As Rates Rise, the Old Economy Has Its Revenge

About the authors: Robert Robotti is president and chief investment officer of Robotti & Co. Advisors. Douglas Meehan is deputy chief investment officer at van Biema Value Partners. Michael van Biema is the firm’s founder.

Among purported investing axioms with enormous pull on capital flows in recent years are the ideas that low inflation and interest rates are sustainable, and that stock-picking doesn’t work. Both would seem to signal the extinction of a substantial set of fundamentally driven investment approaches.

But these axioms are suspect. The myopia of linear thinking has resulted in a broad misalignment of risk and return that is poised for change. Appreciating this requires recognition that the post-global-financial-crisis investment environment has been anomalous and is unsustainable.

The Federal Reserve signaled on Wednesday that it will soon be ready to begin raising rates. It has not meaningfully done so since the 2008 crisis. A frantic quest for yield has pushed investors into longer-duration assets, such as growth stocks, driving multiples to dangerous levels. Even fundamental investors bought in. These businesses are secular growers, collecting eyeballs, clicks, and subscriptions regardless of low broader economic growth. Their growth seems unstoppable, and therefore these investments appear to be safe and attractive. In capital markets, growth is its own reward; profits can come later, or so it’s assumed. But that view has driven valuations to levels that make fundamental sense only if that growth is actually sustainable.

Investors have become comfortable applying lower discount rates in valuing companies, and valuations predicated on substantial future growth are highly sensitive to the rates used. Discount rates take their lead from yields on “risk free” investments, i.e., Treasuries. Enduring low rates have therefore enabled investors’ rationalizations of high valuations.

But arguably, low rates persisted because they failed to drive growth and, crucially, inflation. Markets appear perplexed now that inflation has arrived. It may not dissipate even when supply-chain disruptions end. One key is China.

Declining rates made sense after taming the hyperinflation of the 1970s, but that decline persisted. Interestingly, the onset coincided with China’s dramatic economic reforms under Deng Xiaoping. Those reforms encouraged private investment with the aim of transforming an agricultural state into a modern economic superpower, a goal clearly achieved. China’s economy has grown at an average 9.3% rate since reforms began.

China’s economic miracle depended on its ability to produce goods for overseas consumers at lower cost, largely due to cheap labor. Increased Chinese exports of low-cost goods effectively deflated global prices, preventing global inflation from taking hold, despite low rates. But China-induced deflation was bound to eventually wane. This trend is clear in the prices that Chinese producers are paying for inputs, with the producer price index up 10.3% year over year in December.

At the center are soaring Chinese energy costs, driven by increased demand in China and elsewhere. China has become the world’s largest carbon emitter, a problem that its government intends to combat by building out clean-energy power sources, among other strategies. But that itself will require massive amounts of energy, which in China means burning more expensive coal. Narrowing China’s wealth gap will require a continuous infrastructure buildout, requiring enormous quantities of broadband cable, steel, and cement. So, China will consume more of the materials it produces, and fewer Chinese goods will reach our shores to affect our producers’ prices and margins. It’s difficult to see how curing the pandemic-induced supply-chain ills will suddenly restore China’s deflationary influence.

The capital-market implications are significant. Today’s interest rates seem to imply that inflation is transitory. A sub-2% 10-year Treasury yield is senseless if long-term inflation will run at 2% or more. If inflation persists beyond supply-chain disruptions, interest rates will rise. What happens to asset valuations when you shift their underlying foundations?

When rates rise, investors with significant exposure to longer-duration assets—growth stocks—should worry. If they do, they will probably pull some of that capital from those richly valued growers. They wouldn’t have to rotate much out of a handful of trillion-dollar stocks and into other opportunities to make a significant difference.

As many value investors have shown, it doesn’t require steady 30% top-line growth for 15 years to make for a great investment. Buying even moderately growing businesses at discounts to what they’re worth simply because sellers don’t recognize their values provides both a margin of safety and upside potential, regardless of growth. Such opportunities sell for low multiples of near-term cash flows, not just cash flows expected sometime in the future. They are shorter-duration assets, so rising rates shouldn’t affect them as dramatically as they affect investments reliant on distant-future growth. So, lower-multiple stocks are defensive under conditions in which rates are more likely to rise than fall; in other words, if substantial inflation persists. Many are selling at substantial discounts and should make for lucrative long-term opportunities.

There exists a particularly attractive subset of these cheap businesses that we believe will probably benefit from a new economic order characterized by growing demand for the limited supply of physical goods they produce: well-run, well-capitalized U.S. businesses with operating leverage, producing physical goods in high demand—such as specialty chemicals, steel, and building materials—enjoying competitive advantages from sustainably low costs (despite inflation) and limited supply. That is, we predict a revenge of “old economy” businesses, long left for dead but in fact producing materials of paramount importance.

Even an advanced service economy such as the U.S. depends on physical goods, and select producers will benefit disproportionately and, we believe, represent tremendous investment opportunities. The long-awaited infrastructure law earmarks $1.2 trillion for physical construction projects requiring physical inputs, such as steel, cement, coatings, wire, and equipment. Additional demand will come from ramping auto production after its chip-shortage-induced decline, and increasing demand for renewable power. Wind and solar farms require chips, installation equipment, steel, epoxies, and chemicals.

Meanwhile, industrial supply is constrained. Take steel production. Although U.S. mills enjoy low-cost, low-carbon advantages, we still import steel. Moreover, the U.S. steel-making industry has consolidated to an oligopoly of four participants, suggesting pricing power.

Even if China increases exports, U.S. manufacturers are competitive, low-cost, low-carbon providers. This may seem odd, but points to a key element of our thesis that U.S. producers of physical goods benefit from a world with sustained inflation: Whereas energy costs have skyrocketed in China and elsewhere, U.S. energy prices remain cheap. That confers a huge advantage to energy-intensive American industrial businesses.

The chloralkaline industry further illustrates this. It produces two commodities: chlorine (used to manufacture intermediates for plastics production and end-products like PVC) and caustic soda (for detergent production and with critical industrial applications). Energy constitutes a whopping 80% of the variable costs of the chloralkaline process, making U.S. producers by far the lowest-cost developed-market source, with costs far below those of Chinese peers.

Most will doubtless find the prospect of investing in chlorine and caustic soda production as alluring as investing in record stores or photo film. Something so rudimentary as industrial chemicals would seem to be highly cyclical and therefore absurdly unattractive.

Relevant facts suggest otherwise. The chloralkaline market has consolidated to three players addressing roughly 70% of demand. Moreover, they’ve become leaner and more rational, focusing on returns, not on outproducing their peers. They now produce to match demand, replacing the time-honored practice of going full-bore to leverage costs over increased production. This nimble approach places power in the hands of these producers at just the right time and in a sustainable, nontransitory way.

This all recommends investing in U.S.-based industrials and materials producers. If China, reversing a four-decade trend, is now poised to export inflation, and if demand for physical goods is growing, the operating leverage of these businesses will kick in, resulting in substantial, sustainable, and growing free cash flows.

Still, buying a broad basket of statistically cheap producers could have suboptimal results, saddling portfolios with many investments deserving their low valuations. Finding those companies with the strongest competitive positions, best operations, and greatest capital allocation opportunities that are managed by skilled, savvy capital allocators with proven records of shareholder value creation is critical to maximizing this opportunity. This suggests that experienced, disciplined, fundamental stockpickers will have a tremendous advantage.

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