Staying Focused on Long-Term Growth During Short-Term Volatility

With the U.S. stock market in bear territory, sharp price swings have become unsettling daily occurrences. We’ve already experienced 28 one-day moves of 2% or more on the S&P 500® Index in 2022, compared with an annual average of 17 such moves since 1990.¹

We’re in the trenches with you every day, and we share your frustration with this year’s volatility. We have been through times like this — most recently during the 2008 financial crisis and pandemic sell-off. Of course, past performance cannot predict future outcomes. But we believe that by sticking to our process and focusing on well-managed, high-quality, growing companies over time, we will be rewarded through this bear market.

What We’re Doing Now

We view this high-volatility period as an opportunity to upgrade our portfolios and reevaluate stocks we may have previously passed over since their risk/reward characteristics weren’t attractive. We think this focus on individual company research makes sense because it’s where we believe we can add the most value. And just as the pullback in the market gives us a second chance to buy certain stocks, we are also trimming or limiting our exposure to companies that we believe are weaker or relatively less attractive in the current environment.

Current market conditions reflect the extremes we sometimes see in high-growth, high-momentum stocks. Investors swing from overpaying to selling off and massively undervaluing such companies. We believe these sharp downturns fail to reflect some firms’ tremendous innovation and opportunity. Sell-offs also don’t account for the ability of well-run companies with strong business models to survive and thrive coming out of difficult financial and economic periods.

Investment Horizon Is Key

Given our long-term view and the high bar that stocks must clear to get into our portfolios, we tend to have low turnover, even during volatile times. We believe this longer investment horizon and viewing companies across their lifecycles are two key differentiators of our process.

The market tends to be short-term-oriented because many investors are evaluated on a short-term basis — quarter to quarter or year to year. They react to each day’s financial headlines, which contributes to the market’s sometimes short-term, dysfunctional behavior. We think it’s preferable to have a long-term focus. We can’t tell you what a certain stock will do today or tomorrow, but we are more confident in our ability to forecast how companies will perform over time.

We also believe we can capitalize on the tendency of analysts and investors to evaluate companies at static points in time, like snapshots. Instead, we think it’s more appropriate to think of a company in the way a movie plot unfolds over time.

Inflation, Interest Rates and Recession Fears

The immediate cause of the sell-off goes back to the 2021 surge in inflation. Massive fiscal stimulus and pandemic-related pent-up consumer demand help explain demand-pull inflation.

The pandemic also played a role in supply-chain disruptions. Closures at factories, ports and other distribution networks contributed to higher costs and cost-push inflation. And that was before sanctions on Russian energy exports sent energy prices soaring. As a result, inflation in 2021 broke decisively higher from its long-term trend and remains elevated to this day.

In response to surging inflation, the Federal Reserve (Fed) began to raise interest rates aggressively. These rate hikes have caused borrowing costs to rise and threaten to throw us into recession. The combination of higher interest rates and slower growth goes a long way toward explaining the market’s sharp decline.

Focus on Secular, Rather Than Cyclical, Growth

It is true that stocks — and growth stocks in particular — are negatively correlated with rising interest rates in the short run. We think it’s important to stay focused on the multi-year horizon for growing companies well-positioned to capitalize on enduring trends. Higher rates don’t mean companies will suddenly stop innovating or completely change their research and development spending or marketing efforts.

Our process closely examines the health of a company’s balance sheet. We confirm and assess its cash flows and interest expense. Doing this provides a good understanding of how well a company is positioned for higher borrowing costs.

P/E Ratio — Risk to Both the P and the E

Valuation is the market’s voting mechanism. It is typically expressed as a ratio of a stock’s price to its earnings or the P/E ratio. Some investors reflexively sell growth stocks when interest rates rise, meaning the “P” will come down. In the short run, we expect Fed policy to remain focused on fighting inflation, so there’s a risk for further stock price declines.

Stocks are falling not only because rates are rising but because an economic slowdown threatens a lower “E.” Slowing earnings growth and the forecast for 2023 provide another reason for the sell-off. If investors are adjusting their earnings expectations down, there’s additional risk to equity prices.

Of course, the companies we own are not divorced from the macroeconomic environment. And we try to understand the larger context in which our portfolio companies operate. But changes in inflation, interest rates and economic growth do not affect all companies equally. This is where active portfolio management and individual security selection can matter greatly.

The impacts of these macro events on corporate earnings vary widely. That is why we seek high-quality, financially strong companies that we believe are positioned to do well over time, not only in one type of economic environment.

We’re not investing for a few days, months or even quarters. Our horizon is many years long. Rather than trying to outperform every day and every point in the economic and market cycle, we aim to outperform across the full market cycle. Intuition and experience have shown that companies with durable revenue and earnings growth perform best coming out of these challenging periods.

Stay the Course, Play the Long Game

We believe innovation, technology and the demand for greater efficiency and convenience are transforming the world in meaningful, positive ways. For that reason, sell-offs may disappoint us in the short run, but we view these downdrafts as opportunities to buy incredibly innovative companies at attractive prices.

So, while valuations may have more room to fall due to fears of higher interest rates, we believe that earnings growth is a more enduring performance indicator. Accordingly, we reiterate that it is essential to “be choosey” and build portfolios through stock selection using secular growth companies with long runways of opportunity to grow.

We understand that these bear market periods are painful and unsettling. But we urge investors to stay the course because we believe short-term valuation declines due to interest rate concerns may offer an attractive longer-term investment opportunity.