Dear Partners,
The year 2022 was marked by sharp declines in global capital markets. Inflationary pressures alongside rising interest rates led to fears of a recession. These factors created pessimism among investors. As of today, the severe recession many feared did not occur, inflation pressures are clearly easing, and the interest rate hike cycle appears close to its end. The year 2022 was almost a mirror image of 2021, from the euphoria of 2021 to the pessimism of 2022.
When we met you in January last year, we spoke at length about the euphoric atmosphere in the markets during 2021. The public eagerly bought shares and showed a preference for relatively risky companies, many of which had yet to prove their ability to generate profits from their business activities. This atmosphere, which recurs every few years, was fueled by the US central bank’s policy, which effectively created a mechanism of nearly free money flowing to many risky companies even when their stock prices were too high. To be exact, a flow of 120 billion dollars per month. Given the stabilization of the global economy and rising asset prices (stocks, bonds, and real estate) during 2021, it was expected that the Federal Reserve would begin reducing its market involvement that same year. However, as we now know, the Fed continued to inject money into the economy and capital markets throughout 2021.
The central bank’s policy shift in 2022 was not surprising; the surprise was the pace of change. Instead of starting the process gradually during 2021, the Fed delayed and apparently, realizing the delay was too long, chose to respond sharply due to a timing mistake.
Additionally, the ongoing conflict between Russia and Ukraine led to a sharp rise in oil and other commodity prices, contributing to inflation increases. This rise also pushed the Federal Reserve to implement a rapid interest rate hike.
In 2021 we experienced euphoria, stock prices of companies without profits and without a stable business model soared. In 2022 we experienced the mirror image, a year of pessimism. The inflated stock prices of the euphoric year fell by tens of percent, in some cases by 70 or 80 percent. The pessimistic atmosphere also affected companies that continued to earn profits and even increased their sales and earnings last year.
A large part of our portfolio is directed to technology companies in various fields, chip manufacturing plants, cloud computing infrastructure, media and digital marketing, and e-commerce. Investor sentiment toward technology was especially negative and significantly affected our stock portfolio performance last year.
The enemy of good is better
Another consequence of rising US interest rates was the strengthening of the dollar, which added to the negative sentiment toward American companies since most of these companies also sell outside the US. At the end of 2021, a US company’s sales in Europe totaling 100 euros translated to 114 dollars, while toward the end of 2022 the same 100 euros translated to about 100 dollars. The strengthening dollar hurt these companies’ growth rates. Microsoft, for example, in which we invest, reported in Q3 2022 that the dollar’s strength reduced 5 percent of its sales growth, which grew only 11 percent compared to Q3 2021.
Growth of 11 percent may not seem negative, but compared to 22 percent growth in the same quarter the previous year, it disappointed investors and led to a stock price decline. It is important to remember that company business development is not linear; thus, revenue and profit growth rates are not linear, especially in the past three years, which have been affected by a global pandemic whose economic ripple effects continued during the past year, alongside Federal Reserve policy changes and frequent shifts in consumer preferences. In Microsoft’s case, the company benefited during the pandemic from demand for laptops and gaming consoles during lockdowns, and demand was lower last year for these products.
It is clear that these demand changes are relatively short-term and do not affect longer-term demand. Looking at the bigger picture, Microsoft, despite the “disappointing” quarter, increased its net profit by 70 percent compared to the same quarter three years earlier. In our view, nothing in the company’s story has changed and we expect it to continue significantly growing its profits in the coming years.
Current situation
As described, the pessimistic atmosphere that characterized stock markets last year was the result of a high inflation environment that caused a sharp rise in US interest rates. We believe several main factors caused the inflation increase. The first is disruptions in production and transportation of goods and products, due to lockdowns and restrictions in manufacturing areas worldwide in late 2021 and early 2022.
One side effect was a sharp rise in transportation costs, leading to effectively higher commodity and product prices. The world had experienced hundreds of percent increase in the shipping freight price index during 2021, which led to higher commodity and product prices during 2022. As of early 2023, prices have returned to pre-Covid levels common in 2018 and 2019. We therefore estimate that the inflation easing that began in recent months will continue into the coming year.
Another factor for inflation increase was rising commodity prices, including oil and natural gas, which increased significantly during the first half of 2022 due to concerns about supply delays stemming from the Russia-Ukraine war. We do not attempt to predict oil prices during 2023, but it is clear that as the world “got used” to the ongoing conflict in Ukraine, fears faded and prices returned to lower levels as shown in the graph below. Therefore, looking at the impact of oil prices in coming months, we think it is quite likely they will have a moderating effect on the inflation rate.
A third factor, which economists in general and Federal Reserve members in particular have overlooked, is changes in consumer preferences during the post-Covid period. For example, flight prices in the US crashed at the start of 2020 after the pandemic outbreak, but as movement restrictions eased, flight prices recovered and even rose beyond 2019 levels. Demand for flights and vacations built up over two years of restrictions and then burst all at once. Flight prices rose about 60 percent from late 2021 to their peak in mid-2022, contributing significantly to inflation.
Just as it is clear that Covid caused volatility in demand for laptops and gaming consoles as in Microsoft’s case, it is also clear that the sharp rise in flight prices was caused by one-off factors, the rise is relative to very low price levels during lockdowns and the “boom” in demand after two years of travel restrictions. The recent moderation in flight prices at the end of 2022 indicates these were indeed one-off factors. We therefore estimate that flight prices contributed heavily to inflation in 2022 but should not continue to be a significant inflationary factor going forward.
The inflation rate in the US is moderating. At its peak, it reached an annual rate above 9 percent, while in the most recent report it was closer to 7 percent. This may still seem high, but it is important to remember it includes price increases from the first half of 2022. Looking at the monthly change picture in inflation rate, we see that it has returned to levels characteristic of 2018 and 2019, the normal pace for the current economy without Covid disruptions.
Looking forward
It seems the factors that caused price declines during 2022 are easing and returning to normal. From the economic environment description and the Microsoft example, we understand reality is not linear; data from a single year do not indicate a trend, so it is important to look at the bigger picture.
Looking more specifically at the stock market, we estimate that many companies are still too expensive for our taste. At the same time, we also find investment opportunities at attractive price levels not seen for years. Some even appear to us as once-in-a-decade opportunities. Therefore, we believe selectivity in investment choices will be very important in coming years.
We mainly identify these opportunities in the sectors described earlier, chip manufacturing plants, cloud computing infrastructure, media and digital marketing, and e-commerce. In other areas, we are waiting for more attractive price levels.
Since we avoid investments based on macroeconomic analyses (forecasts for oil prices, inflation environment, etc.), in the sectors where we do invest, it is important to us to choose stable, strong companies with clear competitive advantages so they can increase profits even if interest rates or inflation remain relatively high. If the inflation easing we expect does indeed occur, that will be a bonus for us.
Finally, we want to describe another factor important to company performance over the next 2-3 years. The year 2022 was characterized by a labor shortage, with very low unemployment, and to attract new employees companies improved salaries and employment conditions. This phenomenon was very noticeable in technology professions but was not limited to them. This reality was another factor contributing to the high inflation environment last year. In recent months, there has been a significant easing in the “battle” for employees, due to efficiency measures taken by many companies, large and small alike. Even giant companies like Amazon, Google, and Facebook announced workforce reduction plans, more precise investments in new technology, and adjustments to the real estate they hold or rent for business management.
These companies, like Microsoft, experienced some volatility in their growth rates over the past three years, which in some cases led to excess labor following a year of very high growth. It can be said that the Covid pandemic and the economic recovery that followed created “noise” in the data. Now, as we return to normal reality, companies can focus on efficiency. We expect such measures to significantly improve profitability for some of the companies we invest in, beyond their normal business growth.