Dear Trusted Partner,
Happy New Year! The market finished the year on a high note, building on the rally in October. The benchmark S&P 500 gained +4.52% in the final month. The Dow Jones Industrial Average and Nasdaq Composite appreciated +6.14% and +4.12%, respectively. It has been a strong year for financial risk assets like stocks, even if the performance has been generally limited to a small percentage of the equity indices. The widely followed S&P 500 has almost recouped its losses from 2022. Precious metal gold increased by +0.78% to lag behind the riskier equity indices.
In December, we saw a new record of 71% of companies in the S&P 500 that underperformed the broad index return for the year (the previous high was just before the 1999/2000 Dotcom Bubble). The constant among the Magnificent 7 is their association with artificial intelligence (AI). Indeed, these businesses have operations unrelated to AI but have all publicly invested in significant capital projects involving artificial intelligence. We are firmly in the camp that this craze of artificial intelligence will wane as there will be some benefits but nothing that justifies the market valuations attributed to these projects. We believe this AI speculation will eventually go alongside internet stocks (1999), crypto and NFTs, marijuana stocks, and quantum computing. Separately, as we wrote last month, this extreme concentration occurs while witnessing a historic high in unprofitable companies. Unprofitable companies are struggling to navigate capital markets as we have a continued rise in Chapter 11 bankruptcies that have accelerated through December and are well above pre-pandemic levels. Adding that there is unlikely to be any support from Washington, D.C., in 2024, we struggle to see why this wave of bankruptcy restructurings could stop.
A couple of months ago, we wrote about the concern from the jobs placement company ZipRecruiter; now, we share comments (from 12/23/2023) from business services/human capital leader Paychex. “The macro environment and labor environment continued to be challenging for small and mid-sized businesses. Our Small Business Employment Watch continues to show moderation in both job growth and wage inflation, which is indicative of a stable macro environment and that the actions taken by the Fed are having their desired impact.” We share this tidbit because market participants are very bullish about the economy’s direction going into 2024. This disconnect continued to grow throughout December as consumer confidence surveys peaked higher. Everyone should have varying exposure to the stock market. Not investing in stocks because of bearish concerns about near-term prospects is not the best course of action.
Inflation continues to moderate into 2024, but we are monitoring a couple of pockets of subcomponents that have started to creep higher. The S&P Case-Shiller Home Price Index has begun to appreciate again in the last few months after a year’s worth of declines. The rise is concerning because the home price index tends to lead the two major shelter-inflation subcomponents by roughly a year. In the short term, we expect inflation to continue to moderate and shelter inflation to decrease. In the intermediate term, towards the end of the 2024 summer, if the home price index continues to increase, it would not be surprising to see inflation remain “stubborn” and bounce back above the 2% year-over-year inflation target that the Federal Reserve has set. Remember, depending on which inflation measure you are discussing, rent/shelter makes up 35-40% of the overall inflation figure. If inflation starts to tick back up in a few quarters, the Federal Reserve must maintain a policy that keeps rates higher for longer. All financial asset prices, especially stocks, would not welcome this development, especially considering the rally we have seen in the last 90 days.
Please see the following updates on existing positions held at the firm:
Investment/High-Grade Corporate Bonds- Yields from this asset class have fallen materially (prices have risen) over the last 60 days as market participants continue to place dovish bets on when and how aggressively the Federal Reserve will cut interest rates. The relative value for these corporate bonds has become less attractive as spreads have tightened even more. It is very tough to find an annualized yield of over 6%. As such, we are opening our playbook in search of market-neutral, lower-risk investments that provide a safe, projectable annualized rate of return over our 6% target floor. Be mindful that we want to maintain a short time frame (ideally less than 24 months) for these types of investments to neutralize interest rate risk if inflation happens again during the summer of 2024.
Dollar General- (Ticker: DG)- The discount retailer has had a couple of solid months rebounding from a tough 18 months. In late October, the company’s relatively new CEO resigned and was replaced by the former CEO, who came out of retirement. The market liked this development as the investment community liked the former CEO. The company issued a consensus-beating third-quarter earnings report in early December, which increased the run. While we expect the stock to take a breather soon, we remain confident that the DG’s stores will continue to be visited. Whether it is due to location or brand loyalty, Dollar General will continue selling affordable goods to consumers for years. While we might have been early on our initial investment, we are comfortable with our thesis and initiation price (roughly $138 per share). The fall from last winter’s $260 share price will have generated some tax-harvesting sellers in the prior 90 days, which makes the first couple of months of 2024 more interesting.
Vermilion Energy (Ticker: VET)- On December 12th, the company announced a 20% increase to the cash dividend with upside guidance to projected free cash flow generation in 2024. Applying the projected free cash flow (approximately $700 million) with the company’s Enterprise Value, we see over 20% free cash flow yield. Finally, assisting the company in the coming years is that the European Union has decided to end the windfall tax that impaired VET’s cash flow in the last couple of years. The stock rose +5.5% on the 2024 guidance and dividend announcement.
Unit Corporation (Ticker: UNTC)- In the middle of the month, we closed out of our position in UNTC. The company announced a special dividend that should not have been new news to the market, but the stock jumped another 15% on the announcement. We used this strength to sell our position. The investment thesis behind the company was a large amount of cash, a good drilling company, and second/third oil and gas assets that were cash-flowing. With the cash out of the equation, the company trades above fair value. We have every intention of monitoring this position into 2024 and believe that we could reenter the position if we fall into the mid-$30 range, where we have the company valued post-special dividend.
We are delighted with the strong relative performance over the last couple of years. We will remain diligent in managing the broader risks that are becoming pronounced in financial markets and the economy. Thank you for your continued trust throughout the holiday season!
Stash J. Graham
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