Hundreds of CEOs have spent the last month sounding the alarm. With prices soaring at the fastest rate since 1990, corporate executives are well aware that they face a difficult choice.
They can either swallow higher input costs and watch their profit margins shrink. Or they can raise the prices they charge their own customers and hope it’s enough to stay above water.
In the first scenario, the bottom line stalls. In the second, competitors get a free shot at winning customers who quite rightly don’t want to pay more than necessary.
Wall Street obviously hopes they can find the right balance. Looking at the math, I think there’s a route to that outcome . . . but the odds of disappointment are uncomfortably high.
And the price of failure could be catastrophic for a market priced for perfection. Let’s review the math.
Margins Can Handle A Little Pressure
First, the market as a whole has a little wiggle room to absorb higher costs. Margins across the S&P 500 aren’t quite at record levels, but they’re still tracking a healthy 11.8% in the current quarter.
That’s in the face of 6% consumer price pressure over the past year and reflects massive efficiencies unlocked through automation, shifting consumer habits and other disruptions around the pandemic.
A year ago, the S&P 500 was only able to squeeze 10.8% out of every $1 of revenue coming in. Between management and technology, there’s an extra percentage point to play with now . . . after factoring in inflationary impacts.
Admittedly, not every company is reaping the same windfall. Operating costs in many industries like retail and consumer products are eating a lot of companies alive, even as technology and commodity producers prosper.
The market, like the economy, will always rotate between winners and losers. We want to own the companies that benefit from disruption while shunning those getting disrupted.
But for now, we’re just looking at whether the market in the aggregate can survive this inflationary burst. Wall Street says “yes,” but you know a lot of analysts are more interested in making their clients happy than they are in the truth.
Add up all the targets and investors are being told to expect 8.5% earnings growth on 7.0% higher revenue next year. That’s decent enough on the surface.
The problem is that when the top line moves less than the bottom, the underlying business just isn’t growing fast enough to sustainably support earnings gains.
Instead, it’s usually a signal that executives are cutting their way to growth. You can do that for awhile, but sooner or later, you’re going to hit a wall of bone.
To get around that wall, we need costs to recede. Do the math on those consensus targets and they assume that margins will widen to at least 12%.
That’s not a huge leap by any stretch of the imagination. But it requires a little relief that we know the Fed isn’t really prepared to provide for at least another year.
Inflation isn’t likely to come down much on its own until interest rates go up. If it does, we need to reevaluate a lot of standard economic logic to explain what amounts to a “new normal.”
Is it possible for CEOs to get it right on the margins? Sure. Can they do it without overreacting and cutting their own costs to the point where we see another 2008-style employment crash?
That’s a harder question to answer. And here’s the thing: the S&P 500 is already more than a little overextended.
If interest rates come up, earnings need to grow faster simply to provide relief from overheated valuations. We talked about that last week.
Right now, those Wall Street targets assume about 10-11% upside for the market as a whole in the coming year. That’s ordinarily a fairly safe statistical bet . . . about average.
But when the “P” end of the P/E calculation goes up 10% and the “E” end only rises 8% along the way, you don’t get any relief at all. Multiples actually get more overheated than they are now.
I think Wall Street is telling clients what they want to hear. We don’t do that around here because we don’t buy the market as a whole.
We focus on the stocks that have what it takes to overcome ambient economic conditions, one way or another. They’re either cheap relative to the market, raising the bottom line faster than the market as a whole, grabbing customers from less nimble competitors or (in the best of all worlds) all three.
They’re in the sweet spot. The rest of the market can go its own way.
Ground rule: if your favorite stock doesn’t have what it takes to expand its earnings 11-12% in the coming year, look elsewhere. That’s the math it needs to justify a statistically “average” return in a given 12-month period.
A lot of big stocks fail this test. We don’t buy those stocks.
Cannabis Corner: No News Is Good News
It’s been a huge week for the industry. Massive gains for the big cultivators like Aurora, Tilray and Canopy . . . and the buzz spreads to the hydroponic suppliers as well.
My cannabis index jumped 18% in the last five days. However, it’s worth remembering that the group is still down 8% YTD, largely thanks to persistent weakness around Canopy and other cultivators.
One great week simply can’t overcome months of dead money on those names. But if you’re in Tilray and next-generation producer Organigram, 2021 has been very, very good to you.
The lesson here is quality. Tilray and Organigram focus on medicinal-grade plant matter, not the commodity product that Canopy and Aurora flood the market with.
Quality is where the margins are. And quality inspires loyalty, which in turn makes it less expensive to compete for fickle customers.
Overweight quality in your cannabis portfolio. But what happened this week that got the entire group so fired up?
There’s a bill in Congress to legalize recreational use at a federal level. I’m not impressed. The map is already as green as it’s going to get for the foreseeable future.
But it’s nice to see traders feeling a little confident for a change. The real pressure on these stocks isn’t fundamental. Regulations aren’t the problem.
The problem is the mood. If these stocks can’t make people excited about the future, there’s zero point in owning them.
GreenTech Opportunities: ESG Inflation
The irony is that a greener world is inherently inflationary . . . and if you’re worried about inflation, the best hedges available are actively anti-environmental.
Mining gold wrecks whole provinces. Mining bitcoin and other crypto currencies drains vast reserves of hydrocarbon fuels.
ESG economies simply cost more. Green materials, green buildings, green appliances are expensive.
The long-term costs may be lower, but investors aren’t really looking at that right now. In the immediate future, building new power plants and an entire new renewable economy will cost trillions of dollars.
The new infrastructure plan moves in that direction. Yes, it’s expensive, even shocking.
But it will create new industries. That’s where investors can smile . . . and just maybe keep their net worth moving ahead of the costs.