How Quickly is the Recession on the Way?

If it's not already here, a recession is clearly on the way. A recession is at least two consecutive quarters of a drop in GDP. Of course, GDP is composed of volume and price. It appears to me that volume is already in decline, but price is increasing at a rate that disguises the underlying recessionary trend.

The Fed's commitment here is strong, but the journey is nearly impossible in the short run. Consumer balance sheets are so strong and desires to consume so high that I seriously doubt that 10% interest rates would stop them. So, the slowing must come from somewhere else. Perhaps it will simply take the reverse effect of what kept the economy going during the pandemic - a wealth effect. 

By driving rates higher, stock and bond markets have immediately responded with the worst combined drop since 1932. However, the other more important asset has yet to drop - real estate. Real estate is a backward looking asset class. As a result, it only drops when enough people are forced to sell and the lack of buyers reveals a new set of appraised values. With the lock in long term rates at such low levels, it is unlikely that the recent purchasers are going to be selling. 

So, if the reverse of the wealth effect - call it the poverty effect - needs to occur before the economy really slows down, the Fed will be in hiking mode for some time here - barring a "break" like occurred recently the British pension schemes.

This Time Is Different?

"This time is different" are reputed to be the most dangerous four words for investors. Yet, the past three years have certainly made an argument for their usage. 

One of the many remarkable patterns that I see currently is the attempt for the Fed to slow down the economy while consumers have strong balance sheets. In the past, the Fed has attempted to slow things down (e.g. 1999 and 2007) when spending and speculating have been running hot with a consumer whose balance sheet was weakened with debt. By "tightening," the Fed has been able to slow the economy dramatically due to the drop in asset values, the loss of cyclical jobs and a drop in consumer demand. But this time looks different.

For example, in reviewing AutoNation's (AN) financials, I have been amazed to see how AN has fared. In the midst of this tightening, the volume of cars sold has dropped by roughly 20%, but the price increases have offset this loss. These price increases have occurred even as AN is selling cars with missing chips. Even more, these price increases are based on financing with rising interest rates. At this point in a "tightening" cycle, AN would be marking down cars to clear them from the lot as consumers would step back. It appears that no amount of pressure is reducing this demand.

From where I sit, the "this time is different" dynamic is rooted in delayed gratification. People who have suppressed shopping and traveling desires for three years are simply responding differently. During the pandemic, it appears that people not only missed hanging out with friends and family, but they also missed the joys of new stuff, of new vistas and of new experiences. If that is so, the Fed is fighting a demand drive with more psychological force than previously experienced. In fact, the closest analogy may be the euphoria of post-war spending.

Recession Ahead: Necessary or Not?

Chairman of the Fed Jerome Powell has transitioned from calling inflation "transitory" to no longer transitory. Both positions were accurate at their respective times. This inflation is not driven by an excess of demand, but by COVID-related supply chain issues. It was logical that as COVID receded supply chains would open up effectively, but that has not occurred due to three factors: 1) chip shortages require longer start up periods, 2) the Chinese reverted to COVID policies in light of their zero tolerance policy and 3) the Russian invasion of the Ukraine. So inflation will last for sometime, but is not driven by an excess of consumer demand. Given that the Fed understands this, why would the Fed push ahead aggressively with rate increases? In a word - expectations.

The Fed is responding to concerns that a temporary set of supply chain issues becomes a permanent mindset for producers and consumers. The Fed always uses a blunt instrument. In 1999, the Fed could have used stock market specific tools to deal with the Internet Bubble, but chose instead to raise rates which punished the entire economy. Today, the Fed looks to apply the same punishment to slow the entire economy down to the speed of the supply chain's average production ability. This will certainly create a drop in demand by creating a drop in employment. However, that will quickly lead to a recession while not necessarily fading inflation until these three aforementioned factors abate. Ironically, if the Fed were to not act at all, the economy may more quickly resolve these issues with funding for increased production but at the risk of inflation expectations hardening.

Self-serving Bias in Driving

Owning Berkshire Hathaway (BRK) means taking a sizeable position in automobile insurance through BRK's ownership of GEICO. The possibility of self-driving cars concerned me because it seemed that car insurance would be radically changed or even eliminated. However, as I reflect more deeply, automobile insurance is likely to stay as well as become a critical participant in the adoption of the technology. 

Self-driving cars concern most of the people I talk with, but I find myself eagerly awaiting their arrival. Initially, I viewed this difference as based in my dislike for driving. Again, further reflection revealed a superficial analysis. The reality goes back to studies from decades ago that showed drivers, on average, viewed themselves as better than average drivers. I thought to myself, "am I better or worse than other drivers on average?" At first, I reflected on my age and my aptitudes and concluded that I had better than average possibilities. But further analysis revealed my propensity to talk on the phone, work on my computer and change cassette tapes while driving. Those patterns were rooted in my overconfidence on the road - making me a worse than average driver. That's when I gave up, for the most part, driving.

A friend of mine says "we are all the center of our own universe" which is the root of our self-serving bias. It's weird to have such a maladaptive mechanism that would cause us to overestimate ourselves in a setup for worse outcomes. I've come to believe that this self-serving bias feels so good in its "rose colored glasses" effect that we are all wearing those glasses. Self-serving biases are a kind of first generation augmented reality glasses that can also be called "the Lake Wobegone effect," "the overconfidence bias" and even "free will." I used to think it populated more with men, but now I think it's topical and affects everyone after talking with mothers and fathers about their children.

The beauty of insurance companies is their focus on statistical analyses. Insurance companies are the likely proponents of self-driving technologies because they will reveal the statistical advantages of self-driving. There is no question that self-driving cars have and will have a lower likelihood of accidents, but people will be reluctant to embrace that improvement as long as they maintain the bias that their own capacities will cause them to defeat these odds. It will require the insurance company's pricing mechanisms to shape the consumer's sense of paying a higher price for the "right" to beat the odds.

"Non-Budget Budget" - Individuals and Companies - POOL jumping in

Years ago I met with a client couple and asked them to prepare a budget, but I offered them a shortcut. I said that people spent the maximum allowed. So, rather than itemize, they could simply look at the increase in savings during the past year and that number would tell them what they had actually spent. If there were no increase in savings, then their take home income was their budget.

Because the husband was a prominent business consultant and a business school professor, he argued that my thesis might be correct in general, but certainly did not apply to them. I didn't argue because the customer is always right, but at the beginning of the next meeting he showed me a new folder titled "non-budget budget." He expressed his shock as he discovered that not only had my thesis been correct for the past year, but for the years prior as well.

In reviewing the 2021 annual report for Pool Corporation (POOL), I am reminded of how this tendency also shows up with companies. POOL has an outstanding business with "compounder" tendencies - meaning there are two or more growth areas going on. In POOL's case, there is the increasing cost of maintenance and repair as well as the increasing build out of pools driven by the migration of US citizens from North to South.

However, 2021 was eye-popping in its results. New pools, new refurbishing and updates in maintenance and repair all combined to create a strong top line growth of over 25%, while the operating leverage allowed for margin expansion and operating income to increase by close to 50%. Standing back, these results are likely to be a pull forward in demand - meaning that results will be tepid for the next few years. Ask the folks at Netflix how that feels.

An appropriate approach might be to recall the biblical practices of Joseph with the seven fruitful years. However, POOL made a sizeable acquisition by leveraging its balance sheet and likely paying top dollar for it. This pattern of "non-budget budget" of publicly traded companies shows up just as consistently as the ones I saw in individuals. Perhaps AI systems could be developed to help management with this "money burning a hole in my pants" problem. 

When is Enough Enough?

As I read about the return of Howard Schultz to the helm of Starbucks, I am reminded of the journey of almost every company as it moves from doing for customers to doing to customers. One of the reasons that I prefer company founders as CEOs of our portfolio companies is their non-MBA characteristics. In business schools, students are taught concepts, some of which are constructive and some of which are destructive. I view the most destructive concepts lie in the "profit maximization" area.

One portfolio manager describes the journey of companies as in three stages. Stage One is the Wow! stage - where companies seek to delight customers and, as a by-product, disrupt and change industries. Herein lies the reason why Jeff Bezos focused Amazon on everyday is Day One. Stage One is marked by rapid growth and often prohibitively high stock market prices. 

Most of the time I simply watch these Stage One companies enviously. Starbucks in its early years was in this category. It was the place you could actually get a high quality espresso in the US. I actually chose my Dallas house location based on the fact that I could walk to four Starbucks stores.Tesla has always been in Stage One because its admirable CEO refuses to bureaucratize in his anti-social and probably anti-MBA style. When viewing Stage One companies, I find myself filled with love and admiration for capitalism and creativity.

Stage Two is the maturation stage - where markets get saturated and the companies seek to cross-sell products into their mature markets. Often, there are delightful customer improvements as the Stage One purism settles down. These Stage Two companies have attractive financials as the capex requirements settle down and business practices stabilize. The companies become quantifiably investable, because at this stage, companies are finally profitable. Without profits, ideas are unsustainable. However, this is also the stage in which companies start to wander out of doing for the customer into doing to the customer. The add-on services are usually chosen based on increased profitability, higher operating leverage and all those MBA concepts. The speed at which the company moves from doing for to doing to is a function of leadership and founder leadership is more likely to slow this inexorable journey.

For example, Starbucks finally started to get food products and juices in its stores. But because these cross-selling opportunities are not focal, they are usually inferior to the core offering. It's hard to believe that Howard Schultz could've spent time in Italian espresso shops with their fresh orange juice making and then sell the god-awful juices they put in their coolers. I've never had a Wow! moment in any of their cross-selling attempts - because I believe these attempts are directed financially. When Tesla starts to expand to more accessories, I will probably feel the same about their choices. When viewing Stage Two companies, I find myself filled with admiration for the efficiency and effectiveness of the large scale of services provided - in contrast to government services.

Finally, Stage Three is repugnant stage of screwing the trapped customer, utilizing every trick in the "profit maximization" catalogue. At this point, companies have managed to hold off competition or dominate it in such a way that taking advantage of the customer is a viable business model. Think Jack Welch and the culture he spawned. At this stage, the companies continue to increase profitability and are investable. I believe that owning Comcast today might be one such company. Investors become focused strictly on the "delta" as analysts cheer every clever trick and bemoan every attempt to reinvest in the business. Since the successes at the earlier two stages were strong, this allows flourishing as a Stage Three company. But the end is near as these dynamics set the stage for another Stage One founder to disrupt.

When Howard Schultz left leadership in 2017, the focal point was to reintroduce its premium branding and differentiate itself from a McDonald's-type drive through experience. Yet, his successor with a gaggle of spreadsheet running supporters managed to shut down such directives and scale into schemes to sell more stuff more quickly. Schultz's return may portend a return to at least Stage Two levels. Such changes do occur but require exceptional ability. That type of change occurred at Microsoft when Satya Nadella replaced Steve Ballmer. Steve Ballmer had been continuing to forcefully implement Bill Gates' Windows-centric model on the world. Satya Nadella did the unthinkable - reset the company on a cloud-based journey to meet the needs of its corporate customers. 

When I view Stage Three companies, they fill me with a sense of disgust and even shame. Since all companies end up here, why not support other socio-economic models? My support for capitalism lies in its ability to renew. Much as older generations attempt to hold on to the past legislatively and culturally, they are inevitably replaced by a new generation. Mother Nature knows best. Capitalism and its profit-seeking behavior seems to best imitate Mother Nature's ability to effect the death of the old and the birth of the new.

Big Pharma Big Expectations

When speaking with clients about their pharmaceutical holdings, I consistently hear dissatisfaction concerning the cost and structure of drug development. First, there is dismay over the astonishing cost of some newly developed drugs. Second, there is dismay over the seemingly automatic utilization of more and more drugs as wellness solutions are rarely offered or implemented. Third, there is dismay over the inability to generate better drug outcomes with less side effects. 

In a sense, all of this disappointment is rooted in the pharmaceutical industry's outsize success in treating certain problems, particularly within infectious diseases. As a result of this success, the general public was willing to try more treatments, the medical community was willing to prescribe more treatments and the investment community was willing to fund more treatments. 

The unintended consequence has been to lose sight of what gains are likely to make against various forms of disease. For example, Alzheimer's is a truly awful disease and affects almost everyone by debilitating someone they know. Yet, my reluctance to grant that brain science is even close to solving this problem has prevented some monetary and reputational losses (so far).

My broad takeaways after years of investing within this sector are: 1) the body is much more complex than any of us imagine, 2) wellness practices will continue to generate the best ROI, 3) specific areas of pharmaceutical success are knowable when the mechanism is clearly understood and 4) a diverse pipeline of consumer-like but medically proven drugs is the most investable approach.