2024 Q2 Newsletter
By Jason Lesh, Managing Principal
My family and I were lucky enough to travel to France for three weeks this summer. Long in the making, the four of us explored Paris, the French countryside and the Normandy region in June and July. Going into the trip, my main goal was to expose the boys to what international travel is like and get them addicted: fair to say mission accomplished.
We explored all the Parisian sites including the Olympic infrastructure installations which were nearly complete. Metro passes were acquired, pâtisseries were sampled and reviewed, and countless kilometers were walked and explored daily. Eventually we rented a car and drove northwest to Bayeux, Mont Saint-Michel and Etretat, stopping to take in the occasional tapestry, roadside barbeque, and the American Cemetery overlooking Omaha Beach.
A huge thank you to Nick for working overtime and allowing me to step back a bit from the day-to-day operations of the firm. It was an interesting time to be traveling in France: Olympic preparations, European Football Championship, two weeks of national elections, and three days without cell coverage during an international outage. As I was reflecting on our trip during the flight home, I took note of what made our trip such a success: the inherent uncertainty of travel, excitement for the unknown, thorough preparations, a curiosity and thirst for growth, flexibility to adapt, and an optimistic attitude that no matter what we encountered, we can thrive.
In reviewing our current allocations and positioning, it is not lost on me that these same traits are guiding our investment decisions. As Nick writes in this quarter’s newsletter, despite economic and political volatility and all the associated unknowns, we feel very, very good about our current strategy.
I hope this note finds you doing well and enjoying your summer. If there is anyone you know or care about who you think might benefit from this information, please feel free to share it with them. As always we welcome your feedback, reactions and critique's. We hope you will find this information valuable and validating! Do not hesitate to reach out to either of us if we may be of any assistance.
Could this be the golden age for value investing?
Markets on the surface appear to be very strong thus far in 2024. The S&P 500 has carried the weight posting strong results, while other market measures have been more muted. The market has become overly concentrated in large cap technology stocks with investors showing mass exuberance toward artificial intelligence (AI) especially. This, in spite of a tepid forecast of real economic growth, higher interest rates and above trend inflation. At this time, we prefer the unloved and underappreciated small cap stocks which are approaching historic undervaluation.
Investors have never been so concentrated in large technology stocks. Nvidia, Microsoft and Apple currently make up 21.5% of the S&P 500. They now trade at valuations indicative of the technology bubble speculation of the late 90s and early 2000.
Our portfolios have not benefited in the same way and we will not suffer in the same way. Paying such a high price for an investment is a recipe for a significant risk of capital loss.
Below the surface headlines, markets are mixed. Small cap stocks have been quite weak. This chart shows how small cap stocks (in red) are lower since the end of 2021, while the S&P 500 (in blue) took off from its lows in late 2022 fueled by the generative artificial intelligence (AI) and technology crazed speculation.
With the election approaching, inflation far from controlled and economic growth fueled by budget deficits, uncertainties abound. In such uncertain times, it’s important to check our thoughts (ie. emotions) against battle tested investors who have played this game for decades. They have this invaluable ability to identify these recurring patterns and provide an early warning when the pendulum may begin to swing in a different direction.
Several of these sage investors have pointed out that small cap stocks are trading at a more than 20% discount to large stocks. This was last seen in the early 2000’s when small cap stocks went on to outperform large stocks by a wide margin. Chuck Royce is one of these sages. In a recent presentation the Royce Investment Partners have shown just how undervalued small cap stocks are relative to large caps over the last 24 years.
The last time this occurred in 1999/2000, small-cap stocks (in red) compared to large stocks (in blue) outperformed by nearly 80% over the next 6 years. We like small cap stocks here.
Large technology stocks are extremely risky at these levels and may lead to losses. The poster child Nvidia*, passed Microsoft and Apple as the largest market cap in the world. Combined, the three are valued at $9.9 trillion, 21.5% of the entire market capitalization of the S&P 500. The three are today LARGER than the capitalization of the ENTIRE S&P in September 2011.
Including Google, Amazon, Meta and Tesla, the Magnificent 7 have a $16 trillion combined market value, 34% of the S&P 500 and LARGER than the ENTIRE S&P as recently as February 2016, just over 8 years ago.
“This is the goofiest and likely most dangerous concentration of overvaluation I’ve seen in 34 years of investing and throughout financial history.” -Chris Bloomstran
The extremes extend beyond the magnificent seven to companies like fellow Nasdaq 100 member Costco, now with a $386 billion market cap and an earnings multiple of 54x. You are looking at seven to eight years of no change in the share price for the stock to trade at 25x earnings according to Bloomstran.
The stock market is very good at rewarding business success but to a fault. In the short term, stocks can trade at extremes relative to fundamentals, both on the low side and the HIGH side. The current popularity of index investing contributes to a “buy at any price” mentality.
The difference between the dear and the cheap reminds me of March 2000. From that point the S&P 500 index spent much of the subsequent decade in the red. Meanwhile, small cap stocks performed quite well. In the long run, the market gets it right.
I believe we are entering a golden period for active value investing. We appreciate you trusting us with your hard-earned savings.
