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Performance
For the quarter that ended September 30th, our Flagship portfolio declined 8.07%, net of fees. The S&P 500 Index, our benchmark, lost 4.88%. For the nine months ending September 30th, our Flagship declined 35.68%, net of fees, and the S&P 500 Index lost 23.87%.
Although over the last five years our Flagship has advanced by more than our benchmark and the majority of our peers, these results are not satisfactory.
Review
During the last two and one-half years the world has been crippled by a virus- and government-induced recession and then revived by fiscal spending and monetary expansion of breath-taking dimensions. Throughout this period the earnings power behind our Flagship and our clients’ portfolios has grown strongly. In the first half of this year, the Look-through Earnings in the portfolios grew year-over-year while the aggregate earnings of the companies in the S&P 500 Index declined 3%.
Prospects
Early this year, investors’ anxieties centered on inflation and rising interest rates. Notably, in early 2021, the U.S. Federal Reserve Bank said they would tolerate a period of inflation greater than its long-term target of 2%.
As inflation began to rise towards the end of 2021, central bankers reversed this policy and in March 2022 began to hike interest rates quickly. Higher interest rates compress price-earnings ratios, a topic we have been writing about for some time. It is worth emphasizing that the decline in the portfolios we manage is not attributable to any competitive weakness or lack of earnings power, but rather to the compression in price-earnings ratios that rising interest rates have caused.
As rates have surged a new worry now grips investors: higher interest rates may choke off growth and cause a recession. This fear arose with good reason, the vocabulary of our central bankers toward inflation and rate increases have gone from “transitory” to “soft landing” to “pain.” Quite an about-face in less than a year.
In recessions, companies typically lose earnings power if only temporarily. Markets anticipate this cycle and begin to discount these events: share prices inevitably decline. These share price declines create opportunities for those holding cash that they can put to work and value for those who have a longer-term investment horizon as we do Normally, a new bull market, reflecting that future value, then gets underway while the general economy is still in recession.
We invest in businesses with strong, resilient earnings growth which are less cyclical. In the pandemic recession of 2020, the aggregate earnings of the portfolios we manage did not decline year-over-year, and in fact grew, albeit modestly. In that year many of the holdings reported strong earnings growth including Amazon (AMZN), Domino’s Pizza (DPZ) and Adobe (ADBE) among others.
Looking at the Great Recession which began at year-end 2007 and lasted to mid-year 2009 is helpful too. Our four largest current holdings in the portfolio weathered that period well. UnitedHealth’s (UNH) earnings were resilient.
While it reported modestly down earnings in 2008, its earnings rebounded quickly to record highs in 2010 and the shares responded strongly in anticipation of this. Alphabet (GOOG, GOOGL), then called Google, reported earnings that doubled from 2007 to 2010. During this same period, Mastercard’s (MA) earnings almost tripled. Ditto Amazon. While all four are now more mature companies, our work leads us to believe that our four largest holdings could ably navigate the storms of an economic slowdown.
We also need to point out one global consequence of the rapid rise in interest rates: an irrepressibly strong dollar. This hurts the reported earnings of U.S. companies who sell their goods and services overseas. Foreign currency earnings translate into fewer dollars and thus lower earnings. Most of the companies in your portfolios gain a notable amount of earnings from their international operations.
While the strength or weakness of a currency doesn’t change the quality of a business or its longer-term earnings power, it can change the reported earnings of a company over short periods of time. It is difficult to forecast this effect accurately because many of our companies manufacture where they sell, which to some extent dulls the sharp negative effect of a surging dollar.
Danaher (DHR) and Abbott (ABT), among others, are good examples. Others sell goods that are priced in dollars such as Parker-Hannifin’s (PH) aerospace products. Notably, our largest holding UnitedHealth has little business outside the United States. Our best estimate is that in the quarter just ended, earnings for the portfolios were negatively impacted by six to nine percent.
Historically rising interest rates increase the value of the U.S. dollar against other currencies. When inflation peaks, as is most likely occurring now, the Fed will be able to pause its rate increases or even lower interest rates. The dollar should stabilize and may even decline.
We believe that share prices follow earnings. In the last five years, the Look-through Earnings in the portfolio we manage have grown about 20% per year. For this year we are forecasting continued earnings growth even though in 2021 the growth in earnings was over 50%, a formidable year-over-year hurdle to surpass. At the beginning of 2022, we forecast that the earnings power behind our portfolios would grow about 16%.
In fact, we believe that the portfolios’ growth will now be more modest in 2022 attributable to the strength of the dollar, and increased labor expenses, a situation faced by some of our portfolio companies; for example, Amazon’s temporary slowdown in earnings caused by increased expenses relating to the expansion of its retail logistics build-out; this drag on Amazon’s earnings should abate in the second half of this year. As for the S&P 500 Index’s earnings, most analysts now expect its earnings growth to be flat year-over-year.
Conclusion
Our investment performance this year has been disappointing, but the future growth and valuation of our portfolio holds the prospect of strong appreciation over the next half-decade. The current price-earnings ratio of the portfolio is a bit over 21X, a modest premium to the S&P 500 Index’s valuation of 18X.
More importantly, over the 45-year investment history of the Stewart strategy, the five-year valuation of the portfolio has been the best indicator of future results over time. Our holdings in aggregate are selling at about 11X estimated earning power five years from now. Historically the holdings in a Stewart portfolio trade at 22X-24X in stable environments when the 10-year U.S. Treasury Note yields 4%. And sometimes even more. We, therefore, conclude that your portfolios stand a very good chance of at least doubling from their current level over the next five years.
I look forward to reporting to you again in January.
Thomas M. Valenzuela
Chief Investment Officer
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Important Notices and Disclosures: Stewart Asset Management, LLC (“SAM”) is an Investment Adviser registered with the Securities and Exchange Commission (“SEC”). Registration with the SEC does not imply any level of skill or training. Additional information about us is available on the SEC’s website at www.adviserinfo.sec.gov. There, you can find our current disclosure brochure, Form ADV Part 2. This disclosure brochure, or a summary of material changes to the brochure, is also provided to our clients on an annual basis. Information presented by SAM is for educational purposes only and does not comprise an offer or solicitation for the sale of purchase of any specific securities, investments or investment strategies. Investments involve risk and are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. We cannot accept email requests to authorize, direct or affect the purchase or sale of any security, wire transfer, or to affect any other transactions. Such requests, orders or other instructions, if sent by email, must be confirmed verbally. It is important that you do not forward full account numbers, tax identification numbers, Social Security Numbers or other sensitive or confidential personal information by email unless it is password protected. Please contact us at (212) 759-7551 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of your account or to modify existing restrictions. Additionally, we recommend you compare your account reports from SAM with the account statements from your Custodian. Please notify us if you do not receive statements from your Custodian on at least a quarterly basis. The information contained in this message is confidential, is intended only for the recipient named above, and may be privileged and protected from disclosure. If the reader of this message is not the intended recipient or is not authorized to receive it for the intended recipient, you are hereby notified that any dissemination, distribution or copying of this communication is strictly prohibited. If you have received this message in error, please delete it from your computer system immediately. |
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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