“Never in the field of human conflict was so much owed by so many to so few.”
– Winston Churchill
Never in the pursuit of disruption has so much cash been incinerated by terribly managed firms to so few investor protests. Uber and Lyft are, in many respects, just taxi companies with automated dispatch. Tesla makes electric cars, a clever 19th century innovation. WeWork rents office space. Would these businesses be even modestly disruptive without investor willingness to tolerate and subsidize losses? We doubt it. That these companies can grow by selling a dollar for ninety cents should surprise no one. In just the first half of 2019, these four companies reported combined net income of negative $10 billion. They are valued at only 15.5x half year losses, a bargain for ‘absolute value’ investing if not Full Cycle Investing.
Of course, we may hear about how Amazon succeeded. And who knows - maybe these companies won’t compete each other to death in pursuit of scale or network effects or whatever KPI defines winning this quarter. But public markets can be moody, impatient, and, at times, brutal; these growthier names haven’t performed well in recent volatility. And one issue with these absurd companies is that they make other market absurdities seem tame by comparison.
Take Rollins, owner of the Orkin pest control service and a late 2018 best ideas short addition. ROL was trading north of 60x earnings heading into its 1Q19 earnings report and is still at 47x after two earnings misses. That’s an extremely high multiple for a mature, GDP-ish growth business facing competitive entry and other structural problems. For many, however, it just didn’t look so bad, at least relative to the really bad stuff. Insperity (NSP), a 1H19 best ideas short addition, was similarly overvalued into 2Q19 earnings despite slowing employment growth and decades of volatile results following tax legislation. As we understand it, three years of accelerating GDP growth let these divergences widen and fester; in recent months, decelerating growth has been cleaning them out, often abruptly.
Decelerating GDP growth is a dicey environment for ‘classic’ cyclicals, too. Sales of equipment are usually comprised of replacement demand plus fleet expansion. If certain equipment lasts 10 years and the age of that equipment is evenly distributed, about 10% of the fleet gets replaced each year. If that whole fleet grows at the rate of GDP, and GDP is growing at 4%, industry sales will be ~14% of the fleet (replacement + fleet growth). If GDP growth slows to 1%, industry sales would slip to 10% replacement demand plus 1% fleet growth, or 11%.... a rough 20% decline in a growing economy. That is how the US could experience an industrial contraction absent a recession in 2016, a scenario that is most likely playing out again in 2H19. Many of classic cyclicals are already ‘down’, but some, like late 2Q19 best ideas addition Cummins (CMI), still look like very promising shorts.
The delinking of valuation from fundamentals isn’t only in financial assets. Farmland looks as absurd as Rollins, if not Tesla. Farmland Partners, a REIT, lists the “market cap rate based on gross rental income” as 2.8% for corn belt land. However, farmland prices have started to reset lower and dominates farm balance sheets. As we see it, Deere, which reported this morning, is another cyclical that has yet to reflect a decelerating growth environment. At first read, it looks like a miss with some weak internals on guidance, particularly on US and Canada Ag. US agricultural equipment inventories are elevated, trade rows have hurt demand for US crops, but farmland is the key valuation anomaly.
Of course, it isn’t just TSLA, ROL, and farmland – negative interest rates on government debt abound. The US 30-year yield hit another all-time low yesterday, and it was hard to get a broker on the phone to ask about refinancing. That’s a potential tailwind for our longs in building products, like MHK and OC, and an outstanding call by our firm’s macro team.
But an all-time low in 30-year yields at the same time as a 50 year low in unemployment? Message boards with Tesla shareholders declaring that they own shares not to make money, but to be part of the ‘transportation revolution’? Beyond Meat? Netflix? Or just the “We Co” S-1 related party section? We’re starting to feel less like the greatest generation and more like the greater fool generation.
Our immediate-term Global Macro Risk Ranges with TREND signal in brackets are now
UST 10yr Yield 1.51-1.69% (bearish)
UST 2yr Yield 1.48-1.69% (bearish)
SPX 2 (bearish)
NASDAQ 7 (bearish)
Utilities (XLU) 59.31-61.61 (bullish)
REITS (VNQ) 87.67-92.13 (bullish)
Financials (XLF) 25.59-27.22 (bearish)
Nikkei 203 (bearish)
DAX 116 (bearish)
VIX 15.85-25.73 (bullish)
USD 96.95-98.36 (bullish)
EUR/USD 1.10-1.12 (bearish)
Oil (WTI) 50.94-57.02 (bearish)
Gold 1 (bullish)
Copper 2.52-2.63 (bearish)
Have a great weekend.
Jay Van Sciver
Industrials Sector Head
