September 2024 Quarterly Review

Dear Clients and Friends:
Re: Q3 Investment Review

Change may be happening in stock market leadership. In the third quarter, the S&P 500 produced the lowest return of the three equity indexes we follow. That hasn’t happened in many quarters since the bull market in technology stocks began over five years ago. The “Magnificent Seven” (the tech stocks largely responsible for the very strong year to date S&P) performed no better than the overall market, saved only by a strong performance from Tesla as it rebounded from previously depressed levels. Our high-quality, lower risk holdings performed much better than they have in some time. This is discussed further in our section on our largest holdings.

We will be watching this change in market leadership closely as we consider the environment discussed in the next section of this letter, at least over the balance of the year which, of course, includes the November elections.

Benchmark Index Total Returns	Year to Date Ending 9/30/2024	Quarter Ending 9/30/2024
Lipper Balanced Fund Index	12.22%	5.55%
S&P Dividend Aristocrats	14.18%	11.74%
S&P 500 Stock Index	22.08%	5.89%
Russell 1000 Value Index	16.68%	9.44%
3-Month U.S. Treasury Bill Index	4.08%	1.43%
S&P 7-10 Year U.S. Treasury Bond Index	5.19%	-6.52%
S&P U.S. Gov & Corporate 30-Year Bond Index	1.37%	8.06%

Interest Rate Cuts have finally arrived

Not many were shocked by the decision of the Federal Reserve Bank to reduce interest rates at the September 2024 meeting, bringing the short-term interest rate target down to a range of 4.75-5%. The Federal Reserve Bank had already provided strong indications that a rate cut was coming. What was slightly more surprising was the Fed’s decision to bring the rate down a full 50 basis points (.5%) rather than a more modest 25 basis point (.25%) cut. This was the question that analysts had been volleying back and forth in the weeks prior, with many expecting a 25 basis point cut.

The larger than expected cut is good news for anyone wanting to borrow money. Even a modest reduction in rates can be enough to tilt those on the fence to favor more debt. Homes that were just out of reach become a little more affordable as mortgage rates fall. Businesses in need of loans find it just a little more profitable to take on debt in order to upgrade or expand their operations, and it becomes just a little more affordable for companies to roll over older loans that were taken out at much lower rates years ago. Lower rates help to keep the wheels of finance turning, and these opportunities, collectively, help boost the economy.

On the flip side the rate cut is not great news for anyone holding onto cash and fixed income, those looking for a safe place to park some of their investment portfolio. Just a month ago it was not too difficult to earn a 5%+ return on cash and fixed income. After the rate cut that dropped to a 4.5%-4.75% return. This may not make a huge difference now, as the rates are still substantially higher than we were seeing just a few years ago, but over time the effect is cumulative if rates continue to fall. Lower rates have always tended to punish the “savers”.

The next big question is whether this cut (along with future cuts) will be enough to avoid a recession and provide a soft landing for the economy. The impact of lower rates occurs rather quickly in the bond markets. However, it takes much longer for the Fed’s actions to filter through and impact company earnings and stock prices, which is why there is no way to answer that question right now. Analysts may have strong opinions on the matter, but the truth is that nobody really knows how this movie will end. Not counting the emergency rate cuts of the pandemic, the last time the Fed began a rate cutting cycle with a fifty basis point cut was in September 2007. Initially markets were exuberant at the news, with the Dow Jones Industrial Average logging its largest gain in several years. Lehman Brothers was a top performer that day, its shares surging 10%. But as it turned out, stocks were just a few weeks away from their bull market peak, followed by the Great Recession that began in January 2008 (the worst since the Great Depression) and the collapse of Lehman Brothers less than a year later.

We don’t have any reason to believe that we are in for anything like the panic and Great Recession that took hold in 2007-2009. But the fact of the matter is that historically, as in 2007, when the Fed’s first rate cut is as high as 50 basis points, the economy has usually entered into a recession. And, as a result of the Fed’s decision, many of the major banks believe the chance of a recession occurring in the next year is now slightly increased. There have been 22 bear markets in the last century, which works out to roughly one every five years or so. While the market has reacted positively to the recent rate cut, it is inevitable that eventually something will happen to break the good mood

The next Black Swan?

Most recently the three-day strike of the International Longshoreman’s Association (ILA) looked like it could be a huge damper on the economy. If it had been allowed to continue, we were told that it would only be a matter of weeks before Americans would have difficulty finding medications or stocking up their carts at the grocery store. Before this incident who knew how much power this relatively small group of workers held? Stay tuned for more on this, as the battle is merely paused for now, with negotiations scheduled to pick up again in January. While the ILA did negotiate a very large increase in pay for its members (62% over five years!), the stickiest item on the docket could be the Union’s resistance against any form of automation that would make our ports more efficient and able to handle larger capacities of goods. The US already lags in automation behind most of the developed world. In fact, no US port makes the top 50 list for global productivity, including the three in the US that are fully automated (all on the West Coast). Meanwhile, before the strike, an average full-time ILA dockworker in New York / New Jersey with overtime earned roughly $350K under the previous contract, and in Norfolk, Virginia they made around $200K. The boost in pay will mean that those workers in New York and New Jersey will be making over $500K within a few years. The head of the union currently makes $900K. Given the already generous pay level, we are not sure that this workers’ union will have a lot of sympathy from the American people if another strike were to occur. Our hope is that the matter will be resolved without much impact on the goods and services in this country. However, it just goes to show that the next Black Swan Event could already be lurking somewhere in our economy, well off most analysts’ radar.

With all this negativity swirling around, why do we do what we do? The forever quotable Warren Buffett has a great answer for that:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”

This is why we choose not to pay much attention to all of the intermediate noise. The economy will eventually enter a recession, whether it happens in the next few months or the next few years. The same is true for a bear market. By focusing on long-term investments that we expect will continue to thrive over the long term, and by buying high quality companies that are “cheap” relative to the market and relative to their own historical measures, we aim to add value over the long term. Historically our best relative performance has come when the market is falling, and historically the US has nearly always been the best place in the world to invest your money over the long-term.

In the short-term it often seems that the news is nearly always worrisome. Either, like today, we are in a strong period and waiting for the tide to turn or some piece of bad news to upend it all. Or like in May of 2020 (when we were all still mostly stuck at home due to COVID), we are in the midst of some kind of negative world event for which no apparent end is in sight. Nevertheless, as we look out to future years and decades, we have confidence that the US stock market will continue to be a great place to invest your money, especially if you stick with blue chip stocks – companies with strong financials, reasonable levels of debt, and plenty of positive cash flow.

Top Twenty Holdings

Symbol	Name	YTD Performance (9/30/2024)
CAT	Caterpillar Inc.	33.91%
ABBV	AbbVie, Inc.	31.07%
LOW	Lowes Corp.	23.51%
DLR	Digital Realty Trust	23.20%
ESS	Essex Property Trust	22.45%
LNC	Lincoln National Corp.	22.25%
TFC	Truist Financial Corp.	20.59%
QCOM	Qualcomm Inc.	19.29%
XLK	Technology Sector Fund	17.91%
EPD	Enterprise Products Partners	16.69%
SWK	Stanley Black & Decker Inc.	15.30%
MSFT	Microsoft Corp.	15.05%
G	Genpact Ltd.	14.44%
AMGN	Amgen Inc.	14.34%
FAST	Fastenal Co.	12.15%
TGT	Target Corp.	11.78%
USB	US Bancorp	9.34%
CSCO	Cisco Systems Inc.	7.95%
ITW	Illinois Tool Works	1.75%
CMCSA	Comcast Corp.	-2.61%

Over the third quarter there was only one change in our top 20 list. Polaris was replaced by Target due mostly to changes in price.

The average return of the above largest holdings so far this year is about 16%. Not surprisingly, this is quite similar to the equity only performance of our client accounts.

Over this period there has been a wide range in returns of the indexes we review to see how we are doing. At the low end, the closely followed Dow Jones Industrial Average was up about 13% through September 30 while the S&P 500 Index returned 22%, largely due to the heavy weighting of Artificial Intelligence stocks. In between, the other indexes were more or less in line with our own common stock results. There were no significant changes in the fundamentals of any of our Top Twenty holdings.

If you look inside the indexes to the results of the individual holdings or if you look at our own results above, the variation in returns is very large. Yet, the long-term fundamental expectations are much narrower. The reason for the shorter-term variations is, of course, related to how people feel about the future and particular stocks.

An example of this can be found by comparing the performance of Comcast at the bottom of the list to Caterpillar at the top. Over the past five years, Comcast has fundamentally met all of our objectives. This is reflected by earnings growth of 11% annually. Yet the stock has gone nowhere. Caterpillar also did well by growing earnings even faster at about 16% per year. But the stock has moved up even faster than that as it has more than tripled in value.

The result of this is that Comcast is even more undervalued today than it was five years ago while the opposite is true of Caterpillar. It is now overvalued and we are trimming it back where we can without drastic tax consequences.

We could go through why this has happened but it all goes back to how people feel rather than just how well companies have met their fundamental objectives. Such are the vagaries of the stock market. It helps explain how we can be correct in our analysis of a company ‘s future but still lag one market measure or another. While selling is often based on clearly unreasonable expectations for the future and overvaluation today, buying is more difficult as we are trying to peer into a very uncertain future.

On a broader basis we can also look at all twenty holdings together as a portfolio. The aggregate valuation shows these companies selling at about 16 times expected earnings, a significant valuation discount from the general market. But at the same time, expected returns are about 12% a year (assuming our estimates of the future are realistic), a premium to what the market has generally returned over time. The net of these factors (and others) is that this list of stocks should serve us well going forward.

Conclusions

We believe we are in a period of significant change. After nearly three years of increasing or high interest rates the momentum now seems to be moving in the opposite direction. If the economy remains reasonable, this suggests positive returns from common stocks in spite of many that already seem overvalued.

In addition, market breadth also seems to be improving. An increasing number of stocks played a role in the last quarter’s positive performance. An indication of this is that even though the performance of high-flying AI and technology stocks has moderated, the cooling in that sector has been offset by many other companies now participating in the advance. Performance-wise, this shows up by the much more conservative Dividend Aristocrats Index being the best performer over the past quarter while the formerly robust S&P 500 performance has slowed down. This is the first time in a number of quarters that this has happened.

With change there are always risk factors we cannot anticipate, so while the financial environment appears constructive for future returns, risks are not low. And given the strength of the stock market over the past five years, we are overdue due for a correction almost regardless of positive fundamentals going forward.

We have no plans for significant portfolio changes going into the future. We believe the companies we hold have the underlying growth, dividends and valuation to suggest reasonable returns going forward assuming they are supported by declining interest rates (easier money).

Longer-term, we share the optimism of Warren Buffet.

ELS/DML/JSS/LRO