First Quarter Market Discussion
Equities stumbled out of the gate to begin the year as economic concerns that were simmering in the background at the end of 2021 began to boil over. While the tone on Wall Street was mostly dour throughout the quarter, the list of concerns evolved as did relative winners and losers. Encouragingly, the market appears to be more discerning when it comes to downside risk and valuation, a shift that we welcome.
Large-cap companies that were well positioned to benefit from rising interest rates got off to a fast start in January as investors anticipated the Federal Reserve would be aggressive in raising borrowing costs to rein in inflationary pressure. Conversely, shares of high-quality, small companies lagged large-cap names. We believe the performance disparity was driven by investors being conditioned to “buy the dip” with passive vehicles, a strategy that largely ignores the smaller gems in the market.
The dynamic changed as the surge in COVID-19 cases tied to the Omicron variant subsided in late January, and geopolitical tensions ruptured into the headlines when Russia invaded Ukraine in late February. The move caused a spike in the price of commodities, most notably oil, and caused investors to temper their expectations of aggressive Fed tightening. The likelihood of slower monetary policy tightening forced investors to adjust to the possibility that abnormally high inflation will weaken future demand for goods and services.
With inflation once again a primary concern and the pace of interest rate hikes in question, inflationary beneficiaries such as commodities gained favor while banks lagged. The change in outlook also resulted in smaller companies holding up better than many large counterparts as equities came under continued selling pressure throughout the quarter. Given the meaningful valuation discount of small-cap companies relative to larger names, as shown below, we believe this trend has room to continue.
Room to Run?
Source: ©2022 The Leuthold Group, 1/1/1983 to 3/31/2022. The Leuthold 3000 Universe is defined as the largest 3,000 securities traded on U.S. exchanges. Universe was segregated into large- and small-cap tiers. Blue bars identify recessionary periods of July 1990 to March 1991, March 2001 to November 2001, and December 2007 to June 2009. Price/Earnings Ratio (P/E). Past performance does not guarantee future results.There is no guarantee that a particular investment strategy will be successful.
Security selection was strong on a relative basis with holdings in Financials and Consumer Discretionary holding up better than the benchmark average and the Strategy slightly underperformed its Russell 3000® Value Index for the period. The portfolio’s Materials holdings detracted on an absolute and relative basis.
The power of division. A renewed interest in less-volatile industries helped defensive areas such as Utilities. Our holdings in the sector were up during the period and outperformed the benchmark average for the group, led by Exelon Corp (EXC).
The company is a large multi-state regulated utility that recently spun out its unregulated operations into a stand-alone company, Constellation Energy Corp. (CEG). The decision, in our view, sets the stage for a further re-rating of Exelon and its attractive mid-single digit compounded annual earnings-per-share growth rate.
The position in Constellation Energy, received as a result of the spin-off, gives the Strategy exposure to a rare carbon-free independent power producer at a time when local and national politicians are embracing businesses involved in producing clean power. The company also enjoys long-term power production agreements and has a strong balance sheet that can support a meaningful dividend payout.
While the gap in valuations between Exelon and its regulated peers has closed since Constellation was launched as a standalone company, we believe EXC could command a premium multiple in the future. Similarly, CEG trades in line with its peers and, in our view, should trade at a premium given its desirable clean production.
Financial Fallout. Banks got off to a fast start to the year as investors anticipated rates would climb and financial institutions would benefit from improved net interest margin spreads. The run was short lived due to concerns that economic growth would falter in the coming quarters and, consequently, possible credit deterioration would serve as a previously unanticipated offset to earnings growth. For the past few quarters, we’ve believed that investors weren’t fully factoring in the potential for rising loan defaults when assigning values to lenders, and as a result, we looked for opportunities beyond traditional lenders. Interactive Brokers Group, Inc. (IBKR) is an example of the opportunities we found.
Interactive Brokers is a fully digital brokerage platform with a focus on 1) catering to professional money managers and traders and 2) creating a digital-native platform with a goal of maintaining a cost advantage versus peers. IBKR enjoys industry and sector leading pre-tax margins—consistently ranking in the top decile versus the sector. Its enviable profit profile is the result of the company’s highly automated platform and a lack of credit exposure relative to peers.
Shares of the company began to come under pressure in the second half of 2021 as investors grew concerned that increased trading volume that occurred during the height of the COVID-19 pandemic was unsustainable. As shares weakened, we took a stake in the company and viewed it as an opportunity to upgrade the quality of the Strategy’s holdings in the Financial sector.
Although the stock remained under pressure during the period, we remain constructive on the company and increased our stake. Interactive Brokers continues to take market share from competitors due to its low-cost advantage and has consistently increased new accounts by over 10% per year.
We also view IBKR as a beneficiary of a rising rate environment without the credit risk associated with banks. The company holds customer credit balances in cash-like instruments which until recently have earned minimal income. As the Federal Reserve raises interest rates in reaction to inflationary pressures, the company’s interest margin will should rise, which we believe should benefit earnings.
A strong defense. The Strategy’s Industrials holdings were down on an absolute basis but and included a top performer, BWX Technologies, Inc. (BWXT), a manufacturer of nuclear power and fuel components for the Department of Defense and Department of Energy. The company also services existing nuclear power facilities in North America, and produces radioisotopes used in medical imaging and diagnostics.
Shares of BWX Technologies sold off in the second half of 2021 as growth in the company’s defense business showed signs of slowing. The softening of growth, in our view, is tied to customer ordering patterns that will likely impact growth over the next few years. Over the longer term, there are clear growth drivers that should benefit BWXT’s defense end markets. The company’s margins are also facing pressure as it has ramped up investments in the development of a key component used in radioisotope production. Currently, there is no domestic supply of the component, and the global supply is limited.
Earlier this year when shares were trading at just 14X earnings projections for the next 12 months, we took a stake in the business. The team believes revenue growth from BWXT’s defense business will return to high single digits in the next few years. Additionally, we anticipate the company will gain clarity into the success of its investments in its medical business line that will result in either a boost in high-margin sales or a winding down of associated spending.
Following our initial purchase, the stock moved sharply higher in late February as money poured into defense stocks on optimism that defense spending would grow after Russia invaded Ukraine. While the team does not view the conflict as boosting near-term results for BWXT, we believe the war could support growth in defense budgets in coming years after recently plateauing.
In our letter to close out 2021, we wrote about valuations in many areas of the market reaching levels we viewed as unreasonably rich. Since then, the broad pullback in equities has siphoned some of those excesses, and we are seeing early signs that pessimism may be overdone when viewed against historical normalized earnings.
Economically sensitive areas of the market such as Industrials, Materials, and Consumer Discretionary are among the sectors where we have been finding attractive businesses at valuations that have piqued our interest. However, while valuations have become attractive, we believe earnings expectations have yet to be sufficiently adjusted to accurately reflect the impact of moderating growth and margin headwinds going forward. As a result, we have been patient buyers in an effort to mitigate downside risk.
On the small and mid-cap front, we continue to find opportunities to buy what we view as exceptional businesses at below-average valuations due to market inefficiencies created by passive capital flows
Outlook and Positioning
The past quarter has seen investors begin to focus on economic challenges that just a few months prior they were willing to blissfully overlook. The heightened awareness should benefit valuation-driven investors. Our work continues to lead us to small and mid-sized companies that have already been repriced to reflect a more somber business climate, and our bottom-up analysis suggests there may be opportunities to go on offense in the coming quarters.
As we sort through the companies that hit our radar, we will not change our philosophy or process. The team continues to focus on valuations, balance sheet strength, and catalysts that can result in a change in perception by investors. We believe this disciplined application of our process will be key to navigating the quarters ahead.
Thank you for your continued trust and confidence.