Tailwinds and Headwinds were originally posted in the Weekly Updates for May 6 and May 13, respectively.
When I originally wrote about these two topics in May 2022, the three American Indexes – the S&P 500 Index (S&P), the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite Index (Nasdaq) – were trending downward since the start of 2022. As you can see in the chart below, there had been mini rallies in February and mid March, but if you were to draw a line connecting the tops of any rally you would see the downward trend, especially at the end of March. This is even more noticeable if you connect the bottoms.
In mid April, the Toronto Stock Exchange Composite Index (TSX) joined the downward trend. As of May 13, 2022, the TSX had fallen almost 5.8%, the S&P was down over 16%, the DJIA dropped 12% and the Nasdaq had plunged over 27%. I would rather not know the losses of the three portfolios, so I did not bother calculating their losses. Since they are all more technology oriented, I would guess they were closer to the Nasdaq’s performance (and they have not gotten any better since I originally wrote this five months ago). ☹ Rather than lament my losses on paper, I decided I would write about two characteristics I look for when investing in companies.
So, without further ado, …. my lightly edited take on how tailwinds and headwinds can impact the growth of companies.
With the markets maintaining a downward trajectory its hard to stay engaged in investing and it can be downright depressing. I know I am not following the markets as much as in the past because its discouraging watching my money disappear.
This week, rather than talk about the market, I have decided to talk about one of the things I look for when searching for companies to own – tailwinds.
Tailwinds
If you have ever flown, you have probably heard the terms headwinds and tailwinds. Tailwinds propel a plane forward faster, helping them burn less fuel and possibly arriving at their destination sooner. Headwinds slow the plane down, causing it to burn more fuel and possibly arriving late at their destination. In investing, tailwinds are conditions or trends that will continue through economic ups and downs and help boost a company’s revenues, profitability, and share price. Headwinds, on the other hand, function as a drag on a company and can slow down or even cause growth to decline. Obviously, you want to invest in companies that are benefiting from one or more tailwinds and avoid headwinds as much as possible. Unfortunately, some headwinds you cannot avoid. Let us take a look at how these ‘winds’ can impact your wealth generation plans. This week I am going to talk about how I have looked for tailwinds when selecting companies to invest in.
The tailwind is your friend, an even better friend when you can ride multiple tailwinds.
When I got back into investing in 2018, before I started looking for companies to invest in, I looked for tailwinds, or industries that had trends that could boost a company’s earnings and share price. Once I identified a few tailwinds, I looked for the best companies to take advantage of those tailwinds. If the company was riding more than one tailwind, all the better.
One of the first tailwinds I came across was the demand for chips (of the silicon variety, not the potato kind). Cloud computing was and remains all the rage, artificial intelligence was and continues to improve and expand, the growing demand for electric and autonomous vehicles, the rollout of 5G networks, and the metaverse is supposedly the next big thing (each of these can be seen as a tailwind). Rather than try to pick a top company in each area, I focused on what they had in common – semiconductors, or chips. With that in mind I went looking for semiconductor companies. I ended up investing in Nvidia (NYSE:NVDA), Skyworks Solutions (NASD:SWKS) and Lattice Networks (NASD:LSCC). The tailwinds behind the semiconductor industry are tremendous and all three companies have done very well, and I expect them to continue to ride the numerous tailwinds that drive the demand for semiconductors.
Another industry that has quietly picked up a tailwind is cybersecurity. Cybersecurity was on my radar but not really front and centre. It came to the forefront in mid 2020 when a friend was almost the victim of a computer fraud attack. With increased numbers of people working from home (work from home tailwind) during the Covid-19 pandemic, governments, companies, and individuals suddenly had many more systems to protect. Cyberattacks range from malware to ransomware to state sponsored hacking. The Russian invasion of Ukraine has only heightened the threat of cyberattacks and the need for governments and businesses to up their security game.
After identifying the cybersecurity tailwind, I contacted a friend in the computer security industry to get some insight into the top cybersecurity companies. I decided to become a minority owner 😊 of Crowdstrike (NASD:CRWD) and Cloudflare (NYSE:NET). Crowdstrike has evolved into a cloud-based security platform (there is that cloud trend again, another trend within the cybersecurity trend) with multiple market opportunities. Cloudflare also provides network security solutions, as well as Content Delivery Services (CDN), a geographically distributed group of computer systems which “work together to provide fast delivery of Internet content.” Its like bringing YouTube videos closer to you to reduce the time to access and stream them. I even started using Cloudflare’s free Virtual Private Network (VPN) client Warp 1.1.1.1 to protect my data when I access the Internet. Both companies continue to ride the tailwind for the need to secure remote workers, within the larger cybersecurity tailwind. So far 2022 has been a rough year for all technology companies, including cybersecurity companies, but the demand for cybersecurity remains.
In summary, I try to identify tailwinds and then find the top companies riding those tailwinds. Great companies will do well in the long run but if they can ride a tailwind or two, they will generate better earnings and their share price will rise higher, faster. Next time I will talk about headwinds which can slow the growth of investments and even cause your portfolio to decline.
Rather than dwelling on the pain of 2022, I am going to talk about the conditions I look to avoid when selecting companies to own. Last week I talked about tailwinds that can accelerate the growth of companies when looking for investment opportunities. Headwinds are the opposite of tailwinds. They are unseen forces that drive down growth and earnings of companies. Obviously, you want to avoid companies with their own unique headwinds, but there are other headwinds you cannot avoid. These headwinds are the ones I am going to talk about today.
Headwinds
Unfortunately for us investors, in 2022 the markets in general have been facing the opposite of tailwinds – headwinds. There has been no shortage of headwinds facing the economy and the stock market for a while now. At the end of 2021, investors were concerned about how COVID-19 and its numerous variants would impact the economy. They were also worried about rising inflation and how it would inevitably lead to higher interest rate which would cut into revenues as companies are forced to pay more to service their debt. More money to pay down debt means less money to grow the company and earnings, or to go to shareholder friendly actions such as raise dividends or share buyback programs. In 2022, another headwind was added to Covid-19 and inflation concerns – the Russian invasion of Ukraine.
The Covid-19 pandemic continues to impact the global economy. In North America we are learning to live with it but in China many cities are under lockdown. Currently in China, people are forced to stay home, and factories sit idle, unable to produce many of the parts global industries rely on. This leads to ongoing supply chain issues, a phrase we have become all too familiar with over the last two years. In a nutshell, fewer workers lead to higher demand for workers, which leads to higher wages to attract workers. As well, fewer components mean more demand for those components and more demand leads to higher prices for those components. Higher wages and higher materials costs combine for higher prices for the finished products. Leading to inflation.
Both the Bank of Canada (BoC) and the US Federal Reserve Bank (Fed) aim for an Inflation rate of 2 – 3%. However, the inflation rate in Canada is above 6% and, in the US, its over 8%. In an effort to drive down inflation, the BoC and the Fed have both become aggressive in their respective fights to drive inflation back to their respective targets. This leads to our next headwind – rising interest rates.
One of the tools the central banks (the BoC and the Fed) use to fight inflation is to raise interest rates. Already this year we have seen rate hikes of .25% and .5% in both countries, and both central banks have indicated they could keep hiking in .5% increments until interest rates reach 2%. The higher the interest rates, the more money is required to pay down debt and loans. If you have any form of debt, you should already be experiencing higher debt payments. This is the same for companies with high levels of debt. The additional cash to service their debt could have been used to grow the company. In the case of high growth companies like technology companies, this slows their growth. When high growth companies do not create high growth, their share price gets hammered, as we are seeing in 2022 (and as my Portfolios can attest).
If Covid-19, inflation, and higher interest rates are not enough, the Russian invasion of Ukraine further disrupted energy and food supplies, adding to inflationary and supply chain problems. Russia is the third largest producer of oil, second largest producer of natural gas, and third largest wheat producer. Ukraine is the seventh largest producer of wheat. With these two major suppliers removed from the supply system (Russia due to sanctions, Ukraine busy defending itself), we are already experiencing higher food and energy costs. Not only are we seeing higher prices at the gas pumps, but we are also seeing higher prices in almost everything we consume thanks to higher production costs and transportation costs to get those products to market. Higher energy costs and higher food costs only add to inflation.
Finally, a recent headwind we are now seeing is irrational investor psychology. With the markets in a downdraft since the start of 2022, investors are simply selling to get out. They are ignoring companies that are performing well and selling their shares simply because the market is declining. This is irrational. People cannot wait for Boxing Day sales or Black Friday sales, because prices are lower. However, when the stock markets decline, investors unload their shares even though they know that over time the market goes up. This is one of the few times where people do not want to buy when items go on sale.
So, there you have it, five headwinds currently battering the stock market:
- Covid-19
- Inflation
- Higher interest rates
- War in Ukraine
- Irrational investor psychology
As with all market declines, these will pass, and the markets will resume their march higher. There is nothing we can do about it but ride out the storm.