In the context of the market environment experienced in 2022, Kestrel performed well given our mandate to remain fully invested and avoid market timing. Kestrel’s single-digit loss compares very favorably to the Russell 2000® Value Index (-14.5%), the overall Russell 2000® (-20.4%), the S&P 500® (-18.1%), and the NASDAQ® (-33.1%). We believe this performance is a direct result of our risk minimization approach, where our analytical technique focuses on buying stocks where a near-term negative fundamental outlook is already discounted in the price.
We have been witnessing for several years the apparent overvaluation of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). Facebook and Google have now been renamed Meta and Alphabet, and Netflix should be replaced with Microsoft, but a MAMAA acronym doesn't quite conjure up the same image. It seems that each generation of investors must learn the same lesson about concept stocks that go to valuation levels unjustified by fundamentals. Within my investment lifetime, it has now happened three times. In 1973-74, we witnessed the destruction of the one-decision (buy and hold forever) Nifty-Fifty (Polaroid, Avon, and Sears as poster children). In 2000, we saw the collapse of internet stocks (Cisco, Intel, and Microsoft all dropped 50%+ from their peaks). These past few years, it has been the partial transition to a stay-at-home economy that triggered the latest boom/bust cycle.
The parallels between 2000 and 2020 are very strong. In each case, there was a one-time macro event which greatly accelerated the secular trend toward an evolving technology. In 2000, the Y2K bug (which was theoretically going to cause huge computer problems when the calendar turned over to a new millennium) caused a massive upgrade cycle in anticipation of this event. In 2020, the pandemic triggered a similar cycle, where systems needed to be modified to reflect the changes in consumer behavior and large increases in internet activity. In both cases, extreme speculative behavior emerged, as companies with questionable prospects at best (not even necessarily related to the main theme) soared to unimaginable heights – witness the meme stocks in this cycle.
How is all this relevant to the way we invest today? As small-cap value investors, we are always advocates for our sector, since it is an area where inefficiencies are likely to arise, which we can exploit with our strategy. However, we are not naïve. There will always be growth stocks tied to emerging technologies which will produce the strongest returns if an investor is able to identify the winners – not our skill set. Nevertheless, there are times when our strategy is better positioned to take advantage of sentiment swings.
What does seem to be consistent over cycles is that the pre-existing market leadership needs to be decimated, destroyed, depopulated, (or de-FAANGed in the current case) for new leadership to emerge – and that has now happened. The gap in valuation between the S&P 500 and the Russell 2000 Value Index is wide (trailing P/E ratios of 18.1 vs 11.1), providing a potential springboard as sentiment swings in our direction. Our strategy performed very well in the post-2000 technology meltdown. Cycles tend to last for long periods. We are looking forward to the relative tailwind for value stocks that began recently continuing into 2023 and beyond.
Abbott J. Keller, CFA
Chief Investment Officer