4 Bright Spots For Financial Advisors In An Otherwise Dismal Economic Environment

By Sumit Handa, Partner and Co-Head of Investment Committee, Pennington Partners

While Jay Powell and the Federal Reserve must choose between fighting inflation and saving the economy, as Circe warned Odysseus, the choice between Scylla and Charybdis is not easy.

In other words, there are many headwinds in front of us and unfortunately, the path for getting through them may not be easy. But while this current economic and geopolitical environment is challenging, there are many businesses that will benefit as a result. In my experience as the CIO for the City of Philadelphia and now in my role with Pennington Partners, I’ve seen firsthand how industries evolve to meet the needs of the moment. Below are some of our observations on how to interpret the current environment and the kinds of opportunities we see as a result.

Gas, Inflation, And Real Estate – All More Nuanced Than They Seem At First

Gas prices may have declined a few cents, but food prices have risen year-over-year by 14% - with egg prices rising a whopping 47%. Natural gas, which makes up approximately 40% of an average utility bill, is hovering near a fourteen year high. Some of these increases are the result of sanctions put in place during the Russian-Ukrainian War but that offers little solace for the millions of Europeans in need of Liquified Natural Gas (LNG) and does nothing to help the average American. As noted in Bloomberg, 20 million Americans (1 in 6) are behind in paying their utility bills.

According to Walmart, food inflation is double digits and much higher than it was at the end of Q1. This is affecting customers’ ability to spend on general merchandise categories and requiring more markdowns to move through inventory, particularly apparel. Some of the world’s largest consumer goods producers face a hit to sales in the coming months as shoppers switch to cheaper supermarket-owned brands to manage their cost of living.

In real estate, it appears as if the housing market may be falling apart more quickly than it did at the end of the 2004-2008 bubble. Zillow released new data that shows home prices have begun to decline more rapidly, particularly in the previously hottest markets. In Q1 2022, investors made up a record 28% of single-family home sales vs 20% in Q1 2021, according to a report by the Harvard Joint Center for Housing Studies. A large portion of these buyers were corporates, like Opendoor.com and Blackrock.

With the recent correction in both the stock and bond markets – the first half of the year was the worst performance since 1872, when the nation was still struggling from the Civil War – we are beginning to see something new under the sun as there is a reverse negative wealth effect.

With these daunting challenges, we continue to favor investments linked to pricing power and collateral-based cash flows. This viewpoint is consistent with our focus on owning pricing power stories during an era of rising inflation. 

Learning From the Past – How The 1970s Told Us to Get Long Pricing Power and Upfront Cash Flows in a Higher Inflation Environment

Investors with a long-term horizon would also benefit from looking at the following themes for value and growth:

Regionalization

In response to geopolitical matters, the Inflation Reduction Act attempts to deglobalize, which may be intelligent and necessary as well as strategic, however, it will also lead to more expensive labor, higher taxes, and stricter regulations. Thus, the deflationary winds of globalization have been replaced with inflationary sails of deglobalization. It is a theme that will be with us for a long time.

Nancy Pelosi’s recent visit to Taiwan signals the US’s intention to weaken its dependence on semi-conductors produced in Taiwan, by convincing the President of Taiwan Semi-conductor to embark on production in the US. The US has just approved a $53 bn Bill to boost semi-conductor R&D – President Biden promises it will cut costs and create jobs as well as highlights the steps towards regionalization.  Taiwan produces over 65% of global chip supply, and thus it has a monopoly on producing the most complex chips.

Both the US and China are heavily reliant on Taiwan manufactured chips.  It takes 3-4 years to build a new chip foundry –- there are critical machines to source and install. It takes far longer to acquire the expertise to run it and produce top end designs. Per NXP, a leading semi-conductor company, the industry is set to scale to $1 trillion by 2030.

Thus, the bill could lead to foundries being developed in the US, and huge investment opportunities ranging from the public markets, to infrastructure, real estate and more.

Cloud Computing

The large players today are on an approximately $160 Billion per year run rate, growing at a 30% per year clip. While growth has slowed, these providers also are spending a lot of money to grow their infrastructures, which is indicative of future opportunities. For Amazon specifically, which is the only company that breaks out their cloud results, the company’s backlog stood at a $100 Billion – up 65% year-over-year and 13% sequentially.

Cybersecurity

According to Fortune Business Insights, the global cyber security market is projected to grow from $155.83 billion in 2022 to $376.32 billion by 2029, exhibiting a CAGR of 13.4%. Meantime, recent high-level hacks on critical infrastructure - like the Colonial Pipeline ransomware attack by Russia's cyber-crime group Darkside (demanding a $4.4 million ransom) - demonstrate just how critical and imperative it is to secure digital infrastructure. Further, while the overall market is expected to grow at a 13.4% CAGR over the next 7 years, many of the leading cybersecurity companies are growing much (much) faster than that.

In 2021, an estimated $6 trillion in economic damage was caused by cybercrime, and this already astonishing figure is expected to grow 15% per year to reach $10.5 trillion by 2025 (source: Cybersecurity Ventures).

The need for robust endpoint security has also increased as a result of the widespread adoption of remote or hybrid working, with employees in many cases using personally owned devices which may have inferior security than corporate-issued equipment. Additionally, the rapid growth of Internet of Things (IoT) devices has significantly multiplied the complexity and variety of endpoints which may be vulnerable to attack — in essence, every smart device is a potentially hackable device, and it is projected that there will be 75 billion IoT devices active by the end of 2025. Of particular note perhaps is the rise of autonomous vehicles — cars, trucks, and robotaxis — a new category of endpoint that creates the opportunity for not just cybercrime but also the risk of physical harm to either drivers or pedestrians.

Software as a Service (SAAS)

Good software businesses are likely among the best types of businesses to own in an inflationary environment. They have little-to-no fixed assets - and so will not have to pay to replace depreciating capital at inflationary rates - and significant pricing power, which should allow revenues to keep pace with (if not exceed) cost inflation.

Many generate high-margin recurring revenues from their customer contracts, and so customers would have to rip the software out en masse for revenue at any vendor to decline.  Given the stickiness, this is highly unlikely. Indeed, we expect the software vendors to continue growing at healthy rates through a recession, driven by secular tailwinds of digitalization, automation, and the migration to the cloud. Certainly, all will likely grow more slowly than if a recession occurs (budgets will shrink, new sales will be harder to come by, and some small companies will go out of business, causing down-market churn to increase temporarily), but that is a far cry from more cyclical industries where companies can (and will) see material revenue and earnings declines in a downturn. We believe the FCF margins of SaaS companies will increase substantially over time through a combination of operating leverage and - especially - lower sales and marketing investment once growth starts to slow as companies approaches maturity.

In conclusion, while these are trying times, we expect volatility to continue as well as there to be carnage, we are reminded that Odysseus did reach Ithaca and regained his kingdom.