Client Investment Letter July 2024
âThe least productive people are usually the ones who are most in favor of holding meetingsâ â Robert Solow, American Economist
The world is abuzz with a groundbreaking technology promising immense productivity gains. Every company is exploring it. Startups are popping up all over the place to take advantage of it. One company has been branded by Wall Street as âvirtually unable to be unseated from its top spot.â The company has been growing revenue more than 50% annually and is trading over 25x trailing year revenues. Its inspirational CEO, universally lauded as a genius, graces many magazine covers. It recently split its stock after a meteoric rise in price. For a moment, the company had the largest market capitalization in the entire U.S. market. Can you guess the business?
Cisco Systems, Inc. The year? 2000. Cisco was a canât-miss growth story at the time. Wall Street was right about that. Indeed, free cash flow at Cisco grew substantially, from $5 billion in 2000 to nearly $15 billion in 2020. However, over that twenty-year stretch, its stock price fell from $77 per share at the end of March 2000 to $40 per share in March 2020. It seems Wall Street anticipated even more growth than Cisco could deliver.
In the end, the internet was a huge market, and Cisco was an early leader. A lot of money was indeed spent on the infrastructure to build it out, eventually driving competition. Markets that big and profitable attract it. At its peak, Cisco was valued as if it would continue to dominate the networking equipment market forever.
As it turned out, the real winners of the internet era were the companies that used the infrastructure to solve real-world problems in unique ways. Google provides free access to information, funded by selling ads. Facebook connects people online. Amazon brings an endless variety of goods to your doorstep and allows companies to rent servers and data storage. Apple puts the internet in the palm of your hand. All these companies made many billions leveraging the internet in ways no one in the mid-1990s could envision.
They say history doesnât repeat itself, but it rhymes. Today, Nvidia has captured the marketâs imagination the same way that Cisco did in 2000. Artificial Intelligence (AI) is the technology of the day with the potential to transform the world as we know it by ushering in a new era of productivity powered by AIâs superhuman capabilities. According to Solow, economic growth is determined by the combination of capital, labor, and productivity. The labor force is shrinking as the developed world ages and birth rates decline. Capital has recently become more expensive due to higher interest rates and inflation. Productivity growth is the last remaining hope to drive breakout economic growth, so it is no wonder that people are so excited by AI.
We canât predict exactly how the Nvidia story will play out, but the rapid growth of its market is drawing competition. Chip companies like AMD, Samsung, and Intel are working hard to catch up. Even technology behemoths (and important Nvidia customers) like Microsoft, Google, and Amazon have efforts to design their own AI chips. Furthermore, given Nvidiaâs dependence on Taiwan Semiconductor Manufacturing Company (TSMC) to produce most of its chips, the companyâs fortunes could be disrupted overnight by the whims of Chinaâs President Xi Jinping should he decide to send a fully armed battalion to remind Taiwan of his love.
On the other hand, Nvidia has a lead over most competitors and has presciently locked in many AI developers with its CUDA programming language. TSMC, Samsung, and new entrants into the semiconductor fabrication market like Intel are building plants outside of Taiwan rapidly. Microsoft, Amazon, Google, and Meta, flush with billions of cash, view continuing to invest in AI as essential to their future. No doubt, Nvidia will remain a growth story for a while to come, but its future stock price is probably less certain than market expectations assume.
We continue to express our excitement for AI in your portfolio through other, less expensive proxies with lower expectations such as Google and Qualcomm. Many of these positions we purchased years ago, and they have done what good companies do: adapted to position themselves well in a world where AI is increasingly important. Other holdings, like Match Group, PayPal, and Fortrea are beneficiaries, leveraging the technology to improve their businesses. Today we mostly see value in other parts of the market that arenât making headlines every day like consumer, healthcare, energy, financials, and some industrials.
Indeed, the market has been unusually ânarrowâ this year, meaning a handful of stocks continue to drive most of the returns. Six mega-cap tech companies have driven two thirds of the S&P 500âs returns year-to-date. A turn in sentiment on those six companies could have a big impact on the markets. Combine the narrow market, the prospect of a bruising election, continued pockets of weakness in the real estate markets that will potentially weigh on bank balance sheets, and it could add up to a challenging fall. We are comfortable holding some cash to take advantage of more volatile times ahead.
Speaking of dry powder, Boeingâs recent announcement of its acquisition of Spirit AeroSystems has given us a chance to raise some additional cash. Boeing plans to acquire Spirit for $37.25 per share in Boeing stock, with the deal expected to close next summer. Because the deal is structured as an all-stock deal and given the endemic problems at Boeing (including no clarity on who will be running it), it seemed like a good time to move on. While we were right that Spirit is an essential supplier to the aerospace supply chain and there is huge demand for commercial aircraft with backlogs stretching into the 2030s, we underestimated how messed up Boeing is and how hard it will be to ramp production back to pre-Covid levels, especially now with regulators (rightfully) on their backs. The prospect of holding Boeing stock while we wait for what will probably be several years for them to get their act together didnât seem very appealing, so we took the win and moved on.
We continue to appreciate the trust you place in us to manage your capital. We welcome a meeting either in person or over Zoom to go over your portfolio in detail â and we promise to make it productive. As always, we are only a phone call away should you have any financial question no matter how big or small.
Penn Davis McFarland, Inc.
July 2024
