Partners in WMK Group’s Strategic Opportunities portfolio earned a modest return in the first quarter of 2023. While the results were not robust, the portfolio remains conservatively positioned and prepared to take advantage of volatility in the markets. Given our collective goal is for capital preservation and absolute returns over the long-term, we are happy to own a conglomerate of high-quality businesses that are capable of riding through a variety of economic outcomes.
A reminder that returns should be judged through an economic cycle – even one as unique as the current environment.
Market Commentary
The largest bank failure since the Great Financial Crisis occurred during the first quarter of 2023. Silicon Valley Bank (SVB) went from a well-regarded entity to out of business in a matter of days. The collapse of SVB was a classic bank run, with an enormous deposit withdrawal occurring in a single day. Nearly no bank could withstand that pace of outflows. Since then, both First Republic and Signature Bank have failed.
The goal for long-term investors is to learn from challenging situations. While a full analysis of SVB would be complex, two key points stand out:
Banks generally suffered losses on their bond portfolios due to rapidly rising interest rates. Those that extended into longer-dated bonds experienced more significant drawdowns. SVB was notably aggressive in its bond portfolio strategy.
A high percentage of SVB’s deposits were not insured by the FDIC. This meant that SVB had a large concentration of institutional clients, each with significantly higher exposure, making them more likely to withdraw funds rapidly during times of stress.
Both points have been widely discussed in the media. Many investors were aware of these structural weaknesses in advance, and some even highlighted them months before the failure. However, SVB’s collapse shines a light on a broader issue that all market participants must be increasingly mindful of: reflexivity risk.
Reflexivity in economics describes how investor or consumer sentiment can drive real-world behavior in a self-reinforcing feedback loop. It can result in rapidly changing valuations or business outcomes based solely on perception and reaction.
An academic paper has already examined the role of social media in exacerbating SVB’s collapse. It concluded that online commentary helped accelerate the deterioration in investor confidence and customer behavior.
SVB may have failed regardless, but the amplification effect of social media played a material role. This lesson extends to all modern investments: sentiment can change quickly, and institutions must be increasingly prepared for unexpected events fueled by instantaneous communication.
This reinforces the importance of owning businesses with strong reputations and conservative financial structures—companies that can withstand stress regardless of sentiment. It also suggests that markets may now be more prone to mispricing, both to the upside and downside, than traditional financial theory would suggest.
Portfolio Update
During the quarter, we trimmed our position in Arch Capital Group, a specialty (re)insurance company previously discussed in detail. Arch made a positive contribution to portfolio returns, supported by an increase in market valuation.
Arch has been a significant part of the portfolio since inception, originally acquired at a material discount to intrinsic value. Since then, the stock has more than doubled in price, reflecting strong business performance and favorable underwriting conditions in the insurance market. The company has executed exceptionally well, and the market has responded accordingly.
While Arch’s fundamentals and management remain excellent, its higher valuation reduces the forward-looking return profile. As such, we chose to reduce our exposure as the position size approached a meaningful portion of the overall portfolio. We continue to hold a core position and monitor performance closely.
An additional positive development for our portfolio was the approval of a major merger between Canadian Pacific Railway and Kansas City Southern. The rationale behind this transaction was previously detailed, but in summary, the combination enhances an already strong operator and creates a seamless rail link from Mexico to Canada. This new corridor is poised to benefit from ongoing trends in manufacturing relocation. We remain confident in the long-term value creation potential of this combination.
On the negative side, The Charles Schwab Corporation detracted from overall returns and contributed significantly to our underperformance. The stock experienced a steep decline as concerns surrounding the broader banking sector escalated.
At its core, Schwab enables individuals and professionals to buy and sell securities. The company introduced a bank component to its model, which allowed it to eliminate trading commissions and still generate revenue via interest income on client cash.
Current concerns center around two main risks facing Schwab and other banks:
- Losses on bond investments due to rising interest rates impacting required capital levels;
- Clients moving cash to higher-yielding alternatives, commonly referred to as “cash sorting.”
Both dynamics are indeed affecting Schwab. However, these risks were expected and are being actively managed. Importantly, Schwab maintains a conservative financial profile, which reduces the likelihood of severe outcomes.
Compared to some failed banks, Schwab has a much lower proportion of uninsured deposits. Additionally, Schwab has been a recipient of inflows into money market, fixed income, and certificate of deposit products—showing that clients still trust the platform and are moving assets within its ecosystem.
Short-term challenges remain. Higher funding costs will compress profit margins in the near term, and regulatory changes may increase capital requirements, potentially delaying shareholder returns. That said, we are long-term owners, and these issues are temporary in nature.
Why do we own Schwab? It has built an unmatched scale and a diverse, durable set of revenue streams. These advantages enable consistent asset growth and profit expansion. The company is led by a stable, long-term-oriented management team.
Investor Nick Sleep coined the term “scale economies shared” to describe businesses like Costco that pass along efficiency gains to customers. Schwab embodies this concept—continuously reducing fees for clients while significantly improving its own profitability.
There is also substantial untapped earnings potential at Schwab, including cost synergies from its recent acquisition and the monetization of currently non-fee-earning assets. We continue to view Schwab as a competitively advantaged and long-term compounder.
CFC Required Reserves
Note: This section is focused on those who own a Controlled Foreign Corporation, as many of my investors – and I – do. These entities serve as captive reinsurance vehicles for operating assets and are required to maintain very conservative investment portfolios consisting primarily of investment-grade fixed income.
Bond markets recovered modestly during the quarter as expectations shifted toward future interest rate cuts. This optimistic scenario is based on potential economic slowing and pressure on the financial system.
While this outcome may materialize, it is speculative and largely outside of any investor’s control. As a result, we remain conservatively positioned from a duration standpoint, keeping interest rate risk relatively low.
Despite this shorter duration, the fixed income portfolio continues to generate a healthy yield without reaching for risk—whether through extended maturities or lower credit quality. This results in a stable, low-risk portfolio.
The downside to this positioning is clear: in an environment where interest rates fall sharply, the portfolio will underperform longer-duration benchmarks. However, our focus remains on generating consistent income while preserving capital. We are comfortable with this trade-off given the broader market risks.
Disclosures:
The views expressed above are those of WMK Investment Partners. These views are subject to change at any time based on market and other conditions, and WMK disclaims any responsibility to update such views.
Past performance is not indicative of future performance. Principal value and investment return will fluctuate. There are no implied guarantees or assurances that the target returns will be achieved, or objectives will be met. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal. The values and performance numbers represented in this report do not reflect management fees.
WMK may discuss and display, charts, graphs, formulas which are not intended to be used by themselves to determine which securities to buy or sell, or when to buy or sell them. Such charts and graphs offer limited information and should not be used on their own to make investment decisions. To the extent that certain of the information contained herein has been obtained from third-party sources, such sources will be cited, and are believed to be reliable, but WMK has not independently verified the accuracy of such information.