Category: Contrarian Corner

Special Situation Follow up: Bayer Glyphosate Liability $BAYN

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I did a previous Bayer post back in 2019, as the the market seemed to be implying a massive liability for glyphosate. I know how tough it is to clink a link, but highly encourage readers to look at what the market was / is pricing in for Bayer’s liabilities. It made / makes little sense in comparison to other liabilities in the past and relative to what glyphosate is – a chemical which the EPA basically goes to the mat on saying it is safe.

Specifically, the EPA states:

  • No risks of concern to human health from current uses of glyphosate.
  • No indication that children are more sensitive to glyphosate
  • No evidence that glyphosate causes cancer in humans. And they add: EPA considered a significantly more extensive and relevant dataset than the International Agency on the Research for Cancer (IARC).
  • No indication that glyphosate is an endocrine disruptor

I mean, think about it. Glyphosate is the most widely used chemical out there and one of the most studied. I don’t think the government is some evil entity that would hide whether it caused cancer or not. Nor do I think they’d allow it to continue if there was any doubt.

It is highly concerning that a jury can say that a chemical causes cancer, when in fact the evidence shows it does not. That is a slippery ethical slope.

Since then, Bayer has won 3 other cases determining that glyphosate did not cause cancer. I guess in the future one state can say it does and another says it won’t? Hm.

Maybe not. The Supreme Court may hear Bayer’s case. Or they may not. But given this situation I discuss above, it seems like they should!

If Bayer’s case is heard, they could help resolve about 31,000 cases against it AND a huge overhang on the stock.

If Bayer’s case is NOT heard, I think we’re basically in the same situation where Bayer will slowly but surely have to prove its case one by one. That seems more priced in (dangerous words of course).

Bayer currently trades for 7.4x ’23 EBITDA – this is for a pharma and consumer health giant (that also owns Monsanto and legacy Bayer crop protection which is just 40% of EBITDA). Merck and Bristol Myers Squibb trade for around 10x ’23. Is the market implying Bayer’s crop protection biz is worth, like 4x? That is crazy. Especially for me who is someone who thinks the glyphosate liabilities are overblown. They actually announced they are selling a piece of the business for 12x. Hm, maybe just keep doing that?

Last, we have also seen creative ways for dealing with liabilities, like the talc liability and asbestos. To be clear, I think glyphosate is nothing like those. Those actually caused issues! But I am sure Bayer is running through the options to mitigate risk…

I could see 25-30% upside on Bayer from some sort of resolution and even then I don’t think it’d look expensive.

Stay tuned!

Opportunities in the Muni Meltdown

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First, some personal news. My wife and I have been blessed with our first child, so I’ve been a lot less active on here lately. That said, I’ve been watching the turmoil pretty closely in the market. In particular, the bond market is starting off with one its worst years ever… and it is only April…. And it is happening when the S&P trades off, which is atypical. 

I’ve written before about how bonds probably have a place in your portfolio, despite what you may think of as a low yield. They offer a hedge. Last time I wrote this of course was the last Fed tightening cycle. You would’ve done quite well buying bonds at that time, actually. 

I write this today, treasuries are up, stocks down, with people forgetting about inflation for the moment and fearing whatever other flavor of the month they can dream up of (hard landing in China, War in Europe, Japan devaluation, global recession). 

Despite the barrage of headlines on inflation, I think the risk that still few are talking about is the bust on the other end as the Fed does begin to tighten as demand cools. I wrote about it in my bull-whip post,  and I think a lot of what we are seeing right now can be traced to supply chain issues.

Oil and commodities are a bit different, as they are rising due to the capital cycle playing out as well as another supply chain issue called “war.” Oil price increases, to some extent, is a bit different than just general inflation. 

That all said, as the Fed does slow things down, how many containers of goods are heading here right as demand softens considerably? Hm.

I won’t dwell on this because I doubt I will convince many people one way or another. From my vantage point, I’ll end by saying I am seeing a lot of normalization (or at least things not getting worse) right into a hiking cycle. 

Carnage in Munis

The PIMCO intermediate muni bond ETF is down ~7.5% YTD and the iShares muni ETF is down almost 8%.

That’s tough when starting yields were low. Heck, a 30-yr treasury issued in May-2020 is down 43 points from issuance. Tough when the coupon is 1.25% and the yield is still below 3%.  

However, the carnage leads nicely into what I am looking at buying.

I am in the highest tax bracket and live in Massachusetts. If I can find a 4% yielding MA Muni bond, that’s like finding a near-7% corporate bond. Out of state, a 4.0% muni is still like looking at a 6.2% corporate, as the table below shows.

It isn’t simple to make that comparison, though. High-yield (read: junk bonds) are currently yielding about 6.5%. So finding a corporate bond with equivalent yield to a Massachusetts General Obligation bond isn’t quite apples-to-apples (MA GO bonds are rated AA). 

Can we find any bonds that meet these criteria? 

Part of the “problem” of getting these yields in muni land is you have to accept long term maturity risk, i.e. duration. However on the flipside, locking in a 7% corporate tax equivalent for a long period of time also seems attractive to me.

Further, many Americans own real estate like myself, with 30 year mortgages locked in below 3%. So again, finding a 4% completely tax free bond seems like an attractive use of capital when I am technically short a 3% mortgage at the same time. Let me break down three interesting examples that I found in my search:

Dulles Toll Road (CUSIP: 592643DG2)

The second bond example is the DC Dulles toll road bond. This bond is backed by the revenues generated from the toll road to the Dulles airport of which there are few low congestion alternatives. At 81.625, this bond yields 4.1% to maturity. 

Revenues in 2021 were already coming back to 2019 levels, which supports that this road (and airport) are relatively resilient. Omicron did throw results under the bus compared to budget, but the trend back is obvious. 

For context, 2020 operating revenue declined by 38.2% vs. 2019. Bad, but not “completely shut down” bad.  

You could buy the first lien bonds, but I like the sub notes (third liens) for several reasons. First, the 1Ls are 0% coupon and I’m not going that far (yet). Plus, lien has a segregated reserve fund. The first three liens are funded at the lesser of the standard three prong test: 10% par; 125% average annual debt service (AADS) or 100% maximum annual debt service (MADS).

There are a few attractive covenants (iii and iv matter for these bonds). Rates charged for the toll road must provide net revenue in a fiscal year of at least (I) 200% maximum annual debt service (MADS) of all first senior lien bonds, (ii) 135% debt service of all first senior and second senior lien bonds, (iii) 120% debt service of all first senior, second senior and subordinate lien bonds and (iv) 100% debt service of all outstanding bonds. 

According to the financial disclosures they also have over 2,000 days of debt service costs on hand in cash and there are limited capital improvement projects on the horizon. We could have another pandemic for 6 years and they could still pay interest.

In essence, there is decent coverage here.  

However, due to the pandemic and a development project, this bond is rated A- (but wrapped by Assured Guaranty). I think travel will resume and has already resumed post pandemic and this seems like a strategic asset.  

I am BTFD. 

Mass 2% GO Bond (CUSIP: 57582RN93)

The Massachusetts 2% GO Bond due 2050 (I know, I know, that’s far out but hear me out), was recently trading at 95-100 cents on the dollar. Currently, they are trading at 65 cents on the dollar for a 4% yield to maturity.

This is backed by the full faith and credit of the state of Massachusetts, which I am willing to bet on.

One problem with munis like this is that buying them significantly below par opens up excess discount taxes. These rules are somewhat absurd, but if you buy a muni bond too far below par you may have to pay ordinary income taxes on the discount to par value. That said, in a world where these bonds have some chance of going back to par within the next 10 years. I’d gladly pay that tax.

By my estimates, I could see the potential for a 10% IRR using the assumption that they could go back to 2021 prices at some point in the next 10 years. 

Charlotte Water & Sewer (CUSIP: 161045QQ5)

The last bond is another Charlotte Water & Sewer revenue bond (CUSIP: 161045QQ5). This yield is lower, at 3.70% YTW, but this is a AAA bond (what is the US Federal Gov’t again?). That’s like buying a 5.75% AAA corp bond or a 4.90% treasury. 

Charlotte is a large, growing populace. The raw water sources are ample and the water treatment plants have an average 29 year life remaining. Net revenues are growing, debt is falling, and this also has about 500 days of cash on hand. Did I mention it was AAA? 

What Does The Manufacturing PMI Tell Us About Forward Stock Returns?

Reading Time: 2 minutesWhen you think about all the articles being written about shortages and fears of inflation, it seems like the US economy is doing very well. You can’t really have those things without consumer demand. Indeed, some are calling for GDP growth of 8% in 2021 and a big increase in inflation.

I’m a little cautious on the GDP growth in 2021 causing sustained inflation (mainly because its high growth lapping a year that was beaten down) (as I previously wrote about). Let’s not confuse a one-time increase in prices with inflation…

But I also get pretty cautious when everything I read is all the same – “a boom is here.”

One piece of data that gets thrown around is ISM Manufacturing PMIs. The latest reading was 64.7%! It’s well above pre-COVID levels.

As they say on their website:

A Manufacturing PMI® above 43.1 percent, over a period of time, generally indicates an expansion of the overall economy. Therefore, the March Manufacturing PMI® indicates the overall economy grew in March for the 10th consecutive month following contraction in April 2020. “The past relationship between the Manufacturing PMI® and the overall economy indicates that the Manufacturing PMI® for March (64.7 percent) corresponds to a 6.2-percent increase in real gross domestic product (GDP) on an annualized basis,” says Fiore.

Now, a PMI is a “purchasers managers index” and is basically a survey from a wide array of companies in manufacturing in the US. It basically is asking, “are you growing or shrinking?” across a wide array of topics.

Investopedia says, “when the index is rising, investors anticipate a bullish stock market in reaction to higher corporate profits.”

Actually – it can really be used as a CONTRA indicator.

I went back through the data to 1960 and checked the 6-month, 12 month and 18-month S&P500 returns after the manufacturing PMI was at certain levels. It’s not perfect, but its something.

I’ll just put the data out there – would you rather swing hard with the index around 65? Or below 43? There aren’t many cases when it goes above 70, but that generally does not have a good track record.

Look, I try not to market time. I’m typically nearly-fully invested. But I also understand there’s a time to own some names (e.g. cyclicals) and time to eh… maybe cool it and wait for a better day.

3D Printed Homes Aren’t New

Reading Time: 3 minutesI’ve seen many articles recently about the future of 3D printed homes. It sounds extremely exciting – pick a design, and the 3D printer goes off and creates the home with less waste and less labor and hopefully less price. There have been several recent articles such as this home listed on Zillow for a low price, this new startup that’s starting to build 3D printed communities in the desert,  and these 3D printed homes in Austin which aim to be a more mid-tier offering.

3d printed homes

Wait a second – aren’t 3D printed homes this just another name for manufactured housing? Seriously. Compare the picture above (3D printed home) with another graphic of a manufactured home from Cavco.

Cavco manufactured home looks just as good as 3D printed homes

Tying this into this blog, which is investment related, I just did a post on Skyline Champion and Cavco, which prefab homes in a manufacturing site and then send it along to the plot of land desired by the customer. The difference seems to be having a cool name for your process and doing most of the manufacturing onsite.

This home listed in Long Island was for sale for $300k – lauded for its ability to sell at a material discount to homes in the area. But my guess is that’s probably the same price / more expensive than what manufactured housing offers from Clayton, Cavco or Skyline. And the 3D printed house looks…. mehhhh. In this case, the true cost of this home likely came down to lot value in Long Island.

Let’s call a spade a spade…

I struggle to see how 3D printed homes will disrupt current manufacturing processes, especially in comparable product categories. A lot of these 3D printed homes still need fabrication work onsite after they are completed, too.

Here is the cement-based 3D printed home. The machine builds the structure by adding layer and layer of cement, but it looks like the guts of the home are still fabricated without machines. Not to mention you still need someone to install windows, doors, cabinets, countertops, and electrical work.

My guess is that, today, you can only build these structures where the land is very flat – otherwise it will throw off the machine. Technology improves, but it will improve in the manufacturing process in “traditional” areas too.

Many prefab techniques already exist and are continuing for onsite construction. For example, distributors like BuildersFirstsource often assemble the trusses for a home, or they will precut the wood ahead of time so the frame can easily be stood up on the home (BuildersFirstsource has a brand called Ready Frame which is an interesting watch if you have the time).

This same thing happened in Japan, where manufactured housing and 3D printed homes are more commonplace. Much has been written about applying what Japan does to the US.

But outside of low-cost housing, however, Americans desire too much choice and they might as well choose a Clayton Home over a “Google-backed startup” 3D printed home. Japan differs a bit too, in that their homes depreciate over time, whereas everywhere else they appreciate. So it makes sense to build cheap and quickly, raze it later, and start fresh.

We clearly need housing solutions. There is a housing shortage in the US, as I discussed in this post. I worry about that shortage leaving groups of people in the US behind. And I am afraid our employment trends mean that the shortage in construction trades will likely get worse. This will continue to drive up the cost of building. It’s no wonder why there are growing calls to democratize housing.


But solutions have been discussed in the US literally for 90 years. Architect Buckminster Fuller had the idea for a “Dymaxion House” which was a aluminum, grain silo-looking house that could be shipped and easily assembled with less waste. Frank Lloyd Wright did as well. The idea being that if the automobile was being democratized, so should housing.

Obviously, it never panned out.

The undertones sound exactly the same as today as the 1930’s, though. We need to improve cost, we need to save energy, we need to become more efficient. Democratize housing.

We have solutions to that today, but either consumers aren’t choosing it, there are zoning issues, or something else.

I personally have trouble seeing 3D printed homes offering a meaningful solution in the near term.

Contrarian Corner: Inflation is a Consensus Bet. Look at Deflation $TLT

Reading Time: 5 minutesI’m thinking of starting a new segment called, “Contrarian Corner.” In these posts, I will try to point out the other side of a company perception, trade, or view that I see as pervasive in the market.

When everyone crowds to one side of the boat, there are typically better opportunities to sit on the other side.

Right now, it seems “inflation is coming” is a pretty consistent view. (Somehow, the people shouting inflation think they are contrarian?) Every report, article, or tweet is talking about it…. I really try to avoid macro talk, but this is too good to pass up.

My favorite example of this is pointing to lumber prices as an indicator of runaway inflation.  This totally ignores prior supply / demand dynamics that led to this surge. To me, its picking a data point to support a view.

I follow lumber prices, so I know why they are up. Canadian lumber is high-cost supply. The crash in prices in 2018 meant many mills to the north were unprofitable and were curtailed. Add in forest fires and impact from the Pine Beetle and supply was constrained. Lastly, Canada implemented caribou protection which curtailed logging activity. Lumber prices were still very low so even mills in the US shut. Now that housing has come back strong, this caught supply off guard and prices surged.

Is that inflation? Or is that a short-term supply demand imbalance? Prices are now at a level where everyone can make money if they can get supply back online. Would you make a bet with me that lumber prices will be higher than where they are right now in 3 years?

There are other examples of this. I’ve discussed oil (prices are up and rig count is at multi-year lows) as well as housing (underinvested post-GFC), and used car prices. Each of these are specific  supply / demand issues or the bullwhip effect.

Is that persistent inflation? Is a one time rise in prices due to a demand shock (COVID lockdown), that resulted in a supply shock, inflation?

The reason why *persistent* inflation matters is because that is what is going to move long-term interest rates.

So Why Deflation vs. Inflation?

First, its that the government’s use of debt to stimulate is suffering from declining marginal returns. Second, its that M2 is NOT what drives inflation. Its also velocity, which continues to decline.

As the National Bureau of Economic Research stated in a 2010 study (my emphasis added):

The median growth of the 20 advanced nations in this study fell by half as their debt levels moved from less than 30 percent of GDP to 90 percent or more. The drop-off was particularly significant at the 90 percent threshold: between 60 and 90 percent of GDP, median growth was still 2.8 percent; above 90 percent it was 1.9 percent. The drop in average growth between countries with debt ratios of 60-90 percent of GDP, and those above 90 percent of GDP, was even greater: 3.4 percent to 1.7 percent

What happens when you go from 100% to 120%? Japan is approaching 200% debt to GDP and we all know the impacts there (their central bank also straight up buys equity ETFs)

Essentially, the marginal benefit we  get from adding a new dollar of debt is going down. And has been for quite some time.

Yes, the coronavirus stimulus was big. But a lot of it also went to plug a big hole in the economy.

We had stimulus checks. That put money directly in the pocket of consumers, but it didn’t create a new income stream for them. Wages didn’t go up and in my view and so the spending will be a 1x boost in some select sectors. Unless all the debt we just used goes to create a new income streams, all we’re doing is exchanging current consumption for future consumption.

Velocity of money is going down.

I’m going to let Dr. Lacy Hunt explain the next bit. For context, he’s a manager on Hoisington bond fund and has been right on bonds for about 40 years (i.e. he’s been long duration). I highly recommend his investor letters. All of these are quotes from his Q1’2020 letter, with my emphasis added:

  • When the Fed buys government or agency securities from the banks, holdings of government debt declines and the banks’ holdings of deposits or reserves at the Fed go up.
  • The bank balance sheet is unchanged except that the banks are selling government paper of longer maturity and they receive an overnight asset at the Fed. Those deposits do not circulate freely within the economy. (Diligent Dollar Note: QE is not just printing money)
  • If the Fed’s purchase of the debt is from non-bank entities, there will be a transitory rise in M2. Further M2 expansion from that new level will depend on the banking industry. The banks high level of reserves at the Fed will result in no further increase in money unless they and their customers make the collective decision for new bank loans to be originated and the loans are used to expand economic output
  • This is what happened in 2010-11. M2 surged transitorily to a nearly 12% rate of growth along with an increase in loans. The money and loans were used to shore up financial conditions rather than channeled into the purchase of new goods and services. As such, the velocity of money fell dramatically, and the Fed’s purchases of securities did not lead to increased economic growth and inflation. After financial conditions were stabilized, the depository institutions held large amounts of excess reserves.

I feel like the first two bullets need re-emphasizing, because a lot of people associate QE with money printing. Joe Weisenthal put it (again, my emphasis added):

When the Fed buys a Treasury, what it’s really doing is replacing one kind of government liability (maybe a 10-year Treasury) with another kind of government liability (an overnight reserve held at the Fed). If you’re a bank that sold a Treasury to the Fed, you’ve given a long-term asset that yields something for a short-term asset that yields something else. No new money has entered the system. The government doesn’t have any less debt. All that’s happened is that the consolidated government balance sheet (the Treasury and Fed combined) has shortened the term structure of its liabilities. After the Fed buys a Treasury there’s less long-term debt outstanding and more short-term debt outstanding. That’s it.

Bottom line: in order to actually get a boost to GDP and inflation, you need the velocity of money to go up.

All these headlines of GDP growth in 2021 tend to be missing the point. If we have 8% growth in GDP following a year where GDP was down 3.5%, then you just have 2% growth on a 2-year basis. That’s not that great considering all the debt taken on. And then you actually need the banks to lend out the capital, but that depends on risk they see in the market, returns, and whether people need the capital for investment.

Add in worsening demographics (and I think its possible we are sitting where Japan and Europe are sitting 5 years from now.

I think what will happen is inflation expectations will continue to rise short-term as the economy re-opens and we have some supply constraints that gives further pseudo-inflation scares, but long-term the writing will be on the wall.

So bottom line: Do I think reflation will happen? Yes. We will be lapping a serious decline in our economy and there are supply constraints. Do I think those supply constraints will be overcome? Yes. And therefore, I think we will continue on the longer-term deflation trend.