Assessing the Road Ahead

For the most part, we de-emphasize macro-economic factors and instead focus our time on the performance of a small subset of businesses. Macro-economic fears are usually transient and often forgotten, sometimes as soon as the next news cycle. However, the current macro-factors warrant a higher level of attention given the probabilistic outcomes that may occur and the potential impact on the operations of our businesses in the portfolio.

To be clear, none of these macro-economic factors are a driver of our investment theses. Our theses are predicated upon businesses which lean on the side of change and are developing defensible barriers, allowing these companies to earn durable economic profits for years to come. When we underwrite an investment, we consider how businesses will perform in a variety of economic environments including an inflationary one. We only invest where we believe the business has a competitive differentiation, allowing it to maintain pricing power and/or margins regardless of the environment. In short, finding the “secret sauce” is the key driver of our investment theses not the macro-level factors du jour.

Key Macro-Level Discussion Points:

1. We are experiencing a humanitarian crisis in Ukraine, where the circumstances are evolving at a mind-numbing pace. The multitude of potential outcomes requires us to be mentally nimble - or as Bruce Lee espoused, a “mind like water”. Today’s writing may be stale in days or weeks.

2. The outcomes of the issues we are facing today are vast and impossible to predict. Our approach hasn’t wavered: assess new information, distill it into probabilistic outcomes and iterate accordingly. It’s worthless (arguably of negative value) attempting to make precise predictions. Under any circumstance, we consider a range of outcomes including whether an investment opportunity has the potential to be worth substantially more in the future or if we may lose money in the investment. Now is no different.

3. During times of heightened uncertainty, we must press ourselves past 1st order thinking to the 2nd order. The 1st order response may be fear-driven, lacking a logical approach. For example, it’s natural to think that progress – economically and/or scientifically - will grind to a halt during times of global unrest. However, the unintended consequences of war and disasters are that governments, companies and scientists must innovate to service both the needs of the people and those fighting.

Distilled Big Uglies List

Ukraine-Russia War

War is scary for investors, but history suggests that stocks take them in stride. Below is data that illustrates how markets perform during times of adverse geopolitical events. If history is a guide, long-term investor may find investment opportunities to purchase stocks at lower valuations.

How the S&P 500 has historically performed around major geopolitical shocks. Grey indicates recession. Credit: Truist

While the historical data may be comforting, it’s too simplistic to believe that everything will revert in an orderly manner. The global economy, with its interlocking web of financial ties and supply chains, has grown increasingly complex.

Our framework for navigating the web of complexity is to utilize a Probability Assessment heuristic. Listed below are the main inputs into our probabilistic model. This list is not static – it evolves, and we iterate accordingly. Our intent is to understand directionally where these inputs may lead us NOT to perfectly assess each issue.

Key Inputs:

• Humanitarian toll / Labor Supply issues – Ukrainian and Russian workers in fields such as technology, agriculture, manufacturing

• Supply Chain impact (more on this below)

• Russia produces ~11% of world’s oil

• Potential food supply impact

• Russia’s $120 bn in sovereign debt

• Russian aggression spreads to other independent states such as Moldova, Georgia, etc.

• Cold War redux – an icy chapter begins between the West and Russia

• Cold War on steroids – China staunchly supports Russia

• Political turmoil contagion leading to other conflicts such as Taiwan / China

• Nuclear attacks – this situation is rather binary. We aren’t excluding it but if there is a nuclear escalation and launch, there will be worse outcomes than a fall in stock prices

Inflation Pressures

Every day that consumer price levels exceed nominal wage increases (i.e., the real wage rate), the average person is left worse off. The share of wallet that is spent towards staples is forced higher, leaving less to spend on discretionary items.

While the Ukraine-Russia war may seem like an easy inflation culprit to blame, the fact is that much of the world has been on a monetary and fiscal binge for quite some time and this is a key driver of the inflationary pressure today. The Federal Reserve, long focused on its goals of maximum employment, must turn its attention to the “moderate long-term interest rates” side of its dual mandate. The Fed’s tools to dampen inflation is a stark change to the last decade, which has been defined by a policy that has been highly accommodative in pursuit of maximum employment, lifting asset prices along the way.

Exacerbating inflation are the snarled supply chains and the potential that these issues continue for at least the remainder of this year. Recent reports show COVID-19 is still raging in China, adding another layer of complexity to this challenge.

The Ukraine-Russia war adds fuel to the fire, driving essential commodities such as oil, fuel, and energy higher. Together, Russia and Ukraine account for nearly 29% of international wheat sales annually – this will impact food availability and pricing. Additionally, two Ukrainian companies that produce nearly 50% of the neon gas used in semiconductor production have halted production.

Typically, the cure for high commodity prices is high commodity prices, which attract more producers to enter the market and increase supply, which drives prices back towards more stable levels in the medium- to long-term. The issue is when there is an unnatural phenomenon, such as political turmoil, which upends a traditional smooth commodity cycle. There is a probability that prices linger higher for longer.

The nasty result would be stagflation – where the commodity shock drives prices for everyday goods higher, leaving the consumer with less to spend on discretionary items thus crimping economic growth.

Key Inputs:

• Years of accommodative fiscal and monetary policy has led to the highest inflation rate in nearly 40 years

• Monetary policy is likely to be restrictive in the coming months (i.e., interest rate hikes and reduction of asset purchases).

• Fiscal policy will likely become less accommodating as well

• The messy supply chain issues further complicate matters.

• The Ukraine-Russia conflict is exacerbating near-term inflationary pressure, creates more uncertain in the medium-term and unlikely an issue in the long-term.

Probabilistic Assessments Heuristic

It’s a pathway to madness attempting to predict the multitude of outcomes. However, there are certain outcomes with a higher likelihood of occurrence.

Near Term Outlook:

Fear is a powerful short-term force in the stock market. The total near-term market drawdown is dependent on the severity of the war and whether there is a contagion effect. If the war spreads into a wider conflict, public markets will be further gripped by intense fear. As investors, we understand that this is a probabilistic outcome.

The true economic impact of the ongoing conflict will take time to sort out, but a state of max pessimism will be reflected in share prices well before the final impacts are known. This fear and uncertainty may provide the long-term investor with opportunities. We stand ready to act if opportunity presents itself.

Longer Term Outlook:

Let’s be as binary as possible. Nearly every Key Input mentioned above has one common outcome – increasing pressure on prices i.e., inflation. Whether global unrest spreads, a new cold war begins, commodity prices spike, supply chains remain jammed - each will have an adverse effect on the availability, and ultimately costs, of goods. In turn, businesses will pass along as much of the cost as the consumer can stomach and be forced to eat the rest.

The timing and severity are impossible to predict today, as the circumstances are complex, evolving, and without an easy answer. Some prognosticators will confidently provide a road map, but the fact is that exactly how inflation unfolds is unknown. The best path forward is to take in information, probabilistically assess, and iterate accordingly.

First order effects: inflation is the nightly thief to the consumer’s pocketbook. Nominal wages have little chance of keeping up with consumer prices thus leaving the consumer worse off. If the conditions worsen, we may end up in a nasty stagflation environment – when we have rising prices in combination with low/negative GDP growth.

Many in America will be able to weather the storm. The wealth effect from the fiscal stimuli, stock market rally and rising white-collar incomes allow many to pay higher prices without significantly impeding day-to-day life. However, 35% of adults in the United States have trouble coming up with $400 for small, unexpected expenses. Inflation will disproportionately hurt this segment of the population.

Second order effects: inflation and/or geo-political unrest will force consumers and businesses to become more efficient. Better businesses have already been implementing practices to reduce inflationary impacts. Adaptions include:

• Increased automation to reduce labor costs,

• improved supply chain to get closer to the customer,

• building out a robust logistics network to drive down the costs of getting product to the consumer.

The key point is that businesses that have already been leaning on the side of change are bound to benefit.

As investors not prognosticators, we have the benefit of not needing to be right about all the outcomes. We just have to focus on the essential factors, probabilistically assess how they are evolving and iterate when needed.

Conclusions:

Investing with the mindset of a long-term business owner in companies situated on the side of change is the best way to compound wealth over the long-term. While the current environment may discount stock prices, it hasn’t discounted the intrinsic value of future great businesses. The volatile macro environment may accelerate “Second order effects”, which would be favorable for forward-thinking businesses.

The current market environment is defined by uncertainty and fear, both drive stock prices lower but create tomorrow’s opportunity. Stock prices are a reflection of valuation – the price we pay for tomorrows earnings. As prices fall, our future earnings yield increases.

With a vast range of potential outcomes, the near term may be rocky while the world sorts itself out. Each day will bring new challenges, mostly unknown. Our aim is to constantly update our probabilistic assessments, not make new predictions on the direction of the war/aftermath.