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Quarterly Appraisal Letter March 31, 2023

Important Disclaimer: Past performance and yields are not indicative of current and future results. There is the possibility of loss of principal with any investment.  The views expressed are the views of O’Brien Greene & Co. authors as of the date of the date indicated and are subject to change at any time without notice based on market and other conditions. Its content does not consider any individual investor circumstances, objectives or needs. Any specific securities or asset allocations mentioned may not be included or implemented in specific investor’s account due to the unique circumstances involved in managing each investor’s financial situation.  O’Brien Greene & Co. has no duty or obligation to update the information contained herein. The information is for informational purposes only and should not be used for any other purpose. Certain information contained herein concerning economic data is based on or derived from information provided by independent third-party sources.  This is not an offer or solicitation for the purchase or sale of any security and should not be construed as such. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. O’Brien Greene & Co. may have positions in the securities mentioned in the commentary provided on this site. Investment decisions should be made based on each investor’s objectives, liquidity and risk profile and complete financial situation. Many investments are unsuitable for certain individuals, and investors should consult a professional before acting. Investor should ensure that they obtain all available relevant information before making any investment.

First Quarter 2023 Commentary

While some of our opinions and recommendations did not work out last quarter, (I will discuss Charles Schwab Corp. below), our negative assessment of “long-duration assets”—that is, bonds that mature in the distant future and equities with little or no current earnings–has kept us out of the worst trouble in the last year and a half and remains the core of our investment strategy going forward.

But before getting to the tenets of this market assessment, just how often should an investment strategy change?  With an ever-changing landscape, should not a new quarter mean a new investment strategy? The answer is generally no.  That’s what traders do and we are not traders.  We take a long-term approach that is geared to years and even decades.  A trading strategy requires high portfolio turnover each year, and thus maximal tax-inefficiency along with high transaction costs.  That way leads to “financial exhaustion,” in the words of a colleague here at O’Brien Greene & Co., and difficulty in knowing what you own.  Our portfolio turnover is closer to 20% a year, which gives us time to know what we own.  Even so, we sometimes make major adjustments in strategy.  The end of 2021 was such a period.  The Covid pandemic unloosed a variety of fiscal, monetary and political forces, both domestic and international, that required significant adjustment, because the long-term outlook had changed. We wrote about this in the last five appraisal letters, which are available in full on our website at www.obriengreene.com

As for the dispositive lessons from these letters, I would put them as follows:

  1. Stock market leadership appears to have changed from “growth” to “value”.

Oil, fertilizer, housing, mining, minerals, consumer staples, infrastructure and capital equipment stocks are back after a decade or more of struggling in the wake of the financial crisis of ’08-‘09.  These things-and-stuff companies tend to have stocks with relatively low valuations, strong cash flow and dividends (thus their name of “value” stocks).  Their valuations stand in contrast to the biggest winners of the great bull market 2009 – 2021, which were mega-capitalization technology companies like Facebook, Apple, Amazon, Netflix, Nvidia, and Microsoft that dominated world markets until the end of 2021.  Then, after some 12 years of astronomical performance, tech stocks fell by more than 30% in 2022.  Meanwhile, the energy sector, including oil and gas, long dismissed as an old economy wasteland of stranded assets, returned nearly 65%.[1]

We said at the beginning of last year, and still think now, that we are witnessing a widening and maybe even a reversal in market leadership whose persistence could resemble that of previous cycles.  We think value stocks may continue to outperform other sectors, including tech, for years to come.  They have a lot of catching up to do, as do the sectors they serve of defense, healthcare, mining and infrastructure.

At the same time, though, we think these things and stuff stocks have to be owned to a degree of moderation notably lacking in the period recently ended, when high tech was owned to the exclusion of everything else. Even passive index-based investment strategies, designed to represent all stocks, morphed into concentrated high tech growth funds, but more on this below.

  1. Long-dated, fixed income securities, whether investment grade or junk-grade corporate, municipal, mortgage-backed, government agency, U.S. Treasury, annuities or certificates of deposit, will have their purchasing power eroded when their yields are lower than the rate of inflation

Over the course of 2022 global bonds had their worst year “ever,” which in the case of the United States means since 1788. We do not see bonds doing as badly this year or in the years ahead, but still would stay away from buying the asset class, even though in recent weeks articles have started to appear in the popular financial press arguing the contrary.[2]    Our rule of thumb: until bonds pay an inflation-adjusted or “real” yield, we would stay away, except in specific circumstances where investors have to match known liabilities, for tax considerations, or other idiosyncratic reasons.

When it comes to replacing bonds that come due, we prefer, and most client portfolios already hold, short-term government Treasury bills that mature in 3,6 and 12 months.  These pay as much as 5%, and if rates continue to rise, so will their yields.  In the 1970s, the last time inflation was a national problem, short-duration Treasury bills preserved purchasing power and outperformed the broader stock market (not including the energy sector).

  1. Inflation of 5 or 6 percent and even higher probably is not “transitory;” and learning how to preserve purchasing power will remain the predominant concern in money management.

We predicted a return of inflation in 2008, when the central bank and U.S. Department of Treasury started to expand the money supply in the wake of the “Great Recession” of that year.  We were wrong; inflation did not rise at that time because money remained “trapped” in the banking system due to the targeted nature of the early rounds of quantitative easing.  But in 2020 and early 2021 federal authorities took more extreme fiscal and monetary action—guaranteeing forgivable bank loans to fund private payrolls—that left no doubt what would happen next. And it did, consumer price inflation close to 10%, although we believe even that might be understated.  In any event, we think inflation is here to stay.  We have discussed some of the reasons in prior letters, but the list of reasons keeps growing.

I speculate there might be a cultural or psychological dimension behind the intractable nature of inflation. For central bankers, academic economists, and other policymakers, inflation seems to be the problem they feel most comfortable with; they studied it in grad school, wrote their theses on it and worked on it in first jobs during their formative years.  They know the inevitable trade-offs of who benefits and who loses.  Thus inflation is for policymakers a return to the familiar as opposed to deflation, the alternative condition, which is not nearly as well known, understood or studied.

Apart from this speculation is the deterministic operation of basic mathematics.  That is to say, it is one thing to raise interest rates to fight inflation when national debt is 30% of GDP, as it was in 1980, another when national debt is approaching 130% of GDP, as it is today.  And in 1980 central banks in the West, including the Federal Reserve, operated under the presumption they were independent and non-political.

In October 1979 the Fed raised short-term interest rates to 17% and when that didn’t work, all the way to 20%. Amazing in retrospect that the Fed had the resolve to try, more amazing that it succeeded.  Today we are not sure the Fed has the resolve even to try, not with debt at a 130% of GDP.

But there are other reasons for inflationary pressure. During the recent COVID pandemic, politicians throughout the developed world including the United States hit upon government-guaranteed loans as a way to revive and/or protect favored industries.  The way it works is commercial banks make loans and then the respective legislatures guarantee them.  These guarantees are “off balance sheet”—they don’t even appear in government budgets.  But they have the effect of expanding money supply, while sidestepping the oversight of central banks.   Thus central banks may talk about monetary policy and money supply as though they control these things, but we fear that the real control has shifted to legislatures through the mechanism of guaranteed loans.

What, then, is likely to happen?  Again, let me speculate.  High on my worry list is federal legislation forcing investors to buy government debt at suppressed yields.  Such a maneuver isn’t a subject of discussion today, but the rising cost of debt service could force policymakers to consider it.  This is called “financial repression” and it would be an easy way to help the government pay back the trillions in recently borrowed money.  Practiced in other periods, including after World War II, it is a huge tax on savers disguised as financial regulation. I think politicians could find it irresistible.

  1. A recession is likely; we are overdue for one. It’s been 15 years since the last one, and usually they occur every four years. If there is a recession, though, we don’t think it will be severe or even that it would be in the long run a bad thing.

Elon Musk recently said Twitter is worth less than half what he paid; banks are still some $2 trillion under water with their bond portfolios.  These are just a few of the signs of the healthy, and long overdue, process of wringing out excess. The recent bailout of banks shows the correction won’t be very severe. If presented with a choice between avoiding or postponing recession and fighting inflation, most politicians will choose the former and try to foist the pain onto their successors.  But there are other reasons for thinking any recession will be light, principally new sources of demand.  We are drifting into a period of renewed enmity with China and Russia.  After some 30 years of what was hopefully phrased as “the peace dividend,” we return to Cold War levels of defense spending.  Also, the rise of China as the World’s second largest economy and one of our most important trade partners is being thrown into reverse, and now, as far as the United States is concerned, someone new must make all the things and stuff China used to make.

  1. Index-based “passive” investing may have lost its appeal and even its rationale.

Over the last 40 years the passive strategy of “buying the entire market”, worked extraordinarily well, especially for smaller portfolios struggling to achieve diversification and low cost. Indeed, we think the strategy still appropriate for smaller portfolios where low cost and diversification can be hard to achieve. But for larger portfolios which have more flexibility, we recommend owning individual securities over index-based passive funds.  An example from the energy industry, mentioned above, illustrates one problem with index-based passive investing.

At the start of last year, oil stocks amounted to about 3% of the entire stock market.  If you owned the stock market through a fund tracking the S&P 500 Index, the near doubling in oil company stock prices last year had little impact on performance, inasmuch as 3% doubled is still not much help to performance.

Even after last year’s high tech sell off, 18% of the S&P 500 index is still concentrated in the shares of Apple, Microsoft, Amazon and Nvidia.  Nvidia trades at 24.5 times sales.  The spillover effect is to make the other non-tech members of the index more expensive than they would be outside the vehicle of the index fund.

A final problem is carving out a sector to exclude.  For instance, say you want to own an international bond fund but want nothing to do with China. How would you do it?  Assuming you could figure out a way, it would necessarily require a lot of active management on your part, or somebody’s part, which contradicts the underlying principle of passive investing. Altogether there are too many moving parts.  We think selecting individual stocks and bonds is in most instances a superior way to know precisely what you own and what risks you face.

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The preceding five guideposts were derived in the period 2021-22 long before the end-of-March 2023 banking and liquidity crises currently roiling financial markets in America and other parts of the developed world. I am referring, specifically, to events leading to the failures of Silicon Valley Bank, Silvergate Bank, Signature Bank, the forced restructuring of Republic First and Credit Suisse, and major scares at a host of other financial institutions, some of them of the highest quality.  One of our newest holdings, Charles Schwab Corp. was in this latter category.  Its stock fell more than 30% for the first quarter 2023, which is not what we expected when we bought it last year. More on this later.

Does this banking and financial crisis, which some observers call the worst in 15 years, contradict any of the tenets in our market strategy?   No. In fact we would say just the opposite: the crisis and the government’s putative remedies to end it give a glimpse of a future that is pretty much in line with our thinking.  We say this not out of any sense of glee, but resignation.

The resolution to the current banking crisis will almost certainly be a broad-based government bailout, which is to say, another exercise in easy money.  But easy money is what brought the current problems on in the first place.  From 2008 to 2022, the Fed in cooperation with the U.S. Department of Treasury drove the price of money, expressed as the general level of interest rates in the economy, to its lowest level in American history. Problem is, easy money tends to make people sloppy or lazy or both, and that’s just not businesspeople but also regulators, auditors, and rating agencies that are supposed to be watching over them.[3] It is hard not to conclude that easy money tends to lead to boom and bust cycles along with higher inflation.

It happens this way:  At the beginning of a period of easy money, everything tends to work, including risk-taking of the most aggressive sort.  This is the boom phase.  But the cumulative effect of risk piled on top of risk, along with sloppy and inattentive regulation and auditing, eventually lead to the bust phase.  We are in that now in the banking sector.  When the government “solves” the bust with a bailout, the easy money contributes to inflationary pressure.  And heaven knows there is a lot to bail out—public transportation like SEPTA, BART, MTA, RTA, public education everywhere, the 40 million students with loans outstanding—and we have a political class manifestly inclined to try.

This is the engine that drives boom and bust cycles.  Booms of course are the easy part.  Let me touch on the busts, especially the accompanying panics, which are likely to increase in number in the months and years ahead.

Panics aren’t bad for everyone.  They can result in wealth creation for highly sophisticated investors.  I am thinking of J.P. Morgan, New York Community Bancorp, First Citizens which have been gobbling up the assets at fire sale prices of First Republic, Signature, Silicon Valley Bank and others.  They made out well from the recent panic, with their stock prices jumping as much as 32% in the case of New York Community Bancorp and 45.5% in the case of First Citizens.   But for the vast majority of investors, who are not as adroit, informed or connected, panics are almost always destructive of wealth.

Earlier in this letter I mentioned Charles Schwab Corp. the nation’s largest discount broker, which is one of our recent recommended equity holdings. Charles Schwab also owns a large bank for holding its brokerage clients’ cash sweep deposits.

In the early days of the recent banking crisis, its shares sold off in sympathy with Silicon Valley Bank, Signature Bank and Silvergate Bank, although Charles Schwab Bank is unlike these banks in all but name; it is a well-managed bank with significant funding sources, a diversified FDIC-insured customer base, and sources of brokerage fee income most banks lack.  But panics are not very good at distinguishing between good and bad banks, or anything else; same thing of course for human beings.  It is human nature to want desperately to get away from panics, immediately, at any price.  Certainly I felt this last month with Charles Schwab Corp. stock falling, and I have been managing money for over 40 years.  No one is fully exempt from this kind of fear.

Our recent experience with Charles Schwab Corp. is part of a cautionary tale. We would put the lesson this way: If you are going to own stocks, you have to be prepared for them to fall 50% at any time.  You must expect it and prepare for it.  A big help is to cultivate the virtues of detachment, vigilance and patience.  Detachment provides the distance and perspective to stay sane when the rest of the market isn’t, for surely the worst investment wounds are self-inflicted in times of panic.

In terms of vigilance, I assume you have it because you are still reading this letter; no need to say more. Let me conclude, then, with the last virtue mentioned above, patience.

Generally an investor wants to hang onto quality companies with a competitive advantage, as demonstrated over many business cycles, through thick and thin.   In some cases the object of such patience may even be a turnaround in an out-of-favor sector, one of the riskiest and yet most rewarding investment styles. An investor doesn’t want many of these in a portfolio, as a rule no more than one, but then it can turn into a grand slam. Even so, our patience with these high potential prospects is not unlimited, especially when the company is heavily indebted and interest rates start to shoot up.  Two recent holdings, Lumen Technologies and Digital Realty Trust, illustrate the principle.

Lumen is a turnaround in an out-of-favor sector that is exceedingly inexpensive; Digital Realty Trust is profitable with stable cash flow, but both will have to refinance their capital structures at much higher prices in the near future.  Thus we sold both.  We would put the lesson this way: yes, patience is an essential investment virtue, but maybe not for companies heavily in debt when interest rates are rising. Debt can be toxic, heavy debt especially so.

As individual investors and perhaps as a culture as well, we return to what at some level we knew all along.  I am not speaking just of the perils of heavy indebtedness, although that may be the biggest recovered memory of all.  There are others and we have touched on some in this letter.  It makes sense: after fifteen years of unprecedented wealth creation, a different perspective along with different tools are in order.

Sincerely,

Mark O’Brien

 

 

[1] The S&P Energy Select Sector Index returned 64.56% including dividends in 2022. Past performance does not ensure future returns.

[2] See, “It’s Time to Buy Bonds,” Wall Street Journal, p. B1, 2.28.23; “Alternatives to Stocks Emerge,” Wall Street Journal, op.cited, p. B1, 3.6.23.

[3] See “KPMG Gave Banks Clean Bill of Health, Wall Street Journal, 3.14.23 p. A8