Performance across the stock market in the third quarter could be summed up in single sentence: interest rates went up, and stocks went down. In our Q3 letter to clients, we wrote that “rising interest rates created some short-term volatility in equity markets, but our companies held up well, and the quality of earnings we have in the portfolio allowed us to outperform on the downside.” 

Rising interest rates created some short-term volatility in equity markets, but our companies held up well and the quality of earnings we have in the portfolio allowed us to outperform on the downside, in our view.

We’ve now arrived at a time when earnings are expected to accelerate to the upside in the coming months, with continued earnings growth in 2024 as margins rebound after a period of softness.

A central theme of last quarter’s letter was how generative artificial intelligence (AI) could drive the next productivity boom.

The earnings implications over a short span of time is nothing short of astounding. So naturally our next question was, which companies are positioned to profit most in the immediate term from the proliferation of this revolutionary new technology?

To find out, we got on an airplane and went to Silicon Valley.

The failures of Silicon Valley Bank and Signature Bank New York—as well as UBS’s takeover of Credit Suisse—dominated financial news headlines in the first quarter. In our March 21 letter to clients, we framed the risk of financial contagion as very low. Our analysis at the time pegged the US banking system as extremely well-capitalized, with Tier 1 capital ratios at very solid levels and loan-to-deposit ratios at almost their lowest levels in 50+ years. 

We still hold these views.

We will continue to favor companies that tend to traditionally be seen as value stocks, which just means they have strong financial positions, resilient earnings, elevated free cash flow, and above all, are attractively priced. A lot of times, that just means ‘boring.’

We also know that bull markets tend to start when economic conditions reach a low point, and when earnings are weakest but then start to rebound. That’s why we’re also looking out in 2023 for opportunities to reposition for growth and back into a more pro-risk categories, i.e., fulfilling our mission as genuinely active managers.

Stocks opened the third quarter on a strong note, but largely because investors grew too confident that the interest rate cycle was nearing a peak. WestEnd’s portfolio responded strongly to the upside during the rally, which effectively gave us a preview for how our portfolio would respond during a sustained market rebound.

The stock market’s -20% decline in 2022 arguably means a good deal of negative data and news has already been incorporated in current prices. Our goal now is to own companies we believe can generate solid earnings even in challenging economic conditions, and to remain positioned to capture upside before it becomes clear the economy will regain its footing—which we are confident it will.

U.S. and global stocks started the new year on a volatile note. The first half of Q1 was spent pricing-in the impact of rising inflation, rising interest rates, and the economic toll of Russia’s needless war in Ukraine. From January 1 to the invasion on February 24, the S&P 500 index declined -11.3%. The Nasdaq, small-cap stocks, and global stocks all fell further.