A Look Back and A Look Ahead

The start of a new year frequently brings a sense of optimism that prompts us to look at the just completed year and make predictions about the year ahead. The changing of the calendar also brings predictions from capital market participants on exactly where the indices will finish at year-end, and the exact interest rate on treasuries. While this exercise is fun, we believe such precision should be given for the past only because the future is incredibly blurry until we get deeper into the year.

As seen in the table below, U.S. equity markets were the winners in the performance derby of 2021, and over the past three years overall. The major index missing in the table is bonds, which declined 1.5% on the year due to the threat of rising inflation.

Regarding the future, we have long believed it is not sensible to make predictions about the price level of indices and the level of interest rates even a month forward let alone an entire year. That is not how investing works. Our goal is to invest where we see value that can be added to your accounts while, at the same time, avoiding investments we believe will destroy value in your accounts. Long-term value creation is determined by the fundamentals of the markets and the individual investments in which we can invest. Looking at the domestic equity indices, we are optimistic that 2022 will produce positive returns for investors, but those returns will be below the level of past three years. Our expectation is that large-cap returns are likely to finish the year between 3% and 7% higher with small-caps generating a return above large-caps.

Driving our equity market outlook is our conviction that U.S. and global economies will continue to expand. Consumers are likely to increase spending, and the residual effects of the government stimulus programs will be felt through much of the year. As a result, earnings for both small and large companies should increase, driving equity prices higher. The increase in earnings will, in our view, increase profitability more for small-caps than large, and the higher profitability is likely to drive the outperformance of small-caps over large this year. A significant amount of growth in equity prices over the past 12 years has come from an increase in the price-earnings (PE) multiple, or speculative return. In 2021, this reversed as earnings growth, or fundamental return, exceeded total return - thus, speculative return was negative. We believe this will happen in 2022 for both large- and small-caps, but it will be more deleterious to the returns of large-caps. When the speculative return is negative it is vitally important to focus on the fundamentals of the investments in your account and the investments under consideration for addition. Therefore, investment selection becomes paramount. 2022 should be a stock-pickers’ market rather than an index driven market.

In international equities, we favor developed markets over emerging because we believe profitability in Europe will increase since the return on equity is below the historical average. We believe profitability in emerging markets is likely to decline, partly because of the regulatory changes in China, but also because profitability is above its longer-term average, and we have no reason to believe that average has changed. We are uncertain what the long-term effects of the regulatory changes in China will be, but in the near-term we believe the changes structurally reduce profitability, especially for large corporations. This reduced level of expected profitability tempers our enthusiasm for emerging market equities overall, but not in every emerging country.

Portfolios

We would now like to offer our rationale surrounding a change we are making to investments in accounts. When deciding to buy any investment, we dig into the company and attempt to fully understand the fundamentals of the industry, the business, and competitors since we do not want to suffer a permanent capital loss. After an investment has been made, we are constantly monitoring the fundamentals of the industry and the business to ensure our investment hypothesis remains valid. Many times, the quality of the investment improves, allowing us to increase holdings even after a run-up in price.

There are investments, however, in which the fundamentals change and warrant a reduction or an outright sell. We rarely like to sell an investment, especially if the investment has done well. In the first place, it is psychologically difficult to sell any investment and a great one in particular. Second, we think it is frequently best to hold winners as they are typically sold too early. Holding on to winners works until the investment hypothesis is proven to have changed; and if you do your homework on an investment, the hypothesis should change only over a long time period. That is the case with Lululemon.

Lululemon Athletica (LULU)

We have been investing in Lululemon for several years and the company was a fantastic investment selection, increasing more than 100% since the original purchase. When LULU was added to our portfolios, there were few competitors focused on women’s athletic wear for yoga. As a result of LULU’s success selling women’s yoga athletic wear, numerous competitors have begun selling products that compete favorably with LULU’s offering. The increase in competition is not unique. It happens in every industry with high returns, and the new entrants compete away the high returns generated in the industry. LULU experienced success expanding into other clothing markets such as running and men’s clothing; but the number of competitors in the yoga athletic wear market, as well as general athletic leisure market, has increased with more than 17 viable competitors. This shows that there are very low to no barriers to entry in LULU’s markets. With this situation, industry and company profitability decline, hurting investment returns. Many competitors are selling high quality competing products at a lower price than charged by LULU. Historically, when this is the situation, prices and profitability decline, damaging or breaking the investment hypothesis. We believe we are at that point with LULU.

Conclusion

Our outlook for 2022 is positive overall with an emphasis on U.S. small-caps but large caps posting a mid-single digit return this year. Internationally, our outlook is positive with a better outlook for European equities over emerging. However, emerging equities should be satisfactory this year as well. This means it is likely to be a stock-pickers’ investment environment rather than an index investors’ environment. A focus on fundamentals will be key this year, for both stocks and bonds.