These days the old adage attributed to Nathan Rothschild, “Buy on the sound of cannons, sell on the sound of trumpets,” comes to mind.
A recession 2/3 years after the pandemic, until a few months ago an entirely remote possibility. Such a possibility was not completely discarded by the market just out of superstition. Like when you fear missing your plane to go to the all-inclusive resort in the Maldives, after dreaming about it for years, even though you know in your heart that you will not miss it.
In just a few weeks, recession has become a certainty.
Trying now to rise above the background noise, let us take a look at the cyclical stocks, those that will have to suffer most, alas, from the recession.
Today residential builders in the U.S. are near -50% from their highs of the past twelve months (D. R. Horton and Lennar -45%, KB Home -51%, Redfin -80%). Banks range from-35%(JPM, Bank of America, Wells Fargo) to over -40% (Citigroup). Insurance companies from -20% to -40% (Metlife -17%, Prudential -25%, Lincoln -39%). Transportation companies, those most anticipating a recession, from -30% to -40% (Fedex -29%, UPS -27%, DPW -43%), retailers from -30% to -50% (Home Depot -35%, Kohls -38%, Macy’s -47%, Target -48%), cement and building materials from -30% to -60% (Martin Marietta -31%, Vulcan Materials -31%, CRH -34%, Tutor Perini -58%), finally, automotive by more than 50% (GM -53%, Ford -56%). All the sectors mentioned are not comparable with the same sectors in 2007 or even 2020. Today they are much stronger and have better medium-term prospects. In addition, the consumer is less indebted and scared.
In Europe, courtesy of war, we find the same retracements in the cyclical sector, albeit with even lower valuations.
Is recession inevitable? We believe not, and we continue to think, contrary to what the market thinks, that we will see a technical recession in the U.S. this year and no recession next year. But prognostications, as we know, leave time for themselves and what matters is still the risk/return profile. So is recession discounted in cyclical prices? We think so. Instead, we would stay away (for much longer) from bubble-object tech and so-called “quality” stocks whose quality, with slowing and rising rates, will soon be tested. And since they are on valuations between 50 and 100 percent above market valuation, it will be appropriate for them to confirm it. Finally, watch out for pharmaceuticals as well. Although optically not expensive on earnings, they nonetheless have very juicy margins (they all now stand between 3x and 5x sales), just as the Biden administration is trying to reduce the cost of prescription drugs in the U.S., the geographic area from which almost 2/3 of the industry’s profits come on average.
We waste time trolling the companies we are invested in. We read what they publish. We pester them with bold inquiries about how they compile their sustainability reports (they often don’t know) or to understand the numbers on their balance sheets or to investigate how things are going in general. What we observe is that those that do not sell commodities (metals, paper, fuels, etc.) tend to update prices with some delay because old contracts do not consider surges such as we have seen recently. Wages also require some negotiation before they are raised. What we mean is that inflation is like a boat, you know it’s going to turn if you move the tiller, but it has that thing, which in sailing terms is called a draft, that creates a time lag. We believe that galloping inflation, the terror of every central banker, is now under control. The market crash and rate movement have restored order. But it takes time before it shows up in the numbers. The risk is clearly that a restless and pressured central banker will kill the patient with too heavy and unnecessary therapy. These things the central bank knows, and it also knows that it has to show itself to be bad in order to kill what are called the “animal spirits” of the market, that is, the human positivity reflected in the rise of the markets, a rise that is itself inflationary.
Much of the decline has already taken place, just as much of the inflation has already run its course. Excluding technology, which lives a life of its own, anticipating very future growth, and the CD quality stocks, which we have already discussed, the U.S. market is attractive again today. The European one is worth a song and remains tied to energy normalization and the end of the war. The Japanese one is always exceptionally cheap, with a central bank that, no doubt in agreement with the U.S., is powerfully reflating the patient and bringing it back to life after thirty years of deep coma. On the other hand, the U.S. today needs a strong Japan that can guard a sensitive area well. Korea seems to be following the U.S. market and presenting the same buying opportunity it presented in March 2020. Meanwhile, many of the emerging markets are benefiting from the commodities super cycle.
Robert Armstrong, a nice and good journalist at the FT, talks this week about the downward revision of corporate earnings (click here to read the article). After premising that at 15.2x 2023 earnings the S&P cannot be considered expensive, the journalist nevertheless speculates that if instead of a 10 percent rise in 2023, as expected, we were to find ourselves with a 10 percent decline, the S&P would go from 15.2x to 18.5x earnings. In an area certainly not cheap. Well, assuming a 10% rise in earnings for 2023 actually amounts to predicting flat earnings, because of inflation for the period. So a 10 percent decline in S&P earnings in 2023 would be equivalent to a 20 percent decline in real terms and would be something dramatic, similar to what we saw in 2020 (Covid) and only less than what we saw in 2008, during the worst financial crisis since ’29. These P/Es are then still the consequence of the strong presence of tech and “quality” stocks inside the S&P. In our portfolios it is difficult to find stocks above 10x earnings and about half trade below tangible equity. Let’s be clear that we are not talking about a few extreme situations; in fact, we have in the various products about 500 stocks. As mentioned above, the situation is reminiscent of the 1970s, when stocks in the real economy were extremely depressed.
We are all scared of R, but there is never a better opportunity than a recession to make significant gains, with the exception of those accompanied by a financial crisis. The latter are long and very dangerous. Best to stay away from them. Today, however, the financial system is sound, as confirmed by James Dimon himself, respected and influential CEO of JPM, and will hold up well to the shock wave.
An average bear market lasts about nine months with declines around 36 percent. Under this assumption, we would touch lows in October with a further 17 percent decline from current levels in the S&P500 index. Certainly not a modest amount of downward space. But let us remember that we are talking about statistics that incorporate bear markets such as the very long one of 2000-2003, the one of the great financial crisis and the huge crash of March 2020. Moreover, from the beginning of the bear market to the end, an inflationary wave, as mentioned, will have protected the downside of the index, which, as we know, expresses nominal and not real magnitudes. In the last twelve months the U.S. CPI has risen 10 percent and in the next twelve months it is reasonable for it to rise 6 percent. So in real terms we are already close to the 36% mentioned. Moreover, in view of the financially sound system and good prospects on the investment front (infrastructure, energy transition, deglobalization) it is plausible that, even in the event of a recession, the downturn should be milder than the average of previous ones.
Therefore, the summer months present an opportunity to invest and position carefully, judiciously, and diversified. Before the market, like a jackrabbit, quickly changes direction, right at the peak of negativity, starting to paw, cheerfully and for no apparent reason, toward an uptrend. The next upswing will be based less on speculation and more on the real economy and will have real repercussions on the latter.
R for rabbit…
In the last week, Atos, a stock in which we have significant positions, at least for us who consider diversification vital, lost 50 percent. After it had lost in the previous 12 months already 60%. One might think that this is a stock subject to the Nasdaq bubble. Nothing could be further from that. The stock is one of the titans of IT consulting, with over 110k professionals on the payroll and 11 billion euros in annual revenue. The stock before the collapse of the last 5 days was trading at about 0.4x EV/SALES versus a market trading between 2x (CapGemini or Reply) and 3x (Accenture). Here the problem was governance and management after the departure of Thierry Breton two years ago, who left to become EU Commissioner. A dirigiste chairman of the board, Bertrand Meunier, and a CEO probably without the necessary experience, Elie Girard, produced a series of major mistakes. Earlier in the year the hiring of Rodolphe Belmer, an experienced manager responsible for the successful turnaround of Canal Plus, as the new CEO gave hope to the market. These painfully cleaned up balance sheet (kitchen sinking) and brought the company back to growth in the first quarter. Since his arrival the company has also hired about 10k new professionals (net of departures). Certainly an encouraging sign.
The surprise. A few days ago Belmer was fired, and the company unveiled a strategic plan (click here to access the presentation) that may make sense on paper but lacks the CEO’s support. The plan is based on splitting the infrastructure division from the digital and cybersecurity (BDS) divisions. Split to be done within two years. Belmer, on the other hand, wanted to sell the BDS division, which accounts for 12 percent of sales for which he had received an offer from Thales for 2.7 billion euros (the company before the collapse was worth 4.8 billion considering debt of 2 billion). Airbus also seemed interested in taking it over for more than 3 billion. Selling BDS would have left the restructuring infrastructure division to be managed in the future as a cash cow and the digital division whose growth could be revived.
Faced with management’s show of disagreement and the final decision to pursue a strategy that the recently hired CEO did not believe in, hedge funds jumped in to sell short. Other investors (including us) dismayed tried to make sense of it all. Meanwhile, to make the HFs’ job easier, the French government was issuing a statement specifying how the company could not be subject to takeover.
ATOS vs CAPGEMINI 3Y Total Return
Source: Thompson Reuters
Unfortunately, these things happen. The time to return on capital gets longer but potentially the return increases. Despite the understandable disappointment, there is no reason for the stock to trade at these prices, regardless of strategy. The right management will eventually be found. The company has unique divisions of the highest quality. We believe that the crisis in the infrastructure sector at 12 months will have receded due to the reduction in supply and the trend of industry consolidation. The support of the French state, the company’s first customer, is unconditional. Pessimism and shorting on the stock are extreme. There is no risk of false accounting or bankruptcy. The BDS division can at any time be liquidated at a valuation now equal to the value of the entire company, including debt.
We are therefore buying back the stock, always within the framework of proper diversification and risk control.