Third Quarter 2022: Finding the Bottom
All bear markets are painful, but each has its unique mix of causes, and each is painful for its own reasons. The standout characteristic of the current market is the simultaneous decline in stock and bond prices. When we picture bear markets, we typically picture drops in stock prices. In nearly all prior bear markets, major declines in stock prices have been accompanied by nearly flat or even positive bond returns.
Looking at the chart of capital market returns below, nothing is more unusual than seeing a total return of -14.6% for the Bloomberg Aggregate Bond Index (labeled US Fixed Income) over the last twelve months. That level of decline for investment grade, intermediate-term bonds is almost unprecedented and has put a major dent in long-term returns for bonds (and consequently the long-term returns of balanced portfolios). The five-year annualized return for that benchmark is now -0.3%; the trailing 10-year annualized return is just 0.9%!
Here's a look at the key asset class returns over the short and long term.
The present downturn in stock prices (about 25% for the S&P 500), while a greater percentage decline than for bonds, is a level of decline that occurs regularly and for which long-term investors in the stock market should plan (drops of 20% or more appear 9 times over the last 42 years in the chart of annual returns and intra-year declines below). Despite this volatility and these many sizable drops, the long-term returns for US stocks remain robust and well worth the discomfort.
The primary driver of this year's market declines, and the second standout feature of the current market environment, is the reemergence of high inflation last seen in the 1970s.
Bonds typically provide a fixed return: barring default, they pay a fixed coupon and a return of the original principal. That fixed return, usually a solace in turbulent markets, feels wholly inadequate when prices are rising quickly and the real (i.e., after inflation) spending power of those cash flows is declining rapidly. That same re-valuation of long-term cash flows occurs with stocks, too, and is especially unfavorable to assets whose cash flows are weighted well into the future (e.g., that exciting startup company whose profits don't surface for a long while). A great deal of uncertainty remains about the duration of current inflationary pressures.
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.)
We were relatively active in the large cap portfolio during the quarter, selling one position, adding another, and increasing two existing positions.
We sold MicroFocus Group from the portfolio. We initially received a small number of MicroFocus shares as a spinoff from our ownership of Hewlett Packard (MicroFocus acquired HP's software business in exchange for shares) and later increased the position size. Prior to its purchase of HP's software business, MicroFocus had an admirable track record of squeezing profits out of legacy software products, but they had a much harder time with that playbook over the last half decade. Despite some material dividends over the years, this was a disappointing investment for us.
We added shares of Weyerhauser and Hanesbrands. Weyerhauser is the largest private timberland owner in the United States and a key provider of wood products for the construction industry. The stock is sensitive to cyclical fluctuations in the economy. We trimmed our Weyerhauser position size twice in 2021 as the economy, and particularly the housing cycle, boomed and high expectations were factored into the stock price. With greater fears now of a housing downturn, we took advantage of a reduced price to re-purchase some of the position. We are confident in the long-term demand for new housing construction and Weyerhauser's earnings power.
Hanes produces basic apparel (underwear, socks) that, while not glamorous, does require regular replacement and enjoys a surprising level of brand loyalty. Hanes also owns the faster-growing Champion activewear brand. We initially purchased shares of Hanes for the portfolio in 2018. The outcome to date has been disappointing, with the share price down more than 50% since our initial purchase. Hanes's business was buffeted about during Covid: it made a large pivot into personal protective equipment (masks, etc.) that generated some short-term revenue but ultimately led to a large inventory writedown in 2021. We believe annual earnings over the next five years are likely to be closer to the level they were in 2018 & 2019 (when Hanes earned $1.52 and $1.64 per share) than their recent level. If so, our recent purchase price of under $8 / share should be an attractive entry point.
Our latest new position in the portfolio is Laboratory Corporation of America (LabCorp), the largest independent provider of diagnostic testing in the health care industry. LabCorp has the scale and efficiency to provide diagnostic testing at a lower price point than primary medical providers like hospitals and doctors' offices, so these providers gradually outsource more and more testing to LabCorp (and its primary competitor, Quest Diagnostics). LabCorp has a secondary, somewhat faster growing business, that organizes and implements clinical trials for large pharmaceutical and biotech companies. We think this is an attractive business with modest growth potential selling at a very reasonable multiple of earnings. Our purchase price was about 10x expected 2022 earnings (though we recognize earnings may decline somewhat as the volume of Covid tests recedes).
Together, these three purchases provide a useful snapshot of what we think are some attractive opportunities available in the stock market. We believe these entry prices are likely to generate attractive long-term returns.
What Should Thoughtful Long-Term Investors Do Now?
We are humble enough to recognize the futility of making short-term market or economic predictions and we studiously avoid doing so. There are, however, some useful things to say about the market landscape we see today.
First, whatever the future holds, expected returns from today's levels are higher than they were at the beginning of the year. This is simply a function of lower starting prices. Said differently, today's bond interest rates and stock valuations offer the potential for better returns going forward. We don't know whether the economy is heading for a recession (or already in one), but we do know that a great deal more bad news and uncertainty about the future is accounted for in current stock and bond prices than was the case nine months ago.
If there is a recession in the near-term (we know they will occur occasionally over the long term), there are some good reasons to think it may be moderate rather than severe. Demand for labor remains very high despite current economic uncertainty. The consumer is in relatively good financial shape due to excess savings from the pandemic period. Some key sector contributors to employment and economic activity still have meaningful pent-up demand. New automobile production since the pandemic started has been well below the average of the prior five years due to supply chain problems. And even though housing construction will be hampered by a weaker economy and especially by higher interest rates, the recent brief period of higher new housing starts only went a short way to meeting the nation's housing needs after a nearly decade-plus period of below-average new home construction.
With inflation concerns top of mind, it is helpful to remember that a long view of the history of inflation and stock markets provides evidence that owning stocks of quality businesses provides the best chance of maintaining your portfolio's real spending power over time. We know from the recent past that this doesn't hold true in the short term, when nearly all assets’ prices react negatively to unexpected inflation. In the long term, though, financially productive businesses adapt to changing conditions in various ways and usually can grow their after-inflation earnings over time.
Your portfolio is structured in a way that it should be very unlikely that we are forced to sell stocks at an inopportune time. In fact, in most cases, we can opportunistically re-balance into investments with higher expected returns during periods such as these. That discipline, flexibility and patience are key to preserving and growing your portfolio.
If you have questions or want to discuss your portfolio or financial circumstances, please don't hesitate to reach out to one of us. We appreciate your trust in us most during difficult markets.
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.
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