Portfolio Allocation and Sector Breakup
We ended 2021 with 70.7% of the portfolio invested in equities; 11.9% in preferred shares; 6.4% in fixed income and 11.0% in money markets/cash (see fig.1).
Our largest equity holdings are in the healthcare sector (comprised of pharmaceuticals, biotechnology, and medical equipment), followed by the technology sector. Metals and mining, as well as financials, also make up a larger portion of equity holdings. Detailed percentages of holdings by sector can be found below in Table 1.
We continued to add deeply undervalued securities, particularly during the second half of the year when the correction in stock prices became more evident. November was one of the more productive months for us as we deployed 11.0% of our capital into specific ideas. Our main area of focus is in beaten down value technology names. The bulk of the investments we have made since November have come in value-oriented technology names, telecommunications and media stocks. We also added to our space infrastructure holding.
After three back-to-back positive years for stocks, it only makes sense to temper expected portfolio returns for 2022 even though pockets of opportunity very clearly exist in the market. We are expecting a correction in the market in the second half of the year, as the US Federal Reserve will have stopped its bond buying program and would be well into its interest rate raising cycle by the second half of this year, as it has clearly indicated in recent communications. We believe that more important than interest rate hikes is the fact that the Fed has to begin reducing the size of its balance sheet sooner rather than later. That process could bring a fair bit of pain to the stock market as it will directly impact available liquidity.
The market’s build up of expectation around faster interest rate hikes due to inflationary pressure led to a tech wreck in the latter part of 2021 where nearly 50.0% of the NASDAQ stocks have seen their market value cut in half. However, it is likely that expectations over inflation and the direction of interest rates may diverge. There are signs of it happening already. Most economic commentary focuses on the fact that inflation is here to stay and interest rates will follow suit. That need not be the case. We can have stable or even low inflation and at the same time have higher and rising interest rates. Interest rates rising is a reflection of normalization of the economic environment, but rising inflation is a reflection of disruption. So, once the disruptive elements driving inflation such as supply chain disruptions and rising energy prices are sorted out, we could see a tempering of inflation. But on the other hand, falling unemployment, rising wages and the continued normalization of economic activity, especially as the pandemic subsides, will provide an ideal condition for rising interest rates.
This is not all doom and gloom; the economy is showing all signs of continuing strength (which is the primary reason interest rates are moving up). Besides, despite all the hand wringing over potential increases in interest rates, bond rates in the US, which remains the most relevant market for us, remain stubbornly low. The closely watched US government 10-year bond yield as of Dec 31 2021, was at 1.51%, compared to 1.9% at the start of the pandemic. Even if rates go up by 1.0% from the Dec 31 level to 2.5%, rates will be below where they were towards the end of 2018. So it is not the level of interest rates per se but the pace with which interest rates rise that could pressure stock prices.
In the years past, our portfolio objective was growth (largely predicated on generating long term gains). For this year we are pivoting to focus on stability and income, with growth being a secondary objective, for now.
We have added a bond instrument, called a Treasury Inflation Protection Bond (TIP), to the portfolio that offers some protection from expected inflation. The face value of this instrument changes with changes in inflation; so if inflation rises, the face value of the bond rises and the quarterly coupon payment is made based on the higher face value. Just now, with inflation expectations calming down a little, the value of this instrument has declined slightly since we added it, but we will continue to hold it for the foreseeable future. Our pivot to floating rate bonds and TIPs could be seen through the lens of developments in the energy sector. As long as oil prices are above expectations i.e., greater than $85/ barrel, expect inflation to keep rising. This keeps the direction of interest rates up and is supportive of adding inflation hedges to the portfolio. We have built a small position in gold equities as well, but this is a short-term tactical investment rather than a core or long-term investment at this point.
Tactics and Execution
As part of our attempt to seek stability in the portfolio we are taking a more tactical approach to some parts of the portfolio and are consistently shortening our holding period and expected returns. We have been executing this strategy for the last two or three quarters successfully and expect that to continue into the foreseeable future or until we see a significant correction in the market, then we can revert to our long-term positioning.
We expect to see a lot of volatility in the markets for the foreseeable future, including wild swings in stock prices and consequently in portfolio values. This is the main reason why we are opting for stability in the portfolio rather than incurring the risk inherent in chasing higher returns for the next few months. Unfortunately, over the last few years all the different asset classes have become closely correlated and now tend to move together to a large degree. This makes the task of truly diversifying a portfolio very difficult. Even though we have added floating rate and inflation protected bonds to the portfolio our preference increasingly is towards adding low volatility equities and increasing cash levels.