A MEGA THEME FOR A CHALLENGING RECOVERY | CROUCH CONNECTION | AUGUST 2021 "ADV"
by Dave Crouch
A MEGA THEME FOR A CHALLENGING RECOVERY
We are squarely in the Summer Doldrums, a period when it is not unusual for the market to lack much direction, chopping up and down much of the time. Earnings reports for the most recent quarter have been spectacular, with aggregate earnings averaging a 99% increase year-over-year. At the same time the Delta variant of Covid-19 is reviving fears of an economic shutdown and inflation paranoia is still permeating the airwaves and newspapers almost daily. Granted, CPI inflation data over the past three months has been higher than we have seen in several years, but Fed Chairman Jay Powell continues to tell us that it is “transitory”, or temporary.
INFLATION DEBATE ONGOING
Although we believe Powell will ultimately be right, several of his colleagues are beginning to object to that view and to call for the Fed to begin to tighten monetary policy. Investors are concerned because the broad stock market usually begins to run into trouble when the Fed changes the direction of their policy. One maxim that almost all investment advisors agree on is that you shouldn’t “fight the Fed”.
Barron’s Magazine had two articles this past week that I believe captured two of the most important issues that we face this summer. In an interview with Claudia Sahm, a former senior economist at the Federal Reserve, Sahm boldly gave her vote of confidence in the Fed’s position about the inflation threat:
“They don’t have crystal balls sitting around, but they do have 400 Ph.D. economists, hundreds of whom work on the economic outlook. Jay has an immense amount of firepower to really understand the data. Anybody who gets paid to forecast agrees that this inflation is temporary. The people out there saying inflation is high and going higher don’t [forecast] for a living.”
We continue to agree with that view.
IMPORTANCE OF AN “ALL-WEATHER” PORTFOLIO
Given our optimism, we also admit that we don’t have a crystal ball and want our portfolios to weather any storm that may come along. Recent research done by Kay O’Connell, our portfolio manager (with some input from me of course), has produced some portfolio models that we believe will weather whatever storms might come along and are designed to limit volatility to a level corresponding to a client’s risk tolerance.
Newly acquired software that allows us to “backtest” these models shows that premier, quality companies produce superior returns over time and recover from the inevitable corrections quicker. While US Treasury bonds have always protected balanced portfolios from volatility, we now have the ability to backtest dozens of different combinations of stocks, bonds and funds to help maximize our returns while diminishing the volatility to a level that each client can be comfortable with. Of course, while we can’t guarantee that past results will always be repeated, this gives us a much better way to tailor a portfolio to your individual needs.
A BUFFETT RULE REVISITED
Warren Buffet has always said is the most important rule of investing is to only buy companies with a “wide moat”, or a huge competitive advantage. In fact, he prefers a monopoly. Buffett says “pricing power is the single most important factor in evaluating a business”. Our experience has confirmed that principle and has been a cornerstone principle that we have followed since the founding of Aspen Grove Asset Management.
Another article in this week’s Barron’s underscored the importance of “pricing power” or buying companies with a significant competitive advantage. Henry McVey, the head of global macro and asset allocation for KKR, one of Wall Street’s largest private equity firms, offered what he called a mega-theme for a challenging recovery: “Focus on Pricing Power”:
“This type of environment heavily favors companies with pricing power. The haves – price makers- should succeed. Those without it – price takers -are going to be challenged.”
Daniel Peris, Senior Portfolio Manager and Federated Investors recently put it this way:
“Are dividend stocks well-positioned for a higher inflation, strong growth environment? It really depends on a company’s pricing power. Investors will want to keep a keen interest in the ability of their companies to take what’s called pricing (price increases) to manage their input cost increases.”
So, how can you really identify businesses that have that big competitive advantage?
WHAT IS PRICING POWER?
To explain pricing power, let me offer some examples of well-known industries with almost no pricing power. The automotive industry is plagued by competition from every corner of the world. Unless an auto manufacturer can offer a feature or technology that no other company can duplicate, like Tesla, they must compete primarily on price. This means that they must attempt to keep their costs low enough so that they can offer a quality automobile priced attractively relative to the other cars in its category. This means stiff competition and skinny profits.
Another industry with stiff competition and skinny margins is the grocery store industry. Grocery chains have always faced fierce competition, but it has become even more brutal in recent years with Walmart and now Amazon entering the fray. Two companies that have found a niche allowing them to make good profits in that industry are Costco and Walmart. Costco membership model sets it apart from the competition, allowing it to make attractive profits while pleasing the crowds of shoppers flocking to their stores. Walmart has achieved such size that it can offer better prices on many of its products than most of their competitors. A company must have a significant competitive advantage that makes us want to patronize their business in order to make money in good times and bad.
We found in 2010 and 2011 that companies that compete on price, the most cyclical companies, run out of steam as soon as the Fed pulls back on their accommodation and can fall sharply when investors get nervous. On the other hand, companies with pricing advantages over the competition (pricing power) and a durable growth story, can many times ride out the inevitable corrections more evenly and rebound more quickly.
The regulated utility industry has been one of our favorite groups for years. Regulated utilities operate with a monopoly in their respective territories. Their prices are set by the states in which they operate but regulators understand that the companies must make a reasonable profit or investors will not continue to provide the capital needed to fund the electrical, natural gas and water needs of the state…so they have government-backed profitability unless they make a rare unsuccessful investment. Their earnings have historically been very stable, providing reliable dividend growth year after year.
We also look for companies that are using the remarkable technology available in our country today to deliver their products faster, more conveniently, or with fewer employees than their competitors. Many companies use artificial intelligence to become more efficient and more attractive to their customers. Covid has accelerated the adoption of many of these trends that allow companies to operate more efficiently and allow their customers to use technology to do business with them more easily.
I can assure you that if you ask about any company in our portfolios, we believe that we understand the business, and we believe they have a durable competitive advantage that we can explain to you. Please call us anytime for more details. This is our passion, and we enjoy our conversations with our clients!
Come to see us!
Dave Crouch Registered Principle
Kim Blackburn Branch Operations Manager
Kay O’Connell Portfolio Manager
“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by a tenth of a cent, then you’ve got a terrible business. I’ve been in both, and I know the difference.”
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Dave Crouch and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.