Untangling Supply Chains Post-Pandemic
Supply chains have seemed hopelessly tangled since the pandemic — an understandable phenomenon given the drastic economic shutdowns and reopenings that followed one another with relatively little advance notice. The result has been supply and demand mismatches and timing issues — some of which have taken longer to manifest than others. Recently, we’ve seen an uptick in the number of management teams in a handful of industries, citing supply chain frictions and whipsaws as well as destocking concerns weighing on near-term fundamentals. So, is this just another cyclical issue that may create some interesting near-term opportunities, or might it be something deeper and longer-term?
One helpful illustration for framing some of these recent issues is an old business school simulation called the MIT Beer Game, a staple in logistics classes for years. In the simulation, the class is split into teams, each player representing one node in the beer supply chain. As the professor introduces supply and demand shocks — heatwaves, a fire at a brewery, a bad hops harvest, etc. — the resulting mismatches between orders and fulfillment are more significant than many students anticipate. For example, orders will double or triple, but there will be no inventory to match until suddenly when inventory does arrive, orders will stop entirely — but producers will add too much capacity, so the ripple effects happen in reverse and wreak havoc in that direction, too. This is largely what we’ve been living with since the pandemic: Following a hard shutdown, we restarted in fits and starts, and the result has been havoc in many areas and multiple directions that has lasted longer than some may have anticipated. But if we all hearkened back to the beer game, it shouldn’t be that shocking.
We are seeing the impact on several portfolio names, including Ashland, Wesco, Target, Texas Instruments and others. The challenge for us as portfolio managers is identifying normalized revenue and profits amid rather extraordinary conditions. Were previous levels misleadingly high because the industry was overproducing while inventories were running up? Or are current revenues and margins artificially low, given a wave of destocking? Or is there some other structural problem, e.g., end-market demand challenges or people switching to other products, that explains current fundamentals? The company may be doing poorly relative to competitors. Regardless, it makes calculating normalized revenue and profitability — which has always been the first step in estimating a company’s intrinsic value — particularly challenging.
So, we approach this challenge by wading through the destocking noise and taking a hard look at signals about end-market demand. We examine what competitors are experiencing and look for signs of any change in competitiveness. For now, we don’t see any data suggesting our holdings are experiencing more than transitory supply chain issues kicked off by the pandemic. On the contrary, such situations can sometimes create opportunity.
For example, Ashland is a high-quality specialty ingredients company that primarily provides natural and synthetic ingredients to pharmaceuticals, home and personal care, and coatings customers. Its shares have sold off recently as the company has experienced its second round of destocking among customers. In response, Ashland has, again, backed off on production, accepting lower overhead absorption that compresses current margins. But we don’t think it’s an end-market demand problem or a loss of competitiveness — on the contrary, we think management is responding appropriately by steadily buying back shares on the weak price, and we, in turn, have also added to our position. This illustrates how having done the hard work to understand the situation, we can capitalize on a share-price pullback.
Target is another interesting example of a company that has faced meaningful supply chain challenges but has also presented an attractive investing opportunity. We initiated a position in June 2023 after a year of rigorously researching and discussing the company internally. Just a few quarters prior to purchasing shares, we had liked Target’s long-term prospects given its position as one of only a handful of retailers that has invested heavily in a true omnichannel offering for its customers. The company also has a strong management team with a history of innovation in retail. And we thought it had strong growth prospects in a relatively mature industry over the next several years.
However, we couldn’t overlook the fact that Target had benefited tremendously from the pandemic and had experienced massive sales growth — well above historical trends. We recognized there were many moving pieces underlying that rapid jump, so it was hard for us to get comfortable with how sustainable the long-term earnings power was or the valuation based on the current earnings power. So, we decided to wait for a few quarters, watch the earnings, and continue discussing what we were seeing with our analysts. That time gave us a more attractive entry point in June 2023 when a couple of trends intersected.
The first trend was a normalization of the rapid growth we saw during the pandemic. Sales started trending lower, and management took decisive action to reduce inventories — which induced some near-term margin pain as it discounted prices to reduce inventories to sustainable levels from which they could again grow. We expected such a move at some point — though we didn’t know the precise timing — and it was a welcome one, in our view, as it helped normalize the financials. Second, there was a short-term sales disruption when Target became enmeshed in controversy surrounding its Pride month merchandising, which prompted some boycotts and hit sales reasonably hard in the short term. The combination of these trends resulted in a meaningful sell-off in the shares over a relatively short period, which gave us the opportunity we’d been looking for and allowed us to initiate a position in what we believe is an attractive company with a favorable long-term outlook.
We expect these supply chain issues to continue ironing themselves out over the period ahead — and it will remain our responsibility to do the hard work of trying to identify where the truth lies on every balance sheet. Though this has always been the job of deep, fundamental research-oriented investors, it has arguably become more critical (and possibly slightly more complex) in an era of pandemic-induced supply and demand mismatches. But those willing to do the hard work are likelier to identify compelling opportunities where others might fail to understand the underlying causes of near-term price dislocations.
As of 30 September 2023, Diamond Hill owned shares of Ashland Inc, WESCO International Inc, Target Corp, Texas Instruments Inc.
The views expressed are those of Diamond Hill as of September 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.