Equity markets sustained their upward momentum in the first quarter of 2024, pushing many large capitalization stocks to fresh all-time highs around quarter-end. The U.S. equity market bottomed at the end of October 2023 after a 10% correction, then reversed course when the Federal Reserve signaled a change in monetary policy. Since then, market enthusiasm in 2024 has been bolstered by expectations for the Federal Reserve to reduce the Fed Funds Rate over the next year as well as optimism about artificial intelligence (AI). Market performance has been inconsistent though: small and mid-cap stocks have underperformed large caps – which are still influenced by the very largest technology stocks- and there are pockets of the market that are experiencing outright downturns.
Index | 1Q 2024 | Calendar Year 2023 |
Russell 3000 | 10.02% | 25.96% |
S&P 500 | 10.55% | 26.29% |
S&P 500 Equal Weight | 7.91% | 13.87% |
Russell 2500 | 6.92% | 17.42% |
Russell 2000 | 5.18% | 16.93% |
MSCI Ex US | 4.66% | 16.21% |
iShares Core U.S. Aggregate Bond ETF | -0.74% | 5.39% |
If narrative follows price, expect further optimism and bullish comments from the pundits on your television and radio. But there are brewing risks beneath the surface -there always are. Most prominent is the difference between the Street’s and the Fed’s expectations for rate cuts over the upcoming year. At year-end 2023, the 12-month Federal Funds Rate futures yield was down to 3.95%, which implied five 25 basis point cuts by the end of 2024. The FOMC telegraphed three such rate cuts in their Summary of Economic Projections. However, recent speeches by Fed officials indicate that they are in no hurry to lower rates, particularly in the wake of recent inflation reports showing a rebound in inflation above their targeted level. If the market is wrong about the pace or magnitude of rate declines, the result will likely be negative for both stocks and short-dated bonds. The basis for rate cuts is the subject of much speculation and debate, including:
1. Inflation trending towards the 2% target
2. Risk of keeping rates too high for too long
3. Economic weakness or recession
4. Political pressure
Market reaction to any of these scenarios is impossible to predict, particularly with the perverse investing themes in which good economic data can be regarded as bad news for those expecting rate declines. With Federal Reserve action dependent on negative economic circumstances, we have a normal cautionary stance to brace for volatility, especially as we approach the presidential election. When rate cuts do occur, lower interest rates will benefit indebted businesses and businesses with variable debt structures in the small cap universe, which we tend to avoid due to the risks associated with lower quality businesses.
When investing, there are two kinds of risk to consider - market risk and idiosyncratic risk. Market risk is the risk of being in the market. It cannot be diversified away. Macro uncertainties, politics, and unforeseen events like COVID all drive market risk. As public equity investors, we take on this risk because the markets trend up over time and equities provide the highest return within the public markets to maintain and grow our purchasing power in the future. Since most macro and market forecasters have a dismal record for accurately predicting future events, we typically limit the time we spend on it.
Idiosyncratic risk is company-specific risk. Most of our effort goes into understanding individual businesses and their prospects to mitigate this risk. For many in the finance industry, risk is synonymous with volatility. We beg to differ. Our definition of risk is the permanent impairment of capital that can happen if a business goes bankrupt or does not perform up to our expectations. Stock prices fluctuate far more than the fundamentals of the underlying business. Price is what you pay. Value is what you get. Hype, narrative, emotions, biases, or neglect could be some of the many reasons stock prices get dislocated from their intrinsic value. The dynamic that creates downside dislocation occasionally creates opportunities for us to acquire good businesses at favorable prices. Eventually as the fundamentals shine through, the stock price rises. To outperform, it is not enough to buy good businesses which everyone admires. One must buy high quality businesses for which the market has low expectations and depressed prices. The time lag between the price dislocation and the reversion to intrinsic value varies. It took less than a year for Meta Platforms (META - bought in December ‘22 in the face of terrible sentiment) to revert to its intrinsic value range. For Vontier (VNT), also a portfolio company, reversion to intrinsic value has been a longer process, as we’ll highlight below.
Vontier (VNT) was spun out of Fortive (FTV) in October 2020 after Fortive was spun out of Danaher (DHR) in June of 2016. Spin-offs are a mechanism in which a larger business “carves off” an internal unit to stand alone when the business can support itself in the capital markets. Spinoffs often have volatile price action for a number of reasons. Irrational and non-economic selling can ensue, as the smaller spinoff may be unloaded from the indices or may not meet the market capitalization mandates of discretionary funds. Or it could just be that the original equity holders are only interested in the “main” business. In many cases, spinoffs can create price-insensitive selling which can depress market prices. At Heron Bay Capital Management, we analyze each business units of a company, allowing us to generate an investment thesis for each component of a company. If our research supports that the spinoff is a high quality, cash generative business with enduring competitive advantage(s), negative price volatility can be to our advantage. Helping us is the fact that most investors do not look at the segment level economics of the parent company.
Vontier is an industrial company with a presence in fuel dispensing equipment, automotive maintenance tools, and traffic control software, among other systems. It has a leading position in its main businesses, with a management team trained in the Danaher/Fortive Management System. This highly respected management style is based on continuous improvement pioneered by William Deming, who helped Japan become an industrial powerhouse after World War II. Another hallmark of this management style is emphasis on rational capital allocation. Heron Bay analyzed Vontier post-spin and concluded that the business was durable and cash generative with high returns on capital. Heron Bay started a position in late January 2021 when the company met our quality and IRR hurdles. Early days of holding the business were not easy going in the short run.
In addition to selling pressure caused due to spinoff dynamics, Vontier faced other idiosyncratic headwinds. Regulatory requirements to install chip readers at gas stations generated an accelerated replacement of its installed base that was not clearly broken out in its financials. Increased electric vehicle (EV) sales also created negative sentiment as the market assumed it would impair the fuel servicing business. After we reviewed these idiosyncratic pressures, we felt that the competitive advantages were largely intact, and that management was rational and opportunistic in evolving the business. In fact, during the first year as a standalone company, the wheel service segment and traffic technologies businesses were divested at attractive multiples.
The graph below shows a time series of Vontier’s stock price (right Y-axis) and purchases (green triangles) with associated increases in the ending portfolio position with the blue shading (left Y-axis). Vontier opened around $32 at the time of the spinoff and we added a small position in the portfolio equivalent to 30% of our final portfolio share count. As idiosyncratic events occurred after initiating a position (above), the stock price declined. Over time, as we validated the company performance, we added to the position at lower prices, with substantial increases in early 2022 and year-end 2022. As of March 29, 2024, Vontier closed at $45.36 per share.
We are currently experiencing another spinoff, Consensus Cloud Solutions (CCSI), which we highlighted at year-end. The stock price has declined further year-to-date after being dropped from the S&P 600 due to low market capitalization. We continue to validate that CCSI is streamlining the reporting of revenue and using cash flow to buy back its debt in the open market, retiring debt below par value. The stock continues to trade well below our estimates of intrinsic value, and we have been heavy-handed in increasing exposure at depressed prices. We urge a long-term view and patience.
Consider Warren Buffet’s personal account of investing from Berkshire Hathaway’s Fourth Quarter Letter to investors:
“I can’t remember a period since March 11, 1942 – the date of my first stock purchase – that I have not had a majority of my net worth in equities, U.S.-based equities. And so far, so good. The Dow Jones Industrial Average fell by 100 on that fateful day in 1942 when I “pulled the trigger.” I was down about $5 by the time school was out. Soon, things turned around and now the index hovers around 38,000. America has been a terrific country for investors. All they have needed to do is sit quiety, listening to no one.”
While there is much concern regarding the trajectory of the Federal Reserve Policy, the global economy, government debt, and wars; market risks are always present for equity investors. Please know that we are working hard on your behalf, focusing on the opportunities afforded, the idiosyncratic risks of each holding, and diversification within the portfolio.
Thank you for your continued trust in the team at Heron Bay Capital Management. We look forward to talking and seeing you soon.
Disclosure
Heron Bay Capital Management, LLC (“HBCM”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where HBCM and its representatives are properly licensed or exempt from licensure.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Data is sourced from FactSet and Orion.