Dear Investors,
The ‘Santa Claus’ rally investors hoped for never came, instead, all major indexes fell. The Federal Reserve is telling us to expect higher rates for a longer period leading many to fear a recession in ’23. Professional investors struggled to navigate a market with so much uncertainty. Many amateur investors, who had taken up trading as a past time during ’20 and ’21, saw their game change and many decided to pursue other hobbies instead.
For 2022, our Opportunity Strategy was down 7.73% in ’22 vs. the S&P 500 stock index down 18.11%, (its worst year for stocks since 2008). Even through rough waters, many of the stocks we own ended the year higher. AutoZone, Cummins, Deere, Dollar General, Cheniere Energy, Olin, O’Reilly, Occidental Petroleum, Teva, and ExxonMobil all had gains. However, tech stocks suffered as stocks such as Apple (worst performance since 2008), Amazon (worst performance since 2000), Alphabet (Google), and Intel suffered substantial share price declines. Paramount Global, Home Depot and Target also saw declining share prices.
We sold out of higher growth companies such as Adobe and Booking Holdings which were selling at rich valuations and concentrated more money into companies with a history of sustainable, knowable, and predictable earnings.
Over the past 5 years, the stock market as measured by the S&P 500 index saw returns of -6%, 29%, 16%, 27%, and -19% for a 5-year average of 9.4%. With the 10-year U.S. Treasury bond (a risk-free investment) now earning 3.88%, we expect overall stock market returns to be lower. If you know me well, I often quote Mr. Buffett saying, “the key to happiness is low expectations.” As value investors, we attempt to buy lower and trim or sell as prices move toward what we believe their full value is. Our Opportunity Strategy currently trades at a price to earnings ratio of 14.5 vs. the S&P 500 index of 20.0. One could say our portfolio is about 27% cheaper than the overall market.
Investors can often offset losses in the stock market with gains or smaller losses in bonds. This time was different. The Bloomberg aggregate bond index was -13% for the year. The Bloomberg municipal bond index -8.5%.
Risk
This brings us back to how one should think about risk. Academia defines risk by the standard deviations of returns vs. those of an appropriate index. This is really a measure of volatility, not of risk. We view risk as a permanent loss of capital (money).
Going back to the very fundamentals of value investing found in Benjamin Graham and David Dodd’s Security Analysis, written in 1929. “A stock is not just a ticker symbol or an electronic blip; it is an ownership interest in an actual business, with an underlying value that does not depend on its share price.” In other words, investing is buying an ownership of business, not worrying about the day-to-day price. Warren Buffett, Graham’s most famous student, takes this a step further. He likes to talk about owning a farm. You do not get a quote on your farm every day, nor should you want one. You buy it for its earning power, not because you think you can sell it next week, month, or year to someone else for more money. You are concerned with what it produces over a long period of time, not the short-term value.
You do not need to own 50 to 100 stocks to have a diversified portfolio. I would argue, a concentrated portfolio, comprised of companies one thoroughly understands, has researched thoroughly, and spent much time with it, is less risky than a widely diversified portfolio made up of random securities chosen, based on economic forecasts, or selected by so-called experts which have never even read the company’s annual report.
During ’22, Energy made the biggest comeback since Lazarus. The sector was +59% with all other sectors in the S&P 500 index having negative returns. Consider how bad the S&P 500 return would have been if it did not contain any energy stocks.
This graph is from the Wall Street Journal’s Year-End Review & Outlook. ExxonMobil and Chevron were both resurrected into the top 20 companies as ranked by market capitalization. We also see the fall in Tesla and Meta Platforms (Facebook).
Berkshire Hathaway, our largest holding, ended the year in the number five position. I would like to point out while Berkshire does not rate #1 in revenues, it does rate #2 in earnings with a net income of about $90 billion. Only Apple earns more, roughly $100 billion. Meta and Tesla earned $28 billion and $11 billion, respectively. This was a year that investors looked to companies with earnings and sold companies which had no earnings or are experiencing slowing growth, in the case of Meta.
Eli Lily and United Healthcare rose in the rankings over the prior two years. Pfizer also snuck into the #20 position, likely due to the COVID vaccine. We would be surprised to see them stick in this position. The only healthcare company we own is Teva, which is more of a special situation. Healthcare makes up about 17% of the U.S. economy and the demand for most services is virtually inelastic, meaning people must have it, it is not optional or discretionary. We believe in investing within a circle of competence and healthcare is not within ours.
What will happen in 2023?
As you may know, we do not believe in forecasts. One must however have an opinion or viewpoint on likely future outcomes based upon what is knowable and observable.
We believe interest rates will continue to rise as indicated by the Federal Reserve. They increased the Fed Funds rate (rates at which banks can borrow from one another) by one half of a percent at their last meeting in December to range of 4.25% - 4.50%. Note: Other rates are closely tied to or derived from the Fed Funds rate, thus our reason for discussing. They believe a rate of 5% is within the target range to be sufficiently restrictive. To tame inflation, they are putting the brakes on the economy. A change in the darker orange line (see this graph) may suggest a lower or higher policy rate, therefore we will just have to wait and see where inflation comes in once we are a few months into ’23 and see where the Fed takes it. The takeaway here is we have a good idea of where we are headed.
Companies with maturing debt in ’23 or ’24 will likely have to pay higher rates on new bonds. Loans will also be more costly. Therefore companies with debt maturing far out into the future or carrying a net cash position will have an advantage. Many of the stocks we like continue to be fairly valued, not bargains, in our opinion. There are generally moments which the market becomes pessimistic about an event or misunderstands something, and investors are offered a fat pitch to swing at. We will wait for our opportunities to swing the bat.
Lastly, I want to point out the long-term optimism we have. It is within our human nature to focus on short-term events; however, if we look at life through a longer-term lens, we can see economic shocks, recessions, depressions, and wars are merely bumps in the road. This Morningstar graph is a great picture of 150 years of the stock market. To my young readers, what has worked over time is continuous investing on a regular basis over a long period of time. My prayer for you is when you reach retirement age you have way more money than you will ever need and will seek to help those less fortunate than you.
I hope this provides insightful information with respect to our investment philosophy as well as some of the companies we like and why.
Thanks for reading and please contact us with any questions or comments.
Sincerely,
Brady Ritchey
Chief Investment Officer