RIP: Gold

I find it pretty amazing that 2021 did not turn out to be “the year of the gold bug.” You know the long-standing argument for the precious metal; huge deficit spending by the government leads to surging inflation, which in turn leads to a tremendous performance for gold - cementing its place as the dominant inflation hedge. Well, the consumer price index is setting up to exceed +6% for the year, the highest inflation rate in several decades. So let’s pop the champagne for the gold bugs as their bet finally paid off in spades:

Oh. Nevermind, I guess. Couldn’t even muster a gain of any kind this year.

The nail in the coffin for that strategy, I suppose. Hopefully that moment came a long time ago for many people.

The inflation hedge argument never really made sense to me. Over my lifetime, gold has compounded at about 4% annually versus the CPI at about 3%. Store of value? Sure. A hedge against inflation? Not so much, given that its track record is roughly the same as, well, most everything. It would be like saying U.S. small caps are a good hedge against U.S. large caps (the former narrowly outperforms the latter, on average, over the long term). Not a very compelling argument.

So why hasn’t gold done well this year? Others probably have more insight into that than I do, as I neither own gold personally nor in client portfolios. But I will say that I don’t really think demand for gold has anything to do with inflation. The supply of gold is fairly stable and predictable and the same can be said for demand (fairly narrow uses that don’t shift much year to year).

As we have seen in 2021, inflation really boils down to “too much money chasing too few goods.” In other words, strong demand coupled with constrained supply. You seem to need both to be true for prices to materially move above trend. Budget deficit hawks have been predicting inflation for a couple decades now, as government spending has surged this millennium, but price increases actually decelerated (globalism has only eased any potential supply constraints, such that strong demand has been met adequately).

Only with the pandemic and its impact on supply (of materials and labor alike) have prices surged. So within the commodities market, those raw materials that have seen the bigger supply disruption, and that are simultaneously used in the manufacturing of more “stuff,” have seen the biggest price increases. If anything, those are the inflation hedges.

While I suspect the inflation hedge argument will lose steam coming out of 2021, it will remain a part of portfolios for many managers going forward. Despite a down year, the long-term track record still suggests gold is a store of value. It also continues to have a low correlation with other asset classes, if not strong absolute performance, and that will be useful for investors looking to hedge a diversified portfolio over short periods of time. Over the long term, however, allocations to gold are likely to continue to be a drag on overall portfolio performance.

Maybe We Should Resist Panicking Over Inflation Until Mid-2022

It should never surprise us how short-sighted financial market participants and economists are, given that they all make their living by making moves or commenting on the moves of others on a daily basis. And yet, I am still disappointed that the recent talk of elevated inflation has not been met with more context. Yes, I know that the consumer price index (CPI) rose by 6.2% in October, the largest increase in decades, but why do we never hear about how that compares with 2020 or 2019?

Corporations have been quick to compare 2021 financial results with 2019, the so-called “two-year stack,” because everybody knows that 2020 was an anomaly in terms of sales and profits. Why no talk that maybe 2021 was also an anomaly in terms of inflation?

It reminds me of when people freak out every time gas prices at the pump spike temporarily. Oh my goodness, can you believe gas is $4 a gallon some places in the country? Somebody has to do something about this out of control inflation right away, they say. In reality, gasoline prices have been lagging overall inflation for decades. They should be the last item people complain about when it comes to price increases.

According to the U.S. Energy Information Administration, retail gas prices today average $3.30 per gallon. Ten years ago it was $3.31. The U.S. hit $3 for the first time right after Hurricane Katrina, more than 16 years ago. Yes, gas prices tend to be volatile and thus when you look peak to trough periodically increases will look gigantic. But if you look at the longer term data, gasoline has actually been a relative boon for consumers’ wallets.

Unsurprisingly, the same logic extends to inflation. Focusing on just the CPI figure for October 2021 ignores that for the 2 years before that, October CPI has averaged 1.5%, for a 3-year average of +3.1% (hardly something to be overly concerned about).

Given that in any single year these inflation figures, whether it be for a single item like gas or the entire basket, can be volatile, I think multi-year trends are key. It’s one thing if we get 5% inflation for a year and then it recedes. It’s entirely another if we get that level of price gains for 2-3 years straight.

So when do we start to lap what very well could be one-time pandemic-related spikes in the CPI? Not until the spring of 2022 (the CPI first hit 5% in May 2021). If we get another 5% print this coming May, okay, maybe there is something more going on here that has a long-lasting impact. But if we get a 3% print in May 2022 and 1-2% in May 2023, history will have once again played out as it usually does, with mean reversion telling a completely different story than a single isolated data point.

I suspect that is what Fed Chair Jerome Powell is thinking when he downplays the risk of longstanding inflation well above historical trends. I think it is more likely than not that we see a similar outcome this time around, though zero interest rates are probably still not the correct policy decision.

Are Financial Markets Getting Even Less Predictable in the Near Term?

Earlier in my investment management career it was not uncommon for me to raise a fair amount of cash, say 10-20%, in client accounts when I thought the equity market was overheated. The idea was that I would have plenty of firepower when prices dropped and bargains were abundant. Over the years the data suggested that such a move was rewarding, at best, half the time. Too many instances, though, resulted in prices rising enough before they fell that the cash positions at best offered no alpha.

Don’t get me wrong, I have always been in the camp that market timing in the near term is difficult (hence I would never go to 50, 75, or 100 percent cash), but I learned that mean reversion, while a real thing, could not really be consistently exploited profitably even on just a small part of a portfolio. As a result, cash balances in my managed accounts now reflect the number of interesting investing opportunities I see out there, rather than overall market levels.

As I have spoken with clients this year, I think 2021 has solidified the argument against market timing even more, if that’s possible. Profits for S&P 500 companies this year are currently on track to come in roughly 30% above 2019 levels. And that result has not happened because the pandemic suddenly waned. In fact, we are seeing a lot of data that would suggest corporate profit headwinds; retail supply constraints, a lack of qualified labor, and a chip shortage - to name a few - all of which are profit margin-negative.

Despite such strong profit growth, interest rates remain very low with the 10-year bond yield hovering below 1.5%. The end result is an S&P 500 that fetches 23 trailing earnings after surging for most of the year. Who would have been able to predict that? It seems to me even fewer people than would have done so in more normal economic times.

The current inflation story reinforces the point even more; that short-term market movements are getting even less predictable than in the past. And that’s certainly saying something. We just learned today that consumer prices rose by more than 6% in October, a 30-year high. Remember how one of the main jobs of the Federal Reserve is to raise interest rates to keep inflation subdued? Would any short-term investment strategist suggest that 6% inflation would not result in higher interest rates and thus lower stock valuations? And yet, here we sit with the Fed Funds interest rate sitting at zero. Not just an average rate. Not just a below average rate. But zero.

I didn’t come into 2021 trying to predict the economy and the markets and thank goodness for that. For those who still do try that sort of thing, I think 2021 has taught us that a very tough job is getting near impossible, if it wasn’t there already.

So what to do? Throw up our hands, of course. But in conversations with clients I find myself saying “I have no idea” more often than ever. Some may find that disappointing, especially coming from an industry professional, but if my track record predicting stock prices, interest rates, or other economic metrics six months out was unimpressive before the pandemic, imagine how subpar it would be now. I much prefer to just sit back and try to invest in undervalued companies regardless of the macro backdrop and I think my clients are best served by that as well.

Billy Beane SPAC Inks Deal with SeatGeek

Following up on my August 5th post about a handful of SPACs, we recently heard that RedBall Acquisition Corp (RBAC) has agreed to acquire live event ticketing platform SeatGeek in a deal expected to close during Q1 of next year. There was much speculation that RBAC would wind up buying a professional sports franchise (and supposedly they did have discussions with the Boston Red Sox at one point), but I actually prefer a deal like this to one where the market would likely yawn unless an elite team was involved.

SeatGeek is one of a few next generation online ticketing platforms that not only aims to simplify the overall live event ticketing experience, but also use a mobile platform to integrate other features into the customer interaction. Reselling tickets you can no longer use and ordering concessions at your seat being two of many they are working on.

As with many SPACs this deal is full of lofty projections about revenue growth and underlying profitability in the out years. I am not going to claim their figures are easily attainable and would definitely take them with a grain of salt, but even if we discount them a fair bit, the deal does not look too expensive.

At a $10 share price, the SPAC holders will own just south of 30% of SeatGeek at closing, with an overall equity value of ~$2 billion. Given we are dealing with a software-based platform company with high gross margins, the overall price to sales ratio of 5.8x seems fair (2022 revenue projections are $345 million - this number seems plausible given we are almost into next year already… whereas the out years are likely more aggressive and uncertain).

That said, the deal is not without plenty of risk. SeatGeek is not profitable and doesn’t expect to be until 2024 at the earliest as they rapidly invest in the platform. If we assume their 2025 revenue projection of $1.2 billion is the most bullish scenario (not base line), then the stock looks cheap, but I think a lot needs to go right for them to be able to grow that quickly. Still, even at half that sales level ($600 million), a $2 billion equity value isn’t a stretch in my view.

I also like that sports people are buying this company, as they likely will be better in tune with the desires of customers than any run of the mill Silicon Valley-based software company.

RBAC stock has gone from $9.75 to the $9.90-$9.95 range on the deal announcement, so cash-alternative investors have made their money and have another few cents of risk-free upside if they choose to redeem. While I haven’t decided yet, I think I am leaning toward keeping shares in SeatGeek and seeing how the company’s growth plays out. It won’t be a large holding by any means, but there is plenty of long-term potential and I like the people behind the partnership.

Full Disclosure: Long shares of RBAC at the time of writing, but positions may change at any time

With Meme Stock AMC Staying Elevated, Let's Revisit The Numbers

I get a lot of questions on AMC Entertainment (AMC) as the meme stock crowd continues to buoy the shares despite the underlying business continuing to burn millions of cash per day, so let’s update the numbers behind the equity since my last post on the topic was seven months ago.

From a fundamental perspective, the business itself remains in the red despite being open for business, so I think continuing to value the theater chain based on 2019 actual results is a fair way of taking an optimistic view of the future (assuming normalcy eventually does return to everyday life). AMC owns fewer locations now than they did in 2019, but inflation can probably offset enough that we can safely use the $670 million of 2019 EBITDA in this exercise.

To refresh, here is what the numbers looked like back at year-end 2019, when things were (relatively) good for the company:

Cash: $265 million | Debt: $4,753 million

Share Count: 104 million | Stock Price: $7.24

Equity Value: $753 million | Enterprise Value: $5,241 million

EBITDA: $670 million | EV/EBITDA multiple: 7.8x

The stock has now moved up to above $46 while the share count has nearly quintupled. Using the 6/30/21 balance sheet (and 2019 actual EBITDA), here are the updated figures:

Cash: $1,811 million | Debt: $5,500 million

Share Count: 513 million | Stock Price: $46.09

Equity Value: $23,644 million | Enterprise Value: $27,333 million

EBITDA: $670 million | EV/EBITDA multiple: 40.8x

As you can see, the stock price today has nothing to do with fundamentals, but that statement has been echoed plenty of places. Long term, a short position here will almost certainly pay off, but the timing is the big question mark. AMC has been able to stay out of bankruptcy so far by selling more than 400 million new shares over the last 18 months. Even at their first half 2021 cash burn rate (~$3.2 million per day), they had 18 months of cash in the bank at the end of June.

Therefore, the story as we head into and traverse 2022 is where the next influx of capital comes from in order for them to roll over their debt, repay deferred rent from the pandemic (around $400 million and not included above) and get back to cash flow positive operationally. It seems like a long shot that existing creditors would be excited to dole out more funds, so additional stock sales, if allowed by the shareholder base, is the best bet for next year. If credit gets tight, however, and investors balk at buying more stock, the tide could shift pretty quickly.

Still, we don’t (and can’t) know the timing, even though the end result looks pretty obvious; the business almost certainly can’t sustain a $27 billion E/V on its own, and it likely can’t service $5.5 billion of high-cost debt either. Grab your popcorn, as the next 12 months should be very entertaining.

Full Disclosure: Short shares of AMC at the time of writing, but positions may change at any time

While Many SPAC Deals Overload On Speculation, Some Are Worthy Of A Look

It says a lot about where we are in the cycle when sponsors of special purpose acquisition companies (SPACs) can easily and relatively quickly make tens of millions of dollars merely by taking a shell company public and choosing an acquisition target, before long-term success could ever be determined. But with the free market system we need to take the good with the bad (so long as legalities are considered), so as much as I think the SPAC structure is a strange way to accomplish a goal, it is probably short-sighted to write off the pathway completely and never consider investing in any of the deals.

Don’t get me wrong, assigning a multi-billion valuation to a revenue-less, concept company based on rosy hypothetical financial projections for 2026 makes no sense to me, but here and there we can find real businesses reaching the public markets through a SPAC. As with any other security, what is important to analyze is what you get and how much you pay.

And for some pre-deal SPACs, you can make a risk-free bet if the shares are trading below $10 each. Like the deal? Hold on for the long term? Hate it? Cash out with no harm done.

Specifically, I like some SPACs where the sponsors are legit and the shares are at a discount because we don’t know the target yet. Something like SPGS from Simon Property Group or RBAC from Oakland Athletics EVP Billy Beane. You essentially get a free call option on their process.

Some busted SPACs also look interesting post-deal. Wholesale mortgage lender UWMC can be had for $7 and change - quite a big discount to the deal price. If you think rates stay relatively low and housing demand will stay firm, it’s interesting.

And then there are announced deals that haven’t yet closed. The most intriguing to me is the local neighborhood social media platform Nextdoor, which fetched $4 billion+ from KVSB and only trades at a small (~2.5%) premium after peaking above $11.50 per share. A big multiple to current revenue with no profits? Sure, but longer term the platform seems to have staying power, a long growth runway, and numerous monetization opportunities. All for less than $5 billion; not bad in today’s market.

All in all, most SPACs get a chuckle from me, but it’s still worth looking at some because with the market trading above 20x next year’s profit forecasts there are fewer and fewer bargains out there.

Underlying Earnings Continue to Support Strong Market Action

Most of the commentary I hear around why the U.S. stock market has gotten off to such a strong start in 2021 focuses on governmental fiscal stimulus and the Federal Reserve’s intent to keep their target funds rate low for as long as the data can possibly justify doing so. While strong consumer spending will help businesses rebound from the pandemic, and low rates support elevated valuation multiples, I think the underlying profits being generated now, and those expected over the next 12-18 months are even more of a tailwind for stock prices.

As 2021 began I wrote in my quarterly client letter that consensus expectations for a record high S&P 500 profit figure in 2021 (easily surpassing 2019 levels), while certainly possible, didn’t seem like a sure thing. With the index trading for nearly 23x those estimates back in January, I was cautious about the potential upside this year.

It appears that cautiousness will prove to be unnecessary. Since January 1st, the 2021 profit forecast for the S&P 500 has actually increased (and done so meaningfully) from $164 to over $185. As the S&P has risen about 10% so far this year, profit expectations have been bumped up even more (about 13%). What that tells me is that the narrative of an economic boom post-pandemic (surely aided by government stimulus) is alive and well, and is very possibly going to result in absolutely stellar corporate profit growth.

While I would love for the U.S. market to be cheaper (we are trading at 20x 2022 profit estimates), I take comfort in the fact that the core fundamental driver of equity prices (earnings) is at least going in the direction it should be to justify these prices. Time will tell if the 2022 estimate ($208) can be surpassed as well, but if that number is in the ballpark, and the 10-year bond stays under 3% (plenty of room to lift from here without being a big deal), one can make the argument that the market generally is not in a bubble. And the recent calming down of the likely bubble in the profitless subset of the tech sector is a welcomed development too.

As is should be for those of us who focus on longer term fundamentals rather than day to day headlines, I think earnings will tell the story this year and next and for that I am thankful (until we have reason to fear a material economic slowdown).

Is Casper Worth A Look After A Sleepy Public Market Debut?

While I am not an active investor in the IPO market (if the smart money is selling, why would I want to pay a premium to take stock off their hands?), I do sometimes get enticed by busted IPOs; those that were thought to be up and comers but quickly faded into the background. Casper Sleep (CSPR) seems to fit this bill and I find it to be an interesting small cap to dig deeper into.

Casper took the sleep sector by storm when it started selling mattresses through the mail in 2014. Don’t like it? Just send it back, no worries! Consumers rejoiced and sales went from zero to $100 million by year two and to $250 million by year four. As competitors emerged shortly thereafter, the company lost some of its first mover luster and by the time executives took the firm public in early 2020, investors were past the point of caring (the pandemic probably didn’t help either). After initially trying to offer shares between $17 and $19 each, Casper’s IPO priced at $12 and the stock immediately sank even further. Today you can get your hands on them for $7.50 apiece.

Okay, so why on earth would I want to spend time looking at a money-losing mattress company that has a bunch of competition and no investor interest? Well, as with most value investors, the answer probably has something to do with the price.

At $7.50 per share, the equity value is about $300 million. Despite never having been profitable, Casper is paring losses every year, with EBITDA margins of (28%) in 2017, (25%) in 2018, (18%) in 2019, and (12%) in 2020. Gross margins are around 50%, so there is no reason the company cannot reach profitability, and probably could right away if they wanted or needed to. The balance sheet is in decent shape (net cash of $23 million as of December 31st), so management’s current plan to continue shrinking losses while growing the business does not seem overly worrisome.

Meanwhile, despite their competitors Casper continues to grow revenue and expand its product lineup. Sales doubled from 2017 to 2020, to $500 million, and are expected to continue to grow in the mid teens this year. Based on current consensus forecasts, the stock fetches a forward price-to-sales ratio of less than 0.50. By my math, the bar has been set very low for this company.

Let’s assume Casper can turn profitable over the coming few years and that investors would be willing to pay 15 times earnings for the business, neither of which I think are aggressive inputs. At one-half of annual sales, the stock is pricing in a roughly 3% net profit margin at maturity, and you get any future sales growth for free. It’s hard to argue the stock is overvalued here, unless you think the business model is unsustainable or that there is no room for Casper to take share in the sleep-related markets they enter in the future.

While admittedly not the most exciting business in the world, I think their brand might be strong enough to meet or exceed Wall Street’s currently low expectations, as well as some fairly conservative assumptions I settled on. So what could the future path for the stock be?

Well, let’s say Casper meets their 2021 sales forecasts, grows those sales by 10% annually from 2022 through 2024, and reaches a 5% net profit margin in 2024. That would bring 2024 earnings to $39 million. At 15 times, the stock would essentially double from here.

And there is potentially more upside than that. What if sales exceed those levels (as millennials continue to get married and buy homes), the P/E multiple does not fetch a discount to the overall market, or a bigger player comes along and decides to buy the company outright for a nice premium?

Don’t get me wrong, this is far from a sure thing. Small caps that are losing money come with plenty of risk. But given how low expectations are and based on the current market value of the business, I think Casper might be unloved, unnoticed, and undervalued as a result, which means it’s worth watching.

Olo IPO Highlights Direct vs Third Party Online Food Ordering Competitive Dynamics

There are a lot of bullish opinions on the long-term prospects for third party delivery apps like DoorDash (DASH) and Uber’s (UBER) food delivery segment. When thinking about their business models, the stumbling block for me has always been the fact that they take 15-30% of the order value for themselves (which in many cases is most or all of the restaurant’s profit on the order) and they have to supply the labor as well, which presents headwinds like rising minimum wages and the debate over whether their drivers can be contractors or must be classified as employees.

The end result is a tough hill to climb to profitability (during a pandemic year in 2020, when the business should have crushed it, DoorDash brought in nearly $3 billion of revenue but lost more than $300 million). Even if they expand successfully to serve traditional non-food retailers too, the same issues apply.

Looking at it from the outside, it seems to me the better bet would have been to build the technology platform and simply sell it to the restaurants. You wind up with a high margin software as a service business that would get a huge valuation on Wall Street, and you let the restaurants hire their own drivers to fulfill the orders that come in. Fewer parties involved directly in the order makes it more efficient and allows restaurants of all sizes to compete with the likes of the big pizza delivery chains, who have a head start with a driver network and online ordering technology.

Interestingly, this is the path that Olo (OLO) has taken and the software provider will go public today at a $25 per share offer price. The stock has yet to open, so I can’t comment on valuation, but I am interested to dig into the company more because I far prefer their business model (charge a monthly service fee per location plus a small transaction fee per order that declines as volumes grow) to one that literally makes you a middleman between the customer and the food.

It will probably not be a winner take all situation. Large restaurant chains with huge order volumes will be able to negotiate better with the likes of DASH to reduce fees and make delivery orders marginally profitable. But smaller independent chains likely can’t do the same, and could very well prefer a scalable software solution where they control the customer experience directly (maybe emphasizing carry out more than delivery) and don’t have to give up all of their margin to stay relevant in the marketplace.

As a value-oriented investor, I hope Wall Street discounts the Olo model and affords it a reasonable valuation, as they are a leader on the software side and their model seems to make a lot of sense if you want to be profitable in the online ordering food space. Time to dig into their financials and see where the stock trades in the early going.