June 2024 Quarterly Review

Dear Clients and Friends:
Re: Q2 Investment Review

What is Artificial Intelligence?

From Wikipedia: Artificial intelligence (Al), in its broadest sense, is intelligence exhibited by machines, particularly computer systems. It is a field of research in computer science that develops and studies methods and software that enable machines to perceive their environment and use learning and intelligence to take actions that maximize their chances of achieving defined goals…

In layman’s terms, Al is the result of increasingly fast and powerful computers that have access to almost unlimited memory. This allows the machine to make huge numbers of very fast connections and calculations resulting in the ability to do highly complex tasks formerly limited to humans alone. Still in its early stages, if human ability is ranked as a 10 on a scale of 1-10, artificial intelligence today is still at a 1+.

Nvidia today is probably the most important company in the field of artificial intelligence. It produces the vast majority of processors fast enough to allow Al to even exist. In the stock market it is now worth more than Amazon and Tesla combined and is toying with a total market value of three trillion dollars. Like everyone else, we wish we had bought it a year ago when it was selling at $42 per share. As of this writing it has tripled in value and is selling at $128 per share.

We have participated in the Al revolution, but not nearly to the extent required to catch the performance of the S&P 500 where the technology enabled “Magnificent Seven” has dominated performance. Representing less than 2% of the companies in the index, they now account for over 30% of performance results in the S&P.

While we don’t own Nvidia directly, almost every client does own the S&P Technology Sector Fund, itself one of our largest and most successful aggregate holdings. Within this fund, Microsoft and Nvidia are the two largest holdings. And Microsoft is our largest single holding, along with other participants in the Al technology space such as Qualcomm, up over 80% in the last twelve months.

But in spite of these offsets, our equity performance last quarter and year-to-date significantly lagged the greater S&P. For comparative purposes, the performance gap between the S&P 500 and the Dividend Aristocrats Index shown for the past quarter and year-to-date below has almost never been wider. The gap is even wider if we look back 3-5 years.

Benchmark Index Total Returns	Year to Date Ending 6/30/2024	Quarter Ending 6/30/2024
Lipper Balanced Fund Index	6.19%	1.09%
S&P Dividend Aristocrats	2.18%	-4.15%
S&P 500 Stock Index	15.29%	4.28%
Russell 1000 Value Index	6.62%	-2.17%
3 Month U.S. Treasury Bill Index	2.62%	1.32%
S&P 7-10 Year U.S. Treasury Bond Index	12.28%	6.85%
S&P U.S. Gov & Corporate 30 Year Bond Index	-6.20%	-2.04%

Yet, it needs to be remembered that over long periods of time, the performance of the much less exciting Dividend Aristocrats Index has matched the S&P 500, but certainly not over the past few years as a technological revolution has taken place. Interestingly, there are only two technology companies amongst the Dividend Aristocrat Index. This reminds us that while tech companies can be hugely rewarding at times, the competitive nature of this business makes longer-term success highly elusive. The majority of leading tech companies ten or twenty years ago no longer exist.

The dividend aristocrats are a group of dividend growth stocks that are members of the S&P 500 Index. Each of these companies has increased its dividend for at least 25 years in a row (some over 50 years). This obviously suggests that the firms selected for the Index have both financial strength and some long-termcompetitive advantage over other companies in their business. Stylistically, these companies are very similar to the kind of companies that we are most interested in buying, though we do not limit ourselves to the purchase of these stocks alone.

The dividend aristocrats are also known, as a group, for lower risk than the S&P 500 or the stock market overall. This relates to their generally above average quality, their business consistency and their price action when the rest of the stock market is under stress — during market declines these stocks virtually always hold up better. One of our stated objectives is your “peace of mind”. This is most challenging during turbulent times, major market declines and economic downturns. This type of stock performs at its best when that occurs.

Nvidia is about as far from dividend aristocrats as you can get amongst large companies in the stock market. And while it has been a spectacular winner for those who have owned it, other stocks in the so-called Magnificent Seven (artificial intelligence related all) have not always proved invulnerable to outside forces.

In late 2021, Tesla (a high tech company that happens to make electric cars) hit its peak price at just under $400 per share. A little over a year later it bottomed out at around $120, losing about 70% of its peak value. This is the risky side of the Magnificent Seven type high growth equation. Attractive, highly profitable businesses with a current competitive edge fueled by unbridled enthusiasm for future earnings almost all eventually run out of gas both fundamentally and in the stock market.

In Tesla’s case, very high expectations for future earnings through electric vehicle growth and a superior product just outran Tesla’s ability to deliver, resulting in an ultra-high valuation dropping to a more reasonable price in the face of adversity. While we don’t underestimate Nvidia’s huge competitive strength in the power of their chips and technology at the present time, the business is attracting some very strong competitors that are also very large companies. Sooner or later, one of them is likely to have a breakthrough that will substantially close their current competitive gap and Nvidia’s stock price will respond accordingly. But we have no idea of the timetable. Tesla’s stock price has been recovering, but it still sells at only a little more than half its peak valuation.

Such is the nature of high growth business investing and technology stocks in particular. And for every Tesla or Nvidia, there are a dozen or more who look good today but just don’t make it over time. Often, picking the winners from the losers is nearly impossible. That is why we choose to not generally participate in these markets. We may lag the performance of many others when these stocks are driving the stock market higher, but we hope to do a much better job of hanging on to what has been made when the stock market turns down as it inevitably does at some point.

6/30/2024 Top Holdings

ABBV	AbbVie Inc.	ITW	Illinois Tool Works Inc
AMGN	Amgeninc	LNC	Lincoln National Corp
CAT	Caterpillar Inc	LOW	Lowes Companies Inc
CSCO	Cisco Systems Inc	MSFT	Microsoft Corporation
CMCSA	Comcast Corporation	Pll	Polaris Industries Inc
DLR	Digital Realty Trust Inc	QCOM	Qualcomm Inc.
EPD	Enterprise Products Partners LP	XLK	SPDR Technology Sector ETF
ESS	Essex Property Trust	SWK	Stanley Black & Decker
FAST	Fastenal Company	TFC	Truist Financial Corp
G	Genpact Limited	USB	US Bancorp

For the first time in a long time our top twenty holdings were unchanged from the first quarter. Not surprisingly, tech stocks were our best performers. Qualcomm has led the way this year so far, with a total return of over 45%, and it was our strongest performer in the second quarter. Microsoft and the Technology Sector Index also have year to date returns well ahead of the market.

Qualcomm is largely up on the theory that artificial intelligence should help to drive long-term growth. Qualcomm’s Snapdragon X platform offers both energy efficiency and superior processing power, both which are particularly needed in Al applications for cell phones. Meanwhile Microsoft has continued to gain momentum in Al and cloud computing. It remains the largest investor in ChatGPT, and the company has been putting its Copilot Al capabilities to work in many products including the cloud. While the future seems bright for both Qualcomm and Microsoft, we would caution that the stock prices have already been bid up quite a bit in price in anticipation of this future growth. Any signs of economic weakness or eventual recession could also slow down the rate of investment into new Al technology. At current prices we rate both companies a hold and may trim back shares in accounts where the positions have simply grown too large.

A few other stocks had solid performance in the second quarter, including two very different real estate investment trusts (REITs). Essex Property Trust and Digital Realty Trust both outperformed the S&P 500 for the quarter. Essex owns or co-owns over 250 apartment communities across high income areas in California and Washington State. While we do have some concerns about general migration out of these states, Essex has managed to maintain strong occupancy rates while raising rents at a modest rate, though we continue to monitor these numbers closely.

Digital Realty owns over 300 data centers concentrated across the US and Europe. Data center growth should remain strong, as Al technologies require vast computational power, and these are typically hosted in data centers. In this regard Digital Realty is firing on all cylinders and has formed joint venture partnerships with several large investment firms to help manage its rapid expansion.

Rounding out the gainers, the world’s largest biotech company, Amgen, had a solid return in the second quarter, returning over 10%. Amgen provided some positive financial updates recently, slightly increasing its 2024 forecasts for both earnings and revenues. But perhaps more importantly, one of Amgen’s two investigational weight loss drugs looks promising. Phase 1 trial data suggests that it could have longer-lasting effects than drugs currently on the market.

Moving to the other side of the ledger, our worst performers year to date include Stanley Black & Decker, Comcast, Illinois Tool Works, US Bancorp, as well as recent purchase Genpact (largely purchased because of its price decline). Stanley Black and Decker remains a turnaround story that is taking some time to bear fruit. While results appear to have disappointed investors, the company is making progress in meeting its goals. Earnings per share came in slightly ahead of expectations for the first quarter, general expectations for the remainder of 2024 have been rising, and the company has continued to divest its nonessential businesses. We have remained patient with Stanley since the disappointing stock price movement does not appear in line with the fundamentals.

Cable provider (and more) Comcast is largely down based on slightly lowered earnings expectations for the second quarter. However, looking further out we believe the stock is grossly undervalued right now. The company pays a 3.3% dividend and is expected to grow earnings and cash flow at around 7% or so over the next several years (despite lower results expected for the second quarter). Meanwhile the stock is trading at a forward price to earnings ratio of less than 9, which is well below its historical average. While this is a company we plan to continue to watch closely due to it being in an industry that is changing quickly, we also see opportunity here as investors may be overreacting to what may be very short-term negative news.

Illinois Tool Works stock has struggled year to date despite better-than-expected results. Illinois Tool is a company we have owned on and off since well before the start of the firm. We have always admired the company’s entrepreneurial spirit and financial strength, both of which remain strongly in place today. This is a company that has always been a buy at the right price, and if the price were to fall a bit further we would consider once again adding more shares. The future generally looks bright here, with reasonable growth expected over the next several years, though the company is sensitive to overall economic conditions.

US Bancorp is in our opinion the highest quality regional bank. We purchased the stock in 2023 after precipitous declines in all of the regional bank stocks. Traditionally very conservative in its lending practices, USB has come under some pressure in recent months as businesses and consumers are being more careful taking on new loans due to higher interest rates and inflation. Meanwhile, more depositors are seeking higher returns on their cash by shifting funds from near zero percent checking accounts to higher yielding alternatives. USB has been able to offset this somewhat through fee-based income on trust and investment management, credit card processing, and other services. The stock would likely gain if we see some interest rate cuts later in the year as that would filter through to the bottom line. All considered this is a stock we would not hesitate to sell at the right price. Despite the more recent declines USB has been a success story with a total return of around 25% over the last year.

Lastly, recent purchase Genpact has not made much progress since our initial purchases in the first quarter of this year. This is not unusual. We make our investment decisions based ona timeline of 3-5 years or more, while the market as a whole is more focused on short-term results, and more recently, interest rates. Spun out of GE in 2005, Genpact is a company that provides IT outsourcing and services primarily to customers in the banking, financial services and insurance industries. As a result, they have a growing business in the installation of Al technology. This isa company that caught our eye because of its low price, consistently growing earnings and solid financial strength. While earnings have moved consistently higher over the past five years, the stock price is down about 40% from its all- time high reached in 2021. With a rising dividend and continued earnings growth expected, the stock price should eventually begin to rise to a more normal valuation. This is a position we might consider adding to in the future.

What Next?

As we write this letter, the economy is strong and inflation appears to be coming under control, at least relative to where it was a couple of years ago. We are in the midst of a Presidential year which is almost always positive for the stock market, and the S&P 500 seems to hit new all-time highs daily, thanks largely to the Al stocks. It also looks as though interest rates may finally start to decline as early as this September when the Federal Reserve policy group again meets. This assumes that inflation continues its slow decline as a result of both high interest rates and slowing economic growth as Covid spending peters out.

On the other hand, as there always are when talking about the economy, there are issues. This presidential election will undoubtedly be one of the most controversial in history, and the outlook going forward could change dramatically depending on who wins.

But of greatest concern to us, regardless of who wins in November, is the huge and growing federal budget deficit. Both candidates added trillions of dollars to the national debt in their first terms. Spending has always been a lot more fun, particularly for politicians, than fiscal sanity.

Now at over 120% of annual GDP, the only time the national debt has been larger was in World War Il. This fiscal year ending September 30, the U.S. is set to spend $892 Billion on interest payments alone, more than the figure earmarked for defense spending. And interest payments are set to top $1Trillion in 2025, which is close to the total budget for Medicare. No wonder the economy is doing well. Congress is on the federal equivalent of an ultra-major credit card spending binge.

While the Federal Reserve Bank can force interest rates higher or lower (at least in the short term) it has no control over budget policy or the resulting federal deficit. Our belief is that Fed Chairman Powell has done a good job bringing inflation back down, although hind sighting suggests he started somewhat late. The Fed is the one who must provide the liquidity to fund the debt as well as economic growth, complicating their ability to tighten or loosen the availability of money. But they are always the ones who get the blame when something goes wrong.

The timing of any major change in the government spending trajectory is highly uncertain or perhaps even impossible, leaving taxes as the only way to reduce the deficit. Tax increases are always a drag on the economy and remember that the Trump tax cuts will expire automatically in about eighteen months if they are not affirmatively renewed.

Because of excess spending as a result of the ongoing federal deficit we think it highly unlikely that inflation will stay low for very long. We are in uncharted territory, and because of that we cannot anticipate when change may occur nor what its impact on the financial markets will be, though when change does happen, it will not be a happy time for investors.

This is a large piece of the risk side of the risk/reward equation we are facing in the financial markets. Circling back to the huge valuations of the Al stocks, companies that are farthest out on the price risk/valuation spectrum are almost always the biggest losers when the stock market does turn down.

But, out of all of this, we do remain confident that the U.S. will continue to be the best place globally to put your money. We can’t control the financial situation but we can control what we and you own.

As always, questions on the above are welcomed at any time.

DML/ELS/JSS/LRO