Hall Capital “Market Views” Newsletter April 2024

This is the 56th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

Challenges for the US are Growing
- but they can be met

As a professional investor, I could attend a conference every week if I wanted to. These confabs are stimulating but all too often the speakers/panelists are there in a self-serving role. A conference with speakers whose sole purpose is to share deep expertise to solve big problems is rare. Recently I attended such a conference: the Stanford Institute of Economic Policy and Research Summit.  SIEPR itself described the summit this way: NVIDIA’s Jensen Huang. Ford Motor’s Jim Farley. The Fed’s Adriana Kugler. Former Secretary of State Condoleezza Rice and Australia's Ambassador to the U.S. Kevin Rudd. Our 20th SIEPR Economic Summit brought together more than 300 influential leaders in business, academia, and government to discuss and debate pivotal economic issues — from what’s next for artificial intelligence, electric vehicles, and inflation to how to address problems in health care, big cities, and the U.S. response to China.

In addition to those luminaries, panelists also included national experts who do nothing other than research large problems, such as a member of the Council on Responsible Federal Budget. She is one who testifies to Congress trying to educate legislators on the Federal budget problem.

The clarity of thought was so profound that I thought I would share some conclusions from the speakers/panelists on solving some of the most pressing economic problems facing our country.

China – According to Kevin Rudd, who is the former Prime Minister of Australia and is a Mandarin speaking China expert, Chairman Xi has taken a dark turn toward Leninism. Survival of the Party is paramount in Xi’s mind and total control is necessary to deal with the many growing challenges facing China. And, yes, Taiwan is still in China’s sites. However, Rudd gave a convincing argument as to why China will not make a move on Taiwan until at least 2027, if they do so at all. Jim Farley, the CEO of Ford, said “I’ve never seen a competitor like this before”.  He implied that on a level playing field it would be impossible for US car makers to compete on quality for price with the Chinese automakers, especially in EV.

Inflation – It’s coming down as supply chains normalize and the bite of higher interest rates dampen activity in the interest sensitive sectors. Though this was the Fed’s goal, inflation trending down markedly without a recession surprised almost everyone, according to Fed Governor Kugler. The unemployment rate is the lowest since the ‘60s. Also surprising is that in the recovery following the pandemic, the wages of the most disadvantaged workers increased faster than those of high earning professionals. 40% of the wage compression over the last 40 years was erased. In terms of wealth, the lower half has seen a larger percentage increase in wealth, probably due to robust home prices.  Home value represents a larger percentage of the lower half’s wealth than the upper half, and it is leveraged. Inflation, however, remains stubbornly close to 3% while the Fed’s goal is 2%.

AI – Jensen Huang waxed eloquently on how AI will change the world, mostly for the better.  He asserted that “computing power is approaching zero which will open up untold possibilities (of innovation)”. Responding by AI, which is what we have today, is not the same as reasoning. We don’t have artificial general intelligence yet. But we will. In five years AI will be able to do well on SAT, LSAT, and GMAT tests, according to Huang.

Homelessness and Crime in Big Cities – The newly elected DA of San Francisco noted that her city’s experiment of reducing incarceration is not working. Crime, drugs and homelessness still plague San Francisco. A liberalization of another type - open carry gun laws - in another city, Houston, also increased crime. In fact, violent crime in Houston is 3x that of San Francisco according to the DA. Citizens, at least in SF, have demanded change and are seeing a policy response. It is slowly improving. San Jose is one of the most unaffordable cities in the country due to high housing costs. The San Jose mayor noted that one housing program implemented at the state level ended up costing almost $1 million per “affordable” unit. Newly on the job and new to politics, his more practical and creative approach was able to build housing for only $50k per unit on unused city land where permits were quickly issued. These units were not as nice as the state-built housing, but sufficient to meet basic needs.

Healthcare - The Affordable Care Act launched under the Obama administration gave millions access to insurance they did not have. At that time healthcare cost in our country was 17% of GDP and the forecast was for it to be 23% of GDP by 2024. The good news, even with more insured (because?), the cost is still 17%, well below the 23% forecasted. The bad news is that with aging demographics healthcare cost will start to rise again and become unsustainable. The only practical solution, according to all the panelists, is basic universal health care for everyone. More like “Medicaid for all”.  Not Medicare for all. We can’t afford the generous benefits Medicare offers. But our rich country could afford providing the most BASIC healthcare for all its citizens. And this panel of healthcare experts all agreed that the system needs to reward healthcare providers for providing preventive care, as well as symptom relief.

Federal Debt - Our growing budget deficits are not sustainable. The Federal Government will spend more on interest in the coming year than on defense.  The solution requires reforming both Social Security and Medicare AND some additional revenues from tax increases.  The bipartisan Simpson Bowles proposal made in 2010 had it right.  However, the current nominees for POTUS from both parties are promising not to touch SS and Medicare.

My concluding observations: 1. The world would be a better place if it were run by practical, solution-oriented economists rather than idealogues! 2. China is a formidable competitor, but the US has competed well when we have had a comparative advantage and both countries are much richer due to trade. Given there is so much to gain, both sides should see the advantages to competing and not fighting. 3. Inflation is not fully tamed, and the Fed is likely to err on the side of hawkish policy. 4. AI poses risks to society, mostly through amped up misinformation. But the benefits to society of AI will be greater. 5. Housing, healthcare and the Federal debt are all solvable problems providing we have the political will. Leon Panetta put it this way, “You can govern either by leadership or crisis.”  Let’s hope we develop some leadership.

The Stock Market is Not Efficient
- and that provides opportunity for investors

I believe if a security is truly undervalued, it will outperform eventually; and the converse is true for overvalued securities. Stocks fall into three categories: stocks that almost everyone believes are undervalued; stocks for which the opinion is mixed; and stocks that almost everyone believes are overvalued.  The vast majority fall into the middle category.  A diversified portfolio can’t help but having stocks from the middle category, where the opinion is mixed. But a successful portfolio strategy tries to exploit as many stocks in the first (clearly undervalued) category as possible and always tries to avoid the third (clearly overvalued) category.

One might wonder “How could a stock be undervalued when almost everyone believes it so. Wouldn’t investors just bid the stock up to closer to fair value?” And conversely for overvalued stocks, “Why would anyone buy a stock they knew was overvalued?”  It happens. A lot!

I once counted 57 reasons stocks are bought and sold. Value is just one. Some of the reasons clearly overvalued stocks are bought include a stock that is added to an index and the index funds have to buy it, the buyer likes the company’s product, someone on Reddit recommended it, the stock has good momentum, a stock split etc.   A clearly undervalued stock may be sold (or not bought) because it fell out of an index, the buyer doesn’t like the product, a tax loss is taken, the near-term earnings outlook is poor, and so on.

Examples of stocks from the clearly undervalued first category when we first added them to the Focus List include Lennar, Micron, Meta and Unum. Each were strong competitors in their respective industries, had strong balance sheets, but sold for just 10x earnings on average when we added these stocks to the FL. They have appreciated 125% on average since added within the last two to three years. Unum, for example, was added at 6x earnings and still sells for just 8x earnings despite a 141% rise in the stock price.

As to the clearly overvalued stocks, it’s a fair question to wonder whether the frenzy over AI has bid up the AI oriented stocks to unjustified prices putting them into the third category, like many of the internet stocks in the heyday of that bubble. I don’t think that investors flocking to AI stocks are irrational. NVIDIA trades at 36x times next year’s earnings. I prefer a higher margin of safety against price risk, but if NVIDIA can continue its growth trend for a few more years, it will prove to be a cheap stock today. While the psychology behind NVIDIA and its charismatic founder is clearly ebullient, the record of accomplishment and outlook fundamentally support this enthusiasm.

However, there are pockets of the market where psychology alone is driving stocks. Where values are divorced from ANY reasonable assessment of fundamentals.  Meme stocks such as AMC, GameStop and Bed Bath and Beyond, which you don’t hear much about anymore, were examples of gross inefficiencies brought on by vindictive psychology, market manipulation and FOMO. The very recent IPOs of Reddit and Trump Media and Technology Group are emerging as new meme stocks. Take Trump Media and Technology Group (the holding company for Truth Social) which came public via a controversial SPAC merger.  Total revenues for last year totaled only $4 million with losses of over $50 million. Yet the stock traded last week with a fully diluted market value of over $10 billion. That is more market value than US Steel which booked revenue of $18 billion last year and nearly $1 billion in earnings. And I don’t even think of US Steel as a good value! So, add to the 57 reasons stocks are bought and sold “supporting a political candidate”.

The large US stock market is mostly efficient and behaves in a rational manner because most investors are rational. You would expect the market to become even more efficient in time as investors learn from their mistakes, especially these days with the democratization of information.  But the market is not a large language learning model. It is a stew of emotions made up of the tensions between fear, greed, and hunger for power. And in recent years, even vindictiveness. Markets have always produced distortions and they will continue to do so.

One can make a lot of money catching a wave on meme stocks, hot IPOs, crypto, etc. Or one can lose a lot of money. We will win some and lose some, but we won't be doing it that way. That inefficiencies occur means more opportunity for a strategy focused rigorously on a comprehensive notion of value, knowing full well that other factors may contribute to a divergence. In fact, the active investor is counting on it.

Focus List Returns 10.9% in Q1
- vs 10.6% for the S&P 500

The FL held up better than the S&P 500 in the dreadful 2022 as well as in the Q3 downdraft of 2023, but it also, surprisingly, outperformed to the upside in the strong rebound in Q4 of 2023 and now the Q1 of 2024. I will say again, do not expect the FL to continue to outperform in both up and down markets.

We are not adding any new names to the list this quarter, but if we did they would be even more conservative than usual or resource stocks as a hedge. The equity market has enjoyed a meteoric rise over the last six months during the "Goldilocks economy". Prices are lofty and stocks are now facing competition from rising bond yields. The stock market is due for a rest.

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 6% dividend yield.
Shell - lowest multiple of the global energy giants. Leader in LNG.
Heidrick and Struggles - a 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 exceeds debt >$100 billion.
CVS Health - with Aetna insurance and growing in store clinics, CVS has the chance to become the most integrated US health care company.
Apple - premium 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 - global medical device giant serving 130 countries. Holds over 49,000 patents on life science devices.
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. Potential to exploit treasure trove of data further with AI.
State Street Bank - custodian of scale for $37 trillion in an oligopoly service industry provides durable competitive position, but stock is valued like a commercial bank at 10x Forward P/E
Energy Select SPDR - hedge against energy driven inflation.
Lennar - a leading home builder doing well despite high mortgage rates and more long term opportunity as affordability eventually improves. Strong balance sheet.
Invesco S&P 500 Equal Weight ETF - expect a reversion to mean when interest rates decline given massive outperformance of the cap weighted index vs average stock.
Amgen - strong pipeline including a superior obesity treatment drug according to phase I results. 14x Fwd P/E
Cigna - a leader in value based healthcare (payments to providers based on outcomes rather than fee for service). Solid position among large employers and government. 11x Fwd P/E.

Follow Up – from our letter one year ago

"Some uncertainty about the ability to restrain inflation is being reduced. 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 is stress in the banking system to be sure, but this too shall pass."
- The stress in the banking system did indeed pass and, surprisingly, without a recession.

"Housing is being challenged by higher interest rates, but housing is far from crisis today. There is no new technology that will take the place of the home. China is not a threat to US homebuilding. Nor is Amazon. In the case of Lennar we were able to ‘arbitrage’ the time horizon of investors."
- Home sales dipped due to higher interest rates but pent-up demand only increased making a future rebound almost certain. We held our position in homebuilder Lennar whose stock rose 71% over the last year.

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

HALL CAPITAL | 199 S. Los Robles Ave | Suite 535 | Pasadena | CA | 91101