Patience and Persistence

A quick note to answer the question, “How are things going?” Very well, thank you. We are fortunate and grateful to you, our clients, who found us and continue our relationship. A few words on our company structure and how we manage the aspects of running a business while delivering thoughtful wealth management and investment advice.

PROMETHIUM UPDATE

From the outset, we retained a “middle office” company to handle essential services including payroll, human resources, benefits, accounting, technology, reporting, and compliance, among other things. This is in addition to the custodian’s services which provide trading, statements, and tax reporting. As independent advisors, we “shop” for services that previously may have been bundled. This extra step, to select the optimal product and price, allows us to deliver comprehensive and competitive services.

We have three professionals and more than a dozen “outsourced partners” behind the scenes. We will be adding additional local client support and additional advisory professionals in the coming months. We have been very deliberate in our process, how we grow, and who we take on. Our focus remains on portfolios, risk management, and your client experience. Doing this well sets everything else up for success.

Our 1st Quarter Commentary, “Is Too Much Too Much?”, finished with:

“As challenging as immediate forecasts might be, investing in capitalism and the United States, has been the best course over the last 250 years. Being a little contrarian, investing in quality for the long-term, and having patience through inevitable economic dips is the remedy for most financial disruptions.”

Our outlook remains the same and the list of positives is long indeed. (I will save for later commenting on the Villanova basketball reunion at Madison Square Garden scheduled for October.) We thank you for your support and encouragement.

Markets
2ND QUARTER IN REVIEW

Let’s start with the acknowledgment that owning Nvidia over the last year and a half would have been a good idea. Our bias to avoid buying companies priced at huge valuations underestimated the impact of this dominant producer of artificial intelligence (AI) chips and software.

The S&P500 index was +15.3% for the first six months of 2024 as Nvidia, Microsoft, and Apple’s earnings and stock prices drove the index returns. The first half of 2024 was a “Tale of Two Cities.” A very few companies did very well, most did not. The top seven stocks price increase averaged 25.3% in the first six months of 2024, the next 493 companies appreciated just 2.7%1 , and the equal weighted S&P500 index was +4.1%.2 We owned some of the top performing companies, however, we did not own Nvidia.

Our bias to avoid concentration risk limited recent results. However, this approach is also what helped keep most of our portfolios even or positive in 2022, when both stock and bond market indexes were down 15-20%3. That may seem like a millennia ago, but should we see a shift in sentiment to risk aversion, the biggest companies could be at greatest risk of index fund and ETF outflows.

OBVIOUS IN HINDSIGHT

A major part of our responsibility is risk management and capital allocation. Allocating the proper amount to asset classes (stocks, bonds, cash, and real estate) while balancing current cash flow needs with the desire for potential long term accumulation takes judgment and patience.

In 2021, the decision to avoid overweighting mega-cap tech stocks, despite their popularity, preserved capital in 2022, when several went down 40-75%4. In the last 18 months, however, being out of those companies has led to lackadaisical relative results.

The valuation of Nvidia, in our opinion, has priced in everything going right for the next several years. The valuation assumes no hiccups, slowdowns, margin pressure or competing products. We think that would be very unusual. Every 20 years or so we see something like this. Most of the time, even the best companies’ stock price stumbles. We choose to avoid the risk.

“If something cannot go on forever, it will stop.”5

HERB STEIN, COUNCIL OF ECONOMIC
ADVISERS CHAIR, 1974

We will miss most of the “moonshot” runs as they are almost definitionally enjoyed by companies with much higher risk/return profiles than we prefer. Our objective, and that of clients seeking compounded results, is to earn satisfactory results viewed over several years. We will not attempt to beat the “index” each quarter or year (nor could we if we tried.) Maintaining purchasing power after taxes, inflation and fees is the penultimate goal on the road to financial independence. Peace of mind, that comes from having “enough,” is the desired destination.

BONDS LOST MONEY YTD

The fixed income market results, measured by the Bloomberg US Aggregate Total Return Index (-.7%), were well below that of the average money market funds (+5.0%)6. As you know, interest rates of longer maturity bonds are normally higher to compensate for risk and inflation. For the last two years, yields on shorter maturity bonds and money funds have been higher.

Cumulatively, owning medium or longer maturity bonds has lost roughly 9% over the last three years.7 As we have written, we feel interest rates will have to come down eventually and, when we feel it is time, we will likely move back into bonds. For the last three years, owning short duration bonds and money funds has been the better decision.

Economy
INCREASING LIQUIDITY IS DRIVING THE ECONOMY

The economy seems to be doing just fine, better than most expected. The primary cause is global government’s ongoing deficit spending and mandatory refinancing of their debt.8 We discussed this phenomenon, causes, and implications, thoroughly in our 2Q23, “Liquidity is Everything” commentary and observe it is unfolding as anticipated. We worry about the day when the bills come due, however that may not be for several years. Despite our caution, in the summary we concluded:

“In the intermediate term, if we are right that liquidity drives asset prices and global central bank balances have to increase, the biggest risk may in fact be not being fully invested in the stock market. We will limit exposure to assets that appear to be most overvalued, and we will add to companies we feel have less price risk.”

From a risk management perspective, having a sense of whether the economy is expanding or contracting impacts asset and sector allocation. The US consumer drives about 70% of our Gross Domestic Product (GDP) and is the key. When economies are expanding, having more equity exposure makes sense. When contracting, accumulating cash and fixed income is our preference. The recent trend of household debt and delinquencies increasing while banks are cutting back on credit card lending is concerning. 9 10

CUMULATIVE PANDEMIC-ERA EXCESS SAVINGS

In the last 2 ½ years, the consumer has spent the entire $2T in government stimulus checks.11 Now that the free money, which supercharged the post-Covid economy, has been spent, it is hard to imagine the consumer continuing at the same pace. Like the day after a big wedding, the food and drinks are gone, but the debt remains.

RISING DEBT, SHRINKING MORAL HAZARD

Congress continues to have no appetite to reduce spending or increase taxes enough to eliminate the rising annual deficit. The Congressional Budget Office (CBO) increased the current year’s forecasted shortfall to $2T, up from $1.6T just a few months ago.12 The CBO attributes the increase to “unexpected” items. You will recall, we have regularly highlighted the serial underestimation of the deficit (see “The Sun Will Come Out” 3Q23). Dollars to donuts, the US will post higher deficits going forward.

Although this “can’t go on forever”, we believe that it could go on for several years. We will maintain our exposure to financially strong companies which have, in the past, held up better during market corrections. Avoiding unsound popular investment trends and fads, which can result in air- pocket drops, is key.

TRENDS AND FADS

Below are three examples of trends. Two turned out poorly, the jury is still out on the third.

EARLY OR WRONG?

In a 2018 “Invest Like the Best” podcast, Cathie Wood explained her thesis for the ARK Innovation ETF.13 Since the interview, almost everything she had anticipated has come true. Her vision was remarkable. However, due to massive fund inflows, her ETFs bought shares of thinly traded stocks, many with significant operating losses, regardless of price. Her fund assets soared then collapsed. As a result, in 2024 Morningstar named the ARK Innovation fund the third highest “wealth destroyer”.14 In bull markets, even the most widely followed and admired can do poorly if they buy great companies at the wrong price.

It is difficult to know if, when, and at what price to buy a soaring stock. Mobile phone makers with eco-systems have moats, software embedded in global corporations have moats. Chip makers may or may not.

PRIVATE REITS

Many will remember our caution in 2020 when the world was loading up on the Blackstone and Starwood non- traded REIT funds. Our fear was that the financial industry was over-funding the asset class. Revenue-motivated financial firms were swapping hundreds of billions out of “0%” money funds with clients anticipating a 7.5% yield.15 The narrative was ‘buy high quality real estate with quarterly redemptions and upside.’ With a placement fee as high as 3% plus an annual trailer fee of .85%16, what could go wrong?

Well, we know the office market subsequently fell apart and many office buildings are being “sold” at prices wiping out both the equity and mezzanine debt holders.17 The general partners of BREIT and SREIT cut quarterly distributions and gated principal withdrawals.18

PRIVATE CREDIT – CAVEAT EMPTOR

We observed last fall that the largest wealth management firms were projecting private credit annual cash flows to be in the 11-12% range.19 To get a 11% net cash flow, one needs to lend at 13-14% or use leverage. It begs the question whether there is $2.3 T worth of high-quality borrowers needing to borrow in the next year or two. We didn’t think so. Like us, Standard and Poor’s recent May 1st report, “Rising Global Defaults Will Test Private Credit Funds In 2024”, is not so sure either. 20

Astonishingly, 40% of private credit fund sponsors have no money at risk and only 40% use independent valuation companies.21 We are not predicting a disaster, we simply prefer asymmetric return opportunities to skew in our favor.

Update and Outlook
ENERGY – LOWER RISK, ATTRACTIVE RESULTS

One final comment on trends and mispricings. For years, advocates of renewable energy have insisted that fossil fuels should be eliminated and cite the rising usage of renewables as proof it is happening. Articles, such as the Economists June 22, 2024, “The Dawn of the Solar Age,” attempt to reinforce the narrative by emphasizing the coming affordability of electricity from solar panels. (Sadly, this stand-alone fact ignores the costs of intermittency such as battery storage and transmission infrastructure rendering it expensive and impractical, if not impossible.22 )

Despite admirable intent, the facts don’t support the thesis. On June 20th, the Energy Institute released its annual “Statistical Review of World Energy”.23 which showed the world’s consumption of coal, oil, and natural gas set records in 2023. Global energy producers have provided, and profited from, what the world demands.

We have benefitted over the last four years by heavily weighting portfolios with global energy producers and refiners. We purchased shares at prices with dividend yields of 7-8%+. Since then, companies have increased their dividends 10-40% and doubled or tripled in price. 24 25 26 Investing in out of favor sectors that provide essential products, such as energy is, in our view, a lower risk way to earn rising cash flow. Often, the best investments are available when no one else wants them.

Looking for areas that are not well followed or well understood is one way to find rising cash flows at attractive valuations. Another method is to recognize when popular narratives are aspirational, not accurate such as the demonization of the oil industry over the last five years. The proposed solution of a complete conversion to solar, wind and hydro, is such an example.

DIVIDENDS STILL MATTER

We spend most of our time thinking about, 1) companies we own and want to own, 2) risk management and 3) capital allocation. We focus on how well our companies are operating, and less on the stock prices. Most of the companies in our portfolios have been increasing operating earnings and cash flow. Increasing cash flow, when thoughtfully deployed, supports debt repayment, growth expansion, stock repurchases, and dividend increases. Historically, steadily rising cash flows are normally followed by stock price appreciation.

OUTLOOK

We continue to be quite happy to own well-established companies: fast-food franchises, software and mobile phone companies, healthcare product manufacturers, asset managers, securities exchanges and energy companies – all with great financials and dominant market positions.

Additionally, we are more than happy to own lesser- known companies with the same characteristics that may have smaller market capitalization or limited trading volume such as farm equipment stores, oil, gas and water royalty companies, and quick stop gas and food marts.

Patience and persistence are required to help accumulate assets that steadily generate rising income streams. Staying with high quality, financially strong franchises, with moderate debt and loyal customers has worked in the past. We think it will continue to be a winning strategy well into the future.

THANK YOU

In the coming months we will conduct our annual client survey. This is our opportunity to hear how we can get better. It should only take about 10 minutes to complete, and we read every response. We seek opportunities to improve, and your candor is most appreciated.

We appreciate our relationship with you and work every day to keep your trust. The first half of 2024 has been a wonderful time to be an investor. The best is ahead of us.

1 https://www.slickcharts.com/sp500

2 https://finance.yahoo.com/quote/%5ESPXEW/history/

3 https://www.investopedia.com/ask/answers/042415/what-average-annual-return-sp-500.asp

4 https://www.morningstar.com/markets/5-charts-big-tech-stocks-collapse

5 https://en.wikipedia.org/wiki/Herbert_Stein

6 https://www.bloomberg.com/quote/LBUSTRUU:IND

7 https://www.bloomberg.com/quote/LBUSTRUU:IND

8 https://www.youtube.com/watch?v=_vG3V1AHl3s

9 https://www.newyorkfed.org/microeconomics/hhdc

10
https://www.investopedia.com/why-americans-are-cutting-back-on-credit-card-debt-8645241

11
https://www.frbsf.org/research-and-insights/blog/sf-fed-blog/2024/05/03/pandemic-savings-are-gone-whats-next-for-us-consumers/

12
https://www.cbo.gov/publication/60039#:~:text=The%20Budget%20Outlook,-Deficits&text=In%20CBO’s%20projections%2C%20the%20federal,to%20%242.8%20trillion%20by%202034

13 https://podcasts.apple.com/nz/podcast/cathie-wood-investing-in-innovation/id1154105909?i=1000416930773

14 https://www.morningstar.com/funds/15-funds-that-have-destroyed-most-wealth-over-past-decade

15 https://www.wealthmanagement.com/reits/non-traded-reits-continue-grab-record-capital-inflows

16 https://www.breit.com/offering-terms/

17 https://www.fairviewlending.com/clearest-sign-yet-commercial-real-estate-is-in-big-trouble/

18 https://www.bloomberg.com/news/articles/2024-06-20/blackstone-s-339-billion-real-estate-arm-enters-risky-terrain-after-rates-pain

19 https://www.morganstanley.com/im/en-us/financial-advisor/insights/articles/2024-outlook-private-credit.html

20 https://www.spglobal.com/ratings/en/research/articles/240501-rising-global-defaults-will-test-private-credit-funds-in-2024-13089868

21 https://www.bloomberg.com/news/articles/2024-07-06/private-credit-funds-with-no-skin-in-game-a-worry-credit-weekly

22 https://www.economist.com/leaders/2024/06/20/the-exponential-growth-of-solar-power-will-change-the-world

23 https://www.energyinst.org/statistical-review

24 https://www.nasdaq.com/market-activity/stocks/xom/dividend-history

25 https://www.nasdaq.com/market-activity/stocks/psx/dividend-history

26 https://www.nasdaq.com/market-activity/stocks/tpl/dividend-history