Finding Relative Safety

Special Edition Investor Letter - Q2 2022
May 11, 2022

Dear Partner,

In light of the tumult in global markets and affairs, we want to offer you additional detail regarding how we are thinking about equity markets at this moment and how we expect to deploy your recent investment.

Context:

Inflation driven by financial loosening is winding down just as inflation driven by commodity supply disruptions is winding up. Prior to the Russian invasion of Ukraine, we believed there was a fair chance that inflation would recede to a tolerable level (~5% and consistently shrinking) before it could lodge itself in the public mind as a persistent concern demanding recurrent wage adjustments (creating a wage spiral). However, in light of the disruptions to economic essentials like food and energy supplies related to Russian aggression, we anticipate that a higher cost of living persists long enough to provoke a wage spiral. Though COVID-driven weakness in the Chinese economy has helped limit some demand for resources, it also stoked fears of a global recession. These factors, and others, have instilled a pervasive fear that, while attempting to regain price stability and prevent a wage spiral, The Fed will tighten the money supply such that it throttles economic growth enough to loosen the labor supply - likely causing recession. The certainty of monetary tightening, and the uncertainty regarding most everything else, induced extreme swings in the equities markets over the past few months.

With interest rates rising, investors are fleeing companies with deferred returns (growth companies). If recession comes, financing will dry up and businesses without cash or cash flows will be unable to continue operations. The specter of this outcome sent fortunes bolstered by loose monetary policy stampeding into assets like utilities, commodities, and consumer staples, which tradition holds as safe harbors in inflationary storms.

Clarity:

Rather than focus on the great uncertainty created by these forces, we think it better to focus on those things that seem more certain. Price:Earnings (PE) ratios have almost normalized. This is a relief, though we believe substantial downside risk remains for technology stocks due to sector momentum and rate-related volatility. Disrupted energy markets need infrastructure to reorganize, and energy prices will remain elevated while that infrastructure is developed. Newfound demand for defense should persist and may exceed production capacity for years. The numerous supply shocks that have buffeted so many industries, should incentivize investment in technologies that boost efficiency and profit margins.

Strategy:

We will manage risk from inflation and interest rate hikes by focusing on investments in businesses with positive cash flows and defensible dividends. We can endure recession by investing in businesses with strong balance sheets, good cash reserves, and secular demand growth. We prepare for either a recovery or stagflation by cost-averaging additional investments into the technologies and businesses that we are confident will survive a recession and either drive the next wave of growth for businesses or prove indispensable to consumers. Above all, we will deploy funds cautiously into this downtrending market, so that we can buy the most high-potential businesses at deep discounts.

Execution - Energy:

We expect that a combination of acutely high fossil fuel prices and recent reminders of military primacy will leave Europe seeking to further diversify its energy baseload, regardless of the availability of fossil fuels. We expect fossil fuel and commodity prices to remain elevated, especially in the West, while supply chains re-adjust over the next few years, and we may seek dividends in fossil fuel production and transportation to buffer against energy price inflation.

US Liquid Natural Gas (LNG) terminal capacity is maxed out and new terminals will take 2-3 years to develop. Even if the US could meet Europe's demand for LNG, the low energy density of fossil fuels leaves Europe exposed to acute supply disruptions in the event of a war with Russia. Since there is no ‘quick fix’ for Europe’s energy crisis, we expect the region to pursue a range of options meant to reduce demand, improve baseload capacity, and generally improve the region’s energy security over time. 

The European response will take many forms, but we anticipate that nuclear power will see stronger than anticipated investment. Why? As reports from sources ranging from Time Magazine to The Council on Foriegn Relations attest, the acute energy problems Europe is experiencing are helping to cut through the unjustified PR problems that obscure nuclear’s great merit. Nuclear is safe, carbon negligible, and offers a superior source of defensible baseload power should Europe ever come under siege; It’s everything the continent needs. 

Europe already uses its limited reserves of fossil fuels begrudgingly. Renewables cannot contribute to baseload energy (which Europe sorely lacks) without means for storage, which are currently either hard to scale or cost prohibitive. New nuclear reactor designs are safe (even if attacked) and produce significantly less waste than previous designs. The unparalleled energy density of nuclear fuel makes it easy to store or ship enough energy to buffer against prolonged supply disruptions, such as those brought on by international conflicts. Finally, one of the EUs de facto leaders, France, already has an excellent track record with nuclear power and several key members have businesses that benefit from nuclear expansion. So the economic benefits of nuclear power should be unusually visible as this crisis progresses.

We also expect that Europe will increase investment in kinetic energy storage facilities, which translate excess renewable power into the electrical baseload, thereby addressing the major pain point in Europe’s energy market. The one-off nature of each of these facilities makes them challenging (and risky) to invest in directly. Instead, we prefer to increase our exposure to kinetic energy storage developments by investing in the manufacturers of the pipes, pumps, and valves used in both hydraulic and compressed air storage. We especially like these manufacturers because their equipment is also used to construct fossil fuel pipelines as well as to manage the flooding that so many areas increasingly experience as the global climate changes.

Execution - Industrials:

Beyond energy, there are a number of industrial players we believe offer a compelling combination of steady cash flows and high potential for outsized growth in the next 2-5 years. Lockheed Martin offers a good example of what we’re seeking: It currently enjoys excess demand for some of its existing products, most visibly the Javelin anti-tank system. As a western leader in developing hypersonic missile systems it is likely to see substantial and steady demand for these products as they mature into a key feature of the defense landscape. Finally, Lockheed’s expertise in hypersonics also offers good exposure to the highly speculative promise of suborbital transportation, which would use related technology to enable flights to anywhere on Earth in under an hour. Lockheed’s current PE (~19) is on the higher side of normal, which dampens, but does not destroy, our enthusiasm for investment.

Carrier offers yet another example of the sort of industrial investments we are seeking. This maker of HVAC and refrigeration systems is an utterly unexceptional dividend paying manufacturer. We like it because Carrier is a pure play on air conditioner sales in a world that is getting noticeably hotter. As a deadly heatwave in India is sadly showing us, a large portion of the world will become dangerously hot for humans without air conditioning. As with Lockheed, we’d prefer to enter at a lower PE ratio, but we feel comfortable buying Carrier now for the dividend yield and we appreciate the option to hold it for the long term with the expectation that it will grow along with global temperatures.

Execution - Entertainment:

People always want entertainment and when times are tight they gravitate towards sources that offer lots of entertainment hours per dollar. To illustrate this point: A movie theater ticket offers about 2 hours of entertainment for $20 ($10 / hour of entertainment). A home video rental may offer 2 hours for $5 ($2.5 / hour). Netflix customers were entertained at an average cost (to the customer) of about $0.16 per hour throughout 2020 (a peak year).  A video game can easily offer 120 hours of entertainment for $60 ($0.50 / hour). The Call of Duty franchise releases a new title almost annually with players averaging 170 hours of playtime per year ($0.35/ hour). In a recession, consumer demand roughly moves along this value curve.

While we believe that demand for video games, streaming services, and social media is relatively recession-proof, we are far more confident that video game publisher stocks can weather tough economic times gracefully. Historically, video game sales fared well in recent recessions as under-employed workers maintained or boosted spending in entertainment with higher density per dollar. Streaming services did extremely well in the one, brief, recession they encountered. Social media and other ad-supported entertainment also offer great entertainment value to consumers, but we are concerned that increased consumer demand in a recession would fail to offset the accompanying weakness in advertiser demand. Hence, with the specter of recession looming and stock prices for traditional safe havens already high, we look to find defensive value in video game publishers.

Execution - Technology:

We are excited to see technology valuations reverting to the norm. Though we expect they will overshoot to the downside much as they did to the upside. We are investing in dividend paying, cashflow positive tech businesses, much as we would invest in industrials. However, we are exercising greater caution with these stocks than with traditional industrials simply because the sector is out of favor and thus more prone to irrational despondency.

We still value a great many pre-revenue tech businesses as well, and we have no qualms about investing in those with sufficient cash equivalents to weather an extended financial drought. However, with the exception of biotechs, we do not believe it prudent to invest in most of these until we see sufficient indications of both a technical bottoming of prices and a cessation of recession fears.

Why do we treat biotechs differently than other pre-revenue tech? We believe that the case for our biotech investments is stronger than ever after the wildly successful use of MRNA, CRISPR, and bioinformatics technologies in answering the COVID 19 pandemic. Further, the collapse in long duration asset prices and the self-limiting needs for COVID vaccine production have brought many biotech stocks back into the realm of reasonable value. Most importantly, biotech investors know that deferred cash flows are intrinsic to these investments. Consequently, the current volatility for biotech equities is generally much lower than other pre-revenue tech. In total we believe that these factors make the risk/reward profile for biotech significantly better in today’s conditions than it is for other pre-revenue tech businesses.

TL;DR:

In all, we like the equity environment of today much better than the environment of last year. Markets remain treacherous but, unlike a year ago, we are confident that investments today will be rewarded within our five year investment horizon. We believe that the benefits of having cash on hand currently outweigh the inflationary and opportunity costs and so we may deploy new funds more slowly than usual.

We welcome your feedback and look forward to serving you.

Sincerely,
Nick Carpenter
Manager, NJC Capital Management LLC