Navigating Shifting Tides: Portfolio Strategy for an Anticipated Interest Rate Decline in 2024
Re-Entering Growth, New Positions in US Real Estate, New Positions in Biotech and Global Value
October inflation came in softer than anticipated at 3.2% and has been a paradigm shift for the market. Growth stocks and the Russell 2000 rallied significantly more than the S&P 500. In my opinion, this happened for the right reasons, as the strongly lagged shelter inflation is still at 6.7% year over year, despite the fact that real time rents are actually falling year over year. As shelter accounts for some 35% of CPI, the actual inflation rate is most likely already significantly below 2%. Moreover, the oil price has been falling like a rock in recent weeks, and even Home Depot and Walmart have mentioned in their earnings calls that deflation may be on the horizon near term.
It looks like I am finally being proven right that the Fed has way overtightened and will be left with little other options than to significantly decrease interest rates in 2024. At this point, I believe that the Fed will cut at least 200 basis points in 2024, even though that would still leave the Fed funds rate at 3.5%. In fact, the Fed would probably be well advised to cut to 2% as fast as possible. While that may only happen by 2025, I anticipate that the inevitable will become increasingly clear to the market and the Fed over the next weeks and price action should reflect this. I believe that the “magic 7” have seen the best days in terms of relative performance and that growth stocks and smalls caps will significantly outperform big tech and the S&P 500 in the next 12 months.
I have thus just finalized a significant turnover of my portfolio and you can find the new allocation in the table below:
Re-entering Unprofitable Growth
Compared to my last portfolio published on August 1st, and after exiting all US growth stocks soon after (close to the peak), I am now pivoting back into most of the same growth stocks, but at significantly more attractive prices:
4.9% position in Upstart (52% cheaper than after my article on August 6)
3.8% position in Opendoor (26% cheaper)
3.6% position in Lemonade (1% cheaper)
3.2% position in Carvana (27% cheaper)
All 4 stocks have published relatively strong Q3 reports and Q4 outlooks. Upstart operates at EBITDA breakeven, with significant cash and little debt. The company should be able to get back into growth mode now that interest rates have clearly peaked. Opendoor has very low volumes, but it has limited cash burn and book equity has remained about constant for almost 12 months, with billions of liquidity left. Lemonade has demonstrated the strongest positive surprise in Q3. EBITDA losses have been significantly reduced and management has pulled forward the anticipated break-even date to 2026 with still “hundreds of millions” in unconstrained cash by then. Carvana is now operating at about 400 million (!) in adjusted EBITDA per year.
As we return to an economic environment of significantly lower interest rates, I believe these companies will have enormous fundamental tailwinds. As markets are typically capable of anticipating the future reasonably well, my expectation is that these stocks are likely to significantly outperform the markets.
I have also reentered two German growth stocks at significantly lower prices:
4.0% HelloFresh
3.2% Auto1
New Positions in Biotechnology
Another sector that I believe is ready for a significant recovery with lower interest rates is Biotechnology. The sector is basically trading at the same price level as five years ago and down about one third from 2021 highs. My two picks in the sector are:
4.0% Crispr Therapeutics
3.9% Illumina
Crispr Therapeutics is about to receive a breakthrough approval for the first gene-editing based medicine that not only treats, but heals(!) severe diseases such as sickle-cell disease:
This week, the UK has already approved Crispr’s medicine. I anticipate that the implications for gene-editing based medicines in general are much wider. The volume of gene sequencing should rise exponentially for decades to come and Illumina would be a primary beneficiary, as it is the dominant market leader that produces the machines that are required to perform gene sequencing.
Exploiting the Sell-off in Payment Stocks
Payment stocks in general have been among the most beaten down segments of the stock market this year, with Adyen as the probably most prominent example. After my homerun with Meta platforms last year, I see a potential to ride a similar recovery in the payments sector. My two picks within the payment industry at highly attractive valuations are:
5.5% Shift Four
3.7% Block (formerly Square)
Exploiting the Weakness in US Real Estate
Another key sector that has sold off with skyrocketing interest rates is the US real estate sector - and admittedly often for the right reasons. The combination of high refinancing rates and troubles in the office sector resulting from a new home office paradigm are a deadly combination. However, not all real estate is equal. I have started positions in:
5.0% Realty Income Trust
3.8% Park Hotels and Resorts
3.0% RMR
Realty Income Trust is a US REITs focused on single tenant retail buildings with triple net lease contracts linked to the inflation rate. This means capex and renovation costs have to be paid by the tenants (so FFO and adjusted FFO are almost the same). Realty Income Trust trades at an FFO-yield of about 8% and a dividend yield of 5.8%. It is important to note that Realty Income Trust is growing FFO significantly even in the current environment, which is also thanks to its very low debt levels (LTV is only about 35%).
Park Hotels and Resorts own a portfolio of Hilton Hotels in the US and trades at an FFO yield of about 14-15%. In the case of a hotel REIT, capex are however significant. Nevertheless, the valuation is very attractive here, also considering the very low debt level (LTV about 30%). Basically, Park could pay down all the debt with EBITDA from its properties within about 5 years.
RMR is a diversified real estate asset manager that does not own any properties itself. Instead, it generates fee income from managing a number of REITs and private real estate companies. The contracts have a very long term nature, often 20 years. RMR has an annual EBITDA of about $100 million and a market capitalization of only $400 million. Moreover, EBITDA will continue to grow once the takeover of Carroll is completed. Carroll should increase EBITDA by another $11-13 million per year. The acquisition is expected to close early next year. Even after the acquisition, RMR has left over some $200 million in cash and no material debt.
Why is RMR so cheap? Frankly, the REITs it manages have not done well recently and, judging by their share price, it does not look like all of them will make it through the current crisis. However, this should change once interest rates finally come down significantly. Even if RMR loses one or two REITs, the margin of safety is still high enough for me. Meanwhile, investors in RMR are paid a 6.7% dividend yield while waiting for a better share price.
A Canadian Small Cap Software Company
3.6% Dye and Durham
I have started a position in $DND below $10 CAD after a short seller attack. I will leave a more detailed writeup for the future. However, the most recent quarter has demonstrated that the current level of cash flow should be more than enough to handle the debt load and the stock appears to have more than 100% upside just to trade in line with its software peers, and that does not even account for the unique growth opportunities
Some Deep Value Stocks to Diversify
4.7% Jardine Matheson
4.5% Porsche Holdings
Jardine Matheson is a Hong Kong based conglomerate investing “Berkshire-style” across South East Asia and China. The company has a phenomenal long term track record, but is down about 40% over the last 5 years. Jardine currently trades at about 7x EV/EBITDA, whereby significant parts of the business are still recovering from Covid, as restrictions in Asia have lasted significantly longer than in Europe and North America. For example, Jardine owns the iconic Mandarin Oriental Hotels, whose value alone accounts for some 33% of the current market cap. Jardine produces significant cash flow and reinvests it for future growth. I am long term very optimistic on the economic prospects in South East Asia and Jardine appears to be an ideal company to play this theme. Meanwhile investors are being paid a 5.34% dividend yield while patiently waiting for a higher share price.
Porsche SE offers exposure to Volkswagen and Porsche AG. Volkswagen itself is dirt cheap at a PE of 4, and EV/EBITDA of 3.64, and a dividend yield of 8.1%. VW may trade so cheap due to concerns about the transition to EVs. However, at this point it rather seems that it is the transition to EV thesis that is seeing some serious cracks. In any case, I believe that both Porsche and VW have a relatively strong EV lineup.
What makes Porsche SE special is that it trades at a 41% discount to NAV. Having access to dirt-cheap Volkswagen at yet another 41% discount is attractive enough to me. While Porsche SE investors wait for a higher share price, they are being paid a 5.57% dividend yield.
Exits
I have exited my basket of German Residential Real Estate Stocks after very attractive returns. I sold TAG Immobilien for a 100% gain, LEG Immobilien for a 40% gain, Vonovia for a 40% gain (including dividend) and Grand City for a 30% gain.
I have also sold my positions in long term US treasuries for a modest loss. While US treasuries will benefit from lower interest rates, I believe the upside in the right growth and value stocks is significantly higher at this point. I have also sold InMode following very disappointing numbers and AMD as I consider it less attractive compared to my updated portfolio.
In the weeks and months to come, I will write more about my portfolio positions. Starting with an article on Sea Limited. Stay tuned!
This is not investment advice - Do your own research!