Sharpening our Pencils for 2022

The Covid induced shutdowns of last year created lots of “noisiness” in corporate earnings, which made for many long nights evaluating the financials of stocks. But as we prepare for 2022, the work will not be any easier. This week markets were rightfully rattled by the financial breakdown and potential default of Evergrand, one of the largest real estate developers in China. The Chinese government has since guided local governments to prepare for unrest, as the company has missed paying staff and suppliers, and an estimated 1.5 million home-buyers may not receive their finished houses. Here in the U.S., Federal Reserve Chair Jerome Powell stated that Wells Fargo will continue to be subject to asset caps limiting their lending until they shore-up operational procedures and governance. The White House has proposed the “Chips for America Act” to address semiconductor shortages caused by plant shut-downs in Asia due to Covid outbreaks, while the global supply chain continues to face delays caused by port and shipping staffing problems related to Covid. Despite these challenges, the Leading Economic Indicators continue to rise, and the U.S. Treasury yield curve remains upward sloping, both suggesting that the economy will be solid 6-12 months in the future. So why do we need to sharpen our pencils?

Earnings will likely grow at a slower rate in 2022, so stock selection will be critical to achieving good investment performance while mitigating portfolio risk. Over-valued darlings will fall with even nominal earnings misses. This month, we took a quick dive into the overall financial health of the S&P 500. The average debt:equity ratio, which expresses how much debt a company holds versus its value, sits at 1.98, so they owe twice the value of the company. Imagine owning a home worth $400,000 and owing $800,000 on it! There are only 18 companies with zero debt. There are 90 companies with negative earnings growth (trailing 5-year earnings per share), and only 50 have growth over +25%. The average price:earnings ratio is around 35, showing that any slowing of earnings in 2022 will likely cause weaker stocks to falter. It is so important to not over-pay for earnings streams when the possibility of slower growth rates is likely.

Yes, I still use a pencil and Texas Instrument BAII Plus calculator from time to time – but in reality, we will be burning the midnight oil on Excel as we prepare the Pawleys Dividend Fund and Pawleys Growth Fund for 2022. Constructing a well-thought-out portfolio with stocks of companies with little or no debt, good earnings growth, and rock-solid cash flow will be even more important as we enter 2022. This discipline and balance, in my opinion, positions portfolios to perform well in a myriad of economic conditions while achieving built-in risk management.

Sources: Reuters, Refinitiv, yCharts, Conference Board

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