1Q 2022 Client Letter

The first quarter of 2022 was remarkable for a couple of events: the persistent pressure of inflation on the economy and the Russian invasion of Ukraine at the end of February. Both events rattled markets. After the S&P 500 posted a positive 11% return in the fourth quarter of 2021, the same index declined 4.60% in the first quarter after the Federal Reserve announced a more hawkish plan to tackle inflation. Previously dismissed “transitory” inflationary pressures were finally acknowledged as the Fed detailed its intentions to make price stability is highest priority. Some have argued that the Fed has been successful in facilitating the economic recovery during COVID and stimulating inflation after a persistent lack of inflation for years. Others contend that the Fed was lax in its policy and got behind the curve as evident by the consumer price index (CPI) reading over 8%. Both opinions may be correct.


Market anxiety has increased further while the world watches Russia’s military campaign against neighboring Ukraine. As Ukrainian civilians fled their homes or took up arms, the tech-heavy NASDAQ led the markets lower. The S&P 500 peaked on January 3, 2022, then declined 12.8% through March 8 before rising over 7% into quarter-end. The Russell 1000 Growth – an index that tracks the large-cap growth segment of the U.S. equity universe – declined 9.6% during the first quarter. An even more speculative subset of stocks, exemplified by the ARK Innovation ETF, declined 29.9% during the same time.


The first quarter provides an example in which the “defensive” fixed income portion of a portfolio did not provide the hoped-for protection against volatility in the securities market. Historically, and when interest rates were higher, the 60/40 portfolio (made up of 60% equities and 40% fixed income) was a straightforward asset allocation that was thought to participate in the general equity market uptrend while also protecting against market downturns. In times of distress, a “flight to quality” would push bond prices higher offsetting equity declines. Interest rate declines over the past 40 years have supported a sustained fixed income bull market, making fixed income allocations additive to many portfolios. However, with interest rates near zero and inflation rampant, the probability of large and sustained interest rate increases by the Federal Reserve during forthcoming meetings is high. In this case, being invested in long bonds could arguably be worse than being invested in stocks. The Barclays US Aggregate (or AGG, which broadly tracks the US investment-grade bond market) returned -5.85% in the first quarter of 2022 providing little diversification or defense for a balanced portfolio. For this reason, market analyst Peter Schiff describes the bond market as “return free risk”.


At Heron Bay Capital Management, we believe quality companies bought at attractive prices provide the right balance between preservation and growth. Quality businesses, by our definition, produce current and consistently positive free cash flow as a byproduct of their competitive advantages, industry dynamics, and astute management. These cash flows can often self-fund the business leading to more durable enterprises. As a research organization, we focus on the numbers, not narratives. While there are many reasons stock prices may fluctuate, in the long term the market is a weighing machine. In times of excessive pessimism or euphoria, the markets may reward other company characteristics more. However, focusing on well capitalized businesses with durable and relatively predictable models earning more than their cost of capital significantly reduces our greatest risk: the permanent loss of capital loss.