“The harvest is plentiful, but the laborers are few.” – Matthew 9:37
Imagine that you have a lemonade stand, and you have a bunch of folks who would love to buy lemonade from you. You have the sugar and the water to make the lemonade, but you can’t get any lemons. Where are all the lemons? You heard that the lemon orchards in California can’t find workers because many took higher-paying jobs at restaurants and hotels that recently re-opened. You also heard that other “would-be workers” are sitting on their couches because they are still collecting government stimulus checks – sums that outweigh the amounts they might collect picking lemons. There is also a containership or two in Los Angeles Harbor loaded up with produce from South America, including enough lemons to supply every grocery store in the western U.S. for a month. Meanwhile, customers are flush with cash and getting thirstier and thirstier, willing to pay two times what they paid you last year for a tall glass of ice-cold lemonade. Still, you can’t supply it because you have no lemons. Frustrating.
We have a supply chain issue, and it is a scene that is playing itself out in industries all over the world. Auto dealer lots are empty because automakers can build 98% of a car or truck but are still waiting on semiconductors to create a finished product. Builders can almost build a house but have to send workers home because they can’t get sheetrock or they are waiting on siding. Nearly every conversation we’ve had recently with leaders of public companies ends up going deep into a supply chain rabbit hole. It’s top of mind for every CEO, and in my experience, the challenges that are top of mind for bright, motivated people tend to get fixed. Capital, focus, and time go a long way to solving complex problems… even in a pandemic.
We have seen supply shocks before, and each time they’ve proved to be temporary. While we don’t know how long the current supply shock will last, we believe that, amidst the shock, there is opportunity, and we are working hard to identify the companies that are best positioned to benefit when some of these challenges let up. Also, most companies are in similar positions, and demand is likely to be deferred, not cancelled or met by a competitor.
Supply Chain Traffic Jam
Nothing is more frustrating than cruising along the highway and running into a traffic jam. You almost come to a standstill, and you can’t see around some of the larger vehicles to determine the hold up, nor do you know when you can speed up again. Is it just a stalled vehicle in the center lane, or is it a 20-car pile-up that is going to require an army of tow trucks? You start to speed up, thinking things are back to normal, only to have to slow down again. And so it goes with the supply chain traffic jam.
We recently sat down with a CEO of a popular clothing retailer that sources a lot of its product in Southeast Asia, and he described the current supply chain as just this… an economic traffic jam. “This will loosen up eventually,” he commented.
The CEO then directed our attention to a recent Wall Street Journal article about Nike. The article referenced management of the mega-brand warning of production problems in Vietnam and Indonesia which resulted in 10 weeks’ worth of production lost due to COVID-19 lockdowns. The author explained that product movement from Asia to North America taking an average of 80 days or twice as long as before the pandemic.
Even when finished goods get out of the factories and near U.S. shores, the traffic jam isn’t over. Reports describe more than 60 ships idling off the coast of California, where wait times to unload these vessels is stretching out to three weeks. Meanwhile, with the holiday season creeping up on anxious, cash-rich consumers, demand is unlikely to fade any time soon.
We have a rough idea of the major factors that are causing this traffic jam, and we know traffic jams eventually end. (It generally doesn’t pay to get out of your car and walk to your destination, right?) The difficult question is, “When will it end?” We don’t know, so we are instead turning to a question that we have a chance of answering successfully, “How do we manage risk and invest in this environment?”
First, a few summary observations that are relevant to determining how to invest at this time:
Our Process Remains Consistent
Our investment strategies continue to perform well in 2021 despite this supply chain congestion. My colleagues John Carraux and Paul Dwyer highlight our thoughts on each strategy in this newsletter.
No matter the circumstances, we go about evaluating businesses one at a time based on our perceived risks and rewards under a variety of different recovery time frames. We try to become interested in companies when others are not. We know we will be wrong on some of our choices, but we will be “less wrong” if we are able to buy a company at undemanding valuation levels. We interview management teams and become interested in their companies if they have shown the ability to adapt to a variety of environments, because operating environments are always changing.
While the last year was a great litmus test, we are always asking what about the next five years for any company and its management team. While difficult, we try to identify companies where demand for their goods or services will be the same or greater in the future when they are able to deliver at the rate they were accustomed to pre-COVID. Supply matters. But durable demand may matter more when you consider that your lemonade drinkers could very well switch to orange juice by the time your lemons are delivered. Now that might leave a sour taste in your mouth.
Positioning portfolios for an uncertain future
Occasionally, I attempt to instill some nugget of financial wisdom into my children at the dinner table. Sometimes they listen, often they don’t. In my years of trying, I found the closer I can relate abstract concepts like interest rates or shareholder rights to their own lives, the more successful I am at improving their understanding.
A few months ago, I broached the topic of inflation over pork chops and mashed potatoes, and I was surprised at how quickly they grasped the concept. Everyone knew that a loaf of bread used to cost a penny in the “olden days” and that a house could be purchased for the cost of a car today. That’s inflation! These were vivid images for them, and the thought stuck with them.
We get many questions from clients these days on the problem of inflation. Most vividly remember the runaway prices of the 1970s and their deleterious effect on daily living. We know inflation all too well. Can this happen again, and what should we be doing differently today if higher prices are looming?
Inflation is indeed heating up and it is almost everywhere—housing, cars, food, energy, apparel. What is unclear, however, is how much of these price increases are simply the result of restarting a locked-down economy and how much are due to longer term factors.
During the pandemic, many industries permanently shut down capacity in response to a complete collapse in demand; bringing this productive capacity back up takes time and effort and often results in shortages in the near-term. A good example is the lumber industry, where timber mill closures caused the price of lumber futures to skyrocket by 75% in the first four months of 2021 but then plummet by 70% in the next four months, as production normalized.
Major trends in the world today should help keep a lid on inflation in the years to come. The continued advancement of productivity-enhancing technology, an aging population, and globalization are all powerful forces that can keep prices down.
Many smart, rational, and well-reasoned experts today make arguments both for and against sustained higher inflation. Many of them are guaranteed to be wrong. The direction of global prices is simply too complex to predict consistently and accurately. However, we can take actions today to position portfolios for the potential for adverse outcomes:
Inflation is a vivid memory in our minds, particularly for those who lived through the storied years of the 1960s and 70s. These experiences of double-digit mortgage rates and gasoline shortages make the problem of inflation seem all too real of a risk. However, secularly rising inflation is not a foregone conclusion today. While we should hedge for this possibility and pay close attention to its development over time, we should be wary of assuming it is the only path forward.
The Punch Income Strategy is a total return strategy that emphasizes current income over capital appreciation. The strategy invests in a variety of securities and asset classes that generally share the common characteristic of producing cash flow income that has the potential to rise over time.
Looking for lunkers in non-obvious spots
Every summer my family heads north for a week-long fishing trip. The last night is reserved for a fish fry, but nearly every year we eat leftovers, not fish, due to our lack of success throughout the week. This year, I caved and hired a fishing guide. It was worth it, and at the end of the week, everyone had their fill. Surprisingly, the best fishing occurred in the least obvious spots. The guide’s favorite spots were 100 yards offshore, and there was nothing on the surface that indicated the bountiful fish below.
During the third quarter, the S&P 500 continued its strong year of returns, but contrary to recent memory, it wasn’t the obvious companies leading the way.
The non-obvious “fishing spots” delivered the biggest returns, and the top performers in the S&P 500 this quarter were a business software company, a specialty chemical company, and a power management solutions company.
The Punch Large Cap Strategy also had a solid quarter, largely thanks to the “non-obvious.” The top performers this past quarter included a building products distributor and a scientific instruments company, and neither are household names. The worst performers were two technology companies. Non-household named companies are a staple in our investment strategy. Additional portfolio examples include a uniform provider, a financial services technology provider, and an HVAC manufacturer. These company names aren’t easily recognized, but we think each is an attractive investment based on the market niche they dominate.
After a decade of tremendous returns for the S&P 500, expectations appear elevated across most sectors compared to historical averages. Above-average valuations shown in the chart below may signal over-fishing. An investor may get lucky, but we think the odds of catching a lunker decrease in the higher valuation pools. We do our best to avoid the proverbial congested fishing spot by looking at out-of-favor and non-obvious situations.
Non-obvious companies have led the market in the past. Consider two companies that went public in 2004: Domino’s Pizza and Google. The delicious combination of dough, cheese, and sauce generated an 870% higher return than Google—a company many consider one of the world’s best businesses ever created. One benefit of investing in the non-obvious company is lower expectations. Exceeding lower expectations can be a good recipe for strong returns.
We spent most of our time bobber fishing with our guide, and he insisted we count to three when the bobber was pulled underwater before reeling it in. This was a great tip for learning patience, but my sisters found it ridiculous that their brothers and dad giddily counted “one… two… three!” for the rest of the week every time the bobber went underwater. When fishing, you are limited to one spot at a time, however the Large Cap Strategy can fish in multiple spots at once. As investors, we pursue areas of the market that others may have overlooked. Like the fisherman waiting for the fish to swallow the bait, we try to stay patient and let our companies do the work and deliver successful outcomes.
The Punch Large Cap Strategy invests in large publicly traded companies. The strategy takes a long-term, concentrated approach to owning companies with durable competitive advantages, cash flow generation, and growth potential.
The benefits of in-person investment research
This past summer, as the pandemic seemed to be subsiding, our research team hit the road for the first time since March 2020. We traveled to sunny California to attend a small investment conference and visit a handful of portfolio companies at their offices in the L.A. area. It was refreshing to meet face-to-face with the executives running our companies after a long year of virtual meetings.
Seeing businesses firsthand and meeting with executives in person can yield important—sometimes critical—insights that inform investment decisions. One corporate headquarters was in a dingy building that had not been updated in several decades just off of a freeway access road—a sign of the frugality of the company, and the CEO’s preference to invest in customer stores rather than executive suites. At another company, boxes and equipment covered the office as they completed the final stages of a large manufacturing expansion—a sign of potential growth to come. Both instances reinforced our investment decision.
Visiting offices and meeting with managers allows investors a firsthand look into company culture, the state of physical assets like plants and equipment, and how much energy and activity is happening around the office. These visits offer potential clues to the long-term success or challenges at a business, and are a necessary part of the due diligence required to vet investment opportunities.
Investing in small cap companies offers a unique opportunity. Not many investors are willing or able to do the depth of research that we do on smaller, lesser-known businesses around the country. According to Furey Research, the average Russell 2000 small cap company has only five analysts covering it, compared to 20 for companies in the S&P 500.
Over the long-term, small cap stocks as an asset class perform better than large cap stocks, although that out-performance comes with more risk and volatility. During the throes of the pandemic in the first quarter of 2020, small caps declined 30% compared to a 20% decline for large caps. Since 1926, however, they have averaged 2% higher return annually. In other words, $1 invested in small cap stocks in 1925 would be worth almost $40,000 today compared to just over $10,000 in large cap stocks.
Today, small caps have underperformed large caps for most of the past decade. As a result, the asset class has fallen out of favor and capital has flowed out of many smaller stocks. If history is a guide, we believe this cycle may be turning and setting up better performance in the years ahead.
In the third quarter, we added one new company to the Punch Small Cap portfolio: a medical device company with a unique technology for detecting and diagnosing peripheral artery disease (PAD). The company is growing with strong profitability, but because of its smaller size and lower trading activity, the company received relatively little research and attention. As the company continues to execute its strategy, we think it will garner more interest.
While the recent uptick in COVID cases around the country has again put a damper on travel and in-person meetings, we are hopeful that over the coming year in-person research can resume and we will visit more small cap companies “on the road.”
The Punch Small Cap Strategy is a growth oriented equity strategy that invests in smaller publicly-traded companies, primarily located in the U.S. The strategy looks for higher-quality companies that are trading at discounted prices because they are under-the-radar, out-of-favor, or simply misunderstood.
A few years ago, I was invited to a progressive dinner party. I had never heard of this event, and I was grateful when I learned we wouldn’t be talking politics all evening. My friends described the event to me as follows: We would all meet at one of our homes and start our evening with drinks and appetizers. Then we would travel to another friend’s house for the main course. Once finished, we would end the night enjoying dessert at a third home. The point of moving around was to divide up the work of hosting and add some adventure to our time together.
I have hosted many family meetings as an advisor over the years—some in our office conference room, a handful in families’ backyards, and several around the dining room table of the matriarch and patriarch of the family. Clients often ask us how they should approach conversations with their children about their balance sheet or estate plan. We talk about who should be included in the conversations. Inevitably, these discussions are as unique as the people gathered, and I’ve come to appreciate a common evolution to these meetings that may be useful to you as you begin thinking about communication in your own family.
Setting the Table
Our mission is to enable families and institutions to steward resources with clarity and purpose. We actively engage you in our mission through the process of preparing for the family meeting, and the preparation can begin as soon as you start working with us through financial, estate, and charitable planning. For some, it may take years to be comfortable to dive into deeper family communication. For others, communication is overdue, and parents would like input, so a meeting with adult children might be the first order of business.
The family meeting is about more than sharing information. We want to “set the table” with you by reflecting on the purpose of the meeting, your hopes for how your family members will interact with their money (including gifts and inheritance), and what life lessons you’ve learned through the years. A very analytical client told me recently that he knew where I was going when I asked him to share at the beginning of the family meeting, and he joked that we shouldn’t add anything emotional to the agenda. We encourage you to share more than financial data and descriptions of legal documents at the meeting. This is an opportunity to engage your family in a discussion about family values.
Starting a conversation about money doesn’t necessarily mean your entire situation is an open book. Many parents are concerned that disclosing too much information too early will disincentivize their children or negatively alter their children’s life choices.
You can begin by simply letting your children know you have a plan in place. When I practiced law, I encouraged families at a document signing meeting to let someone know they now have wills, financial powers of attorney, and health care directives in order. Doing so invites the person into a trust relationship with you around important matters and lays the foundation for more extensive dialogue in the future.
Another early entry point into family meeting conversations is to introduce your family to your advisors. This might include your wealth management advisors, accountant, insurance agent, and attorney. These introductions can create teachable moments, allowing younger adults to understand the various areas of financial, tax, and legal advice they may someday need. In addition, the familiarity of a trusted advisory team can go a long way in emergency situations.
Finally, a straightforward way to bring family members into a discussion about financial and estate planning matters is to offer an opportunity to gain financial literacy. We often meet with our clients’ family members who are uneasy about financial concepts to help them build confidence and establish a foundation of vocabulary and knowledge around money matters.
Typically, the most involved portion of your family meeting is reviewing financial information or an estate plan in detail. Our advisory team participates in this part of the meeting by walking family members through a comprehensive balance sheet or estate plan illustration. Sometimes, if a family isn’t quite ready to share numbers, we will talk through the qualitative aspects of a balance sheet or estate plan without specific dollar amounts or values. In other cases, parents decided to review their balance sheet with their adult children, but they ask for copies of the balance sheet to be collected at the end of the meeting to maintain some privacy around the information.
An additional step is letting people know you’ve named them for certain roles (trustee, personal representative, guardian, etc.) and you’ve added them to your legal documents and trusted them to help navigate your incapacity or estate administration when the time comes. We commonly talk with the designated individuals about what each role means in terms of timing, responsibility, and resources available to them.
The sweetest (and sometimes bittersweet) family meetings are those that implement the plans put into place by clients. Sometimes our team has the joy of working with multiple generations to manage a charitable foundation or family donor advised fund. We help other families navigate business succession plans. Other times, we are collaborating with family members on the trust or estate administration after a parent has passed away. The most successful situations are when the family is organized, leans on their advisory team for guidance, and intentionally fosters regular and healthy communication.
Punch & Associates does not provide legal, accounting, or tax advice, and accordingly encourages clients and potential clients to consult professional advisers with respect to these matters.
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