The purpose of this weekly is to sharpen my thinking by sharing thoughts about industries and companies that fit into powerful long-term investment themes. It is also a place to share insights into decision-making, takeaways from the past week, and random thoughts that arise. Thank you for reading this piece! Feedback is welcomed. 

This post: 

• Starting from Abundance, Economic Cycle Impact 

Starting from Abundance, Economic Cycle Impact 

We define abundance for companies as having growth prospects, robust margins, and high returns on capital. Many companies are founded on this goal, and it is a great goal that will benefit shareholders in the long run?

What gets confusing for investors, company employees, and casual observers is that many, if not all companies, have a great pitch deck that outlines how they plan to get to a level of abundance in the future once they grow to a certain level. 

Some companies are already operating in a state of abundance, proven by the combination of past consistent growth, stable margins, and high returns on capital. We favor these companies over all others for many reasons, and the one we will discuss today is the impact of economic cycles on companies, with a specific focus on the pandemic. 

Financial and economic cycles are inevitable, it is part of the process of a prosperous economy. Simplistically, when the economy is strong, more demand for services often exceeds supply. Conversely, when the economy is weak, there is less demand for goods and services. The impact on companies will vary depending on the company and the severity of the pullback in demand. 

The typical person and investor have some level of fear associated with economic downturns. There are always ample predictions reported on in the media about the pending recession and subsequent crash in the market. There are good variations of jokes about prognosticators who have “predicted 30 of the last 2 recessions.”

Putting aside the impact on equity markets, our experience has been that the companies that come from a level of abundance are better prepared to handle an inevitable reduction in demand. It seems obvious and completely intuitive. It doesn’t seem to be a common thought, however. 

Many of the so-called “pandemic darlings” experienced increased demand during the lockdown period of the pandemic. At first, it was going to be a few weeks, but as we all remember too well, it became an extended period when we were at home. When this realization set in, consumer demand went almost entirely toward company products and services that were consistent with the work-from-home and stay-at-home reality. 

We were invested in some of these companies at the time and had a front-row seat for the changes to their businesses. Others we simply observed from a distance. Amazingly, the pandemic started about this time four years ago. 

We believe that it is best to judge a company over longer periods of time and look for the cause and effect of company performance and stock performance. When we go back five years, we can reflect on a period in 2019 where companies were navigating a rise in interest rates in 2018 and a generally stable economy. Following the initial panic in the market during the initial shutdowns, we witnessed a boom for the “pandemic darlings.” 

Revenue increased dramatically relative to both the prior levels of growth and relative to expectations. Markets recovered and made new highs, but the darlings outperformed the rest of the market. 

Once we got through the first two years of people at home, many of these beneficiaries experienced some slowdown in revenue, as what must be considered as a pull-forward of demand during the pandemic period inevitably cooled. 

We segmented the group of “pandemic darlings” into three groups: those that we owned then or own today in one group (“Control Group”), and those widely referenced in the media as pandemic beneficiaries but not owned or followed in another group (“Other Pandemic Darlings”), and the last being the (“Magnificent 7”), which we would argue were beneficiaries as well.

The data speaks volumes about the importance of starting with abundance. The Control Group all had past growth and solid to high returns on capital. Despite facing tough conditions at times, the companies continued to deliver solid returns on capital. Despite a deceleration in growth, the companies’stocks performed well, especially viewed over a five-year horizon. 

The same can be said for the Magnificent 7, who as a group, performed exceptionally well at the corporate level, and were rewarded with truly superior performance over the last five years. This group powered right through the pandemic without serious issues related to growth, and certainly didn’t miss a beat on profitability and returns on capital.

The “Other Pandemic Darlings” group had a wild ride, with the average stock price return from March 2020 to March 2021 of 297%, but when looked at over longer periods such as 3, 4, and 5 years, the results are disappointing. This is consistent with our observation that, in the long term, the market is willing to award companies a valuation that reflects high expectations for future profits and returns on capital for some time but not forever. 

There was so much hope and expectations that the demand from the pandemic would propel all pandemic beneficiaries to new heights. 

How did these companies get investors so excited and then have their subsequent year returns be so bad? These companies didn’t prove their business models. If you look at the first table, the returns on capital are negative. This is a clear indication that the business models have not been proven and have yet to be proven to add economic value to shareholders. The market will award valuations for high growth if there is the potential to have the company show profits and returns on capital in the future. What happened with many of these companies is that the market became skeptical about the sustainability of the growth, and when you combine it with no profitability, the values assigned to these companies plummeted. 

It is important to highlight that some of the companies in both the control group and the Magnificent Seven have seen their revenue growth slow or decline outright. Even with this being the case, the longer-term results reflect the market’s confidence in the strength of the business models.

We have experienced economic downturns before, and the rolling downturns following the pandemic have certainly provided some surprises, both positively and negatively. The overall impact though on individual companies and their valuations are consistent with the way economic downturns mature. Companies that have unproven business models have issues related to growth and for investors, it can be challenging as the market takes valuations down to reflect both uncertainty regarding future growth and its ability to weather a downturn or perhaps permanently lower level of growth. 

Companies with strong business models, those that start with abundance, are not only in better position to weather a slowdown, but market valuations will also reflect the assumption that their business models will allow a recovery when demand returns. 

We have the philosophy that starting from a position of abundance gives companies that we have ownership in a higher probability of success from a business perspective. We also believe that even if there is a slowdown in demand, these types of companies cannot only survive due to their ability to self-sustain, they have the potential to come out the other side even stronger. 

Note: Arrowside Capital owns positions in Pool Corp, Trex, Floor and Décor, Wingstop, RH, Lululemon, Apple, Nvidia, and Microsoft. 

My story 

I am an investor and entrepreneur, having started two investment companies. I am the Founder and CIO of ArrowSide Capital (http://www.arrowside.com), based in Boston, MA. I have more than 30 years of experience in the investment business, investing in companies geared toward innovation and growth. The blog is named 

The Zen Innovation Investor because I believe it is so important to remain calm and focused during the rapid pace of change in the world today. I am keeping a view of the long term while also keeping abreast of developments in the world of innovative companies. I view this as a place to sharpen my thinking and provide some insights that are thought-provoking. 

Disclosures 

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