- Chip Rewey
Re-Think Supply Shocks!
Over the last two weeks, many companies including Federal Express, MMM, Sherwin Williams and Nike have pre-announced weaker than expected results for 3Q21. As would typically be expected, the share prices of these companies declined post these news announcements.* These companies were hardly alone in relating supply chain induced earnings weakness, and indeed, the market in general has lagged over the last two weeks with the S&P 500 down 1.37% from September 7 to September 24th.**
What Problem Would You Rather Have?
All four of these companies, and dozens of others, have cited very strong continuing demand, even record demand, for their goods and services, but blamed their earnings reductions on supply chain issues, mainly in labor shortages, logistics challenges and the availability and price of raw materials. Most of the management commentary in announcements followed the general theme that these supply chain shortages should not cause permanently lost sales, but rather likely push out most of the current excess demand into future quarters.
While we never like to see companies lower earnings estimates, we think the market reaction to weaker earnings as a result of supply shortages is misguided. We ask the question to you: If you could have a scenario with demand that is too strong for supply meet, or a situation where end demand is soft and supply is in excess capacity – which would you rather have? To us, the choice is obvious - strong demand is never a bad thing!
Short-Termism At Its Worst
We believe the market has become too short-term oriented, driven by the rise of quantitative investing, hedge funds and day traders. These investing styles overwhelmingly focused on a investing horizon that is 30-days or less. Thus, when a company comes out and lowers current period earnings, these investing styles tend to sell the news.
We think the negative reaction to these shortgage casued earnings adjustments are misguided. In discussing strong, or record, current demand and a likely push out of sales into 2022, we think these management teams have provided the market with higher visibility on future sales and earnings. As supply chain kinks are worked out over the next few months, end-market demand should be filled and depleted inventories levels likely rebuilt. As we focus on a 3-5 year investing horizon, we see the news announcements of likely sustained revenue strength as a positive.
Small Cap Opportunity?
We believe the 3Q-to-date underperformance of the smaller market capitalization companies vs. the S&P 500 (Russell 2500 Value index down -0.83% vs. the S&P 500 up 4.01%) is also due to the misguided interpretation of current period earnings weakness.
While anecdotal sampling, the vast majority of the smaller cap companies that we follow have also recently complained about shortages of supplies and labor that are impacting their ability to meet current demand. We believe that these smaller companies have been overly punished by the market vs. larger market capitalization companies due to more limited trading volumes and a higher level of investor neglect.
The Power of Long-Term Investing
When considering a time-horizon of 3-5 years, vs. a short-term view of 30-days, we believe the outlook for smaller companies is quite positive. We see a similar set up of easing supply chain constraints, greater labor availability and de-bottlenecking of transportation networks as supporting improved and longer duration revenue visibility into 2022. Moreover, our longer term belief (which we have discussed in previous Market Musing blogs) of rising interest rates benefitting smaller cap companies vs. providing a head-wind to larger and growthier companies, looks to further relatively benefit the group. With time as our ally, we only need to visualize the ‘if’ of when these moves will materialize over our investment horizon, and pay less attention to predicting the impossible short-term question of ‘when exactly’.
*FDX release 9/21. FDX stock down 10.09% vs. S&P 500 -2.33% 9/21/21-9/24/21. MMM comments at Morgan Stanley conference 9/13. MMM stock down 2.26% vs. S&P 500 down 0.26% 9/13/21-9/24/21. SHW release 9/8. SHW stock price down -3.65% vs. S&P 500 -1.37% 9/7/21-9/24/21. NKE release 9/23/21. NKE stock down 6.26% on 9/24/21 vs. S&P 500 +0.15%. Source: Bloomberg. We discuss FDX, MMM, SHW and NKE for illustrative purposes of larger market capitalization companies with broad exposure to the economy in general, and make no recommendation to buy or sell the shares.
**S&P Index down 1.37% 9/7/21-9/24/21. Source: Bloomberg.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index.