The S&P 500 is down 9% so far in 2022 as of this writing. The Nasdaq Composite Index is performing even worse, having fallen 15% year to date. Investors are fearful. And to be sure, there's plenty to be afraid of.
I'm not immune to fear. Indeed, I have concerns about specific macroeconomic issues, including inflation. But I'm not waiting on the sidelines entirely. On the contrary, I've doubled my position in advertising technology company PubMatic (PUBM 1.80%) in recent weeks because I believe it's poised to outperform the market despite my misgivings about the economy.
Here's what I'm scared of
Inflation is my top concern with the economy. The Department of Labor released the most recent inflation numbers on March 10, showing the fastest inflation rate since 1982. Personally, I don't believe the rate will moderate quickly, and I don't think prices will ever return to "normal."
Consider hourly wage inflation over the past year. Many fast-food restaurants have doubled starting pay for entry-level jobs. I can't imagine that new hires will settle for the old hourly rate, especially since the cost of living is rising so quickly. Therefore, higher hourly wages are likely here to stay. And when expenses such as labor costs go up permanently, businesses are bound to pass the cost on to consumers through higher prices for their goods and services.
Image source: Getty Images.
To help me navigate our inflationary economy, I read works by investor extraordinaire Warren Buffett. In the 1970s and 1980s, U.S. inflation was high, and Buffett shared his thoughts on that situation with shareholders of Berkshire Hathaway in his 1983 letter.
Explaining his preference for asset-light businesses (in the mold of PubMatic) in an inflationary environment, Buffett wrote, "Asset-heavy businesses generally earn low rates of return -- rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses."
Some businesses have high ongoing capital requirements to maintain current revenue. This is problematic on its own and exacerbated by high inflation. For example, let's say you have to spend $50 million on equipment to generate $100 million in revenue, and the equipment needs to be replaced every five years. But it won't cost $50 million when it's time to replace; the costs will be far higher due to inflation. Perhaps profits look good compared with old capital requirements, but inflation robs shareholder value when the new capital-expenditure bill comes due.
Image source: Getty Images.
Here's why PubMatic is a good stock to buy now
For some businesses, incremental revenue comes with associated incremental costs. By contrast, PubMatic stock makes sense right now, partly because the company is so asset-light. For 2021, cash used for property and equipment only increased 26% year over year, even though revenue for the year was up by a more robust 53%.
Moreover, PubMatic's gross profit margin increased from 72% in 2020 to 74% in 2021. At the same time, its net profit margin increased from 18% to 25%. In short, PubMatic is generating higher revenue with relatively little extra cost.
Also, consider that PubMatic has above-average control over its future expenses because it owns its own infrastructure instead of relying on public cloud providers. The cost of revenue per ad impression was down 28% year over year in 2021, and management attributed this improvement to owning its infrastructure.
The economy undoubtedly has surprises around the corner, as it always does. But that's another reason why I like PubMatic stock right now. It ended 2021 with $160 million in cash, cash equivalents, and marketable securities coupled with zero debt. The company has the enviable financial flexibility to absorb whatever the world throws at it in the coming years.
And I'd be remiss not to mention the stock's attractive valuation. PubMatic is a highly profitable company, so investors can evaluate the stock on an earnings basis. Its trailing price-to-earnings (P/E) ratio is just 19 right now. According to Yardeni Research, the current P/E average for the S&P 500 is 22. Therefore, with PubMatic, you're getting a high-quality stock at a below-average valuation.
One thing to watch
If inflation leads to a recession, as some economists fear, then it's possible advertisers will cut back on spending. That would be detrimental for advertising technology companies like PubMatic until consumer spending recovers.
However, digital advertising will likely take market share from traditional advertising in the long term. According to eMarketer, growth in digital ad spending outpaced total ad spending in 2021 by a wide margin, as it's done for many years now. So advertisers might cut back on spending some years. But spending will increasingly be on digital channels, to PubMatic's benefit.
Few companies have a great valuation, the ability to weather present challenges, and such a robust long-term tailwind. Having all three is a powerful combination. And that's why I'm loading up on PubMatic stock right now.
