2022 - Q4 - Letter to Investors
Dear Investor,
Many described the past few years as “among the most challenging economic periods on record.” The pandemic started a chain reaction that led to several massive supply and demand imbalances across the economy. These imbalances led to rapid price and wage inflation, which became apparent in 2021, and convinced many that things were spiraling out of control in 2022. After much delay, the Federal Reserve chased inflation with high-velocity tightening of monetary policy. These forces caused wild fluctuations in the ‘real’ interest rate, which sets expectations for the present value of future cash flows. A rapid exodus of investments from a breadth of asset classes ensued, resulting in diminished valuations for many of the fund’s holdings.
The fund’s strategy involves investing in publicly traded businesses with their greatest returns expected far in the future. Consequently, the ferocious decline in real interest rates in the first half of 2022 precipitated a net loss of (35)% in the fund’s portfolio - a bit worse than the (32)% decline of the NASDAQ. Most of this loss occurred before the fund opened to outside investors.
During Q4, the fund delivered a 3.5% net gain even as year-end tax-loss harvesting and investor risk aversion weighed heavily on many of our core holdings. Throughout Q4 we harvested losses and invested the proceeds into the most beaten down sections of our portfolio (semiconductors, software, and communication services). We also took advantage of fair valuations and weak commodity prices to initiate a handful of positions related to hydrogen power, a technology that is starting to ramp into large-scale commercialization and may see a sevenfold increase in production capacity by 2030.
Going forward, I expect inflation to recede to tolerable levels in 2023, though US interest rates may remain elevated for several quarters. Wild bursts of short-term price appreciation in our holdings may occur on speculation of interest rate cuts. One of these bursts will eventually prove durable, which is why we firmly believe that attempts at market timing are unproductive, especially with so many economic forces in flux.
We continue holding 10-20% cash in order to seize opportunities that arise. The next 18 months may be sluggish for our portfolio, but we expect it to outperform broader markets over the next several years as our investments transform large swaths of the economy. The fund holds excellent businesses rising on secular trends. Most have the cash to survive a multi-year recession and they will grow more focused and efficient in tighter economic conditions. I think many of our investment themes, such as global climate change and the rise of AI in the workplace, are close to inflection points that will drive outsized profits sooner than current valuations suggest. I will not pretend certainty about near term outcomes in this noisy economic environment, but I see clear signals for the foundational trends underlying our portfolio. I am confident the recent downturn will prove a blip in the long term growth of our holdings.
Nicholas Carpenter,
Manager, NJC Capital Management LLC