|  | Inflation Protection Model Portfolio |
| Monthly Portfolio Review: July 2024Publication date: August 5, 2024 |
| | | Current portfolio holdings |
|  | | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
| | | The Inflation Protection portfolio marginally outperformed the S&P 500 Index in July with a total return of 1.3%. Upside was driven by precious metal royalty positions, as the gold price continued to show momentum, as well as beneficiaries of the rotation away from large-cap tech. Performance was negatively affected by Lamb Weston (LW), a position we previously cut to a 5% portfolio allocation. We are now eliminating LW from the portfolio and increasing our portfolio allocation to Permian Resources (PR) to 10%. As August begins, recession fears are affecting cyclical stocks. This has the potential to create compelling buying opportunities for businesses in cyclical industries that have attractive long-term structural characteristics. We continue our discussion of the potential impact of the Presidential election on energy-related stocks and provide more detail on specific portfolio positions.
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| | | In July, the Inflation Protection portfolio returned 1.3%, versus a total return of 1.2% for the S&P 500 Index. Within the portfolio, we saw a wide range of outcomes. Notably, there was a significant divergence in the performance of commodity-related names, as copper and energy were relatively weak, while gold provided upside.
As we highlighted last month, performance comparisons with broad market indices have become quite tricky recently given the now immense importance of a handful of mega-cap technology-related companies. With the Magnificent Seven representing over 30% of the market capitalization of the S&P 500, the index arguably provides a distorted picture of overall market performance when these stocks deviate from the rest of the market.
This is especially true when it comes to the Inflation Protection portfolio, which has substantially different exposure to industry sectors.
Whereas Mag 7 stocks drove returns in June, they were on average slightly negative performers in July, having retreated sharply from peaks reached earlier in the month. NVIDIA (NVDA) had a particularly volatile July. While only down approximately 5% in July, this is after shares of NVDA rose 13% on the last day of the month. Over the course of the month, shares of NVDA had a 23% peak to trough move to the downside before rallying on the final trading day.
Given the recent leadership and outperformance of Mag 7, AI/tech and large-cap growth stocks generally, many market observers have applied the catchphrase “great rotation” to describe the market movement that has taken place, especially in the final weeks of July.
Over the course of the month, value stocks and small-cap shares significantly outperformed tech, growth and large-caps. This reflected a sense that the valuation gap had become too wide, especially since the Nasdaq 100 ETF (QQQ) peaked on July 10. Small cap stocks, as represented by the iShares Russell 2000 ETF (IWM), ended the month up 10%, while value stocks, as represented by the Vanguard Value ETF (VTV), were up 5%. This compares with a -2% performance for QQQ. |
|  | The great rotation narrative was visible as well in the relative performance of the different sectors within the S&P 500. Out of 11 sectors, there were 9 sectors that outperformed the overall index, in some cases producing substantially positive returns. Only the tech sector generated a negative return in July. |
|  | While the month of July saw investors move capital from previously high performing large cap tech stocks to other areas, in the very first days of August, we witnessed a pronounced shift in market sentiment and focus. A much weaker than expected jobs report brought down growth stocks and cyclicals. In case you missed it, we commented on this on 8/2/2024 in a 76report Quicktake, which is available here.
The Inflation Protection portfolio has no direct exposure to the technology sector but has significant exposure to commodities, basic materials and industrials, which could come under pressure if the market begins to anticipate a recession scenario.
We have written at length about Freeport McMoRan (FCX) and our views on long-term structural demand for copper. Fears of a cyclical slowdown may create a window for investors looking to buy FCX, despite the potential for near-term volatility, to play the longer term structural opportunity.
Another cyclical holding is Permian Resources (PR), which we have also highlighted previously. As we will discuss in more detail below, we are raising our allocation to PR from 5% to 10%, in part based on recent weakness.
On July 29, PR acquired acreage from Occidental Petroleum (OXY) for approximately $800 million, in a deal financed with both debt and equity. The deal was well-received as the acquired assets fit directly within PR’s Delaware Basin portfolio and provide PR with unique operational synergies. Despite the favorable financial metrics on the deal, such as a 17% free cash flow yield, the equity placement has placed some short-term pressure on the shares.
We continue to view PR as an especially interesting oil and gas producer with a valuable resource base that is undervalued relative to larger peers. Management continues to grow the portfolio prudently with value-creating bolt-on acquisitions. At some point in the future, we would expect PR to be acquired at a premium by a larger player. |
| | | In July, the Inflation Protection portfolio benefited from double digit returns from four stocks within the portfolio: Wheaton Precious Metals (WPM), up 14%; Royal Gold (RGLD), up 11%; Vulcan Materials (VMC), up 10%; WESCO International (WCC), up 10%.
WPM and RGLD, as precious metal royalty plays, performed well as gold continues to hover near all-time highs. We expect gold to continue perform well if current recession fears persist, as interest rate cuts and easier monetary policy historically favor the gold price.
Consistent with our above comments on the “great rotation,” VMC and WCC benefited in July from the sentiment shift towards industrials.
Portfolio performance was hindered by one position in particular, Lamb Weston (LW), which declined 29%. While the Inflation Protection portfolio outperformed the S&P 500 despite the poor performance of LW, we estimate LW reduced overall portfolio performance by approximately 1.4%.
In our May 2024 Monthly Portfolio Review, we reduced LW from a 10% to a 5% portfolio position after it recovered substantially from a sharp decline in the wake of a botched enterprise software implementation. In retrospect, this would have been an ideal moment to exit the position entirely.
We are now fully exiting LW, which reported disappointing earnings and forward guidance in late July with its fourth quarter financial results. While the software transition and disruptions in its ability to meet customer needs contributed to the problematic earnings result, LW also flagged softness in restaurant traffic patterns, which ominously align with emerging concerns about slowing job growth and potential recession.
LW shares have reset to comparatively low multiples on now lower earnings expectations. An argument can be made that the shares offer deep value and have been overly penalized. However, we believe there are many genuine uncertainties at this point with respect to its long-term earnings power and expect the shares to remain in the penalty box with investors for some time until these are clarified.
From the standpoint of inflation protection, we initially selected LW in part for its potential as a hedge on food and agricultural commodity inflation. As the stock transitions into a deep value/turnaround play, we no longer have confidence that it can deliver for investors in this way.
We have decided to reallocate the capital to PR, which we are increasing from a 5% allocation to 10%. PR has also seen some share price weakness in recent sessions. While PR shares will continue to fluctuate with sentiment towards oil and gas stocks, as described above, we feel confident in the long-term value proposition. |
| Spotlight on energy
In a recent 76report, we reviewed our expectations for how the outcome of the U.S. Presidential election could impact the energy sector. The key takeaways are that a Trump administration would likely lead to lower fossil fuel prices, especially oil, but would also de-risk fossil fuel investments and likely generate more investment in the sector. A Harris administration could produce higher oil prices and enact policies that direct more capital into renewable energy. That analysis is available below. |
|  | Energy Markets and the Election |
| As a continuation of that discussion, we review in this context the holdings of the Inflation Protection portfolio that are either direct energy sector positions or closely linked to energy markets.
Permian Resources (PR) and Diamondback Energy (FANG)
As oil and gas producers operating in the Delaware Basin, PR and FANG are subject to similar economics. Higher oil and gas prices will improve their profitability. To the extent a Trump victory translates into somewhat lower oil prices, this could be a headwind. On balance, however, we believe investors will be more inclined to own these asset bases, which consist of long-term oil and gas reserves, if Trump is elected and policy shifts in the direction of traditional energy sources.
A Trump victory could also unleash the “animal spirits” within the fossil fuel sector and drive more aggressive M&A activity. This could benefit PR shareholders in particular.
Vulcan Materials (VMC)
As the leading supplier of construction aggregates in sunbelt states, VMC stands to benefit considerably from any accelerated investment or industrial activity that would be stimulated by Trump policies. And to the extent a possible Harris victory translates into higher oil prices, VMC tends to benefit from higher diesel prices.
As we have previously discussed, one of the most important business model characteristics of VMC is that higher trucking costs give the company greater local pricing power. We recall that VMC aggregates pricing advanced very sharply during the housing bubble time frame (2005-2008), when diesel prices soared, even as volumes declined. Historically, aggregates price hikes tend to stick and rarely reverse once implemented.
As the market leader in a relatively small industry with uniquely attractive pricing economics, we expect VMC to perform well regardless of who wins in November, although a Trump-driven uptick of investment in oil and gas states could be quite positive. |
| | |  | | |  | | |  | | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | Diamondback Energy (FANG) |
|  |  | | Floor & Decor Holdings (FND) |
|  |  | | |  |  | | |  |  | | WESCO International (WCC) |
|  |  | | Wheaton Precious Metals (WPM) |
|  |  | | The 76research Inflation Protection Model Portfolio emphasizes business models that are expected to perform well on a relative basis in periods of elevated inflation. Holdings are typically selected from industries based on supply constrained real assets, including commodity and energy businesses, or companies that otherwise demonstrate superior pricing power. Drawing from an investable universe of expected inflation beneficiaries, specific holdings are chosen based on valuation and general business quality, growth and risk considerations. |
| | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
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