Hall Capital “Market Views” Newsletter July 2023

This is the 53rd edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

Is AI a Risk or an Opportunity?
- both

AI presents risks and opportunities for civilization and investors. When considering its impact on civilization, AI’s potential has been compared to that of transformative technologies like electricity, cell phones, 3D printing, and the atomic bomb. In my opinion, AI has the potential to surpass the impact of cell phones and 3D printing. The comparison to a nuclear bomb is difficult as a bomb is a weapon and AI is not meant to be a weapon, although it could be. While I am sure AI will be used to some degree by miscreants spreading misinformation and causing problems we can’t imagine at this time, I do not perceive a large risk that AI will somehow rule humans. I trust that in due course effective regulation will reduce the risk of a widespread calamity. The benefits of AI far exceed the risks, IMHO. According to a study by Goldman Sachs, the productivity increases due to AI could create enough wealth to pay off the US national debt!

Turning to the investment risks and opportunities in stocks, there are two types of risks: “price risk” and “fundamental risk”. Price risk is overpaying for a stock based on its projected sales and earnings, while fundamental risk relates to a shortfall in expected sales and earnings. Then there are the disastrous circumstances when both are present – the proverbial double whammy.

Currently, there seems to be more price risk than fundamental risk in the AI sector. The excitement surrounding AI since ChatGPT was released last November has inflated the valuations of AI-related stocks based on significant growth expectations. The blue-chip poster child for the leader in supplying the “picks and shovels” to the AI gold rush is NVIDIA. NVIDIA is an extraordinary company with fabulous fundamentals as THE leader in GPU-accelerated computing. However, the stock trades at 42x sales and 227x earnings. While there is price risk in NVIDIA, many stocks caught up in the AI frenzy are subject to the double whammy risk. C3.AI’s stock has tripled this year, increasing even more than NVIDIA. When the company was founded, it was just C3. C3’s original business was helping companies manage their carbon capture programs. When that didn’t work out as planned, C3 changed its focus to the Internet of Things and changed its name to C3IoT. Now the company has renamed itself again to C3.AI CWhateverIsHot has never made a profit and trades at 1000x forward estimated earnings. C3.AI may triple again, but I wouldn’t bet on it. Companies like C3.AI feel gimmicky to me. Avoid gimmicky stocks to avoid the double whammy. My preferred AI winners are in our Focus List: GOOGL, META, and AAPL. Not only do these companies have AI models, they also have the data. More on this below. Other investment opportunities in AI will be companies that can figure out how best to apply the tools the AI companies provide. These stocks in the broader market may be more attractive in the near term given the rapid appreciation of a few Big Tech stocks driving the capitalization weighted indices so far in 2023.

Doesn’t being value conscious on price risk mean that you miss some big winners? Absolutely. However, as you can see from the Focus List performance, it is possible to miss big winners like NVIDA, Amazon, Tesla and Netflix and still outperform the S&P 500. Note at one point in 2022 these four stocks were down at one point -62%, -41%, -69% and -71% respectively. And these companies are hardly weak competitors with lousy fundamentals. Stocks suffering the “double whammy” performed, as you might expect, even worse. Since 2020 or 2021 Zoom, Peloton and Rivian have declined -88%, -96% and -92%, respectively.

Competitive Position
- the key to long term returns

As noted above, I am careful to avoid price risk. On the fundamental side I put more effort in assessing long term competitive position than what next quarter’s earnings are going to be.

Most investors consider the competitive position or “moat” of any stock they buy. However, I would argue it doesn’t carry as much weight for most investors as it should. You tend to hear more about the company’s product, its market growth or the stock’s valuation. These are important considerations but only in context of the competitive position. Factors related to competitive position that we consider in every Stalwart purchased include scale, brand/technology, distribution, pricing power over suppliers and customers, cost position and return on invested capital.

Companies with narrow moats often sell at a discount for a good reason. In the 1967 movie classic The Graduate, family friend Mr. McGuire pulls Benjamin aside at a party, and tells him that his future lies in just one word. “What word is that, Mr. McGuire?”, Benjamin asked. “Plastics”, Mr. McGuire replied. Since 1967 the growth of plastics in our society has exploded improving our convenience while degrading the environment. Today there are over 500 billion plastic bottles alone produced a year. So, Mr. McGuire was right, there was a future of sorts in plastics. But was investing in this large growing industry a good bet? Perhaps so in some specialty areas, but intense competition kept the mainline plastic makers from creating outsized wealth. Dow Chemical, founded in 1857, has grown to be the largest plastics producer in the world. While Dow does have scale, the intense competition has kept Dow’s ROIC to merely average. The stock sells at a discounted P/E with a market cap of just $37 billion. Apple, Meta and Alphabet have all increased their market cap more than twice Dow’s entire market cap in a single day!

A company that has a moat that can allow it to enjoy a high return on invested capital into the distant future is clearly worth more than a company whose pricing power is limited by competitors. Strongly competitive companies may sell at a premium valuation, but the underappreciated value of their moats often warrant yet higher values – sometimes very much higher. Apple, Meta and Alphabet are the strongest competitors in the Focus List. These three (as well MSFT and AMZN which are not in the Focus List at the moment) are scored highly on all six of the aforementioned factors. The manifestation of a wide moat is strong pricing power which all of these have. And, as also noted, these companies have something else which may prove to be highly valuable in the age of AI: data. Lots and lots of data.

Alphabet may be the data king of them all with at least five mega apps: search, Gmail, Chrome, YouTube and Android. GOOGL has over 10 billion accounts. And talk about pricing power. Do you think anyone would drop their gmail or Google Maps if Alphabet decided to apply a $1.50/ month subscription? GOOGL’s main problem is that its competitive position is TOO strong – so much so that the government is seeking to reign that power in, even though it will be hard to prove that consumers have been anything other than helped by GOOGL’s success. Were it not for this regulatory threat, GOOGL’s stock price would be MUCH higher.

AI has only amplified the network effect of these big tech companies. GOOGL has the best search because everyone uses it. And everyone uses it because it’s the best search. That’s a network effect. GOOGL has generative AI models like ChatGPT but that is only part of the moat. The data to feed those models that make them better will ensure that GOOGL will be among the winners in the AI driven world with a stronger competitive position than ever. Meta and Apple are likely to be winners too.

Focus List Returns Returns 17.2% YTD
- including 7.0% for Q2

The cap weighted S&P 500 caught up some with the FL in Q2 with a 8.7% return, but the FL has still outpaced a hard to beat index for the year to date, 1 year, 5 year, 10 year and since inception. (see right).

Since the average stock has woefully underperformed the cap weighted S&P 500 index we are hoping to take advantage of a reversion to the mean by adding the Invesco S&P 500 Equal Weighted ETF to the FL. We are removing the iShares Gold Trust to make room.

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 - 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 >$100 billion.
CVS Health - with Aetna insurance and growing in store clinics, 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. Sales should recover when hospitals inevitably return to normal in a wealthier world which will require more procedures.
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.
Invesco S&P 500 Equal Weight ETF - expect a reversion to mean given massive outperformance of the cap wtd index vs average stock.

Follow Up – from our letter one year ago

"While we are optimistic that inflation will peak soon, we think labor and rents will keep inflation stubbornly higher than Fed targets for some time"
- The next CPI that came out for June of 2022 was the peak: 9.06%. And, yes, it has only slowly declined due primarily to rents and wages. Wages have increased y/y near 7% since the beginning of 2022. And home prices according to the national Case Shiller index dropped only -2% from 6.22 to 6.23 despite mortgage rates rising over 7%.

"Sentiment – both investor and consumer – is VERY negative, which is more consistent with being close to a market bottom"
- After being down 20% in the first half of last year, the S&P 500 has recovered that loss over the last year rebounding 20% back.

" … technological innovations that kept inflation low for 30+ years continue unabated. Technology begets technology."
- Game changing AI app ChatGPT was launched four months later.

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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