Q4 2023 Market Outlook and Investor Letter

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2023 wrapped up with a strong rally in the market, leading to the S&P 500 returning 26% on the year including dividends. However, look past the strong headline numbers and there is plenty to be concerned about. To start, the majority of the gains in the S&P were concentrated in just seven large-cap, technology stocks (dubbed the magnificent seven by market commentators). The seven largest companies in the S&P 500 now account for nearly 30% of the total weighting, which is a historical high.

In contrast, the equal-weighted S&P 500 index (which assigns equal weighting to all 500 stocks) is up a more modest 11% this year. Strip out the tech giants and the rest of the market is barely up double digits. The S&P 500 is increasingly a concentrated bet on technology stocks, which can cut both ways.

If we look at the drivers of returns, the earnings for the S&P 500 are expected to grow just 1% in 2023. This means that the vast majority of the 26% return this year was driven by multiple expansion. In other words, stocks went up mainly because they got more expensive.

Another way to look at how concentrated the market has gotten in tech stocks is to look at the ratio of NASDAQ (primarily large cap technology stocks) to the Russell 2000 index (small cap stocks). The ratio of the NADSAQ to the Russell 2000 index was recently at levels that rival the highs last seen during the peak of the .com bubble.

As market commentators and stock market traders get increasingly bullish on the hope of Fed cutting rates and the economy having a soft landing, we need to be more vigilant. The more optimistic investors become, the more painful any disappointment becomes. As long-term investors, we should stay focused on valuations and long-term expected returns. The current Schiller PE ratio of 32 has historically been consistent with low to mid-single digit returns for the S&P over the next 10 years.

I also want to highlight another indicator which has historically correlated even better with subsequent 10-year S&P returns than the Schiller PE ratio. This is the stock allocation as percentage of financial assets. It is calculated by dividing the market cap of all US stocks by the sum of the value of the stocks, debt, and cash. Historically, the stock allocation has ranged from 20% to about 50%, with the higher the allocation the worse the subsequent 10-year returns and vice versa.

The following chart uses historical data from 1946 to 2023 to graph the relationship between stock allocation and subsequent 10-year S&P 500 returns. Each point in the graph below represents one year between 1946 to 2014 (the last year with completed 10-year returns). As you can see, there is a pretty clear inverse relationship between stock allocation and subsequent returns. As of the end of 2023, I estimate the stock allocation level to be around 49%, which is consistent with expected returns of -1% to 5% for the S&P 500 over the next 10 years (range indicated by red oval). That’s not attractive considering one can earn more than 5% risk free just by investing in Treasury bills.  

I am not the only one who feels this way. Investment firm GMO (which manages $60 billion) recently updated their 7-year real return forecasts for various assets classes. They expect large-cap US stocks to lose 2.6% per year after inflation, which translates into near zero nominal returns.

So what is an investor to do given the relatively low expected returns for the S&P 500? I have positioned our portfolio to deal with this tough environment in two ways. First, despite the high valuations in US tech stocks, there are still some quality stocks which remain attractively priced and at the low end of their historical valuations. I believe these stocks have a decent chance of outperforming the market over the next few years and have made these the core holdings of our portfolio. Please see section below titled “The Magnificent Seven” for a comparison of the largest positions in the S&P 500 and the largest positions in our portfolio.

Second, I continue to maintain a significant allocation to treasury bills (about 33% as of the end of 2023). Although Treasury bills were a drag on overall returns in 2023, I believe a risk free return of 5%+ is relatively attractive given the low expected future returns for the S&P. It is not a bad place to park cash until better investment opportunities present themselves.

When it comes to investing, it is a good idea to ask what would Warren Buffett do? Better yet, we can actually see what Warren is doing. Berkshire Hathaway was a net seller of $24 billion of public equities during the first nine months of 2023. During this period, Berkshire used the proceeds and additional cash to purchase $27 billion of primarily Treasury bills. If Warren Buffett is allocating capital away from stocks and towards Treasury bills, that’s something worth noting.

The Magnificent Seven

Since the magnificent seven drove the lion’s share of returns for the S&P 500 this year, it makes sense to take a quick survey of each one of them to see if odds favor continued strong performance. We’ll start with the largest and move to the smallest.

Apple (AAPL)

Apple needs no introduction given its dominant position in iPhones, iPads, macs, and various accessories. With consumers locked into its iOS ecosystem, Apple’s dominance seems unshakable. I certainly see myself buying iPhones, wearing Apple watches, and listening to Apple EarPods for the foreseeable future.

The problem with Apple isn’t dominance, but growth. Trying to get Apple to grow faster is like trying to turn a massive, slow-moving aircraft carrier.  Unless something is a huge hit, it doesn’t move the needle for Apple. For fiscal year 2023, Apple’s earnings were flat vs 2022. Wall Street expects EPS growth to rebound to 7% in 2024.  

Single digit growth is okay for a mature company that is trading for a mid-teens P/E multiple. However, Apple was recently trading for 30x 2024 earnings. 30x P/E is similar to levels Apple was trading for in early 2008 when the iPhone first launched. That level of P/E is appropriate for a small, fast-growing company, not a lumbering giant struggling to grow double digits. There could be a lot of pain ahead for Apple stock if the P/E ever rerates lower to the mid-teens. Let’s not forget that Apple spent the entire decade of the 2010s trading for a low-teens P/E.

Microsoft (MSFT)

Microsoft is a wonderful business with a dominant position in business productivity software. It also owns LinkedIn and is a leader in gaming. However, Microsoft’s biggest growth potential comes from its Azure cloud business and artificial intelligence (it is an investor in OpenAI). See Nvidia section below for a longer discussion of AI.

MSFT grew earnings 6% in fiscal 2023, but earnings growth is expected to accelerate to 14% in fiscal 2024. MSFT has good growth prospects, but at 33x P/E it is trading at the high end of its historical range and must deliver strong growth or risk disappointing investors.  

Microsoft’s own history serves as a good example of the dangers of paying too much for a great company. People tend to forget that after peaking in 2000 during the .com bubble, MSFT did not get back to those levels until 15 years later!

Alphabet (GOOGL)

There are few things more integrated into people’s daily lives than Google and YouTube. In addition to being the king of advertising, Google also has a fast-growing cloud business and is a leader in AI.

After seeing earnings decline in 2022, Alphabet bounced back with a strong 26% earnings growth in 2023. EPS is expected to see continued strong growth of 16% in 2024.

At 20x P/E, Google is one of the more reasonably valued members of the magnificent seven. It does face some risk of disruption from the fast-changing AI landscape and the popularity of TikTok among younger generations.

Amazon (AMZN)

Amazon is the undisputed king of ecommerce. At 45x, Amazon sports a high P/E ratio, but it is also expected to see 30% EPS growth in 2024. While no one poses a real threat to Amazon near term, the rise of Temu, Shien, and TikTok shop could start to have an impact on lower-value products over time.

Despite being best known for ecommerce, Amazon makes almost all of its profits from AWS cloud services. Any deceleration in growth or margins there would be a serious concern.

Nvidia (NVDA)

Nvidia is by far the sexiest stock in the market this year. It dominates the market for artificial intelligence chips. Its revenue and profits have exploded this year as AI firms rush to buy Nvidia chips to power their large language models. Its chips are so strategic that the US even outlawed sales to China to slow the development of AI technology in China.

I have no doubt that AI will have a profound impact on how things are done over the coming decades. However, I think there is also a meaningful risk that investors may be too optimistic about the near-term growth of AI. If you study financial history, revolutionary technologies have repeatedly led to manias where investors have gotten too carried away.

This was the case with stock prices when automobiles and radios first entered the market.

And the same for the advent of big computing and the internet.

Perhaps NVDA will avoid a similar fate, but the odds are not in its favor as its stock is largely priced for perfection (65x trailing PE). It must see a continued explosion in AI demand. It must not lose share or margins to AMD or others trying to develop AI chips. It must withstand the loss of the China market. In short, everything must continue to go perfectly for it to do well. Anything short will simply not do.

Meta Platforms (META)

Meta is the king of social media. Facebook and Instagram print money in advertising. At 21x P/E ratio and with 21% expected earnings growth in 2024, valuation is relatively reasonable compared to other members of the magnificent seven.

However, Meta’s problem is that Facebook has completely lost Gen Z to TikTok and SnapChat. While near term user trends remain stable, the lack of relevance for the younger generation is problematic for where the business goes long term. It is worth noting that Zuckerberg sold half a billion of stock in Q4.

Tesla (TSLA)

Telsa is the leader in electric vehicles and autonomous driving. It is richly valued at 72x forward P/E.

Look beneath the surface and there are plenty of things to be worried about. Tesla ran into a demand issue in 2023 and had to cut prices multiple times to reach its 1.8 million vehicle delivery goal. The price cuts demolished automotive gross margin, which contracted from 30% in early 2022 to just 16% by Q3 2023. Outside the US market, TSLA has been losing share, particularly to lower priced Chinese competitors such as BYD, which recently surpassed TSLA as the largest EV manufacturer by units.  Earnings per share has declined from $4 in 2022 to a bit over $3 in 2023. One Tesla analyst with a good track record expects unit deliveries to further decelerate from 37% growth in 2023 to just 17% in 2024.

Tesla’s ambitions for autonomous driving have been repeatedly delayed by safety setbacks. Truly autonomous driving (requiring no human monitoring) is likely still many years away.

The common theme among the magnificent seven stocks is that while they are all market leaders in their respective fields, most are trading near the high end of their historical valuation and priced for perfection. Having already doubled in 2023, the risk-reward at current levels seems unappealing to me. Any whiff of business weakness or slowing growth could lead to a painful correction.

Our Key Positions

In contrast, you’ll find that our core holdings are typically trading at or below their historical average valuations. While the S&P 500 may struggle to compound much faster than mid-single digits over the next decade, I think there is a reasonable chance our positions will do better.

Berkshire Hathaway (BRKB)

Berkshire is a collection of the finest and most durable operating businesses. While insurance, railroads, and wind-generation powerplants may not be the most exciting businesses, they have durable competitive moats that are likely to remain for generations.

As a financial holding company, Berkshire has historically been valued relative to its book value. Accounting for the recent rally in its stock portfolio, I estimate that Berkshire is currently trading for 1.37x book value, towards the lower end of its historical range. If we consider that the book value of Berkshire’s growing operating businesses understates their economic value, Berkshire is even cheaper than it appears.

Buffet has continuously repurchased Berkshire’s stock over the past few years, something he has said he would only do if the stock was trading meaningfully below its intrinsic value. I believe Berkshire has a good chance of compounding at 10% over the coming decade.

Prosus (PROSY)

Our position in Prosus is really a way to own Chinese tech giant Tencent in a cheaper way. ~76% of the value of Prosus is in its Tencent holdings with the rest being a collection of public and private tech companies. Prosus still trades at a sizable 36% discount to the value of its holdings, though this discount has narrowed from nearly 50% when we first purchased it. I expect this discount to continue to narrow over time as Prosus has an ongoing asset sale / share repurchase program to reduce the discount.

Tencent itself is trading at the lowest valuation in its history. If we exclude the cash and investments, I estimate Tencent is trading at a low teens P/E.

This is at a huge disconnect with trends in the business. Earnings should finish 2023 up 35% and I expect mid-teens growth going forward. Tencent’s WeChat video accounts (their version of TikTok videos) have gained rapid adoption among China’s 1.3 billion WeChat users. There is significant untapped revenue potential from advertising and ecommerce in this short video offering.

Tencent’s gaming business has also gained traction. Tencent’s recent launch of Dream Star mobile party game is the #1 downloaded app in the Apple app store in China and top 10 in grossing ranking. Its western games have also found new life. Google search trends for League of Legends are up 30% year over year. Fortnite’s recent Lego mode has been a smash hit and Twitch streams of Fortnite are near all time highs.

As for the rest of Prosus’s holdings, there has been tremendous progress made in reducing losses. Prosus recently took up its timeline of reaching breakeven for these businesses, which should happen sometime in 2024.

Just as US tech stocks are all the rage, Chinese tech stocks are deeply out of favor. The Hong Kong stock index (Hang Seng) has been in a bear market for three years. However, valuations will eventually reach a bottom and if earnings are able to grow mid-teens, the stocks will eventually do the same. Should valuations expand again, we could see strong double-digit returns from Tencent / Prosus.

Markel (MKL)

Markel is in many ways a smaller Berkshire Hathaway in that it has an insurance business, an investment portfolio, and owns a collection of operating businesses. Between these three engines of growth, I think there is a high likelihood that Markel can compound its book value per share in the low teens per year. Assuming a stable or expanding price to book ratio, this implies Markel’s stock should compound at low teens or better over time.

For 2023, I estimate that Markel grew book value per share by 21%. However, the stock price only increased 8% year over year. As of the end of 2023, I estimate that Markel trades for just 1.26x book value, near the low end of its historical range. (Please note that the chart below has Markel closer to 1.4x book because it uses book value as of 9/30/23 where I use book value as of 12/31/23 and adjust for changes in Markel’s equity and bond portfolio in the fourth quarter).

Digging under the surface, I find that Markel is even cheaper than it appears. This is because book value has become understated over time. First, Markel’s holdings of operating businesses have increased over time which are not marked to market and book value understates market value. Second, Markel’s bond portfolio is carefully selected to match the duration of their expected insurance payout liabilities. When interest rates go up, both the value of Markel’s bond portfolio and the present value of Markel’s insurance liabilities go down by a similar amount. However, account rules dictate that Markel must mark down their bond portfolio to market value while keeping liabilities at face value. This creates an artificial hit to Markel’s book value when interest rates go up (as happened in the past two years) because it does not recognize that present value of the matched liabilities are also decreasing. Finally, Markel has been consistently repurchasing its own shares which also reduce book value.

If you really want to know what smart money is doing in Markel, follow the insider transactions of Tom Gayner, Markel’s CEO and chief investment officer. Despite already owning $70 million worth of Markel Stock, Gayner has been purchasing Markel stock in the open market. Gayner has purchased an average of $140,000 of Markel Stock in each of the past two quarters. That’s roughly equivalent to his entire after-tax salary during the past two quarters.

Alibaba (BABA)

Alibaba is a Chinese ecommerce giant that has fallen from grace. Although Alibaba faces increasing competitive pressures in both ecommerce and its cloud business, the company remains the largest ecommerce player and cloud platform in China. Its stock has been mired in a multi-year bear market and valuations have collapsed to a single digit P/E, the lowest in its history by far.

At this point, the market seems to be pricing in significant declines in its core business. Yet, reported results have been far better. Alibaba grew revenues 9% and adjusted EPS 21% in its most recent quarter. If Alibaba can just keep its earnings roughly flat, the stock should perform well.

This is because Alibaba has a free cash flow yield of nearly 12% on its market cap (10% even after excluding stock compensation). If profits and cash flows can remain stable, that double digit yield should accrue to the shareholder.

Another way to look at Alibaba is to calculate the amount of cash and investments on the balance sheet less debt. I estimate that net cash and investments will exceed $50 per share by early 2024. With the stock trading for $75, you are effectively getting the domestic ecommerce business, the cloud business, and all the international businesses for just $25.

Alibaba has been working on unlocking value with share repurchases and recently initiated a $1 dividend. The company is on track to repurchase 5% of the outstanding shares each year. Alibaba also seems to be exploring sales of noncore assets, as it recently sold a block of XPeng stock. These actions should free up additional cash that can be returned to shareholders. Ultimately, if a business throws off enough cash, eventually the market notices.  

Alphabet (GOOGL)

Google is the only member of the magnificent seven that I own, though at the right prices, I wouldn’t mind owning some Amazon and Microsoft. I already discussed Google earlier, so I won’t repeat myself here, but suffice to say I find Google’s solid earnings growth and lower valuation appealing.

In summary, if we survey the market, we find the S&P 500 trading at historically high valuations that are consistent with low single digit returns over the subsequent decade. If we further delve into the members of the magnificent seven, we find that most are priced for perfection with demanding valuations. Quite a few have lower expected growth rates in 2024 that don’t seem congruent with their lofty valuations. In contrast, our core holdings are mostly trading below their historical multiples despite growing EPS or book value per share at a double-digit rate. If their growth can be sustained, their stocks should also compound at double digit rates over time. That should give us a reasonable chance to outperform the market over the next 5 years.


I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I hold a material investment in some of the positions discussed.

The information in the article is provided for informational purposes only. It should not be construed as investment advice or advice on buying, selling, or other types of transactions relating to an investment in products or services, much less an invitation, an offer or a solicitation to invest.

The information in the article is provided solely by virtue of the fact that everyone will independently make their own investment decisions: the report does not take into account investment objectives, nor specific needs or financial situation. In addition, nothing in the article represents or is intended to express investment, financial, legal, accounting or tax advice. You should consult your own investment or financial advisor before taking any actions.

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