Markets used an end-of-month sell-off to generate broad losses across all three major domestic indices. For October, the Dow Jones Industrial Average was the biggest loser, losing -1.34%. For the month, the S&P 500 and the Nasdaq Composite Index lost -0.99% and -0.52%, respectively. Our gold tracking position (Ticker: IAU) also saw noted weakness at the end of the month, but the precious metal generated more than 4.4% in gains in October. The 10-year U.S. Treasury consistently rose throughout the month, reaching 4.3% before ending at 4.28%. If the 10-year U.S. Treasury continues to rise at the same rate (an increase of 44 bps) as in October, we expect short-term pressure on long-duration, risk assets like stocks.
The Federal Reserve’s Beige Book presents a much softer picture of the U.S. economy than the hard data over the last few quarters. Two weeks ago, nearly all federal districts reported economic activity that saw little change compared to early September. A few days later, we saw a material decline in job openings through September. This decline and negative development starkly contrast with the broadly positive September jobs report that surprised the market. Employers continue to show little appetite to increase headcount as demand for labor continues to soften. While some projections of future near-term economic growth continue to project a degree of strength, we continue to see reports showing muted economic growth (1-2% GDP growth). As we have witnessed over the years, revisions to labor data have generally been consistently negative, and we feel the recent figures will get revised lower toward our sentiment. Finally, jobless claims increased to almost 1.9 million throughout the month—yet another sign confirming the lackluster interest in businesses hiring new workers. The decline in worker demand and a lower quits rate should help with wage and inflation pressures that have strained the business’ bottom line.
On several occasions this year, we have discussed our concerns about the financial market’s reaction to the new generation of artificial intelligence, also known as “AI 2.0”. Earlier this year, we were concerned about the unrealistic expectations that we thought the market was attributing to this next wave of artificial intelligence. The Magnificent Seven has continued to lag since its peak in July. The lofty valuations already given to these companies were and still are concerning, considering the lack of monetization or profit these AI 2.0 products generate. So far in the third quarter earnings season, the Magnificent Seven companies have shown that their earnings growth is slowing. This slowing is concerning as the technology sector trades at least a standard deviation above its five-year relative multiple in the S&P 500. Excluding technology, S&P 500 stocks are trading at 0.7 standard deviations below their average discount to the sector. Overall, while slowing, AI 2.0 companies continue to have above-average earnings growth compared to the rest of the S&P 500, and the historical relative valuations are even more extreme.
Overall, we expect markets and the economy to drag their way higher. We do not see a robust economy, nor do we forecast a melt-up in broad markets. We believe investors can find value if they are diligent in research and patient in execution. We continue to identify companies with strong near-term fundamentals that the market has jaded. As passive capital continues to take market share, we believe there will be more opportunities for those looking to take advantage of the inefficiencies that passive capital brings, such as our recent investment in Community Healthcare Trust (Ticker: CHCT), which was deleted from the S&P 600 Small Cap Index last month.
Please see the following updates on existing positions held at the firm:
Private Bancorp of America (Ticker: PBAM)—The La Jolla-based bank had a solid third quarter with record earnings per share and strong fundamental metrics. The third quarter return on average assets was 1.62%, and a return of average tangible common equity of 18.18%. Total deposits increased by more than 19% over the last twelve months, and notably, the cost of funds dropped from 2.78% to 2.71% quarter over quarter. PBAM’s tangible book value grew to $36.87 per share, up 22.1% from the year prior. We continue to like this bank, and while it trades at a materially higher share price than when we initiated our position, we still believe the bank’s stock is undervalued.
Farmers & Merchants Bancorp (Ticker: FMCB)-One of our most recent bank investments, Farmers & Merchants Bancorp, reported 3rd quarter figures a couple of weeks ago. The bank grew net income and earnings per share from the prior quarter while increasing capital buffers. The bank’s third quarter, at 15.03% return on average equity, continues a trend of generating solid mid-teen profitability metrics. The bank’s tangible common equity ratio is up to 10.91%, well above the industry average. The net interest margin grew to 4.04% as the average cost of total deposits remained flat, but it started to come down towards the end of the quarter. The percentage of checking account deposits (little or no interest) grew to 50.01% of total deposits.
Community Healthcare Trust (Ticker: CHCT)—The management team of our recent real estate investment announced a slight increase to the cash dividend by a quarter of a percent. The market reaction was very positive, with CHCT trading up by as much as +8% on the day (closed up +6%). Indeed, the minor cash dividend increase does not warrant that much of a positive move; however, the stock is greatly uncrowded, and the market has questioned the viability of the current structure. The slight cash dividend increase by company leadership served the market a notice that it is business as usual for the REIT. As a reminder, we had four executive/Board member open market purchases at prices above what we initiated our position at over the last 75 days. With a possible Russell 2000 inclusion next spring, we feel several variables are skewing in our favor to have a positive experience with this position.
Peoples Financial- (Ticker PFBX)- Our Biloxi, MS-based small regional/community bank announced third-quarter earnings last week. The operating earnings were average, and profitability retreated from strong levels the year prior. The significant development was the bank reversed the valuation allowance on state and federal deferred tax assets. This reversal, supplemented with retained earnings and a decrease in AOCI, increased the tangible book value by almost 30% during the quarter to $20.68. We believe investor Joseph Stilwell will continue his proxy challenge in the spring as he pushes a sale of the bank. In a sale of the bank, we believe the bank will generate a sale price of approximately 15-20% over book value.
We know the last month has been very challenging for many of you. Rest assured that your assets are in good hands. Please let us know how we can help!
Best regards,
Stash J. Graham