A friendly reminder that market is closed for trading today to observe MLK Day. Market will resume trading tomorrow.

Lately, we have seen how negatively the longer-duration assets are affected by interest rates. We discussed the correlation in the context of discounted cash flow (DCF) models— arguably the most diligent way to determine a company's intrinsic value. DCF is not the only valuation method that investors use. Admittedly, we have not been so due-diligent on doing DCF for all of our portfolio holdings. Since we own so many names and have to follow day-to-day movements closely, we have been mostly focusing on valuation multiples. By definition, a valuation multiple is a ratio that reflects the valuation of a company in relation to a specific financial metric. Terms that you often hear include Price-to-Earnings ratio, Price-to-Sales ratio, Price-to-Book ratio, ... these are all valuation multiples. 

In general, investors looking 6 to 12 months (which is what we do) will look at a company's Price-to-Earnings multiple. This is the multiple being placed on a company's near-term earnings. For example, Apple (AAPL) is expected to earn $5.76 per share this fiscal year — so at a price of $172, shares trade at just below 30x earnings. We also look at what Apple is expected to earn next fiscal year and the term is "forward Price-to-Earnings multiple" (you will often see us write variations of this, including forward PE, forward multiple, ...) 

When interest rates rise, similar to re-assessing the discount rate in a DCF model, investors must also re-assess valuation multiples. That's exactly what we saw play out in the past few weeks, especially in the high-valuation names and particularly in the names that don't even have earnings and therefore trade on sales-based multiples. The accelerated sell-off in these stocks are what we call "multiple contraction." When interest rates go up (or are expected to go up), investors see current valuation multiple too high, and therefore seek lower multiples. This is crucial to understand because when a re-rating occurs, you should not look to the recent highs in terms of absolute share prices, especially in the little-to-no earnings stocks, because the environment has changed and the market will be unwilling to look back at the multiples applied in the lower rate environment. For example, imagine you have been following a stock that trades at $400/share, 40x P/E multiple. Now the stock now undergoes a multiple contraction period. We urge that you not look at this $400/share mark (i.e how far the stock has sold off from $400), but rather look at the P/E multiple; perhaps come back into the stock when the multiple becomes 30x and lower.

Lastly, one more term you will often hear in this market is growth-at-a-reasonable-price. This is the term used for those names that strike a nice blend of growth and value. These may be able to hold up better when the selling hits the higher valuation names, while still providing exposure to underlying business growth. The mega-cap tech names in our portfolio including Microsoft (MSFT), Apple (AAPL), Facebook-parent Meta Platforms (FB) arguably all fall into this category given their 20x - 30x PEs combined with 10% - 20% expected growth rates. Even some multiple contraction has been going on for some of these names, as you notice Microsoft going from a ~40x fwd PE to currently a 32x fwd PE.

Bottom line, we reiterate that for 2022 we want the stocks of companies that deliver strong earnings, trade at a reasonable forward multiple compared to the broader market (max we can stand is 30x), and have huge cash flows.