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

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