The end of year is a good time to reflect on where we have been, while also looking forward to what the future could bring. Unfortunately for investors, the last year has been a difficult one. The final quarter of 2022 continued the year’s volatility. As previously discussed in our commentaries, the narrative has shifted from emergency Covid stimulus to dramatic tightening with higher interest rates. Central bankers find themselves looking beyond the impacts of a global pandemic towards an old foe in the form of inflation. The impact on markets has been difficult. Long term bond investors are facing historic losses close to 20%. Global equity markets are down close to 15% for the year while in Canada, the TSX has fared somewhat better.
The last few years have been a perfect example of how unpredictable investing can be. A major pandemic followed by a full-scale Russian invasion of Ukraine was not on any prognosticators list. Most investors would have predicted significant losses in the aftermath of Covid, however, given fiscal and monetary intervention, the opposite was true. The areas of the market that drove these prior year returns are now being punished. When money is “free,” risk taking can move to extreme levels. In this environment, many investors can feel infallible following such momentum. Buy high, sell higher.
Momentum works until reality sets in, and that is what we are beginning to see. No sign could be clearer of this irrational behaviour than the explosion of acronyms that entered the investing lexicon (and hopefully will soon be forgotten). To memorialize them we thought we could go over a few here:
FOMO: Fear of Missing Out – your neighbour is bragging about their latest hot stock. They never talk about the ones that go down.
YOLO: You Only Live Once – see FOMO. So, shouldn’t you protect what you have??
HODL: Hold on for Dear Life – a favorite for crypto investors and what Elon Musk must be feeling about Twitter right now.
There were also “meme” stocks, NFT’s, SPAC’s and the list goes on. The lesson is, that when making money in financial markets seems this easy, that is when you should be most cautious. This excess risk taking is leading to huge losses in assets based on nothing but investor enthusiasm and hope. Our emphasis on owning quality companies has allowed us to perform much better than the market overall. Focusing on fundamentals has protected better than chasing the latest craze. So, in the interest of balance, we thought it would be useful to share some acronyms we prefer:
FCF: Free Cash Flow – cash that is left over after a company has paid all its expenses and capital needs – the more the better.
ROI: Return on Investment – companies invest in projects that generate a durable financial return – novel idea.
PE: Price to Earnings – how much you are willing to pay for one dollar of earnings. 10x to 20x is reasonable; 50x – 100x is not.
Okay, so our acronyms aren’t as “fun” as those other ones but for investors focused on growing AND preserving their wealth, this is the best way to ensure your goals are met.
Now the question remains, where are we headed? Without the benefit of a crystal ball, we can only speculate that rising interest rates could lead us into a recession. There are also unknown variables such as developments in the war in Ukraine and the impacts of China ending its “zero-Covid” policies. On the other hand, there remains significant post-Covid demand for services such as travel and entertainment, and the employment picture remains strong. The number of variables makes guessing the timing and depth of a recession difficult. Furthermore, stock market weakness in 2022 may very well have discounted much of this uncertainty.
Volatility also breeds opportunity. For some time, certain extreme market valuations have not made sense to us. With market weakness comes more reasonable valuations. We are monitoring our watch list closely for compelling opportunities across a broad range of sectors. Interesting themes have emerged or accelerated post covid. Trends around digitization and supply chain nationalization will continue to impact technology and industrial firms. The health care industry had vulnerabilities exposed during the pandemic which will need to be addressed. We also continue to look for opportunities in environmental technology companies with positive cash flows.
Higher interest rates also mean bond investors are finally able to generate decent income from their fixed income portfolios. We have been able to avoid the outsized losses that long term bonds experienced over the last few years by focusing on investment grade shorter term bonds. These are much less sensitive to the negative impact on bond prices from rising rates. Also, given they are maturing more quickly, we can reinvest maturing bonds at higher interest rates.
The markets can feel overwhelming to investors at times. We find it is more important than ever for investors to remain grounded and focused not on “markets”, but rather individual companies. Invest in companies with significant cash flows and healthy dividends. Dividends will be an evermore important (and tangible) component of “Total Return” in volatile times. We won’t always get it perfect, but we will always stick to our discipline and focus on our fundamentals. Owning quality has proven to be the best way to protect and grow portfolios and we believe that will continue to be the case for long term investors. We thank you for the opportunity to work with you in realizing your personal goals and appreciate the trust you have placed in us. Our entire team at Doherty wish you and your families all the very best in the coming year and beyond.