"It is waiting that helps you as an investor, and a lot of people just can’t stand to wait.” – Charlie Munger
In the investment field like many other undertakings in life, activity does not equal achievement. During periods of significant change, investors may be better served by stepping back, assessing risks and possible outcomes before changing direction or committing to a set strategy.
"...inflation may prove less transient than hoped and the cost of money higher than desired."
Changes are underway in our economy and financial markets that we believe may be historic. For years, persistently low inflation and interest rates provided an almost ceaseless tailwind to investment, supporting a risk-taking mentality. Now, inflation may prove less transient than hoped and the cost of money higher than desired. If the changes prove to be as profound as we believe, forward-looking corporate managers and investors should have ample opportunities to take ahold of. Those hoping for business as usual may find a tough road.
THE CROWD IS UNTRUTH
Over the years we have preached a similar sermon. The price of a common stock should, ultimately, reflect the value of the underlying business. The profits of that business will drive the value of the business over time. A growing profit stream will result in a higher business value. We look to invest in companies where the probability of a growing profit stream over longer periods is high. Our goal is to invest in these growing businesses for long periods, with the expectation that the wealth that these high-quality businesses generate will accrue and compound for the benefit of our clients, the business owners.
"The price of a common stock should, ultimately, reflect the value of the underlying business."
A simple and straightforward message. Right? Well, there is another aspect to the sermon that can be quite demanding. We prefer to pay an attractive price for the businesses we invest in, and we have developed a discipline to help us accomplish this part of the investment process.
"...investors have been crowding into a relatively small group of very large companies and, for the most part, leaving large parts of the stock market behind."
A hard lesson of our truth is that the stock market can make a mockery of our discipline...at least for short periods. If we want to remain true to our process (we do!), this takes patience and fortitude – virtues that can be hard to maintain. The last 18 months or so has been just such a period. In part due to the intense interest in artificial intelligence and the companies associated with this technology, investors have been crowding into a relatively small group of very large companies and, for the most part, leaving large parts of the stock market behind.
THE ART OF FORGETTING
The stock market, as represented by the S&P 500 Index, has become quite concentrated with 10 stocks representing about 30% of the Index’s value. Interestingly, many of these very large companies have been benefitting from the post-Covid economic environment as well as the potential for AI investments. Profits at these very large companies are expanding and probably will expand further. While the U.S. economy has been relatively strong, profit growth for the balance of the companies in the U.S. markets has been harder to come by. Higher interest rates, a weak global economy, and challenges brought on by higher levels of price inflation have, in general, hurt company margins. More recently, reports from a few large consumer-facing companies like Apple, Tesla, Nike, and Starbucks have reflected the more challenging economic and financial environment. These companies are reporting anemic sales and pressures on profit margins, while the prospects for renewed growth are unclear. After a period of over-consumption, tighter monetary conditions are forcing consumers to tighten their belts, affecting sales of even the popular consumer brands.
"After a period of over-consumption, tighter monetary conditions are forcing consumers to tighten their belts, affecting sales of even the popular consumer brands."
At this point, investors are betting that the small group of very large, mostly technology companies will remain insulated from the challenging economic and financial environment. However, economic cycles have historically proven more important than investment themes (like AI). The two most evident examples are the Nifty Fifty stocks of the early 1970’s and the Dot Com stocks of 2000. These periods of extreme concentration in the markets were unwound over time, causing tremendous loss of capital for investors. For the most part, the companies that were popular during these periods proved resilient and the investment themes played out about as expected. However, these companies were priced for perfection and earnings did not expand as expected due to changing economic backdrops. Even the best of the lot underperformed for a decade or longer and others did not even make it through the more challenging economic environments.
"...economic cycles have historically proven more important than investment themes (like AI)."
GREAT EXPECTATIONS
For much of the last 30 years, businesses and investors have benefited from relatively benign inflation and declining interest rates. As a result, corporate profit margins have expanded significantly. Since the pandemic, we have seen a record-low level of long-term interest rates and a spike in corporate profit margins, especially for the larger companies. For some time now, the prices of the larger companies seem to be reflecting favorable expectations of a renewed period of low inflation, lower long-term interest rates, and expanding profit margins. Wall Street analysts’ projections of earnings growth for the S&P 500 companies this year are an optimistic 11% and forecast a similar level of earnings growth for the next couple of years. These great expectations do not seem to be factoring in the decisive changes underway and appear to us to be more backward-looking. High expectations coupled with high valuations is a poor combination for investors. Investors’ confidence will likely be tested in the coming months as we learn whether the most popular companies can remain insulated from the changing economic and financial backdrop.
"High expectations coupled with high valuations is a poor combination for investors."
COMMON SENSE
As mentioned earlier, for sometimes uncomfortably long periods, markets can make a mockery of the best efforts of disciplined investors. During such periods, chastened investors may look for guidance and support from the wise and battle worn. During the first weekend in May, the latest Berkshire Hathaway shareholders meeting streamed from Omaha, Nebraska. Renowned investor and Berkshire co-founder Warren Buffett was on his game, displaying amazing stamina and acuity for a 93-year-old. Buffet’s long-time business partner Charlie Munger, who died in November at age 99, was there in spirit, with Greg Abel proving himself a worthy heir apparent. Buffett and Munger may or may not have possessed superior intellects, but over the years have exhibited a rare extreme of common sense as it relates to creating business value as well as managing investments and prudential stewardship.
Buffett and Abel made a few salient points over the weekend that mirror our current thinking. Buffett has been slowly consolidating his stock holdings over the last few years and building up a significant amount of liquidity ($200B). He has kept this liquidity invested in short-term government securities earning a fair return at present. Buffett mentioned that the pool of large companies in which he might invest looks picked over and generally expensive. If, however, he managed a smaller pool of funds that would allow for investment in small or mid-sized companies, the prospects for earning excess returns would be improved (at Clifford Swan, we do not face this restriction in the portfolios we manage). They did not paint an overly optimistic backdrop over the short term but are still confident about putting the large pool of funds to work in high-quality, mostly U.S.-based companies. Ajit Jain, Berkshire’s insurance guru, pointed out that inflation can be a friend for certain businesses. We agree – historically, small companies have outperformed larger companies during inflationary periods. Finally, Buffett also spoke about taking capital gains this year to avoid likely increases in the capital gains tax rate.
"...historically, small companies have outperformed larger companies during inflationary periods."
Their perspectives ring true, and the Berkshire team’s patient approach makes good sense to us against the changing investment landscape. We have been building reserves in conservative fixed income securities and seeking out long-term, tax-efficient investment in the lesser picked over sectors of the stock markets.
Download Article: Reflections on a Changing Investment Environment
The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.
