The Gnostic Capital Portfolio return for the fiscal quarter ended September 30th, 2022, was -3.1%. On June 30th, the portfolio was valued at $594.77 USD per share and on September 30th, the portfolio was valued at $576.60 per share.
For the fiscal year to date, the Gnostic portfolio has declined in value from $661.14 per share to $576.60 per share, a drop of 12.87%.
By way of comparison, the DJIA has declined by 12.9% on the quarter and has fallen by 20.9% on the year.
By way of comparison, the S&P 500 has declined by 13.2% on the quarter and has fallen by 24.7% on the year.
By way of comparison, the NASDAQ composite index has declined by 12.5% on the quarter and has depreciated by 31.3% on the year.
There are periods of time in a full economic cycle whereby all equities decline quite steadily by what is considered to be a significant percentage of loss.
These occasions typically presage or foreshadow an economic recession. It is largely impossible to demonstrate positive returns during such a period of time, the tide has gone out. If one has a portfolio that has allocated the capital well, either through good planning or sometimes just by way of good luck, a portfolio may lose less than market indexes in general. That is as good as it gets in an economic recession, that you lose less than your friends, neighbors or colleagues.
The portfolio was held up, by the skin of its teeth, only due to the weightings in healthcare and consumer defensive equities.
As a long only, fully invested (at all times) portfolio, I accept the periodic possibility of loss. During either an economic setback or event, my only objective is to lose less than peers so as to be in a position to better capture upside potential if/as/when an economic recovery begins anew.
36.53% of the account is maintained in HMO and large pharmaceuticals while 22.65% of the account is comprised of defensive consumer retail. For the second consecutive quarter, these were about the only relative havens of safety; relative is the operating word because even in these sectors, there were few individual stocks that posted meaningful positive returns. Were it not for these outsized weightings, the portfolio would have been savaged in line with any other fund in the global markets.
In a recession, relative corporate performance largely depends, not on earnings, but rather, on margins.
“Margin of error”, margin of “safety”, operating margin, gross margin, EBITDA margin, net profit margin; variations on the term “margin” come up more often in a corporate 10-Q or 10-K filing than do references to actual profit, perhaps we should ponder why that is for a time. Perhaps margins are more important to a security valuation than we are led to believe. What is clear is that one improved line on a quarterly filing, higher net profit per share, does not in of itself, drive a security price higher, and if a rising EPS number is insufficient to move a stock price higher, then it stands to reason that other metrices must hold greater weight, if not in isolation, then in summation.
Investors choose many different metrices to assess the health of an underlying business, at the end of the day, we, the investor, lack a say as to whether or not a stock outperforms, performs in line with indexes or underperforms. The markets decide on outperformance and what the markets have declared, through a wholesale beating-up of almost every equity category on the planet is that we need to assess investments, not as they looked three months ago, but as they are anticipated to look in the coming three to six months.
Markets indices forecast slightly ahead of trend, serving as a leading indicator and anticipating the near future for overall equities by evaluating the cost of money, the risk of loss on capital and the future profitability, not just of any one corporation, but the entire global economy. This flies in the face of Wall Street consensus earnings reports that maintain things are fine, it is just a question of perception, but what global equity declines are telegraphing, in no uncertain terms, is that most analysts presently have their modeling wrong, that operating margins won’t hold up as before and as a consequence of out-of-date data fed into their formulas, corporate net profit forecasts are also wrong, because they are overly optimistic.
Investment analysts, as a group, are largely useless in their abilities to forecast equity movements. Stock markets themselves are a far better forecaster of the future of economies or equities 3-6 months out.
Too much faith is placed in research analysts by the public when in fact, analysts are about as relevant to determine an outlook for corporate earnings as a tv weather reader is at forecasting the hurricane season three months out. What investors expect to extract from an analyst research report is some miraculous predictive ability; investors seek a “forecaster” but that is not the job description, analysts merely analyze, and that assessment is based entirely upon the past, not the present and certainly not the future. If an investment analyst were compared to a tv weatherperson, they would be even worse than a weatherperson, because a tv presenter, if nothing else, describes the weather currently in your area, whereas an investment analyst describes the corporate business conditions using data weeks out of date and then adds in the following: “if conditions remain the same in the future as it was last month, then the result could be this“.
In a recessionary economy, purchasing patterns reported during an economic upswing can change dramatically and in the blink of an eye.
Consumers react to rising interest rates by changing their purchasing patterns, they shift spending during inflationary periods to fewer discretionary items, diverting funds instead toward staples. Corporations then react to economic changes from the consumer shifts by either reducing production volumes, or, if they intend to drive sales, seek to do so for lower profit margins via cannibalizing sales from competitors. Analysts receive news of these purchase shifts well after the fact, because corporations generally will not change production output until a trend is determined, and that may take months. Further, no corporation wants to inform an investment analyst that production volumes are falling, that sales are falling, or that profit margins are declining due to the negative implications of such disclosures on profit and share price. Therefore, analysts generally only find out the information at the same time that investors do, which is when a corporation is legally required to report this information in a public filing, too late to mitigate damage and of dubious utility.
This reaction chain has time lags, and these lags account for the disconnection between what we read from Wall Street vs what leading institutions are actually doing with their own capital. When one reads an analyst report on any particular corporation, we are invariably told that things are fine, that profits are forecast to rise, based upon assumptions of margin growth, margin stability or sales growth. What we are never advised, in public, is how forecasts aren’t worth spit in the event of margin deterioration, sales decline or both.
These time lags in reporting facts can only be offset by building in a sufficient margin of error to any forecast, so as to properly allow for potential profit revisions needed to reconcile the events that have already taken place with the events that are yet to come. Any margin of error almost invariably will shrink during a period of economic recession.
By way of example, consider this number; what separates Costco’s potential to meet the street average profit increase in 2023, vs not earning any increase in profit over 2022, even with a 9% rate of revenue growth, I presently estimate to be just 15/100ths of a percentage point.
15 basis points is hardly an acceptable margin of error, in fact it is ridiculously tight, considering that forex can increase or impair Costco’s gross profit margins by more than 25 basis points in any one quarter. 31% of the Costco stores are located outside of the United States and must convert their revenues into US dollars for the purpose of determining earnings. In Canada alone, the single largest non-US region in terms of Costco locations (13% of all stores worldwide at Costco are located in Canada) the Canadian dollar declined against the US dollar by almost 5% in just the month of September; were this loss to persist for the remainder of the fiscal quarter, Canadian forex could reduce overall corporate margins by a minimum of 10 basis points, and that is less than 1/2 of the non-US locations that generate revenues in currencies other than the US dollar and whose currencies have also declined in September.
Individual investors do not pay enough attention to margins, rather they look through the prism of “earnings growth”.
Quarterly earnings releases are keenly devoured by investors of all stripes, from the smallest retail holder of a security to the largest active mutual fund manager. The retail investor stops at the first headline item, the profit per share, and breathes a sigh of relief should an earnings number be posted that is superior to the number from the year over year prior quarter. Then, they express great shock and dismay should a share price fall in subsequent days. Faced with a cognitive dissonance between what they believed to be good news vs a share price decline that reflects less than good news, blame is invariably laid upon some sort of conspiratorial cabal of illuminati, short sellers, whatever they choose to believe.
What institutional accounts and ultra-high net worth investors do, in contrast, is to pour over the entire report, including footnotes, to probe and assess the likelihood for enhanced earnings potential or reduced earnings potential and just how much of a margin of error exists in the data put forth. It is no longer good enough in the equity markets for a company to produce earnings growth, they must do so with reliable operating margins. Everything flows from operating margins.
Corporations are closer than we think to getting on with the impacts of cost inflation on their top and bottom lines. Now, we must look to forex impacts that seem to have been largely ignored by the analytical community as a source of margin compression.
The strength of the US dollar is beneficial to citizens of the United States. It represents an inflation fighter for imported goods. A strong US dollar is better than a weak US dollar overall, but large multinational corporations with significant revenue divisions outside of the United States typically only hedge their forex within historic ranges of currency movements. In many economic zones, those ranges have been meaningfully breached in 2022 and the movements have been more pronounced as the US central bank raises rates by a faster pace than other central banks. Companies that benefit from a strong US dollar will primarily be buying foreign production and selling them into the US markets. Multinationals, on the other hand, might be in a bit of a pickle for a time. I fully expect more margin disappointments among some of the world’s largest capitalized companies to be reported in the coming quarter, should the US dollar not fall.
The early stages of recession represent the riskiest point of an investment cycle, because individuals, as do corporations, operate with a bias.
In initial stages of a recessionary equity cycle, investors of all stripes are schooled by investment media to consider a stock deterioration as representative of a “buying opportunity”, a chance to “average down”, the “deal of a lifetime based upon historic valuations“, whatever we choose to call it. We all are biased; I am, you are, Warren Buffett is. Bias is a predisposition in favor or against one thing compared to another. Most of us assume market declines to be buying opportunities due to the relatively long duration of bull markets vs the short duration of bear markets. However, the down-cycles, while brief, can prove to be quite savage at times and may undo years, sometimes an entire decade, of positive business performance by a corporation.
What is required of us, as investors, during an economic recession, is a maintenance of discipline. Economies expand for long periods of time; they contract for shorter periods of time. Equities advance with economic activity, and they contract for shorter durations. If we own world class businesses, these corporations will utilize the business missteps of competitors to capture incremental market share and maintain margins that will permit faster expansion in the next upswing.
Bear markets and economic recessions are enlightening in another sense. They provide one vitally important service that is unavailable to us during economic upswings; recessions offer the “great reveal“, clarifying, through an inability to maintain operating margins during an overall setback, that what we were told, or believed, to be a world class corporation, is merely a world class pretender. Only by remaining disciplined will we avoid the temptation, as powerful as it may be, to overcome our bias to purchase stocks for no other reason than a company’s shares have experienced a major share price decline, which might lead to our being stuck with a pretender, holding too much of our portfolio in a company that wasn’t all that was advertised in the prior economic upcycle.
Should we own an investment that is being beaten up far worse than markets as a whole, perhaps it isn’t a bargain, but rather, is experiencing an abnormal decline due to an acceptance, by superior investors, that the shares are less than desirable in relation to other companies or other sectors. In such cases, rather than continuing with our commitment bias (a tendency to remain committed to past behaviors, even when they result in undesirable outcomes) we might want to try break away from our bias and practice a de-escalation of commitment. Just because we want to believe that every security in our portfolio is a great bargain and therefore at half price, it becomes twice the bargain, wishing it to be so does not make it so.
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