Sterling Partners Equity Advisors Portfolio Commentary – Winter 2023

Kevin Silverman, CFA

Forecast 2023:

Long-Term Looks Good

Another year is behind us, and so traditionally a good time to make prognostications about the year ahead. This year we are more optimistic than past years — in part because we’ve waited to see how January turned out, but also because we recognize the power of mean reversion! Last year was a poor year for our SCV strategies, both in absolute terms and relative to our Russell 2000 Value benchmark. The damage was done in the first quarter as we shared the fate of many long-duration strategies when long bond yields jumped at the fastest pace in at least a generation, and the so-called efficient frontier was efficient in delivering worse-than-average historical results in almost every traditional asset class. We wrote last year that we believed the market performance suggested a recession was coming; that is closer to the consensus now, with two negative GDP quarters behind us. But, as often happens, it may be called over before it is officially declared to have begun. So it’s been a tricky period to navigate. Our Director of Research shares his thoughts on recent results about our best and worst performers later in this report.

We have been doing this job a pretty long time. Our SCV-Focus strategy has an inception date of June 2001, and our SCV-Diversified strategy began in December 2006. Before sharing our short-term views, which may be of less interest to long-term investors, it’s worth noting that our historical long-term results have been very good relative to the benchmark, as is our performance so far this year (links located at the end of this letter). One of these things we care about, one we care less about.

Unfortunately for the reader, we don’t know what will happen this year, which makes these annual prognostication letters a tad awkward. On the other hand, we are confident in long-term predictions of growth anchored around estimates of population growth and productivity growth per capita, some of the few trends that have been somewhat predictable in recent times.

Best Regards,

Kevin E. Silverman, CFA
Chief Investment Officer
ksilverman@sterlingpartnersequityadvisors.com
P: 312-465-7096
C: 312-953-0992

Click the following links for our most recent performance:

December 2022
January 2023

Please direct any inquiries to:

Timothy A. Knight
Director of Operations
tknight@sterlingpartnersequityadvisors.com
P: 312-465-7010
C: 773-909-5447

View/Download a PDF of this commentary

Sterling Partners Equity Advisors Portfolio Commentary – Fall 2022

Kevin Silverman, CFA

LESSONS

I had the pleasure of recently attending an investment conference hosted by the Hawk Center at UW-Madison, in conjunction with UW’s Applied Security Analysis Program (ASAP). ASAP is a pioneer in applied investment education and, not coincidentally, a program from which I am an alumnus. It was a pleasure reconnecting with Professor Hawk, former classmates and colleagues and hearing a few good investment ideas. But at least as interesting for me was the eagerness of the students to learn important lessons from seasoned veterans, so valuable in such a volatile and uncertain time.

Learn from seasoned veterans? What advice do we really have? I listened to one panel discuss how the advances in technology over our careers have helped investors but may have made things worse for professionals by making markets more efficient, fees lower, and has left the computers managing more money than the humans. I heard another panel discuss how the current period is unlike any in long careers, leaving the lessons of past cycles somewhat lacking to deal with this one. Clearly, these are challenging times. But for those just entering the business, if neither technology nor experience is helping, what are the lessons of experienced careers in the industry?

Technology has brought faster computing speeds and a ubiquitous internet that has led to many new tools for investors that can measure and visualize the causes of portfolio volatility and performance in real-time. Obviously, this has led to a majority of assets under management being managed by computers applying various forms of modern portfolio theory, first developed in the 1950s. There is now no shortage of data or the computer power to manipulate that data and graph it in HD, a functionality transforming all industries. Since fiduciaries typically need to see whatever level of granularity is available, this leads to even long-term active managers having a deeper understanding of what’s going on day-to-day in the portfolio than ever before. But are these advances helping investment returns or competing them away?

Even for active managers who don’t manage to the real-time volatility and performance attribution information flow and instead continue to value businesses based on the present value of future cash flows, technology has entirely changed the time and access to the information flow that is at the heart of the research process. SEC filings, news releases, management communications, databases, and product demonstrations- the currency of investment research are now available in real-time. There was a time when SEC Filings were only available on the day of filing in SEC regional offices in six cities in the U.S., each with a copy machine that required exact change! Technology has also automated the process of idea discovery, screening, and financial modeling. It has allowed testing a broader range of assumptions to hone estimates of cash flow and, ultimately, business value. But while these are great new tools, they have also vastly expanded access to information and the power to analyze it for the market in general, making markets more efficient and potentially eroding the alpha available to dedicated institutional investors.

As far as experience, in our shop, we hand-make financial models that attempt to predict the future by making judgments about market share changes within product categories and by making judgments about the amount of capital necessary to run those businesses. Are the products winning in the marketplace? Are they faster, better, cheaper, or more convenient? We largely try to predict the future by talking with people smarter than we are about what they think. We make intrinsic value estimates of businesses and expected return estimates from that. This approach was invented a long time ago and was dramatically aided by the invention of the telephone. Our edge is to care less about the present that no manager can talk about — and care a lot about the periods out a few years from now that they can talk about. Arbitrage the time value of information. Invest for the long run. This is an equity practitioner’s lesson: Trust the raw data, make well reasoned valuation judgments, and hold managers accountable for outcomes.

We like companies with little analyst coverage and little institutional interest because it hopefully leads to a better understanding of the intrinsic value than the average participant may have and the potential for rising demand later on. These days, that effort is made easier by the large ownership percentage of many stocks by ETFs, which trade with no concern for the valuation of any individual name. With an average four-year holding period, we normally find ourselves waiting for the stock’s price to move toward our estimate of intrinsic value as market participants come to believe what we believe, and demand slowly moves the stock higher. That is another practitioner’s lesson, patience. Being first in line means you won’t miss the event, but you may be waiting around a while.

In our strategies currently, we are waiting around for the gap to close between market prices and our estimates of intrinsic value. Our expected return estimates on our holdings have rarely been higher over our 20-year history; in that sense, this period feels very much like 2008. Our short-term returns have been holding steady against the benchmark since March or so but remain farther behind than usual year-to-date, again like in 2008. We have detail on our performance and our recent best and worst performers later in this newsletter written by our Director of Research, Nathan Schmidt.

If you have managed to read this far, the best lesson we can offer after a long career managing equity strategies is to own good long-term profitable businesses that sell necessary goods and services and own them at reasonable prices. If we can continue to do that, we can continue to deliver good long-term returns to clients. I don’t think it is really any more complicated than that.

Click here for our most recent performance, and please open the .pdf below to see our Director of Research’s thoughts about our best and worst contributors to our performance in the quarter.

Thank you for your interest in Sterling Partners Equity Advisors.

Best Regards,

Kevin E. Silverman, CFA
Chief Investment Officer
ksilverman@sterlingpartnersequityadvisors.com
P: 312-465-7096
C: 312-953-0992

Please direct any inquiries to:

Timothy A. Knight
Director of Operations
tknight@sterlingpartnersequityadvisors.com
P: 312-465-7010
C: 773-909-5447

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Summer 2022

Is It or Isn’t It?

That’s the question on everyone’s mind these days. It’s understandable because there are so many conflicting data points. We have pointed out in the past that a good thing to do to achieve certainty in stock market returns in the short-run is to avoid owning any stocks — or sell the ones you have; although we don’t recommend that, the market returns in the long-run have historically been pretty good. One thing we know for sure is our 2Q 2022 performance was worse than we like relative to our Russell 2000 value benchmark, and we will discuss the details of those results following this letter.

It certainly makes sense why markets are down this year. With negative GDP, rising inflation and interest rates, a war, collapsing consumer sentiment, and big economy-jolting energy price increases, it feels a lot like 1974, 1979, 2000, or 2008. There’s half a chance we are already in a recession that will be labeled after the fact, something that has happened frequently in the past. Market momentum is negative, retail sales are weak, housing is slowing, auto builds are down, the yield curve is inverted, disposable personal income has been slipping, even video streaming is down, and PE multiples are falling. In other words, good hunting grounds for a value investor.

At the same time, it’s also hard to make sense of record real wage rates, near peak personal consumption expenditures, near record low unemployment, and the Michigan consumer sentiment index at a 70-year low. A combination of the gut punch of post-Covid inflation, war, interest rate hikes, and then both a bear stock and bond market have obviously hit sentiment hard, but not yet employment.

In one post-Covid graph that looks pretty interesting (see chart), historically low unemployment rates seem entirely caused by a growing percentage of the working-age population moving into retirement. While some of this is undoubtedly a post-Covid appreciation for leisure, the demographics say that baby boomers are finally retiring and taking many of their non-college taught skills with them. In what could be a long trend, there seems to be an excess of lawyers and bankers and a shortage of truck drivers and construction workers. Hard to say if that’s bad for the economy.

But again is it or isn’t it?

There is a lot of negative data, but it’s quite possible we are in a slowdown created by the economy working through more than the normal number of global supply and demand shifts at the same time.   We try to keep in mind that most of the numbers that are making people nervous are rough estimates. With GDP and the CPI releases, it seems that a good dose of skepticism regarding the accuracy of these estimates is warranted, particularly as real GDP growth hovers near zero. Is GDP capturing all the productivity that has been created by the recent mass adoption of new technology? Is the CPI estimate capturing the difference between pricing and productivity gains in fast-paced new products and services cycles? Does the CPI basket change frequently enough when web-based product discovery and substitution are now weaved into consumer behavior?

The stock market itself has historically been the best predictor of recessions. This decline did cross the threshold of the definition of a bear market and, therefore, is likely an official market prediction. But in another somewhat unusual case this time, the average market decline so far can be almost entirely accounted for by the mathematical impact of higher interest rates dialed into the denominator of the present value calculation. Does that make the market decline less predictive? Or is it in fact more predictive because earnings declines have yet to be dialed into market estimates?

A lingering question that is key to where we go in the near term is what happens to inflation? Are general price increases a mathematical reaction to wartime-like levels of growth in the money supply? Undoubtedly yes. Are some price increases simply the natural market reaction to a post-Covid period when everyone wants to do everything at once, creating scarcity and higher prices for those who want to be first in line? Again, almost certainly yes. Are some price increases the natural market reaction to shortages caused by a major generational shift in world trade patterns and, therefore, a short-term incentive to build more capacity or invent a new approach? Again, we think yes. And while it’s easy to understand how higher rates can shock buyers and postpone big-ticket lifecycle purchases, a recent history that includes periods of higher housing starts and higher auto builds at a time of higher rates suggests that long-run demand goes beyond interest rates.

For the stock pickers among us, the flip side of a rising inflation and interest rate environment is that it creates opportunities for companies with proprietary products and good balance sheets to raise price and expand margin and earnings faster than competitors. The flip side of historically low sentiment is the opportunity for multiples to improve. Those two paths to good returns, expanding earnings and/or multiplies, say absolutely nothing about the timing, by the way. But in the long run, economic growth equals population growth times productivity growth, and whether properly measured or not, we remain pretty optimistic about that.

Click here for our most recent performance, and please open the .pdf below to see our Director of Research’s thoughts about our best and worst contributors to our performance in the quarter.

Thank you for your interest in Sterling Partners Equity Advisors.

Best Regards,

Kevin E. Silverman, CFA
Chief Investment Officer
ksilverman@sterlingpartnersequityadvisors.com
P: 312-465-7096
C: 312-953-0992

Please direct any inquiries to:

John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Spring 2022

Stormy Weather

The Fed, the War, inflation, the yield curve inversion, spiking commodity prices, among other events, have all helped put the future on sale and near-term certainty at a premium. The long bond and mortgage rate, both of which affect our portfolio in a myriad of ways, jumped at the fastest relative pace in 40 years! (view chart).  As we’ve written about before, it is usually the case that at times when the market price for certainty is rising, a portfolio such as ours, designed for long-term returns, is under near-term performance pressure.  Our experience navigating market cycles leads us to believe that during these periods of high uncertainty, the potential returns are often the highest.

What Happened?

Our long-duration assets have had the largest negative impact on our performance this past quarter. More specifically, cotton price surges, recession fears affecting the lending business, potential trade issues in China, and short-term supply issues resulting from COVID, among others, have negatively affected our strategy’s short-term performance. We offer detail later in this report. Ultimately, we believe it is often life-cycle choices that drive consumer behavior in the long run, and they can be predicted, but the cost of these predictions is recognizing that patience is required in the short run.

What are we Doing?

We are always opportunistic in the quest for risk-adjusted returns, our proudest accomplishment for long-term clients, which sometimes means reducing risk. For example, we reduced a bit of exposure to European business directly because of the War. We also began to adjust near-term earnings estimates as general recession risks rose, but mostly we watched the average long-term expected return of the names in our strategies rise as their stock prices fell. As a result, while the portfolio remains under near-term performance pressure, we see well-above-average expected return estimates for our existing holdings.

We don’t overtly attempt to predict the timing of recessions, although it does seem more likely in the near term than usual, primarily because rising prices can slow demand. But we do understand that for companies to have a chance to realize our future forecasts, they must first successfully navigate the present. So, we take to heart Ben Graham’s “margin of safety” and are pleased to say the strategies have delivered good risk/return results over the long run. We achieve that by owning companies that offer strategically differentiated products and/or distribution that maintain the good cost and capital structures necessary to win against higher-cost competitors during difficult times. We own almost entirely U.S.-based companies with good balance sheets and products and services that we expect to be winning in the marketplace over the long term.

Among other businesses, we are attracted to niches and eddies of the economy that are gaining share with products that are faster, better, or cheaper than alternatives – companies that we think of as having the wind at their back. We try to buy them when they are misunderstood by the marketplace in the short run, during periods that often feel like right now.

Over the years, this has led us to try to understand the cycles of demographics and the life cycles of consumer and household buying habits to build conviction around longer trends and milestones during short-term periods of uncertainty. While we are value investors first, this approach has led to successful long-term investment themes like healthcare, leisure, internet, software, cloud, content, and, more recently, housing; where we periodically can take advantage of flights away from perceived long-term uncertainty, and buy what we believe is good long-term value for our investors.

What’s Ahead?

We are never immune to falling market prices that give up the uncertain long-term potential for the immediate security of receiving a cash-on-sale. Still, we have complete confidence in the underlying long-term value of the good businesses we own, most of which generate free cash and real cash-on-cash yields. As is often a good check on stock market rationality, we estimate that all our holdings would deliver higher than historical real cash-on-cash equity return spreads to private owners, as the bond market currently offers near-zero, inflation-adjusted returns along all maturities on the yield curve.

Our holdings sell at meaningful discounts to our estimate of “true value” or “intrinsic value.” When the market overvalues near-term certainty, we patiently wait for a better price to sell while our companies continue to earn their return on equity, increasing their value while we wait. We continue to look for great new ideas, and when there is a compelling value for a business, we tend to buy a little bit. With an average holding period of four to five years by design, our strategies don’t invest for short-term liquidity but rather for long-term returns, which we have delivered and believe will continue to deliver. It is periods like this, periods of most uncertainly, when the potential returns are the highest, at least in my humble opinion.

Click here for our most recent performance, and please open the .pdf below to see our Director of Research’s thoughts about our best and worst contributors to our performance in the quarter.

Thank you for your interest in Sterling Partners Equity Advisors.

Best Regards,

Kevin E. Silverman, CFA
Chief Investment Officer
ksilverman@sterlingpartnersequityadvisors.com
P: 312-465-7096
C: 312-953-0992

Please direct any inquiries to:

John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Winter 2022

2022 and Beyond!

Sometimes patience is useful.  Had I written this letter a month ago, my optimism for the future would appear so much more incorrect than is likely now, with most indices at least touching correction territory a few days ago.  It appears that concern about inflation and what the Fed may do about it has caught up with actual inflation, an issue we explored in our Spring 2021 Letter, “All is Good Except This M2 Chart.”   It’s worth remembering that January has always been a bit of an odd month for many reasons, hence the phrase “January effect.”  We certainly saw a January effect this year, although maybe not the namesake.

Last year was a fascinating year as cross-currents of new supply/demand patterns, unprecedented levels of money printing and new non-fundamentals driven entrants into the stock market made for a crazy brew.  It reminded me of a college football game where about ⅓ of the crowd is screaming wildly about stuff that has nothing to do with the game on the field yet may impact the players’ ability to hear the play called.  Needless to say, it was an interesting year.  Our strategies, like many, had a pretty good absolute year, and so in terms of our primary goal of delivering good returns to clients, we feel pretty good about that.  There is detail about our performance and the best and worst contributors among our holdings later in this letter.

One thing to note, this Winter of 2022, the impact of the pandemic appears to have normalized. It may not be the winter of content, but at least it seems to no longer be the winter of discontent.  The worldwide lurch to a more internet centric life has become mainstream.  Grandma can deposit a check with her phone and get a medical checkup via Zoom.  Her knowledge worker buddies can now work from an RV in the woods and maintain their weekly bridge game with her.  As we’ve pointed out in past letters, the potential for a sustained period of rising productivity is apparent.  The actual costs of supporting a commuter infrastructure are falling and that unproductive time and capital will be redeployed into more productive pursuits.  We expect leisure to be one of them, but on the other hand, generally when new roads are built, people follow.  Shifting long-term capital spending trends are something we pay attention to.   So, while predicting the intermediate future well remains our core task, predicting the immediate future is not a core competency, and hence, a post-January letter is working better than an early-January letter, at least this year.

This time of year, market participants love to read prognostications about the year ahead.  With January behind us, I feel we have a bit of an edge over our competitors in that our rosy view won’t be immediately rendered incorrect.  Our view is only partially due to our colored glasses, the rest is due to the engine of productivity gains that has driven human activity for millennia.   We like charts, so here is one that shows the long march of real GDP per capita, real disposable personal income per capita and real personal consumption expenditures.  These are real numbers, and in the long run, this is a great source of conviction about the future, maybe not next year, but the next five years.

We do feel good about 2022, but it’s hard not to.  Over most of the history of those rosy charts, interest rates were higher, sources of capital were limited, knowledge sat in silos and computing power was tiny.  We believe a lurch in productivity is underway because of low rates, abundant capital, global collaboration in real time and game changing computing power.  Will that happen in 2022?  Really, we don’t know, but it’s likely one of two things.

If 2022 turns out to be a tough year in the market, our turnover is likely to be muted.  When the market offers us prices below our estimates of intrinsic value, we pass.  Manager research teams may say we had a bad year, and unfortunately the argument that we didn’t sell many holdings would fall on unsympathetic ears.  Meanwhile, we would in fact be paring our best performing names to add more quality to the portfolio at what often in a bad market can be a steep discount.

If 2022 turns out to be a good year in the market, then our turnover is likely to be higher as more holdings reach our estimate of intrinsic value.  We would re-deploy capital into our highest expected return names at that time.  Researchers might say we had a good year, but we might be having trouble finding great expected returns.

Either way, we own well-capitalized companies that earn good returns over cycles.  They sell differentiated products and services that serve a niche, with a “moat” to quote Morningstar, and we buy them at what we believe are attractive prices.  We will be looking for more of them in 2022.

Click here for our most recent performance and please keep reading to see our thoughts about our best and worst contributors to our performance in the quarter.

Thank you for your interest in Sterling Partners Equity Advisors.

See PDF below for a discussion of our top and bottom contributors to performance.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

Contact:
John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

Lara M. Compton
Director of Platform Marketing
lcompton@sterlingpartnersequityadvisors.com
P: 312-465-7093
C: 312-810-1036

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Fall 2021

Productivity to the Rescue!

There’s still a lot of unusual events going on, at least from the myopic view of someone who did not personally live through the World Wars, the Great Depression, the Plague, the fall of the Roman Empire and numerous historic horrible calamities.  Despite that lack of experience, we are managing our strategies much as we have for the past twenty years, which is based on our best predictions of the future.  There is a discussion of our best and worst contributors last quarter and our recent performance later in this letter, so you can see how we’ve been doing.  The future does feel harder to predict these days, but that view may just be hindsight.

Our main job continues to be to make our best predictions for the future and dial those into estimates of the underlying intrinsic value of our candidates for investment.  The future is always uncertain, but at a time when almost all historic patterns of commerce are changing at once, the near term is more uncertain than usual.  It’s unlikely many corporate finance types are just extending last year’s growth rates into next year’s forecast.  While this approach was simple and not terrible in a lot of “steady as she goes” kind of years, now it’s just horrible.

It’s easy to blame the pandemic for the massive dislocation of resources that is disrupting world economies, but in fact, the benefit is that owners of capital have been alerted that moving billions of workers dozens of miles a day to work at maximum productivity may not be the highest and best use of time and resources.  It has become apparent that maintaining offices of information workers in a central hub is not quite as necessary for productivity as we thought, which was the purpose of the central hub in the first place.  The advent of digital banking and digital signatures leaves even fewer reasons to go downtown.

So, we are in a period of rapid adaptation in which all global suppliers and customers need everything shipped to a new address at the same time.  They also need something slightly different than they needed at the old address or a different quantity.  This shift naturally creates logistics excesses and shortages.  Prior patterns of commerce have been disrupted and, like gravity, seek the most efficient new pathways.

The world is working hard to move to a more productive model.  The evolution of the internet and its use is reminiscent of other big productivity enhancing technologies like the road system or air travel, or still the mother lode, electricity, where it took decades to fully realize the full productivity potential of the innovation. If the interstate can bring us the suburbs can the internet take away the cities?  Many of the consumer and business needs that downtown hubs were built to serve, and in the process generate an ROI, can now be satisfied with a smart phone – no real estate or travel required.  Because of the need to work and shop remotely, the pandemic has lurched big swaths of the world into a more productive approach to almost everything at once, and we are beginning to see this in the data.

We speculated about this a year ago when the effects of the pandemic were just becoming discernible. But now we are seeing some data.  When the future is unknown, it’s good to know what people who think about ROA for a living are doing with their checkbooks.  The best source for this is the Bureau of the Census, Manufacturers’ Shipments and New Orders.  For our money, and this is free, this is some of the best lumination into the road ahead so it’s worth looking at.

Granted, a fair amount of the recently strong GDP numbers can be attributed to the pouring of trillions of dollars into business and consumer wallets, and clearly a good bit of that has found its way into the equity markets, but there are clues in the new order data about the future.

In August 2021, orders for all new manufactured goods were up 18.0% and new orders for durable goods were up 24.7% from a year earlier.  These are the highest numbers reported in these series, aside from earlier this year when the comparisons were even easier, since 2010. New orders rose more than shipments, which posted up 12.9% for August 2021 for all manufacturing and up 14.1% for all durable goods.

More interesting than the top line numbers are those categories at the top of the list.  New orders for industrial machinery were up 48.0% in August! New orders for transportation equipment were up 45.7%.  Shipments were up 41.0% for industrial machinery, up 37.3% for Light Truck and Utility Vehicles, and up 32.9% for computer storage. In most cases these are the best numbers since 2010.

There is another useful big picture statistic we like, growth in real GDP per capita.  At the core, until you get higher into Maslow’s Hierchy of Needs pyramid, real GDP per capita is a pretty good measure of a nation’s wellbeing, as it correlates with self-reported happiness, but more specifically, it measures total production per citizen, and roughly speaking the average goods and services available per person in the U.S.

Sustained growth in productivity per capita has delivered modern civilization as we know it so it’s interesting to note that the posted number for 2Q 2021 of 11.78% is the highest recorded since the late 1940’s, beating the second highest of 11.52% posted in 4Q 1950, as the nation began benefitting from the post WW2 reallocation of resources, and beating the third highest 7.63% spurred by the onset of Reagan realignment of tax incentives.  Much of this current gain is of course a recovery from last year’s decline, but there is always a bit of that after steep declines.  Despite an environment stoked by free money, the orders and shipments of capital goods will drive real productivity gains, as the nations’ businesses and consumers adapt, re-allocating resources to maximize productivity.  If we manage to grow productivity fast enough, we can stay ahead of inflation, and the data suggests that may happening now.

It’s worth noting that the 11.78% growth was posted to reach a record U.S. annualized GDP per capita of $69,904. This was the fastest GDP recovery on record.  In the chart below we show Real GDP per capita, which in 2012 dollars reached a new high of $58,478, beating the prior high posted in 4Q 2019 of $58,333.

As an aside the U.S. is way ahead of the pack of large nations with this metric.  In 2019, the IMF estimated U.S. $GDP per capita of $63,544.  Next, 18.5% lower, was Germany at $45,724, the U.K. at $40,285, Japan at $40,113, France at $38,625.  The U.S. has been an engine of productivity for a long time, the country is good at it, and it seems we may be in store for a few years of good gains as the world redeploys resources and capital.

Thinking about this is what makes our job to manage small equities fun.  Please keep reading to see our thoughts about our best and worst contributors to our performance in the quarter.  Thank you for your interest in Sterling Partners Equity Advisors and our small-cap value strategies.

See PDF below for a discussion of our top and bottom contributors to performance.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

Contact:
John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

Lara M. Compton
Director of Platform Marketing
lcompton@sterlingpartnersequityadvisors.com
P: 312-465-7093
C: 312-810-1036

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Summer 2021

The Secret Sauce of Total Return

At all times, even weird ones like this, we worry mostly about earning a good risk adjusted total return. That has always been the goal of our strategies and the team that runs them. Aiming for a specific total return in the short-term is tricky because if your investments require more certainty about the timing, you are almost certainly giving up some piece of total return. With the supply of stock reasonably given in the short term, lower certainty brings lower demand for the shares, and lower prices. More certainty brings the opposite. We are often uncertain about total return in the short-term, a risk we bear that helps drive our total return in the long-term. This uncertainty around timing is different than the uncertainty around survivability, an octane-fueled potential return source that we avoid. It might be worth mentioning that the standard deviation of our monthly returns is below that of our benchmark.

The biggest impediments we believe to total return in the long-term are in simple terms, overpaying. This can come about from overly ambitious financial forecasts about the company and the industry out in the future or it can come about from excessive emotional enthusiasm in the present. Earnings x Price / Earnings = Price and both components have an equal impact. Because total return is created by a shift in the P/E, and a shift in E, we try to identify companies where the potential for an earnings recovery over the next few years is high, and when therefore the potential for the sentiment about the stock, and in turn, the Price / Earnings ratio, to recover is also high.

Inflation has been and can be a big impediment to earning a good real total return. Inflation affects earnings, and price/earnings so it’s double edged. We wrote about inflation risks last quarter and are watching the Fed print money along with everyone else. We try to stay on the right side of inflation by owning proprietary or low-cost competitors that can raise price faster than their costs are rising. Businesses that produce goods and services people need rather than just want, along with Maslow’s hierarchy of needs — we keep these in mind when investing. We also mitigate the potential for rising inflation and interest rates by owning companies that are advantaged in the battle for market share gains in their specific business, are largely cash flow generating and are in a healthy financial position.

Much of our ability to deliver alpha, a greater total return than our benchmark, in my opinion, is our ability to discern a short-term problem which harms sentiment from a long-term problem that harms market share and ultimately cash flow. The difference between the long-term reality and short-term market sentiment is often the difference between earning alpha relative to the averages and not earning alpha — the definition of adding value.

An important element to our effort to add value is that we do long term financial projections of our potential holdings. We know the forecasts aren’t perfect, with much educated guessing involved, but with objective well researched inputs, the forecast models give the team insight and conviction about the future of cash flow and therefore also a window into the potential for shifting sentiments and valuation multiples. This is particularly useful during confusing turning points in the midst of company workouts and turnarounds. Good forecasting also gives us a longer view into our holdings’ ability to weather or maybe benefit from difficult periods. With what we believe is a likelihood of outperforming analyst expectations comes the opportunity to enjoy rising sentiment and P/Es.

When we can predict earnings will rise faster than expectations and we can hold for the typically multiple-year period it takes for sentiment to follow — that is the secret sauce of our investment approach and I believe the source of our strategies’ excess total return. Thank you for your interest in Sterling Partners Equity Advisors.

Click here for our June 2021 performance.

See PDF below for a discussion of our top and bottom contributors to performance.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

Contact:
John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

Lara M. Compton
Director of Platform Marketing
lcompton@sterlingpartnersequityadvisors.com
P: 312-465-7093
C: 312-810-1036

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – Spring 2021

All is Good Except For This M2 Chart

Another crazy quarter and another quarterly letter.  What’s new is that the value space and particularly the small value space is finally getting its 15 minutes of fame with a 20%+ year-to-date gain in the Russell 2000 Value. While it is admittedly tough to predict the future, it is sometimes also hard to believe the past.  Our strategies are performing well, and here’s a link to our recent performance.  A discussion of our top and bottom contributors to performance follows this commentary.

With the market up so much, and GDP revisions moving higher, I am pleased to report that everything is great. The market itself is the best predictor of a strong economy ahead, and that’s what we see.  It is a great awakening of productivity from the boundaries of daily commuting for billions of people, and the realization that all the knowledge of the world is connected in real time to fuel new ideas.  New ideas drive productivity which lead to better lives. It’s a time when less incremental capital is needed to drive the capacity and distribution of goods and services that are increasingly digital and idea driven just at the time that value added ideas are evolving faster and spreading at a faster rate and at lower cost.  Capital is increasingly abundant and therefore cheap, while great ideas remain scarce, raising the cashflow multiple on high conviction annuities.  The U.S. 10-Year Treasury bond yield of 1.5% means a 66.7 multiple on the pretax coupon, for example.

So, everything is looking pretty good.  Except for this money supply graph we dug out.

Isn’t that an interesting chart?  Inflation that erodes the future purchasing power of investors is one of the few things that could creep into the landscape of our good times and cause some bad feelings among asset owners. It turns out that adding money to the money supply at a faster pace than the dollar growth in GDP is viewed by some as potentially inflationary.

A reason to mention it even though everything’s great according to the stock market, is that there is a pretty good inflation forecasting metric, namely the 10-year breakeven inflation rate* published by the Federal Reserve, that has been going straight up.    A good economy and an uptick in inflation certainly do not have to be mutually exclusive, as 10-year inflation could tick up a bit, now estimated around 2.2%, and returns over that period could still overcome that hurdle, or maybe not.  If the current trend continues, history suggests that could be a little headwind to equity markets due to pressure on real returns.

The 10-yr B/E metric turns out to be a pretty good predictor, at least up to the most recent 10-year prediction in 2011, with an r-squared of 27%.  And therefore, unfortunately, it is also a pretty good predictor of real equity returns.

It’s been an interesting time to navigate equity markets, and inflation is the kind of thing we worry about.  When we think about the themes that are apt to deliver good returns over the next decade, our attention is drawn to companies that sell products that, in addition to being proprietary, are also necessary. These tend to be the type of products that can raise prices faster than their factor input costs rise.  Products that improve productivity will tend to gain share faster during inflationary periods, in our view, so we look for that.  Sometimes small companies are quicker to benefit from one or two great products gaining share and are also easier to identify, since the gainers can more quickly become a reportable percentage of total revenue.

Our portfolio is always filled with companies that we believe hold proprietary niches, and we find there is typically a permanent margin advantage because of it.   Owning companies that earn long term sustainable excess returns based on economic competitive advantages is a theme that has helped us earn good returns for clients over time, and which some data suggests may be even more important in the years just ahead.  Thank you for your interest in Sterling Partners Equity Advisors.

*Chart Sources:

Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average, Percent Change from Year Ago of (Index 1982-1984=100), Monthly, Seasonally Adjusted

Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate [T10YIE], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T10YIE, April 22, 2021

The breakeven inflation rate represents a measure of expected inflation derived from 10-Year Treasury Constant Maturity Securities and 10-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_10YEAR). The latest value implies what market participants expect inflation to be in the next 10 years, on average.

See attached PDF for a discussion of our top and bottom contributors to performance.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

Contact:
John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – October 2019

Uncertainty is Our Friend… I Think.

The last few months in the market should be enough to shake anyone’s confidence that they can predict the future. This has been demonstrated in dramatic fashion by the rush toward certainty at any cost.  Investors now want certainty so badly that portfolio managers around the world, according to Deutsche Bank, have invested $15 trillion at a quoted yield-to-maturity that is below zero as of September 2019.  Not only do below zero interest rates cause a variety of quantitative valuation models literally to breakdown, but they also fail to pass the grandmother test, in that my grandmother does not understand how in the world she can pay back less money than she borrows.  Of course, she’s smart enough to immediately ask to borrow a lot of money.

Certainty is expensive.  When lenders are willing to pay you to safeguard their money, instead of demanding a return, it’s a hint that certainty has become perhaps a bit too expensive.  My bond buddies tell me that it’s not the rates themselves, but the spread to longer maturities that are forcing short-term rates below zero.  My grandmother is not convinced.  On the other hand, the math says that if the coupons on a long bond are invested at positive rates, and not the negative yield to maturity that is quoted, that the actual compound return, or realized compound yield will still be positive.  Grandma does not understand that.

Ultimately, the flip side of certainty that is too expensive should be poor long-term returns.  But while current rates keep falling, the low coupon returns are kept at bay by rising asset values, and momentum buyers keep buying regardless of the quoted yield.  Encouraging buyers is the fact that many valuation models start to go parabolic on the upside with quarter point rate drops from such a low base, as demonstrated by the strong long bond returns this year.  So, while certainty should provide a lower return, the growing demand for assets with certain cashflows has pushed prices and returns up and yields down.  Another contributor to negative rates is the excess supply of capital created by the biggest generation of capitalists in history.  As they move toward retirement, they need more certainty, not necessarily more return. So, in effect, low rates may simply be an excess supply driven price decline.  If so, the floor to negative rates is the point when building a safe and hiring security is less expensive than the loss on the loan.  But this is so unusual that the Bank of England had not offered rates below 2% in over 300 years until just recently, a time which also enjoys the most excess capital in history.

It’s equally confusing in the stock market.  Our strategies underperformed in the third quarter ended September 30, 2019, with our Small-Cap Value Diversified strategy losing 2.11% vs. the Russell 2000 Value loss of 0.57%.  Our concentrated Small-Cap Value Focus lost 5.26% in the quarter.  After a strong first half, our strategies in the third quarter were buffeted by growing fears of recession, a recurring theme at several points during the past few years as the length of the recovery goes into record territory.  Initially, the market focused just on the length of the recovery as a predictor of recession, although now there are a few data points coming out of Europe and China that suggest an increasing probability of recession.

Still, the current fears are so strong that we now have many holdings trading at 20-30% cashflow yields, as measured by EBITDA divided by Enterprise Value, meaning if we bought the entire company, we would earn 20-30% on our cash investment, a cash-on-cash return.  While this return is before cash interest and capital investments, these are extraordinary return levels and can only possibly reflect a few scenarios.  One scenario is that EBITDA for these companies falls 70% or more and the yields move toward a more traditional 10% EBITDA yield, or 10x EBITDA, still beating most bonds by the way – an unlikely scenario in our view.  Another scenario is that rates rise a lot, putting lots of pressure on future earnings multiples.  The problem with that is that the excess supply of capital likely prevents rates on certain cashflow streams from getting too high.  So, what we are left with in order to equate low or negative short-term government rates around the world to unusually high cashflow yields among small best-in-class companies is that the risk premium to own small equities is among the highest we’ve seen in 10 years.  Here’s where the title comes in: the uncertainty in the market has pushed the expected return premium on our small-cap equity universe versus a risk-free government security to historically high levels and we are excited about that.  We own quality companies that tend to grow asset values even during periods when the market doesn’t recognize it.

It’s worth pointing out that recessions are not that bad.  Excluding 2008-09 as a mistake by accountants clinging to a mark-to-market rule for too long, most other recent recession have been reasonably mild and getting farther apart.  While there are many theories about the causes behind fewer recessions, one view is that more timely information available through the internet is creating less uncertainty all along the supply chain, leaving fewer opportunities for inventory dislocations that cause recession, and therefore continuing the trends of more years between recession as a natural outgrowth of better information.  As we discussed last quarter, the economy still looks pretty good.  We see a full employment economy with low interest rates, good access to credit, U.S. energy self-sufficiency, and a well-educated growing population.  These are usually good elements for continued economic growth.

With regards to a market outlook, the stock market, according to Ben Graham, is a voting machine in the short term and a weighing machine in the long run.  We subscribe to that view.  In the near term, headline risk of shifting interest rates, trade wars, hot wars, oil shocks, tweet streams, elections –all impact the stock market in ways that often look very much like random.   In the long run, population growth times productivity growth equals GDP growth, and businesses and industries that manage to do things faster, better or cheaper than alternatives will gain share of the economy and prosper.   In the long run, we believe that better education, better access to information, and easier access to collaboration will create an acceleration in innovation and productivity, even as academics find it difficult to measure.  The benefits of the app Open Table, for example, struggle to find a way into GDP.  The time we all save to work on other projects or read a book gets lost in translation.  But these entrenched trends will, in our opinion, continue to drive the economy to new heights, in the long run.

During these uncertain times, we strive to earn excess returns for our clients by continuing to do what we have been doing for nearly 20 years. We use a consistent process that fundamental investors have used for a long time.  Between Ben Graham’s “margin of safety” and John Burr Williams’ discovery of the discounted cashflow model, we use tools that have been honed by time.  Although markets have become more efficient, our universe includes some of the last eddies of opportunity to uncover information that has not yet been absorbed into market prices and we use fundamental research to find those opportunities for excess return.   By identifying undervalued companies with good balance sheets that target growing industries and offer products or services that are better, cheaper, or faster than the competition, we have a universe of superior businesses that we believe on average will prosper in the future.  By exercising discipline around our valuation approach and narrowing the bell curve around our estimates of intrinsic value, we rely on our expected return estimates to allow us to continue to buy stocks that we believe will deliver excess return over time.  Uncertainty has driven the expected inflation adjusted return on our universe to levels that have rarely been higher.  Does that make uncertainty our friend?  For small-cap investors the answer is almost certainly, yes.  Thank you for your interest in Sterling Partners Equity Advisors.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

Contact:
John A. Schattenfield
Head of Distribution
jschattenfield@sterlingpartnersequityadvisors.com
P: 312-465-7037
C: 872-202-2340

View/Download PDF of this Commentary

Sterling Partners Equity Advisors Portfolio Commentary – July 2019

The stock market is making new highs, unemployment is at record low levels, and GDP has never been better.  Corporate revenue and earnings are near records.  Borrowing rates are low and inflation is low.  It’s difficult to find any data that suggests a recession is on the way.  Yet everywhere we turn, pundits are bearish.  Why do we hear so many economists talking about a big chance of a recession sometime in the next few years?  Earnings comparisons are tougher, tariffs are terrible, they say, a weak Europe is the start of a global recession, all the benefits of the tax cuts are over, negative interest rates are bad for asset values, among other things.  When pressed, though, the most common reason is that the economy has been good for too long and that can’t last much longer.

This seems new. Perfectly capable economists are predicting recession simply on the basis of a recession being “due.”  The longevity of the current recovery is simply too long for some people to stomach, believing that the “natural cycle” of recoveries is just 3.2 years, the average of the 1854-2007 time period.  So, we are “overdue by 4.5 years,” according to an October 2018 Forbes article.  The recent market corrections in the fall of 2018 and in May 2019 both unfolded with a healthy dose of concern about near-term earnings, GDP growth, China tariffs, and the policy of the Fed, all of which together formed a mosaic of imminent recession, pundits say by late 2019, or certainly by 2020 at the latest.

Two economic metrics that are key to this discussion are real GDP and inflation.  In part, it is low real GDP growth compared to past recoveries that creates concerns about the longevity of the current expansion.  Inflation estimates are used to make real output estimates from nominal sales reports, which then are used to estimate real GDP.  Real GDP growth estimates obviously help drive analysts’ revenue and earnings growth assumptions and help to inform the Fed’s policy decisions.  The problem with this is that these estimates are wrong and economists know it.

The CPI is the inflation measure used in these estimates.  It is created using baskets of goods in dozens of locations around the U.S.  The current survey methodology ignores certain substitution behaviors, doesn’t account for discounts at outlet stores, doesn’t account for new products, and quite often ignores quality differences between discontinued products and those that replace them in the baskets.  The CPI is known to overstate inflation by as much as 0.4% per year.  The PCE is a better, lower, inflation estimate but it is not as timely and goes unused.  That leads to an understating of real GDP growth, which is of course the remainder after adjusting nominal GDP by the inflation estimate. While that’s a modest error in the short run it’s a giant error in the long run.  Not only is real GDP growth understated, but with inflation overstated, real wage gains are understated.  With real GDP growth and real wage gains understated, the current economy seems more tenuous and it makes near-term recessions easier for economists to predict.

Another element to the mismeasurement thesis is the mismeasurement of GDP itself.  In addition to the problem of measuring general inflation discussed above, there is also the problem of determining whether a price increase is a feature enhancement or inflation.  It’s likely that many feature enhancements are being misdiagnosed as inflation.  There’s the problem of not measuring the convenience of using OpenTable and the time it saves to do other things.  This isn’t captured.  In fact, it’s likely that a whole host of new conveniences along with productivity and lifestyle enhancers from Waze to Live Nation to Amazon Fresh are not being captured in GDP growth because the benefits are hard to measure in terms of time saved, not to mention what beneficial activity is created during that extra time.

Finally, traditional causes of recession, the mismatched timing and bad forecasting of inventory and end demand, are increasingly tamed by transparency in the supply chain.  In general, the vast benefits of the instantaneous flow of information to everyone or anyone are still working their way through the economy, quite possibly in ways that are difficult to measure with tools originally designed to count units and weigh output.  With long-term real GDP growth and living standard gains mismeasured and the full economic benefits of the internet still not fully understood, we believe there is a reasonable case that the economy is not only better than generally believed but also that real wages have risen more than believed for 30 years. If only we were using the PCE instead of the CPI.

Not surprising then that we remain positive on the economy and that we believe our portfolios are well positioned for good results ahead.  By identifying companies with good balance sheets that offer products or services that are better, cheaper, or faster than the competition, our portfolio companies stand to thrive no matter how the predictions of economists turn out.  Our strategies performed well in 2Q 2019, with our Small-Cap Value Focus concentrated strategy earning a 5.9% return net of fees and our Small-Cap Value Diversified strategy earning a 4.02% return net of fees versus the 1.37% return of our Russell 2000 Value Index benchmark.  Details on our results are discussed later in this commentary (see attached PDF).

Thank you for your interest in Sterling Partners Equity Advisors.

Kevin E. Silverman, CFA
Chief Investment Officer
P: 312-465-7096
C: 312-953-0992
ksilverman@sterlingpartnersequityadvisors.com

View/Download PDF of this Commentary