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
John A. Schattenfield
Head of Distribution
Lara M. Compton
Director of Platform Marketing
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