After making it through the busiest three weeks of second quarter earnings season, we would like to synthesize what we’ve learned from companies' reports, market's reactions to those reports, and assess how we should structure our portfolio to correctly reflect the state of the US economy. 

1. The high-end consumers are strong

How’s the consumer holding up in the face of the hottest inflation in four decades? Earnings season so far tells us the answer is not as simple as “well” or “poorly.” It depends where you look.

• High income consumers have been able to weather the inflationary storm better than those in low income brackets. The earnings reports from American Express (AXP) - high quality credit card targeted towards high-income customers - and LVMH group - parent company of luxury brands such as Christian Dior, Fendi, TAG Heuer, Dom Perignon champagne - offer evidence for this bifurcation.    

• On the other hand, for low-income customers, fast food giant McDonald’s (MCD) has said their customers are trading down to value-menu offerings and buy less high-priced items. Walmart (WMT), a low-price retailer, warned that inflation is causing many shoppers to spend more of their discretionary income on food and other essentials. 

The only consumer-focused stock that we own has so far been amazing. 

Costco

Costco (COST) hasn’t reported quarterly earnings yet, as the wholesale retailer operates on a slightly different calendar than others; its fiscal Q4 numbers are set to be released Sept. 22. We have, however, gotten its June and July monthly sales data, and both updates served to only bolster our conviction in owning Costco despite concerns about a recession and consumer slowdown. Recently, Costco said total comparable sales in July rose 10% overall (7% when excluding currency impacts and gasoline price changes). 

The company’s membership model really makes it the right retailer to own in this environment. Membership fees are its main source of profit, protecting the bottom line even as other retailers face pressure there. Those fees also allow the company to offer competitive prices on the actual products in its warehouses, appealing to price-conscious consumers due to inflation. That said, Costco’s members tend to skew toward higher-income brackets, meaning they may not be feeling as squeezed compared to, say, the average Walmart shopper. 

Apple

We actually did not own Apple into the quarter, which admittedly was a big mistake given the stock's incredible rally from $130 to $160 in one-month's time and how impressive the second quarter results were. Apple’s earnings report showed the resiliency of high-end consumers. For example, sales of iPhones in its April-to-June quarter topped Wall Street expectations, and CEO Tim Cook indicated the company saw “a record level of switchers” to iPhone from Android devices. In general, iPhones are thought to be premium smartphones.

2. Banks are doing fine

We continue to hold two financial stocks in the portfolio despite the fact recession fears have weighed on the group: Wells Fargo (WFC) and Morgan Stanley (MS).

Wells Fargo

Our reasons for owning Wells Fargo, in particular, got a bit of a lift Friday morning, when the July nonfarms payroll report came in much stronger than expected, a sign that the U.S. economy is holding strong despite the Federal Reserve's hawkish monetary policy to fight inflation. We're thinking of a best-of-both-world scenario as following, which should send shares "to the moon" 

• The first is a scenario in which inflation remains high, the economy remains strong, and the Federal Reserve continues to raise interest rates. Wells Fargo’s net interest income is boosted by higher interest rates. However, the risk is that if the economy goes into a recession, the banks lose money because of default risks and depressed economic activities.

• The second scenario would also have to occur, which is a strong economy (such as high employment). Remember, one of the risks to owning banks into a recession is higher credit risks (unpaid loans, defaults). The bank set aside $580 million in the second quarter to help cover potential loan losses. Defaults have been at relatively low levels during the pandemic, but with concerns about slowing economic growth, Wells Fargo believes they will likely increase in the coming months. However, if the economy remains strong, employment levels remain high, Wells Fargo could run into fewer bad loans than currently expected. 

Higher net interest income without a recession is a best-of-both-worlds outcome for Wells Fargo, one that's hard to believe for now but certainly Friday's jobs report hinted at. For that reason, we continue to own shares of Wells Fargo. 

Morgan Stanley

Morgan Stanley should also benefit from rising rates, but to a lesser extend than Wells Fargo because Morgan Stanley has less interest-rate bearing assets and less credit risks. Morgan Stanley has set itself apart from other banks, being a relatively conservative, risk-averse firm, catered towards high-income customers, driving stable revenue growth not so much through lending but asset management and advisory. We actually like Morgan Stanley more for its return of capital to shareholders.  

3. Tech earnings are ok

It’s no secret that the market has hated growth stocks this year because high interest rates eat away from valuations. We have been sticking by high-quality, high cash-flow and reasonable-multiple tech companies.

Microsoft

Microsoft delivered consistent growth in its cloud business driven by Azure and other cloud services, offset by softer PC demand, China lockdowns and supply disruptions. Microsoft also returned $12.4 billion to shareholders in its June quarter in the form of share repurchases and dividends, a 19% year over year increase.

Alphabet

Of the three main players in cloud computing solutions, Alphabet (GOOGL) places third. While the Google parent fell short on cloud revenue, we were encouraged to see momentum in this segment. The strong dollar and recession fears weighed on the quarter, but Alphabet has a best-in-class revenue growth, profitability and balance sheet.

Meta Platforms

Meta Platforms (META) - formerly Facebook - was one of the mega caps that missed on their latest earnings. It also delivered a bleak forecast, stemming from concerns about weaker demand from its advertising business coupled with higher expenses and foreign exchange headwinds.

Looking into the future, the metaverse will require the company to spend a lot of money, taking years before it can monetize. Moreover, TikTok is overpowering Meta’s Reels.

4. Oil companies are returning tons of cash

The theme for investing in oil and energy stocks for us has been their ability to generate superior free cash flows, a majority of which are given back to shareholders through share buybacks and dividends.

Chevron and Pioneer Natural Resources

Chevron (CVX) had a knockout quarter benefitting from higher oil prices. 

Pioneer Natural Resources (PXD) returned more than 95% of its free cash flow to shareholders after reporting better than anticipated earnings. Even if oil prices decline, we are confident Pioneer can maintain cash returns to shareholders because it has 20 years’ worth of inventory. Pioneer is the highest dividend-yielding stock in the S&P 500, with an annual fixed-plus-variable dividend yield of ~15% at this price.

Given the recent decline in oil and energy stocks, 10% of our portfolio is in oil. We're getting incrementally more bullish on this sector as oil prices fall closer to $80 barrel price level. Recall, this is the price that WTI crude was trading at before the Russian invasion of Ukraine and subsequent sanctions from the West that disrupts the oil supply-demand picture. The war is going nowhere, and there is no replacement of the oil that Russia used to provide to the world. The supply picture will actually get worse towards the end of the year, when some of the West's sanctions will officially kick in. In short, the supply is not getting better in any way. 

The other side is demand. It is with higher probability that demand will go lower (and that's probably why oil prices have declined from above $100/barrel to now $88/barrel). However, this is an interesting dynamic that allows us to treat oil and energy names as a hedge for our portfolio. If oil prices continue to fall, the inflation picture gets better (lower inflation) and take pressure off the Fed to raise rates so aggressively. That would benefit virtually the 90% of our portfolio.