Partners in WMK’s Strategic Opportunities portfolio suffered a price decline in marketable securities in the second quarter. A broad selloff in equity and fixed income markets impacted the price of most business holdings in our portfolio.
While everyone would prefer to see the external validation of an investment thesis reflected in ever increasing prices, this is not the way auction markets work. Volatility is the price of admission. Luckily, as long-term business owners, we can take solace in the fact that all we care about is the intrinsic value of our businesses based on future cash flow expectations. These values are largely unchanged despite a more challenging near-term environment between rising inflation and interest rates.
Returns should be judged through a cycle, with a minimum of a multi-year time horizon. A longer outlook is a much more reasonable measurement period for long-term investors.
Market Environment
WMK will make no predictions when it comes to the near-term price of our portfolio companies or the broader stock market. Trying to predict the macroeconomic future is a painfully difficult endeavor, even for the most adept economist. Worrying about the macro environment never helps control the outcomes.
Others seem committed to focusing on a recession. Google (a portfolio company down significantly year-to-date) offers the ability to look at trends in search terms. Searches for the term “recession” reached historically high levels! That period includes previous major financial crises and the global pandemic.
We should not be surprised to witness fear in the face of a constant stream of bad news:
- The major equity index suffered its worst first half in decades.
- U.S. Treasuries – a supposed “risk-free” investment – fell substantially, marking the worst performance in centuries according to Deutsche Bank.
- Inflation hit its highest levels in many years.
All of these are very bad facts! But should we be scared? Historically, recessions are a normal part of the economic cycle, occurring on average every several years. During these periods, equity markets have delivered strong annualized returns.
Recessions are a healthy part of an economic cycle. What is of paramount importance is having an investment process that results in the ownership of quality companies with healthy balance sheets, strong cash flows, and agile management teams that can survive and thrive in a recession.
A common saying amongst value investors is that we should cheer for lower stock prices, particularly when a business is using free cash flow to repurchase shares. This is true and reflected in the strategy of many of our business holdings. Cheaper prices mean buybacks offer much greater “bang for the buck.”
A less commonly discussed result of more challenging financial environments is the healthy purging of uneconomic competitors. For years, a low interest rate environment – and enhanced liquidity provided by the Federal Reserve – has resulted in a flood of funding towards innovation.
There are many examples of froth in high growth, unproven business models. One particularly astounding data point is the volume of early-stage, venture-backed companies that held unicorn status. In recent years, the number of companies awarded such valuations in early funding rounds dramatically increased. These are very young companies to hold such high valuations.
While our public equity holdings are far from venture capital, they are impacted by the threat of new entrants. Competitors who do not have a similar prerogative to generate near-term cash flow can be especially disruptive. A healthy result of a pullback in exuberance may be the opportunity to experience less competition as well as purchase small, strategic assets for cheaper prices. In fact, if the managers of our businesses indeed share the owner/operator mindset we seek, the long-term results of investments during this period could be outstanding.
Volatility In Our Business Holdings
It is psychologically difficult to ignore market losses. However, little is gained from watching daily stock price changes. Instead, the current environment is an opportunity to refocus on process. The only question that matters is whether we are controlling the “controllables”?
One of the few things we know for certain in the public markets is that we have zero control over near-term stock price movements. This output is close to random in the near-term. However, there is a lot of control over how we evaluate the quality of a business, competency of the management team, and reasonableness of purchase price.
Because our focus is simple, we can rely on ensuring those metrics remain defensible during market turmoil. To do so, we must know what is being implied by market prices. There are a lot of reasons why stock prices move, but let’s simplify them into two big buckets:
- Technical: Stock price fluctuations in the short-term can be explained bluntly as “there are more buyers than sellers” if a stock goes up and the reverse if a stock goes down. This is true of any auction market. Reasons for short-term buyers and sellers are numerous and can have little (or nothing) to do with the underlying business.
- Fundamental: This analysis recognizes that the current price of a stock reflects the future cash flows of a business, discounted to present day dollars. When we are buying a business, we believe the market does not fully reflect the true value of those cash flows. Fundamental work takes much longer to determine if it is right or wrong because the answer is fundamentally far into the future.
You might ask how far into the future? Take Google as an example. A fundamental analyst (like WMK) might use a multi-year discounted cash flow model (DCF). In this process, the next several years of unlevered free cash flows will be forecasted and discounted to the present day using a required rate of return. There will also be a “terminal value” placed at the end of that period, which is the value someone would be willing to pay for the business years from now.
DCF models are fraught with mistakes surrounding the forecasts and assumptions, but they still offer value, nonetheless. Let’s assume an investor had perfect information at the start of a prior period. This investor could predict the unlevered free cash flow for the next several years and the terminal value (i.e., what the market valued Google for at the end of that period). This analyst would get paid a lot of money for such precision!
If you were to recreate this exercise by building your own DCF and plugging in Google’s actual results, you would find an interesting result: the majority of the present value would have been explained by Google’s terminal value. Only a small portion of the price paid would be explained by the near-term cash flow!
Think about that for a moment, with perfect precision over the next several years, an investor would still be largely betting on the long-term value of the business! Google is somewhat special case where the intrinsic value of the business has grown significantly. A business that generates a lot of cash today and is not expanding its market presence might still see most of its value in the long-term years ahead.
Why is this relevant in a period of market volatility? During big drawdowns and big upswings, the price of a security is likely to fluctuate much more broadly than the terminal – and therefore intrinsic – value of a business. Our job is to determine whether there has been a fundamental change to the quality and value of a business or if there has been no change and the market dislocation provides an opportunity to the long-term investor.
Two examples where this attention to the fundamental value of a business is reflected in our process are the following:
- Current Portfolio: When prices drastically change, it is imperative to determine whether a mistake has been made or if the terminal/intrinsic value of a business has changed. In most cases, the long-term prospects of our conglomerate are unchanged. The current environment has enabled some rebalancing in our portfolio towards the highest quality and conviction businesses we own. This has begun to increase our concentration slightly. Consistently ranking our positions on prospective returns and risk profiles as part of the investment process ensures this is not an “ad hoc” exercise.
- Opportunity Set: Volatility has created a broader range of opportunities in the market that are approaching attractive levels. While we have found the best opportunities thus far within our existing holdings on both a risk/return as well as depth of knowledge basis, it is important to maintain a constant search for quality and value. The process of uncovering opportunities through various internal sources, extensive reading, and constant dialogue with astute investors is yielding a greater number of companies to add to the “watch list.”
Finally, while uncovering new opportunities is exciting, it is also imperative to have a rigorous research process in place to help identify potential risks as well as to truly understand the business and management team. Even when companies are optically cheap, we remain true to the desire to own a small group of very high-quality businesses for the long-term. Inclusion to our conglomerate has an ever-increasing hurdle.
CFC Required Reserves
Note: Feel free to ignore this section if you do not own a Controlled Foreign Corporation as many of my investors – and myself – do. These entities are captive reinsurance businesses for operating assets and are required to hold a very conservative portfolio of mostly investment grade fixed income and a limited exposure to U.S. common equities.
As previously noted, bond markets performed at historically poor levels. The primary benchmark we use for CFC Required Reserves is the broad U.S. Investment Grade Bond market proxy, AGG. The stalwart AGG – which is supposed to be low risk with a significant portion of assets in U.S. Treasuries – fell sharply in the first half of the year.
The pullback has been swift and caused by two primary issues:
- Inflation is hitting multi-decade highs, causing the purchasing power of the dollar – and therefore fixed bond payments – to fall rapidly. Investors are appropriately requiring a cheaper price to earn a higher real rate of return (adjusted for inflation). Therefore, the price of bonds falls with inflation rising.
- In response to inflation, the Federal Reserve is appropriately raising interest rates. This in turn means that investors will pay less for bonds. Higher interest rates are reflected in lower bond prices.
As previously noted, the expectation has been for rates to rise eventually, so the portfolio has had a much lower duration (interest rate sensitivity) vs. the benchmark. While this has aided in relative performance, the market turmoil has still contributed to a poor absolute return.
Our portfolio remains primarily invested in short-term or interest rate hedged investment grade corporate bonds. As spreads of corporates vs. Treasuries fluctuate, so will our mark-to-market performance. However, the risk of defaults (permanent impairment of capital) is very low and the exposure to further rate increases relatively limited.
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.