Thank you for your ongoing confidence in Heron Bay Capital Management! As you recall, we opened our doors at the beginning of 2020. Over the past four-plus years, we have collectively endured COVID, an economic meltdown with a 40% market decline, unprecedented government support with an accommodative Fed, a chaotic election, economic re-opening with long-term supply chain issues, severe inflation, a Fed that reversed course, tightened interest rates, followed by a 20% market correction, and then new record highs on the S&P 500 driven by a small subset of stocks. We apologize for the run-on sentence, but it has been a difficult environment to invest, provide service to clients and grow as an organization.
The promises that we made at the inception of the firm are still our core tenets of service:
We invest only in your best interest as fiduciaries.
We develop asset allocation models tailored to your needs and risk profile.
We adhere to a disciplined stock selection and portfolio management process with a focus on asymmetry (upside potential compared to downside risks)
We have added sophisticated financial planning capability for those needing advice as they enter new phases of life.
We are available for counsel, planning and explanation as desired by you.
In the last quarter we have added special talent to our team. Matthew Latarewicz, a 30-year old CFA charter holder and Northwestern MBA, joined the firm in March. He previously worked on the quantitative research team at FactSet – our data research provider – where he supported back testing and implementing quantitative models for investment companies and hedge funds. On top of this skillset, he is a fundamental researcher at heart with a high work capacity. We are thrilled for him to join Joe Ashmore (another FactSet alum) and Chetan Rastogi to drive quantitative and qualitative research processes for stock selection. Most recently, Kevin Kuhl joined our firm as Chief Operating Officer. Kevin joined the firm from Clarkston Capital Partners, another local investment manager, and brings years of experience in compliance, systems and operations. These additions – bringing Heron Bay’s total staff to seven - give us the depth and scale to serve you and others into the future as an enduring organization. On the professional front, Chetan Rastogi, Heron Bay’s Portfolio Manager and Partner was interviewed on the Compounders Podcast by Ben Claremon, which was posted to iTunes, Spotify, and Youtube in late June 2024. In the interview, Chet discusses Heron Bay’s research process, investment philosophy, and equity strategies. We hope that you’ll dedicate some time to listening to the interview.
Market Review
The U.S. equity markets saw numerous record highs during the second quarter. The market capitalization-weighted S&P 500 returned 14.78% year-to-date and 4.41% over the last three months. This index continues to be driven by just a few stocks. Nvidia has reigned supreme amongst Mega cap stocks, rising 151.36% year-to-date and 37.96% in the second quarter. The equal-weighted S&P 500 index returned only 3.24% year-to-date and -3.87% for the quarter. Small Cap issues, measured by the Russell 2000, are flat year-to-date and returned -3.48% during the second quarter as speculation of rate cuts was delayed considerably.
A recent Wall Street Journal article published the following chart, showing the first six months of performance of the cap-weighted S&P index relative to the equal-weighted index. In the last 6 months, the market weight S&P 500 beat the equal weight S&P 500 by more than 10%. Last year was almost the same level of outperformance. Looking back at history, the last sustained outperformance of the capitalization-weighted index preceded the dot com bubble that burst in early 2000.
What’s the common thread between the current market and 1999? Both were narrative-driven markets. In 1999, the narrative surrounded how the Internet was going to change the world (it did) and today’s narrative is centered around artificial intelligence (AI) trained on large language models (LLMs). AI can probably change the world too, but some suggest that AI could be the last invention ever. Euphoria about a nascent industry tells us little about individual company performance; Euphoria untethered from company fundamentals almost always leads to extreme future underperformance of the stocks caught up in it. Cisco and Microsoft, which were well-established companies and among the darlings of dot come era, are examples of these extreme performance trends. After the market broke to the downside in 2000, it took the S&P 500 5 years to return to the January 1, 2000 level. By contrast, it took Microsoft 14 years and Cisco 17 years to recover from their significant declines after the dot com bubble burst.
We have been asked repeatedly “why don’t you own Nvidia?” The answer, simply, is high valuation. Nvidia is currently enjoying very rapid sales growth - over 125% in the last year - and its earnings have increased over 580% over the same period. It is the darling among AI stocks as reflected in the price multiples: during the past year, the stock has sold for well over 100 times cash flow. It currently sells at over 72 times its trailing 12-month earnings and over 40 times its projected next 12-months earnings. Our investment discipline focuses on buying high-quality companies that have sustained profitability and growth, while selling at reasonable valuation. Price discipline is a central tenet of our investment philosophy. In the case of Nvidia, we have missed out on this extraordinary stock performance during a short period of time. But to buy the stock for fear of missing out on performance would be to abandon our investment process and adopt a short-term mentality. Short-term investors (traders) may chase a stock, purchasing at high valuations. But their short-term gain is also dependent on a sell discipline, which has no guiding principle except that the price is higher than the cost basis. Buying a stock amidst considerable momentum and narrative hype has an inherent asymmetry for a long-term investor like Heron Bay because our default holding period is forever. If the hype isn’t sustained or the company stumbles, valuation can fall like a rock. We believe that not purchasing a high valuation stock protects investors from potential permanent destruction of capital. Heron Bay’s Large Cap Equity portfolio has meaningful exposures to Microsoft, Alphabet, Apple, Amazon, META, and Lam Research, which have exposure to AI in their business models. The balance of the large cap portfolio is made up of a diversified mix of growing businesses that continue to expand via high return on invested capital.
Looking towards the back half of the year, the Presidential election will garner considerable media coverage and pontification about each candidate’s effects on the economy and global standings. On top of international and domestic policy, we’ll pay careful attention to the tax proposals of each candidate and implications on the government deficit. We should all hope for a better solution to the country’s deficit than Modern Monetary Theory, which theorizes that any government that prints its own currency does not need to constrain spending. That theory seems to depend on the rest of the world’s willingness to purchase our country’s debt as the global reserve currency. Let’s hope that isn’t challenged. We continue to watch consumer credit defaults rise as an indication that the consumer, or at least on portion of the consumer base, is struggling.
As stewards of your capital, we are grateful for your trust in us, and look forward to serving seeing you well into the future. We are pleased to report on our new hires, new services (financial planning is an exceptionally powerful tool), and ongoing commitment to the promises that were made to you over four years ago. Please feel free to reach out to any of the team members to discuss the portfolios, the investing environment, or ways that we can assist you. We are here to serve and look forward to it daily. To that end, referrals are appreciated, and we would be pleased to demonstrate our uniqueness and professionalism to anyone you recommend.
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.
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