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US shares: How to cope with inflation

The combination of historically high inflation and a now activist Federal Reserve are causing havoc for US stock market investors
US shares: How to cope with inflation

Having flirted with a possible bear market for the past three months, the S&P 500, along with the Nasdaq, is now firmly in that territory. Investors have taken fright at the combination of rising prices and interest rates increases, with a newly hawkish Federal Reserve resurrecting the ghost of legendary chief Paul Volcker and making its largest single rate rise, of 0.75 per cent, since the early 1990s. That pretty much rules out the possibility of a soft landing for the economy, hence the stampede from equities into cash, with the possibility of better returns for holding cash on deposit. But the paradox for investors is whether any of this really makes any difference to their underlying strategies. Certainly, for our approach, a market rout merely means the opportunity to buy quality shares at cheaper prices.

The Eagle has landed

One advantage of the overall market fall is that it starts to bring companies within reach that had previously traded at relatively high multiples. The 'down draught effect' has brought a couple of interesting companies into view that are worth investigating in more depth.   

In terms of our US portfolio, we had to do some housekeeping after the acquisition of media and digital company Tegna (US:TGNA), which yielded a roughly 12 per cent profit on our buy-in recommendation. Tegna’s disappearance has left a space for a new entrant and our new company, Eagle Materials (US:EXP), encapsulates some interesting economic trends that could work in investors’ favour this year. In short, when inflation is high, inventory and cash margins are both very important in balance sheet management and our new pick has elements that could benefit from an inflationary economy.

Like most building suppliers, Eagle experienced a sugar rush of orders once the impact of the pandemic subsided. The increase in construction from an enforced pause was a boon for the company, which makes and distributes cement and gypsum plasterboard for a range of construction projects. Working on top of a largely fixed cost base, and with inventory built up during the pandemic lull, Eagle's high levels of operational gearing helped operating margins increase to a high of over 25.4 per cent, compared with the five-year average of 21.5 per cent, which meant that return on capital employed was 60 per cent higher than average at 16 per cent. The company also bought back $595mn (£484mn) of its shares at the last full-year results.

That performance wasn’t enough to arrest the slide in the share price since the start of the year, a move which encapsulates the worries that are dragging down the overall market. But while inflation is upper most in people’s minds, it is important to distinguish how this affects different segments of the economy. In base materials, the primary input costs are energy and distribution, and fears that rising costs of both would drag down margins at companies like Eagle are behind the sell-off. In short, investors believe that the combination of a lower demand for cement products as the US housing market comes under pressure from higher interest rates, combined with increased operating costs, will place margins under pressure. Hence the discount applied to the company’s share price.

Arguably, that negative view flies in the face of the facts.

Unlike commoditised businesses – garden furniture makers, as a random example – base materials have much greater scope to pass on price increases. How many cement makers can set up shop at short notice, and how much does the price of cement affect the building cost of a house? While certainly (and literally) a material cost, it isn’t a defining one – unlike the cost of land, for example, which gives producers an element of pricing power. In Eagle’s case, it has been able to pass on mid-year cost increases across its key cement markets, with a further round of price increases expected in July. Eagle sells most of its product in Texas, where it is also the major producer, but traditional growth states like Florida, California and South Carolina are also big customers. To meet that demand, the company has hedged about 30 per cent of its natural gas needs for the year ahead and purchased all its energy requirements for the coming year – although admittedly at far higher prices than last time. In essence, it has a year’s grace before the next round of energy price negotiations.

The biggest problem will be the direction of construction in the US once the unsustainably high house market bubble is punctured by rising rates. No one can say for sure what will occur, but the best forecasts are for a slowdown running into 2023-24, with more muted construction activity. 

 

Inventory mathematics and interest rates      

However, there is still a sense that inflation fears are difficult to quantify when the current generation of investors do not really understand the impact of this on company performance; most people’s memory of inflation’s impact dates to the early 1990s and even that was relatively mild compared with the 1970s.

The key point is that companies who can build inventory have an advantage when it comes to hedging their overall costs. In essence, high inflation subsidises the cost of holding inventory because it outstrips the cost of capital used in acquiring inventory in the first place. By over-ordering inventory at this year’s price, there is a revaluation gain in next year’s balance sheet. It is an effect that is currently visible in even the smallest sole trader enterprises. 

This brings us back to Eagle. While the company has net debt of approximately $955mn, on which it paid approximately $31mn in interest at the last results, that amount is covered nearly 15 times by Eagle’s Ebit income of $475mn. So, in a sense, the danger for Eagle is not from higher input costs, which it seems more than able to pass on to its customers, but from higher interest rates pushing up its cost of capital.

To that end, reducing interest rate risk was the likely motivation behind the recent news that Eagle had replaced a $350mn tranche of its long-term 4.5 per cent senior notes. New debt carries a coupon of 2.5 per cent and will mature in 2031. Overall, that has helped to reduce its total debt pile by $61mn to $950mn – and high inflation in the interim will erode the carrying value of the debt to Eagle’s advantage if its interest rate burden does not rise significantly. Considering the level of the new coupon that is unlikely to be an issue until the next round of refinancing in nine years’ time.   

In essence, in inflationary times, defending the margin and managing the balance sheet are far more important than chasing revenue growth.

 

The best of the rest

The preponderance of finance companies, with some additional technology-based companies, means the portfolio’s performance has taken a beating since the start of the year, recording a 17 per cent decline. That is still better than the 23 per cent fall for the S&P 500 but it is painful, nonetheless.

However, there have been some interesting performers, and the 30 per cent year-to-date gain for CDK Global (US: CDK), which produces integrated software-as-a-service for car dealers globally, is a standout performance compared with the usual share price carnage that the technology sector has produced this year.

US SHARES PORTFOLIO SIX-MONTH UPDATE
TIDM NamePriceMarket Cap ($mn)ROCE (%)PEGEarnings yieldGross gearing (%)Price to NAV%chg YTDPE
ALSN Allison Transmission Holdings $38.09

3,654.00

16.80.210.8396.564.79.3
APAM Artisan Partners Asset Management $34.06

2,747.00

80.8-14.8108.58.2-28.56.8
CDK CDK Global $54.27

6,337.00

191.54.7331.413.73021.1
CIXX CI Financial Corp$10.78

2,809.00

12.50.622.5248.61.7-48.44.4
CNS Cohen & Steers $64.69

3,193.00

61.5 6.29.612.2-3016.1
EXP Eagle Materials $109.72

4,184.00

20.40.58.5863.7-34.111.8
ENVA Enova International $26.66

893

18.1-28.4130.40.8-34.93.5
EVTC Evertec $34.16

2,402.00

20.9-8104.45.3-31.712.5
FHI Federated Hermes $29.12

2,693.00

19.81.29.131.12.4-22.511
LOPE Grand Canyon Education $84.21

2,839.00

23.1 75.93-1.7514.2
PRGS Progress Software Corp$46.10

2,054.00

13.60.24.3143.44.9-4.523.3
ZD Ziff Davis $69.75

3,412.00

6.10.47.259.51.7-37.114

One reason for the outperformance is that the price/earnings valuation previously lagged its peer group by some considerable distance, reaching a low of just five at the turn of the year. The sudden bounce back started with better-than-expected quarterly numbers in May and clear signs that short interest had declined significantly. This allowed a re-rating of the shares when combined with significant stake building by several of its larger institutional investors. For example, Barclays has reportedly increased its stake in the company by 46 per cent, bringing its total share ownership up to 6.4mn shares, now worth over $330mn.

Elsewhere there is a quandary over what to do with Autohome (US:ATHM). The shares have been solid performers, posting a 13 per cent rise year-to-date. However, the company, which supplies marketing, lead generation and transactions services to car dealers, derives all of its revenues from China. That could prove a problem if threats to Chinese listings – initially trialled by the Trump administration, but never really followed through – were to shove China-dependent companies from the US stock market at short notice. That is linked to the problem of rising geopolitical risk around Taiwan that could spiral into sanctions, or worse. Although it is always sad to lose a winner, the returns on offer don’t offer enough margin of safety and it seems best to bank the profits from Autohome and deploy them somewhere else.

Overall, the next few months in the US market aren’t going to be pretty. It is more than likely that grinding attrition for the main indices will outweigh gains on individual shares. Still, that does leave the options open for stock pickers looking for a bargain, and next time we will reorganise the portfolio to reflect the new buying opportunities that are certain to be available.