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4Q 2022 Client Letter

As we leave 2022 in the rear-view mirror, many of us will bid it “good riddance”. From the market high on January 3rd, a barrage of news soured market sentiment: highly contagious Covid variants, continued shutdowns in China, an unprovoked invasion of Ukraine by Russia and the devastation of that war, uneven re-openings in the U.S. and Europe with ongoing supply chain issues, and workforce shortages, among other news. Although there was a steady flow of negativity throughout the year, the market was most impacted when central banks around the world finally woke up that inflation rates might not be “transitory” and responded with a historically aggressive series of interest rate hikes, the largest in over 40 years. Central bank methods of battling inflation are a blunt hammer, and the restrictive policy was coupled with hawkish rhetoric through year-end. Currently, there is increased market fear that central banks will overshoot and cause a recession and earnings contraction. In keeping with the theme of “good riddance to 2022” or “better times ahead”, details and data about the decline of 2022 can be found at the end of this newsletter. Market strategists and other “talking heads’” are incented to focus on the short-term, so we will try to lend some perspective.

Although last year was very painful, it followed a decade long bull market capped by the S&P 500 returning 31.5%, 18.4% and 28.7% for 2019, 2020 and 2021, respectively. Including the 18.1% market decline in 2022, the S&P 500 delivered compounded returns of 7.7% and 9.4% over the past 3- and 5-years, respectively. These returns were well in excess of inflation, bond, and money market returns over those periods. Most impressive is that for over the 10 years ending in 2022, the S&P 500 returned over 12% and the tech- heavy NASDQ returned over 14% compounded. It has paid to be a long-term equity investor. The prolonged zero interest rate policy of the Federal Reserve created an environment favorable to long-term asset prices such as real estate and common stocks while it penalized short-term savers. During the low interest rate years, the market was labeled TINA (there is no alternative) and as the market increased, investors developed a growing sense of FOMO (fear of missing out), driving speculative behavior. With interest rates at current levels, bonds finally have some yield and present opportunity for income-oriented or low risk investors. Higher interest rates have also reduced equity valuations and flushed out some speculative investments, making the prospects for long-term quality equity investments more compelling. It is a good time to remain focused on the long-term, meaning that we expect capital will be rewarded over the next 3 to 5 years.

It is impossible to write about last year without acknowledging our disappointment with the sharper than expected price declines of a few of our holdings. Being subjected to investor preferences (or whims) and aggressive tax loss selling severely punished some holdings late in 2022. We chose to hold many of these stocks in the portfolios after validating the underlying businesses and we believe that the current levels make them very attractive. We are excited that our portfolios are concentrated among companies that have strong and durable profitability and cash flow. Moreover, these businesses are not dependent on external financing and can grow from their internal cash generation. As we had hoped, some of the worst performers of 2022 are leading and outperforming in the early stages of 2023. May it continue and all our patience and discipline be rewarded.

With the significant headwinds of high interest rates and slowdowns in rate sensitive areas of the economy, there will be winners and losers in 2023. We believe that it will be an excellent environment for choosing particular equities - not just to be an index investor. Many companies will have their profitability pressured, as they deal with the trade-offs of raising prices and higher financing, labor and raw material costs. As previously mentioned, many of the earlier highflyers have come back toward earth and perhaps they have not yet landed. Indebted companies will experience the ongoing squeeze of higher interest rates coupled with a potential economic slowdown. We don’t invest in these types of businesses.

Finally, as we begin a new year, we are grateful for the great clients we have who are also long-term oriented and have placed their trust in us. As always, we will diligently work to be worthy of that trust and we welcome any questions or desire for more discussion on the markets or your portfolio.

Happy New Year!

Good Riddance: The Rearview Mirror

· 2022 was the 5th calendar year since 1926 that both stocks and bonds fell.

· 2022 was the first time that both stocks and bonds fell by more than 10%. There was no place to hide and the word “unprecedented” rang true.

· The S&P 500 had its worst year since 2008. The Mega Cap and highly valued winners of recent years (FANGMA: Facebook, Apple, Netflix, Google, Microsoft, and Amazon) fell by over 30%. More speculative companies with high levels of debt and/or no earnings did even worse.

· The CBOE Volatility Index (“The Fear Gauge”) started 2022 at 17.62 and peaked on March 7 at 36.45. 2022 had an average VIX of 25.63 compared to a 10-year average of 18.27.

· The 60/40 Portfolio – exemplified by a portfolio of 60% S&P 500 and 40% U.S. Treasury Securities – had the worst decline since the Great Depression.


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