Wednesday, March 10, 2021

Sector Rotation Value Strategy

I've been thinking about how our value vs growth trade has led us to own tobacco, hydrocarbons, pipelines (among other things) and how we might be able to make this a repeatable strategy. I think we are looking for two things:

  • Capital expenditures in the sector are low (at a local minimum, nadir), while at the same time
  • Cash being generated, and returned to investors (dividends, debt reduction, share buybacks) are high relative to enterprise value and market capitalization.

The reason that the first point is important is because investment (or dis-investment) from capacity has predictable effects on profits:

  • Over-investment -> low profits and bad times
  • Low profits and bad times -> under-investment
  • Under-investment -> high profits and good times
  • High profits and good times -> over-investment

Take a look at recent capital expenditure levels in the oil and gas industry. The first chart below is capex in Canadian oil and gas. The second chart shows the combined quarterly capex of four oil majors (XOM, CVX, COP, and EOG) with the individual companies in green and the combined totals in pink.

The combined capital expenditure at the four largest integrated oil companies dropped 80% from peak levels. The last oil price shock (high prices and good times) led to undisciplined capital allocation in the energy industry. That in turn led to low profits, bad times, and bankruptcies. Over the past couple years we have had under-investment. Since the marginal production comes from fast-declining wells, it falls off fast when there is under-investment.

 

Meanwhile, demand is growing. Even if you doubt it will grow in the U.S., it will grow in the rest of the world.

The stage is set for high profits and good times. Not for nothing, valuations are low in energy. This is important because scarce capital is consistent with under-investment, and low valuations are the second point that we are looking for in this two prong investing approach.

Let's look at a contrasting example. We all know that Costco is a fantastic company. Earnings have been steadily rising the past decade.

The concern is that they may be over-earning - so much of their revenue is from yuppie impulse purchases that are cyclical - and the cycle high earnings are being capitalized at a record high PE multiple. Once you start looking for the double-counting pattern, you see it everywhere.

The industries with the worst trailing 10 year returns (all negative) are: metals and mining, oil, gas & consumable fuels, and energy equipment & services. If this theory is right, there should be mean reversion for them. The rising profits will attract people who will pay higher multiples - double counting.

Meanwhile, the sectors that have been enjoying high profits and good times will have been over-investing. The NASDAQ earnings peak is already in the rear view mirror. As Lyall points out,

Interestingly, earnings have been falling since 2018 and are actually (1) down about 25% from their 2018 peak; and (2) currently slightly below 2016 levels. This is actually not atypical late in a boom/bubble. The flood of capital into an industry usually drives down returns.  Often that's ignored because people are focusing on the growth narrative/top line instead of earnings & returns on capital. Eventually earnings matter though. It goes without saying that the consensus earnings estimates shown in light shade are likely to prove fairly delusional. I think we are most likely to see a continuing downward trend in earnings from here until we have a 2000-style bust & resultant industry capital rationing. If earnings stabilize out at about 150 and the P/E falls to 20x the NASDAQ will fall about 75%. I suspect earnings will probably fare quite a bit worse than that in a legit downturn though. Earnings have already fallen 25% even with extremely favourable top-line conditions. People will argue "but you need to exclude stock comp". The unfortunate reality is that the amount of stock dilution actually significantly increases as share prices fall. You have to issue twice as many shares if the price is 50% lower to give people the same comp package.

Remember that Chipotle spends 60% of revenue on labor and food. Their operating profit margin is just under 5%. As Chipotle's food and ingredient costs rise, they can try to pass it on through higher prices but at a certain point this is limited by hurting sales volumes. Then the margins will just be reduced.

Falling margins at constant revenue will mean falling profits. At that point, the stock could re-rate from 114 times earnings to one-tenth of that multiple. Profound overvaluation can result in some cost inflation causing a 95% share decline in a decent business.

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