At the time of writing, virtually the entire planet is recovering from COVID-19 induced supply shocks and the related “revenge spending” on the part of households flush with cash and facing limited and unappealing choices for how to spend it in the service sector of the economy. As a result, demand for durable and non-durable goods has skyrocketed, pressuring supply chains from end to end, from Shanghai to Long Beach and from your neighborhood auto dealer to your local grocery store.
Upstream, at the “top” of the supply chain, widely publicized shortages of key semiconductor components have upended the auto industry, leaving would be car buyers to face both hefty sticker shock and in many cases lengthy delays in receiving new vehicles, with inflationary ripple effects felt in both used and rental car pricing as well. In non-durable goods, such as food, COVID-19 outbreaks at densely staffed meatpacking plants have severely pressured availability and prices for meat. In other consumer goods categories, the prevailing wisdom, going as far back as September urged Christmas shoppers to shop early, whether in person or online, to avoid disappointment in the form of out-of-stocks or shipping delays.
In the midstream, or transportation segment of the supply chain, problems and capacity constraints are most acute – not surprisingly, since whether the product in question is a cookie, a screwdriver, an iPhone or a new car, they all require shipping of one sort or another. As of New Years Day, a record 106 cargo ships were awaiting a berth to unload in Los Angeles and Long Beach, North America’s busiest cargo ports, with some having waited weeks or even months to dock. Before the pandemic, it was unusual for even a handful of ships to await a berth. Major ports in New York/New Jersey, ports on the U.S. Gulf Coast and the Canadian Atlantic and Pacific coasts are also reporting berthing delays ranging from a few days to a few weeks. Delays are a function of both land and labour shortages, as more ships are arriving than berths exist to accommodate them, and as COVID-19 outbreaks sideline the dock workers who unload these vessels, causing further delays. Inland, rail freight is also severely backlogged due to congestion at ports and in some cases due to damaged track from extreme weather events. Trucking markets at the same time are as tight as many in the industry have ever seen. The all too easy answer to these woes, is to “shop local”, as small businesses have exhorted consumers to do, seemingly forever, but especially these last two years. The reality however is that globalization and the imperative of pursuing efficiency and low cost has created complex, lengthy and insufficiently resilient/flexible supply chains that now defy an easy pivot to “shop local” alternatives in almost all product categories.
Downstream, at retail, scenes like the one depicted below are all too common, with shortages now spanning numerous product categories unlike ‘the good old days’ of 2020 when toilet paper was perhaps scarce but everything else was still plentiful. Data from IRI, the highly sophisticated and leading global consultant to consumer-packaged goods firms and retailers shows a demand index of 103 for their omnichannel broad basket (food, beverage, general merchandise, beauty, health, homecare, tobacco, alcohol) of consumer packaged goods as of Jan 9th as compared to a supply index of 98, and an “in-stock” position of just 89%. Abstracting from the sophisticated math and big, big, big data underlying these indices, which is both over our heads and beyond the scope of this piece, Economics 101 tells us what happens when demand meaningfully exceeds available supply – shortages ensue and prices rise, often dramatically, as we recently wrote about in the e-article Death, Taxes…and Inflation. At retail, upstream supply chain problems at manufacturers and transportation companies are further compounded by chronic labour shortages, particularly in the United States, and acute short-term absenteeism among front line workers because of the recent Omicron outbreak in both Canada and the United States. In short, if you can’t build it, you can’t ship it. If you can’t ship it, you can’t stock it, and if you can’t stock it, you can’t sell it. This is obviously true regardless of the level of end market demand for any particular product.
Much as we might like to, we can no more as investment managers than as consumers wish away the supply chain problems plaguing the global economy. Instead, our challenge is to play the hand we’ve been dealt and position portfolios more heavily in companies that are either resilient to supply chain bottlenecks, or better yet in companies that directly benefit from excess demand/supply shortages while limiting and thoughtfully managing our exposure to companies dis-advantaged by these bottlenecks. Conceptually then, the analytical task is to measure and manage our exposure to four distinct groups of companies:
1. Companies disadvantaged by supply chain pressures
In general, companies that produce unbranded, undifferentiated products, where pricing power is low and where shipping costs are consequential to the overall delivered cost of the good are most at risk in the current environment. Bulk com-modity producers are the poster child for this category of business.
2. Companies well insulated from supply chain pressures
This group of companies sells differentiated product, with strong consumer brand recognition. In addition, this group of companies sell and transport high value-to-weight ratio goods, where shipping costs are low in relation to the overall de-livered cost of the product (i.e. think diamonds, as opposed to coal).
3. Companies totally insulated from supply chain pressures
Service sector companies or companies that deal in intangible goods don’t manufacture or transport physical products whatsoever and are thus immune to raw material shortages and transportation bottlenecks, apart from ancillary and trivial impacts on their general and administrative functions (i.e. shortages of paper and ink for the photocopier, for instance).
4. Companies that directly benefit from supply chain pressures
One company’s cost is invariably another company’s revenue, and thus companies that fulfill supply chain functions for manufacturers and/or retailers stand to benefit from tight market conditions via stronger pricing power and typically higher margins as well. Transportation and logistics companies are the most obvious example of this type of business.
Not every company in our portfolios falls neatly into one of these categories, but many do, including companies that comprise approximately 73% of the combined Canadian and U.S. portfolios by value, and we categorize those as shown in the diagram below. Companies like Brookfield Asset Management, however, defy easy classification because although notionally a financial services company, the company straddles the world of the real economy, where as an owner and operator of real assets they face supply chain problems, and the financial world, where as a fee-based asset manager, they do not. Similarly, property and casualty insurers like Intact Financial and Chubb, operate in the financial services sector underwriting risk, but settle claims for property and auto damages in the real world, where inflationary parts and labour shortages pressure their loss ratios and their profitability. Retailers like CVS, Lowes and Alimentation Couche-Tard also don’t fit neatly into any particular category, since they are at the downstream end of the supply chain, and thus don’t face manufacturing raw material input shortages and cost pressures, nor must they in most cases incur the transportation costs to get goods onto their shop floors, although they are currently struggling to keep stores fully staffed and they do run the risk of lost sales when customers find items out-of-stock, but these are often mitigated by substitute purchases (i.e. Pepsi for Coke in a convenience store, or generic label ibuprofen for Advil in a pharmacy).
Armed with this information, a few insights emerge:
Lastly, it’s important to stress that sound investment analysis is necessarily complex and multifaceted. For this reason, we resist the temptation to take the simplistic knee jerk measure of promptly selling everything on the right side of the diagram and adding to positions on the left side of the diagram, and other similar businesses. For one thing, we don’t pre-tend to know how long the current supply chain choke points will persist, but we can reasonably assume that once they do abate – and they will, otherwise great businesses currently struggling against unusual economic forces will recover quick-ly, and this recovery will be reflected in their share prices. And secondly, we need to acknowledge other mitigating forces at work as well, such as for instance, the generational shift to electric vehicles which GM is capitalizing upon aggressively, and elsewhere, the high and rising commodity prices which Freeport McMoran and Nutrien stand to benefit from.
In the short to medium term, raw material shortages, transportation bottlenecks, out-of-stocks and cost inflation are here to stay, but as shown above, we are confident that the companies we own are collectively very well positioned to weather these challenges. Longer term, it’s reasonable to expect that the current unprecedented supply chain problems will give rise to a comprehensive rethink about the importance of flexibility, resiliency and redundancy in supply chain design, and perhaps even a fundamental re-evaluation of the inherent trade-off between cost and security of supply, perhaps partially reversing the three decades and counting phenomenon of globalization in favour of “onshoring” and “nearshoring” and we will remain attuned to the attendant risks and opportunities that such a seismic shift could bring about.
