A Basic Industries Boom & the Return of the Real Economy

2022 Year in Review: The Bull Case on Essential Industries

Last week’s piece Short Term Stock Speculators Beat a Hasty Retreat, walked through the blizzard of work we did on the continued collapse of speculatively priced stocks in 2022.  Today, we present the best charts on the bullish material we highlighted last year.  We are not perma-bears here at KCR and believe there are tremendous long-opportunities for patient, disciplined, and low-cost active managers.

We believe the stretch from 2018-2021 was similar to the dot.com bubble.  Many novelty stocks soared to empirically indefensible valuations while basic industries were starved of capital.  Lacking novelty, these basic industries include energy, staples, financials, raw materials, the agriculture industry, and an array of other stocks that produce goods and services critical to modern civilization.

KCR understands the aversion to investing in cyclical stocks at what may be an economic high.  They have “earned” a great deal of stigma.   But we reiterate now, as we have since the start of 2021, that the prevalence of capital deprivation in these critical businesses was so severe that a massive investment cycle could occur.  We believe the gears of capitalism are in the process of rotating investors away from makers of “stuff we want” and into makers of “stuff we need.” 

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As KCR’s Bill R. is fond of saying, “starved for capital long enough, the worst businesses in the world can become the best stocks, while the best companies in the world can become the worst stocks after being flooded with liquidity.”  We think that sums the concept up quite nicely.

KCR sent up a bullish flare on the oil and gas industry in March 2020 during the Covid collapse before writing a bevy of bullish pieces throughout 2021.  We reinforced that position in our March of ‘22 piece Undervalued Energy Stocks.   In that work, we updated two charts that we believe summarize the entire energy thesis nicely.  The first chart below showed that by March of 2022, the Energy weighting in the S&P had indeed risen sharply since we became constructive on the sector, but was still near record lows.

The second chart we highlighted showed that capex in the industry was plumbing levels last seen at the peak of the dot.com bubble.   This is despite the fact that global GDP had grown from $33 trillion at year-end 1999 to over $96 trillion in 2021, according to the World Bank.

To the degree that basic industries and the real economy had been starved of capital, we highlighted IT as an area that had been flooded with capital.  In our piece Is it Too Late to Buy Oil Stocks we produced the chart below showing that energy stocks had never been less expensive relative to tech stocks.

One of our favorite groups of “basics” had been staples.  Using robust empirical evidence, we showed that Consumer Staples offered investors a generational opportunity to buy them in January of 2021- a theme we stuck with until September 2022.  In Safe Dividend Stocks, we highlighted that our staples picks had trounced the market and other groups we had panned as “empirically damned” over the prior 20 months.

Producing Tylenol to toilet paper, Consumer Staples stocks had put in such a terrific performance by September 2022 that many sported multiples above high-quality growth stocks.  We again highlighted the below chart showing that Staples stocks have only produced two periods of absolute negative returns since 1989.

This prompted us to shift Staples to the dreaded “hold.”  We advocated for sourcing income and dividends among less expensive, but no-less robust and stable stocks, as seen below.  Our piece, Inflation is Taxation without Legislation or Representation also advocated for a group of healthy, low-volatility stocks with yields above cash.

Most recently, KCR highlighted what has to be the single most hated industry we are aware of: mining.  With the ESG crowd running riot over government policies, even a fractional shift to a green grid and battery electric vehicles will cause the current mining boom to continue for much longer than expected.

Despite the powerful secular tailwinds, we explained in The Role of Critical Minerals in Clean Energy Transitions, mining stocks have never been cheaper than they are today.

The chart below from The Mining Boom Nobody Believes shows this in clear form.  The Metals and Mining industry has a FCF yield of nearly 8%, with many of KCR’s top picks sporting double-digit FCF yields.

Summarily, KCR’s empirically driven, evidence-based models send us a very clear message across various market caps and styles.  Basic industries have only looked this appealing once before in the prior 30+ years.  The last time, during the dot.com bubble, would prove to be a prelude to a nearly decade-long run of basics beating their broad benchmarks.

Investor neglect combined with newfound capital discipline in increasingly concentrated industries with high capital costs are a recipe for terrific returns, in our view.

Every one of our ranking models and model portfolios is overweight sectors and stocks that investors have learned to loathe.  These behavioral biases have been amplified by ESG advocates who rail against many of these basic industries.  Look at energy and the chemical industry.  These businesses are crucial to everything from heating our homes to ensuring the safe production and delivery of the global food supply.

We believe attitudes will soften and those willing to invest based on evidence instead of emotions will be well rewarded.  Investors’ biggest concern with these stocks seems to be a global recession.

As we have written, we are not here to dissuade you from those fears.  But we would ask: which stocks will suffer worse?  Makers of food, energy, and basics you must have or highly valued tech stocks that make discretionary goods?

We would like to thank our subscribers, old and new, for their faith in our team’s work and hope everyone is off to a terrific start to 2023!

Final Note: An Empirical View on an Asset Class & a Familiar Gripe with the Index Fund Complex

We would be remiss if we did not highlight one area KCR believes offers some of the largest pricing errors we have seen in our collective careers: small-cap stocks.

In Small Cap Quality Stocks: the Gift from the Index Fund Complex, we showed that value spreads had hit record levels.  In over 30 years of history, we have never seen such a high quality collection of names trading at such a sharp discount to the benchmark.

KCR added to this small-cap thesis in our brief video Small Cap Investing Strategies. In that video we explained the chart below showing that small-caps has almost never been valued at a such a large discount to large-caps.

We spilled a fair bit of ink over the course of 2022 explaining the brutally obvious deficiencies in Large Cap Core, Large Cap Growth, and Small Cap Indexes.^[1],[2],[3] The fund managers at KCR manage an All-Cap Index Fund and believe cheap beta is a valuable resource for any diversified investment portfolio.  But we also believe the dogma of some “index-only” advocates has never been more prevalent or misplaced than it is today.