To Our Investors and Friends,
The S&P 500 Index began the first month of 2023 up 6.2%, a great start to the new year after such a difficult 2022. Oil finished the month at $79 a barrel, the first down month year-over-year in almost three years. The 10-year Treasury bond dropped 36 basis points in January to 3.5%, while short-term rates fell 20 basis points, ending at 69 basis points above the 10-year. Expectations for both moderating inflation and the end of Federal Reserve rate hikes are encouraging investors to take on a bit more risk. Small cap indexes took the lead early in the year as both the Bloomberg 2000 Growth Index and Bloomberg 2000 Value Index increased by 10.3%. The Bloomberg 1000 Growth Index rose 7.5%. Large value stocks lagged as investors sold off staples, pharmaceuticals and utilities to make room for growth stocks that were shed over the last two years. The Bloomberg 1000 Value Index increased 5.0% in the month.
We believe the early gains experienced in growth stocks this year is the market’s recognition that these companies will take profitability more seriously in 2023 than in the past. The market has made it clear to both company management and investors that in the new era of tighter monetary policy, companies should prioritize positive earnings over top-line growth. Ultimately, the market favors a combination of strong revenue growth and even stronger cash flow growth. Growth stocks that are either not producing positive free cash flow or only moderately so have been sold off aggressively in the past two years, often falling 50-95% off their highs. We believe this “punishment” has hastened their focus on profitability faster than anticipated and investors are likely to see the results of corporate cost control efforts as 2023 progresses.
The best companies have natural operating leverage that reveals itself once businesses reach a certain size. Profitability usually then explodes higher for years, surprising investors along the way, typically fueling higher stock prices. As seen in the following chart, once Tesla began to leverage its corporate overhead and factory expenses, profitability followed even as it expanded its factory footprint and investments in Artificial Intelligence and proprietary battery technology.
What is not appreciated by many market participants, especially quantitative funds and passive indexes, is that a young business has some amount of fixed costs to cover (corporate headquarters and staff, public company costs and investments that help create a corporate identity and culture) before being profitable. More mature businesses that went public decades ago benefited from this operating leverage boost many years ago, and so do not have the same opportunity. Once these young companies can comfortably cover these costs, operating leverage generally is much greater than the market anticipates. This past year, most companies shed unnecessary expenses, and projects with little expected return for years and made efforts to make their people more efficient - often including layoffs. This set the stage for greater profitability in the growth space this year, which likely helps bring investors back to the group.
Kingsland Investments has always focused on finding what we believe to be the best new businesses the stock market has to offer. Our search starts with identifying companies with high, sustainable revenue growth and high gross margins, elements generally present in great companies. Once the companies reach a critical mass, high gross margins are translated into higher operating margins than most believe would be possible. It is this underappreciated earnings power that ultimately drives the stocks of these companies to much higher levels.
All the best to you,
Arthur K. Weise, CFA
The views expressed are those of Kingsland Investments as of February 1, 2023, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. The stocks mentioned are for illustrative purposes only and are not a recommendation to buy or sell. There can be no assurances that any of the trends described herein will continue or will not reverse. Past events and trends do not imply, predict or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.