The first quarter of 2022 proved to be eventful for large cap investors of all stripes, both active and passive.
For Q1, 2022, the Dow Jones Industrial Average declined by 4.4%. The S&P 500 fell by 4.7% on the quarter. The Nasdaq composite index declined by 7.6%.
As for the Gnostic Large Cap portfolio, the account barely stayed in positive territory for Q1, closing with a value of $661.29 per share, compared to the year end 2021 value of $661.14 per share. Considering that the account holds no direct commodity investments, I am somewhat surprised that it remained in the black at all.
Adjusted for inflation, or even against US Treasuries, all broadly based equity indexes, as well as the Gnostic Capital account, underperformed in Q1.
Commodities and materials were the strong relative performers in the first quarter of 2022. Oils, metals, basic industrial and agricultural chemicals as well as food commodities appreciated quite strongly upon the outbreak of the Russian war in Ukraine. Unsurprisingly, these products comprise a significant component of the GDP for both warring nations and represent sources of hard currency. Substitution away from Russia and Ukraine as a supplier is punishingly expensive for a global economy that no longer adheres to a healthy maintenance of inventory surplus at the factory level.
Considering that the carry cost of inventory, using low cost financing, permits a producer to hold about a full year’s worth of raw materials at an out of pocket cost well below that of even a few weeks of production disruption, it appears that yet another consulting solution to maximize profits, the “just in time inventory” practice, isn’t worth spit in a world that is balkanizing into hostile actors who would prefer to not trade with one another. Just-in-time success assumes that all parties work in concert for a mutual benefit; it fails utterly when one or more parties decide to break the supply chain.
Supply chain stressors in Q1 may wreak havoc with many corporate earnings reports throughout 2022.
Belatedly realizing that the global supply chain is now a set of ‘western” vs “anti-western” blocs, each possessing certain components required to manufacture a complete item, and not holding sufficient inventory of the items required to maintain output, will keep manufacturers on edge this year and perhaps beyond. No effective fast resolution of the supply chain shortage issue exists; scooping up scarce inventory, at absurd prices, in a sellers market, is the manufacturing equivalent of retail investors jumping onto equity fads in a hot market; one fraught with risk and as likely to backfire as it is to succeed.
Almost the entire manufacturing capacity of the planet has too fully embraced just-in-time inventory management. For the bulk of manufacturers to shift away from that system and immediately hold enough raw materials on-premises would be highly inflationary in its own right.
Toyota Motor Corp. has been credited as the pioneer of just-in-time manufacturing in the 1930’s using a myriad of suppliers, all geographically situated within an easy driving distance from one another, almost all located within the same country. In the 1990’s, modern efficiency consultants looked at the Toyota model and opined: “why stick to suppliers all within one country when an entire planet of componentry and raw material producers may be pitted against one another, in a winner take all effort to reduce prices? What could go wrong with that?”
As anyone can attest, a whole lot can go wrong with a common sense, regional, manufacturing model that is twisted and stretched beyond its original and sensible application. Lean manufacturing only works with a fully globalized supply chain of, if not outright allies, at least tolerant partners. Covid-19 should have represented the first awakening of deeply structural fissures in a global supply chain overly focused upon lean manufacturing. We got through Covid-19 supply issues, we all swallowed, said “never again” but did little other than mutter slogans.
Russia invaded Ukraine this year; again, we all inhale deeply, thunder “never again“, but have not, as yet, mapped out a game-plan to resolve our inventory issues in manufacturing. What will happen should China invade Taiwan at some point in the near-term and the public is forced to use their same iphone, for three consecutive years in a row?
Just what will it take for the western manufacturers to wean themselves off of models that cannot withstand systemic shocks?
The 2008 recession forced governments to examine global banks, determine that capital controls were inadequate under global stressors, and forced changes. Post 2008, banks and financial institutions were required to hold more capital than they claimed were needed for day to day operations. Banks grumbled for almost a decade, but got through that capital increase and are now better for it. Are similar government interventions needed at the manufacturing and commodity producer levels as well? Do manufacturers need to be regulated to hold more inventory onsite to maintain production, in the event of external shocks? I hope not, but nothing is certain.
Here is one example of how tight the global supply chain really is, and the potential consequences for consumers.
Russia, Ukraine and Belarus produce the bulk of the world’s phosphate fertilizers. Sanctions on Belarus, deliberate withholding by Russia and wartime disruptions in Ukraine have resulted in a very real supply shortage for mined phosphates and chemically produced fertilizers worldwide. Canada is capable of increasing production significantly in the coming years to take up the some of the slack, but railroads lack the railcars capable of shipping more fertilizer output to end users. To increase output sharply requires the opening of new potash mines; it also takes time to make a rail car and to run rail lines to new mines. The fertilizer shortfall could have been a non event had about a years worth of inventory been maintained globally; nobody planned for a major supply shock. Lacking fertilizers, overall crop yields could fall by 15% globally. This would lead to a spike in basic food prices.
Lacking these supplies, farmers, in desperation, are now talking up organic sources to alleviate, in some small part, unavailable minerals and chemicals. Organic fertilizer sounds like a lovely, latte sipping, tree hugging moniker. What it really comes down to, after we peel off the label, is animal derived urea (N), potassium (K) and phosphorous (P). More bluntly, it means the spraying of animal excrement and urine on food crops. Most people would prefer not to know how hot dogs are made nor would they want to know the intricacies of NPK fertilizers. Natural NPK fertilizers are already being used full tilt, have been for hundreds of years and the global supply of bovine, porcine and poultry excrement is already spoken for.
There aren’t many species left on the planets capable of producing a sufficient amount of NPK for crops; but there is one mammal left on the planet, numbering in the billions, capable of excreting enough highly concentrated urea and potassium rich dung to aid in the fertilization of fields, and that’s humans. There will be a lot of farm families in developing nations bottling their urine in 2022, tank spraying it on their fields and pricing their crops at a premium because this application, as gross as it sounds, meets the standard of organic farming. Farm families in developed nations could, in a desperate pinch, also start pumping out their septic tanks, diluting the contents with water and apply it directly onto fields to add NPK. This is what it has come down to, not really so far off from the the famous phrase uttered in the 1973 dystopian classic film, Soylent Green, lamented by Charlton Heston: “Soylent Green is People!” Eerily enough, that movie was set in the year 2022.
“There are solutions with relatively low costs,” he said. But even if simple, they require public investment and technical assistance, which are currently lacking, he added.”
One upside to geo-political macro shocks is that internal weaknesses at the corporate level are often revealed in the aftermath.
Mastercard indicated that Russian and Ukrainian business accounted for about 6% of its 2021 consolidated revenues. Mastercard is completely withdrawing from processing interchange payments in Russia and the result will be a reduction in revenues for 2022. Given the overall growth profile of Mastercard globally and the profit margins earned on each dollar of revenue, Mastercard should be able to overcome that business reduction in as little as 4 months, all else being equal.
Alternatively, PayPal Holdings, which processes its payments in Russia and Ukraine over the Mastercard network and is proportionately tied to Mastercard on that basis, has yet to telegraph their coming top line revenue reductions from the closure of the Mastercard business in Russia. A grown-up company capable of tolerating a financial hit to top and bottom lines will always proactively indicate the impact of external business stresses; immature companies will not.
I consider the Russian business to be proportionately higher margin than many other countries, given the innovative movement of funds and the types of products involved. The disclosure by MA of the Russian book of business and its estimated impact on the top line, coupled with the lack of a similar announcement at PayPal, exhausted all my remaining patience for holding shares in the latter. A company with a $135 billion market cap, savaged by lack of disclosures, should know better than to persist in denial through silence. The BNPL expansion model at PayPal led me to question the investment on a likelihood of margin compression; subsequent lack of disclosures on guidance forecasts, for my purpose, call into question the entire business model and the failure of PayPal to acknowledge the business hit from Russia sealed the deal. Accordingly, the model portfolio, in Q1, fully exited the position in PayPal Holdings. Perhaps, when grown-ups are placed in charge of PayPal who choose to invest profits towards margin accretion, rather than margin reduction, I will revisit the story. Until that day comes, if ever, my equity capital deserves to be invested elsewhere.
It can be disappointing to part with a rather long held investment but some conflate emotional attachment and capital allocation. My supply of emotions are largely unlimited and they are virtually free but my investment capital is in finite supply. Furthermore, to make the most of secular surfing requires that the equipment needed to ride a wave is suitable. I no longer require PayPal to continue surfing the money supply growth wave and I have come to the conclusion that instead of being priced as a major fintech offering a monopoly style service, PYPL is in uncomfortable process of being repriced to a valuation more reflective with a VAR (value added reseller). That seems appropriate, taking into account the margin revision that one is forced to divine in 2022 guidance. I prefer to sit higher up on the margin chain.