What Matters Now: Investment Opportunities for a World in Transition

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Inflation, The Dollar, and The End of Ultra-Easy Money

The decade-long party involving ultra-easy fiscal and monetary policies has come to an end as concurrent food, energy, security, and cost of living crises are reshaping our world. The days of the Fed rescuing markets are over and have been replaced by policymakers working to rapidly tighten economic conditions to bring down inflation. As a result, the world and the U.S. monetary regimes are returning to a more normalized interest rate environment after an extended period of negative and zero interest rates.  Valuations are undergoing the most meaningful re-adjustment process since the Great Financial Crisis to reflect current interest rates and inflation rates. Under present conditions, the global economy will likely experience a recession in the coming quarters with Europe and China among the greatest areas of financial stress. The U.S. remains the most attractive developed market economy and a magnet for capital flows from the rest of the world, but its economy will be challenged as well. The pandemic, its accompanying supply chain problems, and Russia’s attack on Ukraine continues to remake our world and accelerate the rate of change for so many aspects of society. It remains unclear just how much things will change as we still do not know how everything sorts out. Nevertheless, what is clear is that the global economy is experiencing more persistent cost pressures and reduced economic activity while policymakers have less bandwidth to support their economies than they have had in the past. Therefore, the adjustment process will be painful for the most vulnerable governments, companies, and individuals.

Chart 1. When the Fed Tightens, Financial Cries Usually Follows

Sources: Federal Reserve Board, Yardeni Research, Inc

In our April Outlook titled “Everything’s Changed,” we wrote that the global economy would experience trade shocks, financial turbulence, flows of capital, and the flight of refugees. At that time, we felt that the global economy would experience higher levels of inflation which would lead to slower global growth. Unfortunately, all these concerns have come to pass which has raised the probability of a global recession. Historically, when the Federal Reserve begins a cycle of interest rate increases, it causes financial stress in other parts of the world as seen in Chart 1 and investors should anticipate that this tightening cycle will probably cause a problem in one or more economies.  Since March of 2009 when then Federal Reserve Chair Ben Bernanke announced the initial quantitative easing program, investors have relied on central banks and fiscal initiatives to provide support to the economy, equity, and bond markets. As a result, investors were able to be much more aggressive and much less disciplined, while seeing equity and bond markets rally significantly as the policy support provided was massive and unprecedented. Today, market participants are facing a market environment characterized by increased uncertainty and volatility as the previously favorable conditions driving returns have been and continue to be in the process of being reversed. To bring inflation down, the Fed is targeting both the real economy and as a result the asset markets which means slower growth, higher unemployment, and lower asset values. Market participants who have grown accustomed to strong returns across asset classes must now recognize that we have entered a new economic period where assets are being revalued and different investment opportunities are presented. Notwithstanding the obvious challenges in the world today, the pullback in the global equity markets has created an attractive opportunity to selectively purchase some of the world’s leading businesses at much more favorable valuations than just a few quarters ago.

The End of the Easy Money Era and the Strengths of the U.S. Dollar

Since the start of the pandemic, central banks and fiscal authorities have committed more than 35% of global GDP or over $30 trillion in stimulus to combat the virus. That along with the food and energy inflation stemming from the Russian invasion of Ukraine has forced monetary and fiscal authorities to reverse course shifting from easy money policies to restrictive policy to bring inflation under control. Gone are the easy-money days of zero and negative interest rates, and these have been replaced by a rapid tightening of global financial conditions. The Federal Reserve has raised the fed funds rate from 0.0-0.25% to 3.25% within the last seven months with plans to move to an estimated 4-5% level. In the U.S., mortgage rates have risen from around 3.5% to 7% creating a material change in housing market dynamics. Global short-term interest rates have risen from near 0.5% to over 3.5% as there have been more than 180 rate increases by central banks over the last 18 months. After having pumped $120 billion per month into the system, the Fed has started to reduce its balance sheet by $95 billion per month. The combination of these actions has tightened financial conditions with the outcome theoretical as we have never had a reversal of quantitative easing of this magnitude, so no one really knows how this will end as it is all based on monetary modeling.

Chart 2. The U.S. Dollar Strength

Source: Refinitiv

One area where we are seeing the financial dislocations is in currency markets as the multi-decade strength of the U.S. dollar is wreaking havoc on other nations and their respective currencies (see chart 2). Importantly, the strength of the U.S. dollar means that the United States is now importing deflation and exporting inflation as commodities and other products are priced and traded in U.S. dollars (as shown in Chart 3). This is important in bringing down inflation in the United States as the U.S. currently imports $4.065 trillion per year and exports $2.98 trillion per year. The strong dollar also raises the debt servicing cost for foreign countries holding dollar-denominated debt and is placing further strains on the most vulnerable nations in the emerging markets.

Chart 3. The U.S. Dollar’s Importance

Sources: The Global Dollar Cycle, Obstfeld and Zhou, Aug 2022

There are three key implications of the end of the easy-money era. First, many governments now find themselves facing rising deficits, higher debt servicing costs, and growing social strains. When the history of this period is written, many governments will be criticized for wasting a significant opportunity to use zero-interest rates to invest in the structural changes needed to put their economies on a path to sustainable growth. Instead, governments focused on short-term benefits and are now left with big spending needs, but without the resources to stimulate economic activity with a global recession looming. Second, the aggressive moves by the fed to hike interest rates are causing disruptions in the currency markets as the U.S. dollar plays an outsized role in the global economy impacting commodities, global trade, global payments, foreign exchange transactions, foreign dollar-denominated debts, and reserves. This is leading to “reverse currency wars” whereby countries are trying to strengthen their respective currencies to offset inflationary pressures brought about by the strong U.S. dollar as most commodities trade in dollars. Third, the sudden shift from easy-money policies to tightening policies means that valuations are being reset to reflect a return to classic levels of inflation rates, interest rates and equity valuations.

Investing in Secular Themes

Notwithstanding the pressures described, there are five secular themes which should attract capital in the coming period. These themes are the electrification of the world, digitalization to improve productivity and offset demographic challenges, national security around food, energy, cyber and military security, biotechnology that will lower the cost of healthcare in the U.S., and special situation opportunities. Many of these are identified by governments and businesses as areas of mandatory future spending.

ELECTRIFICATION – ARS is investing in this theme in three ways. First, through old energy companies by owning independent oil and gas exploration and production/marketing companies which are typically selling at significant discounts to the market P/E multiples, but their renewed financial discipline and reduction of trusted energy sources for the world’s needs will make these companies even more valuable. Many are allocating more than 50% of free cash flow to be paid out to shareholders through dividends. Second, we are investing in industrial solar plays including one company that is a global provider of utility-scale solar installations and another that is a key global supply chain and manufacturing solutions provider. Finally, we are investing in the shift to EVs (electric vehicles) from ICEs (internal combustion engines). We are investing in two industrial companies that provide the rare earth materials and copper which are essential in EV production, and American multinational car manufacturers committed to expanding their EV fleets.

DIGITALIZATION – The world is facing major challenges of rising inflation and worsening demographics. Technology holds one of the keys to combating these two issues, and it still has a long runway for investors. ARS is investing in the major players in cloud computing, semiconductor chips, cyber security, and companies that improve power and efficiency. In addition, labor supply and costs are pushing more companies to use robotics and automation to improve efficiency, offset wage pressures, and as a substitute in jobs lacking qualified candidates.

NATIONAL SECURITY – In response to recent setbacks on the battlefield in Ukraine, Mr. Putin has doubled down on his aggressive behavior by attacking civilian targets and critical infrastructure while threatening the use of tactical nuclear weapons. The war in Europe was a wake-up call for government leaders, especially those of NATO members, to properly supply their armed forces with state-of-the-art equipment. We expect military spending to increase among NATO members and their adversaries in the coming decade.

LOWER HEALTHCARE COSTS – The use of artificial intelligence to analyze data has led to exciting developments in healthcare. This is leading to an accelerating pipeline and the introduction of new drugs, therapies, and breakthrough medical technology. The benefits of digitalization are being realized in healthcare, and the pandemic illustrated this with the research and development of new vaccines and medicines in record time. The prospect of better healthcare enabling longer lives leads to greater productivity.  

SPECIAL SITUATION OPPORTUNITIES – There are three types of companies that fall into this category. The first is companies with strong and growing free cash flows (FCF) which enable them to invest in future growth ahead of their peers. The second is businesses whose financial positions are so strong that they can use their free cash flows to buy back significant amounts of their outstanding stock over multiple years as well as increasing dividends; ARS currently owns at least four companies with announced plans to buy back 15-25% of their outstanding stock annually. The third is companies that will use mergers, acquisitions and divestitures to enhance shareholder value.

Investment Considerations

Conducting securities research and determining individual security selection is a fascinating, challenging and intellectually stimulating profession. Ferreting out opportunities is like solving a complex puzzle. Some economic conditions are easier to describe, and some have more moving parts which reflect different levels of complexity with the final conclusion always being a probability rather than a certainty.  It is in times like these that managers should balance protecting the downside with taking advantage of opportunities being presented. As the U.S. and global economy are experiencing the most significant inflationary pressure in over 40 years, it is something most investors today have not experienced. The ARS 8-person investment policy committee averages over 30 years in the industry which gives us perspectives and experience in various markets that many firms simply do not have. That experience combined with our investment process discipline which marries our macro-economic analysis (top-down) and fundamental company research (bottom-up) have allowed us to deliver distinct portfolios for clients. Investment process discipline means we know what we own in client portfolios, why we own each business and what our future expectations are for the business as we have done for over 50 years. This process gives us an advantage in being able to invest in the secular themes to position ahead of shifts in capital flows as we have in recent years. While our strategies may be out of step with the market for brief periods as we were last quarter, we remain confident that the beneficiaries of the secular themes we have identified will generate attractive returns over time. The shift from near-zero interest rates will require market participants to be much more selective among companies that will benefit from these changing conditions. Due to surging inflation, higher input costs, and a strong dollar, market participants should expect analyst estimates to be reduced when companies report third quarter earnings as more corporate executives are likely to announce lower earnings guidance, and in some cases, withhold guidance completely.

For ARS clients, it is important to keep in mind that the secular trends we have identified in recent Outlooks will continue to be fundamental to an improving economy, but there will be a time lag between the future benefit as reflected in the stock prices of the beneficiaries and the present economic pressures weighing on the markets. In our view, the best investment approach continues to be a focus on the beneficiaries of the conditions described in this Outlook rather than to try to time the market before committing capital. The fallout from global trade tensions, population displacements, the COVID-19 pandemic, and the war in Ukraine has forced governments and businesses to adapt to changing economic conditions and societal tensions. The global system is undergoing massive transformations due to the current political, social, economic, and climate conditions. Past experience has shown that it is in a time like this that the best investment opportunities are often missed because of excessive focus on heightened uncertainty.  Uncertainty creates opportunity.  

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC.

What Matters Now: Opportunity Knocks During Times of Volatility

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What Matters Now: ARS Focused ETF Strategy – An Active Approach to Passive Investing

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What Matters Now: The Comfort in Reducing Volatility

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What Matters Now: Investing Through the Fog of War and Other Uncertainties

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Everything’s Changed

We are heartbroken to see what the people of Ukraine are experiencing. The extraordinary leadership of President Zelensky and the bravery of the Ukrainian people in defending their homeland and families is inspiring people around the world. The defense of Ukraine is a vivid reminder of the high cost of freedom that many people enjoy but often take for granted.

“The war in Ukraine could not have come at a worse time for the global economy—when the recovery from the pandemic-induced contraction had begun to falter, inflation was surging, central banks in the world’s largest economies were gearing up to hike interest rates, and financial markets were gyrating over a formidable constellation of uncertainties.  The war has aggravated those uncertainties in ways that will reverberate across the world, harming the most vulnerable people in the most fragile places. It’s too soon to tell the degree to which the conflict will alter the global economic outlook… Much will depend on what happens next.” 

– Indermit Gill, Non-resident Senior Fellow at the World Bank excerpt from Brookings Institute, March 8, 2022

Everything changed on February 24th as war is being waged on European soil for the first time in decades. There will be no winners from this war as the damage already done has been far too great in terms of loss of life and destruction of a nation.  Unfortunately, the steepest economic price will be paid by the people of Ukraine and Russia followed by the world’s poorest nations and households that spend the highest share of their incomes on food and energy.  Besides higher prices, the fallout is likely to arrive through several other vectors: trade shocks, financial turbulence, flows of capital, and the flight of refugees.  The global economy will experience higher levels of inflation leading to slower global growth.

After being supported by historically low interest rates and highly accommodative policies, market participants who have grown accustomed to strong returns across asset classes must now recognize we have entered a new economic period where different investment opportunities are presented and invest accordingly.  With additional supply chain disruptions to food and energy being layered on top of the pandemic-related issues, the global economy is experiencing reduced monetary and fiscal policy support, higher levels of inflation and lower global growth.

The world is entering a period of massive geopolitical, economic, and societal shifts.  Russia’s attack on Ukraine will remake the world, but it is unclear at the present time just how much things will change as we do not know when or how the war will end.  What is clear, however, is that the global economy is facing another significant economic shock; the Ukrainian and Russian economies will likely be severely damaged for an extended period; Europeans will be facing significantly higher energy prices and greater prospects for a recession; the world food supply will be disrupted; global trade will undergo a significant makeover; national security has become a much bigger priority; and international alliances will be reconfigured.  Countries closest to the conflict—by virtue of their strong trade, financial, and migration links to Russia and Ukraine—are likely to suffer the greatest immediate harm. But the effects will be felt worldwide.

It is worth noting that since ARS Investment Partners was established in 1971, we have successfully navigated previous inflationary periods for our clients as well as several geopolitical conflicts during that time.  Our investment process, which combines both proprietary macro-economic analysis (top-down) and fundamental company research (bottom up), gives us an advantage in being able to invest in the secular themes to position ahead of shifts in capital flows as we have in recent years.  We began overweighting semiconductor and capital equipment companies, defense companies, Electric Vehicle  manufacturers and commodity producers essential for the clean-energy transition often well in advance of major market shifts.  We have employed the same investment philosophy and approach since our inception, and that approach has allowed us to successfully build and protect capital in challenging environments.  The most important consequence of the war in Ukraine is the lives lost and the humanitarian crisis associated with the huge numbers of besieged and displaced people.  This war represents a human tragedy of epic proportions with significant business, economic and geopolitical considerations as we describe in this Outlook.

Forces Driving Shifts in Capital Flows

“Sweeping and indiscriminate sanctions would only make people suffer. If further escalated, they could trigger serious crises in the global economy and trade, finance, energy, food, and industrial supply chains, crippling the already languishing world economy and causing irrevocable losses.”

-Excerpts from China’s Ministry of Foreign Affairs statement following the President’s Xi-Biden March 18th video conference call

As if fighting a global pandemic for the past two years was not enough, the world is now dealing with a ground war in Europe that has the potential to undo much of the progress made since the Berlin Wall came down in 1989.  In recent years, China and Russia have been seeking a rebalancing of the global order with the desire to reduce the military and economic influence of the United States and its allies. Autocratic nations have been spending heavily on developing their military capabilities.  The sanctions recently imposed on Russia were among the most severe issued in history and have already had a devastating effect on the Russian economy as shown in Chart 1.  As a result, our adversaries are considering new ways to mitigate the costs of future sanctions on their economies by establishing alternatives to existing Western-controlled systems such as SWIFT (Society for Worldwide Interbank Financial Telecommunication) banking system.  The sanctions are also causing nations and companies to reorient their supply chains and currency reserves to protect their economic interests against future actions by rival nations or blocs.  The remaking of the world order and the global economy is underway, and this may be the most meaningful change the world has experienced since WWII.

Chart 1. The Impact of Sanctions on the Russian Economy

Several forces are redefining the global economy.  First, global growth will be lower than previously projected.  Second, headline inflation will remain elevated as labor costs rise and energy and food supplies are being disrupted.  Third, the supply chain issues, which the world has been battling since the start of the pandemic and which had been starting to ease, are now being exacerbated by the war and the sanctions imposed on Russia by allied nations.  The combination of energy and food inflation combined with supply shortages and stockpiling will impact the most vulnerable countries, companies, and individuals.  Fourth, policymakers will increase or shift spending to improve national defense, space, cyber, food and energy security.  One additional issue that investors should consider is the intended and unintended consequences of the sanctions imposed by the West, particularly if the U.S. follows through on threats to add sanctions to China in the event that the Chinese help Russia.  The Russian economy is feeling the full effects of the initial sanctions as it has been forced to raise its benchmark policy rate to 20%, while its stock market and currency have been severely damaged.

Lower Global Growth

Gross Domestic Product for many countries was on pace to return to pre-COVID levels by the end of this year or next, but the war makes those projections unlikely to be achieved.  Prior to the invasion, global real gross domestic product was projected to grow around 3.4% due to the impact of inflation, reduced government stimulus, tighter monetary policies and ongoing supply chain issues which were only starting to be resolved.  The OECD recently released an update which projected world GDP to drop by 1.09% (see Chart 2).  Unfortunately, many emerging economies will be severely impacted by the combination of the lingering healthcare issues from the pandemic, high U.S. dollar-denominated debts, volatile commodity prices and availability, and erratic economic policies.  For the global economy, slower growth will mitigate some of the current inflationary pressures as demand declines.

Chart 2. The War’s Impact on Global Growth

Higher Inflation

Coming into the year, ARS believed that the economy would see its deflationary tendencies return in the second half of 2022 following the supply-driven inflation experienced due to the pandemic.  However, the war has added a new layer of complexity on to the inflation dynamics as Russia and Ukraine account for only 2% of GDP combined but have an outsized impact on the world’s energy and food supplies.  Russia, the 11th largest economy in the world, is one of the world’s leading exporters of oil, natural gas, nickel, aluminum, semi-finished iron, and wheat.  Europe, in particular Germany, is highly dependent on Russia for its energy needs.  Europe had been aggressively shifting away from fossil fuels to renewable energy but was still early in the transition when the war broke out.  The subsequent spike in oil and natural gas prices, as well as concerns about sanctions cutting off supplies to Europe, has governments scrambling to figure out ways to reduce the impact in the form of fuel subsidies, gas tax holidays, and fast-tracking permit approvals for energy companies to bring on additional production sooner.  The food problem may prove to be even more difficult to address as the world may lose a substantial portion of crops if Ukrainian farmers cannot meet this season’s planting deadlines.  Food inflation was one of the key issues leading to the Arab Spring over a decade ago.  Regardless of the actions taken by policymakers, the OECD projects that the war’s impact on inflation will range from increases of 1.36% for the U.S. to 2.47% for the world (see Chart 3).  While it is exceedingly difficult to make projections when the war’s duration and outcome is unknown, the world has clearly entered a period of higher prices.

Chart 3. The War’s Impact on Inflation

Interest Rates to Rise, But Must Remain Historically Low

The interest rate outlook calls for higher rates for the coming period as the Fed grapples with higher inflation arising from energy and food supply shortages as well as higher labor costs.  Since 2009, central bank policy has played an outsized role in supporting the markets and global economy as both struggled to recover first from the great financial crisis, then from the pandemic and now from the war.  Last year, central banks began tightening policy by raising benchmark policy rates, reducing quantitative easing, and signaling the end of the most extraordinary period in monetary policy history.  Central bankers are trying to balance curbing inflation by increasing rates just enough, while avoiding tipping the economy into recession. One of the challenges is that there is little central banks can do to offset inflationary pressures caused by supply disruptions beyond simply trying to reduce the level of aggregate demand, as their tools are designed to address inflation that results from excess demand.

Given the current state of the world’s economy, this interest rate hiking cycle may be quite different than previous ones as much of the world’s economy was still struggling to recover from the two previous crises.  Based on current conditions, it is likely that many countries will experience a recession sometime over the next 24 months.  We believe the Fed will prefer to continue to let inflation run higher than normal rather than cause a recession by hiking too aggressively.  Furthermore, the Fed will likely raise rates fewer times and to levels below what the Fed and market participants currently project, as the slowing global economy will naturally reduce demand and dampen inflationary pressures.  It is too soon to determine the full impact of the war on growth and inflation given the broad range of possible outcomes, and therefore, investors should expect the Fed and other central banks to be flexible in setting the course for policy actions.

Geopolitical and Political Forces

“It now seems likely that the world economy really will split into blocs, each attempting to insulate itself from and then diminish the influence of the other. With less economic interconnectedness, the world will see lower trend growth and less innovation. Domestic incumbent companies and industries will have more power to demand special protections. Altogether, the real returns on investments made by households and corporations will go down.”

-Economist Adam Posen, President of the Peterson Institute

For decades, globalization has brought the world closer together and raised living standards for billions of people, but it also created vulnerabilities for many domestic economies which have been brought to light in the past two years.  First the pandemic and then the war provided a painful reminder just how interconnected and interdependent the global economy had become.  The pandemic and the war in Ukraine underscored the over-reliance on autocratic nations in the global system for necessary resources including food, energy, commodities, and other basic materials.  The war in Europe is remaking the world order and alliances, and it is forcing world leaders to reassess their foreign and domestic policy priorities and dependencies in several key areas including national security (military, food, cyber and energy), the role of intergovernmental agencies such as NATO, WTO, and the UN, and how to properly affect the climate transition.  It is also forcing policymakers to reconsider budget priorities.  The severity of the sanctions placed on Russia by western governments has countries, including China, exploring ways to insulate their economies from future sanctions and to form new economic and defense alliances.  The United States and virtually every nation will now be focused on building up strategic reserves in a variety of essential materials required for the advancement of alternative energy sources, and critical defense needs and technologies.  The buildup of strategic reserves can increase the prices of these materials and keep them elevated for an extended period of time.

being forced to adjust spending priorities and policy around national security.  Given the need to increase spending in certain areas, President Biden’s Build Back Better agenda will likely be greatly reduced or not implemented at all.  Congress will likely be forced to rethink our energy policy, defense spending, and social spending priorities to deal with the new political and economic realities.  For China, the war has put the nation in a difficult position as it has close political ties to Russia, but much greater economic dependency on western nations.  As the world’s second largest economy and largest exporter, China will play an outsized role in how the political and economic issues get resolved. Europe will be facing several new challenges involving energy, defense, immigration, and resources while working to avoid a severe recession.  Some experts are suggesting that globalization has ended, but it will more likely shift to blocs whereby like-minded nations work to protect people and grow their economies in a changing world order.

Investment Opportunities for a Changing World

“The availability of ever-cheaper goods like cars, appliances and furniture produced abroad was a major contributor to the benign U.S. inflation picture in this quarter-century. On the other hand, offshoring also led to the elimination of millions of U.S. jobs, the hollowing out of the manufacturing regions and middle class of our country, and most likely the weakening of private-sector labor unions. The recognition of these negative aspects of globalization has now caused the pendulum to swing back toward local sourcing. Rather than the cheapest, easiest and greenest sources, there’ll probably be more of a premium put on the safest and surest.”

-Howard Marks, Oaktree Capital

Portfolio management is both an art and a science. It is a decision-making process that requires sifting through enormous amounts of incomplete information and making a judgment as to what is really important.  This is particularly true not only in a period of heightened uncertainty, conflict, and volatility such as we are in now, but also when the world is undergoing a fundamental change that is impacting virtually every industry.  Policymakers must address the growing cost of security due to the significant damage from climate change and the effects of war.  For much of the past decade, market participants had the wind at their backs and were able to be more aggressive than in normal times.  This was due to historically low interest and inflation rates which supported higher price-earnings multiples for companies with the promise of strong future growth, but the reality of little or no current earnings.  In a rising interest rate environment such as we are in today, price-earnings multiples have been and are contracting, and valuations are coming down.  While we did not anticipate rates to rise as much as they have this year, we were, for some time, of the belief that multiples would contract for those companies with elevated valuations and little if any current earnings.  As a consequence, in late 2020, we began to reduce positions and completely eliminate those companies whose valuations we felt were not sustainable.  We did this because the preservation of capital in pursuit of investment returns is both an offensive and a defensive process.

The dramatic shifts now taking place in the global economy will have profound implications for every country, company, and household, and these shifts are creating new investment opportunities, while reinforcing some previous ones.  There are two important factors to consider for portfolio positioning: first, the need for nations to reshore and expand onshore manufacturing capabilities critical to ensuring economic and national security, and second, the need to build up strategic reserves to protect future supplies of required resources.  Whereas just in-time inventory management had been considered an ideal way to manage manufacturing processes in the past, the pandemic and war have made “safe and sure” supplies in needed materials the priority over cost savings.  Advanced technologies will also allow companies to offset the former attraction of lower foreign manufacturing costs thereby creating many new jobs at home.

Aside from the opportunities described above, the focus for client portfolios remains consistent with our recent Outlooks as we continue to favor the beneficiaries of the digitalization and electrification involving cloud, cyber security, communications, semiconductor technology, industrials, healthcare, energy companies including wind and power, and commodity and materials producers.  Investors should continue to avoid over-hyped areas of the market, but also to be opportunistic to take advantage of the mispricing of quality companies that inevitably occur in volatile markets and uncertain periods.

We focus on the investment opportunities which meet our standards of valuation under these changed conditions.  We anticipate that companies will move more aggressively to improve productivity and better compete in the coming period through merger and acquisition activity and spinoffs.  Notwithstanding the significant advancements of many of the leading beneficiaries of this Outlook over the past few years, periods of market volatility should be viewed both as the pause that refreshes and an opportunity to add to quality companies with particularly attractive valuations which have significantly increased their revenues and earnings and continue to have bright prospects for strong growth.  Because the economy is undergoing a reorientation, the companies with embedded advantages will continue to fetch the best market valuations over time.  Security of critical raw materials is fundamental to successful investment outcomes. Continuing innovation and embracing the latest technologies will be fundamental for companies to remain at the forefront of competition.

Regardless, a number of leading companies, large and small, will continue to innovate, disrupt, and evolve their business models to thrive in the coming years.  As such, investors should be focused on benefiting from the powerful secular trends and not on speculating in shares of companies whose futures are behind them as they have either lost their way or will be unable to transition in their current forms to benefit going forward.

Published by the ARS Investment Policy Committee: Stephen Burke, Sean Lawless, Nitin Sacheti, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC.

What Matters Now: Shifting from the Fed to Fundamentals, Investment Opportunities for 2022

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What Matters Now: Private Equity Approach to the Public Market

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As the Pandemic Matures, Different and More Equity Opportunities Emerge

The prospects for common stock investing are more positive than the headlines would lead market participants to believe because the investment opportunities are broadening.  The strong equity returns of the past few years should continue in 2022 for investors able to identify strong revenue and earnings growth in a slower growth environment and those undervalued companies that have been previously overlooked due to extreme concentration of investment in a relatively small number of pandemic beneficiaries.  Additionally, investment success will require navigating some subtle and some not-so-subtle shifts that are occurring in market leadership as the pandemic wanes.  Leading ARS to this more positive view is that the determinants of security valuation, namely the outlook for corporate profits, interest rates and inflation rates remain positive even with the elevated inflationary levels and higher cost of living experienced in the second half of 2021.  The world continues to undergo the transformations that ARS introduced to readers in our October 31, 2020 Outlook that define many of the most important investment opportunities.  These transformations will continue to shape the future of the global economy.

In addition to the impact these six transformations will have on the global economy, the United States’ post-pandemic economy will be shaped by the handoff from government spending to corporate and consumer spending as the primary drivers of growth in 2022 and beyond. Against the current economic backdrop, the areas that will attract capital in the new year will continue to be the beneficiaries of these transformations, particularly companies focused on cloud/data management and storage, semiconductor and capital equipment, broadband providers, select commodity producers, defense, biotech, cybersecurity, autonomous vehicles, gaming, and both renewable energy and fossil fuels.  ARS also continues to favor those companies with strong managements, steady earnings growth, and strong dividend policies as we project interest rates to remain range-bound near historically low levels for the foreseeable future.   Furthermore, investors should be focused on U.S. small cap companies which are selling at strikingly attractive valuations relative to larger capitalization companies in the S&P 500.

This Outlook will address the forces that are creating this favorable environment for equities, the risks that investors should consider for the coming period, and the investment implications with examples of businesses that our research has identified as particularly attractive on an absolute and relative basis.  Current conditions suggest that investors must look past the headlines and seek to identify those select companies that are particularly well-positioned to benefit from the secular trends that will drive global growth in a world economy that is undergoing a massive transformation, and one that has little or no historical precedent.   

Why is the ARS view more positive than the headlines are leading investors to believe?

Due to the highly unusual political, economic, and social dynamics present in the world today, the markets have been experiencing elevated levels of volatility.  However, the recent market pullback has created interesting opportunities in companies that are selling for highly attractive valuations. A recent report from JPMorgan highlighted the divergences between and within the indices, particularly the Russell 3000 and the NASDAQ.  The report stated “that outside of the Big 10 stocks in the US, equity drawdowns and multiple de-ratings have been severe. Russell 3000 was down only -4% and Nasdaq Composite -7% from 12-month highs, however, the average drawdown for constituents in these indices was -28% and -38%, respectively.”  A drawdown is the decline in a stock’s price from its recent highs.  In addition to the wide spread of returns within the indices, what some investors seem to be missing is how the sequencing of policy action is impacting the economy and markets.  For example, the Federal Reserve and other central banks acted in March 2020 to lower interest rates and re-instituted their quantitative easing programs (which increased the money supply) adding massive liquidity into the global system.  This in turn fueled the rise in valuations across a variety of assets including stocks, real estate, collectibles, and cryptocurrency. As consumer net worth has increased, this has led to improved consumer confidence which fueled consumer spending. For corporations, the effects of the pandemic and the rise in corporate earnings and cash flows are now fueling the ability to increase capital expenditures to improve productivity. The strength of the economy during the pandemic period has resulted in record profits for many companies which will help drive continued earnings and dividend growth and investments in people and productivity. 

First, the massive monetary and fiscal stimulus that has been implemented in the past 18 months will continue to provide favorable conditions for the next 18-24 months even after the Federal Reserve completes its tapering and begins to raise short-term interest rates. 

Second, the U.S. has experienced rapid growth in its money supply since March of 2020, and this has helped foster a surge in consumer net worth which, when combined with higher wages, supports and augments consumer spending and investment.   For perspective, the Federal Reserve’s balance sheet prior to the 2008 recession was around $975 billion and today is approximately $9 trillion, and other leading central banks also experienced similar increases in their balance sheets.  It is completely impractical for market participants to expect a dramatic reduction in central bank balance sheets anytime soon without engendering a huge global shock. 

Third, corporate profits will continue to hit record levels which will allow many to pay higher wages while investing in the productivity improvements necessary to increase earnings and remain competitive over the long term as they move to replace human labor with technology. 

Fourth, ARS believes that supply chain problems will continue to ease in 2022 which should reduce inflationary pressures, while onshoring and reshoring will further bolster domestic economic growth.

Finally, the global economy will continue to adjust to the issues related to COVID and should begin to return to more normal pre-pandemic levels as vaccination rates/herd immunity allow for reopening to take hold, barring the development of additional variants.  It is the cumulative effect of all these forces that will drive positive returns for equity investors.  In 2022, investors should focus on those companies with the ability to increase revenues, those with pricing power, with the ability to invest in improving productivity, and who can effectively manage their overall wage costs.  Market participants should be careful about their country exposures as debt, currency and health issues are exacerbating the divergences between the handful of advanced nations that are growing in a more sustainable fashion than the rest of the world.  In 2022, the United States should continue to be the primary driver of global economic growth.

What are the risks in the system?

With the rapid spread of the Omicron variant and vaccination challenges in much of the world, the most obvious risks are geopolitical, inflation, debt levels and pandemic-related disruptions including global supply chains.  The Scowcroft Center for Strategy and Security recently released a report entitled “The Top 12 Risks and Opportunities for 2022”.  The areas highlighted in the report are as follows:

1. The lack of effective COVID-19 vaccination in developing countries triggers new variants that are potentially more contagious and lethal. The report states that African nations have vaccinated only about 12% of the population as developed nations have not stepped up to provide sufficient supplies of vaccines.

2. Russia attacks Ukraine. This represents one of the biggest threats to global stability next year as Russian President Putin has poked and prodded the European nations over Ukraine and energy security. Mr. Putin has stated that “Russia and Ukraine are one people – a single whole.” 

3. As China peaks, its economy sputters – sparking global disruptions. The Chinese economy hit several speed bumps last year.  President Xi is positioning for a third term and as the leader for life, but the Chinese economy is experiencing some growth pains as evidenced by the debt problems of Evergrande and other companies in the real estate sector which represents 29% of the Chinese economy.  The government made examples of several companies including Alibaba, Tencent, Didi, and many in the for-profit education sector under its “common prosperity” initiative to address inequality and reinforce the party’s control of the nation.

4. Afghanistan collapses and the U.S. cannot escape the consequences. This nation faces a humanitarian crisis as the U.N. projects over 23 million Afghans faced imminent starvation and its banking system is in an uncertain state as the international community struggles to navigate prohibitions on aiding the Taliban. 

5. Developing countries suffer more severe economic troubles and a rash of political instability. The pandemic has carved out large numbers of the global middle class with more than 131 million more people in poverty.  Adding to the problems are widening inequality which fosters more political instability, potentially more civil strife and forced migration.  The strength of the U.S. dollar places further strains on developing economies to service high U.S. dollar debts. 

6. Oil tops $100 a barrel. The clean energy transition is proving more difficult to effect, and fossil fuels will remain a larger portion of global energy supply for longer than hoped after a period of underinvestment.  The supply issues combined with stronger than anticipated demand pushes prices higher.  The U.S. and other developed nations are in the hands of OPEC and Russia’s willingness to accommodate growing demand for fossil fuels.

7. The world fails to meet its climate goals from the inconclusive Glasgow summit. Global carbon emissions have grown 60% since the 1997 Kyoto Protocol was signed.  The Glasgow summit did little to inspire confidence that the world will achieve the necessary levels of carbon emissions in timely fashion.

8. A bifurcated world emerges, but it’s not a repeat of the cold war with Russia. The report highlights the differences in China’s political and economic strengths relative to where Russia was in the cold warChina’s global aspirations, importance as a growing consumer market, its long-term planning, overall economic strength, and position in the high-tech world are    just a few of the differences that need to be considered.

9. Food security worsens, propelled by COVID-19, climate change and conflict. The World Food Program estimates that 45 million people are on the brink of famine with higher food and transportation costs creating problems for families and organizations that provide support.

10. More countries slip from their current state into failure. While countries such as Syria, Yemen and Somalia are regularly at the top of the list of “very high risk” nations, these and other nations are moving closer to failed state status, if not there already, as drought, water scarcity, food crises, rising inequality, the pandemic and other healthcare issues are pushing nations to the brink.  Two major concerns stemming from this issue are the negative effects on others in the region and migration issues, which pose social, economic, and political issues for other nations, especially European ones.

11. Western efforts to revive the Iran Nuclear Deal fail. Iran is demanding that sanctions be lifted even as it continues to develop its nuclear program.  As involved nations continue to fight proxy wars and engage in cyber-attacks and other provocations, the probability for political missteps increases as does the potential for armed conflict.

12. U.S. democracy further decays. The report suggests that democracy will erode significantly next year in the U.S. which continues a trend that started a decade ago but was made crystal clear during the January 6th attack on Congress, something most Americans never thought they would see in their nation.    

In addition to the 12 risks listed above, inflation has become a concern for U.S. policymakers for the first time in decades.  In addition to supply chain issues pushing costs up, wages have been rising in the past few quarters with some unions, including workers at Deere and Kellogg, having negotiated big wage gains with cost-of-living adjustments (COLA) being included.  These cost-of-living adjustments bear watching as ARS has previously written that our team was more concerned about the wage bill (the total compensation costs for the company) as opposed to wage rate (how much individual workers are paid per hour).  Our view was based on the belief that productivity improvements would more than offset the higher hourly wages for many firms, however, the recent union wins on COLA will require investors to be more company-specific about its impact.

These risks are, for the most part, well known and well understood.  However, that does not mean that investors should not take note and invest accordingly as these factors and new ones will determine the appropriate positioning for portfolios. Interestingly, the authors did not list inflation as a top twelve risk.  ARS believes that after a period of elevated inflationary pressures, the deflationary tendencies that existed prior to the pandemic will re-emerge in the second half of 2022.  The four deflationary forces are globalization, which has been more inflation-prone since the onset of the pandemic, technological advances, which accelerated during the pandemic, debt, which continues to rise globally, and demographics, which continue to worsen.  

What are the investment implications of the Outlook?

For all the risks described above and other uncertainties, there are exciting opportunities as the global economy is undergoing a long-term revolution of digitalization and electrification.  Technology has been advancing at such a rapid pace that we are witnessing a massive reorientation of economic activity which is being further augmented by the necessity to address climate change with advanced technology that did not exist only a few years ago.  The conditions heading into 2022 are positive for equity markets as we expect strong earnings next year and the highly accommodative monetary environment to continue at least through next year.  However, investors must be selective as the potential for equity returns will be driven by absolute earnings and revenue growth rather than expectations of future growth, as it has been since the onset of the pandemic.  Taken in the aggregate, stronger corporate earnings, low interest rates and the gradual easing of inflationary pressures should continue to create favorable conditions for equity returns in 2022. 

The recently passed infrastructure bill in conjunction with increases in consumer and corporate spending are creating positive longer-term investment opportunities in a number of areas.  The following are quotes from an industry leader describing the sector dynamics and an example of an unnamed company in that industry that highlights the unique combination of a high-growth company selling at an attractive valuation. 

Semiconductors and Capital Equipment

What the leaders are saying – “The secular tailwinds around semis, everybody knows what it is. We all get excited about 5G, AI, automotive, all of the things you’ve heard everybody talk about for the last, I don’t know, 6, 9 months, are growing. Semi content is growing on top of that. Capital intensity is growing… And when you look at that, it just sets up to be what I think is a great industry.”

Stock Opportunity – One leading semiconductor company has revenues of $27.7 billion, holds more than 48,000 patents, does business in 17 countries, and has 11 manufacturing sites. It will invest more than $150 billion in leading edge memory manufacturing and research and development over the next decade. Total revenues have risen more than 33% year over year.  Data center revenues were up more than 70% year over year. The company projects “that automotive and industrial will be the fastest growing memory and storage markets over the next 10 years. New EVs are becoming like a data center on wheels, and we are already seeing examples of 2022 model year EVs supporting Level 3 autonomous capability with over 140 gigabytes of DRAM and also examples with over 1 terabyte of NAND.”  This company currently sells for less than 9x earnings and generates free cash flow to raise dividends and buy back stock.  This is an unusual opportunity when companies with much less growth sell for much higher valuations.

Commodity Companies

What the leaders are saying – “Underlying all of this is the fundamental outlook for copper is incredibly favorable. Copper’s role in the economy and as the economy changes with global investments in infrastructure – I know we have a controversy here – but countries around the world are going to build infrastructure. Less developed countries are going to develop. The world is getting increasingly focused on electrification with modern technology, 5G, and artificial intelligence. And then a new major element that people are talking about and recognizing now, for demand that’s coming, it’s not here in real significance now, is all the investments that people are going to be making to reduce carbon. And across the board, those investments are – result in significant demands for copper. And then you’ve got – and we’ll talk about this more, the commodity really supported by supply factors.”

Stock Opportunity – One leading company is selling for 10x earnings, an estimated 7.5x cash flow from operations with 27% return on capital and 42% return on equity.  The company has operating margins of 44% and a net profit margin of 25% with strong cash flows.  The company’s earnings and dividends are expected to grow double digits over the next few years.

Broadband Industry

What the leaders are saying – “As expected, we continue to see very high demand for data by our customers. During the quarter, non-video Internet customers used over 600 gigabytes per month, stable as of late, but more than 30% higher than pre-pandemic levels.  And today, close to 20% of our nonvideo Internet customers use a terabyte or more of data per month.”

Stock OpportunityOne leading company is selling for 12x forward cash earnings while growing earnings at 15% per year and spending all of free cash flow to buy back stock.  If the stock price were not to rise between now and 2025, the company could buy back 35% of shares outstanding and generate $110 in cash earnings per share on a $650 stock or 6x cash EPS. More realistically, should the multiple stay constant, the stock price should increase by 25-30%/year, in line with the free cash flow per share growth.

In a world that is rapidly changing, investors must recognize and appreciate the magnitude of the changes that will impact companies for many years.  It is easy to get thrown off course from a long-term investment plan by short-term factors, so be careful not to confuse speculation with investing.  Businesses that are proactively investing to redefine themselves will have a chance to compete,while those that do not will be left behind. To protect and build capital in this environment, investors should focus on the primary beneficiaries of critical secular themes in this period of significant disruption and avoid the companies that are being disrupted.  These secular themes include the continuation of technological advances and the powerful demographic shifts involving aging, automation, and inequality. Climate change has become a more actionable investment theme across all equity strategies. These themes will have profound implications for investment strategy.  Successful investing in the coming year will require a high level of conviction and insight at a time when many aspects of our lives could be experiencing significant change. 

We wish our clients and readers a happy, healthy and fulfilling New Year.

Published by the ARS Investment Policy Committee:

Stephen Burke, Sean Lawless, Nitin Sacheti, Michael Schaenen, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor.

The information and opinions in this report were prepared by ARS Investment Partners, LLC (“ARS”). Information, opinions and estimates contained in this report reflect a judgment at its original date and are subject to change. This report may contain forward-looking statements and projections that are based on our current beliefs and assumptions and on information currently available that we believe to be reasonable. However, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements.

ARS and its employees shall have no obligation to update or amend any information contained herein. The contents of this report do not constitute an offer or solicitation of any transaction in any securities referred to herein or investment advice to any person and ARS will not treat recipients as its customers by virtue of their receiving this report. ARS or its employees have or may have a long or short position or holding in the securities, options on securities, or other related investments mentioned herein.

This publication is being furnished to you for informational purposes and only on condition that it will not form a primary basis for any investment decision. These materials are based upon information generally available to the public from sources believed to be reliable. No representation is given with respect to their accuracy or completeness, and they may change without notice. ARS on its own behalf disclaims any and all liability relating to these materials, including, without limitation, any express or implied recommendations or warranties for statements or errors contained in, or omission from, these materials. The information and analyses contained herein are not intended as tax, legal or investment advice and may not be suitable for your specific circumstances. This report may not be sold or redistributed in whole or part without the prior written consent of ARS Investment Partners, LLC.


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