The Timber Log is a quick overview of Timber Point Capital’s most recent investment thoughts. If you have questions about the content, please reach out to Patrick Mullin. The information contained herein does not constitute investment advice or a recommendation for you to purchase or sell any specific security.
Source: Charlie Billelo
“You have to be wildly optimistic to believe that corporate profits as a percent of GDP can, for any sustained period, hold much above 6%.”
- So said the Oracle of Omaha, Warren Buffet, and yet corporate profits show no signs of returning to the 6% level…in fact, ex the GFC, it appears that 9% margins are the new support level
- Recent 20% SPX rebound from the lows of early April are in no small measure related to strong first quarter earnings where 78% of companies beat estimates (Factset)
- We describe this as the “virtuous cycle of investment” where productivity increases improve margins and drive earnings increases…AI is only the latest manifestation of this, and still very early in its adoption
- We have seen companies like AVGO where earnings have inflected, followed by its stock price, as custom ASIC’s for AI are growing quickly and becoming a greater % of sales
- But agentic AI is starting to be used across the economy which admittedly may replace some jobs over time but will make the balance of the workforce far more productive
- Unlike the tech bubble of the late 90’s/early 2000’s, this is not a build it and they will come…there are real earnings associated with the AI buildout, across the economy, as it is seen as a productivity driver and companies are loathe to be the last to adopt
- Recent fears about a slowdown in AI/tech capex spend was soundly disavowed by the hyperscalers, with new “sovereign” buyers for AI infrastructure now emerging
- Trump’s recent trip to the Middle East, with corporate leaders in tow, resulted not just in military business but also energy, technology and infrastructure cross border investments – taking a page from China’s Belt and Road playbook and resulting in over $2T in investment agreements
- The bear argument is that corporate margins cannot expand from current levels and are set to mean revert…we think this misses the bigger picture of how innovation is impacting corporate decision making, far outside the tech sector, in a relentless effort to drive greater efficiency through enterprises
- When people discuss the end of “American Exceptionalism” there is little thought given to just how much technology US companies are bringing to bear in their operations and how that ultimately results in improving margins and returns on capital – hence why SPX stock prices rebound quickly and demand premium multiples vs. ROW
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The “Soft Data” is just not lining up with the hard data in the economy…
- Yes, consumer confidence in the Conference Board summary improved in May somewhat, but CEO confidence dropped off the face of the map…it is now at the lowest level since 4Q22 and the largest q/q decline in the history of the survey!
- This survey was fielded from 5/5 – 5/19 so relatively recently…all components of the survey were weaker led by current economic conditions which registered the largest q/q decline in almost 50 years
- The US-China trade deal announced 5/12 appeared to have little impact on viewpoints about the current state of the economy – geopolitical instability and trade/tariffs were the top two business risks
- Perhaps most telling, a majority of CEO’s indicated NO revisions to capex plans over the next 12 months nor anticipated changes in the workforce size over the next 12 months…
- So, while confidence is near GFC and Covid-lows, there are few tangible steps being taken AT THIS POINT to potentially offset what some believe could be a materially weaker environment in the months ahead…
- The above, combined with additional delays on tariffs as well as still strong earnings, are reasons why we continue to see employment remain strong, the Atlanta Fed revise 2Q GDP to 4%-ish level (yes, we understand the impact of imports) and consumer spending remains in positive territory
- We believe that the erratic nature of the Trump administration’s approach to tariffs/trade (where is Peter Navarro?) can be having an outsized impact on CEO confidence who much prefer a steady environment where long term planning can take precedence over short-term reactionary action
- As well, Trump tariffs require another level of long-term thinking about supply chains, input and labor costs and pricing algorithms that can change from day to day making for complex and exasperating scenario planning
- However, the old maxim of watch what consumers do versus what they say appears to be relevant with CEO’s also…yes, we have seen some layoffs but initial claims remain static, productivity is strong and CEO’s, while wary, appear unwilling to throttle back at this point in time
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Source: Ned Davis Research
Is the bottom near for the healthcare sector? It’s getting interesting, perhaps opportunity knocking…
- Above long-term chart details the recent underperformance in the healthcare sector which peaked relative to the SPX in late ’22/early ’23 and is now trading two standard deviations below its long term average
- The current level of underperformance is somewhat historic as one needs to go back to 1978 to find comparable levels of underperformance although there have been a few occasions where poor performance approached current levels
- Healthcare is a broad industry that encompasses many different segments including pharma/biotech, life sciences, managed care, equipment, services, etc. but sector specialty ETF’s show that there have been few broad sectors (IBB, XHS, IHI) bucking the trend and stock picking has been paramount (LLY, ISRG, MCK)
- The main culprit for the performance is likely two-fold; 1) investment flows since the ’22 SPX bottom have been chasing AI-related names with the XLK and XLC up over 100% since 1/1/23 vs. 1% for XLV and; 2) ongoing concerns related to drug pricing (Inflation Reduction Act) and the general belief that healthcare represents a large opportunity for cost savings
- While we can never exactly pinpoint when the worst case scenario has been priced into stocks, based on the above recent price history and extreme relative underperformance, we believe now is a good time to start taking a closer look at the sector
- Innovation has always been a big driver of the sector and we believe that whether through new process, productivity or products the healthcare sector has a good chance of at least mean reverting to better performance over the next 12 months
- Perhaps the final cuts on the recent Budget reconciliation bill will give some solace that worse case healthcare cuts will not develop
- We tend to look in the mid-cap space where companies have shown they have successfully transitioned from micro and small cap status which is a reflection of their ability to drive sustainable and self- financing cash flows while still having large growth opportunities in front of them to potentially disrupt/take share from their larger cap peers
- One will need to sharpen the pencil to find the names but we believe the attractive starting point could make it a rewarding venture
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