A Comment -- General Comments From an Expert (A Commentary)

Why can negative working capital be a sign of great business?

Of course, negative working capital could be a sign of financial difficulty if the company’s fundamentals are deteriorating. For example, if sales and earnings decline year after year, the company struggles to generate cash flow, and the company also has a high leverage profile, then negative working capital could signal near-term trouble for the company.

However, there is a small group of businesses that have a superior business model or strong competitive position in the value chain, which helps them negotiate better payment terms. These characteristics allow the company to be extremely cash generative, while at the same time maintaining steady growth in revenue and earnings over the years.

For instance, a software company, or cable company where customers usually pay annual subscription fees in advance before the company needs to provide any service. Or a retailer that sells merchandise and collects cash well before it needs to pay its suppliers for the inventory, etc. 
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The issue is that the Fed and central banks around the world are really worried about inflation. The really need to get it down to the 2% range. They don't want to change that number because it will make them look wobbly. They're better off pushing up inflation in this environment because we haven't seen a fall in employment and such. It's slowed down, but hasn't collapsed. 

It's an opportunity for them to push up interest rates by 50 bps or so, and bring down inflation. Inflation is a very difficult thing. It affects one segment of the population more than another. The wealthy don't spend as much of a percentage on food and gasoline, where inflation really hits. 

Rates are peaking. They're not going to go up another 5-6%.

The problem is that Covid caused a massive dislocation in the world economy. So it's very hard to figure out when this normalization is going to happen. People didn't expect inflation to go up this much.

That's the risk. We could be in a place where inflation comes down, employment doesn't go up a lot, have a very soft landing recession, and rates stay high longer than expected but decline over time. China is having deflation.

He can't predict recession or not. There's a possibility we don't have one, but we get a soft landing and move on in the world. That doesn't mean that stock markets can't be volatile. It's just that he doesn't have the expectation of a recession that people are talking about and, if we do, it could be much milder than people think.

Yes. This is a chance to do work on companies that you like for the long term. A lot of companies out there are at a reasonable valuation such as Canadian banks, utilities, telecoms. Lots of companies have great dividend yields and are not trading at extreme multiples, so this is not a bad time.

Remember that the stock market goes up a lot more than it goes down. When it goes down, you want the fall to be shallow for your portfolio. Being out of the market is a bad thing if you have a long-term perspective.

Very cheap at these levels.

The really big drugs do not actually solve a health problem; you may have to take them for the rest of your life. In general, healthcare companies are defensive with decent dividend yields. They'll protect you in the market.

It's really about what kind of pipeline they have, and what the value of the pipeline is for a particular drug. For example, the weight-loss drugs could have a massive opportunity, but a cancer drug may only be worth $750M because it affects so few people. Look at what drugs they have and what markets they're working in.

Up till the end of June, the narrow focus of the Magnificent 7 companies accounted for almost all of the gains in the year. Since then and into July the breadth has broadened, which is healthy for markets. We're going to see more of what we've seen this week in big up days, big down days, and lots of volatility due to uncertainty and lots of news stories.

Expanding breadth shows more confidence in the markets, the tech sector, and those 7 companies. Inflation numbers coming down a bit helps confidence levels. When you see investors going into shares of all companies, it signals a stronger conviction. Still, the volatility will continue.

He agrees that the majority of rate hikes have taken place. The bigger question is how long inflation stays high. It's generally perceived that rate hikes are coming to an end next year. That might not be the case if inflation stays above the Fed target of 1-3%. In that case, rates will stay higher for longer, causing markets to lean off a bit of the confidence they've had lately.

He sticks to a diversified portfolio, so if he had to lean, it would be a little more defensive. He has a few of the Magnificent 7 stocks, but the key is diversity. To manage the volatility be exposed to all sectors, some defensive and some growth.

You'll have great up days and then down days. Over time in the markets, the up days are better, but you have to position for those down days. A portion of his portfolios is in cash, which he looks to deploy to his advantage on down days.

He'd agree 100% that investors should not be looking to buy and sell within a year. If you need the money within a year, keep it out of the stock market. The longer time horizon lets you weather the volatility better. Companies themselves don't look just a year ahead, their timeframe is much longer. The longer you can go, the better off you'll be.

The dividend growth metrics are high for all of these companies. If rates stay the same, high dividends are better than what the market's providing, but it might not be substantially higher to justify the additional risk. So you want to keep your eye on it. What you're looking for is if they can grow the dividend as well as assets and volumes going through those assets.

What does negative working capital mean?

Negative working capital means a company’s short-term assets are less than its short-term liabilities. What this financial metric indicates is that the company collects cash from customers in advance before it needs to deliver any of its goods or services or pay suppliers. Of course, negative working capital could be a sign of financial difficulty if the company’s fundamentals are deteriorating. For example, if sales and earnings decline year after year, the company struggles to generate cash flow, and the company also has a high leverage profile, then negative working capital could signal near-term trouble for the company.

However, there is a small group of businesses that have a superior business model or strong competitive position in the value chain, which helps them negotiate better payment terms.
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He expects oil prices to keep climbing. Much of the reason is psychological, driven by a subtle backlash in EVs. Unlimited demand for EVs is over. Maybe that's due to a lack of charging stations, higher prices for EVs, or maybe the novelty has worn out. Also, hydrogen fuels are too early for mass adoption. Better to invest in pipeline stocks (and their rich dividends) than charging stations.