The last quarter was a bit of a rollercoaster, extending the volatility of the previous one. My portfolio and watchlist have hit some speed bumps, with various shares selling off one after the other and only some rebounding. Not everything has been hit but in general small caps seem to have fared relatively worse. The net result is that I have made little progress over the last quarter and have a 13% total return for 2021, underperforming most of my benchmarks over the year for the first time in a while. This is naturally a bit disappointing but could have been a lot worse I suppose.

Performance

The performance of my portfolio (QSS) is shown against its benchmarks in the table below. My main benchmarks have been the FTSE 100, the S&P 500 and a portfolio of the top decile of UK shares according to their Stockranks. I’ve also continued to benchmark my portfolio against a handful of professional fund managers I rate highly.

I’ve underperformed most of my benchmarks significantly over the last six months and as a result over the year. My portfolio has performed more or less in line with my buy and hold benchmark which suggests most of the underperformance is due to the focus of my strategy as a whole rather than my individual trades. Small cap growth has underperformed, particularly in the second half of the year, while large caps and value stocks have done better. That said, I have also caught a few crabs (eg Boohoo, Activision, MaxCyte) that have cost me in the second half of the year.

Despite my relative underperformance, in some ways I think I did better than last year, when a market timing error cost me dearly and prevented me from fully capitalising on what should have been an excellent year for my strategy. This year the going was simply quite a bit tougher and looking back I did make several decent decisions, though a few bad ones too. Overall, there seems to be room for improvement.

Over the longer term my portfolio is still doing well, achieving a compound growth rate of 28% since the start of 2015, which is significantly ahead of both FTSE 100 (5.3%) and S&P 500 (14.9%) over the same period. However, I’m conscious that the lion’s share of this outperformance comes from the earlier years.

Strategy

This year has been a more difficult one for my strategy. I don’t want to get derailed by a spell of short term underperformance or macroeconomic concerns. However, it’s hard not to worry that we may be going through a regime change where the growth-oriented strategies that have worked so well for the past few years may stop working.

It’s no secret that the recent volatility has been caused by the prospect of inflation and the tightening of interest rates needed to combat it looming ever closer. After a few months of denial the Fed has been becoming more hawkish, acknowledging the evidence of sustained inflationary pressures and signalling impending rate hikes and an acceleration of the tapering of its bond buying in its meeting in mid-December. There is a lot of uncertainty at the moment about how sustained the current inflationary pressures may be and whether governments will do enough to get them under control. It’s certainly not something I feel I can predict.

Inflation can be a big problem for many businesses if it gets out of hand. Most obviously businesses can become unprofitable if their operating costs or capital requirements are inflated relative to the prices they can charge. More subtly, they also become less profitable over time in real terms even if their capital requirements increase in proportion with operating profits (so returns on capital remain constant). This is because investors need higher nominal equity yields (ie lower equity prices) to deliver real returns that compensate for inflation, just as they need higher nominal bond yields (ie lower bond prices). Inflation simply erodes the value of any future investment return.

While these concerns affect all equity investments, they do not affect them equally. Higher quality businesses with pricing power, and that can expand their revenues with less additional capital, are more able to increase their profitability to compensate for inflation. This means that they tend to fare much better in inflationary environments than capital-intensive businesses which operate in competitive markets. On the other hand, inflation and rising interest rates disproportionately affect those businesses where the valuation is predicated from returns that are expected some time in the future ie growth stocks.

This suggests that if inflationary concerns persist, the sweet spot may be the cheaper end of the quality spectrum – businesses with somewhat less growth that are nevertheless capital-light, highly profitable and resilient. The stock market’s response so far to the concerns about inflation seems broadly consistent with this. Established quality large caps, such as the tech giants, have held up relatively well. Smaller quality stocks with uncertain future profitability and valuations contingent on growth far into the future have suffered, especially those that looked too expensive to start with.

It’s hard to tell to what extent this trend might continue or whether concerns about inflation are likely to dissipate soon and higher-rated growth stocks come back into fashion. It’s not something I really want to stick my neck out on either way. Given the uncertainty, sticking to quality but paying more attention to valuation seems like the most sensible course of action. It seems likely to me that the best opportunities may be in reasonably valued but less liquid quality small caps that have sold off indiscriminately over the last few months.

Another broader macro concern is simply about liquidity. There is a school of thought that current valuations are irrationally high and have only been sustained by bubble-inducing monetary stimulus over the past few years. The fear is that the removal of this liquidity, as is now on the horizon, will in itself be sufficient to cause the bubble to burst and valuations to plummet back down to earth. I have a lot of sympathy for the idea that markets are not all that efficient and are heavily influenced by flows of liquidity. So to me this seems to be a valid concern. I do believe at the least that conditions will be more difficult over the next few years compared to the last. However, I’m not really convinced that valuations are all that excessive or that the stock market is necessarily likely to crash dramatically. It’s a possibility but I’m not sure it is especially likely. It’s no bad thing that the frothier parts of the market have sold off a bit. As I’ve mentioned in my last couple of posts, I do think it makes sense to keep a small (10-15%) proportion of my portfolio in cash to keep my options open but other than that I don’t think trying to second-guess the timing of the next crash is worthwhile.

Individual shares

I have a couple of trades made in December to update on. Both purchases are of businesses I have held and written up before so I didn’t think worthy of a separate post. I sold MaxCyte and Etsy and replaced them with Autotrader and Pinterest. Both trades were motivated by relative valuations.

Below is a quick review of my holdings to identify candidates where my current conviction is highest to reinvest my cash balance when the time comes, as well as weaker positions to swap should other opportunities arise.

Somero (9.2%): after a very good year Somero has been consolidating near its highs for the past quarter. It had a positive trading update at the start of December where it upgraded its guidance (though this was to some extent foreshadowed in its previous results). Somero is benefiting from booming demand for warehousing at the moment and I think this looks set to continue for some time yet. Given this, and Somero’s excellent profitability, I think it looks too cheap, though need to be a bit careful as it is quite cyclical and trading is likely to slow down drastically at some point. My position is already large enough so not looking to add.

Microsoft (7.7%): Microsoft’s last results were excellent. It’s quite incredible how quickly it is growing for such a large business. The share price has had a strong quarter, benefiting from the rotation to large cap quality, and the price is now consolidating near its highs. As mentioned above I think this relative outperformance is warranted. Microsoft’s obvious quality, profitability and continued growth prospects mean it should be able weather any economic conditions. I think the valuation is still warranted and would be happy to add more here given my long term conviction.

Gamma Communications (5.6%): Gamma has continued to languish over the past quarter, making me now wish I’d sold more when it initially sold off after its results back in September. I don’t really understand the reason for this and having originally thought about adding am now less sure. It has been very consistently profitable and seems good value now but I am wary that the share price weakness may presage slowing growth. There is some uncertainty around how successful fGamma’s European expansion will be (and how long it will take). I’ll wait for the next trading update, which should hopefully come fairly soon in January, before deciding whether I should be adding or selling here.

SDI (5.2%): SDI has had a good year. It has turned out to be a big beneficiary of the pandemic, though this means there is now some uncertainty about how trading across its portfolio of businesses will settle. Consequently the share price hasn’t made much progress for the past six months. While I’m uncertain about the short term, the long term growth prospects still look very promising and I am confident in the competitive strength and resilience of SDI’s businesses and in the ability of the management to continue to make sensible acquisitions.

Liontrust Asset Management (4.9%): the share price has treaded water for the past quarter. This is despite it already having dropped from its highs and some excellent results at the beginning of December. Liontrust is continuing to attract a lot of fund inflows, particularly with its ESG-related funds. It’s a very capital-light and profitable business, the valuation seems reasonable and I think there is scope for Liontrust to continue to outperform but I’m wary that its fortunes could change quite easily at some point so I don’t intend to commit any new funds.

Beeks Financial Cloud (4.2%): this is still a fairly recent purchase. I’m quite excited by Beeks’ prospects at the moment. It is definitely at the more speculative end of my investments and has only just reached the inflection point where it has started to become profitable. However, it has an attractive niche and I am fairly confident that it won’t have much difficulty becoming profitable in due course as it reaches scale. It’s currently experiencing strong momentum in winning contracts and I’m hopeful that this should continue. Given this I think it looks decently valued and has promising short term prospects. The share price has dipped over the last quarter despite the strong results so I took the opportunity to substantially increase my holding. So far so good as the price now seems to be bouncing back. Given this is quite a speculative investment my holding is large enough for now.

S&U (4.2%): S&U’s trading statement at the beginning of December was very promising, though the share price is still yet to reach new highs following its September results. The business has strong trading momentum at the moment and looks very cheap. The downside is that I’m less sure about the long term quality of the business – it is cyclical and not super-profitable. I’m happy to let it run for now.

Fortinet (4.1%): Fortinet is one of the few investments that has continued to make steady progress throughout the year. Fortinet’s current trading is very strong, along with the rest of the cybersecurity sector. It’s been looking fairly expensive for a while since its sharp ascent over the past couple of years. However, since the momentum has continued to be so strong despite the weakness afflicting other growth stocks I have added back some shares at a similar price to where I took profits previously.

Games Workshop (3.7%): selling a lot of my holding in Games Workshop over the summer seems to have been a good idea, as the share price did fall quite a bit in the second half of the year. The most recent update was that trading is fairly flat since last year, though increased distribution costs have made a small dent in profits. This is largely as expected. While the immediate growth prospects don’t seem all that exciting, Games Workshop does look reasonably valued and should be resilient in an inflationary environment. The share price has started to show signs of recovery and I’ve added a few back again.

Calnex (3.7%): Calnex upgraded expectations just after my last quarterly review. The share price subsequently took off but has since fallen back again. Along with my other telecoms related investments, Calnex should be fairly resilient to macro factors and looks reasonably valued. It does seem like a good opportunity but I’m still quite uncertain about the scale of Calnex’s addressable market and this is holding me back from investing much more here.

JD Sports (3.6%): JD Sports hasn’t had any significant news since its excellent results in September – at least none significant enough to affect the share price. There was a bit of drama with the Footasylum merger being blocked and then the executive chairman, Peter Cowgill, being caught meeting in the car park with the Footasylum boss, but I don’t think this is so important in the wider scheme of things. The price dipped since then along with many other shares, potentially due to the fears about increased supply chain costs that were afflicting many other businesses, but more recently has started to recover. I bought a few more shares over the past quarter and will wait to see its next update, which should be coming pretty soon now, before deciding whether to buy more.

Broadridge (3.5%): Broadridge’s last results showed steady progress as usual. The share price has been making slow but steady progress too. This is the kind of more reasonably valued steady compounder that I would expect to do well in a more inflationary environment. I could easily be tempted to buy a few more shares.

Alpha FX (3.4%): Alpha FX is a fairly recent purchase. It is growing very quickly at the moment and it announced that it was trading ahead of expectations at the beginning of December. The valuation is not especially cheap but the price is shaping up to break out to new highs so I am in two minds as to whether to add to my holding.

Impax Asset Management (3.3%): Impax continues to grow rapidly, benefitting from the trend towards ESG investing. It really has done quite spectacularly well for the last few years. As for Liontrust I don’t really have a good sense for when its fortunes might change so I don’t intend to add more, but I’m happy to let my existing position run.

Adobe (3.2%): Adobe’s last results were met with a bit of disappointment as its forward guidance came below what some analysts were hoping for. The business is very high quality and resilient, though the valuation is not that cheap. I’m unlikely to sell unless trading unexpectedly deteriorates but this isn’t at the top of the list of candidates to add to.

Inmode (3.2%): Inmode’s last results great, showing continued breakneck growth ahead of expectation. However, the share price has fallen over the last quarter, putting my investment more or less back to square one. The price looks superficially cheap given the rapid growth rate but I feel somewhat uneasy about an incoming slowdown in growth and don’t trust me ability to judge how sudden this may be. This is nearer the top of the list of candidates to sell.

Adyen (3.0%): there hasn’t been any news for Adyen since my last quarterly review. Most of the payments sector has taken a bit of a pummelling over the past quarter. While Adyen hasn’t been that badly affected it hasn’t been unscathed. I feel ambivalent about Adyen at the moment. My main concern is the rich valuation, but the business seems able to grow profitably at such a rapid and sustained rate that it seems to be worth it. I have quite a lot of conviction in the future prospects so it is tempting to look at any volatility as an opportunity to add to my holding.

The remainder of my portfolio consists of smaller positions in MasterCard, Keystone Law, CoreCard, Diploma, Cerillion, Autotrader, Pinterest, and Canada Goose. Most of these have been acquired more recently, so I’m not thinking of selling and would be happy to add to depending on progress.