Client Investment Letter July 2022

“We suffer more often in imagination than reality.” – Seneca, Roman philosopher

We all hate uncertainty. Oftentimes we dislike it more than any of the potential outcomes. There was a study published in Nature in 2016 that demonstrated that the uncertainty of getting a small electric shock was much more stressful for people than knowing they would get that shock with 100% certainty. The financial markets presently find themselves in a state of considerable ambiguity. The first major uncertainty is when inflationary pressures will peak. Unfortunately, this is very data dependent, and we will only know with a lag. The second unknown is a corollary to the first: how high will the Federal Reserve have to raise interest rates to cool the economy enough to stifle inflation, and will it be so high as to induce a recession? Other uncertainties also exist. How will the war in the Ukraine resolve itself? Will China continue to lock down every time there is a small Covid outbreak, snarling global supply chains? Rather than dwell on all these unknowns it is perhaps best to focus on what we do know.

First, business cycles naturally ebb and flow. When recessions eventually come, they are a necessary cleansing process that prepares the economy for the next leg of growth. We have lived through numerous recessions, and, within a period of a couple years, people always stop worrying about the slowdown and focus once again on long-term growth that lies ahead. Good companies with clean balance sheets come through recessions and out the other side stronger, and you own many good companies.

Second, inflation is insidious and the Fed’s fight to suppress it is paramount. Plenty of economic studies show that high inflation is an impediment to economic growth and reduces efficiency in the economy. While it acted too late, the Fed is now doing exactly the right thing in trying to tame it at all costs. To let inflation become embedded would result in much worse consequences for our economy over the long term. While we would have preferred for the Fed to move earlier, policymakers seem to be on the case now, and we expect them to do whatever it takes to rein in inflation. Inflation is a horrible thing for bonds which can’t raise their coupons, but for companies that can raise their prices in response, we expect it to be manageable. We want the Fed to be aggressive in getting inflation under control, even if it hurts the economy in the short term. Something we are keeping an eye on is if, as stocks swoon and unemployment ticks up, the Fed pivots and stops tightening even while inflation remains above its 2% target. Doing so would risk the institution’s credibility.

Third, uncertainty creates opportunity. When everyone is confident about the future, prices are typically at their highest. True bargains are found when the fog of worry conceals value. Most of the time, we can only find a bargain when a company-specific issue emerges. However, occasionally we get a market-wide selloff like we are experiencing now that gives us the chance to look at many more attractively priced companies. Our shopping list gets longer the deeper the market declines, and we always keep some cash on hand to take advantage of opportunities as they arise. Today we are seeing many more growth companies that are nearing reasonable prices, though, so far, we have mostly been biding our time waiting for companies trading at prices we think are unreasonably good. We expect to enhance your portfolio with more new companies the longer the unsettled market conditions persist. We have a couple of companies in your portfolio that are in the process of being acquired. Those offers provide downside support today, and as those deals are completed, we will have even more dry powder to take advantage of the market environment.

So, while most of Wall Street is busy worrying about that which it can neither predict nor control – and the mainstream media sensationalizes it to get more viewers – we encourage you to remain calm, knowing that you own a portfolio of high-quality businesses that have staying power no matter what comes. People are going to keep searching on Google and clicking on ads, Kinder Morgan and Enterprise Products are going to continue moving oil and gas through their pipelines, and Anheuser-Busch InBev is going to keep selling a lot of beer. We have an opportunistic cash allocation in your portfolio and as interest rates rise, we can start earning a decent risk-free return on your cash. We can’t control what happens to prices as a wave of risk aversion washes over Wall Street, but we do know that this too shall pass, and that we are prepared to take advantage of opportunities as they arise.

So far, the decline in the stock market has primarily been about multiple compression. With higher interest rates, people are willing to pay less for each dollar of earnings now and (especially) in the future. Not too long ago, many people thought rates would be low forever and inflation would be transitory. Now, the worry is that inflation is here to stay, and the Fed will be hiking rates for a long time. They weren’t right then, and they probably won’t be right now. The world will most certainly look quite different at this time next year. If earnings decline, the markets will probably follow, but if earnings hold up and people change their view on the likelihood of further Fed rate hikes, multiple compression may stop. A lot will depend on the path of inflation and earnings over the next six or nine months.

In short, we remain comfortable with your portfolio. You own a good mix of companies that have done well in the current environment like energy, defense, and healthcare, but also long-term growers that are now trading at what we think are very reasonable prices and have substantial upside potential. While times like this are always uncomfortable because none of us like uncertainty, they also are when we often plant the seeds for better harvests in the years ahead. We appreciate the trust you place in us and look forward to updating you again next quarter. Until then, as always, if you have questions, we are delighted to set up a meeting with you, either in person or by Zoom or phone.

Penn Davis McFarland, Inc.
July 2022