Bull Run Investment Management

2021 Year End Review.

Broad MarketRecap 2021:

2021 last yearmarked one of the best years for value, cyclical, and defensive stocks in thepast 2 decades. Notable value sectors such as Energy (XLE) and Financials (XLF)were up 44% and 30% respectively for 2021, while the United States Commodity Benchmark(GSCI) was up 36% for the year. The majority of the expansion we have seen inthe share prices in these groups of stocks are the result of expandingvaluations, not expanding earnings. Historically bank and energy stocks (amongother similar value sectors) trade around 10x earnings. The reason for this isbecause banks have tons of regulations, credit risk, and limitations that alltogether limit their growth potential. Energy stocks have low price to earningsmultiples (P/E) because oil, shale, and natural gas is a dying industry thatvery likely won’t be around in the next 20 to 30 years when renewable energysolves the world’s problems with limited access to raw materials and pollution.Over the past 18 months or so, we have seen valuations in these stocks expandfrom 10x earnings to current levels between 15x and 22x earnings. In fact, rightnow many of these stocks are hitting record highs in valuation – whichhas helped increase the valuation of the overall market as well. On the otherhand, stocks that historically trade above average 20x price to earningsmultiple of the S&P 500 include internet software, entertainment software,application software, semiconductors and non-bank financial services,which typically trade at PE’s of around 35x to 45x. The reason for their aboveaverage multiple is due to higher than average net and gross margins (helpsretain profitability during recessions), and their higher than average earningsgrowth rate due to secular long term growth trends in their industries. Thereis another element of management that plays into valuations as well. Typically,you find some of the most intelligent and brightest minds in today’s world (orat any point in history) find themselves at the forefront of innovation, theyare the ones who take responsibility and action, and they are the ones who maketheir vision to pioneer and change the world for better into a reality. Theseinventors and entrepreneurs quite publicly display their vision and tenacity toinnovate and grow, commanding a higher P/E ratio than companies with badmanagement teams. Today, nearly all of the top 10 Ivy League graduates aregoing to work for the best companies in Cloud Software and Computing, MachineLearning, Fintech, E-Commerce, AI and Blockchain, etc.

In the paragraphabove I mentioned how value stocks have just seen the largest expansion inmultiples in the past two decades. Recently expanding multiples in value stockshave risen as much as 80% or more, while price to earnings multiples in otherareas of the market have expanded around 20%. Earnings on the S&P 500 haveonly gone up about 15% since January 2020, while the index itself hasseen a 45% rally since then, hitting recent all time highs. The reason theS&P 500 is up 45% since then is not because the 500 companies aremaking 45% more money (they are only making 15% more) but because investors aresimply willing to pay more for those earnings. The price to earnings ratio isused to calculate the value of the S&P 500. It’s the multiple thatpeople are willing to pay based on how much the index has earned per share. Forexample, the S&P 500 is earning about $162 per share as of today, multiplythat by 29 and you get $4,968 per share – several points off the index’sclosing value of $4,677 today. As I mentioned above, the S&P historicallytrades at 20x earnings on average. Had we been trading at our historicalaverage of 20x right now – the index would only be worth 3,240. This is why P/Eis so important – it’s exactly what determines the price of the Index. As youmay know, timing what this number will be at any given point in time is verydifficult to do. Another important valuation metric to look at is the “Price toSales” ratio (P/S). This valuation metric is required to analyze fast growingbusinesses like Amazon or Netflix. For well over a decade, both of thesecompanies were losing money quarter after quarter, year after year, generatingnegative earnings. So – what do you value a company like that at, $0?  Of course not, so instead of valuing thecompany on earnings, investors instead value the company on total sales(revenue). For example, a company with $1 Billion in annual sales trading at aprice to sales ratio of 3 has a market cap of $3 Billion dollars. Another wayof saying this is, “The company trades at 3 times sales”, instead of “Thecompany trades at 20 times earnings”.  

Below is a snapshotof the following for the S&P 500: (1) the P/Eratio (price to earnings),(2) the EPS(earnings per share), and next page (3) the P/S ratio(price to sales) going all the way back to 1880. As you can see, the market hasnever been this expensive before aside from elevated levels after the 2000recession and 2008 recession in order to price in future earnings upon theeconomic recovery (see pullback in earnings on graph 2). Meaning in 2008, whenthe P/E went above 65, it was because investors knew there would be a2-3x increase in earnings over the next year (see chart 2 - 2008). Currently,there is not going to be an increase in earnings of that magnitude overthe next year. Wall street estimates earnings to grow by only 9% in 2022. Thereason I bring up this discussion on multiples is to show you what’s going onwith multiple expansion in the market. Sure it does look scary, but statisticsshow after years like we had this year, history points to another great year ofdouble digit-gains for the market. Take a look at 2003, where the P/E spiked toalmost 45. Buying the S&P at that time would have produced a 6x return oninvestment as of today, just over 10% annualized.

What we find fascinating about the market's movementsis the concern of rising interest rates and inflation, which began in Februaryof last year. In most cases, the market responds to these anxieties bycompressing rather than extending its multiple (see early 1980s). Given thenearly 50% increase in the Price to Earnings ratio, and an even greaterincrease in the Price to Sales ratio to record levels, we find it fascinatingthat the market essentially singled out our stocks and went after high-qualitygrowth stocks, while expanding valuations in every other area of the marketduring "fear of rising inflation." This (the gap) does not make senseto us (or many other skilled investors).

For more informationon this for those interested in later readings, see here.

We strongly believe in the companies we own inour Growth Portfolio. The particular ones we own are the highest quality and areat the forefront of innovation. They are involved in the fastest growingsecular trends the economy will experience over the next decade. They are runby some of the most professional management teams on Main Street. They continueto prove their expansion and growth quarter after quarter posting mind-blowingrevenue growth rates well beyond every single company inthe S&P 500 index over the past 5 years. They have incredible economic motesand durable competitive advantage, producing Gross and Net margins higher thanevery industry on the planet.

We have seen multiples in our part of the market collapseanywhere from 50% to 90% from their all-time highs during a period of growingvaluations throughout the wider market to record levels. While this is true ingeneral, it is not true for all growth companies, such as NVDA, AMZN, GOOG, andFB. When it comes to the ones that have plunged to the levels mentioned above,we haven't seen values this low since the Tech Bubble. The difference betweennow and then is that the firms in which we have invested have nearly doubledtheir revenue since the beginning of 2021, avoiding the calamity that occurredduring the Tech Bubble crash. Furthermore, our businesses are not insolvent,but rather are seeing rapid revenue growth. Some of our equities have contractedat a faster rate seen during the Tech Bubble, while others have contracted to alesser degree at a slower rate. However, on average, we are quite close tobottom level valuations seen during the bottom of the Tech Bubble. As a result,we think that right now provides a multi-year opportunity for our growthcompanies to deliver above-average returns.

(Below – the P/S for the S&P 500breaking out to an all time high – while nearly the opposite has taken place ingrowth)

I would like to provide a bit of background on theaverage P/S valuations for the industries we are invested in, and where we havecome from since our peak. For comparison’s sake, above is a chart of the P/SRatio for the S&P 500 over the last 20 years. I’m also going to talk about GrossProfit Margins and Net Profit Margins for the companies we are invested inour Growth Portfolio. The reason I’m going to talk about gross margins, and P/Sratios is because that’s the best way to value our growth companies today, andthe best way to understand how profitable they will be when they stop growingand enter maturity in the future.

To begin with, growth valuations peaked back inFebruary of 2021. As a ballpark estimate, the P/S back during this time for ourGrowth Portfolio was around 18x sales – definitely above historicalaverages. Currently right now, the average P/S ratio for our portfolio hasdropped to 8.01x, representing a decline of over 50%. Many stocks we own nowthat have gone public after the tech bubble are trading at historical all timelow valuations. On the next page you will find some information showing thebreakdown of P/S multiples by industry along with Gross Profit Margins.

Valuation Metrics:

Above is a screenshot from an interactiveweb program I use to analyze different profitability metrics byindustry. On the top left you can see Profitability Margins for all 7,247 publiclytraded companies (not just the S&P 500) in the U.S. The average GrossMargin for all of these companies is 37%, while the average Net Profit Margin is8%. On the bottom left I used the dropdown box to showcase the Software(Internet) Industry, which consists of 305 companies. I had to scroll all theway to the top on the right to display the industries we have exposure to, whichare the ones I’ve highlighted. The Software (Internet) industry shown has Gross Margins of 67% and NetMargins of 24%. Gross margins are vital in determining net profit margins incompanies at terminal growth. In the case I've shown, and in most otherindustries we're exposed to, Net Profit Margins are roughly 1/3 of Gross ProfitMargins. So, in this case, a 24% Profit Margin is just over 1/3 of theindustry's 67% Gross Margin (Software – Internet). These companies oftenoperate on subscription models, host ads, charge platform fees, etc., all ofwhich lead to very low fixed infrastructure costs and physical footprint,leading to very high improvements in bottom line margins. Down from #1 Tobacco,is #2 Financial Services (Non-Bank). Non-bank financial services include creditcard processing and payment companies like MasterCard, Visa and PayPal as wellas Fintech firms such as Square. Noting from the chart above, non-bankfinancial services firms have even higher net margins (26%) vs (Software –Internet) net margins of 24%. These two industries I’ve showcased are 3x moreprofitable than the market average of 8%. This image is significant because itdepicts the mar        ket's average GrossMargins and the industries where our growth stocks excel. It also shows theaverage ratio of Gross Profit Margin to Net Profit Margin (1/3) for theindustries highlighted above.

Below is a table from excelshowing (1) The average Gross Profit Margin for the stocks in our Growth Portfolio(2) The average estimated future Net Income Margin for the stocks in our GrowthPortfolio (3) The average P/S ratio for our portfolio, (4) The average P/Sratio for the industries the stocks in our portfolio belong to (highlighted inyellow). Lastly, at the bottom, I’ve added in our portfolios expected salesgrowth (direct from Schwab) of 77% annually. For this analysis we shouldanalyze the entire growth Portfolio (the averages) as if it were just onestock. Looking at the numbers, we can see the portfolio is producing, today, grossmargins of 59% – well above the 38% average for the market. Using the ruleof (1/3) we looked at earlier, we can now estimate what Net Income Margin ourportfolio will produce upon reaching terminal growth, which comes out to a 19%Net Income Margin. This is well above the market average of 8%. Looking atthe list on the right-hand side of the screenshot, We can see what the averageP/S our industries are valued at, which turns out to be well above the 3xmultiple for the S&P 500. Because these companies are (1) much moreprofitable than average, and (2) have higher P/E ratios in the 35x to 45x range,they are among the highest P/S industries in the market. You can see #1Financial Svc’s (our FinTech’s), where the Industry has an average P/S Ratio ofa whopping 31.49. #2, Software and internet stocks, have a P/S Ratio of 15.67,Semiconductors at 7.16, etc. If you take the average of all 5 highlightedgroups, it comes out to an average P/S Ratio of 14.86x. I mentioned at thebottom of page 3 in this newsletter that at the beginning of this year inFebruary, our portfolio was trading at almost an 18x average P/S Ratio – aboveaverages. Currently, as you can see in the bottom left, our left, our P/S Ratioas of today is sitting at just 8.0x. These numbers were calculated roughly oneweek ago, as of January 5ths 2022 close, this number is closer 7.2x).  

Now we have a lot of information to work with. If weknow the average P/E ratio our portfolio should have upon terminal growth,along with the Net Income Margin our portfolio will be producing, then we cancome up with some exact figures on market capitalization numbers at variouspoints in the future. We can also do some easy math to see what the P/S Ratiowill wind up at as well.  

To make sure we are all onthe same page – I would like to quickly explain why and how the terminal P/SRatio for our portfolio should be 6x or higher. For easy math purposes, let’sassume at terminal growth, the Growth Portfolio will have an average Net IncomeMargin of 20% (rounded from 19%). Our portfolio should trade at an industryaverage P/E Ratio of 35x upon terminal growth – but to be conservative – wewill assume our high quality, well above average margin portfolio tradesinstead at the S&P 500 market multiple of 30x. So our two variables are (1)20% Net Income Margin and (2) 30x P/E Ratio.

All we have to do now isselect any amount of Revenue for the portfolio, let’s use $1 billion dollars inannual sales for simple math purposes. Now we have as follows: $1 Billion inSales * 20% Net Income Margin = $200 million dollars in Net Income. Step 2:$200 million dollars in Net Income * 30 (P/E Ratio) = a Market Cap of $6 billiondollars.

Lastly, we cannow take the $6 billion dollar Market Cap and divide it by $1 Billion in Salesto calculate what the P/S Ratio of the portfolio will be upon reaching terminalgrowth – which comes out to 6x P/S. To determine this number atterminal growth, the two dependent variables are Net Income Margin and P/ERatio. For example, if margins were 30% instead of 20%, then theportfolio’s average P/S would be 9x, instead of 6x.

We stronglybelieve in these numbers. Our most profitable companies already have Net IncomeMargins at 50% and higher. In addition, we expect further improvement in GrossMargins beyond current levels. Lastly, we expect our portfolio to trade in linewith industry average multiples, above the average for S&P 500.  

To providejust a bit more info on P/E’s before so we can wrap up and move into the fun,I’ve attached 4 graphs as of todayof P/E ratios in the sectors we talked about. (Take an average of both lines toget a good sense of the current P/E).

Fundementals

Below is my favorite part ofthis newsletter, and contains two screenshots from excel: (1) Our ExpectedAnnualized Return as of February 2021, when our portfolio was at 18x P/S, and(2) Our Expected Annualized Return as of Today, when our portfolio is currentlyat 8.0x P/S.

The two tablesbelow contain simple values to work with for our Growth Portfolio for thepurpose of projecting share price growth based on the metrics we outlined anddiscussed above. The columns contain Revenue (in Billions), P/S Ratios, andMarket Cap (based on the P/S Ratio). The rows contain years, with “Today” beingthe starting point. In Year 1, Revenue is assumed to grow at 70%, declining 10%sequentially each year until hitting its terminal growth rate of 15% in year 7– following the trajectory of typical innovative growth companies and trends. (Pleasenote – the table shows all 10 years of projections, but the chart displays onlythe first 5 years)

In the table below (February 2021 Projections),you can see beginning revenues of $1 Billion starting “Today”, a P/S multipleof 18x, giving us a simulated market cap of “$18 Billion”. This Market Cap isessentially the initial investment value, or cost, for the portfolio. At thebeginning of last year 2021, we expected that value would grow from $18 to $22,representing about a 22% annual return for the year. Obviously, we underestimatedcontractions in multiples and ended the year slightly in the red. You can seeon the bottom left in bold, 3 different timeframes showcased for annualizedreturns projected at this time – 3, 5, and 10 Years. Given the conditionspresent at the time, over the next 3 years we expected to generate annualizedreturns of 26.83% based on these projections. This works out to exactlya 100% return over the 3 year period – doubling the portfoliosvalue. Over the Next 5 years we expected our portfolio would annualize 23.63%,just under tripling in value, generating a 5 year total return of 188%.You can see the 10-Year expected annualized return at the time of 17.91%.

Notice how over time, theP/S multiple (in Orange) falls rapidly from 18 in the beginning until it beginsto slow down towards year 3 and eventually peters out to 7 in year 5?Meanwhile, revenues (in Blue) have grown from $1B to $7.4B over the same 5 yearperiod that the multiple was being compressed. This increase in revenue welloffsets the 60% decline in valuation over the period, leading to positivereturns. Finally, (in Grey) is the Market Cap for each year. It’s interestingto see how it reflects the relationship between the two variables, and providesa good depiction of what it’s like behind the scenes when investing in stronggrowth stocks.  

At the beginning of February2021 (Graph 1 above), our Growth Portfolio was in a very similar standpoint asit is today with respect to interest rates, revenue growth, and margin growth. Today,our average sales growth rate is about the same as where it was in February. Atthe beginning of last year we expected fabulous revenue growth (which happened)but also expected a severe decline in valuation. We were expecting a decline invaluation to the tune of 30% by the end of the full year. This happened, but toa tune significantly more substantial than we expected – where we witnessedalmost a 60% decline in valuation. Combining these 2 factors together,they canceled each other out a bit and we wound up closing the year 2021 down-7.20%.

Below is the same table asabove, except with updated numbers for the start of Today (January 2022Projections). Year 1 reflects the start of 2023. I mentioned earlier inthis letter, our sales growth estimated by Schwab was 77.71% as of yesterday,Jan 5th 2022. In this example, we use the same logic with 70% initial growth, aswell as the same sequential declines. Notice though – the price to sales ratio– that’s much different. Instead of starting this year at 18x like we did lastyear, we are starting this year at a very comfortable 8x. Given the sameexpectations in growth, and the proven ability to generate such growth asdemonstrated fundamentally over the last year, given our current and futuremargins expectations remain relatively the same – we expect this year and thenext several year to offer substantially above average returns for thegrowth segment of the market, particularly the stocks we hold in our GrowthPortfolio.

Looking at the P/S column year by year, we are notprojecting a drastic 60% decline by the start of 2022 like we experienced lastyear. (It’s actually possible valuations could potentially pop this year giventhe large decline last year). However, sticking to our guns as always we liketo plan for the average of history to repeat itself over time, and therefore weare expecting a small decline next year to 7.8x sales, declining by 0.2 eachyear until it ends at 6 in year 10.

Given the conditions today, we are now expecting overthe next 3 years to potentially generate annualized returns of 55.69%based on these projections. This works out to a 270% return overthe next 3 year period – over tripling the portfolio’s value from where it istoday. Over the Next 5 years, these projections imply a 45.39%annualized return, and 27.87% annualized return over the next 10 years.Cathie Wood, who runs a more aggressive, early growth stage portfolio, ARKK, isthe #7 ETF over the last 5 years, annualizing some 37% over the period. She isregarded as one of the most successful investors of all time. Recently in midDecember, she came out and made similar comments on her portfolio as to herexpectations now versus in February. She publicly said in December that sheexpects a quintupling in her portfolio over the next 5 years,representing a 40% annualized return. These expectations above are simplybased on projections. If these projections do happen, we willreceive these results. If these projections fall significantly short and weonly obtain half of the returns noted above – we would still be greatlysatisfied with those returns.

Based on where we arestarting from today, we are starting the year with a massive increase in marginof safety as compared to last year. Even if valuations get slashed by 30% thisyear – (we don’t think they will be) – we would still be likely to close outthe year with over a 20% gain given the massive increase in revenues that willbe generated over the next 12 months. Instead however, we are expecting, truly,one of the best 3 to 5 year investment horizons for these groups of stocks in avery long time. Throughout 2010 and 2020, these secular growth trends were onlybeing developed, during that time these businesses still offered the bestreturns across the market up until today. Over the next decade into 2030 – weand other professionals are expecting these trends to only accelerate uponthemselves. The advancements in infrastructure, computing, growth in 3^rdworld countries, are all allowing these industries to flourish and developthemselves into some of the most powerful and innovative businesses the worldhas ever seen.

Theadvancements in computing power we are seeing in the chip industry(particularly by Nvidia) are growing so fast to the point where we haverecently broken Moore’s Law several years ago. Computing power for artificialintelligence increased 300,000x between 2012 and 2018. By using AI in synergywith GPUs, many of the top semiconductor companies are now growing faster thanwas ever thought possible. Within the next 2 to 3 years we are expected tounveil the world’s first fully functional quantum computer, operating at 0° Kelvin. Using these technologieswill lead to new S curves building upon new S curves, and will lead to newindustries that were only thought possible in science fiction – such as themetaverse, breakthroughs in genetic engineering, driverless cars, etc.  

Technicals

I’d like to provide a bit ofTechnical analysis and review of last year 2021 in the disruptiveinnovation/growth area of the market, which is best to compare our growth portfolioto. While we’re not happy with our -7.2% return for last year, we are quiteproud that it fared far better than our competitors in this space. Nearly everyETF in this segment of the market realized double digit declines for the fullyear, all of which underperformed our portfolio substantially in 2021. Below isFull Year 2021 Performance for the S&P, ARKK, TAN, IBUY, WCLD, and FINX.Akkk = Disruptive Innovation, Tan = Solar Energy, Ibuy = Online Retail, Wcld =Cloud Software and Computing, Finx = Fintech. (blue arrow points to returns)

In 2021, out of all of high growth/innovation ETF’slisted above, the only one that outperformed our portfolio last year was WCLD –with a -3.21% return. ARKK, the #7th best fund out of all 1600+ equityETF’s over the past 5 years (as of this writing) closed theyear down -24.02%, while the other ETF’s representing our exposure closed theyear in the -20% range as well. Last year we increased the active managementside of the portfolio heading into late spring up until November, this helpedus generate alpha with shorter term trades and positioning, buffering a lot ofthe downside we experienced in our longer term, core positions. Moving into thefirst quarter of 2022, we’re quite pleased with our current positioning anddon’t believe such levels of shorter term trading seen during the mid-half oflast year will be required to outperform the market heading into the firstquarter of this year. Please take note of the chart on the right (linked above),which shows the top 10 Funds over the past 5 years, ALL of which are growth ETF’s.Over the past 1-Year, the average return for this group is just about flat.

Wrapping up with technicals, I’d like to share the chart above as I believethis picture is worth a thousand words. In the bottom right hand of thescreenshot you will see -37.67% in black, which is ARK’s 1-year return as of January6^th, 2022. The darker blue line on the bottom is known as “ROC”, or“Rate of Change” and displays on any given day, ARK’s 252-trading day return,(or 1-year return for simpler language). See at the beginning of 2021 how thisnumber hit a shocking some 220% return – over just 1 year. Notice the orangevertical lines on the chart. Remember how I said ARK’s 1-year return as oftoday’s close is -37.67%? Well – that has never happened in the entirehistory of this fund dating back to 2014. On March 18th, the bottom of theCoronavirus pandemic, ARK’s 1-year return bottomed at -26.16%. Duringthe beginning of 2016, when the market was on the verge of entering an earningsand manufacturing recession, ARK’s 1-year return bottomed at -29.43%. Ifyou zoom in and zero in on the numbers, and then project 252-days later afterthese events occurred, you would be pleased to find some impressive numbers.Buying at the lows in February of 2016 would have generated a return of 53%over the next 12 months. Buying at the lows in March of 2020 would havegenerated a return of 246% over the next 12 months. On average, buying ARKafter these 2 events and holding for the next 12 months would have produced anaverage return of 149.5% over the next year. Are we saying to expect a150% rally in our growth fund next year? Of course not. Is it in the realm ofhistorical probabilities? Of course. As we all know, past performance is notindicative of future results. However, analyzing history and paying attentionto extreme events on either side of the market, and analyzing outcomes based onthose events can give us a clue of what’s more likely than not to expect in thefuture.

Hedge Funds

You may be wondering whatthe smartest Portfolio Managers on the planet are doing in their portfolios.From publicly accessible Hedgefollow.com, I’ve added a screenshot of the Top 20hedge funds over the past 3 years by annualized returns. Keep in mind – hedgefunds don’t subscribe to any particular strategy – they can practically buyanything under the sun. Some are Long-only, Some are Long/Short Managers, someare Macro Managers, some are Quant Managers, Some are Options and Arbitrage Managers,etc. No matter the Managers style though, they have a large amount of leniencyin their holdings month by month. Nearly all top hedge fund managers over thisperiod who generated such outsized returns in their portfolios happened to beLong-only managers that did so by owning the same stocks we own in our GrowthPortfolio. Unfortunately, you can’t copy these Portfolio Managers every day.These positions are reported at the end of every quarter, but you need to wait45 days after the end of the quarter for that info to be released – and thenanother 45 days after that to get the next report (that will be 45 days old). Ihighlighted Jorge Paulo’s portfolio below (36.32% annualized for 3 yearsstraight – pretty good). Take a look at some of his top holdings. 45% isin CVNA, SE, and SQ… talk about volatile, but not too shabby with thosereturns. I encourage you to visit thiswebsite and check out what some of these Portfolio Managers areholding. Most are in the same positions we’re in. Our annualizedreturn since inception is well in line with the list below. In fact, the #1manager on the list has 96% of his portfolio in Sea Ltd (NYSE:SE), a stock inour Growth Portfolio.

To wrap up the discussion on these Top 20 Hedge FundManager’s positions, I’d like to provide Wall Street Analyst’s 12 Month pricetarget for every position we hold in our Growth Portfolio. Looking at theseprice targets and seeing the distance current levels are from Analyst’s targetscan help provide some understanding (including other reasons) as to why all ofthese managers are holding these positions right now.

On the right hand side is a table showing allpositions currently held in our Growth Portfolio as of January 5^th,2022. In the second column is the current price these stocks are trading at,while in the third column are Analysts’ average 12 Month price targets. In thelast column is implied, or calculated upside (over the next 12 months) based onthese price targets. Finally, on the bottom right is the average of allpositions in our portfolio, which comes out to a staggering 94%. I don’trecall if there has ever been a period (especially not in the past 10 years)where this much upside was expected on a diversified portfolio of growthand technology stocks. Take a look at the bottom – where our big 4 techpositions have just over 20% upside. This is a relatively normalprice target for these companies, throughout the past 10 years this level hasoften been the average target, and likewise these positions have compoundedannually at similar levels (20%). However, almost half of the positions in ourportfolio have an average price target set by Wall Street that is over2x the current price of the stock. On the top of the lists, analystsaverage’s are nearly projecting them to triple in Value.

To put all of this inperspective – the average price target set by Wall Street Analysts for theS&P 500 – is right around 10% (give or take a percentage point or two). Iwill reiterate – Around 20% to 30% upside in a portfolio of stocks like this isa relatively normal target set by Wall Street year after year. As I’vementioned, I have never seen such targets remotely this high before, and islikely one reason so many Hedge Fund Managers are loading up on them right now.

Interest Rates

There has been so much fearand discussion of inflation and interest rates in the stock market over thepast 18 months, and the fear has persisted albeit without any negative impactsto the market (aside of course from the attack on growth we talked about inpage 2). I would like everyone to understand some basic relationships betweenhow interest rates affect the stock market and how they impact the present valueof future cash flows.

I’d like tostart with a quote from Warren Buffet, “For inflation acts as a giganticcorporate tapeworm. That tapeworm preemptively consumes its requisite dailydiet of investment dollars regardless of the health of the host organism.Whatever the level of reported profits (even if nil), more dollars forreceivables, inventory and fixed assets are continuously required by thebusiness in order to merely match the unit volume of the previous year. Theless prosperous the enterprise, the greater the proportion of availablesustenance claimed by the tapeworm”.

And one morefrom Warren, “Companies that, through design or accident, have purchasedonly businesses that are particularly well adapted to an inflationaryenvironment. Such favored business must have two characteristics: (1) anability to increase prices rather easily (even when product demand is flat andcapacity is not fully utilized) without fear of significant loss of eithermarket share or unit volume, and (2) an ability to accommodate large dollarvolume increases in business (often produced more by inflation than by realgrowth) with only minor additional investment of capital. Managers of ordinaryability, focusing solely on acquisition possibilities meeting these tests, haveachieved excellent results in recent decades. However, very few enterprisespossess both characteristics, and competition to buy those that do has nowbecome fierce to the point of being self-defeating.”

What Buffet is saying in thefirst quote is that regardless of the level of operating profits a businessproduces, inflation affects all businesses equally. More is required of everybusiness to match the same standards they did last year in unit volume. It maylook like the business is doing ok by reporting increased sales for example,but behind the scenes they could be withering away or under pressure andactually selling less units and producing less than they were the yearprior – even though it may look better on paper. He finished by saying thepoorer the business is with respect to growth and future prosperity – the moreinflation will hurt that business.

In his second quote, Warrenis simply declaring in the first sentence that some Companies are (byaccident or not) simply operating a business (or multiple business arms) thatfare particularly well against the headwind of inflation. He goes on to say thebest two qualities a business can have to fight inflation is (1) aneconomic mote and pricing power, and (2) easy and rapid ability to scalerevenue growth without high increases in variable costs.  

It’s the casethat our Growth Portfolio very well encompasses these traits that Warren listedin the second quote, and surely avoids factors he listed in his first quote.

When inflationpicks up, interest rates tend to pick up as well. When this happens after aperiod of calm for a long time, it can cause a large spike of volatility in thestock market. There are different reactions every time. Last year the reactionwas from a scare in “unprofitable” growth companies and a flocking towards“value” stocks. Was this move based on logic by discounting the future cashflows of all business over the next 5, 10, 20 years? No, it was not based onthat. I can spend the next 3 pages going into the math on this but I’m prettysure most readers would rather be spared of that. What it came down to was thefact that value was simply underperforming (awfully) the broad market, not justgrowth, over the past 15 or so years. Last year’s inflation and interest ratewoes, along with a rapidly changing and fragile economy, were enough catalystsfor people to change their outlook on cash flow generation from the next 3 to 5years or so to the very next year. Now, if the market decides over severalmonths to change its investment cash flow discounting outlook to all the suddenthe next 1 year instead of the next 5 years, then yes – these growth stocks willlook expensive and “overvalued” if the market is now only valuing anddiscounting the next 1 years cash flow instead of the next 5 to 10 years. Thiscauses a lot of short term volatility but does not affect longterm growth, margins, or multiples. However – interest rates (not inflation), nodoubt do those effect multiples.

Interest Rates – Part2

Below is a long term chart of (1) The10-Year Government Note Yield in Blue, (2) The Federal Funds Rate (FFR) in Red,and (3) Inflation in Purple. (This purple line as of today is currently around5%). The FFR is an interest rate set by the Federal Reserve that determines thelevel of interest rate banks charge on loans to each other to meet regulatorycash reserve requirements. This FFR plays an enormous role acting as abenchmark, or magnate for global interest rates. Particularly in the U.S. – theFFR and the 10-Year Treasury Note yield have very highcorrelation with each other. Specifically – the red line controls where theblue line is going, and inflation follows the trend. For example, the massiveboom in commodities led to a big surge in inflation in the 70’s and 80’s. TheFed was raising the FFR along the whole way in order to combat this rise ininflation as best as possible. When inflation calmed down by the early 80’s,the fed eased on the gas pedal and began lowering rates – effectively bringingdown the 10 year yield with it – as you can see inflation follows. This periodwas a short exception from the majority of history when inflation is not goinggangbusters. Right now, is one of those more normal periods where inflation issteadily tracking the FFR. Ultimately, when the Fed comes out to talk, all theytalk about is inflation, and what they are going to do with theirmonetary toolbox to keep it under control. The Fed has notified Wall Streetthat by the end of 2022 – they are targeting a FFR of between 0.75% and 1.25%.Expectations from Wall Street on the 10-Year Yield is about 2.2%. Currently, weare at 1.5%. Year end inflation targets for 2022 are 3.8%.

Over the past century, global and U.S interest rateson the 10 year timeframe have averaged just about 5%. This basically acted overtime as a foundation for the P/E ratio for the S&P 500. ThePE on the S&P 500 has historically been the inverse of the 10 Year yield.Meaning 100/5 = 20x PE for the S&P 500. This is exactly where the 20xaverage P/E ratio for the S&P 500 comes from. Now – this may offer someexplanation for the market breaking out to peak, all time high valuations. Ihave been claiming for some years that seemingly permanent long term globalgovernment yields below 2% would put increasing pressure on stock marketvaluations. The logic is, if you buy a Treasury Bond at a 2% yield – it willeffectively take you 50 years to earn back your money. So – if it only takesyou 20 years to earn back your money in the S&P 500, and you are gettinggrowth on earnings unlike the T-Bond, then why would you not buy equitiesinstead? With a 10 Year yield of only 1.5% right now, the S&P PE cantheoretically hit as high as 100/1.5 = 66.7. Now I don’t think we will get tothese levels, but I do believe that the S&P will likely be able to holdit’s current PE without much issue. Do you remember back in the early 80’s whenrates were so high? The S&P actually hit a low PE ratio of around 9– showing how impactful bond yields can be on stock market multiples.

For 2022 – if the marketdoes begin to suffer on a P/E basis and the ratio drops below 30, the marketcan still close the year in positive territory depending on the growth ofearnings for the year. While we expect the P/E ratio to remain steady this year,a decline is possible. However, such a decline in the PE would likely be in thewake of advancing earnings.

Part of thereason I believe the S&P 500 will be able to hold a 30x P/E is due to thedirection outlined by the Fed. Below is a chart showing the Federal Funds Rate over the past 10 years. As Imentioned above, the Fed has targeted an FFR of between 0.75% and 1.25% by theend of 2022. We just discussed how important this rate is in impacting interestrates and inflation, so it’s helpful to zoom in and focus on the volatility ofthis metric over the past 10 years to understand how it moves. (The black lineis volume on FFR Futures Contracts that came out in 2016 – you can ignorethat). The bottom line here – is that interest rates are the real burden to marketvaluations, and also play a huge role in how fast companies can grow via thecost of money to borrow and fund growth. The cheaper interest rates are, themore money companies can borrow nearly for free. This turns out to be highlybeneficial to aggressive growth companies.

Newsletter Recap:

To summarize, inflation haspeaked in 2021 and we have been seeing declines in readings heading into thisyear. Inflation will likely not be a big factor of market discussion beyond thefirst quarter of this year. Interest rates are expected to be rising slowly tomoderately by the end of the year, but are not projected to grow much beyondthat and will remain below long term averages over the next 12 months. Whilemultiples have hit record highs in recent months across broad markets, this islikely sustainable given negative real yields on bonds as investors havelimited options to generate positive real returns.

To summarize,for the next upcoming year 2022, we are expecting a large return to Growthsegments of the overall market, with the largest upside being in Small Cap andMid Cap Growth. Large Cap Growth should produce on average normal annualreturns for this year. We see Large Cap Value (like the positions in our LowVolatility Portfolio) to perform well in 2022 as well, with an expected returnin the 8 - 13% range for this market segment. With Small and Mid CapValue, we are somewhat pessimistic on many of these names in the financial andenergy sectors, and are expecting a -6 to -12% decline in this segment of themarket. We expect an average to slightly below average year for the Small andMid Cap Core segment of the market, and an average year for Large Cap Core. Asa result, we will execute some minor rebalancing shifts in the Core portfoliothrough the first quarter of this year in order to gain better exposure to Smalland Mid Cap core positions that present greater upside for this year. We areexpecting a return in our Core Portfolio between the 7% - 12% range forthis year. With respect to our Growth Portfolio, we are expecting a return of 25%for this year. The newsletter shows our true mathematical projections, and thereturns (ARK included) this segment of the market has seen over the next yeargiven this technical set up. We looked at fundamental and multiple projections,we looked at the average distance from price targets, and we looked at holdingsfrom the top hedge fund managers. All of this data strongly suggests that wecould potentially see an incredible year in this area of the market for 2022.As financial advisors, not hedge fund managers or salesman, we’d like to underpromise and overdeliver for our clients this year.

DISCLOSURE:

Bull Run InvestmentManagement is a registered investment advisor. Information presented herein isfor educational purposes only and does not intend to make an offer orsolicitation for the sale or purchase of any specific securities, investments,or investment strategies. Investments involve risk and unless otherwise stated,are not guaranteed.

Readers of the informationcontained on this performance sheet, should be aware that any action taken bythe viewer/reader based on this information is taken at their own risk. Thisinformation does not address individual situations and should not be construedor viewed as any type of individual or group recommendation. Be sure to firstconsult with a qualified financial adviser, tax professional, and/or legalcounsel before implementing any securities, investments, or investmentstrategies discussed.

Portfolio performance isshown net of the advisory fees of 1.65%, the highest fee charged by Bull RunInvestment Management and sample trading costs based on our Custodian’s CharlesSchwab’s trading costs. Performance does not reflect the deduction of otherfees or expenses, including but not limited to brokerage fees, custodial feesand fees and expenses charged by mutual funds and other investment companies.Performance results shown include the reinvestment of dividends and interest oncash balances where applicable. The data used to calculate the portfolioperformance was obtained from sources deemed reliable and then organized andpresented by Bull Run Investment Management.

The performance calculationshave not been audited by any third party. Actual performance of clientportfolios may differ materially due to the timing related to additional clientdeposits or withdrawals and the actual deployment and investment of a clientportfolio, the length of time various positions are held, the client’sobjectives and restrictions, and fees and expenses incurred by any specificindividual portfolio.  

Return Comparison: TheS&P 500 was chosen for comparison as it is generally well recognized as anindicator or representation of the stock market in general and includes a crosssection of equity holdings.

PAST PERFORMANCE IS NOGUARANTEE OF FUTURE RESULTS

OUTSIDE CITATIONS IN ORDER OF APPEARANCE:

https://www.multpl.com/s-p-500-pe-ratio

https://www.multpl.com/s-p-500-earnings

https://www.multpl.com/s-p-500-price-to-sales

https://app.powerbi.com/view?r=eyJrIjoiNjY1MGQwNDktY2Y2Ni00ODNiLWI0ZDItYjI0ZWQ2MTg2NjJlIiwidCI6ImVkZmYzMjg1LTk5NGYtNGE1ZC1hNjYxLWRkMTRjMmY1YTU4NSIsImMiOjF9

https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/pedata.html

https://www.gurufocus.com/sector_shiller_pe.php

https://www.tradingview.com/chart/ARKK/fjtB7ME4-S-P-500-vs-ARKK-TAN-IBUY-WCLD-FINX/

https://etfdb.com/screener/#page=1&tab=returns&sort_by=five_ytd&sort

https://etfdb.com/screener/#page=1&tab=returns&sort_by=five_ytd&sort_direction=desc&asset_class=equity&leveraged=false

https://hedgefollow.com/top-hedge-funds.php

https://fred.stlouisfed.org/graph/?g=KBQF

https://www.newyorkfed.org/markets/reference-rates/effr