|DJ Industrial Average||-10.8%||-14.5%||7.2%|
Our performance on the quarter was -22.7% with our main detractor being AOUT and main contributor being SES. The 10-year treasury yield increased 67bps to over 3% and all eleven sectors were negative in the quarter with value outperforming growth by over 800bps. Generally speaking, when the market sells off considerably, in this case down ~24% YTD, we expect to be more constructive about where equity markets are headed. Downswings like these can work as a repairing mechanism for markets and set the stage for better long-term returns. However, in this case, our cash level has been maintained at a very high 30% and this defensive positioning is being maintained for a few reasons: First is valuations, despite a 24% YTD drop in the S&P 500, stocks still aren’t screening cheap with S&P 500 P/E of ~19x. The pocket of the market that has been hit the hardest has been the tech-focused growth names that were trading at obscene valuations. Obscenely high-valued companies whose valuations have been cut in half are generally still overvalued. The second reason being the catalyst of disinflation that we had expected to materialize by now has not happened. Headline CPI readings for April, May, and June came in at 8.3%, 8.6%, and 9.1% respectively. The Powell Fed has taken a firm stance to fight inflation and is credibly willing to endure market and economic pain to see inflation subside. Another 75bps rate hike in June now brings the fed funds rate to 150bps. June also kicked off the lesser-appreciated other half of the Fed’s inflation-fighting plan: balance sheet reduction. They are effectively canceling 47.5 billion worth of money that would otherwise be used to purchase treasuries (the pace of reduction will double beginning September). In the current environment, we are pessimistic about the market’s ability to recover undeterred by a lukewarm earnings environment and unrelenting monetary policy headwinds. Rapid disinflation could still act as a catalyst for markets but this likelihood has been significantly reduced given the resilience of inflation readings. Our main focus over the next several months will be diving through earnings data transcripts in search of signals pointing to a potential earnings recession.
We have initiated a position in META. The myriad of fears surrounding the copmany seems endless: the ascension of TikTok, Apple ATT changes, and the “all in” bet on the metaverse. We see both TikTok and Apple ATT changes as minor bumps in the road for META. A more detailed analysis can be found here.
We see META akin to a pharmaceutical company. With a pharmaceutical, there is the core business which is the drugs being sold that have an eventual patent cliff and whose cash flows can be forecasted. The other part of the business is the R&D, the drugs in the pipeline. Although this is much harder to value, the difference between the value of the core business and where the company is trading is the value the market is ascribing to the R&D. Then a determination can be made if that is a fair value or not. META has three core business (Facebook, Instagram, and WhatsApp) and then it has the Metaverse. The core business has operating margins of about 35% which is about $40B a year. META spends about $12B per year in operating expenses on Reality Labs (metaverse). The majority of the capex is supporting the core business although the narrative is that capex is dedicated to Reality Labs.Although revenues are likely inflated due to the unprecedented monetary stimulus in the economy, the digital advertising space is still growing rapidly as more people consume content on mobile and share is taken away from both weaker digital advertisers and non-digital advertising platforms. We believe META can grow at a 15% CAGR for the next 5 years.
AOUT continues to underperform. Although we were correct about the revenue normalizing to more moderate levels after COVID, we were wrong about their operating margins. Elevated costs from shipping and logistics have kept profitability suppressed along with some one-time duplicative costs of being a stand-alone company and building out an IT infrastructure. AOUT is almost a Graham “net net “(net working capital minus total liabilities) at this point offering downside protection at these levels. Although the majority of this is in inventory (AOUT invested heavily in inventory to hedge against Chinese port closures and supply chain disruptions) we expect as AOUT unwinds inventory, the majority of this will turn into cash. This would free up roughly 50mm dollars or about half the market cap of the company. The next question is what then does management do with this cash. With the shares trading at extremely trough multiples, we would like to see them continue to buyback shares. AOUT has recently finished a 15m share buyback, retiring 7% of their shares outstanding. They have also acquired an outdoor grills company called GrillaGrills for about 2x revenue for $27mm. This was the first acquisition the company has done. Although the multiple paid-for the company was rich – especially given the drop in demand post-COVID- we will wait to assess management’s ability to acquire and grow brands.
INVESTMENT DISCLAIMERS & INVESTMENT RISKS
Past performance is not necessarily indicative of future results. All investments carry significant risk and all investment decisions of an individual remain the specific responsibility of that individual. There is no guarantee that our research, analysis, and forward-looking price targets will result in profits or that they will not result in a full loss or losses. All investors are advised to fully understand all risks associated with any kind of investing they choose to do.