- Stocks fell sharply after rising from mid-June to mid-August, and could fall further.
- James Davolos, a top 1% portfolio manager over the past decade, shared his outlook on the market.
- Here’s how Davolos chose the strains.
The massive rally the stock market enjoyed this summer is quickly fading.
There has been much debate among market experts as to whether the S&P 500 should return to its mid-June low of 3,636, suddenly bounce back to new all-time highs, or do both.
A series of recent declines in widely followed U.S. stock indices suggests that investors are bracing for more pain ahead. Like many investors, James Davolos, his manager at Best Portfolio, who co-manages the Kinetics Small Cap Opportunities Fund (KSCOX), doesn’t expect a dramatic uptick to occur anytime soon.
“I don’t know if it’s going to be below lows, but it’s really hard to imagine a scenario where it’s hitting new all-time highs,” Davolos told an insider in an interview in late August. I think we are much more likely to retest the lows than the highs.”
Indeed, Mr. Davolos knows that the future cannot be predicted accurately, and as the Federal Reserve struggles to keep rampant inflation under control, the economy is facing a “tremendous decline.” Especially given the “quantitative uncertainty”.
But investors could be forgiven for thinking Davolos has a crystal ball. According to Morningstar, his fund has outperformed his peers by 99% both this year and over the past decade, with top 3% finishes in 2012, 2013, 2017, 2018 and 2021. is recording.
Davolos told Insider about his market outlook, his fund’s strategy, and his favorite stocks.
Inflation could persist even as the economy slows
Davolos said economic strength is weakening rapidly as leading indicators begin to roll over. For example, the latest figures from the Empire State Manufacturing Survey detailing business conditions in New York State were the weakest since mid-2009, he noted.
It’s clear to Davolos that the Fed’s aggressive interest rate hikes to fight inflation are working, but they may not be what the US central bank wants. Rising borrowing costs could lead to a surge in unemployment without reducing what Davolos called “extremely elevated” inflation. It’s an investor’s worst nightmare.
“The Fed will have a very hard time balancing its employment and inflation targets,” Davolos said. “Ultimately, I think the smaller the evil, the higher the level of inflation that is acceptable.”
Davolos said he was prepared for higher and prolonged inflation in the 3% to 6% range. Portfolio managers warned that it would put pressure on corporate margins and, in turn, profits.
“Regardless of what happens to the economy in nominal or real terms, the only guarantee whether a company can continue to grow its top line is that margins will be squeezed,” Davolos said. said. “Everything from raw materials to labor to transportation costs are going up and I think it will be very tough.”
Davolos said the market had not priced in lower earnings, echoing concerns recently expressed by Morgan Stanley Chief Investment Officer Mike Wilson.The Fed is hawkish, Davolos said. It will not deviate from its optimistic policy and will alienate investors as the economy weakens.
“I don’t think the market is even slightly closer, at least in terms of future earnings projections. I think it’s only 2% or 3%, maybe 4% down from peak future earnings projections,” Davolos said. says. He said. “I think the average recession is around 22%, which is a pretty tough set-up for the broader market when you factor in margin compression.”
How to invest: 3 tips to remember
The portfolio manager said the success of the Davolos fund rests on three pillars. maintain long-term vision, Avoid index heavy stocksWhen Emphasis on evaluation.
Focusing on the long term is a simple tip that is often forgotten in the 24/7 news cycle. Investors should monitor what is happening in the economy and markets, but overreacting to day-to-day changes can be counterproductive.
“So many people are concerned about what the quarter will be like or what the year will be like,” Davolos said. “But we think that if you push your opinion and try to appreciate the value over a few years, you can have much higher success.”
The following two pillars are related. Davolos tries to avoid equities, which are a large component of the index. Because those stocks were put into popular funds and blindly bought by investors, resulting in excessive inflation and ultimately ripeness for these stocks to fall.
“Buying in valuation-agnostic indices is creating a lot of distortion in financial markets,” Davolos said.
As investors learned this year, so-called distortion is a problem because high valuations can cause stocks to crash. Buying shares in companies with solid growth, capex, cash flow and profit margins is important and rarely followed by crowds, Davolos said.
“It takes a certain amount of contrarian thinking to be good at value investing and looking for value opportunities,” Davolos said.
top stock picks
In Davolos’ view, once you’ve found the right stocks to buy, it makes little sense to water down your portfolio with too many stocks. As such, his funds tend to be “pretty focused and pretty top-heavy” in his 25 to 45 names, with overweight weighting in his 10 of them.
“Fundamentally, we do a lot of rigorous research and want to own the best companies for their size, rather than being broadly representative of the industry,” Davolos said.
Similarly, after finding suitable names, Davolos typically stores them in the Kinetics Small Cap Opportunities Fund for five to seven years. Davolos said the fund would increase or decrease stocks rather than buy or sell them all at once unless there are “extraordinary circumstances.”
Here are six of our favorite stocks that fit Davolos’ criteria. Each, in addition to its ticker, market cap, price-to-earnings (P/E) ratio, and commentary from Davolos.