Q1 2024 client letter

David MoonUncategorized

April 2024

Dear clients and fellow shareholders:

Over a period as short as a few months – or even a year – stock prices can be influenced by almost anything, including factors that are completely unrelated to the actual values of the underlying businesses. The 5-to-10% rise in the U.S. stock market during the first quarter was a pleasant reminder of that fact. (Our stock portfolio increased approximately 13% during the first quarter. Your actual equity portfolio returns in each year likely differed somewhat from our model, due to your specific asset allocation, possible legacy positions in your account and/or rounding errors.)

The first quarter’s stock returns, much like the returns for all of 2023, far outpaced increases in earnings – both actual and projected. Not only is the consensus estimate that first quarter S&P 500 earnings will increase a mere 2.4%, that estimate is half of the initial Q1 2024 earnings growth projection of 5.9% made in mid-December. Excluding the seven large influential tech giants (the so-called Magnificent 7: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla), overall S&P 500 earnings are expected to decline for both the first quarter and full-year 2024.

This is not exactly the kind of numeric optimism one might expect to inspire an entire year’s worth of stock price gains to be compressed into a single quarter.

Informed market decisions don’t require short-term market predictions, which is fortunate because, as we regularly remind you, we can’t accurately predict where stock prices will be three or 12 months from now. (Of course, no one else can, but that doesn’t prevent plenty of people from pretending otherwise.) We can, however, assess current prices in relation to our estimates of business values – and over the long term, values and prices tend to converge. In fact, the single most reliable predictor of future stock prices is earnings.

At least part of the prevailing investor optimism is a result of the Federal Reserve Board’s softening – and reversing – stance on interest rates. At its December 2023 meeting, the Fed’s Federal Open Market Committee (FOMC) “predicted” that it would implement three rate cuts in 2024, each one-quarter point. (Only in economics would someone who predicts his own actions expect to be taken seriously.)

While the love of money is often cited as the root of all evil, it is the cost of money that is the root of all asset valuations.  Although the assumptions needed to value a financial asset are numerous, the actual calculation is simple. If it’s been a couple of years since Algebra 1, the formula may look somewhat intimidating, but you will notice that there is an R (interest rate) in the denominator. And as that R increases, the resulting value of the asset declines.

As much as Wall Street loves cheap money, it abhors expensive money. And in the past six months, the Federal Reserve has transitioned from being laser focused on fighting inflation with rate hikes, to now signaling that it expects to reverse course and begin to cut the Fed Funds rate.

The Federal Reserve’s efforts to tame inflation have been praised for their effectiveness, as they have seemingly steered the economy from a potential hard landing, to a soft landing – and now, to apparently no landing at all.

(That is, the Fed was roundly praised for defeating inflation until April 10, when the March CPI figure increased for the third consecutive month, reigniting – for the moment, anyway – inflation fears and prompting the Wall Street Journal to question whether the Fed will cut rates at all this year.)

Despite 2024 Wall Street stock euphoria, however, the bond market is signaling that it doesn’t quite agree with the Fed’s prediction of its own actions, particularly concerning future projections beyond this year.  Interest rate futures prices indicate that short-term interest rates will bottom out in 2027, around 3.75 percent. The median FOMC forecast of 2.6% is more than a full percentage point lower.

Among the reasons this is important includes the algebraic role of interest rates in determining a fair level for stock prices. And given that stock traders are an antsy bunch, their focus tends to revolve less around current interest rate levels and more on speculating about future interest rate trajectories.

We can’t fully explain why the market produced an entire year’s worth of price appreciation in the previous three months.  And we certainly would have never predicted it. But we can respond to it accordingly – which we are doing with measured risk-reduction adjustments in our portfolio. We have trimmed or fully-liquidated some positions which no longer offered a reasonable margin of safety. And the most recent four stocks we have added to our portfolio sell at an average of seven times earnings, including British American Tobacco, which we purchased in March.

British American Tobacco (BTI, $30)

We recently acquired shares in British American Tobacco (BTI).  It’s certainly no secret that the tobacco industry faces significant regulatory challenges, particularly in the U.S. combustibles sector. (Combustibles are traditional cigarette products that, when lit, the combination of the tobacco (fuel) and oxygen in the air produces a self-sustaining combustion process that consumes the tobacco. This contrasts with various heat-not-burn products, including e-cigarettes.) Despite these headwinds, however, BTI has organically grown its revenue by more than 4% annually over the last five years.  The company’s operating profit has also risen more than 5% per year, even as the company has distributed massive dividends. (The company currently pays a dividend yield of 10%.)

BTI’s current free cash flow yield exceeds 16% – a figure that climbs even higher when adjusted for the company’s non-operating strategic investments. The largest of these is a 29% stake in Indian tobacco company ITC, which is worth more than £14 billion, or 27% of BTI’s entire market cap of £52 billion. On this market cap, the company expects to generate £40 billion in free cash flow over the next five years. Despite significant investments in its reduced-risk businesses, BTI’s free cash generation has remained robust, growing consistently over the past five years.  Yet despite this impressive track record, the stock has traded sideways for more than a decade.

BTI has recently begun selling some of its ITC shares, intending to utilize the proceeds for share buybacks.  While the company expects to maintain an ownership interest in ITC for strategic reasons, excluding this stake, BTI’s free cash yield exceeds 20%.

Following its purchase of Reynolds in 2017, BTI embarked on a process of reducing debt. To meet the upper end of its leverage target, an additional $1.7 billion is required, a figure BTI could fund utilizing cash generated from operations within months – not years. Once BTI reaches this target, we anticipate the company will ramp up its share buyback program and likely repurchase a material percentage of its shares, potentially drawing additional interest to the stock. We have historically had success investing in companies transitioning from a focus on reducing leverage to enhancing shareholder returns, as they often experience a valuation boost post-inflection.

What has also been overlooked by the market is BTI’s rapid transformation away from traditional combustibles.  Its New Categories business (tobacco-free, reduced-risk products) has grown by 30% annually over the last five years and turned profitable in 2023 – two years ahead of the company’s initial target.  We expect revenues in New Categories to continue growing at double-digit rates, with a substantial improvement in the margin profile over time.

While we estimate BTI is worth at least $40 per share today (compared to our purchase price of approximately $30), as the company’s revenue mix shifts further toward its New Categories growth business, the equity has the potential to substantially rerate. Although currently trading at only six times earnings, comparable companies like Phillip Morris International, further along in the smoke-free transformation, trade at double digit multiples.

In January, we made a prediction, one about which we had an unusually high level of confidence. That is, as the election drew closer, the news would be filled with even more fearful warnings, including from fear-mongering financial commentators who would scare people with threats of investment Armageddon if the “other guy” is elected president. That easy prediction has come true, and we expect there to be an inverse relationship between the number of days until November 5 and the percentage of social media posts and news stories that feature election scaremongering.

At some point, we will experience a correction in the stock market. But it won’t be because the wrong guy is elected president. As we wrote last quarter, Wall Street has not only survived more than seven years of Trump and Biden presidencies, but it has flourished during them. When we do have the next inevitable market correction, it will be prompted by almost anything. The 1987 correction was prompted by Treasury Secretary comments on a Sunday network talk show. A 1990 sell-off was triggered by a U.S. military buildup in anticipation of invading Iraq. A Department of Justice suit against Microsoft burst the Internet bubble in 2000. The Great Recession in 2008 and a Great Suppression in 2020 round out the bear markets of the past quarter-century, further illustrating this trend. If we are fortunate enough to live long enough, we will experience several more corrections – each of which, just like the ones that preceded it, will offer a buying opportunity.

While the government is important, fortunately there is a difference between the government and the country. Our economy is stronger than our government, and our people are more productive than our elected officials.