As we cross the midpoint of 2022, financial markets around the world are in full correction. The S&P 500 was down 21%, the NASDAQ was down 30%, and just about every other asset class fell sharply during the first half of the year. As you can see from his attached statement, although we did poorly in the second quarter, our year-to-date numbers are well above our benchmarks.
Our All Cap Portfolio was down 16.7%, our Small Cap Portfolio was down 19.1% and our three LPs performed well on a relative basis. When you consider that all of our portfolios have increased between 50% and 67% each of the previous two years, I am pleased that we have limited our losses.
This was the worst first half for the S&P 500 in 70 years. Some of the worst performing stocks were Amazon (AMZN) down 36%, Meta (META, Facebook) down 52%, Tesla (TSLA) down 36%, Nvidia (NVDA) down 48% and Netflix (NFLX) with a drop of 71%.
In recent letters, he had been warning that the stock market was dangerously overvalued. The only thing this year, however, was the 11% drop in bond markets in the first half, the worst first half on record. Add to that the money lost in crypto, with Bitcoin down 60%, and trillions of dollars have evaporated from American balance sheets.
So where do we go from here? The stock market remains overvalued. Total market capitalization relative to GDP (the Buffett indicator) has fallen from 220% to 169%, but is still 33% above its long-term trend. The market is still dominated by technology stocks with high multiples, and this is where we have a huge advantage. We are value investors who conduct in-depth analytical research on each of our holdings, so our clients will be protected in the long term by owning companies whose share prices are well below their intrinsic values.
Inflation has been a big problem this year, with the consumer price index at 9.1%. Now you can see how ridiculous the Federal Reserve was for not being satisfied that inflation was below its 2% target. The Fed is largely to blame for escalating inflation. Many economists are predicting that the US may enter a recession in 2023, and although I am not an economist, I think it is very likely that we are already in a recession. Skyrocketing prices for gas, food, housing, medical bills and utilities will cause Americans to rein in spending.
The first quarter GDP figure was negative, and if the second quarter figure is also negative, we are in a recession. What is unique about the current situation is the tight labor market. Although I have heard of more layoffs, the labor market remains extremely tight with job openings doubling the number of unemployed. It would be very rare to have a deep recession when so many Americans are gainfully employed.
The recent index of consumer confidence from the University of Michigan was the lowest recorded in the last 45 years. I think there is a good chance that consumer spending will slow down and the rate of inflation will fall moderately over the next year. However, I don’t see inflation coming down to the Fed’s desired rate of 2% for several years. The cost of energy fluctuates so much in daily life (if you bought it, brought it by truck) that higher prices will prevail for quite some time.
During the last few years, cryptocurrencies have received a lot of attention. The reasons given for owning cryptocurrencies were very similar to the traditional reasons for owning gold; a mistrust of government-manipulated fiat currencies and runaway money printing leading to currency debasement. We at Old West have long believed that gold offers protection against the aforementioned risks, and have long been skeptical of cryptocurrencies. The price of gold is down 3% so far this year in one of the most tumultuous years in living memory. With bitcoin down 60% year-to-date, that should put to rest the argument that cryptocurrencies are a store of value.
We have a basket of the best gold mining companies in our portfolios. With the price of gold slightly down to $1,750 per ounce, shares of the mining company are down an average of 20%. Our gold miners have an average production cost (all maintenance cost) of $1,100 per ounce. Mining companies are wasting cash, paying good dividends and buying back shares. The delta between the price of gold and the price of miners’ shares is extremely high.
We expect the price of gold to rise and more importantly the price of miners’ shares to rise much higher in the second half of this year and beyond. There is tremendous uncertainty in the world with war in Europe, persistent inflation, debt levels once again rising, and political turmoil. All good reasons to have exposure to gold.
Each quarterly letter we like to highlight one of our portfolio holdings. Lockheed Martin checks all the boxes on what we look for in a company.
LOCKHEED MARTIN CORPORATION
As I sat in the theater watching Top Gun: Maverick, I was very proud to learn that we are shareholders of Lockheed Martin (LMT). When the Top Gun: Maverick team was looking to push the envelope and stay true to Maverick’s need for speed, LMT’s Skunk Works was their first call. With Skunk Works’ expertise in developing the fastest known aircraft coupled with a passion for defining the future of the aerospace industry, LMT is at the epicenter of our nation’s defense.
Headquartered in Bethesda, Maryland, LMT is an American arms, defense, information security, and aerospace technology company. LMT employs 115,000 people worldwide, including 60,000 engineers and scientists. LMT is the world’s largest defense contractor. They manufacture F-16, F-22 and F-35 fighter jets, Sikorsky Black Hawk helicopters, Skunk Works technology, Javelin, Himars and Tomahawk missile systems and much more.
When evaluating a potential investment, we spend a great deal of time analyzing the financials and conducting extensive valuation analysis. Something that sets us apart from other money managers is our focus on the people running the business, and especially the CEO. We want to ensure that our financial interests are properly aligned with management, and we seek true leadership capabilities and a track record of allocating capital in a shareholder-friendly manner.
I was surprised that Jim Taiclet applied for the LMT CEO position in 2020. Over the years, we invested in American Tower (AMT), the owner of the cell phone towers, and the stock did tremendously. During Taiclet’s 17 years as CEO of AMT, revenue grew from $675 million to $8 billion. Net income grew from a loss of $1.1 billion to a profit of $1.8 billion, and the stock price went from $10 to $260 per share.
LMT had been very ably managed by Marilyn Hewson from 2013 to 2020, and Taiclet had served as a board member during that time. Taiclet amassed significant wealth as CEO of AMT. I’m assuming it was the challenge of running the world’s largest defense contractor that made him throw his hat into the ring.
Another reason could have been his admiration for LMT when he graduated from the US Air Force Academy and served as an aircraft commander. He flew multiple missions in a Lockheed C-141 jet during Operation Desert Storm. Taiclet was 60 years old when he became CEO of LMT, so it is presented as the perfect way to develop his career. Considering that he has been CEO for only two years, Taiclet owns $21 million worth of LMT stock. His compensation is largely stock-based, where he accumulates an additional $15 million in stock per year instead of an annual cash compensation of $1.7 million.
We bought shares of LMT in 2020 for $350 per share, and the stock is trading at $414 today. Revenues have been growing at 9% per year and net income at 12% per year. The stock is selling for 13 times earnings and has a dividend yield of 2.6%. The company is expected to generate $6.7 billion in free cash flow this year, giving it a free cash flow return of 5.8%.
Generating so much free cash flow allowed the company to buy back $4 billion worth of stock last year, and the dividend has been growing at 12% a year for the last ten years. LMT also has a strong balance sheet with $9.1 billion of net debt which is just 0.9x EBITDA.
Another exciting aspect of LMT’s business is its activity in space exploration and tourism. In 2022, its space systems generated more than $11 billion in revenue and more than $1 billion in profit. LMT’s status as a trusted supplier to the Pentagon and NASA is likely to keep it a preferred contractor well into the future.
LMT is currently the prime contractor for NASA’s Orion spacecraft, which is designed for long-duration human exploration of deep space. The Orion ship is also the command and control platform for Mars Base Camp. The concept is to transport astronauts from Earth, via the Moon, to a scientific laboratory in orbit around Mars and confirm the ideal place to land humans on the Martian surface in the 2030s.
As you can see, LMT is a complex and far-reaching company that is vitally involved in making the world safer. The Old West team is confident that under Jim Taiclet’s leadership, the company will prosper in the future.
For investors in our three limited partnerships, we would like to inform you that, effective July 1, we are changing our primary brokerage relationships from Jefferies to Goldman Sachs. We have been with Jefferies since we started our business in 2008, but we have reached a point in our growth where we will be better served by a larger organization with greater business capabilities in foreign markets. ALPS will continue to be our third-party administrator.
Thank you for your continued loyalty and support, and we look forward to navigating today’s troubled waters with a steady hand.
To be honest,
Jose Boskovich, Sr. | President and Chief Investment Officer
Publisher’s note: The bullet points in this article were chosen by the editors of Seeking Alpha.