Opinion: The new rules of investing look a lot like the old rules

Unprofitable growth companies keep grinding lower in 2022.

This brutal bear market for once-high-flying stocks is a painful dose of cognitive dissonance for those who are used to easy gains on what they consider to be exciting companies.

Today, rather than cutting-edge technologies like artificial intelligence leading markets, boring is the new black. Distinctly unexciting companies such as H&R Block
HRB,
+2.11%
(taxes), McKesson
MCK,
-0.15%
(pharmaceuticals) and CVR Energy
CVI,
+3.54%
(oil refining) are posting spectacular returns for investors, including those at the Frank Value Fund
FRNKX,
-0.80%.

There are no points for difficulty in finance, and as investors are finding out, exciting technology does not mean guaranteed gains. The hardest-hit stocks are unprofitable companies, making this less about growth vs. value, and instead bringing the battleground to unprofitable vs. profitable.

The long wait is over

The current predicament in the market reminds me of the 2002 movie “Signs,” by director and writer M. Night Shyamalan, about an alien invasion from the perspective of a family. Each member of the family has strengths and weaknesses when it comes to the invaders, but the youngest, daughter Bo Hess (played by Abigail Breslin), mostly leaves glasses of water around the house.

This habit annoys the rest of the family but goes from useless to life-saving when an alien enters the home and the family figures out aliens are harmed by water.

That is similar to what we have witnessed in investing in 2022. During the mania of the previous two calendar years, value investors wandered around their homes, muttering about fundamentals and cash flows, leaving glasses of water everywhere.

Now, with interest rates rising, inflation roaring and the economy slowing, seemingly everyone wants fundamentally sound businesses with strong cash flows. Investors hoping for a reemergence of the bull market led by growth companies are living in the past.

How did we get here?

Unprofitable companies rocketed higher as the Federal Reserve employed extreme quantitative easing (QE) and Congress gave away trillions of dollars. When it was raining money, investors cheered when companies aggressively expanded, investing for growth by running losses at the bottom line. The more aggressive, the better.

Loss-making companies flooded the market through IPOs and SPACs, their prospectuses tempting investors with buzzwords like TAM (total addressable market). Non-believers were shouted down by those who said Amazon.com
AMZN,
-1.31%
ran up losses for years, only to dominate several industries once it hit critical mass.

While it is true that Amazon is a success story, there are thousands of others that have been liquidated, gone bankrupt and exist today only as investor regrets. How many companies that were birthed through IPOs and SPACs will be the next Amazon now that easy money is a thing of the past? It seems safer to bet on tangible, profitable businesses.

Troubled economy

Inflation may have peaked but it is still uncomfortably high, especially for most Americans whose wages are slow to increase. The Fed has shown no signs of abandoning its schedule of rate increases despite the fact that the broader market — via the S&P 500
SPX,
-0.38%
— fell into a bear market Monday.

Higher rates, combined with the ugly twins of inflation and a weaker consumer, drastically change the investment landscape. We believe this specter will loom over markets for longer than investors expect. Therefore, there is no going back to the way things were. Limitless QE, spiked punch bowls and the never-ending bid for risk assets have been terminated.

The new rules of investing are the old ones: quality profits, attractive valuations and competitive advantages. The dynamics of today’s stock market require “what have you done for me lately” fundamentals such as sustainable dividends, significant stock repurchases and cold, hard cash flows.

There are few other choices in the stock market as once-mighty unprofitable companies have fallen, collapsed under their own insatiable need for capital, stock-based compensation and growth.

Brian Frank is chief investment officer of Florida-based Frank Capital Partners LLC and portfolio manager of the Frank Value Fund.

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