Q3 2024
Kinsman Oak Investor Letter Q3 2024
October 28, 2024
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MARKET COMMENTARY
Financial markets experienced two notable events over the past few months but were otherwise relatively quiet. First, the Yen carry trade unwound in early August and suddenly we found ourselves surrounded by freshly minted self-proclaimed experts on all things Japan. Stocks plunged with the S&P 500 and Russell 2000 declining by 8% and 13% respectively. The VIX surged to 65 which was the 3rd highest spike since the creation of the volatility index in 1990. In our view, while the calamity was short-lived and markets completely stabilized within mere days, this extreme price action highlights the severe fragility within the financial system.
The second notable event was the Federal Reserve’s decision to cut interest rates at the September FOMC meeting. For years the discussion surrounding potential rate cuts felt like an uncomfortably long road trip with impatient children in the backseat. Every five minutes one would ask “Are we there yet?” The destination seems like a mirage far off in the distance that gets further away the closer it appears. After what feels like an eternity, you finally arrive at your destination, and that irritating question won’t burn your ears again until the return trip home.
Interestingly enough, bond yields at every maturity climbed higher despite the Fed cutting overnight rates and the yield curve re-normalized. History would suggest a recession is imminent, but we hesitate to make any macroeconomic prognostications. This is partly because we were surprised at how long the yield curve stayed inverted in the first place. But, more importantly, we wonder if unprecedented monetary and fiscal stimulus have distorted economic indicators to such a staggering degree that historical relationships no longer maintain the same predictive power. Then again, “this time is different” are the famous last words.
Aggressive intervention has severely obfuscated leading economic indicators, but the problem is further compounded by a lack of credible economic data, in our opinion. For example, according to the Bureau of Labor Statistics, the U.S. added 818,000 fewer jobs than previously estimated from March 2023 to March 2024. This was the largest negative revision in the past 15 years. Even worse, this revision includes an addition of +200k government jobs added which means private sector job creation was overstated by more than 1M jobs. This downward revision is not an isolated incident. Even if you possessed a magic econometric model capable of forecasting the future, its output would prove incorrect because its inputs are often retroactively changed. Garbage in, garbage out.
Now that the Federal Reserve’s rate-cutting cycle has officially commenced, the focus has shifted from “Are we there yet?” to “Will we get a soft landing or a recession?” Throughout history soft landings are often talked about yet rarely experienced. Our base assumption is what goes up must eventually come down. But any economic slowdown will likely be met with a new wave of record-setting fiscal stimulus. Because of that, and the reasons explained above, we find it challenging to form a concrete view based on a top-down perspective. Instead, we try to gauge economic health using a bottom-up approach which suggests it’s complicated and the answer is nuanced.
A TALE OF TWO ECONOMIES
On aggregate, economic growth is slowing but remains strong. Beneath the surface, however, the economy appears completely bifurcated. The dichotomy between dollar stores and ultra high-end luxury brands encapsulates that divergence. Both Dollar General (DG) and Dollar Tree (DLTR) are making ten-year lows while Ferrari (RACE) and Hermes (FP:RMS) are pushing all-time highs (Appendix A).
Rampant inflation disproportionately impacts those at the bottom of the economic ladder. While inflation has moderated recently, prices are still increasing and remain 23% higher than they were five years ago. Excess savings from stimulus payments are long gone and dollar stores provide real-time insight into the financial strength (or weakness) of the lowest-income households. A majority of Dollar General customers have an annual household income below $35,000 and over 40% of Family Dollar customers are eligible for government financial assistance.
The following is an excerpt from Dollar General’s most recent earnings call: “More of our customers report that they are now resorting to using credit cards for basic household needs and approximately 30% have at least one credit card that has reached its limit. And in our latest survey, 25% of our customers surveyed noted they anticipated missing a bill payment in the next six months.” Dollar General and Dollar Tree have experienced numerous operational mishaps and face increasing competition from Walmart (WMT) and Target (TGT) which partially explains the poor stock performance, but the financial strain on their core customer base is undeniable.
Meanwhile, compare the above excerpt with the following from Ferrari’s most recent earnings call: “We upgraded our 2024 guidance… The enthusiastic reception of our latest new sports car, the 12Cilindri and the 12Cilindri Spider, drove the order collection in the quarter, adding to an already solid order book on current models, which covers well into 2026.” Ferrari’s order book remains strong for the next two years while an estimated 25% of Dollar General customers anticipate missing a credit card payment for basic household needs.
The following is an excerpt from Hermes: “In the U.S. the situation is quite good, actually, and it’s on top of it we had the historical comparable quite high. So, it’s a great surprise to see the dynamism of the U.S. market lately… We were able to have plus 13% in the first quarter, plus 13% in the second quarter, and we see quite a good attraction of our brand in the market.” Clearly the affluent echelon of society has strong purchasing power for sportscars and luxury handbags.
In our view, certain pockets within the economy are getting crushed while others are thriving. Certain customer groups are under pressure while others are doing well. Certain sectors are experiencing headwinds while others are benefitting from tailwinds. Almost as if there are uncoordinated rotating recessions taking place within an economy that is, on the surface, chugging along despite the gives and takes. Under these conditions, we believe security selection will become more important compared to the previous paradigm where rising tides lifted all boats.
HIDDEN SEGMENTS – UNNAMED NEW LONG POSITION
We recently initiated a long position in an unnamed ~$1 billion market capitalization company at the time of writing. While we felt comfortable enough to get a starter weight, we would like to see more evidence of our thesis playing out before increasing the size of our position and mentioning the stock by name publicly. Early indications are positive, and the stock appreciated faster than we initially anticipated after a strong earnings release.
Our long thesis is a classic example of an underappreciated hidden segment buried within a larger, less exciting business. The company has four segments and screens poorly because its largest segment (75% of total company revenue) is shrinking. Consolidated revenue declined by LSD in the past fiscal year, but the consistently improving gross margin profile despite anemic top-line growth caught our attention. After digging in, it became clear there were many moving parts worth exploring.
On the surface, a business with -3% revenue growth, 32% gross margins and 5% operating margins sounds unremarkable until you break out the performance by segment. When we initiated the position, we estimated the hidden segment could be worth the entire enterprise value of ~$750M. We believe a standalone company growing revenues at 30% with 90% gross margins and 20% operating margins would likely be worth ~6x EV/Forward Sales. Such a scenario would make the rest of the business essentially free.
We do not expect a multiple re-rating to happen overnight. But as the hidden segment continues to scale, we expect it to contribute meaningful EBITDA dollars over the next few years. Gradually, we believe the valuation multiple should expand as this segment becomes a higher percentage of total company EBITDA. Despite a healthy growth rate, it will be difficult for the hidden segment to offset the top-line deterioration from the legacy business, but due to the stronger margin profile, absolute EBITDA dollars should go up.
The legacy business is not worthless, either. The company can harvest free cash flow from that segment and redeploy the proceeds into share buybacks and organic growth. Admittedly, this legacy business is shrinking faster than we would like but we view that annual free cash flow as an added bonus if investors are paying a fair price for the hidden segment.
In our opinion, the last two segments are free options. Both are experiencing healthy top-line growth and possess strong gross margin profiles but require heavy reinvestment back into the business. At this stage it’s unclear whether their financial performance will turn out to be needle-moving over the next three to five years.
It’s worth mentioning this company is founder controlled via dual class shares, has net cash on its balance sheet, and meaningful NOLs. There is no sell side coverage, and no forward consensus estimates we are aware of. The company has incubated and spun-off numerous other businesses with varying degrees of success so we are reasonably confident the management team will explore all avenues to maximize shareholder value.
While we decided not to name the company outright, we have given enough detail that you can probably figure it out if you feel inclined to do so. Key risks to the thesis are twofold. First, the legacy business could deteriorate faster than expected and the management team cannot control costs quickly enough to offset an accelerated decline. Instead of harvesting free cash flow, it could potentially bleed cash. Second, the growth rate in the hidden segment could decelerate for any number of reasons such as market saturation, operational missteps, increased churn, or deterioration of business conditions for their end market.
URANIUM
Nuclear energy has garnered some interesting headlines over the past month. Mega-cap technology companies are beginning to think strategically about how to effectively develop and scale their artificial intelligence capabilities long-term. Accelerating R&D investments requires significant computing power. Rolling out new innovative products and services even more so. Electricity demand to power data centres and cloud computing is poised to skyrocket.
Alphabet (GOOG), Amazon (AMZN) and Microsoft (MSFT) have all suddenly turned to nuclear power. Alphabet, in order to meet additional electricity demand for artificial intelligence, signed an agreement to purchase power from multiple small modular reactors. Amazon is investing over $500M to develop small modular reactors to satisfy growing demand from its data centres. Microsoft struck a deal to restart Three Mile Island.
“We see the need for gigawatts of power in the coming years, and there’s not going to be enough wind and solar projects to be able to meet the needs, and so nuclear is a great opportunity. Also, the technology is really advancing to a place with SMRs where there’s going to be a new technology that’s going to be safe and that’s going to be easy to manufacture in much smaller form.” – Matthew Garman, Amazon Web Services CEO, Oct 16th CNBC.
Our belief is that a lot of questions remain unanswered. It takes many years to build small modular reactors from scratch and the economics of owning and operating them as businesses are unproven. While many investors will justifiably question the significance of the headlines above, these initiatives are at least early indications that smart people have dramatically changed their sentiment towards nuclear energy.
It’s difficult to predict far into the future but it appears the demand for uranium is likely to surge over the next decade. We are not commodity experts or sector specialists but everything we have read suggests the spot price for uranium is nowhere close to being high enough to incentivize new uranium exploration and production. Rising demand combined with declining supply creates a classic supply-demand imbalance. The cost of uranium relative to other forms of electricity is so low that price insensitive buyers could easily squeeze it much higher.
In our view, this set up is interesting and asymmetric enough to justify stepping outside our immediate circle of competency. We currently own a small position in the physical commodity and are prepared to buy more, but uranium will probably never be an outsized weight in the Fund given our strategy. The biggest risk to the thesis is an abrupt plant failure which would essentially make everything nuclear power untouchable for a long time.
LOOKING AHEAD
The news cycle is consumed with the upcoming U.S. election. We don’t have a strong view on which candidate is likely to win. But even if we did, we couldn’t accurately anticipate what it would mean for the stock market. In 2016, the consensus opinion was that a Trump presidency would be devastating for equities. On election night, the S&P 500 futures dropped 5% when he pulled off a surprise victory. Stocks proceeded to rally 7% off that bottom by the end of the next trading day, and those lows were never touched again. Go figure.
However, we view both platforms as different flavours of fiscal irresponsibility. In our opinion, rising budget deficits over the next four years is pretty much a forgone conclusion. The U.S. national debt outstanding is $35.8 trillion (Appendix B). Meanwhile, the U.S. government collected $4.9 trillion in revenue during fiscal year 2024 and over $950 billion of that, almost 20% of total tax receipts, was used for interest payments. Over the next decade, that outlay is projected to climb higher every single consecutive year in absolute dollars, percentage of total tax receipts, and percentage of GDP with no end in sight. Anyways, we continue to own gold.
Valuations appear expensive and, for the since time since 2002, the S&P 500 earnings yield is less than the yield on U.S. 10-Year Treasury Notes (Appendix C). We continue to see pockets of value on the long side and remain focused on uncovering more off-the-beaten-path ideas that should deliver adequate returns regardless of broader macroeconomic conditions. Finally, we anticipate elevated volatility in the event of uncertain election results and will attempt to use that to our advantage.
Sincerely,
APPENDIX
Appendix A
Appendix B
Appendix C
