It is both delightfully simple and genuinely compelling to be able to summarize the behavior of the equity markets, not only in the calendar year just ended but over the last two years. In fact, I can do it in two sentences. Actually, I can first do it in a chart…
In 2022, the Dow and the S&P experienced peak-to-trough declines of 21% and 25%, respectively. At the end of 2023, both indices find themselves right about where they were at the end of 2021. Which happens to be all-time highs. Yes, quite the round trip!
Why stocks did this is irrelevant to the wonderful lessons from this experience. There are almost as many theories and explanations of why as there are market commentators, of whom I am happily not one. (I would point out, however, that the number of said commentators who successfully forecast both the market action of 2022 and that of 2023 is, to my knowledge, plus or minus zero.)
What should matter most to us long-term, goal-focused, plan-driven equity investors is not why this happened but that it happened. Specifically, there could be a pervasive and significant bear market over most of one year, and those declines could be entirely erased in the following year. Although not nearly as quick or as perfectly symmetrical as the 2022-23 experience, in the largest sense, that’s how it works.
As always, then, we break our year-end letter into two parts: first, the timeless and enduring principles reinforced by these two years, and then, a consideration of current conditions.
General Principles:
· The economy cannot be consistently forecast, nor can the market be consistently timed. Thus we believe that the highest-probability method of capturing equities’ long-term return is to remain invested all the time.
· We are long-term owners of businesses, as opposed to speculators on the near-term trend of stock prices.
· Though frequent and sometimes quite significant, decline in the mainstream equity market has always been surmounted, as America’s most consistently successful companies ceaselessly innovate.
· An investment policy based on anticipating (or reacting to) current economic, financial or political events/trends often fails in the long run.
Current Observations:
· We remain convinced that the long-term disruptions and distortions resulting from the COVID pandemic are still working themselves out in the economy, the markets, and society itself, in ways that can’t be predicted, much less rendered into coherent investment policy.
· The central financial event in response to COVID was a 40% explosion in the M2 money supply by the Federal Reserve. It predictably ignited a firestorm of inflation.
· To stamp out that inflation, the Fed then implemented the sharpest, fastest interest rate spike in its 110-year history. Both debt and equity markets cratered in response.
· Despite this, economic activity just about everywhere but in the housing sector has remained relatively robust; employment activity has, at least so far, been largely unaffected.
· Inflation has decreased significantly, though not yet close to the Fed’s 2% target. But prices for most goods and nearly all services remain elevated, straining middle-class budgets.
· Capital markets have recovered significantly, as speculation now centers on when and how much the Fed may lower interest rates in 2024 and whether a recession may yet begin, whatever they do. These outcomes are unknowable—probably even to the Fed—and don’t lend themselves to forming a rational long-term investment policy.
· Significant uncertainties abound. Trends in the U.S. federal deficit and the national debt continue to appear unsustainable. Social Security and Medicare appear to be on paths to eventual insolvency unless reformed. The serial debt ceiling crisis continues, and a bitterly partisan presidential election looms. The markets will face significant challenges in the year just beginning, as they do every year.
As the section title states, these are simply observations. Yes, they are rooted in facts, but observations, nonetheless. We can never be certain of what the future holds for us in the short term. As noted, the past two years succinctly demonstrated this notion. And, unless you have a crystal ball, the only way to continue to prosper through both episodes is to stay invested for the long term.
As always, we welcome your questions and comments, and we look forward to talking with you soon. Thank you again for the opportunity to serve you and your family. It’s a privilege for us to do so.
Below is a review of our portfolio actions in the past year.
Portfolio Review:
At the end of 2023, our core equity portfolio held thirty-eight stocks**. While we were not as active this year as last, the meandering market allowed us to add to our favorite names and take a few new positions. We suspect this top-heavy stock market (i.e., a few stocks are responsible for most of last year’s gains) will continue ignoring other great companies trading at good valuations.
Here's a review of our new positions:
· Veeva Systems (VEEV)
This relatively young company (founded in 2007) epitomizes the old saying, “niches make riches.” They are simply a CRM (Customer Relationship Management) software provider. But, instead of trying to be all things to all people, they are the largest CRM provider to the life science industry. This focus has solidified its leading position while allowing it to meet other needs within this industry (not just CRM-related).
VEEV fits right into our investment themes of Aging Population and Healthy Living. At a $30 billion market valuation, we are pleased with the sizable core business and equally excited about future growth opportunities.
· Estee Lauder (EL)
For years we have watched EL trade at a premium to our valuation. The premium somewhat validated what we have always thought about EL… a market leader in a fabulous consumable products industry (skincare and makeup) that will never go away. In addition, EL participates in the premium segment of the beauty care market. We see this as a great theme that has long lasting attributes… people will forever want to control their appearance (i.e., look pretty and take care of their skin).
Unfortunately, due to the market valuation, we never had the opportunity to buy it at our price… until this past year. While the stock continued to decline after our purchase in August, we still bought this great company at 2019 prices.
Our initial buy is half of what we typically allocate to a new position, as we recognize the uncertain environment in which EL finds itself. With travel and China being two of its biggest markets, the company seeks more clarity before it regains its historical growth. Nonetheless, we are happy to wade into this stock now, with the approach to add to our position over the years.
· PepsiCo (PEP)
We have owned PEP in the past, but our investment this past year takes on a new appreciation for this well-managed company. More specifically, their ability to manage their business to add shareholder value. While beverage companies and snack companies have always been great investments for us in the past, our involvement with PEP is truly on a different level.
As a rather large company, their sales growth will be limited as the years pass. But their financial management acumen and how it translates to shareholder value are the real investment here. Solid business and execution are required, but best-in-class financial management will drive this stock price.
The recent 15% correction in the stock price and near 3% dividend yield, combined with our favorable valuation, makes it a great time to invest. Our expectation is methodical value creation by management. At the same time, we will add to the position over time if and when we see stock price corrections. We suspect PEP to be a great, long-term holding.
In addition to the above brand-new positions, we took advantage of the meandering stock market to pair back a few outsized gainers and add to a few of our other top-shelf holdings. This included the following:
· Paychex (PAYX)
In our experience, PAYX and ADP are two companies that 1) Rarely trade below our valuation and 2) Rarely underperform the stock market. When either instance occurs, it’s a prime opportunity to buy more with whatever cash you have available. When BOTH occur, we do our best to find the cash (i.e., sell other positions) to make sure we can add to these holdings.
In 2023, PAYX underperformed the market and was trading at a discount to our fair value, therefore we did whatever we could to add to this terrific long-term holding. Over the past few years there has been plenty of new competition, but both PAYX and ADP continue to prosper. PAYX specifically, is a slow grower but a wonderfully managed company that knows how to add shareholder value.
· Otis (OTIS)
We have been buying OTIS for new clients since United Technologies spun it off at the beginning of 2020. This year, as the stock corrected nearly 20% at one point, we added more shares to this century-old company. But it’s not just its extensive history that makes this a wonderful company to always buy when the price is right.
OTIS participates in an industry (elevators and escalators) dominated by three companies… so it is an oligopoly. In addition, this industry is operated much like the razor and razor blade model made famous by Gillette… you give the razors away for free and sell the blades. OTIS installs the elevators at break-even prices while securing the service contracts. And lastly, these products are a necessity… meaning building owners cannot skimp on the maintenance of said elevator.
As we’ve written before… OTIS is truly the toll road to the sky.
· Starbucks (SBUX)
SBUX tends to do well over the long term but runs into intermittent corrections. Short-term fluctuations are the norm for this industry leader, as investors give too much weight to quarterly sales updates. As long-term investors, we are OK with this and, quite frankly, appreciate the buying opportunities.
This past year saw the stock drop nearly 20% in five months (while the stock market was advancing higher). We took advantage and added to our position. While we are fully aware of headwinds in China (their largest growth opportunity), we believe this behemoth will find its footing over the long term. At least, that is what history tells us.
· Brown Forman (BF.B)
BF.B is a long-term, slow-growing company best known as the maker of Jack Daniels. While the company or its stock never really set the world on fire, they consistently grow. Therefore, when the stock price sizably corrects, it makes good sense to increase our allocation. This past year, BF.B corrected over 25%, which is quite a decline for this stock. We’ve added to this premium alcohol producer at the current discount.
From an investment perspective, BF.B fits into our Vice theme. Simply, people tend to always drink alcohol making this a company with solid footing. Meaning, they will always be able to sell their whisky (and other brands) so business can only get so bad. On the flipside, there are opportunities to expand their lines (i.e., Jack & Coke in a can). So, we appreciate and know what we are getting with the existing business and view any business extensions as a bonus. A great long-term investment for patient investors.
Lastly, we sold one position outright:
· McCormick & Company (MKC)
MKC has been a favorite of ours for many years. They are the dominant spice/condiment producer for consumers and industries (i.e., restaurants). Over the years, they have made strategic investments that have worked well… like Frank’s Red Hot and French’s Mustard.
At this point, the future is less bright than alternative investments. MKC is an $18 billion company… rather large for this industry. For comparison sake, BF.B is a $25 billion company participating in a far larger industry. We are unsure how much bigger MKC can get without going outside their comfort zone (i.e., They may try acquiring companies outside their core competency). Therefore, we feel now is a good time to move on.
Summary:
As we noted at the outset of this annual client letter, the headline for 2023 is positive returns for the stock market, making up for the declines of 2022. In reality, more than half of the market returns in 2023 were driven by seven companies… labeled the Magnificent Seven. Last year’s market return is just under 10% without these seven stocks.
This is neither here nor there, but it portends that many stocks have yet to do much over the past two years. For long-term investors, you and us, this should bode well in 2024 and beyond as we continue our march to investing in great companies at good prices.
Here’s to a terrific 2024… a presidential election year that will undoubtedly provide surprises resulting in investment opportunities.
**At times individual clients may not hold all 38 stocks due to personal circumstances (i.e., lack of cash, stocks being overvalued at time of cash availability, etc.) that preclude us from buying certain stocks. Over time, it is expected for all clients to hold the same securities.