Q1 2024 MARKET COMMENTARY
While we always feel like Q1 of any year moves quickly, this first quarter really seemed to fly by. Moving into 2024, we expected that some of the trends that persisted in 2023 would continue into the New Year – Technology stocks outperforming, Interest Rates remaining elevated, the US Market in general continuing to outperform foreign markets. However, we also thought we could see some important themes change – Commercial Real Estate showing signs of a bottom (Outside of Office), Reflation starting to show up in Maco Data affecting Commodity Pricing and Capital Raising/Investment activity beginning to pick-up in private markets. While the Yield Curve is still severely inverted there doesn’t seem to be any imminent threat of a recession given the level of liquidity in the economy and the elevated spending from the US Govt.
We’ll lead off with Public Equities as it’s the most talked about area of investing and relevant to just about every investor. The S&P 500 had a terrific first quarter moving up 10.6%, after being up 26% in 2023. The Nasdaq with its tech champions was up a respectable 9.6% in Q1, and the Russell 2000 which holds what could be many of the great young companies of the future was up only +5.2%. Communications was the top performing sector up 15.8% while REITs was the worst performer at -0.5%.[1]
Our philosophy around owning Public Equities has encompassed the following 1) Focus on owning the best companies – the strategy of indexing, where you effectively own all companies (Great, average & poor) has never made a lot of sense to us 2) Look to invest in what people and companies really need, where’s there’s less competition for profits, and watch for that company’s ability to exercise pricing power 3) Look for businesses that are durable that can survive hard times – stock prices go up and down, but a durable business won’t go bankrupt and will increase in value over each economic cycle 4) Where we feel we have competency, own the individual companies, where we don’t utilize a passive basket like a sector ETF or active management through a mutual fund. Timing is always a fickle thing as I attempted to hand off more of the portfolio duties in 2022, it ultimately amounted to several wrong moves/adjustments in our equity allocations at the wrong time. Unfortunately, we had to part ways with that individual and we’ve been focused on rebuilding our strategy in 2023 and now into 2024. While we are not back at the levels where we’d like to be for our clients, I’m beginning to see evidence that new investments made during 2023 and thus far in 2024 are starting to bear fruit. Public REITs, Healthcare and Utilities were largely shunned by investors in 2023 but are showing signs of bottoming here as we exit Q1 of 2024. Gold Miners, also on the back of Gold suddenly breaking out to new all-time highs in recent weeks, has begun to climb off the bottom of recent lows. Finally, Uranium is an area that we’ve tracked for the last 2 years and feel like a trend has emerged that we’re confident will persist. With the increased demands for power due to Electric Vehicles and Data Centers to power AI, utility companies have come to understand that wind/solar will not be able to provide the baseload energy needs required. At the same time, to mee the different carbon targets that have been laid out, increasing use of natural gas plants will not assist in achieving those targets – leaving nuclear as the only viable option. We view all 5 of these sectors as potentially low-risk high reward areas of the market that should be bought now ahead of the “Crowd”.
Private Equity was a new addition to the investment line-up for clients starting in 2021. We made some initial investment in the space which we then put on hold in 2022 to better understand how this investment might perform in a negative Public Equity backdrop. Much to our surprise our Private Equity Allocations were positive in 2022 and have been positive in 2023 and Q1 of 2024. As any investor knows, when you can avoid drawdowns on an investment, you’re generally ahead of another investment that must spend time recovering from a drawdown. While Private Equity may not be appropriate for every one of our clients, it’s something that should be part of the conversation as we move forward – for multiple reasons. First off, while there are thousands of companies that trade on public exchanges globally, they only represent 1% of the businesses out there – 99% are still private and not eligible for an investor to access. Secondly, there are several different ways to invest in Private Equity – traditionally that’s been done via a partnership using a capital call/drawdown structure. When investing in Private Equity this way, you’re effectively handing the manager a commitment to fund their purchases of companies, but you have no clue as to what they’ll actually buy and how those companies will perform – often times you don’t really know what you have until you’re 5, 6 or 7 years into the investment period, with no ability to sell your holdings easily if you don’t like the results. We’ve opted to invest in Private Equity primarily through a strategy called “Secondaries”. A Secondary investment effectively comes together when an LP who’s been invested in a fund wants to exit that fund, however the GP won’t be returning their capital in the near future. If the LP wants to exit the fund, they’ll need to sell their shares (Often at a negotiated discount) to another party who must be approved by the GP to take over their position in the fund. Besides being able to purchase an investment at a discount to the current value, the buyer also has the ability to do due diligence on the investments that are already baked in the fund, which in our opinion lowers the risk for the investor. The exiting LP gets their capital back and the purchaser gets to buy high quality assets at a discount with a high degree of transparency. With the slowdown in Private Equity transactions in 2022 and 2023, this has been a hot area that continues to gather capital here in 2024.
Private Real Estate, which had been so good to our investors from 2019 through the front half of 2022 finally fell upon some tougher times over the last 18 months. The Federal Reserve’s increase of the Fed Funds Rate let to interest rates ratcheting up across the economic landscape – increasing the cost to finance real estate purchases and ultimately raising cap rates (Lowering valuations) on existing commercial real estate assets. While we saw a drawdown in NAV during this period, our investors continued to collect a healthy level of tax efficient monthly income. Given the much smaller drawdown in Private REIT values vs. their publicly traded peers, for many clients we opted to turn off their monthly auto-reinvestment and instead took the cash to reinvest into the Public REIT Market. Our strategy was to look for investments in the Public Market that would be complimentary to our Private Market holdings but also would provide substantially higher returns if they in fact recover as we expect they’ll do. One of these investments is the world’s leading Cell Phone Tower company who in 2021 also went out and purchased a Publicly Traded Data Center REIT. We think this combination of Cell Phone Towers and Data Centers could prove to be valuable as interest in Data Centers have sky-rocketed in 2023 with a surge in investment around the potential for AI (Artificial Intelligence). At current our investment is the only company we know of combining Cell Towers and Data Centers on the same platform – creating a play on Tech Infrastructure that we think could create a lot of value long term. The second investment was a high risk, niche investment into Industrial Real Estate but one we think again could have outstanding total return potential (Combination of the elevated yield and future capital appreciation). This particular investment is the only publicly traded real estate company focused on serving the cannabis industry. Cannabis has been an area of incredible excitement and investment over the last 6-7 years as states have begun to legalize its use. However, as in any new industry it still has a number of challenges which include the following 1) Lack of Federal legalization and therefore limited access to the banking system 2) Cannabis is labeled as a Schedule 1 drug by the DEA which prohibits the companies that sell it to take advantage of normal business tax deductions (280E) which results in Federal Tax Rates well in excess of those of a typical business 3) Despite state legalization, illicit trade is still flourishing and under-cutting legally registered vendors who complying with registration fees, taxation, etc. 4) Too much capital was invested in the area and therefore created too much supply and competition amongst legal players, causing a number to file for bankruptcy over the last two years. With all these headwinds, why would anyone think about touching any investment in this space? Because many have come to that conclusion, they have absolutely hammered the stock prices of any companies directly involved in or providing services to the cannabis industry… but therein lies the potential opportunity. This REIT has sold off 75% over the last 2 years, despite continuing to grow its cash flow and increase its dividend. Its tenants have come under stress, some of which have defaulted on leases – but the REIT has been able to either re-work the leases or replace the tenants with new stronger companies. Although the culling of the cannabis industry has been painful, the strongest operators will survive and despite the competition with illicit sales it’s still growing nicely overall. The final two items that could be game-changers in 2024 1) HHS (Human Health Services) and FDA have recommended to the DEA that they re-schedule cannabis from Schedule 1 to Schedule 3, something they are currently reviewing – if they agree, this would remove the restrictions of 280E on these companies and greatly improve the cash flow health of these cannabis cultivators 2) The SAFE Act is currently winding its way through Congress, which if approved would allow cannabis companies to utilize the US Banking System more similarly to other businesses that operate in our economy, allowing them access to more normal forms of financing to grow and sustain their businesses. In conclusion, we made some very opportunistic investments in the Public REIT space in 2023, that we continue to add to here in 2024. We believe these investments have a lot of upside from current levels on a total return basis. We also believe Private Real Estate has a strong chance to start recovering here in 2024 and return to the more typical positive total returns that we experienced from 2019-2022.
With the recent increase in inflation measurements in the US economy in March and April, we’ve experienced an uptick in 2–30-year rates along the interest rate curve. This has caused a general sell-off in the bond market, affecting bonds with longer maturities/duration to the greatest extent. In our opinion we continue to err on the side of keeping a higher than normal (For us at least) exposure overall to high grade debt in the Public Markets while opting to expose our investors to credit risk through the Private Debt space. Should a credit event emerge in 2024 due to economic weakness or a Geo-Political Event (Pick one!), we would expect our high-grade allocations in the Public Markets to rally or increase in value while our Private Credit investments would be marked down (But we believe to a much lesser extent than what could be experienced in Public Market Credit Investments). While it’s not our base case that we’ll have a credit event during 2024 – the reality is that we’ve seen a massive increase in interest rates globally over the last 18 months after more than a decade of incredibly and even negative interest rates in parts of the world. We believe there’s the potential for more stress to show up on the liability side of the ledger over the next three years. For some of our largest clients that agree with that possibility, we’ve opted to allocate capital to distressed debt which will be available for investment from 2024-2026. Distressed Debt, when executed properly, can be a very interesting asset class. The manager we’ve opted to go with has generated positive returns across its entire history of funds offered with rates of returns ranging from the high single digits to in excess of 40% per annum. Unfortunately, due to its complexity and lack of liquidity, it’s only available to Qualified Purchasers (Individuals/families with 5 mil or more in liquid investments).
2024, in general has gotten off to a strong start, but we will not be surprised to see sell-offs/consolidation of gains at some points or multiple points during the year. If/when they emerge, we’ll continue to view them as buying opportunities for our client’s portfolios. In the first two weeks of Q4 we have noticed a rise in bond yields that has caused selling in the public bond and equity markets. We have started to deploy capital into these lower prices, and we hope it continues in the coming weeks of the new quarter to allow us to place capital for our clients at better entry levels. With the ballooning debt of the US Govt., we are communicating to clients our concern around the necessity to build a portfolio that will be resistant to the threat of higher inflation as we move forward. An equity portfolio must be built with companies with strong pricing power. All portfolios must own “Real” assets with Real Estate as or preferred allocation with some support from commodities. And for the time being we are keeping a balance of fixed and floating rate debt, but in the longer term, we may need to move solely into floating rate debt for our clients who seek income and capital preservation. We are always cognizant that tomorrow’s forest relies on the seeds that we plant today.
[1] Nasdaq.com/articles
PO BOX 231030, Encinitas, CA 92023 | 760-602-6920 | [email protected]
This material should not be considered a recommendation to buy or sell securities or a guarantee of future results. Koa Wealth Management, LLC is a registered investment adviser. Registration does not imply a certain level of skill or training. More information about Koa Wealth Management, LLC can be found in our Form ADV Part 2, which is available upon request or by visiting our website at www.koawealth.com/disclosure. Past performance is not a guarantee 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.
Sources:
[1] Nasdaq.com/articles
