Client Letter 3Q 2022
Let’s cut right to the chase. Ouch. Tough month. Tough quarter. Tough year. We keep hearing “lowest since….” in regard to the stock market and “highest since…” regarding interest rates. Inflation has been the story of the year. We have begun to see signs that inflation may be moderating. Until it drops significantly though, we are going to see continued interest rate hikes. Just to remind you of where we are, the official measure of inflation topped out at 9.1% on an annualized basis in June. We have seen a small tick down in the inflation rate to 8.5% in July and 8.3% in August. That is still an inflation rate we have not seen since early-1982. This has been the big disconnect that is driving much of the volatility in the markets.
Many traders are saying – hoping, actually – that this small tick down in the rate of inflation will cause the Federal Reserve to pause interest rate hikes. Some even go so far as to talk wistfully of the Fed “pivoting” – that is, actually cutting interest rates because they have gone too far. Every member of the Federal Reserve Board has been clear that cutting interest rates is not even on the table for discussion. At best, we can expect one or two more interest rate hikes and then a pause to see how all of this filters through the economic system. In other words, once the Fed funds rate – the interest rate that banks pay to borrow money overnight and that largely determines other interest rates in the system – gets into a range of 4% - 4.5%, we can expect the Fed to perhaps stop raising rates for some brief period.
What does all this mean to us as investors? I am firmly in the camp of “listen to the Fed”. Fed Chairman Jerome Powell has been clear that inflation is their key problem, and they will not back off until the inflation rate is back down to something close to 2% on an annual basis. My personal belief is that they might be okay with an inflation rate between 2% and 3% per year, but that is still a long way off from the current 8.3% annual rate. This means we can expect interest rates to continue to rise. The current Fed funds rate is currently around 3.25% per year. I think we will see this at a 4.5% annual rate by the end of December. Higher interest rates are generally not great for stocks for several reasons.
The simplest reason higher interest rates are bad for stocks in general is that investors have an easier choice. When it comes to investing, the goal is to earn a return on your investment. When interest rates were essentially zero, there was no alternative. Investors we forced to buy stocks either for their growth or their dividends or both. When investors can earn a reasonable interest rate on a bond investment, they now have choices. Do they buy a bond that pays a guaranteed interest rate of 4% or 4.5% or 5% or do they buy a stock that pays a dividend of 2% and may grow in value over the next year? With choices like that many investors, especially more risk averse investors, will sell stocks and buy bonds. This leads to stock prices falling.
Another key reason for higher interest rates being bad for stocks is what we call the “discounted future value” of stocks. Pardon me if I get a little math geeky for the next paragraph or two. A share of stock represents ownership of a business and a claim on any current and future earnings of that business. We invest in businesses that we anticipate will grow over time providing more cash to investors. However, one dollar earned next year is not worth the same as one dollar today. Why? We can take the one dollar we have today and deposit it in a bank and earn interest on that dollar. The more interest we can earn, the less one dollar one year from now is worth to us today. For example, if we can earn 5% interest annually today, we could invest $100 today and end up with $105 in one year. Conversely, if we wanted $100 one year from now, we would only need to invest about $95.24 today earning 5% interest to end up with $100 in one year.
This is a concept called ‘discounted cash flow’ and is the basis for how many investors value a stock today. These investors will estimate how much cash the company will generate per share into the future. They will then discount those cash flows back to today to arrive at what is known as the ‘present value’ of these future anticipated cash flows. This is where interest rates come into the picture. The higher interest rates are on safer investments like Treasury bonds, the higher the interest rate an investor will demand on a stock to make the risk worth investing. If I can earn 4% per year buying a Treasury bond which is backed by the U.S. government, I may decide that I need a 10% return to take more risk and buy a stock that may or may not continue to grow into the future. Going back to the $100 above, if I determine a company is going to return $100 in the future and I discount that at 4%, I am willing to pay $96.15 today for that stock. However, if I require an 10% return to entice me into buying a stock, I would only be willing to pay $90.91 for that stock today to have $100 in one year. Apply this same concept across all stocks. When interest rates were zero, stocks were worth just about anything you were willing to pay. As interest rates increase, the “discounted” value falls.
Given this set-up, stocks are likely to fall a bit further. However, I am not expecting a dramatic tumble. I truly think the worst is behind us. In part, I believe some of the expectations for higher interest rates are already reflected in current stock prices. What is not reflected is that investors really have no idea how far interest rates will increase. I have been saying now for a while that the stock market is seemingly stuck in a range between 3,600 and 4,200 as levels of the S&P 500 Index. The index closed just below this at the end of September. I believe investors are expecting the Fed to cut interest rates by another 0.75% in November. The big question is will they also cut in December and by how much. This is what could portend some additional volatility and lower prices by the end of the year. I think this would be short-lived, though as the likelihood is that the Fed will then pause interest rate hikes to see what effect all their work has had on reducing inflation. That is part of the problem with these hikes. They take a while to filter through the economic system and affect the inflation rate.
How are we dealing with this volatility given our expectations? We have already taken several steps and anticipate several more along the way. In part, we are using the volatility and lower stock prices as a good buying opportunity. We have added to a few current positions in addition to adding a few new positions and eliminating others. We added to our holdings in two mutual funds. One is the Applied Finance Explorer fund (ticker: AFDVX) which invests in smaller company stocks. We also added a little bit to our Janus Henderson Contrarian fund holdings (ticker: JSVAX) which invests in mid-sized companies. As the markets fell, we added a little bit to our holdings in Berkshire Hathaway class B shares (ticker: BRK.B) when the stock fell below $300 per share. This stock may be classified as a “financial service” company based on its insurance businesses, but it almost qualifies as what used to be known as a conglomerate that touches everything from boots to ice cream to bricks and railroads. In addition to the myriad private companies Berkshire owns, there is also an extensive stock portfolio as well making this holding a hybrid between an insurance company, a conglomerate or holding company and a mutual fund.
We added several new positions this last quarter, several of which should take advantage of higher inflation and interest rates. We added two stocks of companies that are primarily fertilizer companies. We bought CF Industries (ticker: CF) and CVR Partners LP (ticker: UAN) to take advantage of elevated food prices and production. We also added two new positions to take advantage of rising oil prices. We shifted away from the oil ETF we had traded earlier in the year to a couple of individual oil company stocks. The first we added was PDC Energy (ticker: PDCE) which is an oil and gas exploration and production firm. We were starting to evaluate more oil companies as potential investment opportunities when we chose to simplify things and bought the SPDR Oil & Gas Exploration and Production ETF (ticker: XOP). This is a mutual fund that invests relatively equally across all the stocks we were looking at for this space which simplified this investment for us. While we readily acknowledge climate change is a real issue, it has become clear that we are not ready to flip a switch and turn off fossil fuels and turn on alternative energy. We need time to get there and, in the interim, oil and natural gas will continue to be viable and profitable. We also added another shipping company, Star Bulk Carriers (ticker: SBLK) to our holdings. This company should continue to profit from the continuing supply chain disruptions though revenues may fall a bit should we have a global recession.
We also added two investments that will take advantage of rising interest rates. One is the Wisdom Tree Floating Rate Treasury ETF (ticker: USFR) which is a mutual fund that buys Treasury bonds with interest rates that adjust up or down based on the prevailing interest rates in the economy. This is another safe place for us to park excess cash and still earn a little bit of a return on our money. This fund has an annual dividend yield around 2.5% with dividends paid out monthly. We also added shares of the Invesco DB U.S. Dollar Bullish fund (ticker: UUP) which is a mutual fund that trades foreign currencies. When interest rates rise in the U.S., foreign investors will typically want to buy our government bonds which pay a higher interest rate then their own bonds. In order to buy our bonds, foreigners need to sell their currencies and buy U.S. dollars. This drives up the value of the U.S. dollar which is what this fund exploits.
We eliminated a few positions over the quarter for various reasons. We sold out of consulting company CRA International (ticker: CRAI) with just over a 10% return. We eliminated Activision Blizzard (ticker: ATVI), which has an offer to be bought by Microsoft. The merger seems to be running into some regulatory issues, and we chose to step back, taking a small 4% loss. Should the regulatory picture become clearer, we may return to this stock. We also sold out of two companies closely tied to the homebuilding industry. We sold our shares of timber real estate company PotlatchDeltic Corp (ticker: PCH) as the price of lumber continues to fall. We also closed out homebuilder Tri Point Group (ticker: TPH) as rising interest rates make this holding more of a “value trap” than a value currently. The Tri Point Group still has value but rising interest rates will likely hamper growth for the next year or two. We figured we could always revisit this stock when we think interest rates are going to start coming back down.
We are continuing to review new investment opportunities and have several new funds and individual investments that we are vetting for risk and potential returns. These challenging times mean we have to seek out creative solutions. Some of these solutions we have already implemented, such as the Wisdom Tree Floating Rate Treasury ETF. This investment is a good short-term solution to rising interest rates but once interest rates peak, we will probably shift much of that investment to bond funds that offer a higher yield. Rest assured we are doing our due diligence before committing client money to any new investment idea.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
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