Participation TrophiesEric Cinnamond
Whoever said “You throw like a girl!” has obviously never been to a fastpitch softball game. I’ve attended many and have seen ten-year-old girls throw 50 mph fastballs from a close distance. It’s very impressive and very challenging for those at the plate. My daughter is one of the lucky players who gets to hit these fast balls. Although it’s been a significant commitment for our family, I’ve thoroughly enjoyed watching her, along with her team, play and grow together.
Organized sports has come a long way since I was a kid. When I was growing up, the atmosphere was more like what you see in the movie The Bad News Bears. It was less formal and much less serious. Today many coaches are paid and there are a plethora of clinics and lessons to improve all the different skill sets. Organized sports, or travel ball, has turned into an industry. I call it the youth sports arms race. To grow, industry participants simply tell parents how much potential and talent their kids have, and boom, we’re all in line signing up for lessons and new equipment! It’s not a bad business model.
I could write several posts on the pros and cons of travel ball, but for now I’d like to talk about a recent exchange I had with my daughter. This is her team’s second season. Last year they were young, inexperienced, and lost most of their games. This season, they’re older and much more competitive. In fact, they recently won a tournament, with each player receiving a large gold – ok, possibly plastic – trophy.
After returning home, my daughter walked into her room and placed her trophy on her dresser, separate from the trophies on her bookshelf. I asked why she placed the new trophy away from the others. She looked up at me and said, “Because this one matters.” It was at that moment I realized her bookshelf was filled with participation trophies, or trophies received for simply showing up. I was proud of my daughter – she understood the difference between accomplishments that were earned versus provided.
The idea of participation trophies made me think of today’s prolonged market cycle. I can’t help but wonder how much of the current cycle’s gains were earned versus provided. With interest rates pegged at 0% and global central banks buying trillions of assets, all most investors needed to do was show up, buy an index fund, and receive extremely generous returns on their capital. For almost a decade, relentless asset inflation has consistently reinforced investor behavior and decision making – yes, you are a good investor, yes, you are a talented investor, here’s your trophy (above average returns with below average risk). Don’t forget to sign up for next season!
While showing up has been a very profitable strategy over the past decade, I believe the investment environment is changing. After reviewing Q1 2018 operating results, it’s becoming increasingly clear to me that the economy and labor markets are tightening. While the current economic cycle has been anything but traditional, it’s beginning to feel more and more like an environment in which many past cycles have matured and ultimately ended.
As investors celebrate elevated corporate profits and equity prices, I believe we may be approaching a point when further gains in the economy and asset prices become counterproductive. For example, additional gains in stock prices and economic growth may amplify many of the late-cycle inefficiencies that are becoming increasingly noticeable in quarterly earnings reports and conference calls.
In my opinion, the days of unlimited investor participation trophies is over – going forward, there will be winners and losers. In fact, we have seen this with stocks and bonds over the past year, with stock prices increasing and many bonds declining. Based on my bottom-up macro observations and analysis (where we are in the cycle), I believe this relatively new and uncooperative relationship between stocks and bonds is likely to continue.
As a patient investor waiting for change, it’s been refreshing watching the bond market move freely again, with the short-end of the yield curve rising sharply over the past year. The 6-month T-bill is currently yielding 2.06%, up 100 bps from a year ago. Meanwhile, the 2-year USTN currently yields 2.48%, up 118 bps over the past year. After years of earning practically nothing, yields near the short-end of the curve are beginning to look much more attractive; especially relative to normalized earnings yields on equities (near 3%).
When I decided to go all-in on patience, I was hoping to eventually be rewarded with a more advantageous opportunity set in small cap stocks. To my surprise, my reward hasn’t been lower small cap prices, but higher yields on short-term T-bills and Treasuries. And while Mr. Market’s offering of higher rates wasn’t the perfect gift, I’m encouraged by the reemergence of late-cycle trends in the economy and bond market.
In conclusion, while I currently have no exposure to equities, I’m enjoying the recent increase in short-term interest rates. I’m hopeful patience continues to pay in the form of higher rates, and ultimately, end of the cycle opportunity. When the current cycle finally ends, I suspect many of the participation trophies handed out over the past several years will lose their shine. For me, the trophy awarded for full-cycle returns has always mattered more.
Also in today’s post…a summary of Q1 2018 business trends I noticed during my quarterly review process (300-name possible buy list). I planned to send this out earlier, but had some unexpected travel this month. My apologies.
- Inflationary pressures grew. I began to notice the shift from 2015-2016’s disinflation to inflation in Q2 2017. Each quarter since, rising corporate costs have become more noticeable. Discussions of reacting to higher costs via price increases have turned to action. Further price actions were also discussed and are in the process of being implemented (typically companies try to limit price increases to once a year). Other actions to protect margins, such as less couponing/promotions and lightweighting, also mentioned. Higher average selling prices very noticeable with many consumer companies.
- Labor availability is becoming a growing concern – regardless of wages. Overtime mentioned. Capacity constraints was also discussed more frequently – relatively new topic. The economy appears to be tightening from labor and capacity perspective.
- Adverse weather was mentioned frequently in Q1. On average weather was disruptive and reduced demand, especially relative to a year ago. A slight weather related bounce in Q2 would not be surprising. Business trends improved in May post poor weather. If there is a weather rebound, and it’s picked up by govt data, I’d expect to see improvement in June reports.
- Freight costs increased substantially during the quarter. Capacity is becoming a growing issue. Companies being forced to pay spot prices for transportation are seeing very large increases in cost. New trucking regulations (electronic logs), in addition to driver shortages, are contributing. Demand strong as well. Does not appear to be a one-quarter issue – as long as demand is there.
- Consumer companies sales trends improving on average. The promotional environment remains elevated in certain subsectors; however, deep discounting is less widespread with more full-pricing noticeable. Inventories are in good shape and fewer clearance sales mentioned. Bankruptcies continue, but some signs survivors are beginning to benefit from reduction in competitor closures. Higher average ticket noticeable for many retailers and restaurants. Weather hampered some results, but commentary suggest improvement in May. Tourism spending appears to be improving as well. QSR subsector is an exception – continues to promote aggressively and appears to be suffering from overcapacity.
- Industrial businesses continue to perform well on average. Construction and aerospace strong. Material costs rising and pricing being passed on. Steel prices and tariffs a growing concern.
- Energy continues to rebound. Capital available. Rig count up 30% year over year. Q2 should be strong. Labor costs and availability could become a growing issue as industry ramps up. Furthermore, it remains to be seen if the industry will drill within cash flow, or grow in excess. The energy industry’s growth is spilling over into other industries. It’s moved from a headwind to a tailwind for the economy. Permian booming. Offshore may finally be bottoming; slow improvement expected.
- Auto slightly down. Little changes expected with estimates for small decline in auto production in 2018.
- Agriculture stabilizing, but concerns as it relates to tariffs mentioned.
- Financial industry is performing well, on average. Bank loan and deposit growth healthy with low losses (as one would expect at this stage of the credit cycle). Credit remains easy, on average. Small caps continue to find capital; junk bond market also open for business.
- Insurance industry tone improving. Premium pricing has firmed from declining to flat/increasing slightly. Despite increases in underwriting losses in 2017, there remains excess capital in the insurance industry. Interest income improving.
- Technology results were mixed.
- Currency, on average, was a positive for most businesses. Some companies noted currency increased international costs.
- Housing and construction is strong. Labor availability and cost remains an issue to meeting demand. Homebuilders average unit prices increasing high single-digits. To date, higher interest rates have not slowed construction. Managements credit tight labor market and healthy wage gains. Weather was a drag in certain regions. Backlogs strong.
- New tax law mentioned frequently. Sentiment is positive; however, few companies could point to specific examples of how the new law has increased demand – still too early to quantify.