Dear clients and fellow shareholders:
Few people saw this coming.
Two years ago, most economists agreed that a U.S. recession seemed inevitable within twelve months. Yet here we are, two years later, and the economy has avoided contraction, inflation is subdued, profit margins are resilient, and investor confidence is resurgent.
And following a 23% return in 2024, the S&P 500 has produced its best two-year return since 1998 – a year before the bursting of the Internet investment bubble.
Equity valuations are undeniably elevated, with the S&P 500 currently trading at approximately 22.5x forward earnings. While this is slightly less than the late 1990s tech bubble peak of 25x, it is comparable to the recent highs of 2021. Analysts trying to justify today’s valuations sound eerily similar to those in 1999 who, in attempting to justify stratospheric valuations, argued that quaint things like earnings were no longer important to the value of a business.
“The S&P 500 is a fundamentally higher-quality index today than it used to be. Companies have higher margins and less debt. And the companies now most heavily-weighted in the index are high-tech firms that can generate significant cash flow with less capital investment.”
This assertion could have easily been taken from the pages of a research report in either 2024 or 1999. And, just as in 1999, it rings somewhat hollow today. The “Magnificent Seven” tech giants (Magnificent Seven: Apple, Microsoft, Alphabet, Amazon, Meta, Nvidia, and Tesla) responsible for so much of the overall market’s 2024 return are not guaranteed to remain cash-generating powerhouses that require minimal investment. Next year alone, the traditionally capital-light Microsoft plans to invest $80 billion in data centers to train artificial intelligence. Collectively, these seven companies are now reinvesting over 60% of their operating cash flow into capital expenditures and R&D. This shift raises questions about whether they can maintain their reputation as the capital-light cash flow machines they were in years past.
And just as a handful of stocks were responsible for an oversized percentage of the index’s remarkable returns in the late 1990s (1999 S&P 500 giants: Microsoft, General Electric, Cisco Systems, Intel, Nokia, Lucent, and AT&T), the influence of these seven stocks on 2024’s outstanding performance is evident in the divergence of the returns of the S&P 500 and Nasdaq Composite (heavy Magnificent Seven weighting) and the Dow Jones Industrial Average and Russell 2000 (much lower weighting.)
More than half of the S&P 500’s 23% return last year came from just these seven stocks.
Even though our 27% equity return last year outpaced the S&P 500, it was not the result of increased risk-taking or any change in our value-focused process. (Your equity return may differ due to legacy positions, liquidity needs/constraints, and rounding.) None of our best performing positions were Magnificent Seven stocks. None were sexy Artificial Intelligent companies. Instead, our performance was driven by a diverse array of businesses including homebuilding, dialysis, tobacco, mass media, and web hosting. Our top 10 performers also included a handful of financial-type companies, and a Toronto-based holding company often described as the “Berkshire Hathaway of Canada.” (Our 12th best performing stock in 2024 was the actual Berkshire Hathaway, which returned 27%.)
We also benefited from fortuitous timing, especially with respect to a handful of late-year sales.
As we have consistently noted, most market forecasts – even those from prestigious investment banks – are simply extrapolations of recent trends. (In fact, a defining feature of economic forecasts in general is their inability to predict the future with accuracy. This has been especially apparent in the post-pandemic U.S. economy, where model after model, including those employed by the Federal Reserve, has consistently proven ineffective.)
We don’t make short-term predictions about stock prices – for individual companies or the market as a whole – a point familiar to anyone who has asked us about market direction. While such predictions are inherently unreliable, that doesn’t stop pundits from (unsuccessfully) attempting. One year ago, the median Wall Street year-end 2024 target for the S&P 500 was 5,000, with the highest estimate at 5,400. The S&P finished the year just below 6,000.
Rather than trying to time the market, our focus is on remaining rational – and that is especially important in periods of heightened investor emotions. We are in the math business, not the prediction business. And in the 4th quarter, several of our positions reached prices that met or exceeded the fair value of those businesses.
(We use the phrase fair value generally to mean the present value of the cash flows a business generates for its owner (shareholders), adjusted by the amount of capital the business needs to invest to maintain its current level of operations. If you are a math nerd, let us know and we would be happy to walk you through examples of how we do this.)
When we liquidated and reduced the size of some of our positions in November, our cash position increased as a by-product of our stock sales. We were not “raising cash” in November because our crystal ball indicated a market decline in December. But we were not disappointed that the 2.6% monthly drop in S&P 500 occurred immediately after we liquidated 9% of our stock portfolio.
CVS liquidation
We sold all our CVS shares in December at approximately $50 per share, achieving a modest (and disappointing) gain over our multi-year holding period. While CVS has generated significant cash flow in recent years – a figure that is likely to grow in the near term due to its Medicare Advantage business – the intrinsic value of the company, has not seen a substantial increase. Over the past three years, the company has burned through more than $18 billion of its free cash flow on acquisitions of Signify and Oak Street Health. (Burned through” is a financial euphemism for “wasted.”)
At the time, we believed these acquisitions were significantly overpriced, and recent developments support that view.
CVS is currently targeting 3-5% of its long-term total operating income from Health Care Delivery, the business unit that includes the Signify and Oak Street Health acquisitions. Approximately 60% of this segment’s revenue comes from these two acquisitions – and they are expected to contribute only a mid-single-digit percentage of operating income over time (compared to an acquisition cost that represents 20% of the company’s current enterprise value). Unsurprisingly, when CVS lowered its guidance in 2024, part of the reduction stemmed from the Health Services division, which houses Health Care Delivery.
While CVS retains a strategic advantage through its unique, vertically integrated set of assets – pharmacy, pharmacy benefit management (PBM), and managed care – the company’s recent business performance has been underwhelming. It reduced earnings guidance an astonishing four times in 2024, with free cash flow estimates falling significantly below historical norms.
The recent appointment of David Joyner as CEO – an encouraging move given his past success in turnarounds – offers some hope for better execution at CVS. However, the current environment for healthcare companies is far from favorable. Last month, a reform bill was proposed that requires any managed care company or PBM to divest its owned pharmacies within three years of passage. While we don’t expect the bill to pass, we believe the legislative uncertainty will continue to weigh on the stock, adding to the already difficult market conditions CVS faces. Given these persistent headwinds and uncertainties, we decided it was time to exit our investment.
Goldman Sachs liquidation
Another of our recent sales was Goldman Sachs (GS), a position we liquidated at approximately $605 per share. While we have held positions in Goldman Sachs at various times in the past, the most recent stake was established in 2019, when shares were trading below $200 per share. Over the years, we’ve had multiple opportunities to accumulate shares at or below tangible book value. Although tangible book value is a crude metric, we generally find Goldman Sachs highly attractive at these levels in relation to its normalized earnings power. Today, tangible book value stands at $312 per share. With the stock recently trading above $600, it was priced at 1.9 times tangible book value – a level rarely seen over the past decade.
Unlike our decision to sell CVS, which was influenced by operational issues and capital allocation decisions, the sale of Goldman was primarily a matter of valuation. While the company remains a well-run business (albeit with room to improve), its stock price has increased more rapidly than has the underlying value of its business.
While Goldman’s major franchises are strong, they are not necessarily firing on all cylinders. The Asset Management business, for instance, has underperformed, losing ground to Morgan Stanley and continues to deliver well below best-in-class returns on equity. Although Goldman’s investment banking operations remain a market leader and are expected to thrive in a potential M&A resurgence, the recent stock price already reflects significant optimism regarding this recovery.
We continue to monitor Goldman Sachs and believe the cyclical nature of the investment banking industry may present future opportunities to re-purchase the stock at more favorable levels.
KKR liquidation
We recently sold our shares in global private equity giant KKR at $153 per share. Our initial investment in the company dates back to 2018, when the stock was trading around $20 per share. At that time, KKR’s net cash and investments comprised approximately 65% of its market price (over $13 per share). These investments had been compounding at a mid-teens rate and had more than doubled in value since the start of the decade. The remaining $7 per share of enterprise value reflected the fee-related earnings, which were predominantly recurring, given that 73% of KKR’s assets under management (AUM) were locked in for over eight years.
KKR is a prime example of a successful investment that, with the benefit of hindsight, was so obviously underpriced, that our profit almost seems like free money.
Our initial purchase price in 2018 implied a valuation of less than 5x earnings for this fee-based business. Additionally, we saw a free option on future carried interest – a lumpy yet highly valuable and growing residual. At the time, KKR had raised more capital in the prior 12 months than in any other period in its history. Conservatively valuing the base management fees at 10x earnings, we estimated the company’s intrinsic value at a per-share figure in the low $30s.
Over the past six years, KKR’s business has exceeded our expectations. The company’s transition from a partnership to a C-corp simplified tax reporting and enhanced financial transparency, resolving prior ownership complexities and helping broaden its investor base. Overall assets under management (AUM) have grown at a high-teens annual rate, expanding from $170 billion to over $600 billion, with significantly greater strategy diversification. Fee-related earnings have expanded in tandem.
The growth has been supported by strategic initiatives such as the 2020 acquisition of Global Atlantic, a leader in life and retirement insurance. Since the acquisition, insurance AUM has more than doubled. Furthermore, KKR has significantly scaled its in-house capital markets business, capturing fee revenues from transactions within its portfolio. In the most recent quarter, capital markets fee revenues reached a record $424 million.
In 2024, KKR’s stock price rallied 80%, bringing its market capitalization close to $150 billion. While the company continues to fire on all cylinders and expects to double its AUM again over the next four years (to over $1 trillion), maintaining its historical growth pace will likely prove increasingly challenging. Further, the $14 billion in on-balance sheet investments now represents a much smaller percentage of the enterprise value than at our purchase, reducing the margin of safety these assets once provided.
Although some of this letter could be interpreted as cautionary, this is the same type of caution we exercise whether the stock market has recently increased 25% or declined 25%. New clients may find the parallels to 1999 unsettling, but our long-time clients will recall that we actually performed quite well through the “bursting of the Internet bubble” in 2000-2002. Our consistent focus on valuation steered us clear of the speculative dot-com bubble, and continues to steer us clear of similar excesses today.
Although we don’t predict market declines or corrections, we know that they occur. And when the next one does occur, we will use it as an opportunity to add to our collection of good businesses, either by deploying existing cash or by reallocating current holdings into even more attractive opportunities.
Lunch with Governor Bill Haslam, January 27
On January 27, we will host a lunch with former Tennessee Governor Bill Haslam. You will receive a separate email invitation, but we want to make sure you have the date saved on your calendar. Please call or email Marsha (marsha@mooncap.com) if you can join us that day. Feel free to bring a guest, let Marsha know so we can plan appropriately.
Lunch with Governor Bill Haslam, Chesapeake’s West, 9630 Parkside Dr., 11:45 – 1:00 pm
Client portal
Over the past several weeks, we have been rolling out our client portal, app, and vault. Hopefully you have had a chance to use them. In addition to being able to easily access real-time reports related to your investments, the vault section of the website and app contains folders with various documents, including your Charles Schwab statements and quarterly MCM reports. Additionally, when Schwab has your year-end tax documents available, they will also be accessible in the vault. (Note, this does not replace the current way you receive Schwab monthly statements or tax forms. They will just be available via the vault as well.)
We think this new technology tool will only increase in usefulness, so we encourage you to try it.