What 2022 Can Teach You About 2023

Table of Contents

Equities

Fixed Income

US Treasuries

High Yield Bonds

Investment Grade Bonds

Municipal Bonds

Case Study: RingCentral

During 2022, the Federal Reserve hiked short-term interest rates seven times, doubling 30-year fixed mortgage rates to ~7% and catalyzing significant drops in stock and bond prices. It was a sea change in market pricing, investor expectations, and asset returns. 

Source: Bloomberg

The market dynamics of 2022 are consistent with our “interest rate spike” scenario that we outline to clients during onboarding. We were not surprised that the increase in interest rates led to a correlated fall in stocks and bonds. 

2022 marked an inflection point

• The Fed increased the Fed Funds rate from ~0% to ~4.3%

• Cryptocurrency assets plummeted, with market capitalization tumbling from $2.2T to $800B [1]. Colossal fortunes that once existed on the backs of Luna, Bitcoin, and private ownership (FTX, Celsius, BlockFi, Voyager) collapsed.

• Traditional asset classes behaved as follows: 

  [1] Source: CoinMarketCap

Source: Bloomberg

Equities

Equity Performance by Indices

Source: Bloomberg

Valuation: S&P 500 P/E

Source: Bloomberg, SPX Index P/E

The ugliest number in the table above is the negative (32.5%) fall in technology stocks. Many sub-sectors of technology (high-growth software stocks, for instance) did much worse.

S&P 500 Price / Forward Earnings (P/E) multiples peaked at 30x in April 2021 and have since declined ~40% to 18x in Q4 (unchg. quarter over quarter), largely in line with its 50-Yr average of 17x.

 We believe last year’s sell-off has created some favorable opportunities to invest in quality businesses at very reasonable valuations. Some of the best opportunities exist amongst the most beaten-down sectors in 2022: COVID winners, high growth, and technology.

We also believe that certain “defensive” companies trade at unsustainably high valuations and have other features (high capital intensity, low revenue growth) that make many of them unlikely to produce satisfactory returns relative to cash over the long term. 

When we invest in the market alongside our clients, we are doing so with the expectation that interest rates (short- and long-term) will likely be higher 5-10 years into the future. That means we assume earnings/revenue multiples will fall in the future. Good investments need to be reasonably valued, with great products and services and strong business moats that can drive significant profit growth over the next decade. 

Fixed Income

Source: Bloomberg, HY Bond: LF98TRUU, IG Bond: LBUSTRUU, Municipal Bond: LMBITR. Tax Rate Assumptions: Federal (37%), State (10%)

US Treasuries

Cash vs. 10-Year US Treasury Yields

Source: Bloomberg, World Interest Rate Probability (WIRP)

The Fed raised interest rates seven times during 2022 bringing short-term rates to 4.33% (the highest level since Dec-2007).  Based on market expectations, an investor should receive a pre-tax return on cash of ~4.5% over the next year. 

Source: Bloomberg, 10-Year US Treasury Yield (USGG10YR)

The 10-Year US Treasury ended the month at a 3.6% yield after having cracked 4% earlier in the quarter.

We believe that cash (which may earn ~4.5% over the next year) looks more compelling than longer-maturity bonds (like the US 10-Year Treasury), which have lower yields and a higher risk profile. 

High Yield Bonds

HY Credit Spreads: Additional yield received above US Treasuries for debt of riskier companies

Source: Bloomberg, BarCap US Corp HY YTW 10-Yr Spread (CSI BARC Index)

The above chart displays a modest decrease in credit spreads for high-yield bonds issued by companies with riskier balance sheets. After having widened modestly in Q3, the spread narrowed in Q4 and we believe it’s not yet compelling enough to justify allocating significant capital to the space.

Investment Grade Bonds

IG Credit Spreads: AAA 10-Yr premium received above US Treasuries (in bps)

Source: Bloomberg, BASPCAAA Index

Investment Grade bonds are debt instruments issued by companies that rating agencies deem high quality and have very low risk of defaults. Compared to last quarter, these debt instruments are trading at lower spreads to underlying treasuries and are less compelling. In addition, these instruments are fairly tax-inefficient and their absolute level of post-tax yield is still quite low.

Municipal Bonds

Municipal Bond Index (Yield To Worst) Chart:

Source: Bloomberg, LMBIYW Index

Municipal bonds can be a tax-efficient way to generate yield. We recommend allocating exposure to the short end of the curve (maturities <1 year) as long-duration bonds do not give adequate additional yield to compensate for interest rate and duration risk. It’s important to understand one’s marginal tax rates and jurisdiction before investing in municipal bonds as those factors determine an investors’ after-tax yield and the attractiveness of the asset relative to treasuries or corporate bonds. 

Curious Case of RingCentral

“Intrinsic value is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses. Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.

 The calculation of intrinsic value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised...”

— Warren Buffett | Owner's Manual (p. 4)

We agree with Warren Buffet and believe calculating intrinsic value is incredibly important when investing capital. When interest rates change as much as they have, it is critical to change the yardsticks by which you value a company. That is healthy and appropriate.

But sometimes, people take it a little too far. Consider RingCentral, a provider of cloud-based communication and collaboration products and services for businesses. RNG IPO’d in September 2013 and since then has grown revenues >10x from ~$160M to ~$2B today. 

 At the end of 2021, the company was worth ~$187 per share. In November 2021, Barclays analysts published a price target of $400 based on 2023 revenue expectations of $2.4B and a 16x annual revenue multiple [2], or ~80x EBITDA [3], a measure of profits excluding certain costs. For a company to be valued at 80x future earnings requires one to believe it will have very strong growth for a long time that will translate into enormous future profits. We think RingCentral is a fabulous company, but not that fabulous.

By the end of 2022, RingCentral’s share price declined by over 80% to $35. The same analysts lowered their price target in November 2022 by 90% to $40, while only lowering 2023 revenue expectations by ~5% to $2.3B.  

How? Why?  Well, their methodology changed from 80x EBITDA to 8x EBITDA. This is not a typo. The analysts dropped a zero in their valuation methodology.  8x EBITDA valuation metric can be appropriate for a mature company with low margins and no growth, but not for RingCentral, which we believe to be a fast-growing company with high margins.

A few takeaways:

• Take analyst price targets with big “grains of salt.” The same analyst viewed the same company 10x differently in the space of 1 year, when the actual expected performance of the company did not materially change.

• You can overpay for a great company. RingCentral is down 90% from its peak [4].

• Price is what you pay, value is what you get. We believe that RingCentral is trading at levels that will likely lead to a satisfactory return for investors who hold the stock for several years. 

[2] Revenue multiple measures the value of the equity, or a business, relative to the revenue that it generates

[3] A measure of earnings before tax, interest, and depreciation & amortization (non-cash expenses), assuming a 20% gross margin profile

[4] Peak price of $443.29 on February 12, 2021. Current price of $36.50 as of January 17, 2023