Results Recap and Investment Outlook

Commentary 

So far in 2022, inflation, rising interest rates, supply chain challenges, and the invasion of Ukraine have taken a toll on the market. While the economy remains strong, there has been some softening as consumers are not quite as confident or as flush with cash as they were six months or a year ago.

For the quarter, we lagged the Russell 3000® Index as our interest rate sensitive holdings underperformed. Many of these holdings are now trading at valuation multiples that we have not seen in several years. These stocks appear to be pricing in a near-term recession, which is a possibility, but far from certain. There has been some deceleration of growth this year, which was to be expected after a very robust 2021. But with few exceptions, these businesses continue to compound revenue and profits at a nice rate, with a favorable forward outlook. 

We are becoming increasingly constructive on our opportunity set. We see good value in our existing portfolio (trading 14.6x our next 12 months earnings estimates – near the lowest level we’ve seen in the last decade) and are finding many Watch List names and new businesses worthy of study for potential investment. We are not naive about the challenges the economy faces in the coming quarters and years, but as long-term, value-aware investors we cannot help but perk up when we see high quality assets on sale. 

Amidst the acute tech sector and high growth sell off, we have looked closely at several tech-enabled growth businesses that we have long admired. Heretofore, we did not expend significant research resources on these businesses since they were market darlings and valued as such. But, with their stock prices down 50%-plus from 2021 highs, we dug in with some optimism. Alas, we found that they still require aggressive growth assumptions, and/or ignoring very high stock compensation expenses to justify current prices; neither of which we are willing to underwrite. Our view is that these businesses need another meaningful price correction to be investable with a margin of safety. For the time being, they sit as new entries on our Watch List, part of our actionable opportunity set if circumstances warrant.

During the quarter we trimmed our investments in Aon and O’Reilly Automotive, and used the proceeds to increase our position in Applied Materials. Both Aon and O’Reilly had been very strong year-to-date and Aon had become oversized relative to our target weight. Also, as we have written in the past, we are patiently scaling down our O’Reilly position since the business is maturing and facing a still distant, but growing secular threat from electric vehicles (EVs). Finally, we exited our position in Marlin Business Services (about 2% of assets) as the business was acquired during the quarter.

After quarter end, we began adding a new position to the portfolio. We are still building this position to its target weight, so we will refrain from sharing many details now. To give you a brief preview, this is a small cap company with recurring revenue, acyclical demand, attractive economics, and a large growth opportunity. We look forward to writing more about this investment in our next client letter. 

To reiterate what we wrote last quarter, our big picture view is that coming into this year we were 13 years into a bull market and the risk pendulum had swung full range from fear to greed. For half a generation, risk seeking had been rewarded, and prudence penalized. While some of the air has recently come out of the hottest sectors, we still see many excesses. In this environment, we think being mindful of downside risk is all the more important.

At the same time, the potential for sustained inflation poses a serious risk to purchasing power for assets held in cash and fixed income. With this backdrop we particularly like our portfolio of what we believe to be high quality, well run, growing businesses, owned at reasonable valuations based upon demonstrated earnings and cash flow.  

From today’s valuation level we expect portfolio returns will track the mid-teens rate of earnings growth we expect from our portfolio over the next five years, with the obvious caveat that a sustained rise in interest rates from here would present a headwind that could clip several points per annum off of our expected returns. 

We remain confident that our five investment criteria position us well to fulfil our mission of compounding client capital at a superior rate, with prudence over time. As always, we will continue to study, learn, and refine our craft as we try to get a little bit better every day.

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