Market Insights: 2024-25 Review & Outlook

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Cambiar Large Cap Value

Transcript

2024 SURPRISES

Probably the biggest surprise for me as a global investor has been the strength of the Dollar. It is expensive on a trade-weighted basis versus just about everything, and it keeps getting more expensive, and that’s not usually how this works. I wasn’t surprised… also, looking globally, I wasn’t surprised that China’s property market has finally been revealed as a monumental bubble. I think what is surprising for me is how dug in China and Chinese leadership specifically Xi Jinping, seem to be on ideological solutions to what is basically an economics and economic structure situation. In the U.S. like many people who saw a steeply inverted yield curve for most of 2022 and 23, it has been surprising that you really haven’t seen anything resembling a contraction. Things aren’t great for small businesses. Things are definitely down for certain kinds of industrial production. Things are definitely down for sensitive sectors like homes and autos. None of this should surprise anybody. What has been surprising is it hasn’t turned into broader weakness.

NEAR PEAK OPTIMISM

Peak optimism, whether it’s an AI bubble or a commodity bubble back in 2007 or an internet 1.0 bubble back in 1990s. It was never obvious until after the fact. So I don’t know if you do look at the valuation of stocks like Nvidia and mega cap tax like Microsoft and Amazon and Google and Meta add it all together. Companies that have, let’s say, a decent amount to do with AI, we’re looking at some 15 to $20 trillion of market cap, so very close to the GDP of the United States. So I would say AI is priced to be transformative. If it is anything less than that, if it’s merely really cool and we have some interesting use cases in software design in the medical world, but it’s not transformative to our day-to-day, I would say there’s some risk in those valuations.

ADDITIONAL RISKS TO AI MOMENTUM

There’s a thing called the hype cycle, and the hype cycle features parabolic level of increase in interest in a particular topic, and at some point it tops out, you just can’t hype it anymore, and then you travel down this thing called the slope of disillusionment, and this happened with internet 1.0. You just did not have profitable businesses and profitable business models emerge very quickly after the peak in the so-called hype cycle. It took about another eight or nine years for those to definitively emerge. It would shock me if that doesn’t happen with AI. I think people have been very quick to label AI as the next great technology leap and there’s a fear, I think, among executives in big technology companies that they don’t want to get left behind. So FOMO, classic FOMO, and that does have something to do with the voracious of the pace of investment in things like AI data centers, but it’s very interesting stuff. I don’t want to convey profound skepticism here. It’s just that there is this concept, all the hype cycle, these things do have a way of repeating themselves and it would not be surprising at all if AI went through a peak hype, a slope of disillusionment, and eventually you will see more profitable applications developed.

MARKET VALUATIONS – DIGITAL AGE

Market valuation in the context of being in the digital age… it is still clearly a moving target. I saw an interesting interview with Peggy Noonan, who if you don’t know who she is, she was Ronald Reagan’s speech writer. She’s an older woman at this point, but a very eloquent writer and speaker and she made the point that if the 21st century is the digital age, we are already a quarter of the way into this thing as of year end 2024. And in other words, this stuff isn’t new. This stuff has been in place for a long time. If you think about the automotive age, starting with the Model T, which was in the 1910s. We are in 1940 when the internet first came out. So this stuff isn’t new. What I find very interesting is that we just continue to see digital analogs develop for physical versions of things. We see it with Amazon and it is basically a replacement for all kinds of retail concepts. They just happen to all get folded into this one superstore. Essentially we see it with Google replacing the Yellow Pages. We’ve owned a position in Uber for a while that is not only displacing Yellow Cabs, which is a very flawed concept, if you’ve ever tried to hail a taxi cab in the rain. You could see that displacing a lot of car ownership entirely over time. So there’s all these interesting digital analogs. I don’t see any reason why that won’t continue. I think the challenge for value investors is that you don’t have the normal industrial leapfrog competitive dynamics that you see in more manufacturing and physical product-oriented businesses. Once you get an established dominant player, doesn’t mean that dominant player can’t lose, but it’s really tough to dislodge that dominant player and the market has a tendency to anoint a fairly high multiple to the dominant player because, well, like I said, they did tend to not lose and these marketplaces that these digital platforms come to capture, they do tend to grow quite durably for a long, long while. I think the other thing that’s very interesting, if you look at the last three to four years, we obviously had a big increase in interest rates in 2022 and 2023. There was a big compression of multiples from elevated levels at the end of 2021, and to be fair to the market, markets hate uncertainty and we didn’t know what would higher interest rates do to the earnings of digital platform businesses. The answer was very little. They weren’t interest rate-sensitive. Other sectors were but not digital platforms, and they came roaring back as it became apparent that there really just wasn’t a lot of damage to their earnings profiles. So here’s a question. Are these even at their current size and some of these are absolutely enormous. Are they a cyclical growth businesses which do command premium multiples even if they are so enormous that you’d think that they would be very GDP sensitive or are we brushing up against the outer limits in particular with a lot of AI, let’s say bullishness priced into these things? So that’s an interesting question for 2025.

FINDING OPPORTUNITIES

There’s a couple areas of the market that we find interesting going into 2025. One area is Industrial semiconductors and let’s call it related products. If you look at industrial activity in the U.S. and even outside the U.S., it’s been in essentially a mild contraction since the middle of 2022. It’s remarkable how long this has gone on. There’s an index called the ISM index that’s been below 50. That’s a contractionary valuation for that index for basically two years. You’d think we were in a much worse economic situation. So it is implausible that this is going to persist for another full year. It just doesn’t make any sense. So we like industrial businesses, we like unit-driven industrial businesses, which industrial semis tend to be. The other area that I think is intriguing as we move into 2025 is the consumer space. Consumers and Consumer Discretionary in particular have not been doing well. The political result in November has something to do with that. Certainly, people on the bottom half to even bottom two-thirds of the economic spectrum have not kept up with inflation. You’ve had real wage declines that has meant that consumers become very choosy. Can they become less choosy in 2025? Will you see better volumes for volume-driven businesses? We think the answer is more likely than not to be a yes. So we’ve been picking our spot, focusing on beverages. We like the travel and leisure space. Retailing is inherently a tricky business. We haven’t focused too much of our energy there.

EQUITY RISK PREMIUM

If you believe that the Fed is in restrictive territory currently, and Jay Powell said so much at his most recent press conference, then the Fed funds rate will eventually go below 4%. Probably the 10 year yield will eventually go below 4%. And if that’s true, then the equity risk premium on a more correct, more sustainable interest rate is in fact a positive value. Right now, their opinions are all over the map as to what the true neutral rate is. It seems that the people at the Fed have some idea, but they’re not very confident in it. I’m not very confident in it, and we will need to feel this out. If the neutral rate and the current price of bonds or current yield on bonds is one and the same, in other words about four and a half percent and there’s zero equity risk premium right now, then markets probably need to settle a bit lower.

THE IMPORTANCE OF DISCIPLINE

Discipline is extremely important. The market bottomed in October of 2022 and we’re up about 60 some odd percent since then and been two years of basically buying the dips, not really anything more than one violent correction in early 2023. And when you go this long and returns are favorable and you’re never really challenged by a nasty market for any great length of time, that’s when loosey-goosey behavior tends to not only happen but actually get rewarded. And as we said at the end of 2024, there’s a lot of that going on. I think there’s some outright tulip manias happening and a few speculative asset classes. For more pedestrian, more vanilla stocks, if you will, which is our main backyard, I don’t see that. But even in those, there’s more optimism expressed. So it’s important to understand that this is a process and it’s happened many times before. Becoming undisciplined, particularly when the risk appetite is elevated, which it’s been in the last part of 2024 is a very dangerous activity. You need to think about doing the opposite. Just peel back a little bit, understand crazy people are going to do crazy things because that’s just what crazy people do and you don’t need to partake in that.

2025 EXCITEMENT

Well, excited might not be the right word, but I’m really interested to see how the global geopolitical picture goes. This is one of the more fascinating times in my life. It’s well disclosed that Trump wants to make nice with Putin and in the war in Ukraine and whatever your opinion about this particular human conflict is, the U.S. is entangled in it by supplying billions and billions of dollars of weapons to Ukraine. And should we be entangled in there or not really? This isn’t our fight. It’s a fair question. Trump has a position on it which is he doesn’t want to be entangled in this. If the Euros want to be entangled in it, they can. It’s their backyard, not our backyard. So I have no idea how this is going to resolve, but this will be fairly interesting. Likewise, if you think about the possibility of higher tariffs, in particular somewhat punitive tariffs directed at countries like China that seem to be adversaries at some level, what does that do to their economic aspirations that force them to devalue their currency in order to earn enough Dollars to buy all the stuff that they need to buy that happens to be priced in Dollars? It’s very interesting, and whether you like Mr. Trump, dislike Mr. Trump don’t have an opinion on him, which is rare. There is some reordering of the global geopolitical order of the Pax Americana that has existed basically since World War II, and I don’t think anybody knows how this is all going to go. And I find that actually rather tantalizing as an investor.

LARGE CAP VALUE PERFORMANCE

We managed to keep up with a very perky stock market in 2024 and a very thematic and somewhat momentum-driven stock market in 2024. And given that our style tends to be a little more of a plotting style, that’s a non-trivial accomplishment. Our best gainers have been in the technology and digital platform space, but we’ve done very well with some other names. We’ve done very well with Delta Airlines where we spotted really a change in the market structure and bought that earlier in the year. We’ve done very well with TJ Maxx, which is essentially an off-price retailer that’s done very well over the course of the year in terms of our financial exposures. Those have done very, very well. There was a lot of fear priced into financials in 2023 that things like a commercial office bust would lead to very poor performance for banks and other credited capital market-exposed financials. It just hasn’t really materialized. Maybe it’s just simply too slow-moving to be that disruptive, and it’s certainly very well anticipated, but those have all done very nicely. We’ve been more active than I expected to be in the fourth quarter of 2024. There’s been some dislocations in Healthcare. We’ve been active, but there have certainly continued to be a lot of underperformers in the consumer and global consumer-oriented areas because of some of the income distribution pressures that we’ve talked about. We’ve been active there. Even in Tech where you’d think, how would you have underperformers tech’s been so great? It’s been very concentrated. It’s been the AI trade. That’s what’s worked great. We’ve taken some profits there, but we have been finding interesting names outside of there, where we think valuations are frankly quite attractive.

WHAT DIDN’T WORK IN 2024

Well, there’s always going to be things that don’t work the way you thought they would work. I think one of the biggest detractors in 2024 was the Energy space. And we did okay there to be clear, but there was a thesis that you had underinvestment in upstream supply capability. This stemmed from an oil crash back in 2020. And as well, a lot of pressure from shareholder demands from ESG-related demands and so forth to invest less in upstream Energy. It just really hasn’t materialized. So we’ve pulled that back. We have a more modest position there. Great thing in Energy is wait around another six to 10 months, you’ll get a whole new narrative, and we expect that we will see a whole new narrative sometime in 2025. The other area I would say that has lagged have been Consumer Staple type of names. We haven’t been heavily exposed there, but between the GLP-1 narrative, which says that people will consume less of these over time, changing habits in terms of consumption, changing dynamics globally, there’s just been a lot of fear and uncertainty in the space, and these stocks have not been able to get going in many ways.

AIRBNB – INVESTMENT THESIS

Airbnb is typical of other digital marketplace businesses. It’s a natural two-sided market. You have lots of people seeking short-term rentals, and you have very fragmented supply from people who own an apartment or a home or a second home or a second apartment that they don’t use, all the time. And you have an exchange in the form of Airbnb where you can allow these forms of supply and demand to meet. So it’s a great idea, it’s a great concept. And our hypothesis is you are still in very early days with respect to all the possibilities that you might have here. Typically, when you see a digital marketplace come into being the company that is running it, whether their name is Amazon or Uber or even Apple with respect to its app store, they have something they call a take rate where they will take a component of the price that the consumer is paying for the product and book it to their own P&L. And over time, as the marketplace becomes more and more pervasive, that take rate tends to go up. What’s very interesting when you think about just how fragmented the supply and the demand for things like short-term rentals is, well, you could have a pretty high take rate for a business like that because if you can’t find somebody who wants to rent your apartment that you’re not using for a month, you’re going to get no money for it. In the case of Airbnb, their take rate was already positioned them to be fairly profitable. When we entered the stock, they generate reliable free cash flow. They have a lot of debt cash on the balance sheet. We think there’s just a lot more that they can do with the concept that can continue to drive value.

INFLATIONARY PRESSURE

Clearly, if we had a second wave of inflation, it would be a problem for the whole stock market. I don’t think there are too many businesses whose valuations would go unscathed if that were to happen. We’re in equities, we’re not in fixed income, and I’m kind of happy we are. It keeps our life a little more simple. We just focus on finding good businesses where we have to find them. We don’t need to make a binary call on exactly which way we think the Fed is going, which way inflation is going, etcetera. But for what it’s worth, I’ll share with you how we are thinking about interest rates. We think that long bonds, so 10 Year bonds will fluctuate between about 3.5% on the low side and about 5% on the high side. And let’s say we have a run towards 5%, it’ll look scary. It’ll look like maybe they’re going to blow through there and then they probably won’t. And conversely, you might see some decrease in inflation, some decrease in economic activity, and you see yields fall towards 3.5% and it’ll look like they’ll go right through there and they won’t. So we’re positioning ourselves to be able to live with the threat of a 5% scare, but probably not much worse than that.

LARGE CAP VALUE – OFFENSIVE/DEFENSIVE 

I would say that we are leaning a little more defensive at this time, but you got to be a little careful with that choice of verbiage. As a for instance, we seem to keep finding very inexpensively, valued stocks in the healthcare space. Healthcare is a classically defensive sector. Having invested in Healthcare for many, many years, it’s not as defensive as you think. It’s, it’s really driven by more specific policy factors for things like healthcare insurance and by scientific developments, if you are a drug maker or something along those lines, which are not themselves driven by the economic cycle, but when these variables tend to be decided in one way or the other, it tends to move these stocks rather violently.