Key Takeaways
- Identifying economic trends is critical to entering and exiting positions. We take you through some of our process for identifying beneficiaries of tactical themes in our Granny Shots portfolio.
- Keep in mind the importance of not shouting at the market, regardless of circumstances.
- Remember in investing that less can often be more. We show you how successful active management requires understanding concurrent cycles and market drivers.
- We use meticulous analysis of historical data and advanced quantitative models to benefit from seasonal and tactical trends in markets and introduce five stocks that we have identified with these processes.
One of the most important things to know before entering a position or tailoring your portfolio: determining which stage in the cycle you’re in. Over time, a natural ebb and flow in economic activity has been repeatedly observed. Expansionary periods lead to peaks, which lead to recessions. The bottom of activity is called the trough, before expansion begins again. With stocks, the economic cycle is an important thing to understand. Indeed, it is central to how we pick stocks in the tactical thematic portfolios of Granny Shots.
Early in expansion credit-related industries, construction, durable consumer goods and transportation tend to perform well. Capital goods and some financial stocks tend to better in the mid to late cycle of an expansion. Later in the cycle, when economic activity peaks or is close to peaking, non-durable consumer goods, utilities and certain sections of the energy complex tend to perform well. To illustrate the point in historical context, let’s look at what happened to various sectors during the Global Financial Crisis
One of the main ways institutional investors make decisions is by orienting themselves into the cycle. Think of it like dancing, if you will. If you can’t hear the music, you’re going to have a tough time dancing properly. In less volatile market conditions, while exogenous shocks are limited, markets tend to act in a more predictable and behaved fashion. If you’re a musician and you know your blues scales, you can sit down and play the blues with anyone. Predictable and repeatable progressions lie at the core of the blues.
However, in jazz, things are more unpredictable. They are more dissonant and unpredictable. Listen to the two examples: here for blues and here for jazz. An adage in circles of musicianship is a blues guitarist plays three chords in front of thousands of people and a jazz guitarist plays thousands of chords in front of three people. Investing is difficult right now because multiple exogenous shocks have derailed the cycle and changed consumer behavior. While transports usually lead in early recoveries, they certainly don’t when airline travel plummets to fractions of its normal levels, for instance.
Blues fans will have been profoundly disappointed by post-COVID markets. The pandemic was probably the greatest exogenous shock markets have seen since World War II. It upended life as we knew it, and in doing so, it also upended many typical and predictable elements of the economic cycle.
There is an important lesson here. We mentioned that COVID was the biggest shock since World War II, but it caused markets to drop significantly less than the Global Financial Crisis in the wake of the Lehman collapse. Why? Endogenous financial crises caused by credit crunches have typically been more severe than exogenous risks to the market, like pandemics and war. For example, markets got about a third cut off the top because of COVID. They got cut in half in the wake of Lehman.
It’s important that credit is at the heart of economic activity. Bank and non-bank lending activity is a key promoter of greater economic activity and investment. When financial crises/credit crunches occur on top of a normal slowdown or contraction, or cause it, the market action is usually worse. Unsecured credit is typically very pro-cyclical.
Therefore high-yield credit can be a great leading indicator for the stock market. Trouble in these markets can often be a canary in the coal mine for equity markets. What has given our team confidence in a relatively more bullish stance than consensus is the strength in high-yield credit in 2022 on a YTD basis. Usually, leading economic indicators such as consumer expectations, new orders for consumer goods, and materials and new housing permits can provide useful signal for cycle orientation.
Now, we’ll walk you through how we orient some of our portfolios to seasonal, cyclical and tactical factors. There is no panacea here; orienting yourself is just as much art as it is science. Also, remember the stock market itself is a forward-looking leading indicator. You want to listen to Professor Price, not lecture him. Or as we say in one of our seven principles of evidence-based research: Don’t. Shout. At. The. Market.
Spinning Plates: Cycle Orientation Requires Understanding Multiple Factors and Cycles
If you orient yourself as to what stage in the business cycle you are in, then you can more accurately pick stocks. For example, this is how we run our models that create our multiple Granny Shots portfolios. Although it’s more difficult to orient oneself post-COVID, there are still valuable signals we can discern from recent data releases and the health of the US consumer, all of which should help you find out the time, so to speak. If you throw onto the multiple co-occurring cycles a Fed against the ropes and first high-intensity ground war in Europe in many decades, you can see why it’s decidedly more difficult to determine what the fates have in store for us sinners trying to build a sufficient nest egg.
While cycle orientation is useful for active traders and institutional investors, we’d also remind you that one of the most successful and time-tested strategies for retail investors is simply to do nothing. If you have time to let returns from quality stocks compound and accrue, then you don’t have to worry about headlines or cycles very much at all. In times of stress (or during troughs), industries like Utilities and Healthcare whose earnings are less tied to economic activity are usually a haven.
During expansion, cyclical industries thrive when the short-term prospects are for increasing demand. A YTD chart of sector performance this year will show you that in headline-driven markets subject to unpredictable exogenous risks, sometimes idiosyncratic factors, such as diminishing productive capacity in the energy complex meeting unprecedented sanctions, can cause unique returns that don’t match historical precedent.
If you want to try your hand at a more active strategy, you can. We’ll certainly help you with our extensive models and expertise. Please also remember that sometimes in investing less is more. We always like to mention that Fidelity found the most successful retail investors had forgotten about their portfolios. In doing so, they spared themselves from their own emotionally driven mistakes. Now, let’s take you through some of the plates we spin to capitalize on various cycles or prevailing economic conditions.
What has been a persistent thorn in the sides of economic forecasters has been the rising inflationary pressure. Much of it has been episodic, and we believe inflation will peak soon. But based on inflation levels, you can discern which types of companies will have a slight edge based on their assets. Do they have hard assets? Or are intangibles a big part of their balance sheet. This is one important “spinning plate” that should help you orient yourself to which stocks have a better chance of performing, based on historical data. Of course, there are exceptions to every rule.
Another recurring cycle that affects economic activity, and therefore the prospects for a company’s future earnings, is a bit simpler. This is simply the natural seasonality that occurs in each calendar year. As weather warms, spending patterns change. We know this seems simple, but it’s a very effective way of identifying which companies might beat expectations in the short-term.
Seasonal tailwinds are a welcome force for anyone managing a company, particularly given the gauntlet of risks many companies have dealt with over the last two years. What we do for our seasonal portfolio in Granny Shots is analyze which industries perform better at which times of the year to identify which have the highest win ratios for a particular period. For example, in our latest update of Granny Shots, we adjusted our picks in large part due to which industries are favored based on historical data for the next few months.
As you can see, some of the sectors that had previously been favored have been replaced by others. This helps you get the seasonal tailwinds at your back to help you achieve alpha. We have meticulous processes utilizing historical data and advanced quantitative models for each portfolio. When enough plates are spinning for a name, we add it to the list. We believe this is at the heart of the Granny Shots portfolio’s long-term success. Past performance never guarantees future results, of course, but utilizing historical data is nearly always better than an uninformed guess.
Similarly, we also group stocks into various style buckets for the final spinning plate in the piece. Should you be buying growth of value? A hard question to answer, but we try our best to use multiple methods to inform our approach. Economic growth, as well as the space and nature of its progress, lies at the heart of investing. Growth stocks are considered names that can maintain levels of growth above long-term economic growth given what we know about them.
The net present value of these stocks is more comprised of future growth than current earnings potential. Hence, when rates rise, these names suffer. When rates rise, the discount rate of future earnings also rises. However, if expectations for economic growth decrease because of war, for instance, the higher growth rate becomes more appealing relative to economically sensitive stocks.
So, you can see how we slice and dice the universe of stocks into buckets above. Now, to finish our third spinning plate, we’ll show you how we rate the prospects for the various styles of investing in the current quarter. We fully acknowledge that we’re in a topsy-turvy world because of COVID, a perplexed and seemingly hawkish Federal Reserve and the horrific and unpredictable conflict in Ukraine.
However, we still believe our methodology has great utility, and the performance of our flagship portfolio confirms this. We know this was a lot to take in. But we wanted to show you how the sausage is made, so to speak.
Crown Castle International Corp. ($CCI)
$CCI was recently added to our Seasonality Portfolio, one of our tactical Granny Shots themes. This company specializes in communications infrastructure and operates as a specialty REIT. It is a great way to play the 5G expansion currently underway in the wireless industry. It has sprawling assets tied to wireless communications and a US-focused strategy that should help insulate it from the troubles abroad.
The company is a quality name within its industry. It derives most of its income from site rentals. The company leases or owns the land on which cell phone towers are built. CCI has a very sturdy business model with consistent revenue since most of its revenue is locked into long-term contracts. Being able to host multiple tenants per site helps lower costs and the company has quality assets focused. It also has an endurable competitive advantage in the fiber market. A risk of this business is that its customers are extremely concentrated. Three major wireless providers account for around 75% of the company’s business.
KLA Corp. ($KLAC)
$KLAC was recently added to our style-tilt portfolio in Granny Shots. It was also removed from our seasonal style tilt simultaneously. However, there are several things about this stock that we think makes it a great pick for the times. It has a dominant position in the Semiconductor Equipment space, particularly the area of semiconductor metrology and inspection. It has a dominant market share of around 55% and has 4x the market share of its nearest competitor. It is a great representative of our style-tile toward Pure Growth and Quality Defensive.
Furthermore, given the prominence of idiosyncratic risks associated with multiple concurrent exogenous shocks, we have a particular reason this name stuck out to us as well. One of the unfortunate consequences of the rising tenor of geopolitical risk and Russia’s brutal invasion of Ukraine has been a push toward economic autarky, particularly in vital industries to national security like semiconductors. The semiconductor industry is typically highly cyclical but as COVID-19 accelerated the digital transformation, the demand curve was shifted in the industry’s favor.
$KLAC is also less cyclical in nature than those to who it sells its enabling technology. As the United States makes efforts to on-shore its semiconductor capacity this stalwart will likely be a key beneficiary. One of the key risks is a high valuation relative to peers. If interest rates continue rising, the net present value of future earnings that comprise a high proportion of the stock’s total current value could decline. The valuation risk is mitigated by the highest dividend payout ratio among its peers.
Allstate ($ALL)
Allstate was added to our seasonal portfolio. Property and Casualty Insurance is one of our seasonally favored industries and Allstate is one of the biggest players in the space. They have been gaining momentum on their returns to shareholders and while they have conservative underwriting practices compared to some peers, we believe this helps investors who want a “set and forget” stock. The company’s management has proven the ability to reward shareholders and this column always focuses on “who has your money.” We are confident in their management team. In 2017 the stock had annual EPS of $6.98 and by 2021 that had nearly tripled that to $18.64.
The company leads its peers in profitability and seems to have a viable strategy to build on its superb brand value and eco-system of complementary products. Elevated incidents of car accidents have proven a headwind in recent quarters. It was a beneficiary of COVID-19 though as the total miles driven severely contracted, so as this normalizes and potentially expands, it could be difficult and risky to navigate. The company is using technology to increase its underwriting accuracy, but there are potential threats. Self-driving will significantly increase safety and lower premiums, but there are probably plenty of gains between now and then. Tesla has a disruptive insurance product, and another risk is that blockchain protocols may improve insurance products. So the disruptors are aiming for $ALL, but we think they have some time to enjoy their entrenched position.
Brown Forman Corporation (BF/B)
$BF/B was added to our seasonality portfolio. Distillers and Vintners are seasonally favored by our analysis. This company has some of the leading spirits brands including Jack Daniels and Woodford Reserve. In addition to the normal seasonal factors, we imagine that alcohol will be a good business as mask mandates and other COVID-19 restrictions continue to be lifted. Many people will want to eat, drink and be merry and a lot of folks will likely start with a Jack and Coke.
The company also appears well on its way to meeting the specific appetites of new consumers and appears to have the finger on the pulse of growth markets like millennials for instance. The company has healthy quarterly dividends and better operating leverage has helped it improve its debt position. The company has a significantly higher gross profit margin than its industry median but also has a higher valuation to match. The momentum has also been declining for margins on a 5-year basis. The brands are entrenched with Baby Boomer and Gen X consumers, but millennial appetites could prove more fickle. Smaller competitors may have an advantage in acquiring new customers and Gen Z likes drinking less than their predecessors. Marijuana legalization could end up diverting portions of consumer wallets usually reserved for alcohol to a new, potentially trendier, vice.
Factset ($FDS)
We added Factset because there is a seasonal tailwind for Financial Exchanges & Data. This is a company that our team uses every day to deliver you quality equity analysis. Data is the fuel evidence-based research runs on and this is a quality provider of financial data. It provides integrated financial information to a wide and global group of consumers.
It serves a wide variety of financial clients who are spending a lot on data trying to figure out just where exactly we are in the cycle given the monstrous risks and idiosyncratic drivers that are influencing markets and financial assets. Again, we love good management teams and this company not only has a demonstrated track record of consistently rewarding shareholders but is decidedly forward-looking. As a client who uses their data on a daily basis, we can confirm satisfaction from that vantage point as well.
The company uses data in diversified and innovative ways. This is a highly competitive space and other competitors have been consolidating. This could of course prove a headwind for the company if they are out-innovated, but based on what we know we think the company is generally one of the best in breed as far as data providers go. It has a lot of recurring subscription revenue, which can be adversely affected in the case of sustained inflationary pressure. It is at the upper end of valuation amongst peers, but not at the top.
The stock certainly could experience some multiple compression if headwinds appear from competitors out-innovating the firm, or in the event of financial instability that threatens the profitability of its primary customers. Generally, we like this space and think the firm has a good competitive moat. Switching costs can be an impediment for this firm as using its products effectively does require a learning curve. So, smaller firms may be hesitant to switch from another provider to $FDS, but their data is indispensable for many astute analysts.