Quarterly Review
After a surge in the portfolio at the end of the year, our investments fell behind the general markets in the first quarter. The underperformance can be attributed to several factors, including lower portfolio earnings expectations, and an expansion of market multiples.
Generally, stocks move in line with the changes in earnings expectations. Last quarter's earnings estimates for our portfolio declined slightly more than the MSCI World’s 1.8% decline. However, the MSCI World experienced a hefty 10.4% increase in multiples while our stocks remained mostly flat. The advance was again led by the Super Cap tech stocks, which dominate indices. For example, investors expect the Gang of Four (a subset of the Magnificient Seven: Meta, Nvidia, Google and Microsoft) to grow Q1 profits 38% year over year while the rest of the market shrinks by 3.9%.
The first quarter market move was not too dissimilar to last year's Q1 AI bump. We recognise AI's potential to significantly boost productivity for many companies. However, we disagree with the market's projected return expectations. In contrast to the Dotcom era, where page views led to unrealistic multiple expansions, the current tech revolution is underpinned by both revenue and earnings. The assumptions driving multiples now are that profit margins are expected to remain nearly double the long-term average. Competition usually causes margins to revert to long-term averages. Without monopolistic powers, AI stocks will also face this pressure. Even if we assume margins and multiples remain high for an extended period, sales growth becomes the sole return driver.
Here, investors are once again assuming the improbable. The market's 10% sales growth forecast is double the long-term average. Despite potential productivity increases, the market appears to be fully valued.
Our research indicates that market multiples also revert to a medium-term average. This suggests that it is unlikely for them to expand further. Since the market hit a low in September 2022, the MSCI World's Price/Earnings (P/E) expansion accounted for 30% of the Index's 35% Total Shareholder Return (TSR). Excitement about AI has driven market multiples to the upper end of their long-term historical ranges, while earnings have only increased by 3%.
Although solid growth is expected to continue, returns may disappoint due to margin and multiple contraction. Microsoft's (MSFT US) stock performance post-Dotcom crash (2001-2013) serves as a telling example of mean-reverting multiples. Despite Microsoft's earnings growing nearly 10% annually over those twelve years, its TSR was reduced to 3.6% due to multiple reversion.
Market Outlook
Over the past year, AI euphoria has led investors to favour momentum and Super Cap tech stocks, often neglecting other stocks. The influence of macro factors on broader stock selection further exacerbates this trend. The market primarily operates as a top-down investor, focusing on fundamentals second.
For instance, at the start of the year, investors anticipated the Federal Reserve (Fed) would cut interest rates six times, reducing the discount rate from 5.50% to 4.00%. Like the previous year, investors assumed lower discount rates would boost the value of stocks with future earnings and thus heavily invested in growth companies. However, as US data held firm and the scale of easing lessened, investors not only sold growth but also penalised several sectors, including small and mid-cap companies.
The rationale is that if rates remain high, smaller companies (with an average of 3x Net Debt/EBITDA) will face higher interest rate costs than larger companies (1.3x Net Debt/EBITDA). This type of trading overlooks the fact that not all small and mid-sized companies carry debt. However, they will be assessed as though they do until there is more certainty around interest rates and the market can refocus on fundamentals.
Lastly, considering the impact of higher rates on leveraged companies, if small and mid-cap companies with 3x leverage are being penalised in public markets, it raises questions about the valuations of companies that Private Equity purchased with an average of 6x Net Debt/EBITDA.
Closing Remarks
In the first quarter of 2024, the Strategy’s returns were lower than expected, influenced by broader market dynamics. We have experienced similar drawdowns and are confident the fundamentals will play out over the longer term. Despite this temporary underperformance, we remain confident in the strength and resilience of our portfolio. Our investments look cheap relative to most indices and we believe they are poised to deliver robust returns over time.
Looking ahead, we will continue to apply our rigorous process to identify and invest in neglected companies led by outstanding capital allocators. We believe such stocks, often overlooked by mainstream investors, can significantly enhance our portfolio's long-term value.
Note
This is a redacted version of CDAM's Q1 2024 Investor Newsletter. Should you be interested to learn more, please contact us by emailing ir@cdam.co.uk.
Disclaimers
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Certain information herein has been obtained from third party sources and, although believed to be reliable, has not been independently verified and its accuracy or completeness cannot be guaranteed.
This material is not an invitation to subscribe for shares or interests in any fund and is by way of information only. The information is as of the date(s) indicated in this document, is not complete, is subject to change, and does not contain certain material information regarding any CDAM investment strategy, including tax consequences and risk disclosures. No investment strategy or risk management technique can guarantee return or eliminate risk in any market environment.