Category: Macro Analysis

Market Déjà vu… kind of…. $SPY $USO $MCHI

Reading Time: 2 minutes

The current market action and headlines is starting to sound eerily similar to that of late 2015. As a reminder, the world was concerned about global growth and China surprised the market with a currency devaluation, very rare for a country that pegs its currency and only allowed it to move with a band. This suggested China’s economy was weakening and a devalued currency would help the exporter nation bounce back. Since China is essentially a black box and essentially no one actually trusts the numbers they put out, this allowed the market to write its own narrative and that China’s economy had to be weak and that would drive everyone else down with it.

Recall oil at the time had also fallen from $100/bbl to $50-$60/bbl (and was about to drop to a low in the mid-$20s). This too pointed to China weakening and slow global growth. Lastly, corporate earnings were not that great. Especially among industrial names, such a Caterpillar, which is a bellwether for the global economy.

However, that actually didn’t seem to be the case. The market eventually rallied strongly, commodity prices rebounded (as it turns out excess supply could be absorbed and production curtailed),  and people became more comfortable that if anything, China was headed for a soft landing and going to go through a bit of a deleveraging stage.

That placated the market for a bit… until now. The narrative sounds too similar to ignore, but the surrounding facts around it all are different. For example:

  1. People are concerned about China: China posted the slowest growth in a decade. Forget that its still growing amazingly quickly for the third largest economy. Forget the well documented commentary about Xi Jinping wanting to move China to a service economy like the US, a dramatic move from its current export economy. Focus on the negative.  This time, its business confidence in China is low and the tariffs wont help…
  2.  Oil posts a 9 day losing streak: For now, people are associating the decline with supply, a mistake from last time I assume they don’t want to repeat, but there are some headlines that say for example “Oil’s unraveling shows global economy is in a tough spot.” Forget US output at record levels and OPEC pumping as much as it can since 2016.
  3. Earnings have not been good so far. And to provide the context for this time vs. ’15/’16, Caterpillar was down nearly 30% since it reported Q3 earnings. However, companies today are reporting “some softness” and most earnings trouble has been related to “inflation”. I put inflation in quotes because it is difficult for me to look at many companies who have benefited from oil falling (decline in raw materials) and able to hold price steady (boost to margins) that now are complaining about giving that back.   Freight and labor I’ll admit are real. Labor obviously because the slack from the financial crisis has been absorbed and freight is higher after new rules limited hours truckers can be on the road… and actually enforced it…

There are obviously other issues at hand such as interest rates at 3.2% for the 10-year (20bps above where it ended 2013, but OK I guess that will stifle growth…) and the impacts to housing.

Bottom line: I am avoiding the headlines which have had very little predictive success. 

 

How do interest rates affect stocks? A DCF-based impact analysis

Reading Time: 3 minutes

When rates have risen in the past, that has been bad for stocks. Some say rising interest rates affect stocks because you need to increase the discount rate on stocks and that will drive prices lower.

It makes some sense. If investments are competing for my next dollar,  it is true that treasuries at 3% look a lot better than <1%.

10yr treasury.png

 


I have already argued that I am bearish on the notion that interest rates will rise much further from here.

I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.

I also argued that the Fed has little impact on long-term rates actually (and check that with Aswath Damodaran writings on the subject as well)


Given rates moved up quickly from their lows to ~3.2%, I wanted to show interest rates affect on stocks using a hypothetical company. 

I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).

Here’s a summary below of where it is currently trading and model:

mini model

As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.

DCFs

As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?

Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt.

As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.

WACC

So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.

DCF Valuation

Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects. Rising rates simply do not affect stocks this much. 

A quick word about Tesla: It is not going bankrupt

Reading Time: 5 minutesTesla’s bonds tested new all-time lows this week, hovering around 87.75 cents on the dollar as negative headlines continue to shake confidence of investors. Is Tesla going to go bankrupt?

To quickly review the updates, JP Morgan has now downgraded the company just after upgrading it up on the now infamous “Funding Secured” tweet from Elon, the Saudi Arabian sovereign wealth fund that was seen as the funding provider has now been reported to actually be in talks with Tesla rival Lucid Motors for investing a material stake, and lastly, Elon had a recent emotional interview in The New York Times.

But now with reports of concern among suppliers related to Tesla and headlines coming out about the going bankrupt, I want to make something very clear…

Tesla is not going bankrupt.

At least not yet, that is. First of all, we need to separate the recourse debt vs. non-recourse debt. The company has ~$3.2BN  of non-recourse debt, mostly related to Solar backed notes and other auto and dealer plan securities in which debtors have no recourse to Tesla, but do have recourse to some certain collateral. A lot of these are asset-backed bonds related to Solar City, which are issued from a bankruptcy remote vehicle, have claim on cash flows from solar assets only and are also very long-dated and not of much concern (2038-2049 maturities).

TSLA Cap Table

Second, Tesla has $4.2BN of unsecured convertible notes, some of which the company can settle in stock and some of which are well out of the money. The 0.25% due 2019, the 1.25% due 2021, and the 2.375% due 2022 will be settled in cash. The converts due 2020 are also in the money and will likely be settled in stock and is relatively small. The rest are out of the money. As such, you can subtract ~$1bn off of this number.

Lastly, the bulk of the remaining debt is the unsecured notes quoted above that are trading at ~88 cents on the dollar.

To make one thing clear, just because the bonds are trading at 88 cents DOES NOT IMPLY BANKRUPTCY. It simply reflects the higher risk associated with the bond. As interest rates moved up recently, a lot of longer dated bonds have gotten crushed. Do you think 3M is going bankrupt too? Because their 2026 bonds trade at 92. What about Microsoft? Their 2026 bonds are trading at 93.5. If treasuries move up and credit spreads of the issuer stay the same or widen slightly, then bond prices must fall. Tesla’s credit spreads widen some, sure, but they were issued with a 5.3% coupon when treasuries were super low.

Therefore, while Tesla is funding a lot of its growth with capex that is hurting cash flow that is only one reason why the bonds are where they are. The move in rates had a larger impact, in my view, and the yield on the bonds is still ~7.3%, which is somewhat high, but not implying bankruptcy. (Some companies issue new debt in the high yield market with 10% yields… investors would not buy that if they thought it was a greater than expected chance of bankruptcy than surviving, it just reflects higher chance of it happening or higher credit risk).

Plus, I’ve mentioned it a lot, but this is a 2025 bond. There are no covenants. The company literally doesn’t have to worry about it until August 2025. The thing to also keep in mind is that $1.6BN of debt with banks (at a super low rate of 1% + LIBOR) and this $1.8BN debt due 2025, is $3.4BN in the context of a $54BN equity capitalization.


Let’s say Tesla wanted to reduce its debt TODAY, but needed to take it out with equity issued at an extreme discount to today’s levels. As shown below, it could take out all the convertible debt and all the credit agreement debt by issuing equity at a 25% discount, or $240 / share, and easily take it down. Sure, they would dilute themselves, but the company survives. This is just a simple example and we will show further below how large the equity cap is in relation to the the debt and total capitalization of the company.

TSLA Share Issuance 2

While headlines try to make Tesla’s debt load seem large… $5.8 BILLION or even $11 BILLION (which includes non-recourse debt which is not correct), the amount is simply is not that big compared to the $55 BILLION market cap. If it had this much debt and only a $1BN market cap, then OK, I’ll start to buy the “Tesla will go bankrupt” case. Let’s also not forget that they have $2.2BN of unrestricted cash on the balance sheet…

Capitalization of TSLA


Lastly, reports of Tesla suppliers are complaining about Tesla asking for better terms? Well welcome to Auto companies friends! Auto OEMs always pressure their suppliers for better terms. Why? Because the suppliers are beholden to a select few companies (GM, Ford, Honda, etc.) and those select few companies operate in very hard and bad businesses. As such, they are always squeezing their suppliers margins to stay afloat.

Sorry to disappoint — This article has nothing to do with valuing Tesla’s equity.

But since you asked, would I buy Tesla stock here? No. I’ve always viewed Tesla as just another auto company operating in a space where they are all piling tons and tons of cash into the industry to catch up. Does Tesla have a great competitive advantage? I don’t really think so, they just have the first mover advantage. As Warrant Buffett says,

“ You give me a billion dollars and tell me to go into the chewing gum business and try to make a real dent in Wrigley’s. I can’t do it. That is how I think about businesses. I say to myself, give me a billion dollars and how much can I hurt the guy? Give me $10 billion dollars and how much can I hurt Coca-Cola around the world? I can’t do it. Those are good businesses.”

I think others will put a dent in Tesla because I view auto companies as challenged. The industry is hyper competitive, so I think people will pour cash to chase Tesla, as mentioned. People also have a wide variety of tastes that auto companies must keep up with year-after-year and make sure they stand out against competition.  The companies also must simultaneously manage very complex supply chains on a global scale. Lastly, cars are high-ticket items, so if consumer confidence falls or we enter a recession, its easy to defer a car purchase. Meanwhile, car companies must then eat the fixed costs.

They are just bad businesses. Simple as that. But I do not think Tesla will go bankrupt soon.

Investments for High Inflation

Reading Time: 4 minutesI recently got back from an industry conference and my main takeaway was that could this year be the year of inflation. What does that mean and how should we position our portfolios? What investments benefit from high inflation?

To start, why does inflation move higher? I think it could move up soon. Anecdotally, I’ve heard from many employers from this conference that wages are up 20% year-over-year. That is significant! Recall, that wage growth has been one area stuck in low gear since the crisis, even as employment levels have recovered. As wages increase, firms costs increase and also increases consumers’ income to spend more, which helps inflation.

Turning to actual economics, demand-pull inflation occurs when aggregate demand grows fast than supply. When the economy is at near-full levels of employment, as we are now, that leads to increases in price levels. Why do I think demand will exceed supply? For one, consumer confidence averaged ~97 for all of 2017. That is the highest level since 2000, and according to University of Michigan’s economist, Richard Curtin, “only during the long expansions of the 1960’s and 1990’s was confidence significantly higher.”

Plus, the stock market is up and setting new records, home prices are up, and while these do not cause inflation, it causes a positive wealth-effect that encourages the consumer to spend more and can buoy economic growth. In other words, these are indirect causes of demand-pull inflation.

I also tend to think cost-push inflation will also occur in 2018. Take oil and its derivatives for example. While not back above peaks, as we sit with it hovering around $60/barrel, that is well above the average levels of 2015 and 2016. Similar to wages, higher costs of other inputs rising leads to higher prices.

There are a few offsets to these inflationary forces, however. The fed is raising interest rates. Higher rates in the US should drive up the value of the dollar, all things being equal. Higher interest rates attract higher foreign investment, which causes the value of the currency to rise, in this case the dollar. This makes US good less competitive on a global scale.

On the flip side however, higher inflation in the US relative to other countries will cause depreciation in the USD relative to those with lower inflation. Therefore, the impact of higher interest rates is mitigated by the fact that the US has higher interest rates than some countries, such as Japan or countries in the Eurozone which are combating deflation. The US also has a pretty bad current-account deficit (that is when a country spends more on foreign goods than domestically produced ones). We likely will continue to spend more on foreign trade than we earn, which will decrease the value of the dollar.

In addition, firms in the US will be able to fully expense capex for tax purposes, instead of the depreciation expense for tax deductions. Firms could invest in automation, crowding out labor and keeping wages down. In essence, we shouldn’t underestimate the deflationary impact technology can have. However, I tend to think this will take time.

But if I had to bet, I think inflation will tick up, which will cause interest rates to rise.


So where should I invest when inflation is high? Let’s start where I do not want to be. If interest rates finally due rise, the one place I do not want to be is low coupon, higher duration bonds and bond proxies (i.e. stocks that are highly correlated to bonds, like utilities and REITs).

I also do not want to be in stocks that have a long tail. For example, some stocks valuations are through the roof based on the expectation in 3-5 years they will be much bigger (think Biotech that will come out with a blockbuster drug). As the discount rate increases, these stocks will get crushed considering their earnings are further out. Growth stocks such as Tesla is another example of this…

On that note, we should consider that the discount rate for all stocks will be increasing. That could hurt the valuations of a lot of names as the S&P grinds higher (e.g. the S&P historically traded at 15x EPS, but now trades at 18x. Could there be a reversion to the mean?).

Where would I invest when inflation is high? I am tilting my portfolio towards commodities. Although they have had a big run in 2017, we are still well below levels seen in 2011 and 2012 for commodities. If inflation ticks up, these have room to run and can serve as a hedge to my equity holdings. Refer to the chart below to see where we sit in the commodities world compared to recent history (chart depicted is the Bloomberg Commodities Index, which is made up of energy, grain, metals, etc.)

Full disclosure, I own MOO, the agribusiness ETF as well as GLD, the gold ETF. I think both of these investments will benefit from high inflation. I personally think gold should be in a portfolio no as a hedge just against the unknown.

Second, a tertiary bet on commodities is countries that benefit from rising commodities. If commodities rise from high inflation, so should the countries that sell them.

Brazil is still coming out of one of the worst recessions it has seen in a long time in addition to a crack down on corruption. As commodities recover, labor improves and consumer confidence builds following the corruption scandals, Brazil could have a multi-year run ahead of it  if inflation improves. I purchased both EWZ as well as BRF, which tilts to small cap, consumer stocks in Brazil as a leveraged bet.

Lastly, while I am avoiding REITs since I believe investors who have been starved for yield have driven up valuations, I do like the building products sector. Real estate values tends to perform well in period of inflation, supply remains constrained, and we are still below average housing starts since the last recession. Even if interest rates rose 100-200bps, affordability is also at great levels. As such, I think building products is the sector to be in for the US.

That may sound confusing as to why I think real estate does OK in inflationary periods, but I’d avoid REITs. It all comes down to yield demand – with interest rates so low for so long, investors have bid up REIT values. I think that will unwind when inflation picks up. On a local level though, many people can increase rent with inflation and have 30 year fixed mortgages, so that should help values.

US housing Starts

-DD

Tax reform’s impact on stocks – the question NOT being asked

Reading Time: 2 minutesA lot has been written about the Tax Plan passed at the tail end of 2017. I recently wrote a post on, while I think the plan is very beneficial to US equities, some considerations we should have on the rest of our portfolio.

And not to be a debbie downer, but I am here again to discuss some questions that are not being asked here. If you’re buying individual stocks today, I think the main underlying question for investing in that company comes down to one thing: Does this company have a strong competitive advantage?

In highly competitive industries, typically those that compete solely on price or sell commodities and have little differentiation, these tax benefits may soon be competed away.

Consider a distributor, which typically sells many goods and the only value it adds is perhaps customer service. Grainger has been an example of a distributor that has faced headwinds from price competition as customers look to Amazon for cheaper products. Take a look at GWW’s stock chart over 2017 to gain an understanding of this impact (stock was down 3-4% when the S&P was up 20%).

GWW’s stock really started to recover at the end of the year, one from earnings being better than feared on low expectations, but also due to its tax rate which should decline from 38%.

Given GWW’s heightened competition, due you think those savings will be used for buybacks or high return projects, or do you think they’ll be used to compete and maintain market share? Let’s say you think that’s fine if they use it to maintain share, as they’ll be in a better position. Well, do you think Amazon and other competitors won’t also respond?

Also consider the recent hikes in minimum wage from companies and $1,000 bonuses. They are doing that to attract and retain talent, which is simply another form of competition.

Hopefully you can see what I am getting at. Low competitive moat industries likely will compete the savings away. While the tax rate will be low, returns on capital may end up being the same.

-DD