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Finding Value in Disruption

Disrupted. Is there a better word to describe the past 12 months? Disrupted lives. Disrupted routines. Disrupted travel. Disrupted work. Disrupted education. Disrupted supply chains. Disrupted markets.

In Q1 2020, US GDP plunged 32.9% quarter over quarter, annualized—the largest contraction on record. Companies directly and indirectly exposed to the uncertainties of COVID-19 slashed orders as demand collapsed and recovery was highly uncertain. However, a combination of government support, new vaccines created with unprecedented speed, and US workforce flexibility led demand to snap back faster than anticipated. This demand whipsaw caused imbalances across many supply chains.

For example, automotive OEMs slashed orders for auto semiconductors last year. Semiconductor companies in turn slashed orders from their foundries. Foundries in turn reallocated to the smartphone and device market, which actually grew demand over the course of the pandemic lockdowns as more people lived and worked and studied on personal screens. With demand for autos recovering faster than expected in 2020, and now accelerating in 2021, semiconductor chips are in short supply and, as a result, automakers have slowed production.

Automotive is but one of many disrupted supply chains. If you tried to replace a dishwasher part or order a new piece of furniture or even buy some home-exercise equipment anytime over the past year, you will recognize this familiar pattern. First, the pandemic spread through the global workforce causing work stoppages and production-line shutdowns. Next, whatever products did make it off the line met a constrained logistics infrastructure, with commercial air capacity cut and ship cargo space at a premium. Then, in the event your dishwasher part actually made it to US waters, our ports were congested due to manpower shortages and COVID-19 protocols. When the goods were finally unloaded, it turns out trucking shortages caused a spike in ground rates! All this might be bad for your dinner parties, home décor or exercise goals, but it can be great for the middlemen, like logistics solutions providers. We couldn’t foresee these disruptions coming. But of course, nobody could. No one can reliably forecast any particular future outcomes with the kind of repeatable certainty that would make for a credible investment process. Identifying cash-producing businesses in strong financial condition that are selling at undemanding valuations can help investors deploy capital in a way that tilts the odds in their favor.

Another, and in our view more welcome, disruption has emerged recently: value’s outperformance versus growth. The difference between the asking prices of companies viewed as growing and those viewed as lacking interesting growth prospects had reached historically wide levels (Morningstar reports Q1 2021 was value’s best performance versus growth in two decades). We didn’t know when the dispersion would correct, but we knew the price one pays for an investment always matters. With a cyclical recovery gaining momentum—unemployment falling, interest rates rising, nominal growth picking up pace—the environment is one that historically favors value stocks, and investors have taken notice.

For the last few years, we have wondered if we are investing dinosaurs—fundamentalists focused on profits, cash flows and returns. We hear and read that “the Internet of everything” disrupts many business models, especially those of stodgy value companies. Bearish views on reasonably valued companies often rested on the case that a high-valuation disruptor would overtake the incumbent leaders. The result of this divergence in performance between value and growth led us to field all manner of interesting questions about our approach to the investing environment: Why should investors care about cash flows and balance sheets, when management-adjusted EBITDA is the preferred metric of Wall Street and debt markets will always be wide open? Why worry about dilution from stock compensation when a company’s TAM (total addressable market) presents bountiful opportunity? No profits now? Minor detail! The terminal value is secured by the always accurate 20-year DCF which is built on consistently rising sales and margins. Worried about interest rates? The Fed has our back and rates are certain to remain low in perpetuity. Extreme valuation? Valuation isn’t a leading indicator of performance, so why worry about the asking price? Tractor companies in a space ETF? Someone needs to mow the lawns on terraformed Mars.

Retail investors received most of the headlines for driving this speculation, but many of the speculative dollars are also pouring in from professional investors (recall Softbank’s aggressive option trades last summer). The volume in YOLO trades wasn’t primarily retail; it was professional investors as well. Now we have the proof large investors using enormous leverage via derivatives and total return swaps are indeed taking concentrated bets to create and drive momentum. These so-called investors are fueled by banks with risk management divisions that somehow allow a $4.7bn hole to be blown in a balance sheet from a prime brokerage business that generates $1bn in annual fees. We’d imagine the behavior of these banks is different now than it was in the global financial crisis, but there’s something all too familiar. From small retail to large institutions, speculation is on the rise.