SUMMARY
- Navigating Past Periods of Disruption
- The Current Phase of Disruption
- Opportunities That Reflect Areas of Investment Focus
“Despite gloomy predictions, the global economy remains remarkably resilient, with steady growth and inflation slowing almost as quickly as it rose. The journey has been eventful, starting with supply-chain disruptions in the aftermath of the pandemic, an energy and food crisis triggered by Russia’s war on Ukraine, a considerable surge in inflation, followed by a globally synchronized monetary policy tightening.” -Pierre-Oliver Gourinchas, IMF’s Chief Economist, April 16, 2024
IN THIS OUTLOOK:
The past 15 years have been among the most difficult for investors to navigate as the combination of the most accommodative monetary and fiscal policy the world has ever witnessed was employed to counter the world’s multiple crises described above by Mr. Gourinchas. The escalation of the conflict in the Middle East and the resulting uncertainty on its resolution, and that of the Ukrainian conflict, continue to shift the narrative for policymakers and investors. There have been three periods of significant disruption for U.S. investors since our firm’s inception in 1971 – the 1970s, the 2000s, and today.
On an April 30th Zoom presentation for our clients, Arnold Schmeidler and Sean Lawless discussed how we have used the same investment process for over 50 years to navigate those past periods successfully, and shared our thoughts on where we are finding opportunities in areas where others are not. With over nine decades of investment experience between them, the conversation between Arnold and Sean offered some fascinating perspectives on the current environment, and they shared a few investments that reflect the exposures in client portfolios. This piece will summarize the views expressed on that call and provide a sense of where we are finding opportunities today in industries and exposures.
Navigating Past Periods of Disruption
Equity market gains have typically outpaced inflation, except for the 1970s and 2000s when the reverse happened. In the 1970s, inflation averaged 7.4% and the S&P 500 total return averaged 5.8%. In the 2000s, the S&P 500 total return lagged inflation by 1.29% annually. The 1970s was a challenging time for the U.S. economy as it started with an oil embargo and ended with high inflation, record levels of unemployment, and the Iran hostage crisis. At the time, the U.S. was a net energy importer, producing approximately 5.5 million barrels per day versus the nearly 13 million barrels it is producing today. The energy sector’s weight in the S&P 500 rose from 7% in 1972 to 29% by 1979. It was not a wonderful time for the U.S. economy, but we saw an opportunity to invest in the energy sector as The Natural Gas Policy Act of 1977 required U.S. energy producers by law to raise gas prices every 30 days. While significantly overweighting one area of the market may be viewed by some as too risky, we held the view that the Natural Gas Policy Act de-risked the investment considerably as it reduced the risk associated with product sales through escalated pricing and lowered our dependence on overseas imports. The opportunity the investment team captured was to buy companies with government-guaranteed pricing power. The global energy market dynamics appeared to guarantee increased demand, reducing the risk for investors. We moved to significantly overweight the energy producers, allowing us to generate beneficial returns for clients.
The second period of significant disruption was in the decade following the dot com crash through the great financial crisis which led to a slow-growth U.S. economy and a shift in market leadership. While most investors sought opportunities elsewhere, we saw an opportunity for U.S. companies in the materials, industrials, and energy sectors to benefit from the Chinese manufacturing-driven economic boom that would reindustrialize the world and help raise billions of people out of poverty. Again, our investors benefitted from our investment process, which is forward-looking, flexible, and opportunistic. This process allows our experienced team of investment professionals to work towards maximizing risk-adjusted returns for our clients even in times of disruption and market dislocation. By investing in the leading U.S.-listed companies in the sectors and industries driving global growth, we were able to deliver better-than-market returns for clients for the decade. The ARS Focused All Cap Strategy posted average annual returns of 6.69% net of fees and expenses versus the S&P 500 total return of -0.95% annually during that period.
The Current Phase of Disruption
The world is currently in the third phase of disruption fostered by multiple global conflicts, the launch of generative artificial intelligence (AI) – which we view as game-changing technology on par with the introduction of the internet – and the difficulties with the climate transition. With the global economy undergoing massive change, investors should reevaluate their portfolio positioning to reflect where the world is going, rather than where it has been. Throughout our history, client portfolios often reflected exposures that varied from those of many other managers in large part due to our forward-looking views. As mentioned in past Outlooks, our investment approach focuses on the three determinants of common stock valuation – the outlook for inflation, interest rates, and corporate profits – to be our anchor in times like the present, as the complexity we are dealing with today is challenging traditional investment thinking given the impact of monetary and fiscal policy, a new era in geopolitics, and changing terms of global trade.
Chart 1. Inflation Dropping and Prices Rising
In simplest terms, the Fed’s outlook for inflation is that it continues its process of moving toward the Fed’s 2% target but that the move from 3% down to 2% will take more time than it took to move from 9% inflation down to 3%. What is particularly troubling for consumers is that while inflation is coming down, overall prices are still high and rising (Chart 1). Our consistent stance is that interest rates will remain elevated for a longer duration than the markets anticipate, although in recent weeks the market has come more in line with our views. The third factor in valuing stocks is the outlook for corporate profits which continue to surprise to the upside as the biggest companies are flush with cash, evidenced by the record levels of stock buybacks by U.S. corporations. Apple’s recently announced $110 billion buyback headlines the number of U.S. companies driving $934 billion in corporate buybacks executed in 2024 as projected recently by Goldman Sachs. One key reason that the decline in inflation has been slowing, and interest rates remain higher than anticipated by the markets, is that the United States economy is showing surprising strength (Chart 2). This is supported by trillions of investment dollars being spent by the government and augmented by corporate capital expenditures which are part of a long-term strategy to ensure national security, strengthen our manufacturing base, and maintain our role as global innovators. The U.S. is combining unprecedented infrastructure investments with technological advancements to drive growth. Further, the strength of the U.S. economy is reflected in the strength of the U.S. dollar, the robust growth in gross domestic product supported by the increase in foreign direct investment, record net immigration figures, and our unemployment rate which is below 4% for 27 weeks in a row.
Chart 2. United States: Gross Domestic Product Growth 2019-2023
Opportunities That Reflect Areas of Investment Focus
Market participants often find comfort in doing what the crowd does, but the more popular an investment becomes, the less its undervaluation. This popularity tends to be colored by short-term news headlines and sentiment. We often hear that one thing distinguishing us from many other managers is that when we construct portfolios, it is done with our view of where the world will be going over the next 3-5 years, what trends will drive capital flows, and what businesses will benefit or be negatively impacted. It is not done with a view of what is popular now. The investment team then looks for undervalued businesses with catalysts we believe will drive earnings growth over the next 12- 18 months that may be overlooked by other managers. That was true in the past periods of disruption and is again today. For some time now, client portfolios have reflected our focus on innovation and technological advances that are enhancing productivity and efficiency, but also include added emphasis on three areas that we feel the market is currently underappreciating – industrials, materials, and energy companies. Those areas combined represent roughly 15% of the S&P 500, and the ARS Focused All Cap Strategy has approximately 48% exposure to these areas. As regular readers know, we have aggressively invested in the tech sector for several years. We have also been lowering our exposures to some of our most successful holdings as we see technology as somewhat less attractive due to near-term valuation concerns as the market has begun to broaden out, creating new opportunities elsewhere.
Chart 3. What Does It Take tTo Build An Intel Facility?
As discussed in recent Outlooks, the U.S. government has implemented multitrillion-dollar spending initiatives to address our legacy infrastructure and national security issues, which continue to worsen due to chronic underinvestment. These initiatives aim to bring manufacturing back home, increase national security, and counter the impact of climate change. The Inflation Reduction Act, The CHIPS and Science Act, and the National Defense Authorization Act have each allocated capital to the industrial and technology sectors.
These investments are critical for developing semiconductor fabrication facilities (fabs) necessary for producing the semiconductor chips essential for consumers, businesses, and the government. Chart 3 illustrates the components involved in building a fab. Constructing a fab is a significant undertaking, with costs of up to $20 billion per facility, and rising to more than $28 billion for the two nanometer (nm) chips currently under development. To put the 2nm chip size in perspective, consider a single strand of human hair is about 70-100 nanometers wide.
Understanding the magnitude of these investments helps clarify our exposures to materials and energy. It's important to note that these commitments are part of a long-term strategy for the U.S. to maintain competitiveness. Notably, the U.S. holds a crucial strategic advantage over its rivals in chip manufacturing, positioned to host facilities for the world’s leading semiconductor manufacturers. Companies like Taiwan Semiconductor, Samsung, Micron, and Intel are establishing new fabs in states such as New York, Ohio, Texas, and Arizona, among others.
Despite the steel industry’s importance to the nation, the top five steel companies have a combined market capitalization of only $86 billion. China produces over one billion tons of steel annually, while the United States produces eighty-two million tons. As shown in Chart 3., the construction of each fab requires a great deal of materials, including 75,000 tons of steel. While steel has historically been a cyclical investment, we see the damage from climate change, increased infrastructure spending, and incentives for companies to bring manufacturing back to the U.S. as likely to reduce much of the cyclicality. A few names we favor in client portfolios are Cleveland Cliffs and Commercial Metals, two of the leading U.S. steel producers. Cliffs has raised prices over ten times in the past year or so and is increasing production with strong demand for its products.
The energy sector has undergone significant changes in recent years as the U.S., using advanced technologies such as 3D seismic technology and horizontal drilling, allowed companies to be more efficient, bringing production costs down as low as $25 to $35 a barrel. EOG, a major producer in the Permian Basin, can earn as much from oil priced at $42 per barrel of oil today as it would have from oil trading at $86 nine years ago. In recent years, banks have reduced lending to oil and gas producers which fostered a shift in business models from maximizing production to maximizing return to shareholders.
A key for the global economy to achieve more sustainable growth is to increase productivity to offset the rising costs of labor, debt, and materials. The advent of generative AI augers a new era of innovation that we believe will change the world in ways most cannot even contemplate. In our view, this technology is on par with the printing press, the steam engine, and the internet in terms of its impact. Like those other breakthroughs, early investments in AI will likely see some tremendous winners and some spectacular losers as it will take some time to determine the most impactful applications. At the same time, it is easy for investors to follow the crowd and invest in one or two of the more obvious investments, and that narrow focus will miss some of the more important companies that are less followed yet equally critical to the theme. Generative AI will require massive amounts of data and enormous power from the electric grid. This is why our team is looking beyond the big tech names (which we continue to own) to include industrial, materials, and energy companies, as they, too, are prime beneficiaries. Arnold and Sean shared some individual stock ideas, which you can access through the link above, via email to info@arsinvestmentpartners.com, or with a call to one of our portfolio managers.
The market is experiencing a necessary pause in its uptrend as it adjusts to interest rate levels, but we are encouraged by the strength of this quarter’s corporate earnings which reflect the resilience of leading U.S. companies and the economy. While today’s world is unsettled and uncertain, we see opportunities to benefit from current disruption in areas where other institutional managers may not. It is difficult for some market participants to capitalize on periods of disruption such as we are experiencing today because their investment processes and business models are designed to look at the world as it is today and not as it will be in the future. We remain focused on where the world is heading, and investing in the areas we see benefiting from this disruption.
“Most investors want to do today what they should have done yesterday.” — Lawrence Summers
ARS Investment Partners, LLC remains committed to a proactive and insightful investment approach that not only navigates but also capitalizes on periods of significant economic and geopolitical disruption. By focusing on a long-term perspective and adapting to new economic realities, we continue to identify and exploit investment opportunities that others may overlook. This commitment to strategic foresight and flexibility is key to our continued success and ability to deliver value to our clients even in the most challenging times.
DISCLAIMER
Published by the ARS Investment Policy Committee:
Stephen Burke, Sean Lawless, Nitin Sacheti, Greg Kops, Andrew Schmeidler, Arnold Schmeidler, P. Ross Taylor, Tom Winnick.
Past performance is not indicative of future results.
Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance, or representation as to the future.
Definition of the Firm – ARS Investment Partners, LLC (“ARS”) was originally founded as A.R. Schmeidler & Co., Inc. in 1971 and is majority-owned by Artemis US Corporation. Artemis US Corporation is 100% owned by Artemis Investment Management (2021) Corporation, a financial services firm headquartered in Toronto, Ontario, Canada. Mr. Miles Nadal is the controlling shareholder of Artemis Investment Management (2021) Corporation. ARS is a registered investment adviser under the Investment Advisers Act of 1940. ARS claims compliance with the Global Investment Performance Standards (GIPS). ARS has been independently verified for the periods 1/1/2000 through 12/31/22. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance of the accuracy of any specific performance report. Benchmark returns are not covered by the report of independent verifiers.
Investment Management Fees – The standard investment management fee schedule that applies to this strategy is as follows: 1.25% per annum of the first $1 million, 1.00% per annum of the next $20 million, and to be discussed thereafter. The management fees for certain clients may differ from this schedule because those clients’ fees are grandfathered or because of relationships with the applicant and related accounts. For institutional accounts, certain asset or fee minimums may apply. Effective 1/1/17 a model fee of 1.05% was used to calculate net returns shown in this presentation.
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