Insights - Kovitz Newsletter 3Q22


And I said, "What about Breakfast at Tiffany's?"
She said, "I think I remember the film
And as I recall, I think we both kind of liked it."
And I said, "Well that's the one thing we've got."


After more than a decade of exceptional equity performance, marred only by these short drawdowns followed by swift recoveries, it is easy to get complacent and become increasingly alarmed when the stock market fails to quickly bounce back from any decline.

So, what do we do now?

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Clearly, 2022 has been a highly volatile year in the capital markets. Elevated levels of global inflation have forced central banks around the world to increase benchmark interest rates at a rapid pace. The volatility has been a product of the uncertainty associated with how high central banks, particularly the Federal Reserve in the U.S., will need to increase interest rates to bring the pace of rising prices back to mandated levels. Investors detest uncertainty oftentimes more than bad news itself. One can price news while pricing uncertainty requires imagination. Imaginations have been running wild as to how far these rate increases may go and how that may negatively impact the economy and, in turn, company earnings.

In Wall Street parlance, volatility is a proxy for risk. At Kovitz, we believe this definition is misguided. To us volatility is nothing more than a function of how often investors change their mind. Real risk is about losing capital that can’t be earned back. For example, investing in a company with a lousy balance sheet is a risk. Deteriorating fundamentals may leave the company unable to service its debt, which could lead to a bankruptcy filing, permanently impairing its equity investors’ capital. This money is permanently gone. Mark-to-market losses due to worsening sentiment are more likely to be temporary reflections of the market’s fickle relationship between price and value than permanent impairments of capital. This is particularly true if these short-term losses are in financially strong and competitively advantaged companies like the kind we tend to focus on.

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In fairness, one reason we’re better positioned to protect against downside risks than most core bond managers is that we play a different game. Our overarching goal as fixed income investors is not beating a benchmark – it’s principal preservation – hence, why we coin the bond bucket in our asset allocation as the “store of value”. The difference may be subtle, but it allows us to think and act differently than most market participants. We’re adding bonds with the goal of helping clients compound long-term wealth, not to improve short-term performance relative to a benchmark.

The store of value concept plays an important role within an overall investment portfolio. Traditional asset allocations are defined as a split between stocks and bonds, but “bonds” is too broad of a term to fill a discernible need within an asset allocation in our opinion. For example, most bond managers will have some allocation to long duration bonds since they make up a significant portion of the most common bond benchmarks. That portion of the market has lost 29% of its value this year4, greater than most equity indices. Given the magnitude of the loss and its correlation to the equity market, it’s easy to see with hindsight why we haven’t found long duration bonds viable for our bond strategy – even if the market defines them as such.

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