, and a strategy focused on high-value customer acquisition and engagement should generate higher returns. In this fickle market environment, though, the stock was down 25% following its earnings report and another 6% the next day. In all, the stock dropped 70% from its all-time highs of last July to its March lows. The business clearly is not 70% worse today than it was just eight months ago. Granted, it was probably overvalued then, but we believe the market has been overly punitive, and so we used this overreaction as an opportunity to add the premier leader in digital payments with a long runway of double-digit growth at a trough multiple of under 18x next year’s earnings.

Third, during the final week of the quarter, Nielsen agreed to be acquired by a consortium of private equity firms for $28 per share in cash, with a go-shop provision that allows the company to solicit a higher offer for the next 45 days. Before a $25.40 all-cash offer was made and promptly rejected by one of its largest institutional investors, the stock was trading at around $17. The company’s turnaround, led by the launch of its forthcoming cross-media solution, Nielsen ONE, will now occur outside the light of the short-term focused public markets. While this is a nice outcome for us after four years of patience, we’re pretty confident that there’s more long-term value in Nielsen than the $16 billion offer. But in today’s crazy markets, we’ll take the win and move on.

The conflict in Ukraine sparked a strong rally in the defense sector, and our holdings in Lockheed Martin and Raytheon were stellar performers in the first quarter, both hitting new all-time highs as geopolitical risk becomes an unfortunate reality. Besides the improvement in sentiment, we believe the fundamental impacts will include bipartisan support for increased U.S. defense spending, higher foreign military sales as NATO allies beef up their own defense capabilities, on top of re-stocking activity to replenish anti-tank and anti-aircraft weapons that the U.S. and Europe have sent to Ukraine. The NATO defense-spending target of 2% of GDP was for peacetime, not wartime, so further upside pressure on military spending could ensue. Germany has already said it will invest 100 billion euros ($110 billion) in a special fund to modernize the country’s military. As China plans to increase its defense spending by 7.1% this year, an arms race against near-peer adversaries and elevated global threat levels should continue to support defense contractor multiples heading into the midterm elections, where any incremental Republican shift should drive improved defense-sector sentiment.

Finally, your portfolio has also benefited from our overweight exposure to energy, which we have been building since the pandemic’s abyss. At the time, the entire energy sector was only 2% of the market value of the S&P 500 (vs. 27% in 1981), crude oil traded below zero because no one could store it, and the stocks were historically deeply undervalued. The ultimate contrarian idea at the time is now the best performing sector over the past year by a wide margin.

During the bout of volatility in the quarter, there was another Sun Tzu quote that came to mind: “In the midst of chaos, there is also opportunity.” As we confront a world full of geopolitical tensions and a new path of monetary policy, we will continue to look for the many attractive opportunities that are sure to arise in their wake (and we have some cash on hand to do so). We appreciate the vote of confidence you’ve placed in us, and hope to continue to earn that trust in the years ahead.

Penn Davis McFarland, Inc.
April 2022