QPD Podcast – 2022 Risks & Positioning (part 2)
In part two of our interview with Brian Barish, he discusses the potential risks that China and Omicron pose. He also talks about portfolio positioning and three names that meet the QPD criteria.
- China continues to pose a serious risk. The country continues to face a middle-income trap and real estate bubble
- Omicron is quite infectious but less dangerous, leading to the possibility that it can blow through society by the end of the first quarter.
- Large Cap Value portfolio has a mild defensive tilt – based on individual opportunities we’ve found and not necessarily a call on the economy
Hello and welcome to the QPD Podcast. This episode is part two of my interview with Brian Barish. If you have not gotten a chance to listen to part one, please start there. In the previous show, we reflect back on 2021, and Brian provided his thoughts on inflation as well as his outlook for equity markets in 2022. On today’s show, we discuss some additional risks to equity markets and what these factors could mean. So let’s dive right in. Welcome back, Brian.
Brian, you’ve discussed recently in both interviews and blogs about the ideological changes occurring in China and the ripple effects we’ve seen in the markets. What would it take for you to become more optimistic towards investment opportunities in that country? There continues to be just a lot of volatility around China, especially their equity markets.
Yeah. The problems in China are considerable. So before you get into ideology or personalities, China faces something called the middle-income trap. It’s a very common term in developing economy analysis. Basically, it means when you get into a low five figures dollars per capita income level, so low 10,000s, the economies that are developing suddenly find themselves unable to continue to develop in the same ways and their GDP growth stalls out and they start having financial instability as a result of that. Basically, what it means at a practical level, it’s very difficult to go up the value added curve.
If you’ve been a low wage manufacturing country and that’s basically been your meal ticket, or you’ve been a commodity-driven economy and that’s been your meal ticket, you need to go to making advanced products, products that have unique properties, unique characteristics, they contain distinctive IP, essentially. That’s hard to do. It’s really hard to do if you’re a country of 1.3 billion people. So China has found themselves in that position.
Then secondly, again, independently of ideology, China does have a property bubble. We know that property bubbles are very dangerous. So you have a lot of housing that’s trading at a nonsensical relationship as compared to average per capita income levels. They’ve got a property bubble and it’s been going on for a long time. This isn’t a new development, but they are trying to pop it in some kind of controlled fashion, very difficult to do that. If you go into an uncontrolled property bubble popping, there are very distinct negative wealth effects that occur there. So those are basic challenges in terms of economic growth in China.
What has happened and what really erupted starting about this time last year is that China has taken an ideological turn as it is combating these developing economy issues. Rather than trying to support its entrepreneurial culture and its most successful entrepreneurial businesses, which it had been doing from, I don’t know, for the last couple of decades, they have decided to go with a more status and somewhat more Marxist approach to things. There is a personality cult element too. So Xi Jinping is dictator for life in China. Basically, what Xi says, you better do or you might just disappear for a little while.
So that is not a good formula for economic development. It is not a good formula in terms of, if you’re invested in blue-chip Chinese equities, you the shareholder, are you really entitled to these profits or is the state just going to come and take 50% of them away because it feels like it. If you actually look at the model that China seems to be pursuing right now. It bears more resemblance actually to fascism than Marxism where they’re not confiscating private sector business assets outright, but they’re basically saying, “Private sector assets, we’ll continue to tolerate you. We’ll continue to tolerate you as the profit maker, but you better be aligned with the state philosophically in terms of specific interests.”
That’s what’s actually what fascism was from a business perspective. So that’s just one of those bizarre history tends to rhyme situations. I think the situation is on a scale of one to 10, 10 being just absolutely horrific, it’s about an eight. It’s pretty bad.
So basically, you’ve seen blue-chip Chinese equities collapse in value as investors have to conclude they’re uninvestable. You’ve seen the chair of the SEC, Gary Gensler, basically go after the auditing practices of all listed Chinese companies and basically declare that if they don’t see changes in the auditing practices and in the auditing of the auditors, that these companies will be de-listed from the United States. The Chinese have no problem with that. They would be happy to have all their liquidity just located in Hong Kong or Shanghai and off of the New York Stock Exchange.
That kind of shortsighted mentality is wrong. There’s no reason to not want global liquidity for your biggest and most successful companies, but they apparently don’t share that perspective. So I think you’ll probably see most Chinese companies de-listed from the U.S. stock exchanges by 2023, unless there’s some kind of change philosophically. So it’s very possible that in ’22, you could see a bounce because this has been brutal, Chinese equities are down massively this year in, if the Chinese government lays off this redirecting of corporate priorities and confiscation of various elements of their profitability.
I don’t think we’ll be buying them for a bounce. To be clear, we see this as a fundamental problem where you’ve got leadership that is not accountable at this point to pretty much anybody that seems to want to go a different way. I don’t know how this gets resolved. There is a bellicose nature to it as well. If you talk to people who live in Singapore, or certainly in Taiwan, they’re nervous about what exactly China may do. So I don’t think it’d be crazy to own a few more defense stocks in the United States or even in Europe because you’re going to see countries want to spend a bit more money there. So it’s challenging, it’s a vexing issue.
Now, let’s move beyond China specifically and just talk about the international economy. So what’s been the case for really the last 15 years is you’ve got two major polls of economic growth in the world. You have the United States and you have China. China was the bigger of the two, not that the Chinese economy is bigger, but that you had more growth emanating from China.
So if China looks like they’re not going to grow very much, we’re not saying they’re going to just disappear into some black hole or something, it just may not grow very much, and in particular may not grow in the property sector very much because the last thing they need is more apartment buildings right now, that has pretty strong implications for certain kinds of commodities like iron ore for energy consumption, those are all areas that we would be very circumspect about the sustainability of demand levels. Beyond that, China’s been a big source of demand for European car brands, for luxury goods, for technology products.
There’s a darker version than even what I’m saying right now, which is they could start to shun all Western brands. I’m not ready to go there yet. I’m not sure that Xi Jinping is ready to go there yet. I don’t think he wants to outfit everybody in Chairman Mao suits again. But that’s if you want to go dark, that’s what dark looks like. That would be very bad for all kinds of major companies on the stock market. But I don’t think so. But as I understand it, the Chinese look at the difference between President Biden’s approach to China versus Donald Trump, as Biden is no different from Trump, he just uses better language. So they see it in their own terms as we are not friends. We might coexist with each other, but we’re not friends either.
So it’s a challenging situation. What we think right now is so for all that negativity, right, that was a lot, China is run by an unelected government. Part of the pact that unelected government has with its people is we will help you to advance, and as long as we’re doing that, you basically put up with us, right? So if it starts to feel to the everyday man in China, I’m not getting anywhere here, I think I’m going backward, then that legitimacy question becomes a more powerful issue. I don’t think the communist leadership wants to fully go there.
Think about the words I just said, I don’t think the communist leadership wants to go there. I’m saying that I think I can understand the mind of a communist party apparatchik, and I can’t actually. I can’t get my mind in there. So there’s elements to this that we just cannot predict.
Great. Thanks. So I’d be remiss if we didn’t talk about COVID. The new Omicron variant is grabbing a lot of headlines. It’s been impacting markets more recently. So just like to get your thoughts just on where we stand with that, potential risks with it as we move into 2022.
Sure, sure. So we’ve had two subsequent waves of COVID from the initial wave. One being Delta and Delta was very deadly, right? It was both very easy to infect other people and now we’ve got… Omicron is still building as we speak. So I’m not a medical person, but we’ve all become kind of closet epidemiologists through this. So as we understand it right now, and it’s just before Christmas, so more data will be coming out quite extensively in early January, Omicron looks to be somewhere between 50 and 80% less likely to land you in the hospital if you’re unvaccinated and probably pretty close to 100% less likely to land you in the hospital if you are vaccinated.
So the reason is that the virus itself seems to infect your bronchi, so your passages that you breathe through but not the actual air sack in your lungs, or at least not the same way as Delta and other variants did. So if a virus that affects your bronchi, you get bronchitis which is annoying. You cough a lot, but you don’t die, right? Whereas if you get your air sacks infected, you get pneumonia and pneumonia is potentially lethal, and also it’s very easy for the virus to get into your bloodstream there and infect other organs so that’s where some of these long COVID issues come from.
So it looks less bad and that’s actually consistent with how viruses tend to evolve, where they become less lethal but more infectious. Now, here’s something that’s kind of interesting. I want to leave a bit of optimism here. So what you do see with most viruses, and this has certainly been true with COVID, is that when a virus mutates and becomes more transmissible, so it’s evolutionarily speaking has an advantage, that advantaged version of the virus tends to outcompete all preceding versions of it.
So that’s what happened with Delta. So by early November 2021, wherever you looked in the United States, East Coast, West Coast, Midwest, practically 100% of cases were Delta. It wiped out the original COVID, the Alpha variant, that Beta variant, all these other Greek letter variants. Omicron is even more infectious than Delta, just requires fewer particles evidently to get in you to give you an infection. It’s very rapidly going to go to 100% of infections will be Omicron.
That’s really interesting because it will basically render extinct these other versions yet it’s a lot less lethal. That also means that subsequent mutations, subsequent versions of COVID, and I’m sure there will be that, will be children of Omicron, right? So they may be even less lethal yet and you’ll have some built-in immunity. I think we’re all going to have to get used to the idea that we’re going to get Omicron, that basically it’s so infectious that the vaccine which were designed to handle the original wild type version of COVID, they’re effective in terms of triggering your immune system to fight it, but not effective enough to prevent particles from landing in your air passages and getting to proliferate.
So we’re all going to have to get used to it. I don’t want to sound like a red state governor per se, but it’s probably better to just let it all happen and not try to do all these closures of public facilities and things. It’s just not going to work. We’re all going to get it anyway. I understand where they’re coming at from. From a medical concern perspective, you don’t want to blow through the hospitals and the hospitals’ capacity to treat people. What it appears to be is that Omicron is so damn infectious that we’re all going to get it. We’re all going to get it by the middle of February and it’s just going to kind of blow through humanity in the first quarter.
If that’s all true, if everything I just said is true and it’s still a lot of gaps in the knowledge here, you could really be in a we’re not having to deal with this stuff anymore by the end of the first quarter. That would be the very optimistic… I don’t think it’s like a plus two Sigma event probability. I think that’s actually a reasonable probability that it just blows through everybody.
The world’s not going to be the same. Business conferences are not going to be the same. Tele meetings are here to stay. Work from home in some capacity, probably here to stay. But I think we’ll be less concerned, a lot less concerned about getting in the hospital or not having hospital beds available and all that business by the end of the first quarter.
Brian, over these two episodes, you’ve laid out some potential risks that could affect markets in 2022, whether it be the fed’s action as it pertains to interest rates, China and Omicron or any future variant of COVID. As the PM of the Cambiar Large Cap Value portfolios, how are you positioning the portfolio to manage through these potential hurdles?
Sure. I would say that we have a very mild defensive tilt. It’s not a call on the economy or rates or some other macro factor. This is just where the opportunities have landed. So we were over the course of 2021 net sellers of technology because the stocks just did really well. We were over the course of 2021 net sellers of industrials, again, because the stocks tended to do very well. We have been very conservatively positioned with respect to commodities and basic materials. Admittedly, that probably cost us some returns in 2021. But given a rapidly decelerating economy, which we’d see in 2022 and a lot of these bottlenecks clearing up, we don’t think that’s a particularly attractive place to be positioned.
Conversely we’ve found attractive stocks in the consumer space. Healthcare does look interesting to us right now where we’re kind of trying to pick our spots there. If you wanted to get super defensive, you could triple down on utes (utilities) and healthcare and things that have very little cyclicality. That is not a strategy that we are employing with respect to financials, which is always a big sector for value-oriented asset managers. We own some banks and we own some interest-sensitive names, but we aren’t super exposed to that as a driver. We think banks already embed higher interest rate assumptions and you’d need interest rates to go a lot further than they currently are to push the banks higher yet.
So that’s how we’re positioned. We do think you will have a lot of opportunities as the year unfolds and as risk premiums are reintroduced into stocks. They were clearly very compressed. You’re going to have very nonlinear earnings performances that will probably flip some people out and lead to some reactive selling and we think there’ll be some opportunities created by that. That’s loosely how we’re positioned.
You’ve discussed a number of themes that are influencing your portfolios. Maybe talk a little bit about some specific stock names that look more interesting to you given the environment.
Sure. So let’s remember, the starting point is we’ve had three above normal years in a row in terms of the stock market. The overall stock market trades at 22 times forward earnings. That’s a high valuation level. There is some cyclical upside, some degree of under-earning by some companies at least, but the overall earnings level is high. So you got to kind of pick your spots.
So I’ll be talking about three names. So the first stock that I would highlight is Sysco, not the networking Cisco. This is the other Sysco. They are in the food supply and distribution business, mostly for restaurants and other larger venues. This is a stock that got hammered due to the pandemic and people not being able to eat out at all. That’s gradually shifted and lots of restaurants became effective at doing online delivery and things like that and their markets have recovered, but not all the way.
So what’s interesting about Sysco, and this is true for other businesses where you have only a couple of major distributors that dominate the market, is that the distributors actually have a lot of power relative to their customers and also relative to their suppliers. That translates into being able to capture pricing both in terms of pricing the end products to the restaurants, as well as being able to play their suppliers off of each other. So we think if we have indeed an inflation bulge that persists, in other words, inflation of 10 to 15% over this pandemic period and then we kind of get back to something a little more restrained, they may capture a lot of that profitability.
What’s also kind of cool about it is it’s a cyclical name right now because we’re still not yet at a fully reopened level. But if we do get to where this becomes endemic versus pandemic and we stop worrying about this and shutting things down and all that, it actually is a very defensive name. So there’s really no reason to rotate out if you feel like defensive names would be in play. It will become stealthily a defensive name. So I think that’s kind of interesting. So that’s one stock.
Another name also in the consumer space that I’d like to highlight is a company called Constellation Brands. So Constellation through a little bit of its own creativity and a little bit of dumb luck managed to have full control over the distribution of all the Modelo Group brands. These are Mexican beer brands like Modelo, Corona, Pacifico, other ones. They’ve done very well with this. This seems to be a growing trend not just because the Hispanic demographic is a growing demographic, but people just like the beer. So this is a stock that was pitched early in the third quarter and I didn’t buy it for a couple months. I just kind of thought about it for a while.
The reason is you don’t want to fight headwinds that you don’t really think you are going to go away. So the headwinds in this case for beer have been that spirits and wine have been growth categories and they’ve been taking share from beer. You’ve also had this phenomenon of craft breweries, though imports seem to be able to avoid that phenomenon. Then secondly, more recently, you’ve seen this explosion in hard seltzers, so flavored type of seltzers that were also taking share from beer. I thought, “Well, I don’t want to really fight these trends. These guys have good volume growth trends, but these overhead factors are concerning.”
As time wore on, it became evident that the hard seltzer fad is mostly that. It’s mostly a fad. I don’t think demand trends from 2021 and 2020 are likely to endure. So hopefully Constellation manages to continue to grow. So it’s an interesting test kitchen stock. I don’t think this is the highest upside name in our portfolio by any stretch of the imagination. But what’s interesting about it is that they have brands that people definitely seem to like. You’ve seen in other, whether it’s beer company stocks or even just consumer businesses at large, blue chip consumer stocks have become a challenging place to operate.
What you’ve seen is their competitive moats have shrunk. This is due to a variety of factors. It’s much easier to start challenger brands online. It is much easier to promote them online. It’s less easy for these big companies to kind of control the market the way that they used to. So I think it lies at an interesting intersection of consumer trends and overall business trends. There is a scarcity these days to consumer businesses that are at scale that can grow visibly. We think they can. Those kinds of businesses tend to attract I’d say medium-high multiples. So kind of low twenties PE multiples are about right.
You do see for competitors like AB InBev, that’s Budweiser nowadays, and Molson Coors. They trade at very low multiples. So like low teens, but that’s not necessarily a sign that they’re attractive. These are companies that are having a very hard time growing their volumes. If anything, their volumes tend to contract. They also are highly leveraged due to a lot of cumulative M&A. So even though the stocks, the underlying businesses are not particularly volatile, the stocks are volatile and risky because you’ve got so much leverage on them. So we have not been comfortable pursuing those.
Let me highlight one final stock that we get a lot of questions about, like Guy says, “Are you sure you’re value investors here? What are you doing?” and that’s Uber. So we bought Uber deep in the pandemic. This was in I think the early third quarter of 2020. We’ve continued to own it. We’ve traded around it a little bit. So let’s try to understand a couple of things, how does a value manager find themselves in these kinds of stocks. We in general have had some fairly good success owning internet platform businesses that have been loss-making that are on the cusp of becoming profitable.
Once they’re profitable, a whole new range of investors are willing to look at it. Oftentimes, the move from not so profitable to profitable is totally within management’s control, they just stopped spending money on silly things. That was the case with Uber. They were investing in flying taxis and rockets and things that really made no sense. So that’s one basic thought.
The second thing is that there are a lot of internet platform businesses that are enabled by technological developments that just simply were not in place not that long ago. So in the case of Uber, you’ve needed smartphones that have a GPS capability. That really didn’t exist prior to about 2010, at least in a wide form. They solved clear and obvious logistical challenges like flagging taxis and just hoping one drives by you that’s got its flag up instead of down. There’s a lot of obvious adjacencies like food delivery, last-mile delivery for physical goods. There are probably others that I haven’t really been able to think of.
Last is let’s focus on market structure and profitability. So Uber generates gross margins in the high fifties. We think they’re capable of doing a little bit higher than that. It trades at a multiple of market cap or enterprise value to gross profit that’s of six times. That’s generally about a floor for internet businesses that are not losing money. If you look at other highly visible stocks like Google and Microsoft, Google trades for about 11 times gross profit, Microsoft, which is not totally an internet stock, it’s more software and an internet hybrid these days, that trades for about 18 times gross profit. So there’s a pretty big spread that Uber could trade up into.
From a market structure point of view, this is a classic liquidity-driven marketplace. There are more customers for Uber because there’s more drivers and there’s more drivers for Uber because there’s more customers. So it’s very self-reinforcing. That is very typical among internet types of businesses. It leads to a market structure that is durable. These gross profits should endure in the longer term. So Uber traded off late in the year mostly on the Delta and subsequent Omicron variants. We think it should do well whether the pandemic ends in the first quarter, if we have subsequent waves that require mitigation, we think it does well. But it’s an interesting name, just becoming profitable and this will trigger hopefully some new investment capital into it.
Great. So Cambiar employs a quality price discipline approach, or QPD as we call it. Why do you think the QPD process is important in the type of market conditions we’re going to get in 2022?
I think it’s very important and it’s a good question. So QPD is an evolution of a relative value style. What we’re looking to do is clamp down on two very discreet risk factors. So one is financial leverage. So that’s the capital discipline part. We just don’t like highly leveraged companies. We really never have. Secondly, we like to buy companies that have good margin structures, so a lack of margin variability. So we think those two factors alone should be beneficial given what we are sailing into in 2022 and beyond.
The quality part, quality is admittedly a generic term that is used by asset managers. What we mean by quality are companies that are able to extract economic rent from the industry sector that they occupy. That’s generally measurable in returns on capital, but it’s going to be due to factors that are more company-specific. So the kind of products that they sell, the kind of market structure that they participate in, those are the things that lead to an economic rent being possible and consistent and reliable.
So in a market where risk premiums are rising, where you’re going to have a lot of margin variability, do we know where the fed is going to stop? No, we don’t know where the fed is going to stop and where this all bites. We think these are all factors that are going to be very important. So in a year like 2021, where you have buoyant liquidity and very constrained economies on the supply side, the merits of this are not as clear because you’re able to see some big earnings performances from businesses that probably aren’t capable over a cycle of extracting economic rents. But we think that there’s a fairly strong probability that that flips around over the course of 2022 and you start seeing the merits of this shine through.
Great, Brian. That’s really interesting. I think there’s a lot of variables at play for 2022, and I, for one, am looking forward to seeing how things play out. Brian. I really appreciate your time today.
To all of our listeners, thank you for tuning in. If you’re looking for more information about the blogs or awards we mentioned earlier in the show, please visit Cambiar.com. Happy new year to everyone and until next time. Take care.
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