Fourth Quarter Market Discussion
During the quarter, the mood of the market continued to bounce back and forth from hope of a quick Federal Reserve pivot to fear that a recession was a fait accompli thanks to aggressive interest rate hikes throughout the year. While these erratic shifts in sentiment proved to be unsettling, this was a constructive environment for active and selective value investors.
As Warren Buffett famously noted, “a wildly fluctuating market means that irrationally low prices will periodically be attached to solid businesses.” We took advantage of this volatility in the fourth quarter—as we have historically—adding several small-cap businesses to our Strategy. As depicted in the chart, we believe small caps are poised to outperform large caps in coming years as a result of their orphaned status and discounted valuation. Normally small caps underperform in bear markets like 2022, but they tend to outperform in bull markets following a period of large-cap dominance.
Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies, Monthly data 12/1/1930 to 12/31/2022. The data in this chart represents small cap’s percentage of the US equity market. Note: Small is represented by deciles 6-10 based on market cap. All indices are unmanaged. It is not possible to invest in an index. Past performance does not guarantee future results.
The economy continues to show signs of weakening, and we’re seeing deteriorating fundamentals across more industries. While the market is getting excited about the possibility of “peak inflation,” there is still the potential for fallout from the Federal Reserve actions taken to ensure inflation does not remain persistently high. Nevertheless, several names we added to the portfolio in the fourth quarter are cyclical in nature.
This is not because we believe volatility and selling are behind us, but rather based on our view that the markets have inched closer to the point where economic risks are starting to get priced into securities. Throughout this downturn, we have been looking for signs that investors are finally coming to grips with the economic realities ahead. This would allow us, as contrarians, to lean into economically sensitive businesses that offer a more compelling risk versus reward and that could lead the market in the early stages of the next cycle.
We have seen some of our four key indicators flash green recently. For starters, a recession is now consensus as a majority of economists surveyed by The Wall Street Journal predict that the U.S. economy will contract in the next 12 months. This marks the first time that the Journal survey put the probability of a recession above 50% since the COVID-19 economic shutdowns.
At the same time, sell-side analysts have begun to ratchet down their earnings estimates, particularly in certain industries. For example, estimates are down from their peak by double-digit percentages in the Semiconductor, Retail, and Building Product industries, and analysts are already expecting lower earnings in 2023 relative to 2022. While we believe broad index estimates remain too high — as evidenced by the consensus sell-side forecast calling for 2023 S&P 500 earnings to grow 5% over 2022 — pockets of extreme weakness reinforce our belief that the market is now firmly in the midst of a negative earnings revision cycle, which is helping to reset expectations.
Another sign of a potential reset is when management teams become transparent about falling demand. Three months ago, we noted that companies were finally beginning to cut their profit outlooks. That trend accelerated in the fourth quarter amid growing concerns about slowing demand. We wouldn’t describe this as broad-based “capitulation” just yet, but we’re moving in the right direction.
Finally, we aim for stocks on our watch list to hit our “buy” targets before starting a position. In addition to favorable catalysts and valuation considerations, we assign price targets to companies under both good and bad scenarios. This helps ensure that we are staying true to our 10 Principles of Value Investing™, which demands paying low prices relative to earnings, cash flow, and intrinsic value to create a margin of safety.
This approach has paid off in a year in which our Strategy was down 2.42%, net of bundled fees, while the Russell 3000® Value Index is down 7.98%. And because adhering to buy targets allows us to play offense slowly and selectively, we believe it sets us up well for the coming year and beyond.
Attribution Analysis & Portfolio Activity
The Strategy’s outperformance during the fourth quarter was driven by robust stock selection in the Information Technology and Healthcare sectors. The Strategy’s Communications Sector underweight also aided performance while Energy holdings lagged the benchmark driven by a decline in refiner crack spreads, a reversal as compared to trends experienced earlier in 2022.
While we selectively added cyclical companies in the fourth quarter, it’s important to note that our traditional focus on higher-quality businesses with defensive characteristics spread out among sectors allowed us to take this approach.
Industrials. These are companies like Simpson Manufacturing (SSD), which designs and manufactures connectors and fasteners used in new construction. Simpson dominates the domestic wood connector market, controlling roughly 75% share thanks to the company’s high value add. If a structural connector fails, the building is uninhabitable, yet Simpson products typically account for <0.5% of a building’s construction cost. As a result, the company enjoys pricing power and a long-term median operating margin (earnings before interest and taxes, or EBIT, divided by sales) of 17%, versus 12% for its Building Product industry peers.
But the stock was down around 45% through late October, as investors grew concerned about a housing recession. Simpson’s earnings will be down significantly in 2023; however, we believe the stock is undervalued relative to normalized earnings. Longer term, the rise in building code requirements should result in more demand for SSD connectors per unit of construction.
When we purchased SSD, the stock was trading at a price/earnings ratio of around 12 based on forecasted earnings over the next 12 months. That was well below Simpson’s long-term median valuation of 21 times earnings. Today, the shares are trading at 16 times earnings for the next 12 months, after analysts cut their fiscal 2023 forecast by around 20% since the end of the third quarter.
Materials. Packaging Corp. Of America (PKG) is the third-largest producer of containerboard and corrugated packaging in North America. Packaging production and pricing is highly correlated to economic activity, so it’s no surprise that PKG is off more than 20% from its April 2022 all-time high. The stock actually held up longer than expected, in part because there was a substantial amount of double ordering by PKG customers in the aftermath of the COVID-19 disruptions. Now that supplies are elevated, it will require lower production and demand stabilization to work off the extra inventory.
Though the company’s earnings are expected to fall by around 20% next year, we think PKG could generate close to $500 million in free cash flow. Meanwhile, investor sentiment is likely to improve as the market comes to grips with the economic slowdown, and our best guess is that PKG can work off its excess inventory in the first half of 2023.
Communications. Fourth-quarter volatility didn’t just allow us to identify potential early-cycle leaders. In some cases, it allowed us to upgrade to best-in-class holdings. For example, in Q4, we recognized losses in a large-cap cable operator to start a position in small-cap Cable One (CABO).
Cable One is a broadband and cable provider with a focus on rural markets in the Midwest, Northwest, and Southeast. Graham Holdings Company (GHC) spun CABO out in 2015, and investors became attracted to management’s strategy to exit pay TV, which has been in secular decline amid the streaming boom, in favor of more-profitable broadband. As a result of this early strategic pivot, CABO operates with one of the highest margins in the cable market.
The stock was considered a “work from home” winner during the pandemic and became overvalued in 2021 as a result. So far this year, though, the stock has fallen 60%, and it now trades at just 8.3 times enterprise value to next 12 months EBITDA. By comparison, CABO’s median valuation post spin-off is 11.5 times EV/EBITDA.
In another example of “upgrading” our Communication sector holdings, we recognized a loss in a company and used the proceeds to increase our existing position in Alphabet (GOOGL), parent of Google.
In February, we initiated a position in a stock that got hit hard on revenue headwinds. At the same time, management was aggressively investing in portions of the business, which we believed detracted significant value from the enterprise. As for Alphabet, we originally purchased shares in 2020 during the pandemic. We subsequently trimmed our position in 2021 as the stock approached our view of intrinsic value, though we didn’t exit the position entirely. Fast forward to September, and GOOGL was back to our “buy” target.
We reassessed the decision to own both stocks and decided to upgrade the portfolio to Alphabet at the start of the fourth quarter.
In a year when the Nasdaq Composite Index lost more than 30%, the S&P 500 fell more than 18%, and aggregate bond indices are down more than 10%, we’re pleased that our investment process provided investors with downside protection. While we don’t believe our performance should be judged over a quarter or a year, we do believe 2022 represented a market environment that rewarded long-term fundamental investors, unlike 2020 and 2021 when the market rewarded speculation.
Warren Buffett’s famous two rules of investing—1: Never Lose Money and 2: Don’t Forget Rule No. 1—was forgotten by many market participants after years of easy money. A plethora of companies that were the best performing stocks of 2020 and 2021 may never see prior peak valuations again because they burn cash and depend upon the kindness of strangers to sustain their lofty expectations. Our focus is on compounding wealth over time, which requires minimizing losses in bear markets while also identifying opportunities that only arise when fear is pervasive. Simpson Manufacturing and Cable One are two examples of small-cap opportunities that arose in the fourth quarter, and we look forward to highlighting others in coming quarters.
We want to thank you for your continued trust and confidence.