J. Paulo Silva, CFA, Senior Portfolio Manager, Senior Partner, Penn Capital Management Company, LLC
December 2, 2022
So far, this year has been about the aggressive posture of the Federal Reserve (Fed) to raise rates to combat inflation, creating a very volatile equity environment. As we close the year and see inflationary pressures peak, the market has begun to anticipate the end of this aggressive Fed hiking campaign as equities have rallied since the last CPI report, indicating a drop in inflation. Rising rates this year were most impactful to growth valuations as small cap growth stocks are down over twice as much as small cap value stocks year-to-date. With higher interest rates, companies’ cost of capital has increased dramatically in a short time frame. Investment grade borrowers saw their cost of capital nearly double, all due to the Fed’s movement of rates this year. Smaller companies experienced an even more significant rise in their cost of capital as high yield spreads climbed over 200 basis points in addition to the Fed raising rates. As the cost of debt capital increases, discount rates used to value equities also climb and companies that use cash to fund growth have lower valuations. Therefore, this environment has been more impactful to growth companies year-to-date. As we look to next year, we believe that inflation and long-term rates have peaked and although the Fed may target a 5% short-term rate, we think yield curves will become more inverted as we move closer to the terminal rate on Fed Policy.
While rates may have peaked, the path to the Fed lowering rates will likely take longer, as we believe that unemployment will remain below the Fed’s targeted level. We think the economy will slow in the coming year as rapid rate increases will likely change a company’s annual outlook for their capital budgets as the cost of capital increases and prospects for growth decrease. The bigger question is how dramatically the economy will slow and at what point does the Fed transition to lowering the federal funds rate. The pandemic and supply chain issues that arose during the rapid recovery have affected companies similarly but at varying timelines. The pandemic cut output very quickly and demand returned rapidly with record stimulus, causing supply chain disruptions across the globe. Some companies have already seen peak demand and rapid demand deterioration as industries that benefited from more time at home have suffered in a post-pandemic world. As we close the year, demand has fallen off in many areas, but supply chain issues continue to affect those where supply has not yet met demand. The auto industry is the most glaring example of semiconductor shortages that have hampered auto production for some time. For various industries, the prevailing trend is that companies overproduced and as demand has fallen, inventory has accumulated. In times of short supply, companies react similarly, competing to produce and guarantee the supply of their product to the market. The result is typically the same and the entire industry ends up with too much inventory as demand recedes. While the semiconductor industry is notorious for these cycles, it seems as though the global economy experienced this during the pandemic. After seeing environments of hyper-demand and short supply, companies often find it difficult to determine normalized levels. Given the dramatic output cuts during the pandemic, it is likely that companies will be more hesitant to adjust their businesses aggressively in what is perceived to be a big inventory correction. Layoffs could be tempered as companies struggle to adjust their cost structures in what could be a temporary environment. No company wants to layoff and rehire employees after the difficulties experienced during the pandemic.
As we think about beneficiaries in this environment, we believe it will be hard to see companies without durable cash flow models perform well. Growth companies that continue to burn cash without a path to positive cash flow will continue to struggle as the cost of capital remains high. Companies with too much debt may also struggle as a slowing economy could impact their free cash flow and potentially increase their cost of capital even further. We believe investors should focus on companies with durable cash flow models that can generate free cash flow that funds their operations. We believe that cash burn companies that need to raise equity and debt capital will likely struggle. We think it will be important for investors to focus on debt maturity schedules as an indicator of a company’s ability to raise capital in the markets, something imperative for their survival. In a restrictive environment, we believe active management becomes increasingly important as the market navigates this more difficult backdrop. At Penn Capital, our integrated approach to investing through examining the company’s business models and their cost of debt capital becomes increasingly important in choosing appropriate investments. We believe that our focus on free cash flow generation and a company’s ability to fund its operations has the potential to drive higher returns in the future.
The views expressed are those of Penn Capital Management Company, LLC, a boutique manager on the Spouting Rock Asset Management platform, as of December 1, 2022, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.
