Dear Partner,
In the third quarter of 2023, Woodbridge Capital Partners I, LP (the “Partnership”) returned 2.28% while the S&P 500 returned -3.27% (with dividends reinvested). Since its inception in April 2020, the Partnership has returned 124.4% compared to the S&P 500’s 70.2%.1
This quarter, the S&P 500 marked its first decline in the past year despite an economy that remains strong on the surface. Though the market’s short-term movements are always unpredictable and often inexplicable, the selling we saw this quarter may have been related to a sharp increase in the interest rate of long-term bonds.
The interest rate on 10-year treasuries rose from 3.81% to 4.59% and, as of the writing of this letter, is nearing 5%, a rather dramatic movement for a period of only a few months. 20- and 30-year treasuries saw similar increases.2 The yield on 10-year treasuries is often considered a benchmark for interest rates in general, and many debt instruments, including mortgages, move in close relation. While we have already seen an increase in shorter-term interest rates, the increase in longer-term rates we are seeing now could presage not only a broader financial tightening but also a reduction in the valuation of assets.
Why did longer-term rates increase this quarter? In theory, the market interest rate over a given time period should be equal to the geometric mean of short-term interest rates over that period. So theory would say that the market must have significantly increased its expectations of where interest rates will need to be in order for inflation to be brought down. And that may be the case. Inflation, while having come down from 6.6% a year ago to 4.1% today, still remains significantly above the Fed’s target, and the job market remains robust with unemployment under 4% and available jobs continuing to exceed available workers.3
While this may explain part of the increase, we find it hard to believe that any data from the past 3 months was particularly revelatory about the next 10, 20, or 30 years — at least not enough to warrant an adjustment of this magnitude. The rise could in part be attributable to the Fed’s shift in behavior from purchasing treasuries and other fixed-income securities to reducing their holdings, which would drive down the price and thereby drive up yields. Since the Fed is the largest holder of US debt, their absence as a purchaser for the last year has continued to substantially reduce demand for treasuries. In addition, large ongoing deficits, among the largest we’ve seen in the last hundred years, could be putting further downward pressure on treasuries.
Even though some of the factors driving higher rates may be temporary, a secular shift away from the ultra-low rates that we’ve grown accustomed to over the last 15 years seems likely. As interest rates return to a more historically normal level, stocks may have a difficult time repeating their performance of the last 40 or so years, a period during which interest rates fell from nearly 20% to 0% and earnings multiples expanded significantly.4 Some of the greatest beneficiaries of low interest rates have been growth stocks. Because their earnings are further away in the future, the value of growth companies are more sensitive to interest rates (recall that the value of a stock is the present value of future cash flows). From the beginning of 2009 to the end of 2021, the S&P 500 returned 16% compounded annually and the Vanguard Growth Index, a collection of large US growth companies, returned a whopping 19% compounded annually.5 For comparison, the average annualized return of the stock market since 1926 is around 10%.6 In contrast, the intrinsic value of stocks that trade at low multiples of earnings, such as the ones we own, are less sensitive to the rate used to discount earnings. While the market has not yet cast its vote in favor of value stocks, we believe that the normalization of interest rates is one more reason that our stocks should outperform over the long run.
From an operating standpoint, the businesses we own are not greatly affected by higher interest rates. We own some businesses that stand to benefit and some that will take a hit. All will have increased interest expenses on their debt, and we own one company that will incur significantly greater interest expense. On the other hand, two of our businesses, a bank and an insurance company, profit from net interest spreads, which typically expand with higher rates.
While the higher rates are driving some investors away from stocks to bonds, we see no need to make the shift. With the exception of one dominant growth company, the earnings yields on our stocks are much higher than prevailing interest rates. We don’t think an increase in interest rates from 3% to 5% warrants trading a stock yielding 20% for bonds. We’re perfectly happy to keep our current businesses and wait patiently for other buying opportunities to arise.
The strength of the businesses in our portfolio affords us confidence despite the significant uncertainty that lies ahead. The possibility of persistent inflation and continued rate hikes pose economic risks while geopolitical tensions have come to a head, most evidently with the war in Ukraine and more recently the Israel-Gaza conflict. Given this fraught environment, I’d like to reiterate that we find our portfolio to be exceptionally attractive. We remain confident that the Partnership will outperform the S&P 500 over the long term. We are grateful to have partners that share our long-term orientation.
Thank you,
Kyosuke Mitsuishi & Jesse Flowers
1https://finance.yahoo.com/quote/%5ESP500TR/history?p=%5ESP500TR
2https://home.treasury.gov/policy-issues/financing-the-government/interest-rate-statistics
3https://www.bls.gov/news.release/cpi.nr0.htm
4https://fred.stlouisfed.org/series/FEDFUNDS