TMO - Stewart Asset Management Q2 2022 Commentary

• Based in New York, Stewart Asset Management aims to provide long-term capital appreciation through a concentrated portfolio of quality growth U.S. equities.
• In the second quarter of 2022, the Flagship portfolio declined 20.77%, net of fees.
• Retrenchments are an ugly stalker in all markets, but, importantly, they create opportunities.
• We believe that a strong case can be made for our clients’ capital at least doubling over the next half-decade.

In the second quarter of 2022, the Flagship portfolio declined 20.77%, net of fees. The S&P Index declined 16.10%. For the first six months of the year, our Flagship declined 29.91% while the S&P 500 Index dropped 19.96 %.

Over the five years ending June 30, 2022, our Flagship advanced by an average of 13.73% per year, net of fees, while the S&P 500 Index gained 11.30% per year. The retrenchment we have been writing about since year-end 2021 continues in 2022 and has become an unnerving bear market. Retrenchments are an ugly stalker in all markets, but, importantly, they create opportunities.

Review

In the past few months, we have written about investors’ fears of inflation and higher interest rates as well the emerging opportunities for long-term investors as valuations compress. The year-end 2021 fear was inflation. Beginning in 2020, Covid-related spending was immense, whether profligate or not. In addition, the U.S. Federal Reserve Bank kept monetary policy loose to a degree without precedent. Ruptured supply chains because of the virus added further costs. But elected officials and central bankers told us inflation was “transitory.”

As inflation soared to 8%, a level unseen in forty years, officials finally reacted. Interest rates were raised, spending slowed, and the Federal Reserve is shrinking its balance sheet. All indications point to continued interest rate hikes.

All this occurred just as the Ukrainian war sent energy and food prices to crippling levels. As a consequence, evidence has mounted that consumers and many businesses were paring back their spending plans. Share prices slumped and this correction then became a bear market as the fears of recession seized investors. Share prices over the last six months have seen the worst decline in fifty years.

We made a few changes in our Flagship portfolio over the past six months. We profitably sold two investments that we had owned for over five years, Meta ( META ) and PayPal ( PYPL ). We were concerned about changes in how Meta can collect and use data and the implied slowdown in growth. In the case of PayPal, we became concerned about the deterioration in user growth due to increased competition in the payments industry. In each case, we just about doubled our clients’ capital over five years. We also sold, at a small profit, our holding in Ross Stores ( ROST ), a well-managed clothing retailer. We used the proceeds to fund the purchase of our new holdings.

Recently we initiated two new investments. One in Thermo Fischer Scientific ( TMO ), a supplier to the life sciences industry. We have followed the company for many years and the recent downturn in share price gave us a good entry price at which to invest. Thermo has had strong earnings growth for many years and is led by a superb team. The company’s recent acquisitions make it a full-service supplier to the biopharma and biotech industries.

We also bought shares in MSCI ( MSCI ), a company that provides data, analytics, and benchmark services to investment institutions globally. In the last several years MSCI has been growing its ESG business notably. We are forecasting rapid growth for this fast-growing global market.

Prospects

The valuation of all your holdings has contracted significantly over the last nine months. More recently, this contraction has been made worse by fears of recession — a recession that may occur while employment is strong, wages are rising, consumer credit is good and our nation’s banking system is well-capitalized and rock solid. All this implies something closer to an inventory adjustment than a full-scale recession. But time will tell.

Despite this contraction in valuation, in almost all cases our holdings’ steady growth in earnings power has remained intact, even as the U.S. economy contracted in the first quarter and most likely will contract in the second.

Our Flagship’s current price earning ratio is just under 25X earnings. Over the next five years, we believe the earnings power of your holdings will grow by 17% annually, far faster than the S&P 500 Index. The valuable growth companies in the portfolios, in aggregate, are selling at a little over 10 times projected earnings five years from now. This valuation opportunity is rare, particularly so when an investor considers that the S&P 500 Index is selling at 12X-13X projected 2027 earnings and we believe the individual investments in your portfolio are far superior in growth, quality and leadership than the typical company in the S&P 500 Index.

The struggle between recession and growth (and its insidious companion, inflation) will most likely continue for a few months, possibly longer. We believe that growth will eventually win as it normally does. The question is how much inflation will accompany that growth. Financial market futures forecast about 3% inflation over the next few years; therefore a U.S. Ten Year Note of 4% or so is a reasonable assumption in that environment.

In our conservative valuation forecast for your holdings, we have been using a 4% interest rate assumption recently. In that setting, a portfolio of exceptional, dominant growth leaders, such as those in your portfolios, can sell at a price-earnings ratio of 22X-24X earnings, and some of the portfolios’ fastest-growing businesses perhaps much higher.

Conclusion

Given the conditions we have outlined, we believe that a strong case can be made for our clients’ capital at least doubling over the next half-decade.

My colleagues and I wish you all an enjoyable summer.

I look forward to communicating with you in October.

Thomas M. Valenzuela

Chief Investment Officer

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