Hall Capital “Market Views” Newsletter July 2024

This is the 57th edition of Market Views from HALL CAPITAL. Our aim is to provide concise views of where we see risk and opportunity for investors.

Is the Narrow Market a Major Risk in the Outlook?
- not really

As noted in our letter at the beginning of this year, “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.”  So far this year, we have seen a validation of this prospering.

If the market leaders, a handful of AI driven tech stocks, enter a correction, will this bring down the S&P 500? Likely, if only due to their weight. If the market leaders sag some or tread water for a while, will the broader market catch up in relative performance? Likely. Could the market leaders give up all their relative performance in the last 18 months? Highly unlikely. Are we in a bubble like 1999 – 2000? No.

For over a year, pundits in the investment business have almost daily lamented the “narrow” market – one where only a few stocks drive the performance of the cap weighted S&P 500, while the thousands of other stocks languish, trailing far behind. First, just how “narrow” is the market? Very. The S&P 500 is up 15% this year, whereas the average stock in the S&P 500 is up just 5%. The Russell 2000 is up less than 2%. NVIDIA alone accounted for a third of the S&P 500 performance in the first half of the year.

The lament is based on two factors: 1. Frustration among professional investors who deploy an array of different investment styles across the broad investment universe and who, by virtue of missing just half dozen or so stocks, find it extremely challenging to keep up with the most popular equity benchmark, the S&P 500. 2. An eerie feeling that the market is unhealthy, and the bull market run could end badly due to its narrow leadership.

I don’t remember a market this narrow except back in 1999 -2000. That eerie feeling among some money managers may be due to worry that the AI boom is like the dotcom boom which became a bubble and popped in early 2000. Professional investors are experts at pattern recognition.  The assumption is that patterns of market behavior become a rule and these patterns will repeat themselves. Frequently, maybe even most of the time, they do. But the world is constantly changing and past is not necessarily prologue.  Many senior investment professionals of a certain age remember all too well the dotcom bubble and its aftermath. Many stock market leaders in the 2000 run-up crashed badly. Some didn’t survive at all. Cisco was the poster child among mega cap superstars driving the index in the late 90s into early 2000. Cisco is still around, but its stock never recovered to the highs reached in 2000. I do not think 2024 will be like 2000. That is, while risks abound, the narrowness of the market is not a major one. NVIDIA is not Cisco.

There are many parallels to 2000, however:  A new technology emerges that has potential to impact everyone - businesses and individuals alike. Stories of the impact of the new technology capture the imaginations of investors. The stock market is driven by a few big stocks surging with no apparent limit, driven by momentum and FOMO.

There are also key differences between the AI boom today and the internet bubble of 2000.  While AI may ultimately rival the internet bubble, we are closer to 1997 than 2000 in terms of the life span. The launch of ChatGPT in the fall of 2022 was AI’s “Netscape moment”. (Netscape went public in August of 1995 and spurred on the excitement of the dotcom era).  And even though the AI boom is young, sales and earnings are already being realized. While momentum, FOMO and required buying by cap weighted index funds were behind the run up in the leading AI stocks, there was another important contributing factor as well: sharply improving company fundamentals.

The leading AI stocks such as NVIDIA, Microsoft, Alphabet, Meta and Amazon were up on average 228% over the last two years.  However, their earnings per share, last quarter compared to two years ago this quarter, were up even more. This earnings increase was from a noisy base but suffice it to say the average P/E of this group, while hardly depressed, is not near that of the market leaders reached at the peak of the dotcom era. The average P/E based on this year’s estimate of the five AI leaders mentioned is 35x. Five years after the “Netscape moment” many of the leading internet companies had only meager profits, if any at all. Cisco traded at 200x earnings with a market value over $500 billion.

And, yes, there is a speculative hue to the market, especially in meme stocks, crypto and even over AI.  However, as noted, the speculation in AI is being rewarded with results, at least for the “picks and shovels” providers. Furthermore, a market that is dangerously speculative is usually one seeing an explosion of IPOs.  Unlike 1999 when there were 560 IPOs launched, last year there were only 154, and 93 so far this year. Hardly an explosion.

If the historical seasonal patterns hold, the market is due for a rest come August or September. But without some bad news on the macro front, I am not expecting more than a rest.  The average stock has performed just average relative to history. The above average performance of the cap weighted indices is due to the AI stocks attracting above average attention – deservedly so. If the market declines modestly absent significant macro headline news, it will be due to natural profit taking or rebalancing. That is, the narrowness itself will not cause a debacle. Political issues are another matter entirely, and some of those will be covered in the next quarter’s letter.

Balancing Risk and Opportunity
- is the essence of good investing

It doesn't take an investment genius to build a conservative portfolio. Nor do you need to be as astute as Cathy Wood to build an aggressive portfolio, especially with all the super charged ETFs available today. A very conservative portfolio may decline some but will usually hold up better than the market in a major market decline. Likewise, an aggressive portfolio should at least participate in the upside of an ebullient market.  It’s more of a challenge to build a portfolio that protects against major loss while at the same time keeping the door open to opportunity. This balancing of risk and opportunity is what we attempt to do with our Focus List. We do this by managing both types of risks: fundamental risk and price risk.

Of course, developing special insights that the market is missing helps in discovering opportunities. Although I have an insight from time to time, I must admit special insights are rare.  Most of the performance of the Focus List is driven by selecting companies with enviable competitive positions and strong balance sheets selling at reasonable prices. While there are a host of other factors that come into play, these few considerations are the most important. The quality of these companies tends to help limit losses due to fundamental risk. Industry leading competitive positions provides opportunity to the upside. And, of course, buying at the right price helps to both limit losses and increase opportunity.

Focus List Returns 11.7% YTD
- vs 15.3% for the S&P 500

Even with some Big Tech it was difficult to outperform the S&P 500 this year without NVIDIA. Our Focus List was no exception. The lack of NVIDIA explained all the difference. It didn’t need to be so. Our process identified NVIDIA as a good value in the fall of 2022.  But by the time the end of the year rolled around the stock was up and I didn’t raise the earnings outlook fast enough. So, it was not a failure of process, but a failure of portfolio management on my part. NVIDIA will likely enter the FL at some point in the future given its enviable competitive position.

The narrow market was particularly evident over the last three months when the average stock in the S&P 500 actually declined over -2%. FL turned in .7% vs 4.3% for the S&P 500 index. While I do expect the market to broaden out when interest rates finally decline, I realize we don’t need the S&P 500 Equal Wtd ETF to participate. So, we are dropping it from the list. We are also dropping Corning on price. We are adding Everest Group, another insurer, but one primarily focused on the re-insurance market. Like Unum, Everest’s large intermediate term fixed income portfolio will benefit if interest rates stay higher for longer as low coupon bonds mature and are reinvested. (I realize that we are buying EG in the face of Hurricane Beryl which is the strongest hurricane in history this early in the season, but our view is beyond one storm).

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. P/E fwd: 14x.
Verizon - largest cell phone service provider in the US. Some debt but 6.4% dividend yield.
Shell - lowest multiple of the global energy giants. Leader in LNG.
Heidrick and Struggles - a leading global recruiting firm with large cash position and no debt. P/E:12x.
Alphabet - Google is the "oxygen of the internet". Competes in cloud computing, AI and many other forward technologies. Controls 92% of Search. Most Googled word is YouTube. Fortress B/S.
CVS Health - with Aetna insurance, large store footprint, and PBM, CVS has the chance to become the most integrated US health care company. P/E 10x.
Apple - most recognized brand in the world, with 1.4 billion users providing new growth opportunities in service revenue and wearables.
Everest Group - Leading reinsurer with good record of risk control. Concerns over impact of climate change overdone as pricing is adjusted regularly. P/E: 6x.
Goldman Sachs - Wall Street's premier investment banking firm.
Medtronic - global medical device giant serving 130 countries. Holds over 49,000 patents on life science devices.
Unum - largest disability insurance provider in US. Benefits if interest rates stay higher for longer. P/E: 7x.
Meta Platforms - controversial dominant social platform which 60% of US use daily via either Facebook, Instagram or Whatsapp. 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. 40% invested in Exxon and Chevron.
Lennar - a leading home builder growing despite high mortgage rates. More long term opportunity as affordability eventually improves. Strong B/S and cash generation. P/E: 10x.
Amgen - strong pipeline including a potentially superior obesity treatment drug according to phase I results. 16x 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

"Is AI a Risk or an Opportunity? – both.  The benefits of AI far exceed the risks, IMHO."
- The run in AI related stocks that began early last year has only accelerated since then.

"C3.AI’s stock has tripled this year . . . C3.AI may triple again, but I wouldn’t bet on it. My preferred AI winners are in the Focus List: GOOGL, META and AAPL. Not only do these companies have AI models, they also have the data."
- C3.AI’s stock declined - 37% over the last year.

"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.. Apple, Meta and Alphabet are the strongest competitors in the Focus List."
- APPL, META and GOOGL were up 48% on average 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

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