First-quarter 2022 proved to be a challenging environment for equities. Early on, markets were roiled by the Omicron variant, which caused economic slowing and raised fears of another lockdown. Mercifully, that is but a fading memory, and while there are no guarantees, it appears the worst of the pandemic is behind us. Here’s hoping.
So Omicron proved to be transitory, but the other big issue, rising prices, did not. It is still with us and continues to bedevil the market. To make matters worse, this inflation, stoked by several factors (and recently made worse by Russia’s invasion of Ukraine), is running in the 8% zip code, levels not seen in decades. The Fed has acknowledged the seriousness of the situation by doing a complete about-face, moving from an accommodative stance to hawkishness in very short order. This change springs from the realization that they are woefully behind the curve. This created a highly volatile market in the first quarter一tough sledding for sure.
SMCO largely followed the trajectory of the overall smid space but declined less than the market. For the quarter, we were down 4.3% gross/4.5% net, which compares favorably to the 5.8% drop experienced by the Russell 2500. We often quip that you “cannot spend relative dollars,” but protecting the downside in negative markets is a hallmark of the strategy. No one likes losing money, but limiting the downside can help produce positive long-term results: shallower dips embedded in a series of returns can improve the overall result, thanks to the power of compounding. Participate in the upside and protect in the down is our mantra, and we take it very seriously.
We avoided market segments where we saw trouble一namely consumer discretionary and high valuation tech and healthcare. The consumer names were hit by Omicron, waning consumer confidence, and a deteriorating fundamental outlook. Looking forward, we see more potential pain for the sector. During the pandemic and early reopening, retailers have seen strong gross margins, driven by full price selling一there has been little reason to mark down product given short supplies and high demand. This also has led some management teams to forget some old, hard learned lessons regarding inventory management. In an attempt to counteract the supply chain issues, there has been heavy ordering of goods. This could end badly, with considerable product hitting right as demand weakens. While this may be troublesome for some retailers, it may be a boon to the off-price sector, providing a great purchasing setup for these opportunistic models. This is one of the reasons we continue to hold Burlington Stores, even though the stock was a drag for the quarter.
High valuation tech and healthcare stocks were impacted by rising rates, a distaste for “covid winners,” and a return of valuation considerations. Investors seemed to have soured on growth-at-any-price stocks. There is a math aspect to this一zero rates have the most significant impact on long duration stocks. But in addition, there may be less euphoria around the latest and greatest. The pandemic accelerated the adoption of new technology and proved some medical innovations, but while these changes are here to stay, the related stocks may be due for consolidation. A little payback, if you will.
We did have some winners in the quarter. Not surprisingly, our energy holdings were all up nicely, reflecting the move in commodity prices. Mandiant was another contributor, as Alphabet announced its intention to acquire the cybersecurity firm. Cullen Frost in banks was a positive, as was Commercial Metals in materials. We’ve been invested in CMC given the material improvement in the company's operational performance, and it also will benefit from the impending infrastructure spending. Stock selection is always a focus for us but is particularly important during down markets. Finding some winners in a primarily negative quarter helped us outperform.
Burlington Stores, mentioned earlier, was the biggest detractor for the quarter. Although we see promise in the off-price model and BURL specifically, the stock was caught in the downdraft of consumer discretion. MACOM was hit by multiple compression as investors fled the semiconductor space but should benefit from the telecom and data center buildouts we see on the horizon. Moelis declined with the expectation of a slowdown in financial advisory, and the specialized REIT Innovative Industrial Properties declined, also due to valuation compression. We cut back MC early in the quarter and have since eliminated the position. We continue to hold the other names as we still see good fundamental reasons for ownership.
We were mostly hands off the controls for the quarter, generating only 4% portfolio turnover. We positioned for this environment in the later part of 2021, so needed only a small amount of trading. Additionally, the organic appreciation/depreciation of holdings pushed us further towards where we wanted to be, providing more repositioning without trades. In other words, we let winners run and did not add back to losers. So what does that mean in terms of our overall positioning? Our risk-off exposure increased, as did our holdings in high-quality and sustainable (recurring) businesses. Interestingly our cyclical exposure decreased, but only a little. This may seem counterintuitive, but the cyclical component of the portfolio includes exposure to businesses that will benefit from infrastructure projects and government spending. These tend to be cyclical companies, but given the visible drivers of these businesses, they may prove more defensive than usual. Not surprisingly our growth/value allocation flip-flopped, going from 52% growth /48% value to 46% growth/ 54% value. Our desire to avoid high valuation stocks coupled with better risk/reward ratios for value stocks drove this change.
Outlook
We expect continued market volatility as investors contend with inflation, the corresponding Fed actions, and a changing macro picture. Inflation may have peaked but could persist, and regardless the Fed has just recently embarked on rate increases and QT. We see strong evidence the economy will slow, which will inevitably bleed into company-level results. Given this outlook, we have positioned the portfolio in stocks where we expect earnings will hold up better than the broad market. Earnings consistency may be more attractive than absolute growth potential for the foreseeable future.
While we see a challenging few months ahead, we believe we’ve identified some investable trends and secular winners, less dependent on macro tailwinds. As always, we will stay attuned to the markets and economy, ready to pivot as conditions change. We are always searching for new names, and recently we’ve uncovered some stocks where we see compelling medium/long-term prospects, but they aren’t suitable for this market environment. We will stay up to date on these stocks, and with the work done, it’s easy to pull the trigger when the time is right.
Our natural inclination towards higher quality businesses tends to be an asset in choppy markets. Given current conditions, this may prove to be more valuable than usual.
Thank you for your continued interest in SMCO and Hilton. Please feel free to reach out with questions or comments.
Please see this document, which contains full performance since inception and important disclosure information. Past performance is no guarantee and is not indicative of future results. All investments and strategies are subject to the risk of loss.
