TDOC - 2023 - The Year We Plant Seeds For The Future

2023-03-11 07:05:45 ET

Summary

• Opportunities in stocks: algos going wild?
• Planting our seeds in the fixed income markets.
• Key takeaways.

Brian Dress, CFA - Director of Research, Investment Advisor

We are more than 2 months into the new year and the market is still working to coping with uncertainty. The Federal Reserve seems unable to back off on its pace of hiking interest rates, as inflation continues to be an issue.

Try as we might to look away from macroeconomic factors and drill down to fundamental analysis of individual businesses, the world appears to have different ideas for investors. Optimism in January has been quickly extinguished in the face of a number of challenges that remain in the economy.

At Left Brain, we are fully aware of the difficult landscape before us. If you are paying attention, how could you not be? However we have telegraphed to you in the early days of 2023 that we think it is time for investors to stop focusing so much on the short-term twists and turns of macroeconomics and start thinking about how to position for the next 2, 3, 5, 10 years and beyond. Our view is that we experienced incredible amounts of market pain in 2022 and, in retrospect, we think that was very healthy for the market's long-term prospects. Stock valuations had become stretched and extremely low interest rates were ultimately unsustainable.

Now I want to make a bit of an admission: as the market pain of 2022 played out, I myself became more focused on the day-to-day gyrations of stock prices. Doing so makes it difficult to remain focused on what really matters, which is the long term strategy of how to build wealth. It may be a bit late in the year for New Year's Resolutions, but ours for 2023 is to bring back to focus the concept that has shown time and again to be successful in financial markets. We want to purchase the best businesses at reasonable valuations, with plans to hold those stocks (and bonds) for the long term, no matter what may happen from day to day and month to month.

It is for that reason that we entitle this week's newsletter "2023 - The Year We Plant Seeds for the Future". We have been made fully aware in the first two months of 2023 that we should expect some measure of volatility in securities prices, even if the worst is behind us. But as we zoom out and look at things through a long-term context, we should realize that short-term volatility actually creates significant opportunities for the long-term investor.

In today's letter, we will make the case, especially to those still sitting with money on the sidelines, that now is just as good a time as any to put money to work. We think this is the case not only in stocks, but also in fixed income instruments, where yields are higher than they have been at really any time in the last 15 years. We are completely mindful that securities prices could fall in 2023 as interest rates continue to ratchet higher, but we make peace with that fact and understand we may not buy the absolute best price on the stocks and bonds we purchase. But if we buy the best merchandise, the fundamentals should ultimately win out.

In today's letter, we will describe some of the long-term opportunities we are seeing both in stocks and in fixed income instruments, so there is something for everybody in today's letter. We have been observing dislocations in markets regularly in the early days of 2023 and they are creating buying opportunities for investors who are willing to endure some short-term volatility. We think those investors that take advantage of softness in the current market environment will be glad they did 2-3 years from now.

We are trying to speak especially to those of you who have cash building up in checking and savings accounts. We think the time is now to look for ways to put that cash to work and lock in some generous fixed income yields and to purchase some stocks and relatively attractive valuations. Also, with tax time approaching, it is important to get your financial house in order. That includes consolidating old 401(k) accounts, getting up to date on IRA contributions for 2022 before tax day, and just generally doing a checkup on our financial plans.

Opportunities in Stocks - Algos Gone Wild?

Earnings season is the most important part of the investment calendar for fundamental analysts like us. We are interested in learning what companies are doing on the ground, what are their challenges and what are their triumphs, along with the trajectory of the financials for the business.

Our observation through the latest earnings season is that there was a major disconnect between the fundamentals of a number of businesses (their reported results) and the stock reactions. One clear and obvious example of this came in the report we read from Snowflake ( SNOW ) . Fourth quarter revenue grew at a very strong 54% year-over-year for the business and the yearly sales growth came in at 70%. The company has now delivered six straight quarters of positive free cash flow and Q4 was the best data point in that series in the company's history.

Results beat analyst estimates in almost every way possible. The company affirmed guidance for future revenue growth rates and profitability targets. Beyond that, management has authorized a stock buyback of $2 billion. What did the stock price do after this report? It sunk like a stone, as you can see in the 1-month chart below (earnings day denoted by the oval drawn on the chart):

For those of us who read the earnings call transcript, everything seems quite strong within the business. But for some reason, the market reaction to that news was profoundly negative. In our view, this created a buying opportunity for fundamental investors who are willing to brave some short-term volatility for a chance to own a very high-quality business at a temporarily discounted price. We saw similar reactions in other stocks we follow this quarter, including Pure Storage ( PSTG ), Box ( BOX ), and Teladoc Health ( TDOC ). Even this week we saw a similar reaction from Ulta Beauty ( ULTA ) after another fantastic quarter for the business.

Before the bear market came, we had a philosophy around the office that we would wait to see 2-3 questionable/bad quarters before selling a stock whose business model we think is durable. But now it seems that investors sell first and ask questions later. Whatever the reason for these knee-jerk reactions, whether it be some market structure issue or algorithmic trading systems gone wild, we cannot be sure. But we do know that when stocks for which we have conviction fall in price after strong earnings, we think that is a buying opportunity.

CEOs of many companies we follow have taken the economic softness and inflation we have observed in the markets as an opportunity to lower the bar for future earnings expectations. This started early in 2022, but we saw this theme playing out even more in the latest spate of earnings reports for the 4th quarter. As profitability continues to pick up and eventually sales reaccelerate in individual businesses, we expect investors eventually to respond positively to reenter positions in high-quality companies. As investors, we want to be forward-looking and take advantage of the temporary loss of investor confidence to buy high-quality stocks in brief moments of lower prices.

The point we are trying to make in today's newsletter is that investors worldwide are jittery and with good reason - the market has scarred all of us over the last 18-24 months with a terrible selloff. But we think the time is now to start taking advantage of some of the knee-jerk reactions investors continue to have, even though valuations have already been reset lower, quite dramatically in some cases.

Let's take another quick look at the stock we mentioned above, Snowflake . This is a business that completed an IPO in 2020, an IPO that was one of the most anticipated in memory. The company, a pioneer in so-called " data lakes " was consistently growing revenues well in excess of 100% annually at the time, and still sports and incredibly impressive growth rate now!

But the problem from the investor perspective for SNOW in the early days of trading was a nose-bleed valuation, with a Price/Sales ratio of well over 100x. We can scarcely remember any stock trading at such a multiple. But we think SNOW is a great illustration of the point that context matters. In the chart below, you can see the price/sales ratio for SNOW charted since its IPO. While of course we can understand investor reticence to purchase a stock at a crazy valuation like SNOW carried in the early days of its being publicly traded, you can see that a combination of lower stock price and continued growth has pushed that price/sales multiple back down to 14x.

A price/sales of 14x is still quite high, but that is before we consider the context that the company continues to grow revenues at greater than 50% annually and is now delivering consistent free cash flow. The point we are trying to make is that we are seeing very attractive opportunities developing in the stock market for companies whose stocks have been beaten down in the last bear market, but whose businesses continue to hit on all cylinders.

We understand the fear that maybe this stock could fall further in 2023 and we acknowledge that possibility. But at the same time, we note that this stock trades at a valuation that appears to be stabilizing, despite the growth picture and a business situation that remains quite remarkable by any measure. For investors looking to buy stocks and hold them for the long-term, we think there are many excellent opportunities like SNOW out there. Let's move away from the ego-driven desire to buy stocks at the absolute bottom tick price and let's look for stocks that are reasonably priced in a historical context with very strong business outlooks.

Some of the best long-term gains in the stock market are achieved by buying incredible businesses at temporarily discounted prices due to factors beyond their control. We think it is time to start planting seeds in the stock market in 2023 that will blossom into portfolio stalwarts in 2024, 2025, 2030, and beyond!

Planting Seeds in the Bond Market

We have been extremely up front with clients, prospective clients, and readers alike that we think they should all consider fixed income as a part of their portfolios in today's climate. We know that interest rates were extremely low for more than a decade, making the task of finding generous annual yields from high-quality bonds nearly impossible since the Great Financial Crisis.

On the other hand, we saw many companies taking advantage of low rates during the early days of the pandemic, refinancing many of their bonds at very low coupons, some as low as 2-3%. As interest rates have risen, the prices of those bonds have fallen dramatically. A good example of this is the 2033 bond of a company called Omega Healthcare Investors (OHI). This is a Real Estate Investment Trust ((REIT)) that invests in long-term care facilities, specifically in skilled nursing and assisted living.

Omega issued the 2033 bond during a time of extremely low interest rates in early 2021. Given those conditions and the company's investment grade credit rating , the bond was issued with a very low coupon of 3.25%. Now that interest rates have risen, that means the bond price has dropped precipitously (as you can see in the chart below). This gives us a great opportunity as investors. Because there are two components of bond return, your interest income plus capital appreciation, the overall yield of this investment grade bond is now nearly 7%!

We love buying discount bonds like this not only for the total return possibilities, but also for the tax-efficiency of the strategy. If I bought a bond yielding 7% at 100 cents on the dollar, I would pay taxes on that income totally at my ordinary income tax rate. However, when I buy a discount bond like the one above, I pay ordinary income tax on just 3.25% of the return (the interest income) and ultimately capital gains tax, which is a lower rate for most investors, for the portion of the return related to the bond's eventual appreciation. Note that even though I pay $7,425 for $10,000 in bond face value, I receive the $10,000 repaid to me at maturity.

The question we have most received from investors when discussing bonds like this is "What happens if interest rates continue to move higher?" The answer to that is that the bond price could fall temporarily as rates continue to increase. But as long as Omega Healthcare continues as a going concern and ultimately pays us back our principal at maturity, we experience no realized loss even if the bond price fluctuates. All the while, we can collect that 3.25% in predictable annual interest each year. The current yield of the bond given these parameters is just under 4.4%, still in excess of what you would expect from a US treasury bond of equivalent yield.

Again, we may not purchase these bonds at the absolute lowest price or lock in the absolute highest yield in the bond's history. But we do think that in 2-3 years if interest rates start to move lower again, you will be very happy that you locked in nearly 7% annual interest for the next 10 years in an investment grade bond like this. In 2023, we will continue to plant seeds for an eventual bounty by buying securities like the OHI bonds, stashing them in investment accounts, collecting semi-annual interest payments, and ultimately generating a nice capital gain.

We have an entire list of bonds just like these, which we think could be very attractive for investors who have cash accumulating in a checking account that is still not paying very much interest. Every month that we let money sit in a low interest vehicle like a checking account and not in an interest-bearing security like this is like a tax on our future nest egg. Considering the pace of inflation, waiting on the sidelines could be a costly move in the long run.

Takeaways

We understand that volatile markets can make it difficult for investors to come off the sidelines and enter into the stock and bond markets. However, an old market adage says that the most important thing is time in the market, not timing the market. We could not agree more with that tried and true maxim.

The likelihood of purchasing stocks and bonds at the absolute lowest possible price is infinitely small. To pursue this goal is more of an ego-driven quest than anything else. What's more is that time out of the market is ultimately a tax against your future net worth. With some of the dislocations caused by market structure, algorithmic trading, and higher interest rates, we see opportunities all over the board for investors to add quality stocks and bonds to their portfolios at reasonable prices. In other words, we think 2023 is the year to plant seeds in your portfolio for a potential bounty 2, 3, 5, 10+ years down the road. We think future you will thank present you for the foresight you displayed in taking advantage of these opportunities.

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