Client Letter 1Q 2022
If you go back to my last client quarterly letter, you will note that I managed to nail what we have seen so far this year. Increased volatility in the stock market? Check. A ten percent correction? Check. Higher interest rates? Check. Lower stock prices? Check. While I did not mention war, anyone who did not seriously think Russia was going to invade Ukraine was fooling themselves. In early-February, I wrote a note that was posted on our website which addressed some of these issues. In that blog post (https://www.aeriecapitalmgmt.com/blog), I tried to explain why we had more volatility this year. Let me address this briefly here. The answer started with explaining how rising interest rates affected the value of stocks.
How do rising interest rates affect investors? Let’s start with the fact that stocks represent ownership in a business. These businesses earn a profit. Let us look at a very simple problem. Suppose we own a business that earns $1,000 per year. We anticipate it will earn this same amount every year until the end of time. Suppose further someone wants to buy our business from us. What would we be willing to accept to sell this business? If we expect to earn the same thing every year and if interest rates are 1% and we do not expect that to change, it turns out we would be indifferent between earning $1,000 each year or receiving $100,000 up front. These two amounts would provide the same outcome. In finance lingo, this $100,000 is the “present value of all future cash flows”.
What happens if interest rates go up? Suppose we can now earn 2% interest on any money we invest today. As you might suspect, doubling the interest rate cuts in half the amount of money we would need to accept today to earn the same set of cash flows. In other words, we would be equally happy with $50,000 in hand today or $1,000 per year forever. Rising interest rates reduce the “present value” of future cash flows. The value of our business has fallen in half. The price a stock trades at represents what investors think the present value of future cash flows are worth. The cash flows, of course, are the future earnings of the companies. This raises two key questions. The first is when the Fed is all said and done raising interest rates, what will be the prevailing interest rate? 3%? 5%? 6%? No one knows. The second question is what will companies earn? If Apple earned $6.00 per share last year, is that sustainable? Might it continue to grow? Could it shrink if we have a recession? These two questions – the level of interest rates and the future earnings of companies – are leading to the current levels of volatility. In other words, if you think Apple will earn $7 next year and interest rates will settle around 3.5%, then you are willing to pay up to $200 per share to purchase Apple stock. Meanwhile, I may think Apple has stalled out and earnings will not grow but will remain at that $6 per share level. Further, I think interest rates will climb to 4% when all is done, so I am only willing to pay $150 for a share of Apple. The disparity between investors beliefs is what leads to volatility.
Besides the increased volatility, the other two key issues – both linked to each other – are inflation and oil prices and gasoline prices. Oil is a key component of the basket of goods that determine the inflation rate so when that spikes, inflation spikes, too. So when can we expect some relief from this inflation and how will that happen? Pardon me while I get just a little bit wonky and discuss economics for a bit.
Let me explain just exactly what inflation is and how it is measured. Inflation is when prices are rising in an economy. This is measured by what we call the consumer price index or CPI for short. This index is based on a market basket of goods and services that most Americans use on a regular basis. Key items, of course, are food, gasoline, housing costs and normal consumer purchases. The value of each item is measured and compared over time and the change in the value of this basket of goods and services reflects the inflation rate. Currently, energy costs comprise almost 25% of the value of the index, so a change in the price of oil would have a large impact on the CPI and thus inflation. Through February, the CPI rose 7.9% on a year-over-year basis. Energy (fuel oil and gasoline) was up 25.6% and was obviously a major component of the current inflation rate.
Up until the end of last year, I was of the opinion the inflation rate we were seeing last year was “transitory”. That is, I thought it was an anomaly that would quickly pass as we returned our economy to a more normal state. Sadly, this is not the case and energy costs are a big reason for this and a major source of controversy. There are several reasons for the spike in price for oil and gasoline. Most have little to do with the memes you see on Facebook or hear about from some politicians. They all want to blame President Biden for canceling the Keystone XL pipeline or for not allowing oil drilling on Federal lands. Neither of these have anything to do with the current spike in oil prices. The Keystone pipeline, which brings oil from the tar sands region of Canada down to the Gulf Coast, has been operational since 2010. The Keystone XL pipeline was to be a shorter route that connected the starting point in Canada to the existing pipeline in Nebraska. TC Energy, the company that operates the pipeline, touted that the XL pipeline would carry “up to 800,000 barrels of oil per day” but failed to mention that most of that oil would come from the Bakken region in Montana and North Dakota as it ran through that area – oil that is already being shipped anyway. In other words, the pipeline would not have added 800,000 barrels of additional oil to the U.S. economy contrary to what politicians and memes claim. There might have been some incremental increase but certainly not to that level.
Congress recently took the oil companies to task for making billions in profits and using this money to buy back their own stock rather than reinvesting in more oil wells. There is some legitimacy to this claim, but it is a gross over exaggeration. Yes, oil companies did earn a tremendous profit in the past year. However, over the past two decades they have had a boom-bust cycle. When oil prices would climb, oil companies would rush to drill new wells to capitalize on the high oil prices. This led to more oil on the market and lower oil prices and losses forcing cuts in production which eventually led to less oil production and eventually higher oil prices. Oil companies may have learned from their past mistakes and are slower to bring new oil wells on-line. Add to this the loss of over 12,000 jobs in the oil patch from the pre-pandemic high and that adds to the difficulty in restarting old wells or drilling new ones. The money the oil companies are spending to buy back their own stock is being done because they really have no other place to spend the money that brings added value to shareholders.
Another issue impacting oil production is a shift in sentiment among primarily institutional investors (think mutual funds, large college endowment funds and large pension plans) that encourage a shift to greener energy and less focus on industries that cause greenhouse gas emissions to rise. This can make it hard for oil companies to raise additional capital for drilling more oil wells. That may be counterintuitive in light of the fact I just said oil companies earned record profits. Oil companies will try to spread the risk of drilling new wells by attracting outside investors who share both the expense and some of the profits for drilling these new wells. Oil companies could do this all themselves but prefer to spread the risk around.
Lastly, we have the war in the Ukraine also impacting the price of oil. Due to Russia’s invasion of Ukraine, stiff sanctions have been imposed on Russia including on Russian oil. Russia is the sixth largest producer of oil in the world and currently no one is buying their oil to punish them for invading another sovereign nation. This has taken about 11 million barrels of oil per day off the market, driving up the price of the oil that is still out there. Should the war end soon with Russia’s complete withdrawal, the sanctions would likely end, and Russian oil would flood the market driving down the price of oil in the short run. However, oil would likely settle in the $80 - $85 range (oil is currently around $96 per barrel as I write this) which is where it was before the Russian-Ukraine situation.
With all of this being said, what are we doing about this either to protect clients or to take advantage of the situation? We made several moves that were designed to protect us from some potential losses. For example, in early January with inflation being universally acknowledged as an issue, retail stocks were starting to suffer losses. This makes sense. Costs for the goods they sell go up. The stores may not be able to pass along all the cost increases. That would be a drag on their earnings. We purchased options that would benefit from a drop in the price of a group of retail stocks. This proved successful as we generally netted a 25% gain in client accounts in the span of about three weeks. We also sold options on two separate occasions that obligated us to buy an ETF (exchange-traded fund) tied to U.S. oil as a bet that oil prices were going to continue to move higher. This is, of course, what happened, allowing us to net 9% the first time and 9.2% the second time we made these trades.
As stock prices fell, more companies became values to us, and we added several new positions this quarter. We bought shares of Activision Blizzard (ticker: ATVI) for around $80 per share. Currently, Microsoft has offered to buy the company for $95 per share. There are a few in Congress who are saber rattling against the merger (Elizabeth Warren and Bernie Saunders, for example) but my expectation is this is a lot of noise and hot air and will come to naught. We also added shares of consulting company CRA International (ticker: CRAI), industrial company Hillenbrand Inc. (ticker: HI), medical diagnostic equipment manufacturer Hologic Inc. (ticker: HOLX), container shipper Matson Inc. (ticker: MATX), interior electrical wiring company Encore Wire (ticker: WIRE), and residential homebuilder Tri Pointe Homes, Inc. (ticker: TPH) to client accounts. We also bought shares of Ford (ticker: F) as we viewed this stock as a reasonable way to invest in electric vehicles without taking the risk of the many new entrants into that space.
In addition to these new equity investments, we made some major adjustments to client fixed income (bond) investments. We eliminated the two bond funds we held as they not only were lagging but promised to be more of a drag as interest rates start rising. We shifted most of our fixed income investment to the Janus Henderson AAA CLO exchange traded fund. This mutual fund invests in CLOs or collateralized loan obligations – bank loans – but only those with the highest credit rating. This results in a slightly lower yield relative to other funds that invest in bank loan debt but more safety. When we started buying shares, the fund sported a dividend yield around 1.13% but we expect that to increase dramatically this month. The loans the fund holds are floating rate loans, meaning the interest rates paid on the loans adjusts periodically. These CLOs reset their interest rates quarterly and are set to adjust in April. In our conversations with the portfolio managers, he expects the dividend yield to increase to around 2% for the fund. In addition to this fund, we have found a solid “core plus” bond fund that will be our “go to” bond fund. We have started with a small allocation of around 1% of client accounts to this fund and expect to gradually scale into this fund as interest rates continue to climb, and we can add shares on periodic price drops.
We weren’t just busy adding new investments this quarter. We also eliminated a few holdings and trimmed several others. We sold out of our Atlas Air Worldwide stock earning a 30% return in about a year, eliminated retailer Citi Trends with a small gain in some accounts and a small loss in other accounts. We trimmed several growth-oriented mutual funds including the BlackRock Mid Cap Growth fund, the Putnam Small Cap Growth fund, and the Putnam Growth Opportunities fund. We eliminated our holding in the Virtus KAR Mid-Cap Growth fund. That fund had been a stellar performer for us but had become quite the anchor in the first quarter of the year. In retrospect, we probably should have trimmed or eliminated these funds sooner and faster as the values of these funds fell, dragging down our performance a little more than we would have liked for the quarter.
At quarter-end, we are in a reasonable position with our stock and bond holdings. We are being a bit more aggressive in hedging client portfolios with options as well as using option strategies to add income to client accounts. I would expect to see a few more equity positions coming into client accounts as stock prices continue to be volatile providing opportunities to add good companies at great prices. As a last note, we recommended to many of you a direct investment in Series I Treasury bonds. These bonds, which can only be purchased through the website http://treasurydirect.gov , are currently paying a little over 7% interest through May. The interest rate on these bonds is reset semiannually and is based on the inflation rate. As the inflation rate is expected to remain above 7% for now, we can expect these bonds to continue to pay at this rate through November. We will keep you informed on what to do with your I Bond holdings.
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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