Major questions about vaccine approval and the political sphere have been clarified. While there are certainly hurdles to clear, our strategic focus is to concentrate on the better long duration opportunities for the post-Pandemic world. Although acknowledging we cannot offer any precision, it is still possible to share our overall conviction about the preferred investing approach for the next five years and beyond.
On this longer-term path, with these risks front-end loaded, we launch with the awareness that there are issues that represent hurdles along the way.
▪ The 2020 market rally created some disparities on the way to record setting Index results.
▪ A Top-Heavy Bubble. Ten stocks contributed about 60% of the S&P 500 Index return in 2020. This represents concentrations reminiscent of the 2000 Tech Bubble, which resulted in a massive valuation correction.
▪ Related to the bubble in the S&P 500 Index, expectations for forward results test positive for frothy exuberance. Consensus earnings expectations now forecast 20% or better growth for over 150 S&P 500 Index companies over the next two years. This is a vivid demonstration of herd mentality and historically speaking, it is unrealistic.
▪ The Pandemic is compounding.
▪ The vaccines are good news. The logistics of inoculation and immunity are complicated. Meanwhile, entire countries are shutting down, variants introduce new risks, and the caseload grows. These factors all have an economic impact. In 2020, the markets eagerly looked beyond economic dislocations and discounted an eventual recovery. It cannot be taken for granted that light at the end of the tunnel will continue to be enough.
Managing for These Risks
Our strategy for negotiating these hurdles is to practice risk management by being highly selective and steering clear of the more pronounced risks.
- Stay out of the bubble. This is not a categorical condemnation of the Tech sector. There are, and will continue to be, exceptional opportunities in high quality companies at reasonable prices in the Tech Sector. The issue is with the momentum driven, very expensive, fast lane stocks, where the market price has raced ahead of a reasonable connection with business value. We are willing to leave a bit of money on the table in the cause of sustainable compounding.
- Valuation matters when it matters. Hot momentum markets induce valuation amnesia. But being priced for perfection in an imperfect marketplace is a higher risk approach. Without being dogmatic about cheap and discounted prices, it remains prudent to think critically about valuation. We are willing to pay up for quality, and we are willing to look out two years in estimating business results. We are loathe to chase after marginal profitability and a 10-year cash flow projection. Maintaining qualitative standards provides plenty of opportunity to invest for reward and to manage risk.
Defining our Strategy
Strategy is all about emphasizing higher probability outcomes, such as the following:
▪ Quality delivers competitive advantage. A great balance sheet, superior margins, and high returns on capital do not guarantee success, but they REALLY help. A disciplined focus on quality creates a portfolio filled with businesses that have competitive advantages and first-class business models. This discipline helps to stay clear of the drag of lower quality, as well as concentrate to the advantages of high quality.
▪ Focus on operating performance. Operating results from better businesses align with higher probability. Attempting to forecast share prices independent from operating results is a much lower probability activity. We are confident great business results will be recognized in the marketplace.
▪ Earnings Growth matters. Businesses that deliver on better earnings growth deliver on better results for shareholders.
▪ Better Category. The economy is not an equal opportunity playing field. Certain sectors and industries offer enhanced opportunity. We are purposeful in putting this higher probability advantage in our investment process.
Putting these pieces together, our approach emphasizes:
▪ A longer-term outlook,
▪ Utilizing selectivity as strategic business investors to manage for risk and reward, and
▪ A focus on higher probability correlations from quality operating results, growth, and category advantages.
All these factors differentiate us from the business-as-usual approaches that emphasize broad indices or tactical trading. We have conviction that in the endurance race of investing, this discipline will continue to serve us well.