Fuzzy Math

To Our Investors and Friends,

The S&P 500 rose 23.3% in 2024, the second year in a row of more than 20% gains, a rare phenomenon not seen since the beginning of the internet boom in 1997 and 1998. Today’s enthusiasm is largely driven by Artificial Intelligence (AI) and the Mega Cap Technology companies known as the Magnificent Seven that are focused on transforming their businesses with exciting technology. The 10-Year Treasury Note rose 63 basis points for the year, to end at 4.58%. The 2-Year Treasury Note fell 8 bps through the year to end at 4.25%, ending the yield curve inversion mid-year. Oil remained flat at just under $72 for the whole year. For the year 2024, the story began and ended with mega cap stocks dominating performance. With approximately 56% of the Russell 1000 Growth comprised of the Magnificent Seven, the index soared 33.4% in 2024. This far exceeded the performance of the Russell 2000 Growth Index, that increased 15.2%, the Russell 1000 Value Index, that rose 14.4%, and the Russell 2000 Value Index, that gained a more modest 8.1%.

The Magnificent Seven, comprised of the largest technology companies on the planet, Apple, Nvidia, Microsoft, Alphabet, Amazon, Meta, and Tesla, have made a spectacular two-year run, leaving the rest of the market behind and in many cases still off their highs achieved in 2021. There is no doubt that these are fantastic businesses, but we think the market’s intense focus on their opportunity has created an S&P 500 index of “haves” and “have nots.” In fact, as these companies trade near the highest valuations in history, many other stocks are at or close to the lowest valuation levels they have seen. It reminds us of the internet bubble that ended poorly for many internet darlings, while beginning a great bull run for many forgotten parts of the market.

As shown in the chart below, the Magnificent Seven experienced a cumulative 75% increase in revenue over the last two years compared to an 11% gain for the entire S&P 500. Excluding Nvidia, this growth was a more modest 24%, which although good, is not transformational (as it has been for Nvidia). The market responded to this growth with a 268% increase in the value of the stocks over the same time frame. Excluding Nvidia, it was a 175% gain. This compares to the index that experienced a 54% gain over the same period, and the equal weight index, a much more modest 24% increase. The S&P 500 Equal Weighted Index is an index that assumes that every stock in the index carries the same weight, while the S&P 500 Index ended the year with the Magnificent Seven representing 33.8% of the index.

It appears to us that the market is expecting the Magnificent Seven to grow a lot more than the group is capable of. Excluding Nvidia, the group’s stocks have appreciated seven times more than their businesses grew over the last two years compared to only about two times for the S&P equal weighted group (both from a cyclical low). What does this suggest? Given the rapid appreciation of the stocks, it appears the market is anticipating these companies to accelerate their growth from current levels. We believe that if AI does not accelerate their growth in 2025, the Magnificent Seven may quickly lose its luster and its catchy name. Is a Mediocre Seven in our future? If it is, we own portfolios consisting of the next technology leaders that the market may seek out as replacements.

At Kingsland Investments, we seek the next generation blue chip leaders of the digital age that we believe can grow into much bigger stocks. Once these stocks become widely owned and reach business maturity, we seek replacements by discovering new companies that offer compelling growth but have not been fully discovered by the market. This process is designed to produce compounding returns over time.

All the best to you,

Arthur K. Weise, CFA

The Challenges of the Working Man Before the Age of Artificial Intelligence

To Our Investors and Friends,

The S&P 500 rose 5.7% in November, a strong showing that coincided with an election result that brought with it hopes of both less regulation and lower taxes for the corporations that comprise the index. The 10-Year Treasury Note fell 10 basis points in the month, to end at 4.18%. The 2-Year Treasury Note dropped 3 bps to end the month at 4.13%. Oil fell about 1% in the month to close at $68 a barrel. Small cap stocks rallied strongly ahead of large cap stocks, potentially ending a decade of underperformance. The Russell 2000 Growth Index rose 12.3% and Russell 2000 Value Index increased 9.7% as investors embraced the prospects of greater acquisition activity and less of an impact from a potential global trade war for this group of companies. The Russell 1000 Growth Index gained 6.5%, and the Russell 1000 Value Index rose 6.4%.

Many describe the stock market rally as a relief rally that comes with the certainty of a smooth transition of power. We believe that the election shed light on the disenchantment of many working age men and the stock market rally reveals the hopes that they have for an improvement in their circumstances with a new administration. Time will tell whether these hopes are validated.

In his book Of Boys and Men, Richard Reeves describes the predicament of non-college educated working men as structural in nature and believes that a change in the administration will do little to improve their prospects. According to Reeves, the information age has materially changed our economy, and as a result, “labor force participation among men of prime working age has dropped 7% points over the last half century from 96% to 89%.” He further explains that this is an acute crisis for Generation Z and Millenial men as “the biggest fall in male employment has been among young men between the ages of 25 and 34.”

Reeves states, “Male jobs have been hit by a one-two punch of automation and free trade. Machines pose a greater threat to working men than to women. The occupations most susceptible to automation are more likely to employ men.” Brookings Institute fellow Mark Muro explains, “Men make up more than 70% of production occupations, over 80% of transportation occupations, and over 90% of construction and installation occupations. These are all occupational groups with current task loads that have above average projected automation exposure. By contrast women make up most of the work force in relatively automation-safe occupations such as healthcare, personal services, and education.”

The one thing we can be certain of is that automation will only increase during the AI revolution. This means that the answer to solving the challenges of the uneducated male workforce is not a return to the past but rethinking what their roles can be in the future. It is important that we find ways to reverse the unemployment trends tied to automation and help these men again find purpose.

At Kingsland Investments, we will continue to search out those companies that are making life better for their customers, employees, and shareholders by coming up with solutions that are superior to those that they are replacing. We will use periods of short-term market enthusiasm to make sure that the portfolio is well positioned for the long run.

All the best to you,

Arthur K. Weise, CFA

Keeping the Political Noise in Check

To Our Investors and Friends,

As it often does, the S&P 500 finished October lower, down 1.0% for the month. The 10-Year Treasury Note increased 47 bps in the month, to end at 4.28%. The 2-Year Treasury Note rebounded 50 basis points to end the month at 4.16%. Oil remained fairly flat to close at $69, less than one percent higher than where it started the month. For this negative month, large capitalization stocks modestly outperformed small. The Russell 1000 Growth Index fell .3% and the Russell 1000 Value Index dropped 1.1%. Small cap stocks, which had benefitted from falling interest rates, faired poorer with the Russell 2000 Growth Index falling 1.3% and the Russell 2000 Value Index dropping 1.6%.

The stock market’s volatility has frequently been attributed to election jitters that are leading many to hold off on major decisions until there is clarity on what happens next week. Early voting has created a longer stretch of time that likely increases participation and most certainly has enhanced anxiety among the voting public. In fact, according to Arthur C. Brooks, Love Your Enemies, “political scientists are finding that our nation is more polarized than at any time since the Civil War. This is especially true among partisan elites.” As a result, surveys have suggested that a full 80% of Americans fear a decline in the stock market if the other side wins.

The American public is afraid that people who think differently from them will make decisions for them. Considering that Congress will determine how $6.8 trillion is spent, this is a justifiable fear. That is an insane amount of money. It is enough to bring out the very best and worst of us, and it has contributed to the political environment we have today.

We believe the real danger in the election is a sweep on either side, which could make the misappropriation of funds possible, and may put at risk our most important institution – a fair legal system that both Americans and the world depend on to realize their pursuit of happiness. Thomas Jefferson once said, “a difference in politics should never be permitted to enter into social intercourse or to disturb friendships, its charities, or justice.” Any material change to the legal system on which most Americans have built our lives will take away from the desirability of the country as a place to live and grow a business or a family. It is the one thing that could threaten the American dream.

At Kingsland Investments, we recognize that no matter which side wins, if there is no material change to our legal system, any stock market reaction should be fleeting. Companies with great businesses supported by supportive work cultures should continue to lead the market higher. We will look for opportunities that may present themselves as many may sell stocks in the days following the election.

All the best to you,

Arthur K. Weise, CFA

Ignoring the Cyclical Downturn

To Our Investors and Friends,

The S&P 500 continued to advance in the third quarter, ending up 5.5%. For the first time in a long time, returns were driven by large groups of value stocks, not just a handful of mega cap growth stocks. The 10-Year Treasury Note came down 55 basis points in the quarter, to end at 3.81%. The 2-Year Treasury Note fell even more – down 105 basis points and is now below the 10-year at 3.66%. Oil fell a sizable 16.4% in the quarter to $68 a barrel as weakening economies in both China and Europe depressed demand for the commodity. For the quarter, value took center stage while large growth lagged. The Russell 2000 Value Index was up 10.2%, the Russell 1000 Value Index increased 9.4%, and the Russell 2000 Growth Index appreciated 8.4%, largely driven by performance in more interest rate-sensitive sectors including utilities, real estate, industrials and financials. The Russell 1000 Growth Index grew a more modest 3.2% as the semiconductor sector, most notably Nvidia (NVDA), lost steam.

We believe the stock market’s rally this quarter can partially be attributed to the Federal Reserve’s 50-basis point rate cut that took place on September 18th. Inflation is coming down, and the FED is now willing to more aggressively lower rates to avoid a recession. We will see in the coming months if they adjust quickly enough to enable a soft landing, or if employment trends weaken further, leading to both a bigger decline in inflation and a recession.

The post COVID world has been defined by the dramatic increase in inflation across sectors, which is often attributed to the massive amount of fiscal stimulus applied to economies across the globe just as supply chains broke down, leading to significant supply shortages. We believe that during this time frame, many management teams pushed through significant price increases on their products to levels that far exceeded the price hikes that they were experiencing themselves. The result is a level of profitability that in many cases has never been experienced by these companies before.

We examined the top 5 industrial companies by market capitalization in the Russell 2000 Growth Index, which we think is a good representation of the small cap industrial sector. They include Applied Industrial Tech (AIT), Fluor (FLR), Mueller Industries, Inc (MLI), SPX Technologies Inc (SPXC), and the youngest of the group, Casella Waste Systems (CWST). These five companies are all very mature businesses, CWST about 50 years old, and the rest are all over 100 years old. Mature companies tend to experience marginal unit demand increases, meaning revenue growth is far more tied to price increases than anything else.

As can be seen in the chart below, these five small cap industrial companies had high single-digit operating margins in 2014, a cyclical peak that ended with the busting of the fracking-related oil and gas bubble. As a result, in 2015 the stocks experienced a significant drop in both their P/E multiples and their operating margins. In 2024, price/earnings multiples are vastly greater than they were in 2014, and operating margins are in the low double digits. If these five companies’ businesses are anything like what they were during the last cyclical peak, the near-term future may be outright scary as stock prices collapse when margins return to historical levels, and multiples give up the gains they achieved in the last few years. Unfortunately, the algorithms that have been driving these stocks to current premium levels will react only once the cyclical downdraft has already begun.

At Kingsland Investments, we seek out young companies that can grow their profit margins as they get bigger, selling the same products or services to an increasingly larger group of customers. This secular growth does not carry the same risks that the mature, cyclical companies inherently have in their businesses. We believe secular growth may quickly regain the attention of investors should the businesses of mature cyclical companies start to struggle.

All the best to you,

Arthur K. Weise, CFA

Algorithms Everywhere and Not a Brain Cell Betwixt Them

To Our Investors and Friends,

For the first time in a very long time the Magnificent Seven began to weaken (down 70 bps) as the rest of the S&P 500 strengthened during the month of August, finishing up 2.3% for the month. Concerns of a potential recession grew, driving the 10-year Treasury Bond lower to 3.91%, an 18-basis point decline from July as inflation continued to moderate and unemployment to tick up. The 2-year Treasury ended the month 38 basis points lower to end flat vs the 10-year, which has not been seen since before the Federal Reserve started to move rates higher. Oil remains at year-to-date lows, finishing the month at $76 a barrel. Despite the weakening of the largest companies in the index, it remained a large cap dominated market. The Russell 1000 Value Index finished 2.7% higher, the Russell 1000 Growth Index grew by 2.1%. Fears of recession helped push the Russell 2000 Growth Index down 1.1% and the Russell 2000 Value Index to decline by 1.9%.

This past month, the market Volatility Index, or VIX, moved from what has been a steady range of between 11 and 20 all year to a high of 66 on August 5th. On this day, the Tokyo Nikkei 225, the major Japanese index, plummeted 12.4% in a day, the worst decline it experienced since October 1987. The trigger was The Bank of Japan’s move to increase interest rates to .25% on July 31st as the rest of the world looks to start cutting rates. This increased the costs of capital many hedge funds were borrowing to buy stocks and prompted them to liquidate their positions. What ensued was a major unwind of positions that occurred simultaneously around the world, and a resulting flash crash. The VIX had last been seen at this extreme level at the onset of COVID in March 2020, and before that at the onset of the financial crisis that began with the collapse of Lehman Brothers in October 2008.

We believe that the shock was not triggered by an economic event that market participants were reacting to as they have in the past but is an indication of how the stock market participants have changed. Market participants themselves are now highly concentrated, which can lead to significant volatility for the most minor of events. More than 50% of equity investments in the US markets are now in passive indexes -- the largest amount in the S&P 500 Index -- up from about 10% at the time of the financial crisis. Of the actively managed funds, a large percentage of these investment strategies are directed by algorithms that are programmed to do some variation of the same trend following strategy – buy what is going up and sell what is going down. Add these two groups together, and the concentration of actions leads to the extreme volatility that we see today among individual stocks, sectors, and the major indexes themselves. This is precisely what Economics Professor Nassim Taleb warned us about in his book Antifragile.

As can be seen in the chart below, such robust, one-way trading is leading to a growing number of notable bearish to bullish stock reversals – situations where a stock moves from being severely punished by the market to rewarded in a relatively short period of time – during times in which there is no change to the fundamental trend. We can see that software producer Intapp (INTA) declined 33% earlier this year to only fully recover this decline in the last three weeks. Next generation credit provider Affirm (AFRM) dropped almost 60% this year before almost fully recovering from the decline in the last three weeks. This is coinciding with similarity extreme bullish to bearish reversals – Super Micro (SMCI), the most recent example of this, advanced over 300% through March of this year and since then has given up all but 53% of the gain.

We believe that the one-sided trading focus of algorithms is creating some very scary upward moves in stocks leading to valuations that may take years for the businesses to grow into. Conversely, there are also some incredibly attractive opportunities as some stocks drop to valuations far below what their fundamentals would suggest they are worth. It just takes a little thinking to appreciate these overshoots, which is far too much to expect from the algorithms. Once the trend changes direction, however, we can be sure that the algorithms will fall right in line, supporting the new direction of the trend.

At Kingsland Investments, we spend our time seeking and discovering the emerging leaders of the digital economy. Unlike the algorithm-based strategies, we focus only on these companies that we think will become much larger in the next several years, and therefore will have the fundamental strength to support a meaningfully appreciating stock price. We leave the fads and fashions of the moment to the algorithms that will drive such stocks higher and then lower in the blink of an eye.

All the best to you,

Arthur K. Weise, CFA

Taking Age into Consideration

To Our Investors and Friends,

The S&P 500 ended the month of July up 1.1% as investors began to take profits in the Magnificent Seven (Apple, Microsoft, Nvidia, Meta Platforms, Amazon, Google, and Tesla) to invest in other neglected parts of the market. The 10-year Treasury Bond fell in the month to 4.09%, a 27-basis point decline from June as inflation continued to moderate. The 2-year Treasury ended the month 22 basis points lower to end at 4.29%. Oil drifted lower, ending the month down more than 5% to $78 a barrel. The Russell 2000 Value Index advanced 12.2%, the Russell 2000 Growth Index increased 8.2%, and the Russell 1000 Value Index expanded 5.1% in the month. The profit taking on the Magnificent Seven led to a 1.7% decline in the Russell 1000 Growth Index.

The stock market is not the only place where there has been a significant change in leadership. After a poor debate performance, and with the encouragement of his fellow party leaders, President Joe Biden announced he would no longer seek re-election to the most powerful position on the planet. Although he didn’t explicitly say it was because of his advanced years, we can be confident that it was a primary factor. It is clear Biden’s age has generated much conversation and debate about older Americans and forces us to consider how aging is changing the world in new ways.

Andrew Scott, author of The Longevity Imperative, states that “Aging doesn’t start at 65. Aging occurs at different speeds for different people, leaving the task of defining old age impossible.” As can be seen in the chart below, humanity has done a terrific job materially reducing infant mortality and finding cures for those diseases that shortened life, allowing people in developed countries to live well into their 70s and 80s. In fact, Scott claims that a child born in the United States today has a 50% chance of reaching 95 years old.

As the world gets older, society is changing in unanticipated ways. What used to be a population structure resembling a pyramid with many young at the bottom and fewer old at the top is becoming much more inverted across the ages. This means that older Americans wield greater political and economic power, while younger Americans are no longer able to support the long retirements and healthcare expenses of their elders. Society will have to adapt to this new reality by changing both the current healthcare system, and by developing what Scott calls an “economic longevity dividend” - an economic benefit derived from an older working population.

Scott explains, “A healthcare system that brilliantly supported the first healthcare revolution is not set up to achieve the second and is unsustainable. The second longevity revolution will need more than just a new health system, it will also require scientific progress and medical breakthroughs that help us age better.” To achieve this, the 1% of total healthcare costs currently spent on preventative care will need to increase considerably.

An economic longevity dividend can be accomplished by rethinking retirement and rejecting agism. We are on our way to doing just that. Scott explains that “over the last ten years, workers over 50 accounted for the majority of employment growth in the world’s richest nations.” In fact, according to social entrepreneur Mark Friedman “old people are the only natural resource that is increasing in the world.”

At Kingsland Investments, we spend a considerable amount of time studying how the economy will change in the future and then determine the likely beneficiaries in the stock market. Those companies that embrace significant trends, such as the impact of an aging population, set themselves up for a brighter future. Investors can do the same, preparing for a significantly longer retirement by appropriately investing in the great growth companies of the future.

All the best to you,

Arthur K. Weise, CFA

The Dark Side of Social Media

To Our Investors and Friends,

The S&P 500 ended the second quarter up 3.9%, again driven by a concentrated group of mega cap technology stocks. The 10-year Treasury Bond increased slightly in the quarter to 4.36%, a 16-basis point increase from last quarter as inflation moderated. The 2-year Treasury ended the quarter 12 basis points higher to end at 4.71%. Oil remains in a fairly tight range, ending the quarter down almost 2% to $82 a barrel. The Russell 1000 Growth Index advanced 8.3% (driven by a handful of powerful movers), while the rest of the market declined. The Russell 1000 Value Index decreased 2.2%, the Russell 2000 Growth Index fell 2.9%, and the Russell 2000 Value Index declined 3.6% for the full quarter.

One of this year’s best stock winners has been Meta Platforms (META), formerly known as Facebook. It is up 42% year to date, which has far exceeded the performance of the S&P 500, that is up 14% YTD. We have not owned this stock at Kingsland Investments because we believe their products have become detrimental to society and are especially harmful to teenage girls. Burn Book author Kara Swisher explains, “social media has a scary ability to generate anxiety and rage and it is addictive…in the new paradigm, engagement equals enragement. This is made worse by the people who run these companies for whom anticipation of consequences is lacking and whose first instinct is to let it all through the gate regardless of potential damage or danger. It is all private with no accountability.”

As can be seen in the chart below, ever since the widespread adoption of smartphones by teenagers beginning in 2010, depression and anxiety have significantly increased. According to author Jonathan Haidt’s The Anxious Generation, “we know that Facebook intentionally hooked teens using behaviorist techniques thanks to the Facebook files, a trove of internal documents and screenshots and presentations brought out by the whistle blower Frances Hogan in 2021.” He further explains that “social media platforms can ping you continually throughout the day urging you to check out what everyone is saying and doing. This kind of connectivity offers few of the benefits of talking directly with friends. In fact, for many young people, it is poisonous.” The result, Haidt explains, is that when attending college “the previous exuberant culture of Millennial students in discover mode gave way to a more anxious culture of Gen Z students in defend mode. Books, words, speakers, and ideas that caused little or no controversy in 2010 were by 2015 said to be harmful, dangerous, or traumatizing.”

At Kingsland Investments, we spend our time examining every investment for the impact it is having on its customers, community, and employees. Those that significantly benefit all three are most likely to grow to a much larger size in time, while those that are inherently detrimental to society will experience a decline in their businesses as society moves away from the negative effects their products or services are creating. We would not be surprised if the recent school smart phone ban becomes national policy, and as the addiction breaks, Meta Platform’s advertising business materially suffers.

All the best to you,

Arthur K. Weise, CFA

The Hot Potato Market

To Our Investors and Friends,

The S&P 500 ended the month of May up 4.8%, a level that is close to an all-time-high. This bull market continues to be driven by a very narrow group of mega cap stocks, and is the most concentrated market in the index’s history. The 10-year Treasury Bond backed off on moderating inflation data to 4.51%, an 18-basis point drop from last month. The 2-year Treasury ended the quarter 15 basis points lower to end at 4.89%. Oil continued to moderate, ending the quarter down almost 5% to $78 a barrel. The major indexes all rallied. The Russell 1000 Growth index advanced 6.0%, the Russell 2000 Growth index increased 5.4%, the Russell 2000 Value index moved up 4.7%, and the Russell 1000 Value index gained 3.2%.

We have noticed some unusual activity at the beginning of this new bull market as some unexpected stocks make moves that are uncharacteristic of both their histories and their businesses. Abercrombie and Fitch (ANF) advanced 470% in the last year but declined by 30% the previous decade. Industrial equipment provider Powell Industries (POWL) advanced 211% in the last year and increased just 22% over the previous decade. Finally, insurance provider Jackson Financial (JXN) shot up 169% as its revenue and earnings declined since its 2021 IPO. These incredible moves have generally been made by incremental positive improvements in fundamentals that are supported by steeply increasing stock charts. It is important to note that these businesses have mid-single digit operating margins. Such low margins can lead to both significant positive and negative surprises and that is why the long-term stock performance of these businesses has historically been less than stellar.

We think the extremely short-term view of market participants including hedge funds, algorithms, and day traders is creating a game of hot potato with many stocks. They rocket up on price momentum, only to come crashing down when the momentum stops. The reason for this behavior is clear – these market participants are primarily interested in immediate price changes and are playing a game of the greater fool theory (a belief that a greater fool will buy the stock at a higher price from them in the future) as justification for their purchase. We fear that many of the AI hardware stocks, which also have low operating margins, will follow this same volatile path as soon as their growth slows down.

We believe this market behavior is far closer to gambling than it is to investing and expect that it likely will generate a significant number of losers as it plays out. It may be the only way to rationalize one of the biggest developments over the previous two decades, the incredible proliferation of hedge funds. As can be seen in the chart below, there are now almost 5 times as many hedge funds as there are stocks in the US indexes. It is not a surprise that when there are so many market participants seeking short term gains, a significant amount of randomness, for which there is little fundamental rationale, is the result.

At Kingsland Investments, we recognize that there is an unusual opportunity to buy the next generation leaders that we seek at uncharacteristically low prices when the momentum players sell. We believe that the most patient investors will be the most rewarded over time. At some point, great businesses experiencing transformational growth will be discovered and valued at much higher levels. By sticking to our process of buying and owning great young businesses, we think investors can benefit materially from the advances these companies will experience in their stocks over time.

All the best to you,

Arthur K. Weise, CFA

Taking Advantage of the Little Company

To Our Investors and Friends,

 The S&P 500 ended the month of April down 4.2%, a minor contraction after a very strong first quarter result. It should come as no surprise that the Magnificent Seven significantly outperformed the rest of the market as investors continue to crowd into this narrow group of stocks. The 10-year Treasury Bond advanced to 4.69%, the second meaningful increase in consecutive months (39-basis points this month) as fears of an inflation resurgence dominate Wall Street. The 2-year Treasury ended the quarter 45 basis points higher to end at 5.04%. Oil fell slightly, finishing the month at $83 a barrel. The major stock indexes fell in the month, led once again by small cap. The Russell 1000 Growth declined 4.2%, the Russell 1000 Value fell 4.3%, the Russell 2000 Value was down 6.4%, and the Russell 2000 Growth dropped 7.7%.

We have discussed the significant disparity between the performance of large cap companies versus small cap companies for some time now. In fact, the difference in performance between the Russell 1000 Growth (R1G) and the Russell 2000 Growth (R2G) indexes continued to widen this past month. Over the last 10 years ending in April, the R1G appreciated 322% cumulatively and outperformed the R2G by 214%. This is a standout performance compared to previous decades. Over the decade ending April 2014, the R2G advanced 134%, beating out the R1G by a mere 18% cumulatively. During the large cap technology dominating decade ending April 2004, the R1G advanced 150%, beating the smaller index by a less significant 73%.

We believe the last decade of large cap dominance is not merely a difference in the anticipated impact of a higher interest rate environment. It is also being influenced by such factors as a preference for passive ETFs that favor large cap stocks, macro hedge funds that avoid illiquid small caps, and institutional demand for alternatives that are selling their small cap exposure to make room for larger private equity and venture capital allocations. There is one group that is beginning to take advantage of this disparity – corporations that seek to buy new products or services in a shorter time frame than they could accomplish through organic efforts. As can be seen in the chart below, such acquisitions are generally at a significant premium to the price the market has assigned them. The average premium from the list below is 80%, a nice premium, but in most cases below the level the acquiree was trading at three or more years ago. (Note: we currently own CoStar Group and sold Shockwave Medical after the acquisition announcement).

We believe that large corporations will continue to swallow up their smaller competitors, especially if the financial benefits are obvious. Over time, investors may notice, and this large differential between small and large capitalization companies may begin to narrow. We suspect that if interest rates begin to fall, maybe this trickle into smaller companies will likely become something more meaningful.

At Kingsland Investments, we believe that the value of small companies is being heavily discounted relative to past history for reasons that are not economic in nature. We think that in time, great businesses experiencing transformational growth will be discovered. By sticking to our process of buying and owning great young businesses, we think investors can benefit materially from these dynamics as they get discovered by either the market or a lucky corporate buyer.

All the best to you,

Arthur K. Weise, CFA

The Risk Aversion Bubble

To Our Investors and Friends,

The S&P 500 ended the first quarter of 2024 up 10.2%, the biggest first quarter return since 2019 and a record high. A narrow group of companies including the Magnificent Seven and AI-associated hardware companies (including many semiconductor and server companies) drove the outsized move. The 10-year Treasury Bond advanced to 4.20%, a 32-basis points increase as the economy proves more robust than anticipated in the face of higher Fed funds rates. The 2-year Treasury ended the quarter 36 basis points higher to end at 4.59%. A stronger US economy also helped crude oil to rise 16.1% to $83 a barrel, adding to fears of an inflation resurgence. All major stock averages started the year on a positive note with large again outperforming small. The Russell 1000 Growth grew 11.4%, the Russell 1000 Value increased 9.0%, the Russell 2000 Growth advanced 7.6%, and the Russell 2000 Value moved up 2.9%.

This emerging bull market is unlike most previous bull markets in that the very largest companies are leading the way higher, and many of the smallest companies continue to struggle, some still unable to move up from low levels achieved more than a year ago. As can be seen in the following chart, Microsoft (MSFT), the largest company in the world, is leading the market recovery, up 27% from the previous market high achieved in October 2021. The Russell 1000 Growth Index, of which almost 50% is comprised of the Magnificent Seven, is up 16% over the same time frame. This contrasts with the small cap Russell 2000 Growth index, 10% lower than the previous market high, and Olo (OLO) – a software company growing quite robustly, but much smaller than Microsoft – trading 80% lower over this time frame.

We believe this noteworthy disparity of performance is a function of the underlying risk aversion bubble, which is causing misallocations of resources everywhere that most likely will be followed by significant reversions in the coming years as the risk aversion bubble deflates. The most obvious bubble is in mega cap companies, with the Magnificent Seven exceeding 30% of the S&P 500 this past quarter. Fueling this bubble is a depletion of many other asset classes including small cap and international stocks, both of which represent historically low levels of asset allocations over several decades. We think a major driver of this risk aversion bubble is the move into passive indexes, that began to gain favor after the financial crisis and now represent more than 50% of all dollars invested in equities.

The risk aversion bubble is also evident in the proliferation of alternative asset classes including private equity, venture capital, and hedge funds. Here, institutions’ attempts to escape market volatility have resulted in a flood of assets into these alternatives that mask volatility by delaying it or hedging against it. These asset classes generally reduce the volatility of current returns but ultimately will realize lower long term returns now that the higher interest rate environment has disrupted their exit strategies. These alternative asset classes have grown from hundreds of firms to thousands of firms since the end of the financial crisis and the beginning of an extended period of low interest rates. We suspect that a reallocation away from these asset classes likely propels unloved asset classes such as small caps in the years ahead.

At Kingsland Investments, we believe in patient, long-term investing in some of the most creative management teams building the best businesses we can find. We think that great businesses are built over decades, and that a long time horizon is necessary to benefit from the miracle of compounding. By sticking to our process of buying and owning these young businesses, we think investors can benefit materially from these dynamic companies over time.

All the best to you,

Arthur K. Weise, CFA