For a printable version which includes all graphs and tables, click here.
If you are a client, click here for a copy of the client commentary which includes discussion of recent investment activity.
Behavioral Biases
“Occasionally we are asked whether it would make sense to modify our investment strategy to perform better in today’s financial climate. Our answer, as you might guess is: No! It would be easy for us to capitulate to the runaway bull market in growth and technology stocks. And foolhardy. And irresponsible. And unconscionable. It is always easiest to run with the herd; at times, it can take a deep reservoir of courage and conviction to stand apart from it. Yet distancing yourself from the crowd is an essential component of long-term investment success”
– Seth Klarman, December 1999
Seth Klarman is a well-respected value investor at The Baupost Group and wrote one of our favorite books on the practice of investing, Margin of Safety, which was published in 1991. It has been out-of-print for decades, but you can find a used copy on Amazon for $2,000. The Baupost Group is widely acknowledged as one of the highest performing investment managers of our time. Mr. Klarman’s above quote came in 1999 at the height of the dot-com bubble and after a decade of underperformance (see chart). The pressure to adjust his investing process during that period of sharp underperformance was intense, as it was, for all underperforming investors. FRM was no exception. The pressure is similar today after the S&P 500 had its best consecutive year performance since 1997 and 1998. Also, the Russell 1000 growth stock cohort lapped the value factor by 19 and 31 percentage points during the past two years according to data compiled by Charlie Bilello, Chief Market Strategist at Creative Planning. That’s the most lopsided showing since at least 1979, eclipsing the cumulative 48.9-point gap seen during the acute phase of the dot-com mania in 1998 and 1999.
Mr. Klarman has argued that markets are governed by behavioral science. We agree and find that to be especially true during periods of speculative excess, like the late 1990s and today. There are many behavioral biases that exist in investing (textbooks will tell you there are 14) but there are four that we believe show themselves in healthy doses during periods that in hindsight turn out to be manias or bubbles in the stock market. We describe the four biases in the table below and give examples that indicate their overwhelming presence.
Speculative trading driven by the mania created by these behavioral biases led to the sharp underperformance of value stocks in December, and our portfolios were no exception. Traders sold out of value stocks to purchase more of the Magnificent 7 and AI-related growth stocks that have driven index performances the last two years. This led to value stocks declining for 14 consecutive days, the longest streak on record (see chart on the following page). The Dow Jones Industrial Average experienced a concurrent 10-day slide, its worst losing streak since an 11-day slide in 1974. The slide was mostly caused by a rotation out of old economy shares and into technology stocks. As we observed the irrational trading and reviewed the companies we own, we discovered no significant fundamental changes that affected the intrinsic valuation of our companies. We believe the frenzied trading has set up a highly attractive absolute and relative valuation opportunity in our portfolios similar to the late 1990s and 2021 (see chart). By continuing to follow our investing discipline, we believe our portfolios are well-positioned to protect the capital you have entrusted us to manage and to potentially provide strong results when this latest mania subsides. For what it is worth, the FRM composite had good performance when the dot-com mania receded, as did Mr. Klarman.
Watching the Crazy Train Pass By
All aboard the crazy train! Below we elaborate on the speculative trading we mentioned in the previous section. These are examples of speculative risks that we normally observe during the late stages of bull markets in stocks. For those of you that are not paying as close attention to financials markets as we are, some of these crazy trading actions may surprise you. This is not a comprehensive list, but we believe it makes a strong point.
• Leveraged exchange traded fund (ETF) assets reached new highs last year both in assets under management and in their percentage share of all new ETFs (see chart). These funds purport to amplify the daily returns of a specific index or security and use options and other strategies to achieve this goal often unsuccessfully. The largest of these ETFs is the ProShares UltraPro QQQ, which strives to achieve 3 times the daily performance of the Nasdaq-100 Index and has approximately $25 billion in assets under management. The largest levered ETF focused on a single company is the GraniteShares 2x Long NVDA Daily ETF that aims for 2 times the daily return of Nvidia and has approximately $5 billion in assets under management. By definition, these ETF vehicles are speculative, and they have grown quite large very quickly.
• MicroStrategy (Nasdaq: MSTR) is an enterprise analytics software and services company that was founded in 1989. The company has had negative operating income for the last five years. In August of 2020, MSTR started purchasing Bitcoin. On October 30, 2024, they announced a $42 billion capital plan to sell $21 billion worth of stock and raise $21 billion from the sale of fixed-income securities to purchase Bitcoin. This compares to a MSTR market capitalization of $50.1 billion on the announcement date. Before the announcement the company had $4 billion in debt. The plan would increase debt by 600% to purchase Bitcoin. Even Bitcoin’s most ardent proponents will acknowledge that it is one of the most volatile financial instruments ever invented. Borrowing to purchase more may work while Bitcoin is going up, but it does not strike us as an enduring long-term approach to building capital. After the announcement, speculation in MSTR shares increased to the point where the dollar value of the shares changing hands at one point in November topped every other U.S. stock and ETF, except Nvidia. MSTR is trading at a valuation that is very confusing to us. It is valued at somewhere around 4 times the value of its Bitcoin holdings (see chart). Somehow MSTR was added to the Nasdaq-100 index on December 23.
• Even crazier are those willing to speculate in the T-Rex 2x Long MSTR Daily Target ETF and Defiance ETFs’ Daily Target 2x Long MSTR ETF which are meant to provide 2 times the daily return of MicroStrategy.
• Stock option trading volume grew in 2024 for the fifth straight year to all-time highs (see chart). Even more concerning is the number of speculators plowing into options that expire the same day. These zero-day-to-expiry options, or “0dte” trades, make up more than half of the options activity tied to the S&P 500 index, up from 17% at the start of 2020, according to market research from SpotGamma. These trades are a bet on a single day’s movement in stocks. Yet again MicroStrategy is attracting a large amount of the speculators’ attention with option activity sky-rocketing after the October 30 announcement from the company (see chart).
• During the fourth quarter the total market capitalization of all outstanding cryptocurrencies totaled $3.8 trillion, a sum greater than the $3.4 trillion market capitalization of all Russell 2000 index members.
• Meme coin mania took off. At one point in November the total market value of memecoins grew to over $125 billion. It is currently around $100 billion. Some of you may be wondering: what is a memecoin? That is a great question, and we do not have a very good answer for you. They are defined as cryptocurrency that originated from an internet meme, defined by Oxford English dictionary as “an image, video, piece of text, etc., typically humorous in nature, that is copied and spread rapidly by internet users, often with slight variations.” Examples of memecoins include Dogecoin, Shiba Inu, Pepe, Pudgy Penguins, Bonk, Dogwifhat, FLOKI, SPX6900, and Peanut the Squirrel. Each of these has a story or joke associated with them, but none of them are tangible in nature or have cash flows or earnings associated with them.
• Destiny Tech100 (DXYZ) is a closed-end fund that invests in private technology companies. The fund purports to provide everyday investors access to private market leaders for the first time, a fine aim as far as it goes. Our quibble of course is with the price everyday investors are paying to “participate.” DXYZ has 36.9% of its portfolio in SpaceX. SpaceX is Elon Musk’s company, which designs, manufactures, and launches rockets and spacecraft. SpaceX has achieved amazing advances, which includes catching a Starship rocket booster at its original launchpad with “chopstick arms” on its descent. The company was valued at $350 billion during its latest funding round in early December 2024, a 65% increase from the previous round 3 months earlier. The funding valued SpaceX at 26 times sales with expected revenue for 2024 of $13.3 billion. OpenAI is another large holding for DXYZ, which accounts for 5.1% of the portfolio. OpenAI is the startup behind ChatGPT. OpenAI nearly doubled its valuation to $157 billion in its latest funding round in October 2024. The company expects to lose around $5 billion in 2024 on revenue of $3.7 billion. It projects revenue will grow to $11.6 billion in 2025 (with no projection on losses). The latest funding round valued OpenAI at 42 times 2024 sales but “only” 13 times expected 2025 sales. Maybe these valuations are reasonable for these companies in the private offerings. Maybe. The problem for everyday investors purchasing DXYZ is that its market capitalization of around $625 million represents a 1,000% premium to the (already stretched) net asset value of the fund’s holdings!
• AI startup Anthropic is raising $2 billion in a deal that would value the entire company at $60 billion, more than triple its valuation from a year ago and making it the fifth-most valuable U.S. startup. According to the Wall Street Journal, the startup’s annualized revenue – an extrapolation of the next 12-month revenue based on recent sales – recently hit $875 million. The private markets are valuing a company founded in 2021 at 68.5 times hypothetical sales!
A Portfolio with Enduring Value
It is exceedingly rare that at the same time the broad market is at extremely high valuations due to a small number of very large leaders, we are finding such great investment bargains. In contrast with the examples listed above, we believe FRM owns a portfolio of companies that are creating enduring value with the businesses they operate, the assets they own, and the cash flow and earnings they produce. In most cases these companies are returning a good portion of that cash flow and earnings to shareholders via dividends and buybacks. The combination of those two returns is known as total shareholder yield. The S&P 500 had a total shareholder yield for 2024 of approximately 3.2% (a dividend yield of 1.3% and buyback yield of 1.9%).
The oil and gas companies in our portfolios have a total shareholder yield of 7.9%, one of the highest of the industries in our portfolio. The shares of these companies traded off sharply in December and were down a little under 9% for the month. This was surprising to us in a month where WTI oil prices were actually up 5.5% and NYMEX natural gas prices were up 8%. The oil and gas companies in our portfolios remain attractively priced on average at 12.2 times expected earnings for 2024 and 12.3 times expected free cash flow and 1.5 times sales for the same period. Investors continue to sell shares of energy companies, in spite of what we view as a very attractive setup for the future of the industry. Worldwide oil demand is expected to continue to grow from 2024’s record demand of 102.8 million barrels per day (b/d). The U.S. Energy Information projects demand growth of 1.2 million b/d (see chart). One interesting point to note is that India has emerged as the leading source of growth in global oil consumption in 2024 and 2025, overtaking China. China’s oil consumption grew by more than India’s in almost every year from 1998 through 2023, with China’s oil consumption regularly having grown more than any other country during those years. Over 2024 and 2025, India accounts for 25% of the total oil consumption growth globally. While oil demand has reached record levels, global oil inventories are now at the lowest levels they have been in a decade (see chart). Record demand and low inventories will put the pressure on the supply side of the equation. The world has relied on the growth of U.S. shale oil over the last decade to meet rising demand, but shale oil reserves are not unlimited. We have seen knowledgeable analysts put forth compelling studies indicating growth in U.S. shale oil basins will be harder to achieve going forward (see chart). Aside from the many geopolitical risks to supply, lower than expected shale production could push oil prices much higher.
Another part of our portfolio with an even higher total shareholder yield than the oil and gas sector is our shares of agricultural companies with a total shareholder yield of 8.26%. The agricultural cycle has been at a low point, and our companies have been earning at a lower level than their cyclical average earnings (clients can read about our newest portfolio addition to this industry in the portfolio activity section). Even at the lower earnings level these companies are attractively priced on average at 14.7 times expected earnings for 2024 and 15.6 times expected free cash flow and 0.75 times sales for the same period. The shares of these companies also sold off sharply in December, down a little over 7% for the month. While we do not know when the agricultural economy will enter a strong part of the cycle, we believe that the long-term underlying growth drivers are intact. The global population will continue to grow and the amount of arable land per capita will shrink. The need to use arable land efficiently and productively will only increase, and each of the agricultural companies you own contributes to that goal. With global grain stocks expected to end this year at decade lows and the global stocks to use ratio also at lows, we think the cycle could turn sooner than the market expects (see chart).
Dollar General (NYSE: DG) is a company that we added to our portfolios in the third quarter of 2024. The company has a total shareholder yield of 3.3%. DG is truly a “growth” company having grown their same-store sales (SSS) in 33 of the last 34 years (2021 exiting the pandemic boost being the one exception.) We believe that owning this company is a chance to buy a growing business for a very reasonable price, one where even very conservative assumptions could lead to a very positive total return in the stock. We thought a more detailed investigation of the return potential for this purchase would be helpful in understanding how it is possible to earn attractive returns from an out-of-favor stock even if fundamentals don’t fully revert to their historical averages.
The table nearby shows the five and ten-year average annual growth rate for DG’s overall sales and same-store sales (SSS), calculated as of the third quarter of fiscal 2024 and calculated as of the quarter ended January 31, 2020 (pre-pandemic). Before we go further, we need to define SSS for those who are not familiar with the term. SSS are the sum of all sales generated by those stores that have been operating for the previous 13 months. We analyze SSS growth to gain insight into how much of a retailer’s overall revenue growth is derived from opening new stores versus how much existing stores contribute to sales growth. So, the difference between total sales growth and SSS growth can be thought of as the growth contributed by new stores, those in operation for less than 13 months.
If we make some conservative assumptions about DG’s future sales and margins, you can see how the stock could generate significant returns even if its fundamentals do not return to their historical averages. If we assume growth from new stores (difference) will be half of DG’s 10-year historical average (5.01%/2 = 2.51%) and add to it the lowest SSS figure (0.93%), we get a total sales growth rate assumption of 3.44%. Applying this growth rate to expected sales for 2024 for three years would result in fiscal 2027 sales of approximately $44.9 billion. If we apply a conservative operating margin estimate (5%) relative to DG’s historical operating margins of 8% to 9% (see table) and a statutory tax rate of 25%, we get an earnings per share estimate of $7.42 for fiscal 2027. If we apply a price-to-earnings multiple of 15 times, which is a discount compared to DG’s historical average multiple (see table), we get a future share price of $111.24. If we add three years of dividends (3x$2.36=$7.08), we get a potential future value of $118.32 which represents a total return of 48% over three years or approximately 14% annually on our average purchase price of about $80 per share. We hope this demonstrates one of the ways in which value investors see opportunity in situations where the market has put a company in Wall Street’s version of timeout.
Interest Rate Update
The U.S. 20-year Treasury yield topped 5% on January 8, 2025 (see chart). This is the first time it has traded at that level since 2023. The 10-year yield and 30-year yield are also trading at higher levels. While the yield on 10-year notes hit as much as 5% in late 2023, the auction result in January was the highest for newly auctioned securities since August 2007. Long-term bond interest rates have risen since the Federal Reserve started cutting rates in September. The yield curve has shifted to a more normal shape as investors start to appreciate the strength of the U.S. economy and the sticky nature of the current inflation. While we do not have a crystal ball on the economy or inflation, we continue to believe that interest rates will remain at higher levels than during the 2010s and that should benefit our bond and equity portfolios through higher current income and more disciplined financial markets.
2024 Milestones
As discussed earlier, FRM’s relative performance in equities did not follow the speculative market trend that began in 2023 and continued throughout the past year. However, our conservative positioning in fixed income was rewarded by a return to a normal yield curve (long maturities yielding higher than shorter maturities) in the second half of the year. If that trend continues and inflation remains difficult to subdue, which we expect, we believe that stocks with low fundamental valuations such as those in our portfolio will be looked at in a different light. In the meantime, our equity portfolios are producing double the market’s dividend yields.
The FRM family took a hard blow in April when our friend, Debbie Hill, widow of our former colleague, Tom Hill, suffered a massive stroke. Debbie fought with all her might, but her body finally succumbed late in September. It has been a tremendously difficult four years for the Hill Family. That said, the next Hill generation did end the year with two tremendous blessings. On November 3, Mary Claire Hill Imbro and husband Daniel received Luke Thomas Imbro into their lives at seven pounds and seven ounces and measuring 20.5 inches. Shortly thereafter on November 14, Rosemary Leigh Bingham was born to Elizabeth Hill Bingham and her husband, Andy. Rosemary was only slightly smaller than her cousin, weighing seven pounds and two ounces and 19.5 inches long. The new parents and babies are all doing well. No doubt Tom and Debbie are bursting with pride from above.
Speaking of newborns, we hinted in our September commentary that our most recent staff addition, George Sellers, and wife, Savannah, were proudly sporting their first family addition. William Graham Sellers was born August 26. William weighed eight pounds and twelve ounces and measured 19.5 inches. If you look at our Christmas card picture, you can see why we were expecting a longer little boy. It appears, at least for now, that Savannah’s height genes ruled. Nevertheless, George gets a huge grin any time he is asked about William.
Abby McKelvy and Stephanie Hills both had sons graduate from Catholic High School here in Little Rock. Abby and Damon’s son, Fletcher, headed off to the University of Arkansas and enrolled in the business school. Stephanie’s son, Trey Parham, chose Arkansas State and is also studying business.
In mid-December, we announced to our clients that FRM’s ownership transition plan that we disclosed in 2018 was scheduled to be completed on February 1, 2025. Greg and Mark have an employment agreement and will continue to work and serve clients, and they are glad to let the younger folks share the administration of the business side. Meredith Moll will lead the firm as Managing Principal and majority owner. Zach Riley will also serve as Principal and owner. We are very proud of the integrity, work ethic and commitment to our clients that has made both of these team members deserving of this new status. It is with great pleasure that we reflect on the capability of all of our next generation owners, including Abby McKelvy, Chris Fleischmann, and John Garmon who will continue to be shareholders as well.
Thank you for letting us serve you. We know our clients are the only reason that FRM has been able to exist for 32 years, and as we move forward, you can rest assured that we will continue to strive for improvement in all aspects of our work. We wish you and your families a healthy, safe, and prosperous 2025. Thank you again, and may God continue to bless you.
Disclosure
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. “FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at amckelvy@frmlr.com.
Comments