January 2023: Prepared for Opportunity in 2023

In 2022 in the following equity indices, the results were as follows:

We manage an equity strategy in each of these asset classes and our results compared well in what was tough year regardless of the asset class. No one prefers to be down, but in down markets, down less is better than the alternative. Defending in down markets is just as relevant to long-term compounding as is getting your share of offense in up markets. We feel humble about the decline and constructive about our risk management.

In 2022 in the following fixed income indices, the results were as follows:

We manage two fixed income portfolios in the short-term credit asset class and posted better-than-peer results in each. We utilize fixed income in asset allocation to manage risk and provide defense. When do you care about defense? When the marketplace and the asset class is stressed. When the market is stressed and your defense does not defend, that is an issue for your strategy. We believe that having a defense that defends matters, and we are pleased that our results were so favorable amidst the stressed market.

We want to speak to how strategy helped us with risk management in 2022, share our perspective on 2023 and beyond, and revisit the important topic of behavioral finance.

Looking back at 2022
Using the S&P 500 Index as our example, the market declined for the first-five-and-a-half months of the year, -23% from January to mid-June. Interest rates went up and valuations regressed back towards a mean, with the S&P 500 Index PE ratio (using 2022 consensus estimates) declining from 21.5X in January to approximately 17X in June. In this period, earnings estimates held firm and multiples contracted by about 20%. As of December 31st, the 2022 earnings consensus estimates showed modest growth for 2022 and have been revised down modestly since the beginning of the year. This was a largely predictable and unremarkable valuation correction in a market dominated by a handful of expensive stocks. There was plenty of froth and froth is risk. Paying premium prices and investing detached from fundamental business values (which was rampant by the second half of 2021) is a higher risk approach. Given the reasonable price element of our ‘Quality at a Reasonable Price’ discipline, we selected out of the froth and this kept us out of the more severe parts of the correction. High quality companies at reasonable prices declined less and delivered better relative performance. We were down less because we did not attempt to replicate the market. Instead, we worked to differentiate our portfolios from the marketplace, and focus on our strategy.

2023 and Beyond
As we look ahead, we are struck by the negativity of the market narrative. Sentiment about inflation and the economy is downbeat, where the additional complications of political events – both foreign and domestic – do nothing to help. We see that the problems are real, and that negative sentiment usually provides for opportunity. Without attempting to be too precise about timing, we are approaching 2023 opportunistically. We have been in a trough and we expect the economy to climb out of it. We expect crabby markets to run for shelter and to deliver new bargains in exceptional companies, and we are prepared for others’ impatience and tactical fears to provide us with a chance to add more great businesses to your portfolios.

From mid-June to year-end, the market was trading in a fairly narrow range and was actually up slightly from the June lows. We anticipate more of the same distracting volatility from day-to-day and week-to-week with the Indices trading in a range. Crabby and anxious, but not likely a collapse. For example, if the S&P 500 Index earned something like $225/share and traded at a multiple of 17x earnings, that would project to 3,825; which compares to the 12/31 close of 3,839.50. A flat market does mean that all stocks are flat, it only means that the average is flat. There will be a number of businesses that will prosper in 2023 and market results will align with their business performance. Our focus is to use our discipline to select into the opportunities.

Behavioral Finance Matters
Here is our behavioral finance point: emotionally driven decision making in a trough is a way to sabotage your investing. Concentrating on fundamental advantages and a longer time horizon is the right antidote, and we are eager to help with that.

Opportunistic in Bonds
As for the bond market, the Fed has more medicine to deliver to offset the high rates of inflation. Stay short and stay patient. We see this as a good time to capture better returns for your bond portfolio.

Win the long game
Experienced investors know that turbulence is part of the ride, and that it is likely to be difficult to even recall in the not too distant future. Stay focused on the durable advantages and capture the benefits. The forward five years are likely to reward your patience. We look forward to a period of strategic advantages and productive results.