From the editor-in-chief...
There are many reasons why US stocks have massively outperformed over the last few decades – low interest rates have helped, as has the stunning success of America’s tech giants. But the huge gains have also been about America’s embrace of “optimisation”, says Edward Chancellor on Breakingviews.
In the name of efficiency,
US companies have run down inventories and contracted out their manufacturing to the other side of the world (mostly to China) and replaced as much equity as possible with debt. This has worked absolute wonders for their return on equity (ROE). Last year listed US companies produced an ROE of 17% – against a mere 9% in Japan. No wonder investors have been keener on paying more for the former than the latter.
Until now at least. The new world is not like the old: “optimisation has rendered the corporate world more fragile”. Indebted companies are very vulnerable to recession and rising interest rates. Those dependant on offshore manufacturing are vulnerable to supply-chain disruption – something that became nastily obvious during the pandemic – and given the war in Ukraine and endless brutal lockdowns in China this is clearly not a short-term problem.
This tells us something very important about the thing companies should be prioritising in the 2020s: not efficiency, not optimisation, but slack. Vertical integration is making a comeback: some luxury-goods brands are buying up their suppliers and chip giant Intel is planning to build its own plants in the US and in Germany. Just-in-time manufacturing is on the way out. Reshoring (something we have been talking about for some time at MoneyWeek) is very much on the way in.
The search for slack
The problem, of course, is that slack is hard to find, as the inflation numbers show: US inflation is now running at a 40-year high of 8.5%. There is significantly less than is comfortable in energy (ie, none – see Jeremy Grantham on page 15), far too little in most metals (including uranium – see page 5) and nowhere near enough in agriculture (see page 38 where Bill discusses the misery of rising food prices).
How should investors react? First, make sure you are not overinvested in the companies that are going to need to buy in slack by moving manufacturing onshore, by cutting back on debt levels and by holding high levels of inventories (and which will have to take the hit to their margins and share prices and all that implies).
Second, invest in the firms that will be lack-of-slack winners – think about the fossil-fuel and mining companies that have been relatively capital starved over the last decade. Lack of supply and rising prices will be very nice for them. Of that 8.5% rise in US prices, 32% of it was down to rising energy prices.
Third, look for companies that never gave up their slack in the first place and have been underpriced as a result. There are still opportunities in the US (see page 18). But for Chancellor this new dynamic means you have to look at Japan, “one of the few developed economies to have retained its manufacturing base” and one in which many companies still operate “with plenty of redundancy”. He isn’t the only one to have noticed this: on page 14 we look at just how excited private equity is getting about the bargains in Tokyo.
“Companies should be prioritising slack, not efficiency and optimisation”