First Quarter 2024: Investors Excited about Artificial Intelligence (AI); Interest Rate Worries Grew; 20 Years of Bristlecone
After rebounding strongly in 2023, stock markets continued their upward trajectory in the first quarter of 2024, with many of the same underlying drivers. US large company stocks led the way, especially those companies with a credible claim of participating in the surge of AI-related spending. The S&P 500 rose 10.6% in the quarter. Most other areas of the stock market delivered good but more mundane performance.
No company has benefited more from the surging interest in AI than Nvidia, the designer of semiconductors with a large early lead in supplying the processing power for the AI revolution. Business history, especially the technology sector over the last half-century, is replete with hardly believable success stories, but Nvidia's recent achievements are without parallel. The company was founded in 1993 by Jensen Huang, surpassed $1 billion in revenue in 2002, and surpassed $10 billion in revenue in 2019. In its just-completed fiscal year, revenue increased from $27 billion to $62 billion!
The company's incredible fundamental growth was well rewarded in the stock market. Its market value rose from $360 billion at the end of 2022 to $1.2 trillion at the end of 2023. Astonishingly, Nvidia's market value rose by another $1 trillion just in the first quarter of 2024.
Here is a look at the major asset classes' short- and long-term returns.
Real estate-related stocks were the notable laggards during the quarter (-1.4%). The current period of markedly rising borrowing costs and a tighter lending stance from banks has been very tough for a sector that employs significant leverage. Offices have understandably been the hardest-hit segment, but higher rates create a headwind for real estate valuations more broadly.
Smaller Company Stocks Look Attractive
One pair of columns in the above chart is very telling. Over the last three years, the performance gulf between larger and smaller company stocks has been historically wide (11.5% annualized for large vs. 2.3% for small). Over the very long term (think 100 years), smaller company stocks produced higher returns than larger company stocks. Academics reasoned this was because of the greater volatility they exhibit, causing investors to demand a premium return. According to Ibbotson (one of the best sources for long-term market returns), from 1926 - 2023, small company stocks delivered returns of about 1.5% higher annually than large company stocks.
That premium return has certainly not been the case recently, and we think it may be an area of opportunity going forward. Although there are many lower-quality companies among the thousands of small-cap stocks, we find good quality, profitable, smaller-company stocks to be attractively valued right now. You might consider this the flip side of the market's focus on the magnificent seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) that have driven superior S&P 500 returns recently. These companies have all grown to market valuations between $1 - $3 trillion (Tesla has fallen back below that level now), leaving the overall market more concentrated in a small number of names than it has ever been.
The combined value of all 600 smaller companies that comprise the primary small company fund we employ sums to just over $1 trillion, or roughly one half of the value of Nvidia alone. We began moderately increasing the weight of smaller company stocks in our diversified portfolios during the quarter.
Bad News for Bonds This Quarter
Alongside AI, the other main market story this past quarter was changing speculation about the future trajectory of interest rates. The main gauge of inflation, the Consumer Price Index, peaked at 9% in the summer of 2022. The Federal Reserve (the “Fed”) reacted by significantly raising short-term rates, and inflation slowed materially through the summer of 2023.
At the beginning of 2024, expectations were widespread that the Federal Reserve would begin lowering short-term rates, loosening the reins for economic growth. In the first three monthly readings of 2024, however, inflation came in above expectations and appears to have stubbornly stuck in the 3.0 - 3.5% range. This has caused investors to believe rates will remain higher for longer. You can see the shift in interest rates over various points from the last five years in the below chart.
These higher rates have made for a miserable environment for bond investors. The main index for US Bonds, the Barclays Aggregate Bond index, was down 0.8% in the quarter; now shows a 5-year compounded return of just 0.4%; and a 10-year return of 1.5%. Given inflation over the period of about 3.0%, bond investors suffered a negative real return for the last decade.
There are two bits of good news on this front. First, we over-weighted short-term bonds in your portfolios, which means that the bond portion of our balanced accounts performed better overall than the bond market during the same periods. During the quarter, our positioning also allowed us to benefit from the inverted yield curve (when shorter-term rates are higher than long-term rates) while dampening the impact of the more recent shift upwards in rates.
Second, future bond returns are highly correlated to the starting level of interest rates, and there is good reason to expect higher returns from this part of the portfolio over the next decade.
Large Cap Value (LCV) Review
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy, depending on the overall portfolio size and the client's objectives and constraints.)
The LCV portfolio's performance was positive in the first quarter but trailed the S&P 500. In line with the AI theme, Meta Platforms was the portfolio's best performer during the quarter (and remember, we mentioned in last quarter's review that it was the best portfolio performer for all of 2023). Meta is using AI in myriad ways, including making AI assistants available to users of its Facebook, Instagram, and WhatsApp platforms. The primary way the company is benefiting from AI today, though, is by helping it to serve up more relevant advertising to its users, thus making its enormous platforms more valuable to advertisers.
The increase in Meta's stock price prompted us to trim our investment during the first quarter of 2024. We initially bought shares (the company was then known as Facebook) in 2019 and added to it twice subsequently. Our most recent purchase was in April 2022, when investors were concerned the company was spending too much on projects with only distant (if ever) payoffs (the very projects that prompted the name change to Meta). In the meantime, the company has worked to become more operationally efficient while continuing to invest in its metaverse vision. It has also benefited from a rebound in digital advertising and the perception that it has mostly countered the competitive threats posed by TikTok and privacy changes in the iPhone operating system.
Our only other trade during the quarter was to increase our position in Howard Hughes Holdings (HHH). We mentioned above that real estate-related stocks had suffered from rising interest rates and Howard Hughes was no exception. HHH owns and develops nearly the whole range of real estate projects (e.g., residential, office, retail) across the country from New York City to Hawaii. Most of its value, though, is in massive residential master-planned communities in Arizona, Texas and Nevada. The United States needs vastly more housing, and HHH is in a good position to supply build-ready lots in attractive markets over decades. We believe the company will be able to navigate the current interest rate cycle successfully and reach a point where the stock price better reflects the value of its extensive real estate holdings.
The top three portfolio performers during the quarter were Meta Platforms, Disney, and NRG Energy. The bottom three performers were Liberty Broadband, Bayer, and Howard Hughes.
20 Years of Bristlecone
This coming June 1st will mark the 20th anniversary of Bristlecone. Many of you were there with us at the beginning of the firm, many more have joined since. We deeply appreciate the trust each of you has placed in us over the years.
We founded Bristlecone as an independent, employee-owned firm for a few principal reasons. First among those was to provide us with a solid platform to make good, long-term investment decisions on behalf of our clients. This sounds simple and obvious (shouldn't this be the goal of every financial services firm?), but this industry is not at all uniformly - or even mainly - set up with this aim. Much of it is focused on short-term results and a continuous process of selling products. We wanted to help clients build their wealth over the long term and invest our family money right alongside them so our incentives were as aligned as possible.
We also understood that we would need to be independent to take better advantage of the trend of declining costs of investing over time. Right from the start, our clients were able to benefit immediately from much lower transaction costs at our broker-dealer partners, and those costs have happily continued to decline over time. Even more substantial, as an independent advisor with nearly the full range of investment vehicles at our disposal, we've been able to take great advantage of the trend towards lower fund expenses. Our only incentive is to make the investment choices that are most likely to meet the desired return and risk characteristics of our clients.
The other principal reason we formed Bristlecone was to have control over the ethical and compliance culture of the firm. We have made good and bad investment decisions over these two decades, an inherent consequence of making lots of decisions over time when the future is uncertain. We accept that. We are confident in saying, though, that all our decisions were made with our clients' best interests in mind.
One remarkable fact we are happiest about is that the three of us - Jean-Luc, David, and Josh, the three owners of Bristlecone - have been working beside each other for all of those twenty years. The constancy of this trio has allowed for a consistency of purpose, philosophy, and service that has greatly benefited our clients. We are also extremely grateful to our past employees who played big roles in building the firm. We have really enjoyed working together in your service.
Investing is an endeavor where experience and knowledge accumulate only over time. We have experienced and learned so much over these last twenty years, and we genuinely look forward to putting what we have learned to work for your benefit for many more years.
With great appreciation,
Disclosure Brochure Offer
Securities laws require Bristlecone to make available every year to clients the latest version of our disclosure brochure (Form ADV Part 2A). This form contains important information about our firm, such as services, business practices, potential conflicts of interest, a summary of our Disaster Recovery Plan, and Privacy Policy.
If you receive your 1st quarter statement by mail, a copy is included for your convenience. If you elected to receive your statements through our online portal, the disclosure brochure is available for download on our website by clicking here or on the U.S. Securities and Exchange Commission's Investment Adviser Public Disclosure website by clicking here, but we'll be happy to mail you a copy free of charge (call 310-806-4141 or email clientservices@bristlecone-vp.com)
You may find additional information about our firm on our website and through the same Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov. We must also adopt a Code of Ethics and provide a copy to clients upon request.
Contact us immediately if you have had any changes in your investment objectives or financial circumstances. Any changes could impact how we manage your portfolio and will become part of your client file. You should contact us anytime during the year if your investment goals or financial circumstances change. Should you hold equity securities in your portfolio, you will be responsible for voting proxies concerning those investments. We typically do not vote client proxies unless specifically requested.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.This content is developed from sources believed to be providing accurate information, and it may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.