by Hodges Investment Team, on Nov 8, 2021
“The market is always making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks.” -Benjamin Graham
The third quarter of 2021 proved to be a choppy quarter for U.S. equity markets as stocks consolidated gains from the first half of 2021. The continued recovery of corporate earnings was partly shadowed by concerns over what new COVID variants might mean for the near-term economic trajectory. Uncertainty regarding fiscal policy in Washington, supply chain disruptions, and the likelihood of higher taxes also dampened market sentiment in the recent quarter. We believe positive relative performance in the first nine months of 2021 reflects a shift in market leadership that has favored fundamental investing and rewarded individual stock selection.
We view the market's sideways trading on low volumes during the September quarter as a healthy function of earnings and profit margins moving back to a normalized trend. According to data published by FactSet, the S&P 500 ended the third quarter at 20.1X forward earnings estimates compared to a five-year average of 18.3X. The inverse of the current P/E multiple is an earnings yield of 4.98%, which is well above the 10-year Treasury yield of 1.52% on September 30, 2021. Although we expect to see further earnings strength well into 2022, we see limitations for multiple expansion in the months ahead. It is also relevant to point out that P/E multiples are highly bifurcated, with the most prominent growth stocks trading at historically high multiples relative to their long-term growth rates and industrial and cyclical stocks trading at low multiples consistent with the latter stages of an economic cycle. Headwinds for P/E multiples include the prospects for a higher U.S. corporate tax rate, an increase in the capital gains tax, and the possible increase in long-term interest rates brought about by a pickup in inflation. While many industrial and economically sensitive stocks trade as if we are in the late stages of an economic cycle, we do not see the typical signs that would suggest that the economic cycle is nearing maturity. Such signs would include a build-up in inventories of consumer goods or excess capacity in manufacturing. As a result, the investment team at Hodges Capital remains laser-focused on the trajectory of earnings improvement among the individual stocks we hold in our portfolios. At this moment in the cycle, we believe it is also critical to evaluate unique productivity and growth factors that could offset headwinds to multiples in the future.
As we enter the final quarter of 2021, we are paying close attention to the impact that supply chain dislocations, a tight labor market, and rising material costs could have on profit margins. For many businesses, inflation and logistical challenges will adversely impact profit margins and revenues in the months ahead. Companies that exhibit pricing power and a low threat from substitute products can often pass on higher costs and see profit margins benefit from an inflationary environment. We believe this environment will also create opportunities for companies that are low-cost producers or have structural advantages in providing goods and services that can take market share and fortify their competitive position. Furthermore, we have been surprised to see a muted market reaction to signs of inflation, which the Fed has called “transitory.” Although supply chain dislocations and labor shortages will eventually improve, we would not be surprised to see inflation stick around as consumption and liquidity remain abundant.
Although we are encouraged with the current positioning in our portfolios, we would not be surprised to see volatility in the months ahead resulting from a dubious earnings season and political rhetoric over the debt ceiling. Historically we have found bargains during periods of increased volatility as we rigorously look for investments in well-run businesses that control their own destiny by relying on ingenuity and well-calculated business decisions. Investors can be assured that we are not changing our core investment discipline, designed to seek out quality companies running great businesses with excellent management teams trading at reasonable prices. Furthermore, we see this as an ideal environment for active portfolio managers to carefully select individual stocks that we believe can generate long-term value for shareholders.
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Horse Sense. Street Smarts.Don W. Hodges, founder of Hodges Capital, shares special quotes he collected over his 40 years as an investment advisor and student of personal and business success.
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