Weekend thoughts: "easy" opportunities and what am I missing?
At the beginning of the year, I was asking “what am I missing” a lot. In particular, I thought cyclicals and sporting goods stores looked way too cheap. The high level thesis was these companies were producing record results and buying back shares pretty aggressively, yet the market refused to give them credit for the results and they traded for insanely low multiples.
I’ve been thinking about those posts recently. I’m hearing from lots of friends about companies and set ups that seem no brainers. A few hypothetical examples (that are very similar to current pitches I’ve heard):
Across the board, commodity companies still look cheap. Six months ago, oil and gas stock prices probably implied a curve ~$10 below where the market was pricing (I.e. if the futures curve was ~$70/barrel, most energy stock prices implied ~$60/barrel). Today, many of those oil companies have seen nice appreciation, but the appreciation far undershoots the current oil curve (I.e. the stock now implies ~$65 oil, but the oil curve’s moved to $80).
I used energy stocks above, but you could use the same logic for just about anything touching the current commodity boom. Fertilizers, refiners, etc. All of them are minting money right now, and they’ll print a huge piece of their market cap at the current curve. At current prices, the stock market is basically implying no terminal value for these businesses.
Another way to frame the commodity / energy opportunity: There’s a big divergence between the futures curve and the price implied by the stock market; there should be opportunities there.
I’ve mentioned the “rumored deal” set previously, but it seems there remains huge opportunity there. Stocks with insider buying and offers from financial buyers continue to trade at huge discounts to the offer price until a deal is officially locked down.
Honestly, it’s got me a little nervous. In investing, deep insights that make alpha are rare. A lot of times, you get paid for assuming risks that you don’t realize you’re taking. Investors in Lehman Brothers made huge returns for years…. until it all got taken away because it turned out they were taking on huge illiquidity and accounting risks. Often, you can make a fortune in commodity plays because you’re implicitly making a bet on the commodity curve, and if the curve goes up you make money but if it moves against you you get demolished.
I keep looking at these situations and wondering what I’m missing. On the commodity plays, you’re buying with built in “if the curve moves down 20%, the stock is still undervalued” protection. Many of these “rumored deal” stocks look incredibly cheap even if their deals fall through (or never get finalized), and they often have insanely strong balance sheets that would allow them to aggressively return capital if they decide to remain public.
The market is a very competitive place. There’s generally not easy alpha laying around, and if there is “easy alpha” it’s generally because there’s lots of risks you’re missing….. but there’s lots of situations I see at that look “easy”, and that’s got me worried.
What am I missing?
Let's just wait until (1) Consumer Confidence hits at 10am ET today haha; (2) We start moving into 1Q'22E earnings where mgmt finally starts to say that they're seeing weakened consumer demand; and (3) We near 5/4, the next FOMC meeting and pending ~50bps rate hike, and more importantly, how big daddy, Powell figures out how to unwind the b/s
A few things you could be missing:
· IMO, a lot of massive spikes we've seen across commodities and commodities related equities has been heavily exaggerated by retail trading particularly via trading community platforms, groups, etc. hopping from the new hot name/sector with a very short attention span. Their heavy trading in short-dated options and other derivative products in less liquid names once again causes gamma squeezes and those stocks to rip. This attracts more retail and institutional attention further driving these stock prices up until retail crowd, which is trading off (technicals & trading charts, news headlines, and hype) gets exhausted and/or bored before moving on to the next hot sector play.
· This commodities spike has largely been driven by supply side constraints vs. the demand side, and my concern would be flash crashes in commodities prices once they become unstainable as they flow through the economy on a lagged basis. And how quickly those commodities related stocks sell-off
· If you take a look at 2023E-2024E estimates, I've noticed that Consensus estimates for Energy or Agriculture/Fertilizer stocks are lower than 2022E likely implying analysts are assuming commodities prices normalize, so (1) Until we have clarity or you have a strong view on the sustainability of higher pricing; or (2) We get into 1Q'22E and 2Q'22E earnings where mgmt and analysts start updating their estimates. Would be much more inclined to buy these stocks when earnings are increasing into 2023E-24E, and thus, have lower multiples than this year (2022E).
· Energy stocks (more E&P & Oilfield Services) stocks had already been significantly outperforming this year through Jan-Feb-22 due to rising oil prices & market rotation from high-growth/high-multiple/unprofitable stocks to more "value" (hate how this is constantly thrown around, and should be better defined). Take DVN that was nearly up ~20% already on a YTD basis through Feb-22.
· Then when the Ukraine/Russia conflict really began to escalate around 2/25-2/28 and caused oil prices to erupt from the low $90's to over >$100/bbl, Energy stocks obviously ripped immediately. DVN ran up another ~18% in the month of March alone up ~37% YTD
· However, after oil prices seemingly went parabolic and kind of peaked above >$120/bbl on 3/8 (I sadly expect this was a temporary peak), Energy stocks have seemed to trade in tandem with daily oil price moves
· As a previous comment mentioned, the increasing push for ESG initiatives have restricted some Institutional money from investing in certain Energy stocks
· They were also a very low % of the S&P coming into the year, so we have seen and will likely see increased exposure to the Energy sector
· I think nearly every recession has coincided with an oil price shock. And if oil prices continued to rise (1) exasperating already strained supply chains; (2) Fed hiking rates and reducing its $9tn b/s; (3) Commodities inflation spiking as well, it created the perfect storm for a sharp demand shock and recession. This would put a cap on Energy stocks or a temporary plateau despite their valuations still screening attractive
· Somewhat similar setup to Energy stocks, as they already had strong performance into the Ukraine/Russia conflict benefitting from increasing fertilizer prices
· The input costs for Fertilizer producers have also skyrocketed since they require certain gas or chemicals, so that's a big risk to implying earnings upside solely off higher fertilizer prices
○ For example, European fertilizer plants are cutting production because of higher energy prices
· There's also the impact that higher fertilizer prices and the sustainability it has on Farmers and that whole dynamic (Fertilizer can comprise ~20%-30% of crop expenses). Farmers may move to lower yielding crops that require less fertilizer, or try to stave off using as much fertilizer until next season hoping that fertilizer prices will come back down to earth
· Risk that gov't intervention could cap pricing given the significance and huge risk of a global food shortage
A few things you AREN'T missing:
· Other than trying to quantify or think about the risk to the topline side (1) from demand shocks and how much commodities-linked pricing could fall, and on the expense side (2) higher input costs and margin compression, I definitely agree these still look attractive particularly Energy names
· Attractive dividend yields that are still in the >4%-6% range, and I'd expect those to be raised throughout the year has helped give me additional comfort around downside protection for these stocks especially in an inflationary environment
· Since I have the view that oil prices will remain elevated over the N-T and M-T (2-3yrs) above what Energy stocks seem to pricing in (call it ~$70/bbl), I'm expecting further upside to consensus estimates in 2023E-24E. (E.g. Expect economic sanctions on Russia to remain in place for 5-10yrs+)
· New World Order/Onshoring/Continued Restructuring of Supply Chains:
○ And more importantly, Energy has become a national security concern, and buyers are more likely to reduce their energy dependence on Russia
○ Agriculture/Fertilizer stocks should also benefit from onshoring for national security purposes given Russia's one of the biggest producers. That's why I've been trying to nibble at those 2nd derivative beneficiaries like MOS, NTR, and CF
· Given I've missed some of the rally in the Metals stocks like X, CLF, CENX, AA, etc., I've been trying to look internationally at those beneficiaries like in Australia and Brazil, which are more Commodities heavy economies and likely to see increased demand due to this shift in the world order and reliance on Russia's exports
· For me, I think it's very interesting to focus on these 2nd or 3rd derivative plays that may be beneficiaries from this restructuring, so the energy names I like tend to have much more domestic exposure. I've bought some Natural Gas players like CTRA
I'd argue for certain Cloud/SaaS names and other Tech names will be very attractive on another big pull back/drawdown over some cyclicals, but can leave that for another day or long ass post lol
Wrt energy (particularly oil and gas), it may be a matter of funds flow. Clearly, lots of institutions will not or statutorily cannot own these businesses.