Seeking Safety

Well, this has certainly been an eventful quarter. Russia invaded Ukraine, and although not to downplay the severe humanitarian crisis that has resulted, it has caused a major disruption in the trade of commodities as well as intense geopolitical tension and uncertainty. At home, inflation is running rampant, and only recently did the Fed decide to enact the first of a series of planned interest rate increases. Powell and his comrades also announced their intention to shrink their nearly $9 trillion balance sheet. And although we can only assume this move comes with good intentions to curb inflation, it might prove too little, too late, at least in the short term.

So, what are investors to do with this information?

Typically, when encountering general economic uncertainty, people turn to safe assets—savings accounts and government bonds. The latter proved to be the less popular option at the onset of the pandemic due to the Fed’s decision to decrease the target federal funds rate from 1.75% in February of 2020 to 0.25% in March of 2020. Consequently, 10-year Treasury yields dropped from as high as 1.66% to as low as 0.54% during that same time period, while the more liquid 3-month T-bills dropped to as low as -0.05%. Current inflation levels are further destroying the value of fixed rate instruments, as it devalues future repayments of principal. And with the inflation rate being greater than are interest rates, investors are losing purchasing power.

The turn to the former, on the other hand, resulted in household savings more than doubling from 2019 to 2020. However, this proved to be a less than fruitful decision, as FDIC data shows the national average APY on savings accounts currently sits at a pathetic 0.07%, and inflation has since eroded any earned interest. Plus, there is no sign of banks increasing interest rates for depositors any time soon—and what incentive do they have to do so? People sought safety in savings accounts despite low APYs and they got safety at the expense of nearly nonexistent returns.

Not great options so far.

When faced with little to no return in safe assets, investors tend to turn towards riskier investments that promise a chance at far greater returns; namely, this includes the IPO, SPAC, and cryptocurrency euphoria of late as well as early-stage venture investing. But, as alluded in the careful choice of words above, risk only promises the chance of greater returns. The relationship between risk and return is generally simplified as being a positive linear relationship, meaning only increases in risk will result in increased returns. In reality, as risk increases, the distribution of potential returns increases. As such, returns can be either far greater or far lower than otherwise expected using the typical linear approach. So, you can take your chances here, but despite their popularity, recent IPOs, newly-announced SPACs, and brand new cryptocurrencies appear unlikely to produce long-term track records of success. And although venture capital has a longer history, it is still inherently risky, especially as valuation multiples and enthusiasm for start-ups rise. With these methods, you can either hit it big or lose it all, and even if you want exposure to them, they should probably make up a very small percentage of a total asset allocation.

Take this route at your own risk.

Then there is what many would consider to be the “tried and true” method of growth investing, which has been the investment strategy of choice over the past decade. The general goal in investing is to more than outpace inflation, and growth investing has regularly exceeded this benchmark, particularly over the past decade or so. But with the Fed’s intention to enact six additional interest rate hikes by the end of this year and targeting 2.75% by the end of 2023, there will be pressure on equity valuations, particularly those of growth stocks. This is due to the fact that higher interest rates lead to a greater discount of the present value of future projected earnings. Essentially, the “cost” of waiting for the future earnings potential of growth stocks to materialize increases as interest rates increase. As a result, investors may be less willing to pay a premium for growth stocks, which will bring down their valuations.

This is probably not the best route either.

That leads us to value investing. Uncertainty unquestionably causes people to seek safety. By focusing on a company’s fundamentals rather than on the market consensus of the future earnings potential of whatever popular growth stock you can name, we are prepared to invest in high quality companies without regard for popularity. Eventually the market will correct mispricings in recognition of the value created by the quality of the company and its earnings, not its potential five years out. To allude to a popular quote from Benjamin Graham, the market prefers popularity in the short term but quality in the long term.

Regarding inflation, interest rate increases are typically the method of choice to combat inflation, which is just what happened at the latest Fed meeting. We wouldn’t be shocked to see some significant market corrections in its revaluation of growth stocks over the next few months, during which time several interest rate increases will take effect. Investors may consider turning to value strategies to provide earnings quality and strong cash flows that already exist rather than wait and hope for growth stocks to realize their potential at some point in the future.

Is value investing the best option? We certainly think so.

You might be wondering why this letter has been so blatantly inconsistent with our typical focus on specific stocks and other microeconomic elements of investing. Although we are inherently fundamental, bottom-up value investors, we recognize the importance of taking multiple variables into consideration, including various macroeconomic factors. So, while we are paying attention to what is going on around us and considering the influence of the current macroeconomic environment, our focus remains on company fundamentals.

People are seeking returns via safety, and although nothing in the world of investing is risk-free, our research suggests that value investing provides the best balance of risk to return you can get in this environment. We are excited for the opportunities this environment provides and will continue to seek high-quality businesses with successful management teams, strong earnings quality, and competitive advantages that are trading at a material discount to intrinsic value.