Third Quarter 2022
The Frank Value Fund Institutional Class returned -8.30% YTD 2022 compared to a loss of -23.87% for the S&P 500 TR Index and -20.36% for the Russell Midcap Value Index. Please see the end of this letter to shareholders for more performance information.
Boring Value – Exciting Returns
Before addressing the ongoing bear market, here is a bit of great news. During the third quarter the Frank Value Fund sold its position in H&R Block, (NYSE: HRB) generating a 176% return in 21 months, not including dividends. Since our purchase of HRB in December of 2020, the company has paid a 6.1% annual dividend. Over this time-period HRB accomplished an amazing feat – it was one of the best performing stocks in the S&P 500 yet revenue grew at an unexciting 3% annualized rate. That’s right, boring, old H&R Block outperformed Amazon, Nvidia, Tesla, and Facebook/Meta. How did this happen? Frank Value’s valuation discipline and focus on the stability of taxes as a business contributed to these outsized returns. Also, H&R Block’s management team opportunistically repurchased shares at a rapid pace. None of the exciting tech companies could repurchase as high a percentage of their shares in part because they traded at extreme valuations. We realized the gain on HRB because the company will now have difficulty growing enough to justify its current, higher valuation. Additionally, precipitous declines in other stocks allows us to reinvest the cash at higher expected long-term returns.
How to Invest in a Bear Market
With both bonds and stocks suffering painful declines in the first nine months of 2022, investor sentiment is dour. Scary headlines like DailyWire’s “Investment Giant BlackRock loses $1.7 trillion in six months” spark concerns over recession and potential systemic shocks, should an institution like BlackRock or Credit Suisse fail. Yet, as we mentioned last quarter, the Market Cap / GDP indicator is still over 145%, implying low single-digit returns on a broad investment in equities over the next decade. Analysts are just beginning to reduce earnings estimates for 2023 despite companies like Nike and Micron releasing frighteningly negative outlooks. At the index-level, stocks are still far from pricing-in an earnings recession. The Fed has taken the training wheels off, but index investors never learned to ride a bike! If you’ve read our letters in the past, you know where this is going: active stock-picking with a value discipline is setup to generate superior returns over the next decade.
The Fed has taken the training wheels off, but index investors never learned to ride a bike!
Where do we draw the confidence to hold equities with turmoil in the markets and a recession on the horizon? Our unchanging discipline. The same discipline that kept us from chasing stocks at ridiculous valuations in 2021 is now slowly revealing long-term buying opportunities. Most of the companies on our watch list are still above target valuations but bear markets are long, with plenty of volatility. Thus, we continue on the road to fully invested. During the third quarter we found some compelling opportunities with stable, recession-proof earnings. The yield on the Frank Value Fund is now over 2.1%, compared to 1.5% on the S&P 500, with the fund’s positions trading at roughly 50% discounts to the average S&P 500 company. This is a setup for great long-term returns, and we still have the flexibility to increase expected returns further by deploying the remainder of our cash into market weakness.
Equity Risk Premium – Invest by Numbers
The single most important number in finance is the discount rate. This is the rate investors use to determine the present value of expected future cash flows. Normally for equities, investors will use the risk-free rate, or the US 10-year treasury, plus a few percentage points of equity risk premium, as equities are riskier than treasuries. Professor of finance at New York University’s Stern School of Business, Aswath Damodaran, writes extensively on equity risk premiums. Professor Damodaran’s website has a trove of data related to earnings, interest rates, and the equity risk premiums used to justify valuations. Over the past ten years of near-zero interest rates, discount rates were their lowest in history, meaning the price investors would pay for future cash flows was at its highest. Here in 2022, we would argue everyone familiarize themselves with Professor Damodaran’s work. The US 10-year yield has gone from essentially 0.7% in 2020 to nearly 4.0% today. Therefore, present value of future cash flows should plummet. A lot!
If we take the same amount of residual cash flows in perpetuity and change the discount rate from 3.7% to 7.0% (10-year yield plus 3% equity risk premium) the present value of those cash flows is worth nearly 50% less!
Continuing the trouble for valuations, earnings typically decline in recessions, with S&P 500 earnings declining from a peak of $87.72 per share in 2006 to a trough of $59.65 in 2009, or -32%. Prudent investors, seeing an inverted yield curve since July 6th should be discounting a recession and resulting earnings declines into their valuations. With the S&P 500 off only 20% from its all-time high, it appears investors are banking on hope rather than math. In our view, you can’t have it both ways. If 0% interest rates justified the insane valuations towards the end of the bull market, then investors should be well-aware that interest rates today are saying the S&P should be at least another 30% lower from here. This should the equity risk premium. You don’t have to take my word for it, here is a chart from Professor Damodaran. If you look at the leftmost three columns of the chart, S&P 500 earnings 30% below estimates, a risk-free rate of 4%, and an equity risk premium (ERP) of 5%, put the fair value of the index at 3183, or 15% below the Q3 close. A 6% ERP knocks another 530 points off the index, or downside of nearly 30% from the Q3 close. Only head-in-the-sand assumptions like no earnings decline and a return to the low interest rates policies that enabled governments to spend into inflation can mathematically justify a higher S&P 500 from here.
In our view two things are certain in finance: an inverted yield curve predicting recessions and Wall Street analysts overestimating future earnings. We are investing accordingly. Interest rates and inflation have dramatically changed the investing landscape and equities and the equity risk premium are still catching up to this reality. As stock-pickers we specialize in succeeding in these types of markets. We welcome this return to fundamentals and are excited for the opportunities ahead.
|Performance as of 9/30/22
|Average Annualized Total Returns
|1 Yr. %
|3 Yr. %
|5 Yr. %
|10 Yr. %
|Since 7/21/04 %
|Frank Value Fund
|Russell Midcap Value
|S&P 500 Total Return
Please see our website for distribution information. Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. You may obtain performance data current to the most recent month-end by calling the Fund at 1-888-217-5426 or visiting our website at www.frankfunds.com. Returns include reinvestment of any dividends and capital gain distributions.
Non-FDIC insured. May lose value. No bank guarantee. The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the Fund, and it may be obtained by calling 1-888-217-5426. Please read it carefully before you invest or send money.
This publication does not constitute an offer or solicitation of any transaction in any securities. Any recommendation contained herein may not be suitable for all investors. Information contained in this publication has been obtained from sources we believe to be reliable, but cannot be guaranteed.
The information in this portfolio manager letter represents the opinions of the individual portfolio managers and is not intended to be a forecast of future events, a guarantee of future results or investment advice. Also, please note that any discussion of the Fund’s holdings, the Fund’s performance, and the portfolio managers’ views are as of October 5, 2022 and are subject to change without notice.