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2023 Second Quarter Commentary

For printable version which includes all graphs and tables, click here.​​​​

The Benefit of Not Being Sure

It is easy for the volatility of one’s outlook to match the volatility of the stock market. The stock market provides real-time feedback on what market participants are willing to pay for a share of any publicly traded company. These prices are often trumpeted by various media and commentators as an immediate sign of what is happening in the economy at the moment or in the very near future. Judgements are made quickly. Our hope with these commentaries is to lend perspective, provide context, and possibly (after a deep breath or two) lengthen the time horizons of your thinking regarding your investments, particularly your equity portfolios. We approach our stewardship of your hard-earned capital with a healthy dose of HUMILITY. This is because there are any number of variables about the future of which we are not sure; we can’t be sure. The only thing we are sure about is that no one can know the future. We believe there is great benefit to not being sure because it leads us to make conservative assumptions about the future and to focus intensely on making sure the price we pay for any investment reflects that we cannot know how the future unfolds.

The timeliest example of quick judgements being made by the stock market is the excitement around artificial intelligence (AI) and the valuations being assigned to companies with perceived exposure. The S&P 500’s 16.89% gain in the first of half of 2023 has been driven in large part by seven mega capitalization technology-related stocks: Apple Inc., Microsoft Corp., Google parent Alphabet Inc., Inc., Nvidia Corp., Tesla Inc. and Facebook parent Meta Platforms Inc. In fact, these seven stocks posted an equally-weighted return of over 50% in the first six months of the year. The other 493 stocks in the index had a return of 2%. Much of the optimism around these seven stocks is related to the market’s impression of their ability to benefit from the future growth of AI. The main perceived winner of the AI boom is Nvidia Corp. (NASDAQ: NVDA). The market has assigned an extremely optimistic valuation to NVDA shares in large part because of the company’s projection of rapid growth in their semiconductor sales for use in AI applications. We believe that AI will likely be a larger part of the economy in the future, but that doesn’t mean investing in AI stocks will be a good investment. We will use NVDA as an example of why a high valuation on the stock of a company makes it hard for an investor to achieve a reasonable return, even when the actual fundamental business growth is astounding.

Nvidia is a leading developer of semiconductor platforms that utilize its graphic-processing units (GPUs) and software for many specialized applications. In 2022, 56% of the company’s revenue came from data center sales, 33% came from gaming/crypto currency mining sales, and the other 11% came from smaller segments. Total revenue for the company in 2022 was approximately $27 billion. Total global industry revenue for all types of semiconductor chips was $572 billion in 2022. According to the World Semiconductor Trade Statistics, total 2023 global chip revenues are projected to decline by around 10% to $515 billion. One reason the stock market is so excited about NVDA is because management has projected strong growth for the company’s chip revenues this year and next year. The shares of NVDA currently trade at 220 times price to earnings per share for the last twelve months and 39 times price to revenue for the last twelve months. The consensus Wall Street analyst projection anticipates NVDA doubling revenue and quadrupling earnings by the fiscal year ending January of 2025, merely 1.5 years from now. To quadruple earnings on twice the revenues, NVDA will either need to double its overall profit margins or the new business will need to have 67% profit margins which is triple the already very healthy current margin of 20% on existing business. Even after that rapid and tremendous growth, NVDA’s $425 share price represents a valuation of 55 times price to extremely optimistic projected fiscal 2025 earnings per share and 20 times price to projected fiscal 2025 revenues. The earnings yield of under 2% is well below the 2-year US Treasury Bond yield of approximately 5%. A rich price indeed!! In our framework of thinking, to pay such high valuation multiples for NVDA shares suggests that the buyer is very sure that projections for the company’s future growth and profitably are the bare minimum they will achieve. We are not so sure.

NVDA’s valuation level reminds us of the euphoria present during the Internet Bubble of the late 1990s and early 2000s. In particular, relating to Sun Microsystems. Sun was an American technology company that sold computer hardware and software and created the Java programming language. Sun Microsystems’ valuation peaked at 10 times price to revenues in 2000. Looking back on the stretched assumptions that went into that valuation, Scott McNealy, the co-founder and CEO of Sun Microsystems, made the following statement to Bloomberg in 2002: “…2 years ago we were selling at 10 times revenues when we were at $64. At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero research and development for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don't need any transparency. You don't need any footnotes. What were you thinking?”

Within your portfolio of companies there are many examples of AI beneficiaries. Intel Corp. (NASDAQ: INTC) acquired autonomous driving technology company Mobileye in 2017 and AI start-up Habana Labs in 2019 to accelerate its efforts in the AI semiconductor chip market. While INTC currently has a small share in AI-specific semiconductor chips, the company has the opportunity to increase its share of this rapidly growing market. Your pharmaceutical companies have been incorporating AI into the research and discovery process for a number of years. Sanofi (NASDAQ: SNY) is using AI to slash research time through improved predictive modelling, selecting better trial sites for more successful clinical trials and to analyze and improve manufacturing batch performance by identification of low inventory positions and optimizing usage of raw materials. Pfizer (NYSE: PFE) has partnered with an AI-driven health company to enable the early suspicion of cardiac disease. Two of your largest energy positions, Exxon Mobil Corp. (NYSE: XOM) and Chevron (NYSE: CVX) are using AI to improve leak and flare detection and to predict and diagnose upsets in processes or issues with drilling equipment. Additionally, they are using AI to map subsurface reservoirs without as many exploration wells. The Kraft Heinz Co. (NASDAQ: KHC) is utilizing AI to enable real-time sales insights. These are just a few examples of how the companies in your portfolios continue to evolve and improve their operations and increase their competitive advantages in each of their respective markets. The real advantage for the companies in your portfolios is the vast data from their operations. They will be able to use this wealth of data to produce effective AI models. While not the obvious winners from the improvements in AI, many of your portfolio companies should increasingly benefit from the various evolving AI technologies.

Of course, AI is not the primary reason we are optimistic about the prospect for future returns in your portfolios. As we discuss extensively with you any time we have the chance, the valuations that are present in your portfolios are what has us most optimistic about the future. In contrast to the extremely high valuations on NVDA shares that make its prospective future returns less than ideal by our assessment, the low valuations of our portfolio companies indicate the potential for attractive prospective returns. Our composite portfolio today trades for only 9.8x trailing one-year earnings. This is the cheapest level in the last seven years, the earliest time we have been tracking this composite statistic (see chart beside). Said another way, our composite has an earnings yield of over 10%, which is a true rarity. This is despite a highly-valued broad stock market.

Inflation Update

Investor sentiment around inflation has shifted dramatically over the past 12 months. As measured by the Consumer Price Index (CPI), year-on-year inflation has come down from a high of 9.1% in June of 2022 to 3% in June of 2023. While we are encouraged by this improvement, we believe the easiest part of the work to fight inflation has been done. To get CPI down from 3% to below the Federal Reserve Bank’s target of 2% is likely to be increasingly difficult. One reason for that difficulty is that core inflation (inflation minus food and energy) has remained high at 4.8% in June 2023 (see chart beside). Core inflation is more stable than headline inflation due to the absence of volatile commodities like food and oil and gas. Most of the CPI inflation is now concentrated in core services. Wages are a key input to core services and historically wage increases have been sticky. Another reason service prices become entrenched is that nearly two-thirds of core services, excluding shelter, are comprised of: (1) service prices that are regulated (particularly insurance) and (2) services with infrequent price resets (like tuition, medical services, and subscriptions).

We believe the reconfiguration of global supply chains will contribute to the entrenched nature of inflation. For much of the 20 years after China joined the World Trade Organization in 2001, the world has been focused on supply chain and manufacturing efficiency. A large part of that supply chain buildout took place in China to take advantage of its large labor pool and low initial wage rates. However, China’s wage rates are up 15-fold since 2000 by some estimates. Pandemic disruptions and trade disagreements exposed the fragility of current supply chain configurations. In response, a supply chain reconfiguration is unfolding. Linear, lowest-cost supply chains are giving way to more multi-dimensional supply networks that better balance risk, sustainability, speed, agility, and cost. Total construction spending on manufacturing in the US reflects this transition (see chart beside). Spending on building up manufacturing and logistical infrastructure is also happening in Mexico, India, and Vietnam among other locations. This spending is likely to be inflationary.

For those of you who enjoy math, an interesting thought exercise on CPI inflation figures can be performed by using the monthly changes in the observations. The headline CPI inflation number is a string of 12 monthly or “month-over-month” (MoM) figures. Each time a new monthly figure is added to the headline figure, the year-old monthly figure rolls out of the calculation. While we don’t know what the July of 2023 or August of 2023 monthly figures will be, we do know the figures from those months in 2022 that will roll out of the calculation. We have included these figures in the table to the right. You can see that the monthly figures from May of 2022 (1.1%) and June of 2022 (1.4%) were high figures and coincided with inflation reaching its current cyclical peak of 9.1% in June of 2022. Those figures were replaced in 2023 by 0.3% in May and 0.3% in June leading to a current inflation figure of 3.0%. Here is where it gets interesting: the monthly figures that will drop off from July of 2022 (0%) and August of 2022 (0%) are much lower figures. That continues for the rest of this year. Unless we average monthly inflation of less than 0.1% for the rest of this year, June’s 3% reading is mathematically likely to be the lowest CPI inflation rate in 2023.

Bank of America put together an interesting chart of different scenarios and the resulting inflation figures (see chart beside). The graph models out different possible rates of monthly inflation figures. It highlights perfectly that inflation does not move in a straight-line.

If inflation remains elevated, interest rates should remain higher than they have been for the previous 15 years as well. At some level, higher interest rates will threaten the lofty valuations of some parts of the stock market. It is just a matter of when. We never know the when.

Updates on Portfolio Companies

Two of the better performing equities in your portfolios so far this year are Canadian companies. Below we discuss why we believe the intrinsic values of these companies have increased even more than their share prices.

In our 4th Quarter 2021 Quarterly Commentary we explained why we were glad to continue to hold the shares of Fairfax Financial Holdings Limited (TSX: FFH, OTC: FRFHF) despite the fact that the stock had languished for years. The heading for that section was titled Waiting For Our Patience To Be Rewarded. It turns out we did not have to wait much longer. In 2022 the stock rose 29%, in addition to the $10 per share dividend. The stock is up another 26% at mid-year and has already paid its $10 dividend.

Fairfax is a holding company for global property and casualty insurance and reinsurance operations and other diversified investments. The stock has been one of our largest holdings for over 20 years. You might think with the kind of appreciation we have enjoyed over the last 18 months that we would be close to realizing the intrinsic value in the stock and targeting it for sale. Not so!

At the end of the first quarter, book value stood at $803 per share compared to a closing market price on 6/30/2023 of only $748.90. Over the course of the last 37 years, Fairfax has enjoyed annual growth in book value of 17.8% with an annual increase in the stock price of 16.1%. The stock price would need to increase 71% to catch-up! Thus, to be able to hold or buy this stock below current book value as it trades currently appears extremely attractive on a long-term basis. Two second quarter transactions will add approximately $20/share to book value net of tax. You can see in the nearby chart how the company’s recent results have dramatically increased our estimate of intrinsic value.

Fairfax ownership carries with it many attributes that we love to see in an investment. Prem Watsa, Founder, Chairman and CEO, owns 10% of the company. He receives a modest salary and a high percentage of his wealth is tied up in the stock, strongly aligning his interests with ours. Moreover, management has proven to exercise conservative accounting and reserving for the insurance risks it underwrites. Finally, Watsa and his investment team have added a tremendous amount of value over the years through direction of the company’s bond holdings. The company went into the current bear market in bonds defensively positioned and continues to be so. That has had an immediate positive impact on interest income as short-term rates shot up. Given the unrecognized intrinsic value in the stock, we are definitely a buyer of these shares for new portfolios. We would not be surprised if we end up holding Fairfax for another 20 years!

We have also been long-term investors in Cameco (NYSE: CCJ), one of the world’s largest uranium producers. We last wrote about Cameco as a “back door” opportunity for exposure to the decarbonization of electrical power production in our 3rd Quarter 2021 Quarterly Commentary. The company has a more than 30-year proven track record of providing secure and reliable nuclear fuel to a global customer base for the generation of safe, secure, and affordable baseload carbon-free energy. Until recently, uranium prices had struggled for over a decade since the tsunami-induced 2011 Fukushima Daiichi nuclear accident in Japan. However, new positive momentum continues to build as nuclear power advocates such as Bill Gates (Small Modular Reactors) and famed green energy proponent and film-maker, Oliver Stone, (Nuclear Now Trailer) implore the world to realize the favorable attributes of nuclear energy as one of the key solutions to the world’s CO2 and climate change challenges.

Cameco, through the astute direction of its CEO, Tim Gitzel, has prudently managed its business through the decade-plus long uranium price depression by idling tier-one capacity (large, long life and low-cost mines) and even buying uranium on the spot market to fill contractual supply commitments rather than depleting their low-cost reserves at loss-creating prices. Cameco’s rock-solid balance sheet includes a sizable net cash (cash in excess of debt) position along with likely additional cash from a favorable settlement of Canada Revenue Agency tax disputes. The strong balance sheet has allowed Cameco to be disciplined and maintain a long-term focus through the uranium market downturn.

It appears the industry downturn is finally over as contract prices for uranium have been rising for the last year. The Russian/Ukrainian war has accelerated this situation since much of the world’s uranium production (14%), conversion (27%), and enrichment (39%) come from Russia. Furthermore, Russia’s neighbor and former territory, Kazakhstan, is the world’s largest producer of uranium and has exercised considerable discipline by limiting its uranium production. Accordingly, many nuclear power producers around the world are accelerating their interest in contracting with dependable non-Russian suppliers such as Cameco. Since fuel costs are a minor expense of building and operating a nuclear plant, increased prices will do little to hinder demand from utilities that need secure long-term supply. Likewise, a flood of new uranium supply is highly unlikely given that new uranium mines and enrichment facilities can take 10 to 15 years to build according to International Atomic Energy Agency estimates.

We are also excited about Cameco’s timely October 2022 announced acquisition of a 49% interest in Westinghouse via a strategic partnership with Brookfield Renewable. This provides Cameco with mission-critical technologies, products, and services for light-water reactors across most phases of the nuclear power sector.

We believe that nuclear energy is a critical factor in the growth of worldwide energy demand, especially as a baseload, carbon-free, energy-dense option. Cameco should be a beneficiary of these trends, and the stock, while recently beginning to reflect those benefits, is a long way from representing full valuation.

A Note Regarding Security

The security of your personal financial information is always at the top of our priority list. Scammers’ methods of trying to steal your personal information change daily. Whether it is a scammer calling and pretending to be from your custodian with an urgent matter or a phishing email from your bank, Amazon, the IRS, or another well-known company, sometimes it is difficult to determine when calls, emails, or texts are legitimate. Although this list is not all-inclusive, listed below are ways that you can protect yourself:

• Remember, you can rely on FRM as your trusted contact. If you receive a communication (email, text, phone call) that you are not sure about, do not respond.

Call us first, and we can help you determine if the communication is legitimate.

• Do not click on links or attachments included in unknown or suspicious emails and be on heightened alert when receiving any emails with Office, zip, or other common file types as attachments.

• Look for clues within the text of emails that may indicate they were sent by bad actors. These include errors in grammar, capitalization, or spelling.

• Hover your cursor over links to reveal the website's URL and see where the link really leads. Do not click on the link if the destination is not what you would expect to see.

• Listen for any voices in the background who are providing instructions to the person calling you—advice on what to say, or on the details of any proposed transactions. Also, don’t trust Caller ID. It is common for impersonators to spoof the names and numbers of known agencies/companies.

• Clients should avoid providing any personal identifying information in an email or over the phone, even if they say they're calling from your custodian/bank. Note: Clients can verify that they're speaking with a representative of their custodian/bank by hanging up and calling a phone number that is known to them.

Privacy Policy/Proxy Voting

As there have been no changes in our Privacy Policy, we are no longer required to provide our clients with a notice of our privacy policy on an annual basis. Our relationship with our clients is our most valuable asset, and we know that respect for your privacy is the very foundation of that relationship. Also, please contact us if you would like a copy of our Proxy Voting Policy. Our Proxy Voting Policy describes how we vote with regard to measures concerning stockholder/corporate democracy; routine matters such as the election of directors or the appointment of outside auditors; management compensation and “anti-takeover” provisions. Please contact us with any questions you may have regarding how we have voted the proxies of the securities that you hold.


Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy


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