Friday, February 11, 2022

New Milestones in the Value vs Growth Trade: $90 Oil and 2% Ten Year Bond Yield

Our value versus growth trade started in the second half of 2020 when two key ideas clicked together for me. The first happened when I was writing a post, "What I Would Buy Instead of Tesla?", when Tesla had a $460 billion market capitalization:

"[I]nstead of Tesla's $25 billion in annual revenue and no profit (in fact, a cash burn of maybe $5 billion a year), you [could buy a basket of companies with] revenue of about $400 billion (1x revenue, how about that) and net income of maybe $30 billion a year and distributable (as opposed to reinvested) income that's greater than Tesla's revenue."

To put together my shopping list - a hypothetical trade of a business valued at half a trillion with zero or negative free cash flow for a collection of businesses at the same price and tens of billions of dollars of cash flow - I dived into the sectors of the market that had the lowest enterprise value to free cash flow valuation multiples.

The second piece that clicked was reading Lyall Taylor's essays (1, 2) that describe the mechanisms (principal-agent conflict and positive feedback loops) that cause secular cycles in value and growth investing. Instead of a low-agency belief that one example of a bubble anywhere (and there were plenty, of course) meant that everything was a bubble everywhere (i.e. Prechter, Hussman), Lyall had a much more nuanced theory that indicated that a bubble could (perhaps must) coexist with an anti-bubble elsewhere. 

By the end of December 2020, I had realized that there was an opportunity to buy anti-bubble, value stocks (e.g. energy, tobacco, banks, coal, and timber) while simultaneously betting against the Robinhood bubble as a hedge. (A hedge against a Great Depression collapse, anyway. Being long value and short growth actually amplifies day-to-day correlation with the value vs growth trade rather than hedging it.)

Last month we had a third insight. Lyall's 2020 essay had predicted that when a growth cycle ended, the reversal would be violent:

Outperforming in the long term is actually not very difficult, but it requires highly lumpy results, often marked by long periods of lackluster returns punctuated by short periods of spectacular results, which happen alongside liquidity flywheel/momentum reversals, which are inflection points that do not happen very often. Furthermore, usually, the worse value is performing, the closer one is to the end of a liquidity flywheel bubble cycle (value had a woeful time in 1999, for instance), because value is the 'anti-bubble' expression - a Newtonian equal and opposite reaction - of liquidity flywheels driving bubbles elsewhere in markets. It is redemption flywheels that drive value opportunities, and redemption flywheels are often the result of investors pulling money out of unpopular areas of the market in a rush to get exposure to hot areas of markets.

This implies that if you see a major reversal in growth versus value, it needs to be acted on aggressively - pushing one's chips in, so to speak. Earlier this month, we saw that someone helpfully computed this:

Was 2021 the end of an era? Figure 2 shows the rolling 12-month performance of the Long-Term Reversal factor in the US. This compares the returns of the best- and worst-performing stocks of the previous five years, excluding returns to 1-year Momentum, and thus isolating the extent to which longer-term trends are changing. A high reading means that a reversal is underway and previous losers are performing strongly. Conversely, a low reading means that previous trends are continuing.

While we are not yet at all-time highs for the factor, investors have experienced the biggest overall swing in the data set. In the space of a year (highlighted in Figure 2), the dominance once enjoyed by mega-cap tech and Growth stocks has almost entirely reversed, with previous losers approaching the outperformance they enjoyed when the tech bubble burst in 2001.

The problem that growth investors have is that this far into a cycle of growth out-performance, their investments are staggeringly overvalued, and all they had going for them was momentum. Now the momentum is gone.

Meanwhile, the reason people didn't want to own value investments that were fifty cent dollars was because the trades "weren't working". Sure, they had become really cheap, but the share prices had gone nowhere for a decade or more. But now they have momentum and valuation in their favor.

We may have tipped into a new feedback loop - one where value outperforms growth for a secular cycle. For this to be a false alarm, either growth would have to rally to new highs that far exceed their peak levels (since the denominator, value, has risen quite a bit), or value would have to collapse.

Both of those seem dubious given an important fundamental factor: the net issuance anomaly. Growth companies issue torrents of stock, both as a class (with new companies raising money from investors) and individually (from existing companies). Existing growth companies especially like to issue stock as compensation, which makes their reported cash flow numbers look better. As they now have significant share price drawdowns, they are entering an adverse positive feedback loop where they have to issue more stock to maintain existing employee compensation levels. Conversely, as we see when looking at quarterly earnings reports, the energy, tobacco, pipeline, and small banks are all using free cash flow to buy back rather significant amounts of stock.

Further signs that the value vs growth trade is continuing will be redemptions from growth funds (that beget further selling), reversal of the ESG mandates and divestments of value stocks by institutions, insider selling and share issuances to fund losses at growth companies despite the lower prices, and a ripple effect up the growth quality and maturity ladders as the unprofitable growth companies buy less advertising and other services from even the profitable, mature FANGs ("cascading revenue declines"). 

We should think about signs that might confirm that growth has faltered irreversibly. It is certainly a good sign that as the Federal Reserve balance sheet continues to expand at a rock-steady 20% year over year growth rate, the price of crude oil goes up and growth stocks go down. Notice too that the Vanguard IT vs Vanguard Energy ratio has fallen again and retraced almost the entire covid move. It is hard to believe that this is a head fake for value since we have all but completely retraced some of the craziest blowoff moves like Zoom vs Exxon, and Carvana vs Penske.

Another question is: how long do you ride a new secular cycle of value? (Hopefully it's not too presumptuous to be asking that already.) Arguments that the trend is just getting started: there have been no shutdowns or liquidations of growth funds, growth investors, VC-backers of unprofitable companies, or of Ponzi companies. I'm thinking Cathy Wood's ARKK ETF, the RIA Ross Gerber, the VC's who "invested" in cryptocurrency Ponzis, and of course Tesla. Similarly, while there have been some meteoric rises of value investors, they are tiny, tiny fish. Depressed energy investors on Twitter think the rally is overdone because a guy with eight figures under management swung for the fences and tripled it.

You'd get worried if you saw something like Ken Heebner's CGM Focus mutual fund, all-in on natural resources and being called "America's hottest" in the summer of 2008. (At the trough in 2016, the CGM Focus Fund's assets were down 90% from peak in 2008.) Just to look at his June 30, 2008 holdings with $10 billion in the fund is to marvel. When was the last time you saw a mutual fund that was 17% in steel? He had 19% in oil services, 10% in oil refining, 11% in oil E&P, 10% in coal, and 8% in copper miners. Even the people today who believe in the energy transition and think that electric vehicles will take over (and which use 10x as much copper per vehicle) are not making a copper bet like that. Which goes to show that professional investors have lost the ability to translate a worldview into a portfolio if it involves natural resources.

Value investors and especially energy investors still seems skittish. (Again, except for some young guys who are swinging for the fences.) I have been thinking about making a Twitter list called "paper hands" or "NGMI" to keep an eye on their sentiment. There are two guys who are smart, who I like and follow (and they follow me), who are not patiently stacking hydrocarbons because they think some boogeyman (the Fed, the energy sector managements) is going to pull the rug out from under them again. 

Oil had a bear market rally from 2009 through 2014 before collapsing for another six down years. People are scarred by that experience. And the E&P sector managements were and are truly bad because of their principal-agent incentive problems, and we are staying out of that area. But he difference between now and 2014 in hydrocarbons can be seen in the cash flows, capital expenditures, reinvestment percentage, and valuations. 

The following is a compendium of the blog posts, by category, on these subjects since we started thinking on these lines in 2020. Please let us know what you think in the comments.

Conceptual Pieces - secular cycles in value vs growth, plus strategies for finding value

Energy: Oil and Gas - under-investment, implausibility of energy transition, forced ESG divestment

Gold Mining - overlooked because of cryptocurrencies?

Pipelines - implausibility of energy transition, forced ESG divestment

Cryptocurrency - total cryptocurrency supply is infinite at nearly zero marginal cost

Big Tobacco - cheap, with potential earnings growth from "Re-Nicotinization"


Anonymous said...

Excellent post. I invested in the value sectors you wrote about last year and have been richly rewarded! said...

Fantastic piece
I too made that low agency mistake and thus not properly weighting the value opportunities during the bull market....

CP said...

@anonymous - that is nice to hear

@vienna - what are you doing now? and would you care to share what you have learned the past decade?, e.g.:

Dead Cat Bounce said...

Excellent track record, which I have benefitted from financially as well! Does the growth rate of active readers of CBS predict where we are in the economic cycle? When are we getting CBS merch?

- Adam

Viennacapitalist said...

Hi, am of course stil investing - expanded my activities into the start-up field which, unfortunatey (or fortunately, if you like a steep learing curve) is much more time consuming than anticipated...
Substantially increased family size and an intensive study of monetary theory (on which I intend to write a book someday) hav left me with less and less time to write on a regular basis. Monetary theory is a much more time consuming read than the typicall non-fiction or investment book, so this is mentally quite exhaustive. Under these circumstances, I am already more than happy when I can stick to my reading schedule...

Yeah, it is probably a good idea to share a few mistakes with your readers, although I have to put a substantiall effort into this thing given the high level of your blog...

CP said...

"Substantially increased family size" - familymaxxing?

Viennacapitalist said...

Yes, sort of :-)

CP said...

Must give us similar write-up?: