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.
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.