The stock market continued its recovery from the 2022 bear market in the second quarter of 2023. Large capitalization US stocks, especially the major technology companies, led the way again as they did for so much of the last decade.
Recent and long-term performance for key stock, bond and cash indices is shown below. Performance during the quarter and trailing 12 months was very strong for the main stock indices (US large cap, international developed, and US small cap) that form the core of the stock portion of your diversified portfolios.
With inflationary pressures receding, the more inflation-sensitive segments of the market have fallen back. Commodities delivered a negative return in the quarter and for the last 12 months, but their strong performance through the period of high inflation remains evident in the 3-year figures.
For a last bit of useful perspective regarding stocks, the below chart is a reminder that calendar quarters and years can be arbitrary demarcation points. Most key stock indices still sit below year-end 2021 levels.
Bond markets delivered negative returns in the quarter. In the 3-year numbers in the Capital Markets Returns chart at the top, the -4.0% annualized return for bonds (the lone downward bar in that group) really stands out. In real terms (i.e., after accounting for inflation that averaged 5% over the same period) even high quality, intermediate-term bonds lost around 25% of their spending value over the last three years. We are not out of the inflation woods yet, but these figures illustrate well the trouble with bonds during inflationary periods. Similarly, it is no surprise that stocks reacted negatively to the initial inflation shock but now have managed to produce positive after-inflation returns over the three-year period.
It's worth stepping back and appreciating the dramatically changed landscape for bonds compared to 18 months ago. The chart below shows the US Treasury yield curve (interest rates across different maturities) for year-end 2021, year-end 2022, and the recent quarter-end. Intermediate-term bond yields (those with 3 to 10-year maturities) have risen 2.5% or so. At the very short end of the yield curve, where Federal Reserve policy has the most direct impact, rates have increased more than 5%! While it has been painful for bondholders getting to this point, expected long-term returns from bonds, now with much higher starting interest rates, are better than they have been for some time. Yields from cash and other very short-term bonds are also currently attractive.
Don't Be Distracted!
This currently inverted yield curve (inverted refers to short-term rates exceeding longer-term rates) has sometimes in the past signaled a forthcoming economic recession. In some ways, it might be a surprise if the economy didn't fall into at least a mild recession, given the sharp upturn in borrowing costs and the reduction (or end) of much of the pandemic-era stimulus, but long-term investors shouldn't be too focused on this question. Whether or not the Federal Reserve can engineer a soft landing, as opposed to tipping the economy into recession, is one of the hottest topics of debate among market observers today. It's clearly an important question for the economy and the millions of people who might lose their jobs or otherwise suffer in a recession. For investors with a multi-year, or multi-decade, time horizon, and with a well-diversified global portfolio, it's not a question to be fretting over. Long-term investors should assume there will be recessions during their investment horizon and plan for it.
This goes too for the other small or large crises that regularly crop up and cause investors to question the future of the markets. Early in the second quarter, we read regularly in the news (and consequently heard from a number of clients) those questioning whether it wouldn't make more sense to just sell everything until the debt ceiling crisis was resolved. Why put up with the short-term risk? Well, the reward for riding out the short-term volatility associated with this (or similarly the mini banking crisis in the first quarter), is a much-improved chance of reaping the rewards of long-term investing. The uncertainty these events cause is surely scary, and we certainly can't answer all the good questions they raise, but we also know that markets and the economy show remarkable long-term resilience.
Large Cap Value Review
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the overall portfolio size and the client's objectives and constraints.)
The Large Cap Value portfolio delivered a positive performance in the quarter but was unable to match the stellar performance of market-capitalization weighted indices such as the S&P 500. Despite tracking hundreds of companies, any index of US large cap stocks that is weighted by market capitalization currently finds itself with unusually high levels of concentration, both in terms of the weight of the largest holdings (per JP Morgan, the top 10 positions account for 32% of the S&P 500) and in terms of industry focus (today's largest companies are almost all technology companies). We have seen this dynamic unfold for much of the last decade, but especially since the pandemic. Morningstar did an analysis of its own index of US large cap companies and found that three quarters of year-to-date gains were attributable to just seven stocks.
While the large cap value portfolio does have some exposure to these names (Apple and Meta), and indeed the US large cap mutual funds we own outside of the large cap value portfolio have significant exposure to some of these names, it is not nearly to the degree of the major indices and we are comfortable with our posture.
The most significant move we made in the large cap value portfolio during the quarter was the sale of our entire position in long-term holding Wells Fargo. Our sale was prompted by concerns about the risks to their portfolio of commercial real estate loans. Wells Fargo is one of the largest commercial real estate lenders, with a portfolio of commercial real estate loans totaling more than $150 billion (out of about $950 billion in total loans). While their portfolio is diversified in many ways, it does include a significant component of loans and securities collateralized by office buildings with a significant portion of these in California (30% of their office loans). We are beginning to see notable signs of deterioration in credit quality, and we foresee a difficult two to three-year cycle for property owners needing to refinance loans in a much tighter lending and higher interest rate environment.
In most scenarios going forward, we see it as likely that Wells Fargo will muddle through without significant harm. But we know with banks, because of their leverage, it doesn't require a huge amount to go wrong for profits to decline. While not unusually levered for a bank, Wells Fargo has about $10 worth of assets for each $1 of equity, and its ability to absorb loan losses must be seen in that light.
We increased the weight of two other positions during the quarter: Liberty Broadband and Nutrien. Liberty Broadband's primary asset, as a reminder, is a 26% stake in Charter Communications, the country's second largest cable television and broadband internet provider that provides service to 30 million residences and 2 million businesses. Ongoing concerns about shrinking cable television subscribers and the potential for broadband internet competition from the wireless phone companies have created an opportunity to purchase Liberty Broadband at a very attractive valuation. While it is true that video subscriptions are dwindling, Charter is still a growing business with an enviable, essential, and very profitable competitive position that we see enduring for some time.
Nutrien (known as Potash Corp. at the time of our initial purchase) primarily sells crop nutrients to the agricultural sector. It's a somewhat cyclical company that is dependent on swings in agricultural demand and, more importantly, commodity prices. Potash prices increased dramatically following Russia's invasion of Ukraine. Russia and Belarus, the 2nd and 3rd largest global potash producers, came under sanctions and this helped push prices and demand higher for Nutrien, whose production is primarily based in Canada. We had trimmed the position near $105 per share in March 2022 and took advantage of a subsequent near 50% drop in the stock price to repurchase shares and increase our position size at a favorable valuation.
One final housekeeping item: the index that we used historically to compare the performance of the Large Cap Value portfolio was discontinued by Morningstar on March 31st, 2023. Starting on April 1st, the charts and tables in your report will track the returns, including dividends, of the Russell 1000 Value Index.
We welcome any questions or comments you may have. Please don't hesitate to reach out to us.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly, and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward-looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered a recommendation to purchase or sell any particular security. You can identify forward-looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward-looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index, and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.
Economic factors, market conditions, and investment strategies will affect the performance of any portfolio, and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions, or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.
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