Investment Commentary Q4 2022
2022 turned out to be one of the most difficult years on record for investing. This is largely due to both stocks and bonds generating negative annual returns, an event that occurs infrequently. A traditional 60%/40% portfolio invested in the S&P 500 and Bloomberg US Aggregate bond index would have lost 16% last year, one of the worst performances in recent decades.
For the calendar year 2022, the S&P500, Nasdaq, Russell 2000 and TSX Composite returned -18%, -32%, -20% and -6%, respectively, while the Bloomberg US and Canadian Aggregate bond indices were down -13% and -11%, leaving investors with few places to earn positive investment returns.
Inflation and rising interest rates were the main drivers of negative market performance. Investors have benefited for more than a decade from low inflation and loose monetary policy after the Great Financial Crisis of 2008, however the disruptions brought about by the global pandemic, and most recently the war in Ukraine, finally broke the status quo this year.
At least for the foreseeable future, it is clear we will be operating in a different investment environment. The upside to a higher interest rate world is that income-oriented investments including corporate bonds, private debt, publicly traded real estate investment trusts and value-oriented, dividend paying stocks have become more attractive. On the flipside, we have already seen that investments in growth-oriented companies, particularly those with low quality, unprofitable business models, will be challenged. Indeed, valuations for these types of publicly traded and venture-capital backed, private companies have already declined by 50% or more in some cases.
We think the outlook for private real estate and private equity in general is a bit more nuanced. Returns from private real estate will depend heavily on the timing of future asset acquisition or development, geography and subsegment. Investors in some historically popular areas like multi-residential apartments could experience their first unrealized losses in decades if required income yields (i.e. capitalization rates) increase from their historically low levels at a faster pace than rental income.
The story in private equity is likely to be similar. Opportunities will undoubtedly emerge in certain segments allowing astute investors to take advantage of lower earnings multiples and purchase prices on new acquisitions. However, valuations for existing investments, especially in some of the frothier segments of the market like venture capital, may decline.
As we have mentioned in previous reports, if the economy goes into recession in 2023, it will be the most anticipated recession in recent memory. While recessions are impossible to predict, it is worth noting that the stock market typically bottoms out and rebounds well in advance of a recession ending.
Since 1931, there have been 17 years in which US GDP declined and the S&P500 has actually increased in 13 of those same years. As shown in the chart, the probability of negative performance in the year before a GDP decline is actually much higher; the S&P500 declined in 12 out of 17 years prior to a year in which GDP declined, suggesting that the stock market reflects negative macroeconomic conditions well in advance of their occurrence (a situation that could resemble 2022 assuming GDP declines in 2023). In any event, the historical data does not necessarily offer any firm conclusions beyond suggesting that timing stock market investments based on expectations for a recession is a difficult game.
Relative to the broader stock and bond markets, Bridgeport’s portfolios performed well in 2022. Bridgeport’s three Equity Funds and High Income Fund all earned better returns than their relevant benchmarks and our private asset funds generated positive results, helping to offset losses in stocks and bonds.
Bridgeport Canadian Equity Fund took advantage of market volatility in the fourth quarter by adding to investments in Allied Property REIT and Colliers International. Despite their stock prices selling off on negative real estate market sentiment, both companies are high quality enterprises that can grow their businesses through a full economic cycle. We also initiated a position in Bank of Montreal during the quarter as we like its US growth strategy, attractive valuation and the positive fundamentals of the Canadian banking environment. Lastly, the Canadian Equity Fund invested in Saputo, a global branded dairy processer with a strong US market position.
Bridgeport Small & Mid Cap Fund had seven completed (or pending) takeover offers for companies in the portfolio during the year (representing about 25% of the fund’s total holdings). Takeover premiums paid for these stocks mitigated losses in other investments and helped the fund to significantly outperform the Russell 2000 small cap index. We believe this level of takeover activity is a strong indication of the quality of companies in the portfolio and the extent to which they were undervalued. Takeovers during the year included Intertape Polymer Group, LifeWorks, Points International, Switch, Twitter, Summit Industrial REIT (pending) and IAA (pending). Additions to the fund in the fourth quarter included Global Payments, a top tier supplier of payment processing and software solutions for small and mid-sized retailers, and Watsco, a leading distributor of HVAC equipment in the United States.
During the fourth quarter, we added shares of Fiserv to Bridgeport US Equity Fund. Fiserv provides digital banking solutions, payment processing software and owns the Clover point-of-sale software platform. We also increased the fund’s position in Walt Disney as its stock price had sold-off on poor quarterly results, creating an opportunity to increase our investment in a company with irreplaceable assets we think are being undervalued by the market.
Bridgeport High Income Fund had a rare down year in 2022. While significantly outperforming the broader bond markets, the fund suffered unrealized losses on its fixed income investments as a result of higher interest rates and rising bond yields. As mentioned in our last report, the good news on a go forward basis is that the fund’s income yield has increased significantly and there are more opportunities to earn higher returns from bonds, potentially making this one of the most attractive times over the last decade to be a fixed income investor.
Bridgeport’s three private asset funds all contributed positive investment performance to client portfolios last year, mitigating overall volatility. Bridgeport Alternative Income Fund, Private Equity Opportunities Fund and Private Real Estate & Infrastructure Fund each continued to scale their investment programs and diversify into additional private asset strategies. New allocations in 2022 for these funds included: (i) income-oriented strategies focused on various types of private corporate lending, agricultural finance, auto finance and structured private asset finance, (ii) private equity strategies focused on special situations, middle market buyout, the insurance industry, direct co-investments and secondary fund investments and (iii) real asset strategies focused on various types of real estate and infrastructure asset ownership such as industrial, medical office, self-storage, single family homes and digital, transportation and energy infrastructure.
Regardless of the macroeconomic environment in 2023, we remain positive about the collection of investments in our portfolios. The common element among all our pooled funds is that they focus on investing in assets that generate significant cash flow, are well-managed with strong competitive positioning and are reasonably valued.
We wish you all the best in 2023. As always, please feel free to reach out with any questions.