May 20, 2022

Review and News

Meals shares defy the downtrend

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Good morning. Another ugly one yesterday. The big news was the April CPI report. It was disappointing rather than horrible. The most important point was that, on a month-to-month basis, goods prices were flat, while service prices continued to rise. More proof that inflation has dug in even in places where broken supply chains do not reach. In a tweet, the economist Jason Furman provided a crystalline chart of the problem:

Despite the poor news on inflation, the two-year Treasury — which tracks expectations for the policy rate — only inched up. Long bond yields fell, and stocks did too. The message from the market is increasingly clear: the Fed is not going to have to tighten very much before economic growth grinds to a halt.
Meme stocks such as GameStop, bitcoin and at least one “stablecoin” — a crypto token pegged, in theory, to the dollar — kept falling Wednesday. Apes together are not strong enough, it turns out. Ethan will have something to say on this when he returns, but he has a cold. Email us: [email protected] and [email protected]
Taking shelter in food
We noted on Tuesday that in the midst of the equity rout, a group of consumer staples companies — the very staple-est of them — was holding up well. Food companies make up the core of that group. Campbell Soup, for example, is up 8 per cent in a month. Canned soup! Part of the reason the packed-food group is interesting now is that it has outperformed the index massively for years. A chart of some of the big names:

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As you can see at the far right of that chart, the performance gap with the S&P 500 (the darkest blue line) has closed a lot in recent weeks. Is there still value to be found in the group? A chart of forward price/earning ratios over the past year is as good a summary as any of how the stock market has changed in 2022:

Most of the group (barring relatively fast-growing Mondelez) was trading at a 50 per cent discount to the index in January. That gap has closed.
The tricky thing is that although food companies are paradigmatically defensive, their profits are also very exposed to inflation. Here is a table of growth in revenue and operating profits in the past 12 months:
With input costs rising, this is not an easy time to be a food company. This was evident in the companies’ first-quarter analyst calls. Here, for example, is Kellogg, talking about its outlook for the rest of the year:

We are raising our forecast for organic basis net sales growth to about 4 per cent growth versus our previous estimate of about 3 per cent. This reflects the momentum in our business and the fact that price/mix is likely to come in higher than we previously planned as we seek to cover incremental cost inflation. This higher net sales should offset the incremental pressures of accelerated cost inflation and supply disruption. As a result, we continue to focus currency-neutral adjusted basis growth of 1 per cent to 2 per cent in operating profit.

Pushing hard, in other words, for 1-2 per cent profit growth. A similar tune was played by the others. Investors are not buying food stocks because the companies can grow even in a downturn. They are buying them to preserve capital.
Margins redux
Last week we pointed out that the valuation of the S&P 500 looks deceptively low, because Covid-era margins are unnaturally high. And margins seem very likely to fall. Ian Harnett of Absolute Strategy Research suggested to me that smaller companies generally suffer margin contraction first; they have fewer levers to pull to maintain profitability when inflation rises and competition starts to heat up. He turns out to be right. Here are operating margins at the large-cap S&P 500 and the small-cap S&P 600. For the little guys, margins returned to pre-pandemic levels this quarter:

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If you look at other measures of profitability, such as return on equity, you get a similar picture. In this context, it is worth looking at the monthly small business survey produced by the National Federation of Independent Business. Respondents’ expectations for better business conditions over the next six months are at their lowest in the 50-year history of the survey:

The crucial question for profitability in an inflationary environment is whether customer demand is sufficient to absorb higher prices. The NFIB survey may reflect acute anxiety on this front.
One good read
A very good, data-rich discussion of America’s housing shortage (hat tip to Matt Klein for pointing it out).

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