It’s been a year since Jerome Powell led his first FOMC meeting as Chairman. Powell’s outlook on the economy at the time was rosy. During the March, 2018 meeting the economic outlook strengthened and the 2019 GDP growth forecast rose from 2.1% to 2.4% with benign inflation expectations. Despite political pressure from the White House, the Fed’s “dot plot” indicated three rate hikes in 2018, three in 2019, and two in 2020.
Current Market Environment
Dear Shareholders of the LS Opportunity Fund:
It’s been a year since Jerome Powell led his first FOMC meeting as Chairman. Powell’s outlook on the economy at the time was rosy. During the March, 2018 meeting the economic outlook strengthened and the 2019 GDP growth forecast rose from 2.1% to 2.4% with benign inflation expectations. Despite political pressure from the White House, the Fed’s “dot plot” indicated three rate hikes in 2018, three in 2019, and two in 2020. Additionally, Powell stated the Fed’s balance sheet would continue to run off barring a significant and unexpected weakening in the outlook.
Fast forward 12 months and the Fed outlook has changed entirely. The 2019 GDP growth outlook has slowed. The Fed is also expressing concern regarding current market sentiment and global growth. Internationally, 10-year government yields have once again gone negative in Germany and Japan. As a result, Fed officials are unlikely to raise rates and will halt the run off of the $4.0 trillion balance sheet at the end of September.
The market’s prognosis on the economy is worse. The yield curve is partially inverted (which could be indicative of a looming recession) and the market is assigning a significant probability the Fed will cut rates this year. No doubt the White House will pressure the Fed to cut rates in front of the upcoming 2020 election. That said, numerous Fed officials are dismissing the possibility of a rate cut. Whether a cut comes to fruition or not, the yield curve should remain relatively flat this year. We also believe the fixed income markets will remain in a “holding pattern” until further economic data is released and as we wait for developments on trade talks and Brexit.
In past letters we have asserted that there are no immediate signs of a U.S. recession, despite what the curve is indicating. To summarize, credit quality is excellent, GDP growth is robust (albeit slower), most investment-grade corporate balance sheets are in good shape, the consumer remains healthy, and there aren’t obvious financial excesses. The only recession indicators we can point to is a widening of credit spreads off the early 2018 low levels and inversions in the yield curve (which can be a false flag as we discussed last year). That said, recessions are often sourced from exogenous events which arrive with little warning.
If a recession occurs in the near term, it will likely be a mild one and unlike the 2008 recession. It has been some time since we experienced a garden variety recession (the last one occurring in 2001 when the U.S. economy realized a mere 0.6% contraction). We also do not see asset bubbles that could result in a disastrous implosion. However, one area of concern is in the private equity and leveraged lending markets. Given this extended period of low rates, investors have “chased” returns by flocking to illiquid assets. The private credit market alone has nearly quadrupled in size since 2007. There has also been a dramatic rise in “dry powder” and deal valuations. The average private equity deal through the cycle has risen from 7x Enterprise Value / EBITDA to 13x, coupled with an increase in leverage. Our interpretation is too much capital is chasing too few deals. This results in private investment firms paying higher prices and/or accepting a lower return. In the event of a “normal” recession, lower-quality leveraged loans and portfolio companies will likely come under pressure. While not a large systemic risk to the economy, pressure on private markets could create a negative wealth effect, freeze up the alternative credit market, and leave many portfolio companies “broken” which could exacerbate an economic contraction.
Another area of concern is the national debt level of the U.S. which now stands at $22 trillion. This figure represents a $2 trillion increase since President Trump took office. Today, national Debt / GDP stands at 104%, far above the 63% level in 2007. A higher debt level constrains future growth and makes it harder to engage in discretionary fiscal spending to limit the impact of an economic contraction. Additionally, the recent tax cut will further exacerbate the fiscal deficit, effectively removing a fiscal tool that could have been used in the next downturn.
As for the international markets, China is worrisome. The U.S. / China trade talks are a wildcard with an uncertain outcome. However, our greatest concern is the Chinese leveraging cycle of the past decade. Total debt / GDP is estimated to be over 300% which has almost doubled in size since 2007. With growth in China modestly slowing (if you trust the official numbers) and a surge in known defaults ($120B yuan defaults in 2018, four times the 2017 rate), China looks increasingly due for a deleveraging cycle. While we are not experts on China and hold no direct exposure in your portfolio, any economic contraction will inevitably spill over to the global economy.
If a recession or economic shock is around the corner, we believe our focus on first questioning the downside of every potential investment will act as a buffer. Your portfolio is invested in companies with conservatively stated balance sheets, substantial franchise values, significant cash flow generating capabilities, trading at reasonable valuations, and avoiding excessive risk taking. Importantly, we are short companies that exhibit the opposite characteristics. That said, if an economic contraction does not occur, we believe your portfolio should continue to produce what we feel are acceptable risk adjusted returns.
Portfolio Implications from the Dovish Turn by the Fed
Given the defensive nature of your portfolio, performance lagged this ebullient first quarter rally as stock market sentiment swung from “risk-off” to “risk-on.” Technology stocks once again led the S&P 500 with the sector realizing a 20% return during the quarter. We continue to avoid the “buy growth regardless of price” segment of the market in general and this sector in particular. Value investing, with an emphasis on capital protection remains our focus.
Given our value bias, you might expect an inflection in Fed policy would drive some level of portfolio rebalancing. Surprisingly, that is not the case at this time, as we see significant opportunity to two traditionally value oriented industries: property casualty insurance and banking.
Our case for property casualty stocks revolves around: stable business conditions where pricing continues to modestly outpace loss costs; reasonable valuations; accretive capital management; and a steady wave of industry consolidation that has seen seven portfolio companies acquired at premium prices over the past five years.
On the banking side, one might expect us to be nervous this late in the economic cycle at the prospect of an adverse credit cycle slashing banking industry profitability. This cycle looks different to us. The significant credit exposures are resident in the non-bank leveraged-loan market as well as the bloated Baa- / BBB- and high yield securitized debenture markets. We believe that the banking institutions we own in your portfolio will outperform the credit experience of a typical bank through a normal recession. When combined with discount valuations, modest earnings growth, robust capital management, and a reawakening of consolidation, we feel the investment prospects of our banks are bright.
Spill in the Ketchup Aisle
On February 21st 2019, Kraft Heinz (KHC) reported earnings results that sent the stock cratering down 27% the next day. KHC not only reported EPS below the consensus estimate for 4Q, but they also issued weak 2019 guidance, slashed their dividend by 36%, and most notably recorded a $15.4B impairment charge on the carrying value of its U.S. Refrigerated and Canada Retail units, along with the trademarks of its Kraft and Oscar Mayer brands. While our philosophy of avoiding highly-levered companies kept us relatively safe from this catastrophe (portfolio holding, Berkshire Hathaway did decline on the announcement, given their large ownership of KHC), it inspired us to reevaluate the category as a whole, and make some modest portfolio changes.
First, some background… In June of 2013, the Brazilian private equity firm 3G Capital, with the help of Berkshire Hathaway, closed on a deal to take the centuries-old ketchup maker H.J. Heinz private. The deal came at a price of $28B (including the assumption of Heinz’s debt) and represented a 20% premium to the company’s stock price the day before the announcement. Later, in March of 2015, the group merged H.J. Heinz with then publicly-traded Kraft Foods to create Kraft Heinz (KHC), the third largest food and beverage company in North America.
3G Capital has earned a reputation for ruthlessly cutting costs and driving profit margins higher by implementing a strategy known as Zero-Based Budgeting, or ZBB for short. ZBB is a framework whereby managers must justify all expenses from scratch each year, no matter how small, as opposed to using the prior year’s budget as a baseline. This process is more time consuming than traditional budgeting practices and often requires a significant shift in the culture of an organization, as non-necessities such as private jets, expensive hotels, or even seemingly innocuous activities such as single-sided printing are removed from daily practices.
While 3G did not invent Zero-Based Budgeting, they are often cited as the ones who perfected and popularized the practice after implementing the strategy at various acquired companies. The results were most notable at two giants in the consumer staples category, AB InBev (the product of InBev’s $52B purchase of Anheuser Busch in 2008 – orchestrated by 3G), and Kraft Heinz. For example, AB InBev currently boasts an industry leading EBITDA margin of 39.2% for fiscal year 2018 (compared to Heineken at 21.2% and Molson Coors at 21.8%), while Kraft Heinz expanded their EBITDA margins from 18.8% in 2012 (pre-3G acquisition and Kraft merger) to as high as 31.9% in 2016.
Although ZBB often required significant layoffs, amongst other difficult choices, the results were simply too great to ignore. Zero-Based Budgeting became the Topic Du Jour at investment conferences and in company earnings calls in the years that followed as companies announced that they would be launching their own ZBB programs, whether due to pressure from activist investors or their own boardroom. The premise was that ZBB would allow companies to realize cost savings that would then enable them to reinvest behind their business and drive growth.
While 3G changed how companies viewed themselves internally, it also inspired investors to view these companies through a 3G-like lens. “If 3G drove margins to 39% at ABI, why can’t the same be done at XYZ beverage company?” There is no doubt that the prospect of 1,000+ basis points of margin expansion had a significant impact on the private market value assumptions of investors (such as ourselves at Prospector), thus boosting valuations of lower-margin businesses throughout the past couple of years. Despite revenue growth in the low-single-digits and inflation in commodities and transportation costs, the earnings growth playbook was still possible with continued cost cutting.
Things began to change as large legacy brands started seeing their market shares eroding to competition by more specialized local brands and private label competition (a trend we discussed in past letters, and also a major theme to our short positions in the sector). It appeared that years of overhead reduction, including marketing and advertising investment, might be putting these companies at a disadvantage in an ever-changing consumer landscape marked with shifts to specialized and online channels, along with consumer preference towards better-for-you products. These fears seemed confirmed with KHC’s earnings results.
As mentioned earlier, this event caused us to reevaluate our holdings in the sector – Mondelez International (MDLZ) for example. While MDLZ has been executing well, has strong brands, and has had an impressive run of margin expansion (growing adjusted operating margins from 10.6% to 16.7% since 2013), our thesis (and estimate of private market value) called for further expansion into the 18-20% range. Given the likelihood that excessive cost cutting will be called into question by the industry, and MDLZ stock’s relative strength, we decided to reduce our position.
We continue to believe in the long-term prospects for well-run consumer staples franchises. We prefer those companies that remain on the cutting edge by identifying the needs of today’s ever-changing consumer, delivering differentiated products, while investing at appropriate levels that enable these brands to flourish. We avoid those who are overly reliant on a small number of powerful retailers for their distribution as well as those who are unduly exposed to volatile commodity prices for their inputs. Not surprisingly, we seek to short companies challenged by the aforementioned industry dynamics.
Outlook
After a ten-year post-financial crisis period of consistent underlying conditions for equity investing, fundamentals are shifting. Modestly slowing economic growth and macro concerns have given investors pause and led to a rerating of certain risk assets. Regardless, the U.S. economy remains fundamentally healthy and continues to be a global leader.
Interest and mortgage rates continue near historically low levels, having retraced by 90 basis points from the November highs as inflation remains benign and economic growth moderates. Although we are clearly late in the economic cycle, the odds of a 2019 recession without a full-blown trade war seem low. Investment-grade corporations have decent balance sheets and are currently producing acceptable free cash flows. We are carefully monitoring aggregate corporate debt levels (especially the BBB- debt which is a single notch above junk status), which now sit above pre- 2008 crisis levels. The 2018 corporate tax cuts and the ability to repatriate foreign cash holdings should continue to drive higher employment, M&A activity, and capital returns including buybacks and dividends. Profit margins remain near all-time high levels, currently 11%, and look to be at some risk from higher wages, interest expense, and input costs.
In our estimation, equity valuations have quickly bounced back to elevated levels. During the last four months of 2018, we moved to the seventh decile from the tenth decile on trailing operating earnings only to rebound back to the ninth decile by March 2019. Equities look most reasonable when comparing earnings yields to Treasury or even high grade corporate bond yields. In any case, the values inherent in your portfolio should attract acquirers and other investors over time. Meanwhile, we believe equities are a superior asset allocation alternative to bonds over the longer term.
Steadfast, we remain committed to our goal of making you money while protecting your wealth.
– Your Investment Team at Prospector Partners