Cheap vs. Expensive | The Threat to Incumbents

 

“Business is the systematic playing of games.” ― Reid Hoffman

 

We gathered some data on the changes in the make up of S&P 500 Index over time and did some good old fashioned number crunching in MS Excel. In this week’s piece we share some of the analysis and insights from this number crunching, which covers the following:

 

  • Price-to-earnings spread between ‘expensive’ and ‘cheap’ constituents of the S&P 500 Index;
  • Return profile of stocks added to the S&P 500 Index between 31 August 2017 and 30 April 2019; and
  • How the largest US companies, in a rush to return cash to shareholders, may be unwittingly setting themselves up to be disrupted.

 

As a disclaimer, the analysis presented below is neither meant to paint a bullish nor bearish picture. We have, however, on a number of occasions in the last year expressed our constructive view on the market, most recently here and prior to that here.

 

Price-to-Earnings Differential

 

The below chart presents the trailing price-to-earnings ratio spread between the 25th and 75th percentiles for the constituents of the S&P 500 Index ranked by their trailing twelve month price-to-earnings ratio.

 

A rising line implies that the spread between the upper and lower quartiles is expanding or simply put expensive stocks, in terms of trailing price-to-earnings, are getting even more expensive relative to cheaper stocks.

 

Differential Between 25th & 75th Percentiles TTM P/E Ratio of S&P 500 Constituents

PE Differential.png

Source: Bloomberg, S&P Global

 

The dashed lines in the above chart are the levels marking +/- 1 and +/- 2 standard deviations from the average TTM P/E ratio differential between the 25th and 75th percentiles.

 

As can be seen in the above, this is yet another market metric reaching levels last seen during the tech bubble.

 

S&P 500 Index Inclusion: Return Metrics

 

For a stock to be added to the S&P 500 Index is quite a big deal. The sheer amount of passive and non-discretionary assets tracking the S&P 500 Index means that any stock included into the index should see an uptick in its trading volumes and a near perpetual bid from S&P 500 trackers and ETFs.

 

What, however, does inclusion mean in terms of returns for investors holding stocks included in the S&P 500 Index? We try to answer that question by looking at a relatively small sample: stocks included into the index between 31 August 2017 and 30 April 2019. We are aiming, in the next two weeks, to extend the sample set to as far back as 1 January 1990 and also to include the impact on stocks dropped from the index.

 

Post Inclusion Alpha
1 Month 3 Months 6 months 1 Year
Average 0.73% -3.46% -3.12% -7.32%
Median 2.54% -1.42% -5.91% -6.39%

 

Based on the analysis of the limited sample, it suggests that one would be better off, one average, selling a stock that has been included into the S&P 500 Index immediately after its inclusion and buying the S&P 500 Index instead.

 

The data set used for the above calculations can be found here.

 

Research & Development

 

According to alternative assets data provider Preqin, at the end of 2018 the amount of dry powder committed to private capital funds and investment programmes stood at US dollars 2 trillion, of which approximately US dollars 400 to 450 billion was committed to angel investing and venture capital funds. To put that in context, the amount dry powder available to angel and venture capital investors as recently as 2014 was estimated to be in the range of US dollars 100 to 150 billion dollars.

 

An estimated three-fold increase in the amount of capital gives venture capitals a lot of money to throw at a lot of problems.

 

We recently listened to a podcast featuring famed venture capitalist Bill Gurley in which he passingly mentioned something along the lines of incumbents being more at risk of being disrupted today than ever before.

 

This got us to thinking that what if US corporations were prioritising returning capital, through buybacks and dividends, to investors to such a degree that it was coming the expense of the future profitability of the respective businesses?

 

While we do not have an answer to our question, we do have some interesting data to shares.

 

R&D Expense as a Percentage of Net Sales (Average) for S&P 500 Constituents 

RD Exp Sales.png

Source: Bloomberg

 

There appears to have been a structural step down in the amount of money, as a percentage of net sales, that has been invested in research and development following the Global Financial Crisis. There was a spike up recently, we suspect that is due to US tax reform and the repatriation of non-US profits.

 

Year-over-Year Growth in R&D Expenses (Average) of S&P 500 Constituents 

RD Exp Growth.png

Source: Bloomberg

 

Similarly, even in terms of absolute dollar amounts, there has been a slowdown in growth of absolute dollars being invested in research and development by the constituents of the S&P 500 Index. This is all the more surprising given the makeup of the S&P 500 has shifted in favour of healthcare and technology companies over the last decade. Healthcare and technology companies are generally known to be heavy investors in research and development. Businesses operating in the more “old economy” sectors are, it seems, investing even less in research and development.

 

Average Cash and Marketable Securities Balances for S&P 500 Constituents

Cash.png

Lastly, the above chart is of the average cash and marketable securities balances of S&P 500 constituents, excluding major financial services businesses.

 

The largest corporations in the United States are draining their cash in financialisation at a record pace just as their predators in the venture capital industry have been building up their war chests. The picture gets even worse once you exclude the major technology companies with large piles of cash ready to be invested in acquiring and developing up and coming technologies.

 

Low interest rates did not encourage large US corporations to invest, rather they encouraged financialisation. The unintended consequence of which may be the death of the incumbents.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

Durability of the US Bull Market

 

“Having insurance doesn’t guarantee good health outcomes, but it is a critical factor.” ― Irwin Redlener

“Seeing the bigger picture opens your eyes to what is the truth.” ― Wadada Leo Smith

As the key indices in US equity market are once again approaching all-time highs, we look to assess the durability of the bull market in the face of a plethora of negative headlines and rising valuations. We also identify a few leaders in the retail sector as long ideas.

 

Technology Leadership

 

When a bull market is turning over, the tell tale signs can usually be found in the segment that has led the bull charge. And as we all know, technology has been the clear leader in the most recent incarnation of the US equity bull market.

 

The below monthly chart is a ratio of the NASDAQ 100 Index to S&P 500 Index. The ratio is now in territory witnessed during the tail-end of the tech bubble. The difference this time ― ominous last words ― being the steady, as opposed to parabolic, rise in the ratio.

 

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 09-39-55

 

The quarterly rate-of-change of the above ratio, shown in the chart below,  is another way to see the stark difference in the relative rise of the NASDAQ 100 over the last ten years as compared to the relative rise during the tech bubble.

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 10-22-11.png

 

What the rate-of-change, or momentum, chart does suggest is that the recent waxing-and-waning in technology stocks, be it due to slowing earnings or fears over antitrust action against the mega-capitalisation technology companies, is still within the normal bounds of volatility.

 

If the NASDAQ 100-to-S&P 500 ratio fails to make new highs in the coming weeks and months or there is a marked deterioration in the ratio’s momentum, we would become concerned about the durability of technology’s market leadership.

 

Growth and Value

 

Other ratios in tech bubble territory are those of the S&P Growth Index-to-S&P 500 Index and the S&P Growth Index-to-S&P Value Index.

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-17-07

 

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-16-27

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

Heavy Truck Sales

 

The below chart compares the S&P500 Index (magenta) to heavy truck sales in the US (orange). Heavy trucks sales are a barometer for economic activity in the US. Heavy truck sales rolled over in 2000 and in 2006 ahead of the cyclical peaks in the US equity market. Heavy trucks sales have thus far remained strong.

 

USASHVTK Index (United States He 2019-06-14 14-46-20.jpg

 

Cyclical to Defensive Stocks

 

The below chart is a ratio of the MSCI USA Cyclical Stocks Index to the MSCI USA Defensive Stocks. We see this ratio as a gauge of ‘animal spirits’. A rising line suggests a preference for profit over preservation.

 

The ratio has recently broken out to fifteen year highs. This is a but surprising given that Treasury yields have come in quite a bit in recent months, which should have benefited defensive sectors such as consumer staples and utilities.

 

MU704866 Index (MSCI USA Cyclica 2019-06-13 15-24-54.png

 

We would avoid or reduce allocations to bond-proxies such as utilities and REITs for now and search for alternative sources of diversification for portfolios with growth and technology heavy allocations.

 

The Smart Money Flow Index

 

The technology led rally from the lows recorded in February last year was not accompanied by a recovery in the Smart Money Flow Index. Rather, the index was hitting new lows just as the NASDAQ 100 was approaching new highs.

 

The rally in 2019, however, has coincided with a rebound in the Smart Money Flow Index. If the index starts retreating again we would be concerned.

 

SMART Index (Smart Money Flow In 2019-06-13 14-03-59.png

 

Corporate Yield Spreads

 

The below chart is the yield spread of Corporate BBB bonds to the US 10 Year Treasury.

 

Corporate yield spreads remain below the levels reached during the “volmageddon”on 2018 despite the sharp drop in oil prices in recent weeks. If yield spread breach the 1.65 per cent level in the below time series, we would think about scaling back equity exposures. Moreover, if we see exuberance take yield spreads below 2018 lows, we would worry that we are entering the “melt-up” phase in the bull market and also look to sell into strength.

 

CSI BBB Index (US Corp BBB_Baa - 2019-06-13 13-10-40.png

 

Consumer Leaders

 

If the Federal Reserve cuts interests rates, the US consumer will benefit from lower debt servicing costs on its mortgages and other debt. This should boost consumer spending, at least at the margin. We identify retail leaders that we add to our ideas on the long side.

 

ETSY  $ETSY

 

(The bottom panel is the relative strength to the SPDR Retail ETF $XRT.)

 

ETSY US Equity (Etsy Inc) Retail 2019-06-14 14-59-54

 

Five Below  $FIVE

 

FIVE US Equity (Five Below Inc) 2019-06-14 15-00-53

 

Under Armour $UAA

 

UAA US Equity (Under Armour Inc) 2019-06-14 15-00-22

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Two Ideas: Advanced Emissions Solutions & A Bitcoin Proxy

Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options. — Simon Sinek

Advanced Emissions Solutions $ADES

In Environmental Concerns: Ideas on Long Side we discussed the lack of progress in reducing global emissions since the Paris Climate Agreement was signed by 190-plus countries in December 2015. At a high level we suggested Advanced Emissions Solutions as a potential long idea that could benefit from increased regulatory pressure to control emissions.

$ADES owns a 42.5 per cent stake in a joint venture with Goldman Sachs and Nexgen Refined Coal called Tinuum Group. Tinuum is awarded tax credits when it produces refined coal — coal that has been processed to reduce emissions when burned.

In the American Jobs Act of 2004 there was a provision to encourage the use of chemically treated coal to reduce the emissions from US power plants. To qualify for the refined coal tax credit, producers “must have a qualified professional engineer demonstrate that burning the refined coal results in a 20 per cent emissions reduction of nitrogen oxide and a 40 percent emissions reduction of either sulfur dioxide or mercury compared with the emissions that would result from burning feedstock coal”. The tax credit was designed to increase with inflation and was valued at US dollars 6.91 per short tonne produced in 2017 and US dollars 7.10 per short tonne in 2018. As an added bonus, some operating expenses incurred in running a refined coal facility are also tax deductible, making the tax credit’s effective value in 2018 as much as  US dollars 9 a tonne.

The tax credit, as originally structured, was not easy for refined coal producers to take advantage of. The policy required producers to increase raw coal’s market value by 50 percent to qualify for the tax credit. This clause made cost-conscious utilities unwilling to buy refined coal.

A policy edit to the structure of the tax credit in 2008 by senators from Montana and Iowa, two coal producing states, however, removed the market value clause. The removal of this clause made it possible for refined coal producers to benefit from the tax credit even if they sold their product at a loss. This shift in policy incentivised  the creation of Tinuum and other refined coal producers like it.

Tinuum financed the construction of facilities to produce refined coal situated next to coal-fired power plants. The window to construct these facilities closed in 2011 and the tax credits expire in ten years from commencement of operations. Republican Senator John Hoeven from North Dakota, also a coal producing state, has, however, introduced legislation to extend the tax credits by another ten years.

On average, each facility cost between US dollars 4 and 6 million to construct.  Tinuum constructed 28 of them, making it the second largest operator in the refined coal space.

How does Tinuum benefit from the tax credit? 

1. Power plants lease refined coal facilities from Tinuum at say a rate of US dollar 4 per tonne of refined coal (plus, at times, additional royalty commissions) — 42.5 per cent of which goes to $ADES

2. The refined coal facility is used to process feedstock coal and generate a tax credit at the prevailing inflation adjusted rate. Operating the refined coal facility costs power plant owners a further US dollars 3 per tonne.

3.  Power plant owners receive the ~US dollars 7 per tonne in tax credits and at the same time the operating expenses  incurred in running the refined coal facility and the lease payment to Tinuum are tax deductible. At a marginal tax rate of 21 per cent, the power plants tax bill is reduced by approximately US dollars 1.47 per tonne.

Tinuum presently has 20 of 28 refined coal facilities (representing 55 to 65 million tonnes of refined coal capacity) contracted to the owners of coal-fired power plants.  In 2019, it has an opportunity to increase the utilisation of its idle facilities. A number of tax advantaged refined coal facilities that began operations in 2009 have seen or will see their tax advantaged status lapse during the year. One of the 20 operational facilities was contracted and brought online in January 2019. Management expects a further 12 millions tonnes of refined coal capacity to be contracted over the course of 2019.

Based on the 20 contracted facilities through 2021, when the tax credits expires, $ADES’s share of net refined coal related cash flows from Tinuum is estimated to be between US dollars 200 and 225 million. To put that into perspective the market capitalisation of $ADES is US dollars 248.8 million.

What other areas does Advanced Emissions Solutions operate in?

In December 2018, the company acquired ADA Carbon Solutions (ACS). ACS owns and operates an activated carbon manufacturing plant focused on “mitigating mercury emissions” from coal-fired power plants.

In its first full quarter since acquisition, ACS contributed US dollars 14.6 million in revenue to $ADES.

Management’s plan is to cross-sell ACS’s solutions to existing customers and also expand the mercury mitigation solutions services into other adjacent segments. One adjacent market they intend to target is the municipal water treatment market, a highly fragmented sector “comprised of many producers and re-sellers”.  Management does not expect the entry into adjacent markets to require incremental investments to be made by the company.

Investment Thesis

$ADES currently trades at trailing twelve months earnings of 6.9 times and a dividend yield of 7.50 per cent with return on equity of 46 per cent.

Given the majority of the company’s market value is covered by its share of Tinuum’s contracted cash flows, we see $ADES as a cheap call option on (1) the potential increase in tax credit by another 10 years, (2) contracting of Tinuum’s remaining 8 refined coal facilities through 2021 and (3) the activated carbon segment.

A Bitcoin Proxy

Famed short-seller Jim Chanos, using his Twitter alias Diogenes (handle: @WallStCynic) recently tweeted:

“How the F is this bitcoin nonsense being resurrected again? Are people really this stupid?”

We do not know if buyers of bitcoin are being clever or not so clever. We do not know what is driving the buying. Maybe it is the employees of Lyft, Uber, Zoom or Pinterest, newly minted as millionaires, using a portion of their winnings to buy bitcoin. Or Chinese capital fearful of an imminent devaluation of the renminbi finding a way around capital controls by buying bitcoin. Or [insert here whatever is the narrative du jour for crypto-aficionados or crypto-sceptics].

What we do know is that it has been going up and it may go higher still.

Our aim here is not to argue for or against bitcoin. There are far smarter and far more informed people on both sides of the argument for any contribution we may have to make the debate to be value accretive even at the margin. Rather, we have found the process of buying and selling bitcoin somewhat cumbersome and want to suggest a proxy for those that may want to trade bitcoin and not necessarily own it.

The below is a normalised chart of bitcoin and The Bitcoin Group ($ADE.GY) starting 31 December 2016. The Bitcoin Group is a holding company focused on investing in businesses and technologies in the fields of cryptocurrency and blockchain. Presently, the holding company owns one asset: 100 per cent of the shares of Bitcoin Deutschland AG, the only German authorised trading platform for bitcoin.

XBTUSD Curncy (XBT-USD Cross Rat 2019-05-16 10-53-39.png

So if you want to trade bitcoin but find the whole process a bit cumbersome, The Bitcoin Group might be worth a look. As the chart seems to suggest, it has been a pretty good proxy to buying bitcoin, at least since the beginning of 2017.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.