Get your Xanax ready. Annualized inflation will drop to a still highflying 5% during the next six months. Then it will retreat to around 3.5%, but could bounce up again. So says one of today's successful pickers of value stocks.
The deflationary era of falling costs and prices that extended from the 1980s until 2020? That's history, he adds.
But Michael Petro, manager of $292.6 million Putnam Small Cap Value Fund (PSLAX), sees a silver lining to inflation's clouds.
Petro — who is a bottom-up investor, picking value stocks based on individual merits — expects to find more investment opportunities among banks and energy companies. In those sectors, larger portions of companies stand to benefit from tailwinds created by inflation, he says.
This year through Sept. 30, the strategy has enabled Petro to outperform. Putnam Small Cap Value is down, but less than the broad market. The fund's return was -19.85% vs. -23.87% for the S&P 500 and -19.03% for the fund's small-cap value rivals tracked by Morningstar Direct.
Petro, 54, discussed his investment strategy with IBD from his Putnam Investments office in Boston. He addressed topics such as how he is dealing with warfare in Europe, when he expects the broad stock market to bottom and some of his favorite value stocks.
Value Stocks: How To Pick 'Em
IBD: What do good value stocks look like to you?
Michael Petro: They have a combination of attractive valuation, better than average quality business and some fundamental catalyst that is going to unlock the value that we see. Not all buys have all three attributes. But we try.
IBD: What do you like about small-cap value stocks in particular?
Petro: They're simpler. They don't have 15 divisions and operate in 38 countries. Instead, they usually have one or two or three key products.
We also like companies with upward earnings revisions. And we like a little share price momentum because these are small companies. They can literally be forgotten. So a little price momentum shows us that we're not catching a falling knife with a buy. Price momentum shows us other investors haven't forgotten the stock.
How Long Will Inflation Stay High?
IBD: How long will high inflation be a problem?
Petro: It looks like inflation has peaked. The shipping bottleneck is loosening. Semiconductors are becoming more available. We're also seeing an initial easing in tight labor markets. And of course the Federal Reserve has been raising rates aggressively.
But it takes time for inflation to retreat. Inflation will break below 5% in the next six months. By the end of 2023, it should come down to around 3.5%. But I am concerned it could rebound up later.
IBD: When will the market bottom?
Petro: We're just entering the bottoming process. It might be in the next three months or so. But the market can't move up in a sustainable way until investors have confidence that the Fed's rate cycle is done.
IBD: After that, is inflation going away?
Petro: The long-term deflationary cycle that we saw from the 1980s until 2020, that trend is over. We're now in a secular inflationary trend.
How Can Inflation Help You?
IBD: What's fueling inflation?
Petro: For one thing, the ratio of GDP going to wages is going up. We're seeing strength in the unionization movement and increased political willingness to raise minimum wages.
For another, globalization is reversing. Companies got burned by long supply chains during the pandemic. And China is a less desirable supplier for political reasons. So reshoring manufacturing is not an exercise in cost savings. Moving manufacturing back onshore, to America and North America, will add cost to production. That's inflationary.
IBD: Which industries are inflation plays?
Petro: Banks' stock-in-trade is money. So if inflation causes other businesses to require more working capital, that often means borrowing from a bank. And that's what we're seeing across the small-bank space.
IBD: Their lending fees rise faster than their deposit costs, right?
Petro: Yes, they do better as rates go up.
Value Stocks To Like
IBD: Does your stake in Eastern Bankshares, whose banks operate in Massachusetts and New Hampshire, reflect that?
Petro: When they did their IPO two years ago, they raised more capital than they needed. So, they're overcapitalized. They can use their excess capital to buy back their stock, even though they just issued stock. They've bought back 5% already. They'll buy back another 5%.
They've also used capital to acquire Century Bank.
And they've got good loan growth. It was over 10% on an annualized basis in their most recent quarter. That drives earnings.
And 35% of their deposits are noninterest-bearing. So when interest rates go up, they're going to be able to hold their cost of funding down more than other banks.
And their valuation is 1.75 times tangible book value, 12.3 times the next 12 months earnings. That's fair.
As for the catalyst, it's the stock buyback. And there's another. You can't sell your bank stock until three years after you go public. We're two years in. Investors are going to start wondering if this will be a takeout candidate.
Energy Sector: More Room To Run
IBD: Name another industry poised to benefit from inflation, please.
Petro: In past cycles, energy exploration and production companies got carried away. As energy prices rose, they increased production. But that hasn't happened this time. They got the message from the investing community that they need to make money. They've drilled a little more, but not a lot. So their costs have (been) stable. That will also help extend this cycle.
IBD: Name a likely beneficiary you hold.
Petro: CNX Resources is a low-cost provider of Marcellus Shale gas in Pennsylvania.
They're not into oil. They have super strong free cash flow. They have really low debt to equity, and it's dropping every month because they have great cash flow. They also have significant gathering and processing facilities, which gives them a cost advantage vs. other producers.
The cash flow yield on their 2022 guidance is 25% free cash flow to equity. That's a nice big number.
Plus, they're 86% hedged for 2022. (Hedging is the portion of production that's presold at set prices, which eliminates risk but limits upside potential.) That gives them high visibility for hitting their 2022 number. This is a nice defensive way to play the natural gas market. If you think the natural gas market will double, there are better ways to invest in it.
Energized Value Stocks
IBD: War is awful. Nonetheless, name an investment opportunity created by Russia's war on Ukraine.
Petro: There isn't any good that comes out of war. For people or for economies. But we're forced to weigh impacts. One we figured out early was the disruption to energy flows. That caused an increase in the number of ton miles to transport products like gas.
It is causing day rates of tankers to increase significantly. We invested in Scorpio Tankers (which owns petroleum tankers) in March. They generate tons of cash flow, which they're using to pay down debt and buy back stock and improve their balance sheet. They're making a lot of money right now.
Also, you're seeing refineries spring up in a lot of places. That requires tankers to handle the trade flows. It puts (upward) pressure on pricing as well.
IBD: Name a play you've made on a potential recession.
Petro: WillScot Mobile Mini Holdings leases mobile and modular storage units to everyone from retailers to construction companies. They're leased on two- to three-year terms. Let's say we have a recession. WillScot is defensive because customers don't want to pay for shipping units back and forth as demand rises and falls. They'd rather hold onto units (and) ride out the economic cycle. WillScot makes more money.
Tech Sector Bet
IBD: You've got about 7.5% of your portfolio at work in technology stocks. What's your thesis for Jabil, which makes electronics for the aerospace, automotive, computer and medical industries?
Petro: They put together products that everyone knows, (such as) Apple phones and iPads and computers. They make subcomponents like aluminum cases.
They're in the middle of a multiyear transition to what we think is a permanently higher-margin structure. We don't think that's reflected in the valuation.
They saw opportunities years ago and invested in them. So they've got partnerships with Johnson & Johnson Medical Devices. They're also into electric vehicles.
They've climbed from a 3% operating margin in 2019 to 5% in the quarter they just reported. So they beat their quarterly number, and they gave guidance for their fiscal year that was above the consensus estimate.
Agriculture Cycle
IBD: Titan Machinery, which runs a chain of agricultural and construction equipment stores, has seen shares fall since late August. Is there a problem?
Petro: The agricultural cycle is still under way. Strong commodity prices are supporting farming income, which drives equipment usage. They had supply chain issues, hampering deliveries. But that has simply extended their cycle.
Also, we see better margins because Titan is focused on their aftermarket and service offerings, and on improving those. They've also started restructuring their European operations. We think they'll get additional profitability out of those initiatives.
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