The majority of the major indices posted negative results for the first quarter of 2022 as investors reacted to the winds of war, heightened levels of inflation and rising interest rates. While our benchmark lost value during the period, the Focused Value portfolio returned positive results. A large portion of our positive return was due to our overweight allocation to the Energy sector coupled with strong stock selection in Health Care.
|Period||Composite Gross||Composite Net||Russell 1000 Value Index|
Equity Prices Driven By Inflation and Monetary Policy Action
The prices of commodities from wheat to corn to aluminum have hit multi-year highs, while oil surged to over $100 a barrel. Meanwhile, the labor market recovery has been particularly notable with the unemployment rate declining to 3.6% (Figure 1), the lowest level since February 2020. With dynamics swinging in favor of workers over their employers and a tight labor market, wages are likely to continue to move higher.
U.S. Unemployment Rate
The unemployment rate represents the number of unemployed as a percentage of the labor force. Labor force data is restricted to people 16 years of age and older, who currently reside in one of the 50 states or the District of Columbia, who do not reside in institutions (e.g., penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces.
Source: Federal Reserve Bank of St. Louis
Concerning higher prices, the economy continues to experience supply-side inflation, which we expect to persist. The commodity price shock exacerbated by the Russian invasion of Ukraine should continue to stoke real asset prices higher and could suppress private consumption, ultimately contributing to lower aggregate demand. Given the aforementioned forces, it was not surprising that the Federal Reserve lifted its policy interest rate during the most recent meeting, marking the first increase since 2018. Forecasting six more rate increases this year, the Fed has demonstrated that it is solely focused on inflation and has very little sensitivity to slowing growth in the U.S. With the increase in policy rates and investors expecting aggressive tightening in the near-term, the shape of the yield curve flattened substantially during the first quarter, especially between the two and ten-year notes (Figure 2).
Treasury Yield Curve
Termed Quantitative Tightening (QT), the central bank will also end its large-scale securities purchases and reduce its massive holdings of Treasury and mortgage-backed securities. These changes in monetary policy mean that the curve may lose some of its predictive power in the future. Since central banks have bought long-dated bonds in quantitative-easing schemes, they now affect both sides of the yield curve directly, making long-term interest rates a less reliable proxy for market expectations.
How Have Corporate Profit Margins Peaked?
As the pace of globalization increased after 1990, corporate earnings (Figure 3) and profit margins grew at accelerated rates. Much of this was due to technology facilitating the integration of the global economy, which led to pools of capital and labor coming together efficiently. As international borders opened, corporations increasingly shifted their operations abroad using cheap labor and low-priced goods.
Companies benefited from the broad-based decline in labor’s bargaining power, lower anti-trust enforcement and gains in technology, which allowed for greater scale and lower marginal costs. At the same time, lower corporate taxes, interest rates, and tariffs further buoyed margins by directly reducing the cost of goods sold. Lower corporate costs in turn exerted downward pressure on wages and resulted in quiescent levels of inflation (Figure 4) for several decades in the United States. Taken together, these factors have produced the most pro-corporate environment in history.
U.S. Corporate Profits
Source: St. Louis Fed
Year Over Year Inflation
Source: Bloomberg – Year over year annual inflation
In our view, many of the forces that have driven profit and margin increases will erode going forward. Primary factors include global labor costs moving closer to equilibrium and the end of the effectiveness of international corporate tax rate arbitrate. Meanwhile, Russia’s invasion of Ukraine has led to sanctions reaping havoc on the global economy and as a result, many governments are likely to attempt to be more self-reliant. Similarly, several politicians have commented about onshoring manufacturing and relocating the supply chain to the U.S., which could foreshadow the end of globalization. It is unknown how these factors will weigh on profit margins, and how much can be offset by further advances in technology, but in our opinion, it will be hard for companies to maintain the current level of profitability, let alone increase margins further from here.
One of the companies we think will perform well given our thesis is Intel Corporation (INTC), which offers complete semiconductor solutions to its customers in the PC and server processor markets. The COVID-19 pandemic highlighted the fragility of the global semiconductor supply chain with 80% of global manufacturing capacity in South-East Asia vulnerable to shut-downs.
Even before the war in Ukraine caused the globe to scrutinize its dependence on a global supply chain, INTC had been taking steps to expand semiconductor manufacturing in the U.S. and throughout Europe. This included an initial $20B (which could ramp up to over $100B) for two new chip factories in Columbus, Ohio. This will be INTC’s first new manufacturing location in 40 years and the state’s largest private sector investment in its history. An additional $100B was promised last year for two other existing U.S. facilities, while a $35B injection into the EU was announced in March 2022, where INTC is seeking to establish the new “Silicon Junction”. We expect capital expenditures to run upwards of $30B over the next three to five years as INTC executes this strategy which they have dubbed “Integrated Device Manufacturing (IDM) 2.0” in an effort to become the primary provider of foundry capacity throughout the US and Europe. The war in Ukraine has ushered in a new sense of urgency for reliable production and supply chain resilience in the western world, where INTC has the engineering talent, product breadth, access to capital, political backing and scale to reinvigorate domestic competitiveness both in semiconductor products and manufacturing roadmaps.
Macroeconomic Backdrop Favors Value Stocks
During the first quarter, the Russell 1000 Value Index outperformed the Russell 1000 Growth by more than 8%. Value has become defensive again, just as it was in the aftermath of the late 1990s Technology Bubble. As we detailed in our previous newsletter, heightened levels of inflation and rising interest rates are macroeconomic tailwinds to value stocks. In our view, value should continue to outpace growth in the period ahead.
While we expect inflation to pull back from its recent high, we think it will settle above its long- term average. Higher average accelerations in underlying prices often coincide with investors rewarding value stocks. Low price-to-earnings companies produce cash flows that track inflation and the revenue streams of these assets are typically tied to higher prices as well. In our portfolio, many of the businesses have continued to report higher input and labor costs. We expect companies to raise prices as they have demonstrated in the past, though margins could be compressed in the short run. Looking forward, we expect these stocks to perform well as price increases hold and supply constraints abate with the backdrop of strong demand.
Moreover, the value style of investing has historically outperformed during rising interest rate environments. With the recent decision by the Fed to raise short-term interest rates and additional increases anticipated, the rotation from growth to value is likely in its early stages. There is also the strong possibility of increased regulations for high growth technology companies which may curtail their revenue and earnings power. At the same time, the differential in valuation multiples between the two styles continues to remain wide by historical standards.
In our opinion, the greatest opportunity is in the Financials sector. As a group, financial stocks have a more attractive balance of risk and reward than any other sector. Within the sector, banks generally benefit from higher rates, as they are able to increase profit margins from the spread between deposits and loans. At the same time, many banks have the ability to drive significant shareholder value in the form of dividends and share repurchases. Our focus within Financials is on those firms that are well capitalized with strong credit quality and the ability to grow net interest margins, as well as market share.
Market expectations are extremely elevated in the high price-to-earnings (P/E) sectors and are more prone to upcoming earnings disappointments. This further leads us to believe that low P/E stocks will remain in favor as investors look for opportunities in a late-stage bull market. Conversely, higher interest rates may lead to a contraction in elevated P/E growth stocks. Therefore, our outlook is for near-term volatility, with future gains being driven primarily by valuation and fundamental earnings growth. All things considered, we believe the current environment is particularly well suited to our value investment approach.
Coterra Energy (CTRA)
Shares of CTRA appreciated alongside the surge in crude and natural gas prices. The company’s relatively unhedged production profile generated significant free-cash flows, of which 60% were returned to shareholders through dividends. CTRA also announced a buyback authorization for ~5% of the market cap.
Marathon Petroleum Corp. (MPC)
The company is a leading midstream and downstream energy company. MPC operates the nation’s largest refining system with approximately 2.9 million barrels per day of crude oil refining capacity. Additionally, through their 64% ownership of MPLX, MPC controls one of the nation’s largest energy MLPs, providing energy infrastructure and logistics. MPC contributed to performance during the quarter as energy companies rallied due to strong demand and supply concerns. With global inventories remaining below 5-year averages, refiners should see continued strong demand for finished products as we move into summer driving season.
Kohls Corp. (KSS)
KSS shares added to performance following rumors the company may be acquired at a premium. We used a subsequent spike in the share price to opportunistically liquidate our position and reallocate capital to equities with greater upside potential.
MetLife Inc. (MET)
MET shares positively contributed to performance, benefitting from increasing rates, robust demand for group benefits and strong expense control. MET has a significant excess cash balance and trades at ~1.1x tangible book value. In addition, the company is an avid repurchaser of its stock.
Cardinal Health Inc. (CAH)
CAH shares appreciated towards the end of the quarter after a sell-side report suggested the company could be a target for an activist campaign. CAH results have been negatively impacted by elevated freight costs, while sentiment for the stock is weak due to an ongoing opioid case. We believe shares can re-rate as these issues abate.
PVH Corp (PVH)
PVH detracted from performance as macroeconomic uncertainty, a delayed recovery in US tourism and a strengthening dollar have caused investors to fear the near-term outlook for the company. With shares trading at 8.7x 2022 earnings, we believe PVH’s current valuation does not accurately reflect the resilience of business. New CEO Stefan Larsson has only just begun executing his plan to improve PVH’s profitability and we think there are major margin unlocks that will play out over the next few years. This message will help to drive both earnings growth and multiple expansion over the next few years as we move past the near-term headwinds.
American Eagle Outfitters Inc. (AEO)
Shares of AEO underperformed during the quarter following disappointing guidance and rising uncertainty around consumer demand. This is a well-run company with an attractive market position, multi-year revenue growth opportunities and cost initiatives that allow the company to generate strong shareholder returns including a share repurchase and an attractive dividend. 90% of revenues are generated in the United States.
Hasbro Inc. (HAS)
HAS shares underperformed in the quarter as concerns about a recession weighed on sentiment for consumer spending. The company reported a strong holiday quarter and maintained its long-term targets; HAS is positioned to benefit from several product launches in 2022. Recently, an activist has called for spinning off the video game business.
Citigroup Inc. (C)
Shares of C negatively impacted performance as investors weighed the company’s European exposure following Russia’s invasion of Ukraine. The geopolitical uncertainty led to a flattening of the yield curve during the quarter, negatively impacting sentiment for C and its peers. In addition, the company’s long awaited investor day and strategic plan reveal failed to convince investors.
Pfizer Inc. (PFE)
PFE detracted during the quarter, pulling back from an all-time-high reached late in the fourth quarter of 2021 as investors debated the long-term contribution that both Comirnaty (COVID-19 vaccine) and Paxlovid (COVID-19 antiviral treatment) would have on normalized earnings. We liquidated the position in the early part of the second quarter of 2022 and reallocated capital into ideas with higher upside and more timely catalysts.
Looking ahead, the key variables for investors in 2022 will be the conflict in eastern Europe, the path of inflation, and central banks’ response to acute increases in prices. We believe the road ahead remains positive for our Focused Value strategy. The stocks in our portfolio have compelling business fundamentals, strong balance sheets, skilled management teams, reoccurring cash flows and the flexibility to adapt to an inflationary environment. We believe these stocks will compound earnings over an extended period through both rising and declining markets. At the same time, our portfolio is significantly cheaper based on relative multiple valuations compared to the Russell 1000 Value (Table 1). All told, we remain dedicated to delivering strong long-term performance and transparent communications to our shareholders. As always, thank you for your commitment to Easterly Investment Partners.
|Multiples||FV||Russell 1000 Value Index|
|Forward Price-To-Earnings Ratio||11.80||15.28|
|Free Cash Flow Yield||7.86%||5.06%|
Source: Easterly Investment Partners
Easterly Investment Partners (EIP) is a registered investment adviser. Registration of an Investment Advisor does not imply any level of skill or training. This composite has been assigned to Easterly Investment Partners (EIP) effective July 1, 2021. Performance presented prior to July 1, 2021, occurred while the Portfolio Manager(s) and the research team were affiliated with a prior firm (Snow Capital Management, L.P.). EIP claims compliance with the Global Investment Performance Standards (GIPS®). A fully compliant GIPS presentation along with a complete list and description of all composites is available upon request. The Focused Value composite contains fully discretionary accounts consisting of an equity portfolio of less than 25 stocks that invests at least 80% of assets in companies with market capitalizations greater than $1 billion and dates back to December 31, 2008. This composite has no minimum requirement and for comparison purposes is measured against the Russell 1000 Value. The U.S. Dollar is the currency used to express performance. Leverage is not used in this composite. Investing involves risk; clients may experience a profit or a loss. Past performance is not indicative of future results. Performance is preliminary. Composite returns are shown gross of fees and do not reflect the deduction of advisory fees. The performance of any individual portfolio may vary from the Composite’s performance.
The performance figures are based on a composite of many accounts and not all accounts owned the securities mentioned in this commentary. Holdings and sector allocations are subject to change. The latest copy of our Form ADV Part 2A (Brochure) and a complete list and description of EIP’s composites and/or a presentation that adheres to the Global Investment Performance Standards (GIPS®) is available upon request.
Russell 1000® Value Index
The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged. It is not possible to invest directly in an index.