December 2023 Quarterly Review

Dear Clients and Friends:
Re: Q4 Investment Review

The last quarter of 2023 produced very good returns from both the stock and bond markets. For the first time since the year began, the super high tech grouping known as the “Magnificent Seven” merely performed in line with other stocks. It remains to be seen if the long-awaited move back to rationality in terms of stock price performance for these companies has begun.

Benchmark Index Total Returns	Quarter Ending 12/31/2023	Year Ending 12/31/2023
Lipper Balanced Fund Index	9.00%	13.90%
S&P Dividend Aristocrats	8.33%	8.44%
S&P 500 Stock Index	11.69%	26.29%
S&P 500 Equal Weight Stock Index	11.87%	13.87%
Russell 1000 Value Index	9.50%	11.50%
3-Month U.S. Treasury Bill Index	1.41%	5.11%
S&P 7-10 Year U.S. Treasury Bond Index	6.58%	3.92%
S&P U.S. Gov & Corporate 30-Year Bond Index	12.75%	2.41%

Last year was one of rising earnings and declining inflation, a great recipe for solid stock returns. As noted above and commented on in previous letters, the S&P 500 performance was head and shoulders above the other indexes. This is shown above for the full year but leveled off in the last quarter as the S&P performed more in line with the other indexes. And while bond returns didn’t match equities for the year, they too did a lot better in the fourth quarter with the possibility of the end of rate increases. Most people have the impression that the traditional S&P 500 Index is a diversified balanced equity index as it holds about 500 different stocks. However, the Index is anything but balanced. In fact, it is currently so unbalanced it probably has more risk than the stock market as a whole.

For performance calculation purposes, each of the 500 stocks in the index is weighted according to its total stock market value (the number of shares outstanding multiplied by the price of the stock). This calculation method has caused 7 stocks in particular to dominate the Index as their aggregate market value represents 28% of the total S&P market value, though they only represent about 2% of the number of stocks in the index. The seven companies include Apple, Microsoft, Amazon, Nvidia, Alphabet, Tesla, and Meta Platforms. They have become known as the “Magnificent Seven” because their stocks moved sharply higher this year as all are expected to be very large beneficiaries from the development of artificial intelligence (AI). The S&P 500 Index return is misleading because of last year’s dramatic run-up of the Magnificent Seven. In contrast, if we just take the simple average of all the returns from the S&P stocks, the return drops all the way to 13.9%. This is still very attractive but only about half the S&P reported return of 26.3%. Both indexes are shown on the previous page.

So where do the financial markets head next? Looking back over the past four or five years, the dominant themes impacting the markets were COVID (now under quasi control?), supply chain issues (a follow on from COVID and precursor to inflation), inflation itself and finally rising interest rates. With all of these seemingly in the rearview mirror, what about 2024?

To start with, the stock market is currently priced at about 22 times earnings, a huge premium over the market’s long-term valuation of 16 times earnings. This means the S&P (or at least these seven stocks) is priced for perfection. The highest priced of the Magnificent Seven sells at over 72 times last year’s earnings. But we all know that perfection, particularly in the financial markets, rarely if ever exists. So, what are the major risks to our economy and the markets that could knock things off the perfection algorithm?

A much discussed, but not new issue, is the U.S. budget deficit. Short-term it is unlikely to cause many problems, but the cumulative effect of needing to finance several trillion dollars a year (over 25% of the federal budget) on a continuing basis, much of it from foreign sources, can only grow in significance. To help fund the deficit, the Federal Reserve Bank would like to keep interest rates low and money easy. What is effectively a highly stimulative fiscal policy is the reason we have been able to avoid recession over the past several years.

But contrary to the above, the Fed needs higher rates to fight inflation which partly is the result of the excess demand created by the deficit. The tighter money becomes, the greater the odds of too tight money (higher interest rates) tipping the economy into recession.

At the moment the monetary authorities seem to be threading a very small needle resulting in both a reasonably strong economy and declining inflation. But this is unlikely to go on indefinitely. Eventually the risks implied by a deficit this large will make themselves known. We have no special knowledge to suggest that 2024 will be the year. But it could be.

One theme that doesn’t seem to have had any impact so far is geopolitics. Wars and international skirmishes seem to be proliferating. The Israeli conflict in Gaza has been added to Ukraine as a major event. General tension in the rest of the Middle East is also rising between the U.S. and Iranian proxies in Syria and Iraq. The Yemeni Houthi attacks on middle east shipping must also be added to the list of active conflicts. And always, will Taiwan versus China be next, and how will the U.S. react if conflict does break out?

Any one of these could blow up into a much broader conflict with major consequences. The increasing alliance between Russia, China and Iran makes the possibilities even more substantive.

Finally, we are not convinced that high inflation is completely behind us. It is difficult for us to see inflation of 2% or less (the Federal Reserve Bank’s objective) in the face of a huge ongoing budget deficit.

The Federal Reserve has no choice but to provide money to fund the deficit of about two trillion dollars annually. This unfunded spending creates increased demand for goods and services, and this can in turn lead to shortages relative to demand, producing higher prices. Wars and social programs are very expensive. If something happens elsewhere in the economy, it could cause a real problem. At the moment the restriction of shipping in the Red Sea, as a result of Houthi fire on ship traffic, could be the issue that pushes inflation higher. Many companies are now rerouting traffic around the horn of Africa, a much longer and more expensive route than through the Red Sea and the Suez Canal. The impact could be similar to the logistical snafus that occurred as a result of covid.

With the stock market (or at least many technology stocks) priced for perfection, this could be the final stressor that causes the problem for stock returns in 2024. At a minimum, it seems that we could have a year of declining valuations, particularly if earnings, though up, don’t fully meet expectations.

Top Twenty Holdings

As of the end of the year our twenty largest holdings were as follows:

ABBV	AbbVie Inc.	FAST	Fastenal Company
AMP	Ameriprise Financial	ITW	Illinois Tool Works Inc
AMGN	Amgen Inc	LOW	Lowes Companies Inc
ADM	Archer Daniels Midland	MSFT	Microsoft Corporation
CAT	Caterpillar Inc	QCOM	Qualcomm Inc.
CSCO	Cisco Systems Inc	XLK	SPDR Technology Sector ETF
CMCSA	Comcast Corporation	SWK	Stanley Black & Decker
DLR	Digital Realty Trust Inc	TFC	Truist Financial Corp
EPD	Enterprise Products Partners LP	TGT	Target Corp
ESS	Essex Property Trust	USB	US Bancorp

There was not much movement in the holdings in the fourth quarter, as the only change was that Target, which had dropped off in the third quarter, came back on the list to replace Polaris. Target had a great quarter, returning over 28% for the last three months of the year. This movement higher, along with our repurchase of shares that had been sold for the tax losses, was enough to push Target back into our top holdings. While Target stock did recover quite a bit in the last quarter, it finished down for the year and still looks cheap by our metrics. The current dividend yield of over 3% is well above its five-year average yield of about 2.25%. And the stock, currently priced around $143, remains well off the previous high of over $260 reached more than two years ago in August ’21. Looking out a few years, we can potentially pencil about 10% growth in earnings and the dividends over the next few years, which would help to provide a very reasonable return. All in all, Target is a company we will likely continue to buy as opportunities arise.

On the other side of the equation, Polaris did not have a great year in 2023. Polaris had a negative return of about 3% last year. Most of the selling pressure materialized in the third quarter as the stock fell from its July highs. Mainly investors appeared to be concerned with a possible slowdown of the economy and rising interest rates. These factors may make it more difficult for consumers to make purchases for big ticket items like Polaris’s ATV, boat, and motorcycle offerings. While these are valid concerns, we believe the sell-off in the stock price has been overdone and are willing to remain patient and give the stock some time to recover. Polaris recently became a Dividend Aristocrat by increasing its dividend every year for 25 years. Any company that can do this within the context of a cyclical business deserves the benefit of the doubt.

Looking inside our list of large holdings, there have been some interesting announcements and movements. Here are a few highlights:

AbbVie announced that Cordavis, which is co-owned by AbbVie and CVS, will produce a generic version of Humira that should be available by the second quarter. The Cordavis version of the drug will be identical to Humira, while all other biosimilars are nearly (but not quite) copies of the original. This should help AbbVie, as the main overhang for the company in recent years has been the patent expiration for its blockbuster Humira. We have often wondered why more drug companies don’t do this in practice. AbbVie had a solid final quarter of the year gaining around 12%, well ahead of the S&P 500, though its return for the year as a whole was relatively flat.

Our largest holding, Microsoft has begun to challenge Apple’s role as the world’s most valuable company. Driven by the growth in artificial intelligence, Microsoft’s Azure and other cloud services now account for over 40% of revenues, and the company continues to expand AI into all aspects of its operations. The company’s Security Copilot is a generative AI program that was designed to thwart cyberattacks and can be used to provide security across the Internet. AI is not going away, and we expect to see more applications as 2024 continues to unfold. Microsoft was our best performer for 2023, up over 50%, and it also had a fantastic Q4 gaining around 17%. Though it currently seems overvalued by our parameters, we consider it one of the fundamentally strongest and most reliable of the AI participants.

Speaking of AI, during the third quarter one of our other largest tech holdings, chipmaker Qualcomm, outlined its products and strategy for on-device generative AI for smartphones, PCs and other devices. Through its Snapdragon chips, Qualcomm is quickly becoming a leader in generative AI for smartphones, laptops, Internet of Things (IoT) and automotive. Most of the gains for the year came in the final quarter for Qualcomm, with the stock up over 22% for the period (our second-best performer).

Lastly our regional bank holdings, Truist and US Bancorp, which we continued to load up on during the summer and fall at unusually attractive valuations, were two of our three top performers for Q4, up 24% and 19% respectively for the final three months of the year. Many of the regional banks began to recover from the problems that appeared earlier in the year as a result of the collapses of Silicon Valley Bank and First Republic Bank. The fears of more failures and additional regulations for the midsized banks finally began to subside and the stocks rose from very depressed valuation levels.

Conclusion

If nothing else, 2023 has been interesting. The rise in interest rates in 2022-2023 was so rapid and persistent that it was without precedent and led to great fears of recession. But potential weakness was balanced by the extra demand resulting from federal spending implemented to offset the economic ravages caused by COVID – it overshot what was needed by a large amount and led to high inflation.

So, in some ways, we are sitting on the edge of a knife. So far, so good, but circumstances of this sort don’t usually end without incident. We don’t have a crystal ball to tell us if or when something bad will happen, and we doubt any potential incident will be excessively painful, though it might be.

Having said all of this, we do need to remember that these are largely cyclical events that one way or another will be reconciled and pass with time. That, as we have said many times, is why we don’t try to time the market. Better to buy high quality companies and hold them, if possible, forever. This avoids taxes on capital gains and thereby gives the portfolio much more money to work with and to compound over time.

Although we always have questions, we like what we own for the long-term and this makes it nearly impossible to not be optimistic for the future.

DML/ELS/JSS/LRO