We are in an interesting economic environment. Consumers are still spending pent up savings. Jobs are plentiful and the unemployment rate is at multi-decade lows. The economy is growing at a faster clip than many expected, but an inverted yield curve (where short-term interest rates are higher than longer-term rates) gives caution to soft landing scenarios. Overall, the stock market is fairly/fully valued. In such an environment, stock selection is critical.
Fed officials are not yet seeing results from the largest rate increase cycle in decades. Many companies are finding they can raise prices further than their management teams thought possible pre-pandemic. Companies that get the price/volume mix right are seeing substantial margin expansion even as overall profit margins are declining. So long as companies can press prices higher with minimal impact on sales volume, the Fed will find it hard to bring down inflation.
A recent report by Bloomberg noted that companies, overall, reported 14% more income than cash flows in 2022 through September. For every dollar in reported profits, only 88 cents was matched by cash inflows—which the report says is the largest discrepancy since at least 1990.
The euphemistic term that analysts use is ‘poor quality of earnings’. Bloomberg cites ‘accruals’ (where companies have the leeway to book sales they haven’t been paid for yet) and counting inventory that is sitting unsold in warehouses as assets on the balance sheet. Accounting tricks can only last so long before reality catches up to the balance sheet—and for some, it already has. Bloomberg reports that over the 12 months through January, 32% of the firms in the Russell 3000 Index are actually losing money, and such a widespread decline has happened only twice since 1978.
Our focus remains on companies with low debt, strong free cash flow and managements that are committed to return a significant portion of that cash flow to shareholders in the form of increasing dividends and share buybacks while still investing in the growth of their business. U.S. companies in recent months have spent hundreds of billions of dollars on share repurchases, which are often seen by businesses as a good use of capital that reduces the number of a company’s shares and can lift stock prices. Stock buybacks by companies in the S&P 500 are projected to top $1 trillion in 2023 for the first time in a calendar year, according to S&P Dow Jones Indices.
2023 marks LVM Capital’s 35th anniversary and the 25th anniversary of opening our Naples, FL office. We will be celebrating these milestones in Naples on Wednesday, March 22 and in Kalamazoo on Thursday, June 29. Please save these dates and plan to join us!