It was yet another tough week for the stock market that tested investors' pain tolerances, as the major benchmarks all hit new lows for the year. The S&P 500 was the biggest weekly loser, saw its worst week since March 2020, the month the Covid pandemic was declared.

Driving the action once again this past week was inflation and recession fears altogether. On Monday and Tuesday, market was still selling off from the red-hot inflation report last Friday. On Wednesday, the Federal Reserve stepped up its fight against inflation by hiking interest rates by 0.75%. Stocks were slammed Thursday and seesawed Friday as investors worried that the Fed’s more aggressive posture would tip the economy into a recession.

While words of encouragement may do little to make any of us feel better when the declines have come week after week, we nonetheless want members to take some time over this three-day weekend to sit back and remember why they own stocks to begin with (the stock market is closed Monday in observance of Juneteenth). As long-term investors we must remember that these pieces of paper represent ownership in real, important businesses that consumers around the globe interact with every day, and have come to play indispensable roles in their lives.

Fundamentally, we must acknowledge that the risks are real and will hamper near-term earnings from even the strongest companies, be it due to foreign exchange dynamics or margin pressure resulting from inflation and supply chain bottlenecks. However, that's why we are where we are, with all major indices being in bear market territory (>20% decline). If history is any guide, unless the world is actually going to end this time (which if it is, stocks would be the least of your concern), we have to be mindful that this too will pass. The next question you should be asking is what things look like on the other side. Are we done using Google Search? Are enterprises going back to doing business on papers rather than digital? Are people done driving cars? Has semiconductor use peaked? How do we replace the oil and energy deficiency while President Biden would rather talk to Jimmy Kimmel than the CEOs of Chevron and Exxon?

The point we're making is, none of these trends have peaked and the macroeconomic events driving the market are simply speed bumps on a longer time horizon. As a result, we are staying the course, using history as our guide and being mindful that the reason equities have historically been the best house in the financial market neighborhood is because they compensate investors to endure the kind of volatility we are now experiencing. 

All of that is to say, we want to be buyers into this carnage, because there will be the other side. However, that's never to say buy whatever is out there. As we talked endlessly over the past few months, our buying focus remains in high-quality, dividend-paying stocks that are industry leaders; ones with little economic sensitivity and pristine balance sheets that will weather any type of storm that comes its way. In today's long post, let's discuss a couple of names on our focus list. 

1. Johnson & Johnson

Johnson & Johnson fits perfectly in our buying criteria. Each of its three businesses — pharmaceuticals, medical devices, and consumer products — have little to no economic sensitivity. The stock is paying nearly 2.7% dividend yield for investors to wait out this volatile market.

What also has us interested in J&J is its upcoming breakup. The company announced last November its plan to separate the consumer unit from the pharmaceutical and medical device businesses. We believe this breakup makes a lot of strategic sense as the two independent, market-leading companies will become more focused. Management will be able to move faster and more effectively allocate capital as they navigate different industry trends to meet the needs of their customers and patients. 

2. Procter & Gamble

There was only a handful of stocks in the S&P 500 trading higher Thursday as the broader market was down nearly 4%. Portfolio name Procter & Gamble (PG) was one of them. In fact, P&G shares were up 0.6%, among the best-performing stocks in an otherwise ugly session.

The reason for the outperformance is rather straightforward: most of S&P 500 constituents in the green fall into the category of recession-resistant stocks. That is, their core businesses tend to hold up well during economic slowdowns because consumers still need to buy whatever it is they’re selling. Wall Street’s recession fears appear to be accelerating Thursday after the Federal Reserve’s 75-basis point interest rate hike and subsequent commentary from the central bank’s chair, Jerome Powell, that he's willing to do whatever necessary (including inducing a recession) to bring down inflation.

P&G management recently offered an update on how the company and consumers are handling inflation.

Inflation is still a problem

Procter & Gamble CEO Jon Moeller and the company’s finance chief, Andre Schulten, talked candidly about the currently challenging economic environment at a conference hosted by Deutsche Bank on Thursday. Schulten was frank: P&G’s products continue to sell well, but the process to make them and ship them to shelves remains challenging.

That’s not exactly surprising, and we think the market was anticipating it based on the way P&G shares have traded over the past few weeks. After all, in April when P&G reported its fiscal third-quarter results, it raised its full-year fiscal 2022 after-tax inflation impact to $3.2 billion. It was the third quarter in a row P&G hiked its forecast for that figure.

Now, as then, the question is, when will inflationary pressures for both businesses and consumers ease significantly? Schulten’s comments Thursday morning suggest the answer is definitely not yet. Here’s what he had to say:

“While some feedstock costs and spot rate prices have begun to stabilize, upstream labor and energy cost inflation hitting our suppliers and service providers, along with inflation in our own direct costs, are affecting us more this quarter and will have a larger impact next fiscal year. Taken together, the headwinds this quarter are modestly higher than expected on both the top and bottom line. While these are relatively modest deviations from where we thought we’d be, we want to be transparent about where we are trending in this dynamic environment and about our intention to continue to invest in our business.”

P&G will provide official guidance in late July when reporting results for its March-to-June quarter, which will close out its fiscal year 2022. At present, Schulten said the company estimates more than $2.5 billion of after-tax “incremental costs” from freight, commodities and foreign exchange in fiscal 2023, next month.

Q4 guidance unchanged

Despite cost pressures, management said there’s been no change to P&G’s previously issued guidance. For fiscal 2022, P&G forecasts core earnings per share growth between 3% to 6% compared with its core EPS of $5.66 in the prior year. Schulten said EPS growth will likely be toward the lower range of that guidance. Management also stressed it plans to grow sales and earnings in fiscal 2023, even as inflationary pressures drag on. One reason P&G can still hit its guidance is because the company has been able to pass through higher costs to consumers by way of product price increases.

“We’ve not seen broad pushback on pricing, and we don’t expect that going forward,” Schulten said, noting P&G has announced additional price increases.

Sales picture

Moeller emphasized P&G’s focus on product innovations as a way create “superiority” in various categories. That perception of superiority establishes stickiness among consumers and allows for market-share growth, the CEO contended.

Moeller offered up another example, this time with Dawn soap, to show how improving products can also help P&G manage its own inflationary pressures. Here’s how Moeller explained that relationship:

“When we launched the Dawn EZ-Squeeze innovation, we also upgraded formulas across the entire Dawn lineup while taking a high single-digit price increase. The EZ-Squeeze innovation checks all the superiority boxes: superior product, package, brand communication, in-store execution, and consumer value. With the strength of the consumer proposition, some retailers chose to merchandise EZ-Squeeze with full price and capped displays, enhancing shopper awareness of the innovation while improving in retailer value in the process.”

While P&G believes this strategy is successful, Schulten acknowledged that in the current quarter in particular, some external factors weighed on the sales picture beyond just inflation.

• He specifically pointed to China’s strict Covid lockdowns in recent months, saying they’ve caused “softer market conditions than anticipated when we last gave guidance.”

• In Russia, the CFO said the pace of shipments has slowed as a “streamlined portfolio” and increase prices hit sales “more significantly than expected.” Some orders also were pulled forward into March because retailers were worried products may not be available, he said.

3. Oil and Energy (PXD, HAL)

Lastly, we want to provide our view on the energy sector, which is going through a very tough week of decline after outperforming the market all year. Make it clear, we have always been mindful that the energy sector, at some point, would get crushed from the high because it simply was too overextended. That's why we have been very disciplined since the start of the year, trimming gains in names like Chevron, Devon and Corterra. What we're trying to discuss here is to be mindful of the important role energy plays in any diversified portfolio.

All year energy stocks have been our hedge to inflation and it has been an excellent hedge. As oil prices went up, energy stocks went up, but at the expense of the rest of the market (because higher energy costs pressure profit margins). Now, when energy prices are sliding, we need to believe this would be positive for the rest of our portfolio. This dynamic is what we mean when discussing negative correlation in our diversification strategy. 

With that in mind, that's not to say we see any risk of our energy hedges become worthless. One, many energy stocks we own (or plan to own) have very large fixed-plus-variable dividend payments. We do not see any material risk to that, because these companies have very low break-even oil prices (in the $40 per barrel), and we can't think of any way WTI can go to $40/ barrel from the current $100/ barrel level in the short term. 

Pioneer Natural Resources (PXD)

Into the carnage of the energy names, we bought shares of this oil producer to enjoy a very large dividend yield. To combat this inflationary environment and the Federal Reserve aggressively raising interest rates, we continue to believe investors should prioritize cash flow generating, dividend paying stocks with great balance sheets like Pioneer. If you annualize Pioneer’s most recent base plus variable quarterly dividend of $7.38 per share, the dividend yield at the current share price would be about 12.2%. That means PXD pays shareholders nearly 4x benchmark 10-year Treasury yield of around 3.2%. In addition to the dividend, Pioneer also regularly repurchases of its stock, which reduces the outstanding shares and gives investors a bigger ownership in the company even if they don’t buy an more shares. 

Halliburton (HAL)

This purchase underlies our view that without a resolution to the war in Ukraine, global oil supply is too tight to meaningfully lower prices. The International Energy Agency said this week that they see risk to 2023 with global oil supply struggling to keep pace with demand due to the sanctions on Russia and producers brushing up against capacity constraints. This why we like Halliburton so much. It is not in the same camp as the exploration& production names such as Devon, Chevron or Pioneer. The company is a North-American-focused oilfield services company, that makes its money when producers increase spending and investment in production and capacity. Think of this name as a technology play for the oils: producers need to invest in high-grading their production process to increase efficiency.

When looking at the recent pullback in energy stocks, Halliburton doesn’t have the same type of dividend yield and share repurchase protection as our other oils names. HAL currently pays a dividend yield of about 1.4% and management is waiting for the business to generate more excess free cash flow before reinstituting the buyback. Current estimates on FactSet see Halliburton increasing its free cash flow to $1.94 billion in 2023 from $1.28 billion in 2022. 

Despite the relative differences in capital returns, we remain quite bullish on Halliburton’s fundamentals and believe the company is still in the early innings of a new up-cycle that will be more sustainable compared to ones in the past. This is because the industry has shifted to more profitable, short-cycle investments and away from capital intensive long-cycle projects. And with Halliburton’s equipment supply already tight as is, we see the potential for it to pass through many price increases and expand margins over the next few years. And we know the producers can absorb such price increases because they are so profitable at $115 West Texas Intermediate with sub-$40 break evens.