How inflation swindles the Equity Investor

How inflation swindles the Equity Investor
The equity markets continue to trend downward over the month of May. This is the one of the more sizable stock market downturn since I started investing, with the first one back at 2015-2016, the second at May 2020, and the third one which started around Jan 2021. As the valuation metrics has been extremely elevated in the US market on 2020, I believe this is a fairly healthy correction and I am not too concerned about the inflation / interest rate impacts on the companies I hold. As a bottom up investor, I believe this is one of those rare times that I can build up my positions in the higher quality companies at a more reasonable valuation, and I will try to consistently execute on my accumulation plan for the months ahead. Despite the stagflation, supply chain, and nuclear warfare worries, I still prefer an aggressive allocation to ownership stakes to a diversified portfolio of cash generative assets.

As my workplace has fully transited back to return to office, the dining expenditures with my colleagues as well as public transport has led to a significant spike in my operating expenditures. While shopping for groceries for my family, the effects of shinkflation on food portions and inflation and daily essentials is apparent and definitely impacted the ability to maintain my covid-era savings rate, leading to a deterioration in my Net Take-home pay (Net profit Margin). Unfortunately, my salary negotiating power (ability to negotiate for higher top line salary) is far inferior to the pricing power of the companies I own, Nonetheless, when I can find spare time after work and on weekends, I intent to continually put in the capex (self development) to continually upgrade my skillsets so that I can command a better salary if I rank up / search for different roles in my industry in the future.

History may not always repeat, but it often rhymes. Warren Buffett's piece on <How inflation swindles the Equity Investor> is startlingly relevant despite it being written 42 years ago. The description of the <stagflation period> in the United States is paralleled by the fear mongering headlines that dominated the news as of late.

Some of the most useful tidbits are as follows (per my personal understanding)
1) The inability of most companies to increase their prices despite being hit by inflation worries. There are very few companies with unique / superior products and services that commands superior pricing power. Most companies DO deserve a hit on their valuation metrics as their profit margins and inventory turnover (sales) will get impacted. A slowdown on sales will have a sizable impact on highly indebted companies and increase the discount rate / risk profile.

2) In my biased opinion,
i) Higher gross margin companies with intangible assets are worth re-looking as they usually have unique products / services that provide superior pricing power, as well as a lower dependence on commodities / input costs.
ii) Asset light companies with low physical infrastructure reinvestment needs can allocate capital more effectively towards projects at an better internal rate of return.
iii) Companies with sticky customers, low customer acquisition costs, and products / services with strong pricing power is worth looking into.
iv) Software companies with developed online infrastructure (limited capex needs) with distribution means will be less impacted on their cost of distribution as well as supply chain issues. They are way more attractive at their current valuations than they are a year ago.
 

3) The widespread ill conceived notion that commodities and real estate will definitely preserve their value and benefit during inflation. The margins of commodity traders will still be compressed on their cost of production and inability to raise prices unless they cornered the market. Real estate development will be subject to huge raw material prices impacting their ability to reinvest at a profitable margin, compared to REITS / completed buildings which can simply negotiate for higher rentals without a sizable hit on their operational expenses. 

4) Inflation is a a heavy tax on all forms of economic activity. It benefits people whom can borrow money and erode their cost of debt, and penalizes savers heavily by eroding the time value of money.

5) The determinants of quality company (sizable ROE) is the arithmetic breakdown of
i) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business;
ii) cheaper leverage
iii) more leverage;
iv) lower income taxes;
v) wider operating margins on sales.
However, due to the foreseeable hike in interest rates by the Fed to attempt to stamp out inflation, high indebted companies will be forced to deleverage or try to refinance their loans instead of borrowing more to benefit from depreciating their cost of debt. 

 

 Portfolio Decisions for the Month of May


Importance of fortifying one's mind
After been through the previous two market meltdowns in my investing journey, I am more mentally prepared on what to do when the opportunity comes along. The best returns are made when there is a market downturn, and <diamond hands> work very well if there is no permanent impairment on the underlying company. However, it is tremendously difficult to stay disciplined when the market (participants) and the herd bombards you with the tantalizing message to <Run> and <Sell in May and go away>. As I am keenly aware I do not have any secret technique to predict market movements in the short run and the most <loud mouthed influenzas> are not running market beating long-short hedge funds, I will continue to abandon the illusion of false precision, execute my plan in a mechanical matter, and not let human emotions disrupt a process that is fundamentally sound.

Initiated position on Adobe at USD 400 on 05 May
Adobe is a company that has a successful and highly monetisable software business model that is asset light, strong pricing power, and acts as a leading industry standard for the creative arts / design industry. As the appetite for online advertisements, videos, and posters will continue to expand over time, Adobe has a full-set ecosystem of software solutions that allows said companies to pay subscription fees to their core software suite, as well as upsell ancillary solutions like E-signature authentication, music synchronization and subtitle tagging etc. What is most attractive about this company is its cloning of the successful business model of Microsoft, whereby it markets and offers its products to be included in curriculum in schools, forcing creative arts developers to learn this tool as a monetization platform in the commercial world. Its strategy to distribute its products free of charge to retail and the ability to monetize from its corporate relationships allows it to create instant brand recognition, and its transition from software licensing to SAAS led to its strong free cash flow generative ability, in a more lightly regulated space compared to MANGA stocks.

Averaged down on Disney at USD 107.2 on 15 May
I averaged down on Disney after attaining reasonable assurance that Omnicron/Covid is now under control in most of the world apart from China (Disneyland Shanghai)  which is currently under lockdowns. I like the high margins of the Disneyland theme parks and the foreseeable pent-up demand of the (experiential) needs of the people from lockdown, and I am pretty certain that the negative public sentiment from woke people in the US towards the CEO is not a permanent impairment on its business model. I like the progress of the Disney Plus platform whereby it is claiming back its content base from Netflix, and monetizing its <violent and adult content like Hulk Deadpool Logan> through Hulu.

Disney is duplicating the successful parts of Netflix whereby it has a huge catalogue of content and is creating experimental <call options> such as the Inhumans, which is wildcard / hit and miss and possibly transit to a monetisable franchise like <Guardians of the Galaxy>. Its recent movie releases is guiding the viewers to subscribe to older movies / Disney Plus content for fans to keep up with the plot continuity. By marketing its content as family content / suitable for kids (which is difficult to reason with), it will always serve as a base for kids to keep up with popular culture and a forcing function for adults to subscribe to for the family.

DisneyNetflix
Pent up demand and Artificial scarcity (creating anticipation and lunch discussion topics)Instant gratification and binge watching. Not suitable for lunch discussion in fear of spoilers
Experimenting with call options on potential content on DisneyPlus, then develop / monetise successful content on mainstream movies and theme park rides
Incentive structure on creating new content over building up on successful ones. Heavy tax on production crew affecting screenwriting and production standards
Retaining talented storytellers and ability to monetise its successful history of storytelling (to create new genres) like WandavisionDarwinian culture of Hire then fire. Unlikely to instill employee loyalty when the share based compensation starts falling
Ability to use Green-screen tech to produce content reliably and curtail costs / risks towards its actors / production delaysEnjoy huge operation leverage and efficiency to produce content compared to other network subscriptions.
Encroaching on Netflix pipeline of Korean Content to be eventually launched in its own subscription plans. Due to heavy competition, subscription plans are more commoditised with limited pricing power, but provide content base to other monetisation routes like plushies, movies, and theme parksNeed to reduce its churn rate from its subscribers, Renegotiate with existing content creators from withdrawing their content on Netflix, partner with other content developers for content as well as build up their own, then increase monetisation rates on its huge subscriber base to improve its free cash flow generation ability. Currently unable to monetise its user base beyond its subscription fees, and always requiring to reinvest in content to retain them.

Decision to HODL Coinbase as a mental writeoff position
As the newly minted (diamond hand Hodls) are being spooked out by the huge volatility (and risk of permanent impairment on scam coins / projects) in the crypto space, I will stick to my original thesis of retaining my (mental write-off) position as a way to monetise off the volatility of this asset class, while preserving a call option on having exposure to potential real projects that may be picked up by the venture fund / exchange. I do not intend on increasing my position on coinbase as of now as there is a real risk of permanent impairment on the overall market if there is regulatory intervention in this space, or if the degeneracy of scammers like Do Kwon (Terra) and Tether could mentally scar institutional and retail allocators into this space, and permanently kill off the market for years.

I am keenly aware of the huge talent pool of developers that has moved from traditional finance to crypto projects in this space, but I do not have superior insight that will allow me to increase any allocation to coinbase / any crypto projects for now. As long as there is no permanent impairment on the appetite of investors into this space, and merely sharp violent bursts of activity every now and then, the thesis of coinbase will hold, even if they are over-earning in crypto bull run in the previous few quarters.

Plan to continue to average up/down across the following months.
I will stick to the retail advantages of a having a permanent capital structure, and not force my portfolio to undergo involuntary investor redemption. Nonetheless, as my expenses spiked up across the past few weeks, I will have a lower capital base to allocate funds towards my portfolio. I will try to stay opportunistic and continue to allocate capital for the months ahead!

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