The Double Dogs
"I Double Dog Dare You to Buy a Low Multiple Cyclical as the Supply Chain Crisis Eases"
The Year is 2021. The economic and market backdrop is CONFUSING to all trying to navigate. Are we about to exit a once-in-a-century pandemic? Yes. Did that pandemic totally crush aggregate demand? Absolutely not. Most don’t like to admit it, but a powerful, coordinated, rapid policy response buoyed aggregate demand and for lack of a better term, ‘saved’ the economy from what could have been a vicious downturn. Let’s face it, this is a pandemic, so of course “it’s not that simple.” While aggregate demand was incredibly well supported, the nature of the pandemic meant that the economy was crudely rearranged for a couple of years. Enter stage right, a freakish gorging on “Goods” at the same time that spending on “Services” went well below trend. Give the many orders of magnitude increase in complexity on global supply chains during a time of lockdowns, rapidly shifting demand patterns and policy uncertainty, we have various level of supply chain crises and skyrocketing commodity prices depending on where you look. These supply crunches in the face of strong demand have completely transformed many cyclical stocks, i.e. cleaned their balance sheets, helped them generate absolute gushers of cash flow, and the duration in certain sectors seems to be pointing to another very strong year in 2022.
The unprecedented use of the word unprecedented has led many to discontinue use of this term, even though many of the setups in various stocks, sectors and commodities is, well, unprecedented.
Young Buck: Buck is trying to figure it all out. He knows he’s not a SaaS or Compounder Bro, but he struggles to define his style in one pithy line. When pressed, he’ll generally say that he ‘tries to buy dollar bills for 50 cents.’ For this reason, he looks at a wide range of sectors and investment themes and is constantly trying to stay wide, not deep, in order to find asymmetric setups.
Johnny Griswald, aka “Grizz”: Grizz has been around the block. He spent his formative years trading the commodity boom of the 1970s, and while he has long since retired, he remains active in the markets, with a particular interest in commodity equities and mentoring younger analysts. He speaks with Buck frequently, especially since Buck has been poking around various commodity equities.
Act 1: Buck is perusing his four screens, with Tweetdeck and a PDF on the verticals and Bloomberg on the horizontals. He rummages through the piles of paper on his desk to find his phone and call his mentor, Grizz
BUCK: Grizz, you’re never going to believe what I’ve stumbled across. Either the market doesn’t understand that $ARCH opened a massive expansion last quarter, or I’m going blind, because this company has locked in a boatload of Thermal EBITDA and is in the middle of domestic contracting as Met Coal prices stay freakishly high and I think they are going to make, at a minimum 75% of their market cap in free cash but probably over 100%….
[Grizz interrupts Buck just before Buck’s eyes begin to look crazed]
GRIZZ: Buck, have you done any work on Steel?
BUCK: Not yet, but there are some seriously smart guys pitching these names
GRIZZ: Ok, how about shipping?
BUCK: I thought you told me to stay the *%$& away after the Great Tanker Headfake of 2020?
GRIZZ: That’s neither here nor there. How about Tin?
[Buck darts his eyes away from the flashing lights of Bloomberg just long enough to let out a sigh of frustration]
BUCK: Ok Grizz, you’re doing that thing where you teach me a lesson by asking me a bunch of questions.
GRIZZ: Indeed, I am. You need to understand that the $ARCH investment setup is available across a wide range of commodity sectors at the moment. Don’t waste your time trying to understand ‘what’s wrong’ or that ‘somebody knows something’ about ARCH. Frankly, a lot of talented commodity equity folks have been blown out in the last decade. We have just come out of a fallow period and there is max macro uncertainty. On top of this, you are messing with the oldest cyclical maxim in the book - you want to pay a high multiple when things look dire, not a low multiple on blowout earnings. There is so much pattern recognition out there that this is how you trade these stocks - and this is another reason why you are seeing this opportunity on your screen. My point is this - when there are rules of thumb that generally work, the required return to take the other side of the trade needs to be incredibly large. How large? Pull up a GIP50 of Avis and you’ll see what I mean. This was one where ‘everybody knew’ used car prices have only one way to go from here, and then…. POP!
BUCK: Ok, so what would you do, Grizz. Are there any great precedents in the commodity sectors for this trade?
GRIZZ: Sadly Buck, no. The panoply of confusing cross currents is simply too great to try and pretend anybody knows exactly how to trade this. If you have dotted all your I’s and crossed all your T’s and you truly believe ARCH is going to free cash flow a minimum of 70% of its market cap through the end of 2022, then you just have to put the bet on. Yes, macro could be abysmal from here. Yes, there is evergreen idiosyncratic risk in all of these names. But if you truly believe you are generating this amount of cash on a debt free company with somewhat competent management, you just have to bet. What you’re not even considering is that the duration of these high prices could last longer - who knows what could cause the next bottleneck. You are also buying in Year 1 of a bull market after a vicious bear market that restrained investment in many different commodity subsectors. The ‘never pay a low multiple maxim’ was usually a good rubric when we were many years into an upturn. And by the way, Buck, I actually think we might have a real economic recovery in the next 3-5 years, not that pathetic post Financial Crisis drivel that we all struggled through!
BUCK: Thanks Grizz, I needed this perspective. I am obsessing over the screen every day, and all I hear about is this market maxim, China macro and the Fed, and it’s truly shaking me.
GRIZZ: Good talking to you, Buck. Oh, one last thing. Do you know what this trade is called?
BUCK: I don’t
GRIZZ: ARCH and ZIM and X and many other like them, I refer to them as the DOUBLE DOGS. You see, my favorite movie, especially this time of year is “A Christmas Story”.
[BUCK Interrupts Grizz]
BUCK: Grizz, you know it’s a Triple Dog dare, right?
GRIZZ: Young Buck, please don’t mess with alliteration, ok? As I was saying, the market is just DOUBLE DOG daring you to put this trade on. The only difference compared to the Christams Story is that it’s not just Flick sticking his tongue on that pole. Flick has his ARCH, but he’s standing right next to his best friend with US Steel, and their buddy Bobby is getting long shipping for g*d’s sake. Oh, and Flick and Friends get a lot more than just playground respect for daring to lick the pole. The Schwarz’s who are daring you and selling these stocks (and bless their heart, shorting them) are going to be absolutely taken to the woodshed if Flick wins the dare. We are talking double, triples, quadruples if there is longer duration in Met Coal or Steel or Freight Rates or Tin.
BUCK: Thanks for the chat, Grizz, I will see you in six months and we’ll see what happened after I stick my tongue on the pole.
GRIZZ: Merry Christmas Buck.