CWS: 3rd Quarter 2022 Portfolio Review

At the end of the third quarter of 2022, the S&P 500 finished at its lowest point since 2020. The latest—and since the Covid-era collapse, largest—bear-market rally had run out of steam. Since the start of the year, the stock market has trended lower, yet it has tempted investors with what looked to be several surges. All have failed.

The third quarter was a difficult time for the stock market. During the quarter, the S&P 500 Index lost 5.28%. With dividends, the index was down 4.88%. The good news is that the AdvisorShares Focused Equity ETF (CWS) continues to lead a difficult market. For the third quarter, the Net Asset Value of the ETF fell by 2.63% while the traded shares fell by 2.58%.

It’s no secret what’s been plaguing Wall Street. The Federal Reserve (Fed) has made it clear that it intends to raise interest rates until inflation has been defeated. Unfortunately, there’s not much evidence to indicate the Fed is winning the battle. That’s led Wall Street to expect interest rates to trend higher and to stay higher for longer.

This gets to the heart of what interest rates do to stocks. Higher interest rates are like kryptonite to the stock market. It’s a double whammy effect. They cut into profits because they raise borrowing costs. That makes it more expensive to fund operations or expansion plans. They also make it more difficult for consumers to buy large-ticket items like houses or cars. The average adjustable-rate mortgage payment has rocketed higher over the last year.

During the summer, the stock market staged an impressive rally. The S&P 500 gained more than 17% in two months. Was the bear market finally over? Bear-market rallies exist to lure us back in and convince us that things are safe, only to then slam the door on us. That’s exactly what happened.

In just six weeks, we gave the entire summer rally back. Not only did the S&P 500 break below its June low, but the Dow Jones Industrial Average dropped below its pre-Covid high from 31 months ago—this isn’t adjusting for the impact of inflation, which is running at close to 14% over the last two years.

When the pandemic broke, the Fed responded early and strongly. However, it responded in the way it should have responded to the financial crises of 2008: by lowering interest rates to the floor. What that means is that the Fed took risk out of the equation for investors. The market responded with a furious rally, but thanks to the central bank, the rally was heavily tilted to risky and highly volatile sectors of the market, while many conservative stocks barely budged.

In November of 2021, that dynamic started to change. Wall Street was alarmed by the amount of inflation, despite the Fed’s repeated claims that it was merely “transitory.” Wall Street expected rate hikes to start. Finally, in April, the Fed caved and raised rates by 0.25%. That wasn’t nearly enough. Even so, the stock market started to fall and the losses grew and grew.

In May, the Fed raised rates again. This time, it was 0.50%. Once again, that wasn’t enough. The Consumer Price Index reports kept showing that inflation was not going away. In June, the Fed raised interest rates by 0.75%. Since then, they’ve added two more 0.75% rate hikes. The futures market expects several more rate hikes.

What’s interesting is that this year’s selloff was the mirror image of the bull market. Those risky stocks that had done so well are now doing the worst.

Consider a stock like Peloton (PTON). I don’t mean to pick on it, but its case is telling. Three years ago, the exercise-bike stock had an initial public offering price of $29. Bear in mind it had never made a profit.

Investors fell in love. The stock soared even higher once the pandemic came. Apparently, we were all supposed to ride exercise bikes while we were holed up in our homes. Wall Street loves a great investing pitch, and within 16 months, PTON’s price rose to $170. Did I mention that it’s never reported an annual profit?

When interest rates are at 0%, no one cares about outdated notions such as “valuations” or “profits.” That’s so three years ago. But things started to change slowly in 2021, and then in November, tons of former high-flyers fell off the cliff. Since then, they’ve only dropped lower.

Fast-forward to today: shares of Peloton are under $9, and the company’s operating losses are accelerating. For its most recent fiscal year, Peloton reported a loss of $7.69 per share. The company just announced it will cut 500 jobs, which is about 12% of its workforce. The number of people working at Peloton has dropped by half over the last year.

Again, I don’t mean to pick on Peloton, since so many other companies have similar stories. The key lesson for us is not to underestimate the importance of having the Fed’s strong winds at your back versus having them in your face. One year ago, the one-year Treasury rate was yielding 0.1%. Today it’s at 4.2%.

It’s not just higher interest rates. There’s also the thorny issue of quantitative tightening. In plain English, that means the Fed is working to reduce its gigantic balance sheet. When the Fed was doing its quantitative easing, that certainly helped the stock market rally, but what will the opposite do? I think we’re seeing the results now.

What’s happening is that the Fed is allowing all those Treasury and mortgage-backed securities to roll off its balance sheet. The Fed recently doubled the value of bonds it will roll off to $95 billion.

Investment Highlights from Q3

We had some very strong earnings reports during Q3. In late September, FactSet (FDS) said it made $31.3 per share for its fiscal Q4, and $13.43 per share for the entire year.

These results blew past the company’s own forecast, but they were seven cents short of what Wall Street had been expecting. Although the stock pulled back some, I want to stress how strong these results were.

In March, FactSet raised its full-year guidance to a range of $12.75 to $13.15 per share. Three months ago, the company said results will be in the “upper end” of that range. Let’s put FactSet’s earnings miss into some context. Given the results of the first three quarters, FactSet’s range implied Q4 earnings of $2.47 to $2.87 per share. The company beat its own guidance by 26 cents to 66 cents per share.

“Once again, we delivered a record year, achieving $2 billion in ASV plus professional services. We continue to build the leading open-content and analytics platform, accelerating our organic-ASV-plus-professional-services growth to 9.3% in fiscal 2022,” said Phil Snow, CEO, FactSet. “Investments in our product portfolio and digital capabilities are driving growth in differentiated data and workflow solutions.”

Q4 revenues rose 21.2% to $499.3 million. Revenues for the year were up 15.9% to $1.844 billion. For Q4, FactSet’s operating margin was 31.5%. For the year, it was 33.9%. That’s an increase of 140 basis points. I really don’t see much to be disappointed with.

At the end of the quarter, FactSet’s Annual Subscription Value (ASV) stood at $2.0 billion. That’s up from $1.7 billion one year ago. The figure “represents the forward-looking revenues for the next twelve months from all subscription services currently supplied to clients.” The company’s adjusted EBITDA grew by 15.9% to $158.5 million.

Let’s look at some more details. FactSet has now increased its revenues every year for the last 42 years in a row. The company has grown its earnings-per-share for the last 26 years in a row. Last year, FactSet’s client count rose by 16.8%, and users rose by 11.8%. Annual ASV retention was greater than 95%.%. As a percentage of clients, annual retention improved to 92%.

Last December, FactSet was added to the S&P 500. Earlier this year, the company suspended its share-buyback program so it could pay off some of its debt. Still, the company returned $144.6 million to shareholders last year. That was 25% of its free-cash flow. There’s $181 million left in the current buyback authorization.

FactSet also offered initial guidance for this year. The company expects earnings to range between $14.50 and $14.90 per share. Wall Street had been expecting $14.76 per share.

We also had a very good report from SAIC (SAIC). In September, the company said it made $1.75 for its fiscal Q2 (ending in July). That beat the Street by six cents per share.

Revenues were $1.83 billion, which was basically flat from a year ago. Net bookings for the quarter were about $2.1 billion, which reflects a book-to-bill ratio of 1.1.

“I am proud of the results we delivered in the quarter and fiscal year to date, which contribute to our improved outlook for the year,” said SAIC CEO Nazzic Keene. “The investments we have made to build differentiated solutions in the areas of Secure Cloud and Systems Integration position us well to gain share in a growing market. Our focus remains on converting a strong pipeline of opportunities into sustained, profitable growth and increased value for our shareholders.”

Now for the best news: SAIC increased its full-year guidance. The company sees full-year 2022 revenues coming between $7.50 billion and $7.55 billion. That’s an increase of $70 million to the low end.

SAIC sees full-year earnings ranging between $7.00 and $7.20 per share. That’s an increase of 10 cents per share to the low end. This is SAIC’s second guidance increase this year.

This was a very good quarter for SAIC. Previously, I’ve called SAIC the “IT help desk for the Pentagon.” This is a high-quality company. 

What to Expect Going Forward

Sadly, the Fed still does not have a handle on inflation. Despite assurance that inflation is merely transitory, inflation is becoming annoyingly persistent. The Fed now realizes that it will have to take bold action to defeat inflation. Christopher Waller, a Fed governor, said, “This is a fight we cannot, and will not, walk away from.”

As long as the Fed is determined to raise interest rates, the stock market will be soggy. I’m not predicting a crash, or even a downward market, but bulls will find it difficult to get a sustained rally going. As fun as this summer’s rally was, it’s come to an end.

The other important takeaway is that holding risky assets right now is dangerous. I’m mostly speaking of high-volatility stocks, but this spills into NFT and crypto as well. With higher rates on the way, conservative stocks will fare much better. This is good news for the AdvisorShares Focused Equity ETF. I see our strategy continuing to lead the market.

We remain very optimistic for the stocks in our fund and our overall strategy. We outperformed the market handsomely in Q2, and we foresee these trends lasting for the rest of 2022 and into next year.

As of 09.30.2022.

In a first for the ETF industry, the portfolio strategist of CWS has “skin in the game.” The strategist’s compensation is directly tied to portfolio’s performance. Using the trailing 12-month returns of CWS vs. its S&P 500 Index benchmark, stronger outperformance is rewarded with a larger management fee while weaker underperformance is penalized with a smaller management fee. The CWS fulcrum fee was 0.85% during September 2022. After the Fund’s September performance, the CWS fulcrum fee will remain at 0.85% in October 2022.

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2nd Quarter 2022 Commentary