As we've said in last week's round-up, the broader market is in correction territory, down ~10% from all-time highs. Under the surface, the carnage is even uglier with a lot of stocks down more than 20% from their all-time highs. Undoubtedly, it hurts to see the value of your portfolio declines, but you must remember, gains never come easy without pain. With that said, not all pains are created equally and not all pains are worth undergone. For example, we do not endorse pain in the expensive, concept, story stocks with no earnings such as Virgin Galactic (SPCE), Palantir (PLTR), Rivian (RIVN) ..., while we are willing to endure pain in the great valuable names that are making so much money such as Ford (F), Boeing (BA), Morgan Stanley (MS). We believe it is important to explain to you what is going on in the market so that we are more willing to endure the carnage, have a strategy to hold our noses and buy, to be more confident that the upside still remains for our stock picks. 

Explaining The Sell-Off: "Pricing In" High Interest Rates

Over the past few weeks, the main theme that has been taking the market down is a more hawkish Federal Reserve, with tightening monetary conditions that reduces liquidity in the market and hampers economic growth. Taking a quick peek at the CME Fed Watch Tool, the market is currently factoring in 4 x 0.25% interest rate hikes in 2022. However, more telling is how those expectations have changed over the past month. Expectations for three hikes this year declined from 30.2% to 22.7% over the past month, while expectations for four hikes jumped from 20.5% to 32% and expectations for five hikes jumped from 8.2% a month ago to 24.3% on Friday.

With that in mind, it’s worth remembering that nothing has officially/ actually happened. The market has only heard from Fed officials who have been striking a hawkish tone, otherwise, as far as monetary policy is concerned, the Fed is currently still doing quantitative easing (buying bonds). However, market is a forward-looking machine, it tries to predict what will most likely to happen and then try to price that in. We're undergoing such pricing in right now. The Federal Reserve's change of tone from dovish to hawkish has achieved two things:

• First, the Fed now has cover as the market believes they will raise rates should the inflationary data keep going up. That’s because for the past few months, they have consistently stated their focus now is controlling inflation, and the market believes them (again, with the fact that market is factoring in 1% interest rate by end of 2022).

• Second, the Fed has gotten the market to do some of the work for them as the 10-year Treasury yield has finally broken out to pre-pandemic levels. The 10-year Treasury serves many purposes: it is the so- called risk free-asset which return is used to discount potential returns on actual risk-assets. Treasury yields are also used as a benchmark for debt assets such as corporate bonds, auto loans or mortgage rates. So, once the 10-year yield starts moving to the upside, rates for other assets rise as well, therefore serve as a natural “pumping of the breaks” on the economy. Take home prices for example, when rates were at 0 for the past 2 years, home prices have sky-rocketed. However, with the 10-year yield advancing in the past few months, mortgage rates have started to advance. When mortgage (borrowing) rates advance, the monthly payments (a combination of the interest rate and the amount of money borrowed) become more expensive and reduces demand for buying homes.

Strategy: Focusing On The Fundamentals

Now that we have covered discounted cash flow analysis, price-to-earnings multiples, and the importance of rate expectations over the past three weeks, lets remember the single most important thing as longer-term investors, the one thing we have to fall back on when markets want go down endlessly: company fundamentals.

While interest rates and valuation multiples fluctuate and investors have a tendency to overshoot on both the upside and the downside when attempting to price in future market environments, the one thing we can do look at the underlying fundamentals: have they changed. We do this with industry checks and by listening to investor presentations and earnings calls from both the companies we own and their peers. 

This is what we are doing now as we put money to work, we are looking for stocks of company’s where the price has come down (the numerator in a P/E valuation model) but the underlying fundamentals and therefore earnings power (the denominator) remain intact. When you find a company like this it means the stock actually is getting cheaper. So just as you do when your favorite store has a sale, you should be looking to buy, not sell because the item you are getting is just as good as it was a month ago but it’s selling at a lower valuation — i.e, you are paying less per dollar of earnings.

This is not the case when the fundamentals are deteriorating, in that case the price may come down but if the earnings power declines the stock doesn’t get any cheaper. If anything, it may actually be getting more expensive. For example, Netflix reported Q4 2021 results after the bell on Thursday last week, and stock declined 20% on Friday on the back of really weak subscription number and lower earnings guidance. This is a case that we don't want to touch, because everything is going wrong in this name: deteriorating fundamentals and a multiple compression process. 

Bottom Line: The recent sell-off in the stock market has proven us right that in 2022, you want to own stocks of companies that “do things and make stuff” because the companies with real, big earnings power become more attractive as the stocks decline and that provides us the conviction we need to stick with our discipline.