January Newsletter 2023

     January 4, 2023

“Uncertainty”

With 2022 now in the rearview mirror, all of us at Intelligent Investment Management, LLP are preparing for the potential of another challenging year of managing your hard-earned nest egg in 2023. The challenges of 2022 remain in clear focus, as we believe the portfolio changes made last year will continue to bolster the invested principal and position the portfolio for the anticipated economic turnaround in 2024. The realized losses taken in 2022 provided the opportunity to reinvest the proceeds from the sales back into the portfolio in the basket of remaining core equity positions which have provided the bulk of our long-term investment success from the inception of our investment management company in 1997. Many of those core equity positions are closed end funds that were formed as far back as 1927 as the country entered the Great Depression, when many investment companies collapsed along with the economy. You will recognize in your portfolio such names as: Adams Diversified Equity Fund, Central Securities Fund, General American Investors, Tri Continental Securities and others; all representative of the skill and tenacity needed to survive the worst of times and excel in the best of times.

Stepping back for a minute, let’s put our portfolio’s results in perspective. First, it is hard for me to have to report that your portfolio declined in value in 2022 as the Federal Reserve repeatedly raised the cost of borrowing in its attempt to control the runaway inflation brought on by the government’s efforts to bolster the economy in the face of the pandemic. We must now all suffer the pain in the form of higher prices as we work through the recession. The bear market produced by these impacts will most likely continue until inflation is “under control” and the Fed once again lowers the cost of borrowing. It should be noted that no bear market has ever reversed without the Fed lowering interest rates.

The securities markets suffered losses in 2022 not seen since the Financial Crisis of 2008.

As a frame of reference:

• the broadly followed S&P 500 Index lost almost 20 percent of its value.
• the NASDAQ Index of mostly technology stocks lost over 33 percent of its value.
• the Bloomberg/Barclay Bond Index declined in value by almost 26 percent.

The takeaway is that there was “nowhere to hide” in 2022, as even cash lost value from the inflationary scourge:

• For comparison, our aggregate managed portfolio of diversified equities declined in value by just over 17 percent.
• Our aggregate managed income portfolio declined in value by almost 13 percent.
• As of December 31, our combined portfolio invested 51 percent in equities and 49 percent in income and cash returned a net, after fees, return of roughly negative 16 percent.

It is worth noting that when we look back for ten years, the absolute amount of dividends and interest coming into all managed accounts was well over thirty million dollars. For perspective, the realized and unrealized losses in the portfolio are just over three million dollars. The takeaway is that our emphasis on cash flows to meet all client needs continues to keep us “ahead of the crowd”.  The results of your portfolio as of December 31, 2022, are included in the attached report.

When you review your report, please carefully review the last report in the package which details all the individual CDs, notes and bonds held in your accounts with the “coupon rates” and the maturity dates. As we have educated our clients over the years, the ending market value of each fixed income position is not as important as the face value that will be received in cash upon maturity. In the current rising interest rate environment, the value of lower rate positions creates an “unrealized loss” as part of the reported return for your portfolio. The three-million-dollar unrealized portfolio loss referred to above would be significantly less if the calculation would have been based on the maturity value in cash and not the reduced market value. The importance of that fact is that the clients who have been invested under our management for more than a few years are most likely “in the green” based on the accumulated equity gains still embedded in the overall portfolio. That is illustrated in your report in the “Illustration of Active Management Results: Last 5 Years” graph prepared by Laura. I do believe that a picture is “worth a thousand words”.

So, how does 2023 look through our eyes? In a word: “Uncertain”. First, two-thirds of all economists are forecasting a recession in 2023. And, to not let the recession get totally out-of-hand, the Fed will need to raise the cost of borrowing in relatively small increments, with the goal to get the interest rate above the inflation rate. With the inflation rate on January 1, 2023 still above seven percent and the most recently announced Fed funds rate at 4.25 percent, it will most likely take all of 2023 to get the borrowing rate above the inflation rate. It should be noted that the borrowing rate has not been this high since 2007. Current projections by the Fed are for interest rates to climb to 5.1 percent in 2024, with a GDP growth rate in 2024 of 1.6 percent. Our read on the situation (shared by many market observers) is that it will take until 2024 for all rates to “normalize” and for the economy to gain its steam and grow at historical levels once again.

As a leading market indicator, the markets are expected to turn upward once again in anticipation of the 2024 recovery. From an investment management perspective, we know that the portfolio’s recovery will come from “time in the market” and not from “timing the market”. Accordingly, we will continue to stay the course and keep all cash not needed for distributions “fully invested” in accordance with each client’s Investment Policy Statement.

Once normalized, the expected total return on the equity portfolio will return to its historical ten percent growth path and the interest rate obtainable on investment grade notes and bonds maturing in ten years to be at the six percent rate. Accordingly, a portfolio invested fifty percent in equities and fifty percent in income securities should generate a blended rate of return in the eight percent range.  In the meantime, it will be our job to protect the portfolio from the flames of recession, war, and rising interest rates. We firmly believe that we are up to that task.

Our long experience provides some expectation of future results (although no guarantee is made). In 2008, our managed portfolio declined by 32.58 percent and then returned 30.73 percent in 2009 and 12.49 percent in 2010. Similarly, our managed portfolio declined in 2002 (post 9/11) by 9.13 percent and then returned 24.00 percent in 2003. In our current world, 2022 and 2023 may be different, but our 2022 decline of 15.71 percent has set us up to achieve outsized returns once again in 2024 and thereafter. Looking back over our entire twenty-six-year period of managing client portfolios, our aggregate total return as of December 31, 2022, is 261.25 percent. We are now working to continue to provide similar long-term results for our clients.

We continue to keep our promise to you to manage your nest egg with as much care and expertise as possible. We acknowledge that down markets are expected from time to time as economies are affected by extraordinary and generally uncontrollable events. The key is that at the end of the road reasonable expectations and goals have been realized.  With inflation running at such a high pace, we are talking to clients about reasonable withdrawals in retirement and the longevity risk associated with depleting accounts with excessive distributions during the downturn.

We are also continuing to focus on the inflation hedge opportunities within the Alternative Equity allocation. The real estate investments should grow in value with the underlying inflationary growth of the assets. Rents may be at risk until the economy gets back on sure footing, but the REITs in the portfolio are reporting acceptable occupancy rates and the rents received will grow with the inflation rate over time. We expect the dedicated energy fund in the portfolio to continue to produce outsized results. Adams Natural Resources (PEO) has independently reported a return of over forty-three percent for 2022. We added PEO back into the portfolio in 2022 when we sold a fund whose management did not convince us that it should be kept in our portfolio. In 2022, PEO distributed to its shareholders a dividend yield of over seven percent. PEO is a sister fund to Adams Diversified Equity Fund (ADX) and has also been in existence since 1929. PEO has a policy of distributing annually a minimum dividend of six percent; and historically, has exceeded that minimum based on its performance. We believe that PEO can continue to meet our expectations for the long-term and is now included in most client portfolios for both its growth potential and its dividend income.

In closing, here is a quote taken from the team at General American Investors that has successfully managed its portfolio of high-quality positions since 1927: “..We seek investments worldwide in leading public and private companies with significant long-term opportunities, defensible competitive advantages, prudent and profitable business models, and committed first-class management teams with the vision and energy to succeed.” We have held GAM as a core position in our managed equity portfolio from our first year of existence. In fact, when looking back at my and Jeannie’s retirement accounts (fully invested since 1997), the cumulative return on GAM is just under 240 percent.  In fact, the growth and dividends have allowed us to take our invested principal “off the table” and our current holdings in GAM represent only the accumulated profits.  When we made the decision to take the losses on some underperforming positions in 2022, we put a meaningful portion of the proceeds into GAM, along with the other high-quality equity positions we have maintained for many years now. All-in-all, we believe that the portfolio is on stronger ground for continued future meaningful results to meet our clients’ goals.

As always, call with any questions and feel free to give our name to someone who could use our Intelligent help.

Best wishes for a healthy and prosperous New Year!

Sincerely;

Intelligent investment Management, LLP