Back to Basics

More than 20 million people began investing since the onset of COVID, by some estimates. Dubbed “robinhooders, meme traders, redittors, or stonk investors,” many have received a crash course in how riding a bull market can go wrong. Concepts like profitability, free cash flow, and diversification were unnecessary and mundane. What these investors lacked in investment savvy, they more than made up for in their ability to HODL (hold on for dear life).

The first five months of 2022 have tested many of these investors’ resolve. As the drawdown gathered steam, portfolios that were overly concentrated in stay-at-home stories, cryptocurrencies, and growth-at-any-price stocks are experiencing returns reminiscent of the technology-bubble burst. Indeed, by mid-May,  retail trade darling, the ARK Innovation ETF, declined 74% from its 52-week high. Bitcoin had similarly lost more than 60% of its value. While many had grown accustomed to volatility from these types of investments, they banked on it being short-lived.

For a generation of investors and entrepreneurs, the length of the current drawdown is uncharted territory. While valuations grew to be especially grotesque for these types of assets over the last couple of years, they enjoyed more than ten years of being almost immediately rewarded for buying every dip. The easy money in the stock market impacted corporate behavior too. Company management teams raised large amounts of capital from investors eager to float their negative earnings in the hope of someday unlocking huge total addressable markets. However, with rising interest rates, investors are demanding positive earnings now instead of later. Indeed, at least one private equity firm has reportedly begun coaching its portfolio companies on how to thrive in an environment where fiscal discipline and valuations reign supreme. We welcome the shift.

Our team has invested through manias and busts before. Each period certainly has had its idiosyncrasies: the dot.com bubble was different from the great recession, and the COVID crash certainly tested the limits of our knowledge of epidemiology. However, with each new challenge, we have found that being cautious during manias and remaining calm through busts has paid off.

Balance Momentum with Fundamentals

Momentum is a factor that we sometimes utilize to help make investment decisions. As animal spirits take hold, winners tend to soar beyond reason. However, there is a powerful gravitational force that eventually pulls prices back down – fundamentals. For this reason, we refuse to invest in assets solely on their popularity. It must be something we want to own for the long term no matter the investment. For equities, that means understanding the growth potential, valuation, and management’s ability to execute. In short, momentum often signals that other investors see value in a company, but it does not define the value.

We believe patience is often one of an investor’s greatest advantage

Our financial plans and strategic asset allocations are built on assumptions with a twenty-year horizon and incorporates the inevitability of corrections and bear markets. We believe this disciplined process begets a significant advantage – patience. While we actively seek to adjust portfolios based on our view of the markets over the intermediate-term, we rarely feel impelled to act on forecasts with a lifespan of a few weeks or months.

When long-term holdings undergo periods of stress, it is imperative to re-underwrite our initial thesis. We believe the best action is to hold (or even add) through the volatility in our opinion. Maintaining a diversified portfolio can provide the dry powder needed to reduce volatility and lean into mispriced investments.

Morningstar annually evaluates the returns generated by retail investors versus the returns of the funds in which they invest. The gap between the two is significant. Investors tend to add to funds whose recent performance has caught their attention and move on from those currently out of favor. The result is often jumping from loser to loser.

Look for the baby in the bathwater

The financial media thrives on catchy headlines. It is a lazy trope to label the recent rout of NASDAQ technology stocks as a “tech wreck,” in our opinion. Nevertheless, detailing how single-product companies that saw earnings pulled forward from future years as people stayed at home due to a once-in-a-lifetime pandemic and did not exercise financial discipline causing recent earnings growth to fall below investors’ expectations, is a mouthful. Unfortunately, “tech wreck” is received by many as a dismissal of the entire sector, even firms who are sustaining healthy growth and, through innovation, poised to help other businesses solve for the challenges of tomorrow. Indeed, even some ARK Innovation Fund holdings are attractive companies that are being tarnished by association.

It’s similarly easy to declare China “un-investable” without doing work to fully understand the nuances of investing in the world’s second-largest economy. We believe that these shortcuts taken by the financial media create tremendous opportunities for us to find value in the wreckage. Readers can learn more about that, here link to China blog.

High volatility environments are typically when great wealth is made or destroyed. All too often, investors feel the need to “do something, anything!” FOMO (Fear of Missing Out) often transitions to GMO (Get Me Out), and careless investors risk turning volatility into permanent capital loss. We believe that discipline, patience, and a willingness to be contrarian, are the best ways to create wealth.

¹ Source: Yahoo Finance