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


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

While Jay Powell and the Federal Reserve must choose between fighting inflation and bailing out the economy, as Circe Odysseus warned, choosing between Scylla and Charybdis is not an easy one.

In other words, there are many headwinds ahead and, unfortunately, the path to overcome them may not be easy. But while this current economic and geopolitical environment is challenging, there are many companies that will benefit. In my experience as CIO for the City of Philadelphia and now in my role at Pennington Partners, I have seen firsthand how industries are evolving to meet the needs of the moment. Below are some of our observations on interpreting the current environment and the resulting opportunities.

Gas, inflation and real estate – all more nuanced than meets the eye

While gas prices are down a few cents, food prices are up 14% year over year — with egg prices up a whopping 47%. Natural gas, which makes up about 40% of an average electric bill, is hovering near a 14-year high. Some of these increases are the result of sanctions imposed during the Russo-Ukrainian war, but that offers little comfort to the millions of Europeans who need liquefied natural gas (LNG) and doesn’t help the average American. As Bloomberg noted, 20 million Americans (1 in 6) are behind on their utility bills.

According to Walmart, grocery inflation is in the double digits and much higher than at the end of the first quarter. This affects customers’ ability to spend on general merchandise categories and requires more discounts to move through inventory, especially apparel. Some of the world’s largest consumer goods makers are set to face a drop in sales in the coming months as shoppers switch to cheaper supermarket brands to control their cost of living.

In real estate, the housing market looks set to fall apart faster than it did at the end of the 2004-2008 bubble. Zillow released new data showing house prices have started falling at a faster rate, particularly in what were previously the hottest markets. According to a report by the Harvard Joint Center for Housing Studies, investors accounted for a record 28% of single-family home sales in the first quarter of 2022, up from 20% in the first quarter of 2021. A large portion of these buyers were companies like Opendoor.com and Blackrock.

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

Given these daunting challenges, we continue to favor assets associated with pricing power and collateral-based cash flows. This view is consistent with our focus on having pricing power stories in times of rising inflation.

Learning from the Past – How the 1970s told us to preserve long pricing power and upfront cash flows in a higher inflation environment

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

regionalization

In response to geopolitical issues, the Anti-Inflation Act seeks de-globalization, which may be smart and necessary, as well as strategic, but will also result in more expensive labor, higher taxes and stricter regulations. Thus the deflationary winds of globalization have been replaced by inflationary sails of deglobalization. It is a topic that will stay with us for a long time.

Nancy Pelosi’s recent visit to Taiwan signals the US intention to reduce its reliance on Taiwan-made semiconductors by convincing the President of Taiwan Semiconductor to start manufacturing in the US. The US just passed a $53 billion law to boost semiconductor research and development – President Biden promises it will cut costs and create jobs, while highlighting moves toward regionalization. Taiwan produces over 65% of the world’s chip supply, giving it a monopoly on manufacturing the most complex chips.

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Both the US and China are heavily dependent on chips made in Taiwan. It takes 3-4 years to set up a new chip fab – critical machinery needs to be procured and installed. It takes much longer to acquire the expertise to operate and produce top notch designs. According to NXP, a leading semiconductor company, the industry is projected to grow to $1 trillion by 2030.

Thus, the bill could lead to the development of foundries across the US and huge investment opportunities ranging from the public markets to infrastructure, real estate and more.

cloud computing

The big players today have an annual run rate of about $160 billion and are growing at 30% per year. While growth has slowed, these providers are also spending heavily to build out their infrastructures, hinting at future opportunities. Specifically for Amazon, which is the only company to disclose its cloud results, the company’s backlog was $100 billion — up 65% year over year and 13% sequentially.

Internet security

According to Fortune Business Insights, the global cybersecurity market is expected to grow from $155.83 billion in 2022 to $376.32 billion in 2029, at a CAGR of 13.4%. Meanwhile, recent high-level hacks of critical infrastructure — like the Colonial Pipeline ransomware attack by Russian cybercrime group Darkside (demanding a $4.4 million ransom) — show just how important and compelling it is it is to secure digital infrastructures. While the overall market is expected to grow at a CAGR of 13.4% 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 staggering number is expected to grow at 15% per year, reaching $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 work, where employees are often using personal devices that may be less secure than corporate-owned devices. Additionally, the rapid growth of Internet of Things (IoT) devices has vastly multiplied the complexity and variety of endpoints that can be vulnerable to attacks — essentially, every smart device is a potentially hackable device, and predicted to be 75 billion IoT devices will be active by the end of 2025. Perhaps most notable is the rise of autonomous vehicles—cars, trucks, and robo-taxis—a new category of endpoints that not only create the opportunity for cybercrime, but also the risk of physical harm to either motorists or pedestrians.

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Software as a Service (SAAS)

Good software companies are probably among the best types of companies to own in an inflationary environment. They have little to no fixed assets — and therefore don’t have to pay to replace falling capital at inflationary rates — and significant pricing power, which should allow revenues to match (if not exceed) cost inflation.

Many generate high-margin recurring revenue from their customer contracts, so customers would have to rip out software en masse for revenue to drop at each vendor. Given the stickiness, this is highly unlikely. In fact, we expect software vendors to continue to grow at healthy rates during a recession, driven by the continued tailwinds of digitization, automation, and migration to the cloud. Sure, all are likely to grow more slowly than they would in a recession (budgets will shrink, new sales will be harder to come by, and some small businesses will go out of business, leading to a temporary increase in market churn), but that’s so far from it more cyclical industries where companies can (and will) see significant revenue and profit declines during a downturn. We believe that over time, through a combination of operational leverage and – specifically – reduced sales and marketing investments, SaaS companies’ FCF margins will increase significantly once growth slows as companies near maturity.

In summary, we expect continued volatility and carnage during these trying times. We are reminded that Odysseus reached Ithaca and reclaimed his kingdom.



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