Client Investment Letter July 2023


“When you are in the eye of the storm, you are often not aware of the whiplash around you.” — Hugh Bonneville


In the last quarter, a sense of calm has come over the equity markets. The tumult of the first quarter of 2023, with its bank failures and high equity volatility, has given way to an eerie sense of calm. Tech stocks have made a huge comeback on the heels of excitement about the growing applications for artificial intelligence (“AI”). The labor market has remained strong, with unemployment off its all-time lows but still at a very low 3.7%. The Federal Reserve didn’t hike rates for the first time in the last eleven meetings but promised that unless inflation cools closer to its 2% target, more hikes are in our future.


While the better tenor of the market has been a welcome respite, we remain somewhat cautious on the outlook from here. Fed policy impacts the economy with long and variable lags, and the rate increases the Fed put through months ago are only just now working their way through the economy. A prime example of this is in commercial real estate. Last year, transactions basically froze after the huge increase in rate hikes over a short period of time. Now that the shock is over, buildings are starting to change hands again and in some cases the picture isn’t pretty. Office properties generally are down over 20% from their prior values and in certain coastal markets things are worse. Couple this with a banking sector that has lost a lot of funding as deposits have fled and it looks like there could be a significant credit cycle coming in commercial real estate. Indeed, in some cases, building owners are already handing the keys over to their lenders rather than trying to salvage their equity. As more and more commercial loans hit their maturity dates, the challenges in commercial real estate will become more prevalent. This small subsegment of the economy probably isn’t the only one that will face headwinds as higher interest rates make their presence felt.


One important area of the economy that has been quite strong lately is the consumer. Sentiment, spending, and savings have all grown so far this year, thanks in large part to a strong employment market. Additionally, prices at the gas pump and certain other commodity costs are down substantially year over year, helping consumers to feel wealthier. However, there is a chance this will change. One Covid-19 policy that has been ongoing for over three years now has been the suspension of student debt payments. With the passage of the recent debt ceiling deal, payments of these loans will resume starting in October. Considering nearly 43 million Americans had their payments deferred, this could be a headwind for consumers in the fall. Plus, unemployment might pick up as the Fed’s restrictive policies take hold.


In sum, the possibility of an interest rate induced economic slowdown remains front and center. Indeed, that is the Fed’s stated goal with inflation still running at a too hot 4.0% and at 5.3% excluding food and energy. The yield curve remains inverted, a sign that the bond market still believes a slowdown is coming. We continue to remain patient, waiting for the opportunities that would allow us to convert some of your cash reserves into investments in high-quality companies at more attractive prices. But we don’t need broad macro weakness to find good investments. In fact, aside from a handful of tech names that are up a lot this year, most of the market is broadly flat after having a rough 2022. There are interesting companies already approaching prices that we think are attractive. Indeed, one such opportunity presented itself this quarter.


We were able to purchase an initial position in Match Group, a leading provider of online and mobile dating apps, at what we believe was a very attractive price. Match’s strategy is to own a portfolio of dating properties, starting with the early days of PC-based website As new properties have come out, Match has often acquired or developed them. Tinder, which is today the world’s leading mobile dating app, was incubated by Match. Hinge, which originally leveraged Facebook connections to allow people to meet friends of friends, has been growing like a weed since it was acquired by Match in 2018. Additionally, we expect Match to continue to launch new organic dating apps as it did in June. The company, through its portfolio approach, has over 60% market share in U.S. online dating and additional opportunities globally. We believe the online dating market is attractive as it no longer has a stigma associated with it, and as younger generations delay marriage, they are dating for longer. Human connection is a basic need, and we expect people to continue to date no matter the economic environment. Match stock had declined from $180 to less than $40 over perceived concerns about Tinder where growth has slowed down. We expect Match to improve the situation at Tinder through operational and product changes, while Hinge becomes big enough to help reinvigorate growth for the whole company. At a nearly 10% free cash flow yield, we felt the need to “swipe right” and add Match to your portfolio.


While the relative calm of the last quarter probably won’t persist indefinitely, we continue to believe your portfolio is well positioned. You own many high-quality companies that should weather any near-term challenges and stand ready to participate in the growth that will undoubtedly ensue during the next economic cycle. You also have a healthy dose of cash and short-term Treasuries to take advantage of additional opportunities that may arise if the calm of the most recent quarter proves to be the passing of the eye of this economic downcycle. Higher rates now allow us to earn in the neighborhood of 5% on idle cash while we wait. Additional weakness driven by a recession would allow us to buy more new companies and add to existing holdings, planting the seeds of tomorrow’s investment harvest.


We are actively scouring the markets for new investments that will be additive to your portfolio and we are prepared to guide it as best we can through whatever comes next. Thanks as always for the trust you place in us and please reach out to schedule a meeting or phone call if you’d like to review your portfolio in more detail.


Penn Davis McFarland, Inc.
July 2023