Very few investors will rue the passing of 2022. The Financial Times headlined its final issue of the year with ‘Markets lose more than $30tn in worst year since financial crisis’. In stark contrast to the crisis of 2008 however, 2022 offered investors almost nowhere to hide, with high quality bonds suffering significant losses alongside equities, thanks to the cascade of interest rate increases imposed on economies in response to an inflation shock that built progressively over the year. With the key central bank, the US Federal Reserve, still talking tough on further rate hikes and concerns that the impact of a possible recession is not yet fully discounted in share prices, the traditional, rose-tinted outlook that greets most New Years is notably absent. In this note, we revisit a key lesson from last year, try to put some context around the derating of equities with help from Wall Street legend Peter Lynch and consider what this implies for investment markets and portfolios as 2023 begins to take shape.
The Fed
If there is one lesson we might usefully re-learn from 2022 it is that forecasting macroeconomic variables such as inflation, unemployment and interest rates is very difficult. Believing that Fed. chairman Jerome Powell had any special insight when he repeatedly stated that inflation was transitory and that interest rates would not need to increase in 2022 was a pit into which many stumbled. Despite the innumerable economists working for the Federal Reserve, Powell’s assertion proved no more than misplaced optimism. Looking ahead, this might lead us to question the degree to which we should believe his latest pronouncement – that interest rates will now need to rise further and stay higher for longer. They may or they may not, depending on the path of unemployment and inflation data from here. Powell and the Fed are ‘data dependent’, they will respond to the evidence as it evolves – especially with regard to the labour market and wage growth. We should keep this in the front of our minds as we contemplate the consensus view – that investment markets will continue to struggle. The chart below shows the extent to which equities and bonds fell last year. After such marked weakness we need to be mindful to avoid the trap of allowing past performance to colour our judgement about the future. Asset prices are now meaningfully cheaper, and we should factor that into our investment decisions moving forward.
Fidelity’s legendary manager
Our Christmas-break reading included revisiting one of the great books on investing, One Up on Wall Street by Peter Lynch. Lynch was the celebrated manager of Fidelity’s Magellan fund in the 1970s and 80s. He achieved returns of close to 30% p.a. over 14 years until his retirement in 1990. We were struck by his humour and clarity of thought, particularly about what he could and couldn’t do as an investor. With regard to equity markets, his straightforward but very helpful insight was that, while he had no idea at all whether the next 1,000 point move in the stock market would be up or down, he knew with some certainty that the next 6,000 points would be up. His logic is simply that the short-term volatility of the economy quickly becomes irrelevant, while corporate earnings grow over time – and share prices move higher to reflect this fact. This is useful not only when putting last year’s weakness into context, as discussed above, but also when digging into individual stocks:
‘I don’t think people understand there’s 100% correlation with what happens to a company’s earnings over several years and what happens to the stock’.
It forms part of One Up on Wall Street’s repeated focus on the obvious, but seemingly often ignored fact that behind every stock there is a company, and an investor must know what they own. This brings us to our next section – on the sorts of stocks we prefer at this time of great uncertainty.
Ferrari
We were struck by a CNBC article late last year reporting, in a surprised tone, that despite surging fuel prices, rising ESG concerns and the hype surrounding electric vehicles, the best performing car manufacturer in 2022, in share price terms, was Ferrari.
Truth be told, the hurdle was not high. Ferrari shares declined by c15%, compared to most of the start-up electric vehicle manufacturers losing c75% of their market value, and volume car makers such as GM and Ford losing c40%. In fact, one might have hoped for better from the shares of the Italian sportscar maker. The chart below illustrates perfectly the Peter Lynch quote – the Ferrari share price has closely followed the company’s earnings growth since its flotation as a standalone company seven years ago. At least it did so until late in 2021. Since then, earnings have continued to grow but Ferrari shares have fallen back.
Is the recent divergence of the company’s share price from its earnings noteworthy? What is the correlation breakdown telling us? In our view, nothing at all. The fall has been part of a general de-rating of equity markets as higher bond yields began to offer investors attractive levels of income for the first time in 15 years – and analysts used higher interest rates when calculating target share prices for equities. The latter simply resulted in lower ‘theoretical’ share prices for all companies – but particularly those faster growing companies trading on higher PE multiples. How do we know that the share price is not signalling declining earnings ahead? Of course, we cannot be certain, but we do know that as recently as November Ferrari raised its profit guidance for 2022 and stated that it foresaw no problem with demand in 2023, regardless of the economic conditions. In our view, Lynch’s 100% correlation will reassert itself in due course.
Moving from the specific to the general, charts for many of the largest holdings in our recommended portfolios look similar; at this juncture we prefer to own high quality companies that possess a history of delivering consistent earnings growth through the economic cycle. Below we share just one more example, LVMH, the French luxury goods company. It too has suffered a derating despite continued earnings growth. Sooner or later, as long as the business model remains intact and management continue to execute, the share price should catch up – and track higher along with continued profit progression. The key point is that the strong underlying business economics of such companies mean that they are largely insulated from the short-term ups and downs of economies and interest rates. The appendix displays the impressive 5-year annualised total return and earnings per share growth for the 10 largest underlying equity holdings in our recommended portfolios.
Portfolio characteristics
As 2023 gets underway, the range of possible outcomes for investment markets appears extraordinarily wide. A positive year for equities and bonds is entirely possible should inflationary pressures ease more quickly than currently assumed. At the other end of the spectrum, inflation and wage growth could remain stronger for longer – leaving the Fed with little choice but to continue hiking interest rates. This would most likely result in another year in which markets struggle. Other factors will also, no doubt, come into play, not least the Russia-Ukraine war and its continued impact on energy prices but also, for example, the path of China’s reopening and possible changes to Japanese monetary policy. Clearly, there is plenty to concern investors, however, as noted above, equity markets have endured a reset and valuations are now much more attractive. This is also the case in bond markets, where yields are now more attractive than they have been for over a decade.
As a result of this heightened uncertainty, recommended portfolios are positioned for flexibility. Allocations to cash and short-dated bonds are included to provide yield and defensive characteristics while the equity allocations, much reduced through 2022, are skewed towards the types of companies discussed above – those with strong business models which should prove resilient to short term volatility while also having the potential to participate in the upside when the macroeconomic picture brightens. Should the likelihood of the latter increase, holdings of defensive assets give us the flexibility to rebuild risk asset positions to capitalise on an economic upturn.
Appendix
The ten largest equity holdings within Heronsgate Capital Model portfolios:
| Stocks | Annualised Return, 5 Year (%) | Annualised EPS Growth, 5 Year (%) |
|---|---|---|
| Microsoft | 24.2 | 24.1 |
| Mastercard | 18.4 | 12.6 |
| ASML | 30.3 | 27.7 |
| LVMH | 24.2 | 18.2 |
| Novo Nordisk | 25.4 | 10.1 |
| TSMC | 18.2 | 24.8 |
| Lonza Group | 12.2 | 2.0 |
| Alphabet | 11.1 | 28.5 |
| Ferrari | 15.8 | 9.6 |
| Cadence Design Systems | 30.9 | 24.4 |
