Quarterly Review
Recapping 2023, the US regional banking crisis that created the year's lows faded from the market's attention by the second quarter without causing widespread contagion. The recovery of the broader indices was driven mainly by a narrow group of technology stocks, colloquially referred to as the 'Magnificent Seven'. This group, comprising Microsoft, Apple, Alphabet, Meta, Nvidia, Tesla, and Amazon, dominated the market (+107% return), leaving most other stocks, including the ones in our portfolio, behind.
The distortions of the first two quarters and the US Federal Reserve's 'higher-for-longer' interest rate policy created gaps in the capital structure. The Fed's policy held back most interest rate-sensitive assets, leading to the most significant valuation disparity between small and large caps since the Dotcom days.
However, despite this challenging environment, we reiterated our conviction that small and mid-cap equities were well-suited for the current economic climate. These companies offer undemanding valuations, rebound potential, and have a predominantly domestic profile. Their relative size allows them to grow faster, providing a genuine source of long-term outperformance. We believed our portfolio was particularly well positioned for a bounce back, and we rebalanced as opportunities arose.
The final quarter of 2023 saw a continuation of the previous quarter's trends, with the ‘Magnificent Seven’ leading the markets. However, there were some noticeable shifts in investor sentiment as the quarter progressed. Towards the end of the year, the markets began to reflect a more cautious approach towards these tech giants and started to look elsewhere. This was likely due to stretched valuations and the market's anticipation of interest rate cuts in 2024.
Our portfolio did remarkably well, even with small and mid-caps failing to gain ground relative to large caps. Our portfolio's performance was also unrelated to many factors, including traditional Quality, Growth and Value. We attribute its strong run to the underlying company fundamentals and strategy independence. We have often compared our portfolio to the proverbial beach ball underwater on similar valuation dips.
Overall, 2023 was a year of significant market fluctuations driven by macroeconomic factors, policy decisions, and sector-specific trends. Our long-term view and focused investment strategy helped us endure short-term challenges and turn volatility into opportunity.
Market Outlook
Over the long term, 'macro' has less impact on the returns of a concentrated portfolio. These returns are mainly driven by security selection and the performance of the underlying businesses. However, there are times when macroeconomic factors are all that matter. We have found that balancing this dichotomy while avoiding distraction and complacency has been helpful to our long-term success. Most recently, our three decades of 'macro' experience served us well as the Fed completed its first tightening cycle since 2005.
The fourth quarter saw an interest rate rally that eased monetary conditions. However, short rates remain notably high, which will slowly affect the US economy. Over the next year, we believe the geopolitical and economic fundamentals can only lead to a gradual slowdown of US GDP. The US economy is the most flexible and robust globally, but there are too many headwinds to foster growth. The strongest of these is the Fed's restrictive monetary policy. Most Western Central Banks are unnecessarily holding interest rates higher until backwards-looking inflation numbers reach their targets. A by-the-numbers approach is a familiar Central Bank trait, and historically, it has been the cause of business cycle volatility. Fed Chairman Powell has shown signs of taking a more practical policy approach, but we've yet to see a Central Banker who pre-empts a recession while inflation numbers are still above their goals. China, the second-largest economy, suffers from persistent below-trend growth, another hindrance to world GDP. If the US and China are the world's engines, one is trying to slow while the other is sputtering, leading to lower world growth. Slower world growth also means the inflation equation reverses where too many goods are chasing too few dollars. We expect US inflation to fall below trend and the Federal Reserve to reduce rates closer to 4% in 2024.
The prevailing expectations for interest rates and the equity market seem overly optimistic. We predict that all asset classes may undergo a short-term correction as data begins to support a slower easing by the Fed. We expect credit spreads to remain tight in this scenario, offsetting some of the impacts rising interest rates have on equity valuations.
We also see the potential for a boost in portfolio performance as small and mid-cap multiples normalise relative to large and super-cap multiples. The long-standing divergence in these values is unsustainable, and its correction would benefit our portfolio.
Closing Remarks
In conclusion, 2023 was a challenging but ultimately successful year for our Strategy, with our portfolio outperforming the general indices and relevant sectors. Despite the distortions and fluctuations in the market, our long-term view, focus on fundamentals, and strategic rebalancing allowed us to capitalise on opportunities and withstand volatility.
Looking ahead, we anticipate a gradual slowdown of the US economy but see the potential for an additional boost in portfolio performance as small and mid-cap multiples normalise. We maintain our conviction in the value and resilience of our portfolio and look forward to the opportunities of 2024.
Note
This is a redacted version of CDAM's Q4 2023 Investor Newsletter. Should you be interested to learn more, please contact us by emailing ir@cdam.co.uk.
Disclaimers
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Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed.
This material is not an invitation to subscribe for shares or interests in any fund and is by way of information only. The information is as of the date(s) indicated in this document, is not complete, is subject to change, and does not contain certain material information regarding any CDAM investment strategy, including tax consequences and risk disclosures. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment.