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