Hall Capital “Market Views” Newsletter April 2023

This is the 52nd edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

Investing in Uncertain Times
- must recognize that ALL times are uncertain

When uncertainty is perceived to be low, security prices are high and vulnerable. When uncertainty is the highest, prices, whether for individual securities or for entire asset classes, are low offering above average returns. Discussed below are some key uncertainties and implications for investors.

Inflation is trending down - slowly as expected. Some uncertainty about the ability to restrain inflation is being reduced. That’s the good news. The risk of recession, however, is trending up due to the retrenchment of credit, partly due to the failure of two “medium size” banks.

There were other contributing factors to the failure of Silicon Valley Bank, the 16th largest US bank, than mismanagement. To be sure there was mismanagement, but the bank would not have failed were it not for the pandemic. The pandemic, an out of the blue “Black Swan” event, triggered massive government infusions of liquidity, i.e., free money. This in turn created a tech bubble and an IPO stampede which quadrupled SVB’s deposits from $49 billion in 2018 to $209 billion by the end of 2022. With so many dollars rolling in from the riches in Silicon Valley, SVB put much of their deposits to work in US government securities. The yields were low, but not zero for bonds of extended maturities. We all know what happened to interest rates and bond prices last year. SVB failed, not due to bad credit but due to a duration mismatch within high quality securities. The bank would have survived had depositors held steady long enough for the government bonds to mature. What happened, however, was a classic run on the bank. Signature Bank had a similar problem, but one compounded by exposure to crypto currencies.

There is stress in the banking system to be sure, but this too shall pass. Will there be other shoes to drop? Probably. And credit will no doubt be harder to obtain, which will slow the economy. We said last year that there was a good chance of a recession in 2023. That chance has only increased. Some added caution is in order, but this is NOT 2008, a year in which we experienced a deep recession due to a widespread housing crisis. Housing is being challenged by higher interest rates, but housing is far from a crisis today.

There are always potential Black Swans out there – Russia launches a nuke, China invades Taiwan, Congress defaults on the national debt – any one of which would be damaging to markets. And by definition there are Black Swans we can’t imagine. That’s always been a fact of life in investing. For most of our clients, who have earned more professionally in the past than they expect to in the future, the Black Swan threat argues for a careful approach but not one that is hamstrung by fear of possible, but unlikely, long term losses.

The unwinding of the $8 trillion Federal Reserve balance sheet is a headwind, not a Black Swan. The Fed is now in the mode of Quantitative Tightening, “QT” which will continue for years. This is not a Black Swan because it is an expected and gradual occurence, rather than a low probability unexpected single point event. Nor will QT necessarily be very damaging to markets. Our base case is that the draining of liquidity from the system will RESTRAIN returns, holding them back from above historical levels, rather than causing steep losses. The same can be said for another headwind: the cost of dealing with climate change. Providing growth to offset these headwinds to some extent will be remarkable technological advances. Recent advances in artificial intelligence alone will have a major impact on the economy.

While I acknowledge that these macro issues are very important, our focus is more on how individual companies are navigating the environment. This has proven very productive historically through good times and bad times. A fully invested portfolio rebalanced to our Focus List over the last 13 years has provided an average annualized return of 15.8%, well ahead of the market.

Time Horizon Arbitrage
- can add handsomely to returns

I was watching CNBC recently and within 15 minutes I heard three quotes on the show from different investors that confirmed their focus on the short term: “In this market environment…” ; “At this time…”; “Right now…”. Of course, the “market environment” eventually changes. Do these investors then move on to take advantage of a new environment? Maybe there are those who are nimble enough to make these shifts. I am not, and I have seen little evidence of those who are, despite the millions of investors who try. On the contrary, I have seen ample evidence that investors who stay focused on the long term do quite well – especially on an after-tax adjusted basis.

Many of the commentators on CNBC seem to be trying to position for market turns over the next month, quarter, or balance of the year. I can say as one experienced investor, I have little insight into what the market will do over the next month, quarter, or even year for that matter. While I may share my opinion, I confess it isn’t worth much. When it comes to expected returns over say five or ten years, my confidence, while far from absolute, is much higher.

So, what do I mean by “time horizon arbitrage”? Time horizon arbitrage is capitalizing on a short-term aberration that momentarily makes an otherwise attractive long term investment look somehow less desirable. This is what we are trying to exploit when we add a “Fallen Angel” to the Focus List. These Fallen Angels are stocks that fall sharply due to near term earnings shortfalls or fears of shortfalls, but, according to most informed analysts, still have an attractive long term outlook.

Let’s take Lennar, the second largest US homebuilder, as an example. We added Lennar to the Focus List nine months ago. At the time everyone knew that the increase in housing prices during and after the pandemic outpaced inflation. The sharp increase in prices challenged affordability. The Fed started raising interest rates in March of 2022 and everyone knew that the Fed would have to continue raising interest rates aggressively to thwart inflation. Everyone also knew that housing prices were very sensitive to higher mortgage rates which only exacerbated the affordability issue. And to continue what everyone knew, housing sales were going to plummet for the homebuilders. Lennar’s stock, similar to all the homebuilders, was down 38% in the first half of 2022, much worse than the drop in the S&P 500. Lennar was trading at just 5x 2022’s earnings estimate. Meanwhile, the company had no debt net of cash, not to mention land banked for future development. Investors were caught up in the very visible short term challenges. Many analysts pulled their ratings a year ago. At the same time most analysts conceded that Lennar would perform well over the long term due to the mismatch between supply and demand in the US housing market caused by underbuilding since the 2008 financial crisis, not to mention the impending wave of millennials coming of homebuying age.

To be sure, shortfalls in earnings can signal long term problems. Eastman Kodak was a leader in film cameras and film production. However, they became a follower into digital cameras as their film sales waned. The likes of Panasonic, Fuji and Canon did them in. Lennar is no Eastman Kodak. There is no new technology that will take the place of the home. China is not a threat to US home building. Nor is Amazon. In the case of Lennar, we were able to “arbitrage” the time horizon of investors. The stock has returned 50% in the nine months since last July.

(One might ask if some of the regional banks, such as First Federal, which have sold off dramatically recently are Fallen Angels. Note our Focus list has no regional banks and we are not viewing them as Fallen Angels with only short term problems. Do you think their loss of cheap deposits is temporary for First Federal? I doubt it and cheap deposits are central to their business model. Furthermore, many regional banks are heavy into commercial real estate, including office buildings.)

Focus List Erases All of Last Year's Losses
- and then some

Our FL had a bountiful quarter up 9.5% vs. 6.0% for the S&P 500. Returns were boosted by big tech but were restrained by the pull back in our financial stocks, such as our two insurance stocks and Goldman Sachs. The whole financial sector was dragged down by the SVB debacle. Unum and Allstate were no exceptions, even though insurance companies are not vulnerable to a run on deposits. Goldman Sachs is an investment bank, not really a commercial bank. This quarter helped boost our the FL returns (see right).

We are adding the C-suite recruiting firm Heidrick and Struggles to the FL. Although it is a small cap stock, H&S has a global reach and has served over 70% of the largest 1000 companies in the US. Clearly, once an executive has been placed by H&S, that executive is unlikely to forget who placed her/him. The stock is down 40% from its high. Earnings are coming down from the post pandemic rebound. This is an average business with average growth prospects. However, H&S has a much better than average balance sheet (no debt and a large net cash position) and sells at a 50% discount P/E from the average stock. H&S takes the place of NovoNordisk which has become fully priced.

For individual stocks as well as selection strategies, past performance is not necessarily indicative of the future.

Hall Capital Focus List

Allstate - strong brand. Strong balance sheet. Steadily higher dividends.
Verizon - largest cell phone service provider in the US. Some debt but safe 6.6% dividend yield.
Shell - lowest multiple of the global energy giants. Leader in LNG.
Heidrick and Struggles - leading global recruiting firm with strong balance sheet and depressed stock price.
Alphabet - Google is the "oxygen of the internet". Competes in cloud computing, AI and many other forward technologies. Cash on hand >$115 billion.
CVS Health - with Aetna insurance and growing in store clinics, the chance to become the most integrated US health care company.
Apple - brand with 1.4 billion users providing new growth opportunities in service revenue and wearables.
Corning - technological leader in glass for fiber optics and displays.
Goldman Sachs - Wall Street's premier investment banking firm. Stock trading near book value.
Medtronic - world's largest medical device company. Sales should recover when hospitals inevitably return to normal.
Unum - established life and disability insurance provider which benefits from higher interest rates.
Meta Platforms - controversial dominant social platform which 60% of US use daily. Stock has rebounded strongly due to massive cuts in expenses.
Micron - a leader in memory chips with strong balance sheet able to withstand the expected cyclical downturn.
Energy Select SPDR - hedge against energy driven inflation.
Lennar - a leading home builder facing near term slump in sales but long term opportunity as affordability eventually improves. Strong balance sheet.
iShares Gold Trust - hedge against uncertainties.

Follow Up – from our letter one year ago

"Our view is that inflation will remain stubbornly high (rent and wage increases are not transitory) and interest rates will move higher"
- Inflation has moved down some but only very slowly. The Fed has expunged "transitory" from its vocabulary.

"… we wish to hedge against higher inflation/interest rates. We will continue to do this by 1. avoiding long term bonds 2. holding equities that benefit from higher interest rates, such as our insurance holdings, 3. avoiding high p/e long duration stocks …"
- All aspects of this strategy worked in our favor which contributed to the FL holding steady in a market that was down -7.7%

"Avoiding Common Mistakes - could be the key to long term returns. Trading rather than investing (is one)."
- Note that all the stocks in the FL, but one, a year ago are still there. We are investors, not traders.

NOTE: Now in addition to ALL our quarterly letters, on our website is a tab with just the Follow Ups.

About HALL CAPITAL

HALL CAPITAL, LLC is a registered investment advisor and was formed by Principals from Arcturus Capital in 2010.
For more information, contact Donald Hall 626 578 5700 x101 dhall@hallcapitalmanagement.com

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