Fourth Quarter 2021 - Fundamental Growth Update
In the fourth quarter and full year 2021, Shaker’s Fundamental Growth and the major U.S. equity market indices had strong returns on a percentage basis. In the fourth quarter, the strategy and the S&P 500 rose as large cap stocks outperformed small cap stocks in US markets. The S&P 500 increased more than 11% in the quarter, while small cap stocks rose approximately 2%. A similar trend played out over the year in 2021 as the S&P 500 rose nearly 29% and small cap stocks increased 15%.
As you know, we invest across small, medium, and large market capitalization stocks. This approach along with our research into the fundamental outlook for these investments has resulted in the composite strategy outperforming the Total Market Index over the last 5, 10, and 15 year time periods. Our investments in smaller capitalization stocks weighed on performance relative to the overall market during 2021, but we remain confident in our approach over longer time horizons. The relative performance of large vs. small stocks tends to go through cycles, and by investing across all market capitalizations we have a larger investable universe to identify the best opportunities.
The last three years have produced cumulative total market returns of almost 100%. These strong returns in the US stock market have been fueled by low interest rates and substantial increases in the money supply in the U.S., Europe, and Japan. We expect that these conditions will change in 2022 and thus do not expect that market returns in 2022 will match recent returns.
The following is a summary of returns for the composite strategy and selected major indices for the fourth quarter, last year, five, ten and fifteen year time periods. Multi-year returns are average annual returns:
| 3 Months Ending 12/31/21 | Year to Date Ending 12/31/21 | 5 Years Ending 12/31/21 | 10 Years Ending 12/31/21 | 15 Years Ending 12/31/21 | |
|---|---|---|---|---|---|
| Shaker Fundamental Growth | 4.98% | 24.34% | 23.21% | 16.37% | 11.91% |
| US Total Market Index | 9.14% | 25.66% | 17.92% | 16.24% | 10.64% |
| US Small Cap Equity Index | 2.14% | 14.82% | 12.02% | 13.23% | 8.69% |
| S&P 500 Index | 11.03% | 28.71% | 18.47% | 16.55% | 10.66% |
Discussion of Fourth Quarter Performance and Positions
Multiple stock positions positively impacted performance in the fourth quarter and for the full year. Our largest winners in Q4 were:
The Trade Desk (TTD) – a self-service, cloud-based platform that helps ad buyers optimize their purchases of digital advertising
WESCO (WCC) – a distributor of electrical products and other industrial maintenance, repair, and operating supplies as well as a provider of integrated supply services and logistics
Broadcom (AVGO) – a leading semiconductor and infrastructure software solutions provider
Micron (MU) – a manufacturer of DRAM, flash, and other solid state memory components
Encore Capital Group (ECPG) – a debt recovery solutions company
Other major contributors to our annual performance include:
Axos Financial (AX) – a branchless bank
Concentrix (CNXC) – a provider of customer experience solutions and technology
Alphabet (GOOGL)
Zebra Technologies (ZBRA) – a leading manufacturer and designer of ID and data capture products to support supply chains
Fortinet (FTNT) – a cybersecurity solutions provider
Our largest detractors during 2021 were PayPal (PYPL), CoStar Group (CSGP), and LivePerson (LPSN). We reduced holdings in CoStar earlier in the year at higher levels though we continue to like the company’s dominant market position, and we still to see strong potential in both PayPal and LivePerson, albeit at an increasingly attractive valuation.
Individual position performance was impacted by the broader market trend of small cap underperformance relative to large caps. To be more specific, our investment strategy tends to be more heavily weighted in small- and mid-cap growth stocks, as that is where we tend to find many companies with the greatest long-term return potential. In 2021, small cap growth stocks were the weakest segment of the market – flat in the fourth quarter and up less than 3% for the full year.
Despite these headwinds, we were pleased with our ability to generate strong returns due to our ability to identify growing businesses with competitive advantages at attractive valuations, even among small cap growth stocks. This includes the top three contributors to returns for the year – WESCO (WCC), Axos (AX), and Concentrix (CNXC).
Investment Outlook for 2022
The US Investment Outlook has changed significantly in the last year. One year ago, the Federal Reserve was committed to maintaining the easy money policies in place since the onset of the pandemic in March of 2020. The outlook was robust as the economy snapped back from the pandemic – job growth continued at record rates, businesses confidence was high, vaccines were on the way so our lives could “return to normal” and fiscal stimulus would support consumers and businesses through what remained of the pandemic. The financial markets were fueled by a speculative frenzy as “meme” stocks like Gamestop (GME) headed “to the moon” and a record number of companies (mostly unprofitable) entered the public markets via IPO or SPAC at extreme valuations.
Oh what a difference a year makes! The Fed’s perspective for most of 2021 was that, although inflation had increased, it was only transitory as the economy and supply chains returned to normal and was likely to decline by the fourth quarter of 2021. Today, inflation is higher than at any time in the last 35 years. The Federal Reserve is in the process of tapering its economic accommodations and has indicated that it will soon be removing some of the past liquidity assistance through higher interest rates and a reduced balance sheet.
Many of the stocks that achieved abnormally elevated valuations have started to plunge in price and a broad small capitalization growth stock index is now down 30% from highs reached in the first quarter of 2021.
This change in the posture of the Federal Reserve impacts markets in a number of ways:
There is increased uncertainty of the ultimate effect of this change in policy. Will the Federal Reserve be too slow in tightening? Will it do too little (excess inflation persists far too long and the Fed ultimately has to raise rates much more than would otherwise be required), or will it do too much too fast and trigger a recession? At present, the range of potential outcomes is quite wide and that is likely weighing on the willingness of investors to put more money to work in the market.
The expected increase in interest rates is causing investors to increase the discount rate used in valuing investments, which typically impacts high growth investments as more of their value is derived from projected cash flows further in the future.
The expected shrinkage in the Fed balance sheet will reduce the significant increase in the money supply, which made more capital available to invest in increasingly speculative assets. This especially impacts companies that are currently unprofitable in addition to highly speculative assets like crypto currencies, NFTs, collectables, etc. These assets are already being hit by the expected change in monetary policy.
Specifically for 2022, we expect the Fed will be able to make progress on reducing inflation without triggering a recession in the US. Although this environment is different (high inflation, lingering effects from Covid-19 and the fact that the Fed is shifting to a tighter money policy from a very easy money policy) we believe that there is a good chance that US equity markets could end the year higher. On average, markets have historically continued to move higher after the Fed begins an interim rate hike cycle. We also expect that the more speculative assets will underperform high quality companies that are not dependent on raising additional capital. That said, our forecast could change, especially if inflation does not moderate and the Fed elects to take more drastic actions.
As always we will dynamically adapt to changing conditions and do expect increased market volatility vs. 2021. Additionally, we always look to use downturns to better position our investments to take advantage of the evolving investment climate. We expect numerous opportunities to emerge and are already seeing a significant improvement in the valuations of specific stocks and sectors.
The ten largest positions are 35.2% of the overall portfolio, which is a lower concentration than we typically holds for the top-ten holdings. In general, the average cash position in accounts that we manage is also higher than normal. We are actively looking to take advantage of more attractive valuations in individual stocks and have begun to do so with the recent market pullback.
We look forward to updating you further as the year progresses and we are always available to assist in any way we can.
General Disclosures:
The information contained in these materials is as of 12/31/2021. This document is confidential and for the sole use of the intended original recipient. It is not intended as investment advice or recommendation, nor is it an offer to sell or a solicitation of an offer to buy any interest in any fund or product.
Risk:
An investment in any of our strategies is speculative and involves a high degree of risk, including potential loss of principal. There is no guarantee that the investment objective will be achieved, or that the investment strategies will be profitable. Investments in smaller companies may be riskier, less liquid, more volatile and more vulnerable to economic, market and industry changes than investments in larger, more established companies.
Performance:
Past performance is not indicative of future results. Returns in the current year are preliminary. The strategy’s overall return is a composite of clients’ separately managed account returns. Some clients’ investment returns were more or less than the overall strategy return. Not all our client’s returns surpassed the benchmark. The index return information herein has been obtained from public sources and we do not guarantee its accuracy. The following disclosures applies to information mentioned in this document:
1. Gross returns are net of expenses.
2. Net returns are net of expenses and a 0.25% quarterly (1% annual) management fee for the corresponding period.
3. Inception date for the Fundamental Growth Strategy is 10/01/1991. The period commencing 1/1/2007 is significant because it covers full market cycles that include the recession and bear market of 2008/2009 and the sharp recession, bear market and subsequent sharp recovery of 2020-2021. Growth of $100,000 invested as of 1/1/2007.
4. The benchmark for the Fundamental Growth Strategy is the Dow Jones US Total Market Index, a broad All Cap index. However, the strategy is more concentrated and contains a higher percentage of growth stocks than the benchmark.
5. Risk metrics are estimated using monthly returns net of fees for the last 3 years, unless otherwise noted.
6. Sector allocations may not add up to 100% because of rounding.
Recommendations:
The specific securities identified and described in this report do not represent all of the securities purchased, sold or recommended for clients. It should not be assumed that investments in the securities identified and discussed will be profitable in the future. Holdings and sector weightings in any strategy are subject to change and should not be considered investment advice or a recommendation to buy or sell a particular security. Actual holdings may vary by client. A list of the stocks selected for any of our strategies during the trailing twelve months is available upon request.