Client Investment Letter October 2021

“There is nothing permanent except change.” – Heraclitus

Heraclitus probably didn’t imagine future capital markets when he is thought to have said the quote above, but his ancient Greek wisdom remains applicable. Nothing in the markets is eternal, and in our opinion some previously popular views that have sustained the market are beginning to wobble. During the third quarter, the S&P 500 added a few more all-time highs to its win streak, supported by the major macro pillars of high and durable global growth, an exceedingly dovish Federal Reserve, and inflation that’s only transitory. Each of those themes, however, is now looking less permanent, more temporary.

The delta variant and a hodgepodge of global restrictions have stifled spending in many sectors like travel and leisure and, in others, curbed production and manufacturing, driving a slowdown in growth in the U.S., China and Europe. Supply-chain bottlenecks are pervasive. Companies are facing labor shortages and cost pressure, port congestion, shipping-container shortages, and higher raw material prices, which will squeeze margins or be passed on to consumers who will bear the brunt. There’s no clearer (and more ironic) signal than the fact that retailer Dollar Tree recently announced it would soon be selling products that cost more than a dollar. Inflation clearly deserves attention, and we expect to hear a lot of discussion on the topic on upcoming third-quarter conference calls.

One area where inflation is most acute is in energy. The global race towards decarbonization – the so-called energy transition – has backfired by moving too quickly towards intermittent clean energy sources while demonizing everything else. Regulatory uncertainty, management response to investor pressure, and a higher cost of capital for oil and natural gas producers has led to underinvestment and production cuts, which has created a shortage in traditional energy sources, supporting much higher prices. It’s simple economics: When something that there’s demand for becomes scarce, its price must go up. Crude oil, natural gas, uranium (fuel for nuclear power) and coal prices have had epic surges this year, accelerating energy costs which are likely to make central bankers wonder just how transitory this jump in inflation is. Our thesis has been that the energy transition must happen more gradually than widely expected and that there will be demand for fossil fuels for decades; we added to our energy exposure when no one wanted it, and it has certainly helped during this period.

The Fed seems to be taking note of all the liquidity slushing around and sounds like it will soon start reducing the amount of bonds it’s purchasing every month, with the hopes of winding down its quantitative easing program altogether by next summer. We would note, though, that this is the fourth time since the 2008 financial crisis that the Fed has tried to taper, and it has never been able to finish. As soon as there is a growth hiccup or a stock-market scare, the Fed invariably reverses course and turns back on the liquidity. With inflation stubbornly high and no need for emergency monetary support, the Fed will likely begin to reduce its accommodative bond-buying binge soon, most likely in the fourth quarter. But we imagine its bloated balance sheet will be in a state of semi-permanence for quite a while.

With growth slowing, inflation elevated and a somewhat less-accommodative Fed – combined with a stock market that has barely paused to catch its breath in a year and a half – we would not be surprised to see some volatility over the coming months or quarters. While we have certainly enjoyed the party, we are always mindful that there are still market cycles; nothing is permanent. That said, a breather is nothing to worry about. It would be healthy to remove some of the speculative froth and create a foundation from which further gains can be more safely built. And with the delta variant seeming to have peaked, economic growth might rebound. Your portfolio is prepared for a variety of outcomes.

As you know, we don’t chase fads or concept stocks that proudly plan to lose money for the foreseeable future. We don’t speculate on short-term binary outcomes, and we don’t rely on an exit strategy that entails a “greater fool” to pay an ever-higher price for our securities. On the contrary, we believe owning high quality companies, fairly valued, with little debt and strong free cash flow which can be used for dividends and buybacks is the best course of action, and so we feel well positioned for any eventual volatility. In fact, we have some sub-scale positions that we would like to add to.

We did find one new opportunity this quarter, initiating a small position in defense contractor Lockheed Martin. Even with Democratic control of Congress, the defense budget is well supported given persistently high global threat levels and an ongoing need to rival near-peer adversaries China and Russia. Lockheed seems well positioned given its exposure to high-priority programs in hypersonic weapons and space, as well as having a substantial international business, where demand is strong for the F-35. We believe Lockheed is a high-quality company, attractively valued, with strong free cash flow and a healthy balance sheet supporting solid cash returns through a 3.2% dividend and aggressive share buybacks. We also like having more defense exposure, complementing our Raytheon position, as the defense sector is not typically driven by macro cycles and is insulated from inflation due to cost-plus contracts or inflation adjustments typical in fixed-priced contracts. Finally, next year are midterm elections already, and if Republicans gain some seats, it may lift sentiment (and multiples) for defense stocks, while the outlook is unlikely to get worse if the status quo remains in place.

For accounts low on cash, we used eBay as a source of funds to make this new purchase. While eBay remains a good business and we continue to hold it in underinvested accounts, a lot of the low-hanging fruit has been realized and the one-off benefit from locked-down consumers shopping on its marketplace last year is waning. We still see longer-term upside from continued growth in advertising and payments, and at 16x earnings the valuation is reasonable.

In other portfolio news, healthcare data analytics company Inovalon agreed to an all-cash management-led buyout at $41. We always believed that the end game here was an acquisition, and given that Inovalon started the year at around $18, this was a big win that’s been five years in the making. We look forward to the deal closing later this year or early next.

We have been turning over a lot of rocks looking for new ideas for your portfolio, but in today’s richly priced market, it’s been increasingly difficult to find new investments that meet our valuation criteria. However, in our experience, periods of little opportunity are generally followed by periods with an abundance of opportunity. After all, nothing is permanent.

Except, that is, our gratitude to you for entrusting us to manage your money, which we do with great care. We hope to end the year on a strong note and look forward to visiting with you soon.

Penn Davis McFarland, Inc.
October 2021