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Second Quarter 2022: Keeping Our Eyes on The Ball

As the chart below illustrates, the second quarter of 2022 was challenging for investors. Stocks officially fell into bear-market territory. Bonds sold off, too. Technology stocks and cryptocurrencies crashed, triggering bankruptcies or closures of several crypto lenders and hedge funds. Over the past 12 months, only commodities provided positive returns. Rising interest rates, an appreciating US dollar, and high inflation stressed markets, and economists began discussing a possible recession as soon as this fall.


The current upsurge in inflation worldwide and the consequent need to raise interest rates and risk a downturn in the economy was the primary reason behind the slump in global financial markets. Investors worried that if a recession develops but inflation persists, we might even have "stagflation," a challenging environment for stocks and bonds not seen since the 1970s.

As some commentators observed, today's inflation was sparked mainly by a misdiagnosis of the consequences of the COVID pandemic: governments worldwide attempted to stimulate demand by pushing interest rates lower and sending cash to households and businesses. However, the main impact of the pandemic was not weak demand but a lack of supply, with disruptions in commodities (energy, fertilizer, metals, to name a few), essential industrial components like semiconductors, and even in labor thanks to the Great Resignation, an increase in retirees, as well as fewer immigrants.

Central banks worldwide were quick to correct course and started raising interest rates. Although doing so will eventually reduce demand, monetary policy is largely ineffective in solving supply problems. On the positive side, there are emerging signs that consumers, economists, and investors expect inflation to cool in the months ahead. Expect more upbeat markets to return eventually.

Why Diversification Did Not Work

Whether you are still accumulating savings for retirement or already enjoying it, we incorporate bonds in your portfolio mix to help offset the inevitable roller-coaster ride that comes with investing in stocks. Making money on bonds from income is typically a secondary objective. The intent, supported by history, has been that bond prices will rise, or at least not fall as much when stocks drop.

Unfortunately, that hasn't been the case in 2022. As bad as it has been for stocks,  it's been amongst the worst years in history for bonds around the world. Core broad-based fixed income funds are down roughly 10% this year. Here are the 6-month returns since 1926 for a hypothetical 60% Stocks/40% US Treasury Notes portfolio:

Thankfully, we took measures in recent years to reduce the sensitivity of our clients’ bond allocation to rising rates and inflation. While this move did not sidestep this year’s negative returns, it did improve relative performance versus the overall bond market. With average yields now exceeding 4% on some of our taxable funds, interest payments will also help going forward.

Still, as you can see from the chart provided by Visual Capitalist, a balanced investing strategy – owning a mix of stocks and bonds – has also historically offered a faster recovery following significant stock market declines.

Whether or not the economy falls into a recession, another down leg in the stock market is undoubtedly possible. But we believe that holding fixed income securities remains relevant going forward, and we will continue to offset equity risk with short to intermediate-term high-quality bonds.

Overall, our clients' balanced portfolios fared better by declining less than a similarly blended benchmark during the quarter (your portfolio's results may differ—please refer to your Quarterly Portfolio Review Report).

Within our stock allocation, commodities-related and value funds were the main drivers for the better than average performance in 2022. On the bond side, our fund selection, including our holdings of TIPS (Treasury Inflation-Protected Securities),  improved relative returns versus bond indices

Large Cap Value Portfolio Review

(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the size of the overall portfolio, and the client's objectives and constraints. All our partners and their family are invested in the strategy)

As a reminder, companies in the LCV portfolio tend to be relatively large, slow growing, pay dividends, and have moderate to low business risk from a strong competitive position. We invest when their shares trade at an attractive valuation compared to our estimate of their worth. We view these companies as the foundation of our client's stock portfolio. Our top 5 holdings remained the same: Bank of America, Liberty Broadband (cable), Markel (insurance), Anheuser-Bush, and Valmont (irrigation and utility poles).  

During the 2nd quarter, the LCV portfolio lagged the S&P 500 and the Morningstar Large Value Index but continued to exceed both benchmarks year-to-date. Over longer periods, the portfolio’s returns generally lag the former but exceed the latter. (Again, your portfolio’s results may differ—please refer to your Quarterly Portfolio Review Report).

Only two of our holdings made a positive contribution to the portfolio: Pfizer (pharmaceutical +2.1%) and NRG (power utility +0.3%). Our top five detractors were Micro Focus (software -36.5%), Howard Hughes (real estate -34.3%), Hanesbrands (clothing -30.0%), Agco (farming equipment -29.5%), and Meta (f.k.a. Facebook - social media -28.9%).   

During the quarter, we added to our investments in Polaris (recreational equipment) and Meta, as we felt that lower valuation warranted an increased commitment in both cases. We sold our holdings in Qurate (common and preferred shares). This sale represented a loss of capital for most clients and a poor investment return for all. As such, it deserves an explanation.  

Qurate is the owner of both QVC and HSN, the shopping channels. Historically, this has been an excellent business with high margins, a core of valuable returning customers, and a management team that proved adept at managing ever-changing tastes and allocating capital in a shareholder-friendly manner.

The pandemic proved quite challenging to the company's model. Although it benefited in some areas (e.g., internet sales), it was not always able to procure the goods that its customers wanted and missed out on millions of dollars in potential sales. Its vaunted inventory management fell apart due to industry-wide issues (labor shortages, war in Ukraine, volatile shipping costs) and some self-inflicted problems (fire at one of its warehouses). The result was a dramatic revenue deterioration and cash generation ability during the last two quarters.

When one of our investments' results weakens suddenly, our first goal is to assess what's cyclical or temporary versus what might be more permanent. Either way, it is also crucial to stress test the balance sheet to ensure that the company can survive without restructuring and diluting existing shareholders.

After reviewing results throughout the pandemic, we felt that Qurate perhaps suffers from more than just temporary issues. The company likely lost some of its best customers and is seeing increased competition, particularly within its younger demographics, from influencers live streaming on YouTube, Meta's Marketplace, or TikTok.

Finally, the recent revenue drop exceeded the speed and size we had previously modeled in our "downside" analysis. Declining sales with fixed costs and high financial leverage could easily lead to trouble. While the shares were already discounting a dire scenario, we felt that this investment had lost the margin of safety necessary to ride out a complex turnaround. We decided to sell.

Risk vs. Price Volatility: Keeping Our Eyes on The Ball

To the long-term investor, risk is not volatility: fluctuations in stock prices and portfolio values can be stressful, particularly the declining bits (no one ever complains when stock prices rise quickly). Volatility can even be an opportunity for the long-term investor by delivering discounted asset prices with higher-than-average future returns.

As we explained during prior bear markets, short-term volatility is the price investors must pay for their portfolio's returns to exceed inflation over time. The values of CDs, money market funds, and savings accounts are stable but do not keep up with rising prices, thus making them a poor choice for long-term investment goals.

Rather, our definition of risk is quite simple: failing to reach your financial goals. A prime example would be outliving your assets in retirement but could also be things like failing to set aside enough for college tuition. People can fail to reach financial objectives for all sorts of reasons: some can be self-inflicted (spending more than they make, careless speculation, etc.) or through no fault of their own (large unexpected medical bills, natural disasters).

In our experience, though, a recurring trap is paying too much attention to the short-term volatility tree (and the talking heads who make a living off it), while missing the forest, i.e., how inflation takes a chunk out of one's assets every year. This confusion, unfortunately, frequently leads investors to sell during downturns at a loss. Compounding this first mistake, they also subsequently miss the recovery.

Our core duty is to help you reach your financial objectives. There are both quantitative (goal setting, asset allocation, investment selection, rebalancing…) and behavioral aspects to succeeding. By focusing on what you can control (emotions, saving discipline, advancing your career, etc.) and ignoring what you can't (market fluctuations, news, the direction of interest rates…), you make a vital contribution to securing your financial future. The biggest threat to your long-term financial goals is allowing short-term market volatility to derail your carefully crafted long-term plan.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly, and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog. 

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions, or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.

This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.