As we enter the final quarter of the year, the economy is noticeably slowing under the weight of higher interest rates. The stock market has become more volatile in recent weeks, and there is a lot of uncertainty. In our opinion, high-quality companies can continue to grow their earnings in this environment. However, slower growth and higher interest costs make security selection more important. What we have seen this year is that not only stocks can experience large bouts of volatility. Losses on longer-dated Treasuries are beginning to rival some of the most notorious market meltdowns in U.S. history. Bonds maturing in 10 years or more have slumped 46% since peaking in March 2020, according to Bloomberg.
Our investment philosophy is based on the belief that diversification is key. This means that we invest in a variety of different asset classes as well as sectors within the stock market. This helps to reduce our overall portfolio risk if one particular asset class or sector underperforms.
As we’ve discussed, the stock market has been unusually concentrated this year. The Magnificent Seven account for 69% of the total market return year-to-date. This means that the valuation of the overall market is disproportionately impacted by the valuation of these few stocks. Based upon valuations, much of the tailwind that these stocks have provided to drive the market higher is more than likely behind us. For the rally to continue, returns will need to broaden out. Having a broadly diversified portfolio of high-quality companies allows us to participate in future market advances without having all of our eggs in one “over-priced” asset class or sector.
Our stock selection process begins with the supposition that price changes more than value. Stock prices fluctuate all day long, some up some down. The question is whether that price is reflective of the company’s underlying value? That’s where our proprietary model is able to identify those stocks with unusual price-to-value relationships. One day a stock is trading at 20 times earnings and the next day it is trading at 10 times earnings but nothing has fundamentally changed. Our model evaluates multiple price value factors over those stocks own ten years’ worth of trading history to determine whether in fact a stock is “cheap” relative to its historical relationships. That is where the opportunity presents itself.
We don’t need to forecast the next quarter’s sales. Most Wall Street analysts try to figure out whether sales are going to improve by a percent here or their next quarter. We think that’s almost impossible to do with any degree of certainty. Once the model has determined that a stock is cheap relative to its historical price-to-value relationships, we simply have to determine whether the company is running a good business over the long term. Certainly, whether a business is going to increase sales 10% – 20% next quarter is relevant, but more relevant to us is whether the company is a good business and therefore a good investment? If you can take a longer time horizon for one or two years, you can buy good companies when the price-to-value relationship is cheap. Often this occurs when the company is out of favor and the stock price is down. So sometimes, volatility is your friend!
We believe that the current environment presents both challenges and opportunities. By diversifying our portfolios and investing in good businesses, we can position ourselves for success in the long term. Thank you for your continued trust in us, and please get in touch with us for a personalized portfolio review.