Lockstep’s Monthly Update – September 2022

Our Funds’ Performance for September 2022

Premium Fund

The Premium Fund declined -9.6% for the month and is down -17.1% since the fund was launched in February 2022.

The Value Fund

The Value Fund declined -13.7% for the month and is down -24.3% since the fund was launched in February 2022.

Performance vs the Market

Both the S&P 500 and the Nasdaq Composite indices declined during the month with the S&P 500 down -9.3% for September and -24.7% Year-to-Date (YTD) while the Nasdaq Composite retreated -10.5% for the month and -31.4% YTD.

The market selloff was largely driven by August inflation coming in higher than expected causing the Federal Reserve (US Central Bank) to increase interest rates another 0.75% while hinting that there are more rate increases in the near term should inflation continue to rise. This in turn increased the likelihood of the US entering a recession.

A few large companies reported earnings during the month. One such business, Fedex (FDX) reported extremely disappointing results and provided a weak outlook for the remainder of the year. This shocked the market as FDX is generally a good gauge for the health of the global economy and where it is heading. As a result, FDX’s share price tumbled 30% dragging an already spooked market down with it.

We hold FDX in our Value Fund, and it was a significant contributor to our weak September performance. Despite the poor results, we believe the long-term outlook of the company is far better than the market is suggesting as the new CEO looks to drastically cut costs and improve margins over the next 3 years. Based on our conservative assumptions we value the company at 6.4x forward operating income which is attractive for a company that should be valued closer to 15x operating income.

Besides the Fed action and weak US corporate earnings, global dynamics continued to negatively impact sentiment as the war in Ukraine, China’s pandemic struggles, and some governments’ unorthodox response to rising inflation and recession concerns further weighed on the market.

Drivers of Performance

Although the majority of our investments traded down this month, the largest detractor, in both our funds, was our investment in Seritage Growth Properties (SRG) which traded down close to 30% as interest rates continue to rise. The increasing lending rate impacts the company’s ability to liquidate its assets as suitors are put off by the lower cap rates they can earn while the ability for them to borrow capital to purchase the properties reduces.  Our view is that the market is making a mistake and while it is painful to see one of your highest conviction stocks trade down we believe the upside remains intact. We have laid this out in more detail for those of you who are interested in our recent research article.

Another detractor, for both our funds, is our investment in a data storage company that guided for continued weakness for the next few quarters. There is little doubt that the entire data storage industry has entered a downturn. This quarter and the next are going to be tough as demand has come down as quickly as it went up during the pandemic. However, there is as little doubt that the industry will pick up again as the long-term demand profile for both data storage and memory continues to be exciting. At 8.5x normalised operating income, based on conservative assumptions, it is clear that the market is putting more weight on the short-term than we are.

Thoughts on the Market

This market downturn has been necessary. When interest rates are at record lows for close to a decade and central banks are printing money, it creates the illusion that money is “free”. As a result, companies have been able to borrow outrageous amounts to grow their businesses with little thought to the bottom-line. Market analysts, with their low discount rates (as a result of low lending rates), have been willing to assign favourable valuations to these companies based on multiples of sales regardless of the profitability or cash flow outlook.

But the good times have ended and we are now in a period of rising interest rates and quantitative tightening. All of a sudden that “free” money has consequences on a business’s ability to survive. Once generous analysts are not so gracious with their valuation assumptions and as such market participants are waking up to the fact that perhaps it is not a good thing to pay 20x revenue for an overleveraged, unprofitable business.

The problem is that negativity is not prejudiced and is pulling the entire market down with it regardless of the quality of the company. Not all businesses are overleveraged, not all businesses are unprofitable, and not all businesses are impacted by rising interest rates.

A perfect example of this is our manufactured housing investment which reported record results during the quarter, as tailwinds continue to act in the industry’s favour, yet the company remains deeply undervalued. Another example is our investment in our media business which traded down over 10% during the month even though there was positive news that certain investors want to take the company private.

 

Closing Remarks

If we were to take a short-term perspective looking at only the next 6 months then we agree with the market sentiment but we are investing in businesses we can hold for the next 3, 5, 10 years or more. With that long-term mindset, we are finding high-quality businesses we are going to be invested in well after when the market does turn more favourable.

 

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