The Forest, and the Trees

The past few years have been dominated by big "macro" concerns like COVID, inflation, war, as well as rising borrowing costs and political tensions. While the "macro" undeniably has a huge impact on the global economy and often dominates the news headlines, the "micro" impact of management decisions for individual companies to drive profitability and growth can be equally important on the market's prospects and often gets overlooked. While sentiment around corporate earnings is decidedly downbeat given well publicized growth headwinds and rising costs, the reaction to company reports since this earnings season started a few weeks ago has been better than expected. While it's early days in this earnings season, this is likely a reflection of bad news already being "priced in" to depressed valuations for certain companies' share prices, while investors are getting a better handle on the levers well managed companies can pull to improve their earnings profile, in addition to a macro backdrop that, while gloomy, is improving at the margins (falling inflation pressures, peaking borrowing costs, falling political risks).

Here's what we've observed to date:

• Aggressive cost cutting. Many companies hired aggressively during the COVID lockdowns, and are now right-sizing their workforces to reflect softening growth outlooks and protect their margins. Google's 12,000 person layoff announcement (or 6% of their workforce) is just the latest in a string of job cuts by technology and other companies that staffed up during the lockdowns. This has positive implications for inflation down the road as wage pressures are a key driver of core inflation.
• Easing supply chain strains. The supply chain has been a major headache for companies over the past two years, as shipping or production delays meant they either they didn't have the products to meet demand or they were suddenly flush with product just as demand was softening. ASML, a Dutch lithography company that is integral to the global semiconductor market, issued a positive earnings pre-announcement this week and highlighted a normalized supply chain as the key driver of the improved outlook as they were able to book more of their order backlog into revenues.
• Improved demand from a re-opening China. While big mining companies like Rio Tinto and BHP Billiton also highlighted dropping freight rates in their earnings reports (further evidence of improving supply chains), they also flagged how much China's re-opening process and measures to support failing property developers is constructive for end market demand for key industrial metals like copper, iron ore and coal. One negative read-through of this development is that it may place upward pressure on global commodity prices, which has contributed to softening headline inflation figures for the past few months. The positive read-through is that key exporting partners to China (Japan, Europe and the U.S.) should all see their revenues flattered as a result.
• Cleaner inventories. Companies like Target and Wal-mart who overstocked during the COVID lockdowns made the difficult decision several months ago to flush out inventories at heavy discounts to clean up their balance sheets and improve their pricing power going forward. If comments from big consumer goods companies like Proctor and Gamble last week are any indication, much of the hard work has already been done which should flatter future earnings reports. P&G's management team commented on their earnings call that they don't expect to see further inventory cuts among U.S. channel partners and that they feel inventories are now back to pre-COVID levels. There are still pockets of weakness (note the price cuts from Tesla announced last week amid a collapse in used car prices), but the broader backdrop is improving.
• Bank results have been good, but expectations are high.  Banks are navigating through this credit cycle well with provisions for bad loans coming in line with or below market expectations. This indicates that the global consumer is absorbing the rate hikes of the past year and banks learned their lessons from past crises and have been more conservative with their lending practices. One negative for this group is that they aren't benefiting from rising rates as much as the market expected they would, with net interest income and margins coming in below expectations for most. As expected, investment banking and trading revenues have declined precipitously as IPO and Merger & Acquisition activity falls from its 2021 highs.

Our broader takeaway is that while it's sometimes hard to distinguish the forest from the trees, some trees may be a lot healthier than the forest as a whole.  In short, there’s a lot of quality management teams that are doing what needs to be done to drive long term shareholder value, which, along with a macro landscape that is improving at the margin, should be a key driver of investment returns going forward.  Naturally, we are trying to identify the healthiest trees in the forest to park our tents under, while harvesting those that are going to fall down anyways.