The Return of a Stock Picker's Market
We believe the idea of risk management has generally been missing from investor’s mindset for the last few years. In our view, the investment mentality of the past few years has been something like this:
· The Fed is keeping interest rates near-zero because inflation is transitory.
· The Fed is buying treasuries and mortgage-backed securities at a record pace.
· The Government is flooding the system with liquidity in special ‘relief’ packages, and massive unemployment checks.
Given the above, many investors embraced what was called ‘The Fed Put’, meaning that any stock market weakness would be quickly overcome by the continued stimulus actions injected into the economy. As a result, we think investors believed they would be rewarded for taking as much risk as possible, investing in momentum growth stocks and new-fangled assets such as Bitcoin and NFT’s. Like the childhood game of musical chairs, this form of investing was fun until the music stopped.
In our previous Market Musing Blogs and Quarterly Letters (www.reweyassetmanagement.com) we have written that that the combination of the post-Covid reopening of the economy, and the stimulus and easing actions would drive inflation substantially higher, destroying the notion that inflation was transitory. Additionally, we wrote that the Fed’s reaction to fight inflation would be an aggressive campaign of rate hikes and balance sheet liquidating bond sales, that would have the effect of raising the estimates used for the Weighted Average Cost of Capital (WACC) in Discounted Cash Flow Models (DCF). Essentially, a higher WACC assumption in the denominator of the DCF calculation has the impact of dramatically reducing the projected value of stocks, especially those with low or negative cash flows in the near-term – as the pushed out future value of expected cash flows are more greatly impacted with a higher WACC over time. See our blog, “Mind the GAP”.
The Inflection Point has Arrived – “It Matters When It Matters”
One of the most valuable investment lessons we have learned over our 32-years is that it is better to be ‘early’ in opinions and portfolio construction, than being late and reactionary, as investors tend to move in a panicked herd once an inflection point is widely understood. The market sell-off post the May 31st 2022 reading of CPI (Consumer Price Index from the Bureau of Labor Statistics) released on June 10, 2022 that showed a recent high of 8.6% inflation year-over-year, is the latest example, in our opinion, of the inflation we foresaw, that now “matters” to investors.
Since the Fed’s first 25 basis point hike in the Fed Funds Rate (this cycle) on March 17, 2022, the market sell-off has been dramatic.
Source: Bloomberg (March 16th 2022 close to 11:00 am 6/13/22)
It Isn’t Different This Time
While not immune from a decline, we believe the small cap value sector has declined less than the S&P 500 and the Nasdaq, because this sector offers better protection from the ending of stimulus and the advent of rate hikes, as the valuation levels are lower, and near-term cash flow projections are generally positive. Interestingly, and in our view just as predictable, the new-fangled “its different this time” asset class of digital currencies, shown by Bitcoin (as represented by the Grayscale Bitcoin Trust), has fared much worse than the underlying stock market and the traditional asset class of gold. It looks like another lesson we have learned over our 32-years is holding true as well, “it isn’t different this time”.
The Return of a Stock Picker’s Market
The ending of the era of the “Fed-Put”, in our opinion, could likely bring a return of a stock picker’s market. Said differently, the evaluation of individual securities on metrics like balance sheet strength and near-term cash flow, could likely once again be as important as the factor of revenue growth. We have consistently stated that value is not the opposite of growth. In our view, value investing is about trying to minimize the investment risk one takes in balance with the upside investment reward projected. A strong balance sheet and good cash flows allows an investor to weather market turmoil, like we see now, and likely add to stocks that have sold down too dramatically, versus having to sell broken-growth momentum stocks where investment cases were overly reliant on unsustainable assumption of low interest rates in perpetuity.
In our view, the market has never been about “risk-on”, “risk-off”, or even sector bets that are represented by investors using Exchange Traded Funds (ETFs). We believe the individual analysis of equity securities is critical to building a portfolio that offers both upside return potential and downside risk management assumptions.
While no individual stock is immune from the risk of a decline, we believe that fundamental analysis of the balance sheet, business model and growth prospects can provide the conviction needed to invest ahead of the herd, and to accept the ‘risk’ of being early. With a high level of conviction, built on fundamental analysis, we believe investors can take advantage of market weakness, like the current period, to invest in individual securities that offer good risk vs. reward characteristics. We’d rather risk being early, than trampled by the investing herd.
This material is for informational purposes only and is not a recommendation or advice. Investments and strategies mentioned are not suitable for all investors. Opinions are based on current market conditions and are subject to change. No one can predict or project performance, and forward-looking statements are not guarantees. Past performance is not indicative of future results. Investing involves risk, including the loss of principal.