Client Investment Letter October 2023


“The ideal policy would bring about a soft landing, with inflation subsiding without a recession. But this is a difficult task to accomplish.” – Robert Hafer, St. Louis Fed, May 1971


The above quote is thought to be the first time that the aeronautic term was applied to economics. It has since become a popular, even overused, analogy to compare a non-consequential economic slowdown to a pilot landing a plane on a calm, sunny day, gently touching down as the aircraft settles onto the tarmac. While this peaceful descent happens roughly 100,000 times a day at airports around the world, in economics it is a rare feat.

This summer’s combination of moderating inflation and a slackening labor market provided hope that the elusive goal of a soft landing may be possible. Alas, Chair Powell said in the press conference following the FOMC’s September meeting that a soft landing, while plausible, is no longer his baseline expectation. So perhaps we should introduce a better term into the economics lexicon.

A crosswind landing is a more challenging maneuver, requiring the pilot to actively use the rudder and ailerons to keep the aircraft aligned with the center of the runway when the wind is blowing perpendicular to it. While the crosswinds cause the final descent to be slightly bumpier, skilled pilots are trained to handle such conditions and ultimately, the plane comes to a stop just where it’s expected to.

Today, the market is facing several crosswinds. Labor unions’ demands for higher wages combined with rebounding energy prices threaten to put upward pressure on inflation. Market-determined Treasury bond yields have hit levels not seen since 2007, increasing borrowing costs for companies and consumers. And, in its latest update of interest-rate forecasts, the Federal Reserve expects to remain more restrictive than previously thought to safeguard against inflation bouncing back.

Dysfunction in Washington brought us to the brink of a government shutdown just four months after the U.S. barely averted a debt default. A last-minute temporary spending agreement to keep the government open bought some time, but not much. While much less is at stake because it won’t affect the Treasury Department’s ability to pay its bills, a shutdown of certain government agencies could delay the release of fresh economic data which Fed officials rely on to set policy. Making a landing with the pilot flying blind is not ideal, so we hope Congress gets its act together.

While there is a real possibility of a recession in the U.S. next year, parts of Europe and China are likely already in one. Economic contractions are a normal part of the business cycle – indeed, even a healthy cleanse of prior excesses – and so we are not too concerned. You own great companies that are largely profitable and cash-generative with strong balance sheets, and we have plenty of cash ready to deploy into new names on any significant setback. In fact, we just recently found an undiscovered gem that we’ve added to your portfolio.

In September, we initiated a new position in Fortrea, a late-stage contract research organization (“CRO”) that was spun out of Labcorp at the end of the second quarter. In simple terms, a CRO helps drug companies design, run, and manage clinical trials. Due largely to technical dynamics following the spin, as well as a clunker of a first quarter as an independent company, the stock has traded off substantially, creating an opportunity for us.

Fortrea is a new issue but its predecessor company, Covance, goes back 30 years and is considered one of the CRO pioneers; it was acquired by Labcorp in 2014. In January 2023, Tom Pike was hired as CEO of Fortrea ahead of the third-quarter separation. Tom’s deep industry experience is key to our investment thesis. He previously led CRO-industry bellwether Quintiles through its May 2013 IPO and, three years later, its acquisition by IMS Health for $9 billion. His track record at Quintiles was consistently good.

At Fortrea, there are a lot of duplicate costs weighing on margins, as the company is building out its own infrastructure while still paying Labcorp under a two-year transition service agreement. As management gets its cost structure in order, we anticipate that the company will be able to get EBITDA margins from 9% in 2023 to industry benchmarks in the mid- to high teens. If it does, which we anticipate happening in 2025, we can see the stock trading into the low-$50s on a fundamental basis, and potentially much higher if it’s acquired based on recent transaction multiples. We’re really excited about this opportunity.

We end with two other brief portfolio notes.

After a long 18 months of regulatory limbo, Microsoft’s acquisition of video-game maker Activision appears set to close at $95 per share in cash, as the UK gave the deal preliminary approval once Microsoft offered some token remedies. To compensate us for our patience, Activision also added a $0.99 per share dividend that was paid in August. If all goes as expected, that position will convert to cash by mid-October. We first started buying Activision in February 2019 at around $40.

Finally, at long last, in late September Liberty Media proposed to acquire the minority interest in SiriusXM that it does not already own, which would collapse the discount entirely. The deal is under review by the SiriusXM Special Committee, but we believe there is a high likelihood that it’s consummated next year.

As we make our final approach on year-end 2023, we thank you for your vote of confidence in us as we navigate these challenging crosscurrents and make sure you arrive safely at your financial destination. As long-term investors, we welcome the volatility and look to be opportunistic in adding future winners to your portfolio at reasonable prices. We hope to continue to keep you on course, whichever way the wind is blowing.

Penn Davis McFarland, Inc.
October 2023