MITSY - H1 2023 Portfolio Review - Revenge Of The Mega Caps

2023-07-03 02:25:57 ET

Summary

• A resurgence in mega-cap growth stocks caused my portfolio to underperform the S&P 500 in the first half of 2023.
• Key lessons learned were that personal debt is sometimes OK if it means staying invested, watch out for tax implications, and pay attention to changes in market sentiment.
• Persistent high inflation and higher interest rates for longer could bring my portfolio back to outperformance, but the "risk" of a soft landing and continued market melt-up remains.

Market Recap

The first half of 2023 was strong for the S&P 500, with the index ETF ( SPY ) returning 16.8% including dividends. If we look under the hood, however, we see narrow leadership with just 3 of 11 sectors driving most of this performance. These 3 are Technology ( XLK ) at 40.3%, Communication Services ( XLC ) at 36.2%, and Consumer Discretionary ( XLY ) at 32.1%.

These 3 sectors contain the "Magnificent 7" mega cap stocks which now make up 27.4% of the index.

The worst performing sectors in the first half were Utilities ( XLU ), Energy ( XLE ), Health Care ( XLV ), Financials ( XLF ), and Consumer Staples ( XLP ). There sectors were either negative or barely positive. This is almost a complete reversal from 2022 when 4 of these 5 sectors were the top performers for the year and Financials had a strong second half.

Growth outperformed Value in 1H 2023, also a reversal of last year's performance. The iShares S&P 500 Value Fund (IVE) returned 12.0% for the year compared to 21.1% for the Growth Fund ( IVW ).

The real performance differentiator so far in 2023, however, has been market cap. The Vanguard Mega Cap Growth ETF ( MGK ) returned 37.1%, compared to only 8.8% for the SPDR MidCap ETF ( MDY ) and 8.1% for the small cap iShares Russell 2000 ETF ( IWM ).

Within fixed income, returns looked much more like typical historical levels rather than the horrible performance of 2022. Performance of lower credit quality bond funds was slightly better, which as I mentioned in my 2022 year-end review , is a contra-indicator for a recession.

The iShares Core U.S. Aggregate Bond ETF ( AGG ) returned 2.3% in 1H 2023. The Investment Grade Corporate Bond Fund ( LQD ) returned 4.3%. The High Yield ETF ( HYG ) returned 4.5% and the Preferred ETF ( PFF ) returned 4.2%. About half of these returns came from price performance and the other half from dividends.

So far, it looks like I was very wrong at the end of 2022 when I thought higher interest rates would cause the market to slump in the first half of 2023 before recovering in the second half. Although the Fed Funds rate has continued to climb higher with expectations of a couple more hikes to go, longer term rates are only up slightly for the year and remain below where they were when the S&P last bottomed in October 2022.

Nevertheless, average stock valuations, driven by the mega caps, have pushed the earnings yield down to nearly the same level as the 10-year Treasury note ( US10Y ) yield. This has not been the case since the end of the dotcom collapse in 2003, except for a brief period during the 2008-09 financial crisis. I discuss this more in my recent article on bond ladders .

This has been frustrating as a value investor, and I can think of only 3 explanations for this behavior:

1. Long-term interest rates are about to drop

2. Earnings estimates are about to go up.

3. Investors have reduced the risk premium required to own stocks because of rosy growth expectations, whether real or not.

While we are not completely out of the woods as far as dodging a recession, the possibility of a "soft landing" scenario is gaining believers. This could produce further gains for mega cap growth stocks similar to what we saw in the second half of the 1990's and cause my portfolio to underperform the S&P. On the other hand, I could easily move back to outperformance similar to 2022 if interest rates stay high or if anything happens to derail growth expectations.

Quick Accounting Note

My portfolio review articles on Seeking Alpha have always referred to my taxable account, which is larger and more frequently traded than my other account, which is an IRA. Until this year, the IRA consisted of one individual stock of a former employer ( BP ), and 5 index ETF's ( IVW ) ( IJR ) ( IEMG ) ( IEFA ) ( AGG ).

In early March 2023, I made some trades to reduce taxable income in my taxable account and increase income in my IRA (from which I am not yet taking any distributions.) This included selling AT&T ( T ) and PIMCO Dynamic Income Opportunities Fund ( PDO ) in my taxable account and buying similar investments in my IRA. I also bought AGG and a small amount of BP in my taxable account after selling them in my IRA. This reduces my current tax bill but also reduces the portfolio income reported in these articles.

My combined income from the 2 accounts increased by 9.3% in 1H 2023 compared to 1H 2022 but grew only 2.2% in the taxable account. The trade had negligible impact on overall total return from the two accounts but has contributed to 0.3% of the total return in the taxable account.

Further performance discussion will remain limited to the taxable account to be consistent with my earlier portfolio review articles. Before making similar tax optimization moves yourself, please consult with a tax advisor and be aware of wash sale limitations if sales from a taxable account produce a capital loss.

Portfolio Performance

My portfolio underperformed the S&P 500 in 1H 2023 by 10.15%, nearly reversing the outperformance in 2022. My portfolio returned 6.58% compared to 16.73% for the SPY. My ending asset allocation was 80.0% equities, 19.9% fixed income and preferreds, and 0.1% cash. That marks a shift of 3.9% out of equities, 4.3% into fixed income, and 0.4% out of cash compared to the allocation at year-end 2022. The improvement in bond yields relative to stock earnings yields discussed above led me to make this reallocation.

As for investment income, I had a yield of 1.27% (non-annualized) in 1H 2023 based on starting portfolio value. This is higher than the 1H SPY yield of 0.82%. Individual bond purchases and stock dividend increases helped to drive this yield, partially offset by the sales of high-yielding AT&T and PDO as discussed above. My portfolio income in total dollars was 2.2% above 1H 2022 levels. Looking forward, my projected yield for 2023 is still about 2.7%, in line with what I estimated at the start of the year, although it would have been higher without the tax optimization moves.

Largest Holdings

My top 10 common stock holdings make up 55.2% of my total portfolio. I made no trades in any of these holdings, except for reinvesting dividends. Since the end of 2022, Target ( TGT ) has moved out of the top ten as its supercharged growth during the pandemic reverted to more typical levels even before its highly discussed merchandising missteps. Back on the list is Eaton ( ETN ), which has pleasantly surprised me by powering ahead despite starting the year at what I thought was fair value . Outperformance by Eaton and Penske Automotive Group ( PAG ) are further indicators that the market is becoming less certain of a nearby recession.

My top 6 fixed income holdings now make up 11.6% of my total portfolio. PDO has come off the list, replaced by AGG as discussed above. The T-Bill is another new holding, purchased along with my bond ladder in May. I also added to my position in Synchrony Preferred Series A in March when it appeared unfairly dragged down by the regional bank crisis.

The top fixed income holdings have performed well except for Nuveen Quality Muni Income Fund ( NAD ) due to its long duration and leverage in a rising interest rate environment. As I stated a month ago, if rates flatten out or come down, the pain may be over soon .

Top And Bottom Performers

My third best performer in 1H 2023 was Mitsui & Co. ( OTCPK:MITSY ) with a return of 29.4%. Mitsui is one of the five major Japanese trading companies which Berkshire Hathaway ( BRK.A ) ( BRK.B ) has been buying more of. Despite a slowdown in commodity inflation, the company continues to increase dividends and repurchase stock. This continues strong performance from 2022.

My second-best performer (believe it or not) was Warner Bros. Discovery ( WBD ) at 32.3% mainly due to its low starting point after being the worst performer of 2022. Streaming remains a tough business with many competitors and difficulty of customer retention, but the company is gradually increasing cash flows and paying off debt.

The best performer so far in 2023 was Penske Automotive Group ( PAG ) with a return of 46.3%. The company is now expensive relative to competitors but that may be justified by Penske's diversification into truck sales and leasing as well as its global presence, particularly in the UK, Canada, Japan, and Australia. Penske has a best in class dividend and still has cash flow left over to acquire new dealerships or buy back shares depending on which looks more economic at the time.

The third worst performing stock in my portfolio so far this year had been Toro ( TTC ) at -9.7%. The company is well run and has done a great job growing by acquisition from its core landscaping equipment into less seasonal underground construction equipment. Still, it ran up a lot last year and was relatively expensive to start 2023.

The second worst performer has been Target at -10.1%. As noted above, the retailer grew strongly during the pandemic but was unprepared for consumer spending to swing from high-priced goods to services and basic needs as things got back to normal. The social backlash from recent marketing campaigns also has not helped, but I do not expect it to be a lasting headwind.

The worst performer has been AbbVie ( ABBV ) at -15.0%. The company is facing serious headwinds from the loss of patent protection for its largest selling drug, Humira, and low sales of its cancer drug Imbruvica. These were known issues heading into the year and its newer drugs Skyrizi and Rinvoq are growing sales nicely. The stock is also simply out of favor due to being in a defensive sector and a high dividend payer as cash and bond returns become more competitive.

Special Situations

Activision Blizzard ( ATVI ) remains the one merger arbitrage stock in my portfolio. As we approach the merger deadline of 7/18/2023, rumors have become more positive that the company has been proving its case with regulators in the US and UK to complete its merger with Microsoft ( MSFT ). The best possible case as an Activision shareholder is that they win these court cases but do not get to close the deal until after 7/18, in which case they could possibly renegotiate a special dividend or higher price at closing. Even if the merger eventually fails, the company has improved over the past year with growth in its latest Call of Duty and Diablo releases.

I'm also placing in the special situation bucket my purchase of 7/21/2023 $356 QQQ Puts. I made this trade in June, as I discussed in the article " QQQ: Too Good To Be True ". This has not worked out so far, and the position is down 81.3%. With three weeks to go, I need ( QQQ ) to drop about 5.8% from current levels to break even. This is not out of the realm of possibility, but I may be proven either early or wrong about my call that QQQ is overvalued. As mentioned in the earlier article, I risked 0.25% of my total portfolio on this trade, so a total loss would not be very impactful on overall results.

Other Trades

I made few trades so far this year, most of which have already been discussed. Here is a quick and full list:

3/8/2023 - Sell PDO and T, buy AGG and BP

3/15/2023 - Buy additional SYF.PA, sell 2-year Treasury

5/1/2023 - Extend bond ladder with individual bonds maturing from 2023-25 and 2030-32. (See bond ladder article for more details.) Used cash from home sale to fund purchase.

6/5/2023 - Buy QQQ Puts

6/15/23 - TravelCenters baby bond ( TANNL ) called. Used proceeds to buy Micron ( MU ) bond due in 2033 and increase position in TVA PARRS due 2029 ( TVE ).

More significant to my performance was my final trade of 2022, in which I sold VICI Properties ( VICI ) and John B. Sanfilippo & Son ( JBSS ), and also closed out an Alphabet ( GOOGL ) short put position. I used the proceeds from these trades plus cash set aside to cover the GOOGL assignment to fund a home purchase, thinking that my previous home would sell quickly and I could reenter these positions. It actually took 6 months to sell the old house. Since this trade, VICI has gotten cheaper but Google has come up 35% and JBSS - a boring consumer staples stock that I thought wouldn't move much - increased 46%!

This was a colossally bad trade, costing about 1.8% of my total portfolio value. Nearly any other financing method for funding my new home would have been better - a mortgage, bridge loan, margin loan, or even pricing my old home below market to sell faster. While I still like Google and JBSS, I am not going to chase them up here, which led to my purchase of the bond ladder in May instead when I finally got paid for my old house. I will revisit these names if they come down significantly.

Lessons Learned

While I still expect to be competitive with the market over the long term, the underperformance in 1H 2023 provided several lessons. The three biggest ones are:

1. Debt isn't always bad. My aversion to it caused me to sell stocks at the worst time to fund a home purchase. The avoided interest costs turned out to be insignificant to the missed capital gains.

2. Watch out for major swings in sentiment. While I accurately used the March banking crisis to buy more Synchrony preferred, I missed the big swing back toward mega cap growth that one might expect if credit is getting tighter and cyclicals are about to slow down. It remains to be seen if March was a long-term turning point of just a countercyclical rally, but I was not positioned for it.

3. Pay attention to tax considerations. I really should have put high-yielding investments in my IRA much earlier if I was going to just reinvest the dividends and not spend the current income.

Outlook

I still expect the Fed to do what they say and increase the Fed Funds rate twice to 5.5% - 5.75% by the end of 2023 and then reduce it 100 basis points in 2024. The futures market anticipates a most likely case of only 1 more hike this year to 5.25%-5.5% followed by a 125 bp cut to 4%-4.25% in 2024. The recent declines in inflation have been largely energy related while core inflation stays persistently high. The market is just beginning to price this into the 2-year and shorter part of the Treasury yield curve, but not yet the longer maturities. If longer rates start to increase, it will negatively impact stock prices, especially the growth names that have done so well in the first half of the year.

While I no longer expect a new bear market bottom below the October 2022 level, I still expect some reversal of the mega cap rally resulting in better relative performance for my portfolio. It may take some time for stock earnings yields to regain their premium over bond yields, so the opportunity for investors to rebalance their portfolio with more fixed income will remain for a while. This strategy risks opportunity costs in the event of a 1990's style melt-up but provides added safety in any other case.

Appendix

A full list of my holdings as of 6/30/2023 is below:

For further details see: