12th May, 2022
Dear Clients,
We hope you and your families are doing well. Throughout the first quarter of 2022 the stock market faced multiple challenges. Rising interest rates, inflation fears, weakening consumer confidence, COVID excess, trade disruptions, and foreign conflict all contributed to a market correction starting off the year. The bull market we experienced in 2020 and 2021 was put on pause as the world reopened and people returned to their 2019 lives.
Highlighting a few of the obvious drags on sentiment are the war in Ukraine and high inflation. The conflict between Russia and Ukraine is cause for concern as Ukraine is major global provider of wheat and corn, not to mention Russia provides western Europe with much of their oil. The sanctions imposed upon Russia have proved to be a net negative for the world economy as they exacerbated inflation within our borders and fueled higher oil prices. This added concern drove the Federal Reserve to a 50-basis point interest rate hike to tame inflation and in turn has led to recession fears. The Fed is also reducing its balance sheet and telegraphing future interest rate hikes.
Our past assertions regarding peak earnings growth and peak valuation multiples are now being adopted in the marketplace. We have seen many expensive stocks contract aggressively as the market is weighing what valuation multiples are appropriate. Even though we sold our higher valuation companies early last year and shifted to a more value conscious portfolio, the lack of liquidity in the market has caused many of our names to decline as investors are “throwing out the baby with the bathwater.”
Investors' willingness to pay a premium for every dollar of earnings is lessening and their approach is becoming more discriminatory. That being said, much of the confidence we have in the portfolio is based on our higher-than-normal cash position, and low valuations. Most of our portfolio is less than 10 times earnings compared to the S&P 500, the Russell 2000, and the NASDAQ with multiples of 17x, 20x, and 23x, respectively. In addition, our companies expect to grow much faster than the indices and the underlying economy. One example is our position in Silicon Motion which was under 9 times earnings at $75 when Maxlinear offered to acquire the company for $115. We think that there could be competitive bids for SIMO and we continue to hold it in your portfolios.
Outlook
Since our last letter, the marketplace has changed. Valuations have contracted across the board, inflation is more permanent, the Fed is aggressively shifting its policy, and economic growth is slowing. In some instances, earnings growth is positive, but the market doesn’t much care. We expect continued volatility due to several cross currents. We are now witnessing the unintended consequences of aggressive monetary and fiscal policy and the distortion of free market forces.
What has not changed is our approach. We continue to evaluate companies rather than concentrate on “the market.” Our primary focus is and always will be to invest your money in companies that we believe are poised to grow in whatever market cycle we find ourselves in. Two quarters ago we said we have confidence in our portfolio because of valuation support. Today our resolve is even stronger. As you have witnessed in years past, coming out of these time periods our stocks tend to do very well and while past performance is no guarantee of future returns and the timeline is uncertain, we believe this time is no different. (see chart below) We are starting to see many opportunities in this environment and are well prepared to take advantage.
Portfolio
In prior letters, we highlighted RingCentral, DocuSign, Twilio, Alarm.com, Quanterix, Clean Energy, Full House Resorts, Ranpak Holdings, and Silicon Motion. This quarter we would like to discuss Diamondback Energy (FANG) and Civitas (CIVI). Both FANG and CIVI engage in the acquisition, exploration, development, and production of oil and gas in the United States. We believe that higher crude oil prices are here to stay and energy stocks tend to be a good hedge on inflation. Oil prices spiked to above $100 (up from $75 one year ago), and many of the top performers in 2022 have been energy stocks. As long as oil prices remain relatively high, that bodes well for profits for major oil producers, drillers, and anyone with exposure to crude. Both Diamondback and Civitas are less than 6 times their earnings and pay nice dividends as well.
As we have mentioned in past letters, we sold our high multiple stocks and shifted to more value-centered names. Since then, we have raised cash in order to stay nimble and have added the commodity-centric names above to anchor your portfolios.
Conclusion
We thank you for your continued trust and support. We welcome any questions or comments you may have. Please let us know if you would like additional information on any of the companies or topics mentioned.
Sincerely,
The GROW Funds Team