Hall Capital “Market Views” Newsletter January 2024

This is the 55th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

The Artificial Intelligence Revolution
- is just beginning

Usually, it takes a surprise to drive stocks and bonds up at an above average rate. This was the case in 2023 when the S&P 500 recovered its losses of 2022 and rose to within a whisker of where it was two years ago.

That surprise was the "Goldilocks economy"- not too hot, nor too cold.  Inflation steadily trended down, but the economy and employment stayed firm, even with short-term interest rates held higher than they have been in 16 years. Now that inflation is near 3%, most pundits think the Fed will start to lower interest rates at least three times in 2024 which should extend economic growth further. If inflation warms back up causing the Fed to do anything other than lower interest rates, that would be a surprise not welcomed by the market.

In addition to inflation improving and the economy holding up despite a challenging interest rate environment, another factor contributed to investor ebullience. It was the remarkable coming together of our political parties and lack of partisan rancor. Hardly!  No, it was the excitement over the growth and profit potential of Artificial Intelligence.

I believe we are in the second inning of the AI Revolution which will provide untold opportunities as well as risks. If we look at the introduction of the internet as an analog, the investor enthusiasm began in 1995 with the IPO of Netscape and went into early 2000 before the dot com bubble deflated. We could very have five years of exuberance associated with the rollout of AI, but without suffering the same fate of the dotcom bust. The market is indeed exuberant, but more rational – at least so far.

Winners in AI will be of two types: AI Enablers (those who provide AI) and AI Exploiters. Seven leading companies in AI (Alphabet, Apple, Amazon, Microsoft, NVIDIA, Meta and Tesla) aka "The Magnificent Seven" contributed as much return in capitalization weighted S&P 500 index in 2023 as the remaining 493 stocks!. The Enablers have the data and are forging the tools for the Exploiters to use. The Exploiters are the companies that will use AI to their competitive advantage.

The Enablers will be the first to gain from the AI Revolution. Unlike the exuberance in the late 90s over potential, but speculative internet derived profits in the future, profits associated with AI are in some cases already being realized. NVIDIA is minting profits now, making the "picks and shovels".  Considering the soaring stock prices of The Magnificent Seven, you might be wondering if there is still opportunity. I believe there is. Given the lead in AI the Mag 7 has on top of existing great businesses, at least some of them, if not all seven, are likely to prosper in an AI-driven world.

We are looking at three strategies to exploit the investment opportunities in AI. One, keep the three of the Mag 7 we already own: AAPL, GOOGL, and META. (Note GOOGL has been on the Focus List for seven years and my description "Oxygen of the internet. Leader in AI" was not added recently, but a label I coined years ago). The second strategy is to be patient and look to buy more names in the Mag 7 at the right price, MSFT particularly. Note the three on the Focus List were all selling at a discount to the market multiple when they were added to the FL. The Mag 7 climbed steadily in 2023, but the group can be volatile. Remember in 2022 these seven stocks were down 40% on average. It took a 67% gain just to bring them back up to even with the beginning of 2022. The third strategy is to look for AI Enablers and Exploiters outside the Mag 7 that may have more upside. Enablers outside of the Mag 7 such as Micron, TSMC, Intel, AMD, and even IBM are likely to profit first, followed in a year or two by the Exploiters. Even some of these Enablers not in the Mag 7, including our holding of Micron, have surged due to the AI play. As always, we will be patient for the right entry price.

A Legend Has Passed at 99
- Charlie Munger

Charlie Munger could be classified as an old school investor, but he wasn’t. His judgement had a timeless quality which was as keen and relevant in recent years as it was when he joined Warren Buffet at Berkshire Hathaway some 45 years ago.

It takes both knowledge and judgement to be a superior investor. While Warren Buffet clearly had good judgement and Charlie Munger had plenty of knowledge, I always thought Warren’s forte was keen knowledge and Charlie’s strength was sound judgement. In any case, the pair proved to enjoy an extraordinarily synergistic relationship - for themselves and for thousands of Berkshire Hathaway shareholders.

I was lucky enough to have collaborated with Charlie once on the subject of “Behavioral Finance”, the psychological side of investing. My first lesson in this field was years before I met Charlie. It occurred right after college when I, unwittingly at the time, applied more Behavior Finance than calculus to estimate how many pennies were in a wheelbarrow in a bank lobby. I am not going to bore you with how I did it, but suffice it to say that I won the contest and took home the value of the wheelbarrow full of pennies. Charlie was practicing Behavioral Finance on a much grander scale well before it became a term of art in the 1980s when I began to study it in earnest.

Charlie's views were part of my study. A powerful influence on me was Charlie’s advocacy on being open-minded to new evidence. Charlie disclosed in an interview, “Part of the reason I’ve been a little more successful than most people is I’m good at destroying my own best-loved ideas. I knew early in life that that would be a useful knack and I’ve honed it all these years, so I’m pleased when I can destroy an idea that I’ve worked very hard on over a long period of time. And most people aren’t.” This astute observation is a corollary to Mark Twain’s assertion, “It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that ain’t so.”

Charlie’s ability to be agile in judgement profoundly impacted Warren Buffet and the success of Berkshire Hathaway. In addition to having sound judgement and being knowledgeable, a key to being a successful investor is striking the right balance between a sound investment discipline and “destroying one’s own best ideas.”

Focus List Returns Returns 30.6% in 2023
- well ahead of expectations

The FL held up better than the S&P 500 in the dreadful 2022 as well as in the Q3 downdraft of 2023, but also, surprisingly, outperformed to the upside in the strong rebound in Q4 of 2023. The FL bounced 12.7% for the last quarter vs 11.7% for the index. To suggest that the FL will outperform in both up and down markets going forward would be a stretch. Note, however, over the last decade through ups and downs, the FL has managed to produce a mid-teens return outperforming the S&P 500 by 2.7% per annum.

We are adding three new stocks to the FL: State Street Bank, Amgen and Cigna. They have these factors in common: strong competitive positions, good balance sheets, have lagged the market over the last year bringing their P/E multiple down below average. Furthermore, they are either exploiting AI or have plans to.

We are removing Micron on price. We said when we added it Micron would "sustain a downturn." That was an understatement. This cyclical which has jumped 70% in a year appears now fully priced. Our strategy of "time frame arbitrage" worked well on "Fallen Angel" Micron. We bought cheaply in the face of a nasty downturn knowing there would be another side of the valley, only to sell now as the cyclical upturn comes into view which is reflected in the stock price.

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 7% 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 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. 15x 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

"We continue to believe that inflation has peaked and will continue to come down, but more slowly than the Fed desires."
- Inflation did indeed peak and while it didn't come down as fast as the Fed desired, it dropped quick enough to restore confidence

"Corporate earnings will come down and a "normal" recession is likely. A recession or not, our Focus List still has a long term 10% annual return potential."
- No recession, but we were not worried about the impact of a recession on long term returns, but more concerned about inflation which improved steadily helping boost the prices of both stock and bonds.

"The Fed will continue to raise rates barring a surprise on the inflation front"
- They did indeed raise interest rates, four times until past mid 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