Q2 2021
Kinsman Oak Investor Letter Q2 2021
July 20, 2021
MARKET COMMENTARY
We continue to believe tail risks to both the upside and downside remain extraordinarily fat. Churning continues beneath the surface and single stock volatility is higher than broad index returns may suggest. This year can be characterized by rolling corrections and factor rotations, primarily driven by yields and inflation expectations, with the underlying trend moving higher. It’s easy to get whipsawed.
The actual strength of the U.S. economy remains difficult to gauge. Government stimulus programs and central bank emergency measures are still obfuscating traditional economic analysis. Headline figures suggest a robust recovery is underway, but we wonder exactly how much of that is artificial. What would consumer spending figures be without stimulus checks? What would the labour force participation rate look like without additional unemployment benefits? What would happen to the housing market if MBS purchases were scaled back? More importantly, so long as these measures continue, does it even matter?
Vaccine rollouts have largely been completed across North America but federal government and central bank “emergency measures” remain intact with no end in sight. We find it interesting, and somewhat amusing, that jawboning about a potential rate hike two years from now is considered hawkish.
Investor Sentiment Remains Euphoric
Citi Research maintains a proprietary Panic/Euphoria Model that charts the market’s 12-month forward return versus investor sentiment dating back to 1987. Not surprisingly, these two factors are inversely correlated. Any sentiment indicator below -0.17 is considered panic territory and anything above +0.38 is considered euphoria. This week Citi Research’s Panic/Euphoria model hit 1.06 (Appendix A).
Exuberance is pervasive and extends well beyond equity markets. For starters, many meme stocks mounted a noteworthy comeback. We can’t think of another instance of widespread bubbles inflating, collapsing, and then re-inflating again with such vigor so shortly thereafter. Perhaps the upcoming Robinhood IPO will sound the alarm bell at the ‘Meme Stock Top’ in hindsight.
Real estate has gone parabolic partly due to input costs and partly due to supply shortages. Enthusiasm surrounding cryptocurrencies has waned somewhat but those along with NFTs are still wildly popular. Junk bonds have a negative real yield for the first time ever (HYG yields 3.5% vs. 5.4% inflation).
The market feels predominantly psychological at this juncture. A scenario where excessive liquidity is never withdrawn or reduced, earnings growth continues, and inflation pressures abate is a fine needle to thread. Historically, breadth narrows before tops occur, so we will be monitoring potential risks closely.
Labour Market Shortages
Labour shortages continue to be widely cited especially in the restaurant and hospitality industries. For instance, a McDonald’s in Florida reportedly paid job applicants $50 to show up to the interview.2 Other fast-food chains are offering referral bonuses to employees and increasing hourly wages.3 Even large companies like Disney are having difficulty enticing individuals back to work and reportedly offered $1,000 signing bonuses to recruit new housekeeps and kitchen staff at its theme parks.4
The number of job openings continuously hits record highs, but unemployment remains elevated.567 While these instances may seem anecdotal, we could continue to list numerous other examples. Many management teams we have spoken to tell us these are real problems, and the severity varies by state.
We are inclined to believe that this is one of the unintended consequences of offering overly generous supplemental unemployment benefits. Investors assume wage inflation translates to CPI inflation in a rather linear fashion. The line of thinking is as follows: a business experiences increased cost pressures and will push those incremental costs onto their end customers, causing inflation.
However, the process is more complicated. Businesses are typically unable to pass along large enough price hikes to completely offset rising wages, resulting in some degree of margin degradation. Rational decision makers will stomach increased costs so long as contribution margins from incremental volume remains positive. But if costs continue rising, there comes a point at which each new sale is unprofitable from a unit economic perspective. Under this scenario, sacrificing potential revenue growth is the best option for maximizing dollar profits.
Ultimately, fewer sales combined with margin degradation create headwinds for real GDP growth. Fiscal spending measures, as well-intentioned as they may be, create short-term tailwinds but knock-on consequences stifle sustainable economic growth. Everybody seems to be focused on the first order effects from wage and commodity inflation, but we feel concerns from second order effects such as disappointing economic growth will come into focus. Bizarre labour market conditions are another reason why ascertaining true economic health is difficult.
RECALIBRATING
Long duration technology stocks that were trounced last quarter reversed most of that underperformance as yields plummeted (Appendix B). We previously discussed our belief that secular inflation was far from a foregone conclusion. Anything was possible but having that much conviction seemed premature. The overcrowded reflation trade unwound rather quickly, as things tend to do when participants overwhelmingly clamour towards one side of the boat (Appendix C).
Right now, we view the market to be in a period of recalibration of sorts, where the consensus will likely meet somewhere in between the two extremes until the future becomes clearer. Yields are basically the fulcrum underpinning factor rotations and underlying market structure dictates a lot of price action too.
Disruptor Tech Has Become Very, Very Expensive Again (Briefly Only Very Expensive)
While many tech stocks experienced significant selloffs during the first quarter, almost none of them would have been considered cheap even if you bottom-ticked the lows. Software investors will tout business quality, disruption, exponential growth, network effects, and Wright’s Law until your ears fall off. But the reality is the hurdle that needs to be cleared in order to justify 20-50x EV/Sales is almost unfathomable even if your business becomes a government guaranteed monopoly.
Investors point to the FAANGM stocks as if companies of a similar calibre grow on trees. For every Amazon there is a wasteland of other companies that had promising growth prospects all the way to zero. Simply put, they are exceedingly rare. It is also worth noting Facebook went public at ~11.5x EV/Sales and promptly declined by more than half to a trough valuation of ~5.5x EV/Sales, while growing revenues by 55% and generating a profit at the same time. Investors buying shares of “ultra-high growth disruptors” are doing so at far worse starting valuations than the FAANGM stocks ten years ago that it makes any comparison between these two groups plainly absurd, even if we ignore the difference in business quality.
“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 R&D 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?” – Scott McNealy, CEO, Sun Microsystems, April 20028 (Appendix D)
Value Buying Opportunity
On the flip side, value stocks experienced significant drawdowns during the second quarter, and we believe many are oversold. The reflation trade unwound to the point where sentiment has swung too far in the opposite direction. We took the opportunity to add shares of cheap stocks that we feel possess favourable risk-return characteristics. We would rather have a strong FCF yield setting a floor under our stock prices at this point in the market cycle than an implied floor derived from perceived business quality or unrealistic terminal value growth rates.
LOOKING AHEAD
Investor sentiment remains firmly in euphoric territory and there are obvious pockets of gross overvaluation across certain asset classes and sectors. We continue to see opportunity on a stock-specific basis and will accumulate shares while being cognizant that the broader market appears to be very stretched. We feel many of our more off-the-beaten-path ideas should compound healthy returns over the next few years regardless of what happens from a macroeconomic perspective.
Sincerely,
APPENDIX
Appendix A - Citi Research - U.S. Equity Strategy, Haver Analytics, Pinnacle Data
Appendix B - Bloomberg
Appendix C
Appendix D - The Felder Report
https://thefelderreport.com/2017/10/26/what-were-you-thinking/