Back to the Future

Most equity investors would love to have the Doc and his DeLorean on call in order that, in Marty McFly style, they could correct errors that they had made in the past. However, hindsight is helpful in order to learn from any mistakes made in order to ensure that they are not repeated.

Although initial market reactions can be quite pronounced, in times when valuations are stretched, to a company issuing a profit warning or missing market expectations, Mr Market is often more focussed on what the company management expects to see in the coming quarters (or more preferably, years); unfortunately management teams do not have a call on the DeLorean either, but they do have visibility over current trading, order books and percentage of recurring revenues.

Coming into the reporting season fears around supply chain bottlenecks, rising wages, labour force participation, raw material costs and component shortages were all factors that led to the uncertainties that investors and companies had to grapple with. Companies such as Sherwin Williams, Nike and Apple all warned the market early on factors such as Hurricane Ida, the pandemic shutting factories in Vietnam, and semiconductor chip supply were all limiting supply of their products in the current quarter.

Encouragingly, while most companies cited one or more of the headwinds in their calls with investors, many companies had offset them with price increases and in many cases, they had experienced record levels of demand but they simply had not been able to fulfil from current inventories. Although some price increases were implemented to sustain margins in the quarter, given the rate of increase in input costs, many companies will experience a lagged effect of their list prices catching up, which if costs stabilise, should boost margin in coming quarters. Furthermore, the record levels of demand give management teams greater visibility of orders into 2022 enabling them to optimise their working capital and cash flows into the coming year; if Apple is facing semiconductor shortages from TSMC then it is likely that all the other handset manufacturers are as well, so that demand is likely to remain with Apple rather than being substituted by an alternative producer’s product.

With the headwinds and the impacts becoming clearer, the variable becomes when will we pass peak pressure, or indeed whether it has already passed. As the chart above shows the number of companies reporting raw material inflation in the state of Texas remains at a high level, but down from the peak in September.

Looking at other issues, the port congestion in Los Angeles is yet to show any sign of abating despite President Biden encouraging the US West Coast ports to implement 24 hour, 7 days a week offloading. The delay in semiconductor delays between order and delivery is still increasing, however the rate of increase appears to be slowing; Apple highlighted that the shortages only are present at certain nodes, but where there are shortages, the picture is exacerbated by some customers who are overordering to ensure that they do not face similar shortages in the future. The Baltic dry index which is the benchmark for the price of raw materials by sea has fallen significantly since the quarter end and seems to suggest that in this input cost we have indeed passed peak pressure.

With 45% of European companies having reported their third quarter results by the end of October the overall picture is fairly positive for the coming quarter and 2022, with over 40% of management teams upgrading earnings guidance from that previously given, and less than five percent downgrading numbers.

While Michael J Fox only managed to travel into 2015, it appears that the modern-day future appears better than feared for the majority of companies and given that consumer demand has picked up in the US and Europe (the UK sadly is still languishing behind), which is particularly important as household consumption accounts for 69% of US GDP, 59% of UK GDP and 51% of European GDP, the 2022 future may prove to another fruitful year for global equities.