MCN Capital Management commentary for the second quarter ended June 30, 2017.
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For the second quarter of 2017, MCN Partners, LP returned -4.0%, net of fees. This compares to 0.9% for the HFRX Global Hedge Fund Index, -0.8% for the HFRX Equity Market Neutral Index and 3.0% for the S&P 500 Total Return Index. The muted first half of 2017 follows a strong 2016 in which we returned +37.0%. Throughout this period, we have been running with negative market exposure and continue to do so.
Everything is Awesome and Disruptors That Can Never Be Disrupted?
During the first half of this year, many high-flying, bubbly stocks in the consumer staples and technology sectors performed strongly as economic growth and inflation optimism following last year’s election faded. This benefited yield alternatives such as staples and expensive organic growth stocks. The S&P 500 returned 9.3% during 1H17 with a substantial portion of this return driven by the strong performance of some mega-cap consumer technology stocks which have come to dominate market indices, ETFs, passive strategies, active funds, closet index funds, performance chasers, algos, etc.
The same themes that have driven the market in recent years remain in place to push crowded, popular stocks to even loftier levels, discounting sustained long-term growth and market share dominance with minimal long-term competitive threats pressuring sales or margins. The so called “disruptors” are being priced as if they can never be disrupted. Fund managers have capitulated because they must own what’s working to stay in business.
Knowing that you have many other investments in your portfolio aside from this partnership, these “loved stocks” likely now comprise a disproportionate part of your and most portfolios (without the portfolio holder often being aware given the cross ownership in many indices, ETFs, and actively managed funds noted above). Given their size and over-representation in the indices, a mental exercise is in order. (Please note that we do not have material short positions in all of the following names at the current time, but highlight them given their enormous market weight.)
While rapid changes in technology have benefitted many, ongoing technology shifts have the potential to materially disrupt the disruptors. Few seem to be discounting or even considering the possibility of the disruptors ever being disrupted, so perhaps it’s a good time to think, and at least consider what could possibly go wrong with a some of these names. Antitrust factors may also come into play.
Amazon (~$475BN market cap) trades at an enterprise value to sales ratio of 3.0x projected 2017 sales compared to 0.55x at Walmart, a business that was until recently considered the disrupter and best of breed operator. Amazon is an amazing and disruptive growth story and there is an undeniable share shift going to Amazon and online sales more broadly from traditional retailers including Walmart. However, for the market to value a dollar of Amazon sales at nearly 6x that of a dollar of sales at Walmart doesn’t seem to compute longer term. Retailers are just beginning to consolidate and this is about to accelerate. They will cut costs by firing duplicative staff, pressure vendors and land lords for lower prices. They then will use these savings to invest in more online/direct sales and compete on price. Furthermore, radical advances in transportation technology and networks (Uber, self-driving vehicles, drones) should radically decrease the cost of distribution, Amazon’s number one competitive advantage. Yet the market prices Amazon as if it will never face a more intense competitive environment and will perpetually dominate.
Thus, a very crowded trade is to go long Amazon and short traditional retailers which has worked very well in recent years. With headlines like the following, however, it may be getting late in this game.
“A trio of new ETFs proposed by ProShare Advisors LLC take positions against retailers that are most likely to suffer from the dominance of internet shopping, bricks and mortar companies that rely on a physical store to sell their wares, regulatory filings show.” Bloomberg News July 10, 2017
Finally, the more established interests Amazon attacks, the more likely true political pressure may arise against Amazon from both sides of the political spectrum.
"He (Jeff Bezos, Amazon CEO) thinks I'll go after him for antitrust. Because he's got a huge antitrust problem because he's controlling so much, Amazon is controlling so much of what they are doing," Donald Trump….Reuters…May, 12 2016
“Could Democrats’ New Message Align Them With Trump?...The agenda will specifically focus on “cracking down on corporate monopolies” and other potential anti-trust violations that some Democrats blame for contributing to growing wealth inequality, as well as creating “a 21st-century ‘Trust Buster’ to stop abusive corporate conduct and the exploitation of market power.” - The Atlantic. July 24, 2017.
As noted above, Amazon has caused enormous disruption in much of the retail landscape and this is being reflected in share prices of many beaten up retailers, yet there is one popular high margin retailer that the market considers immune to Amazon and which has yet to be punished in fear of it. In 2008, in the heart of the housing and then financials crisis, Home Depot (~$185BN market cap) was my favorite stock at $20 as shares lost nearly 2/3rds of their value up to that point. The market hated it. However, it was a duopoly that owned its real estate and was clearly going to survive and thrive. That it has. Nearly ten years later shares (with dividends) have increased ten-fold and trade near $150 per share. It is a now a universal Wall Street favorite just as it was universally hated in 2008. Let us not forget however that this is a cyclical business trading at 12x this year’s EBITDA and more importantly nearly 17x the past ten year average EBITDA (margin).
While Amazon cannot compete in categories such as lumber, it certainly can and does compete quite well in across a number of other categories which Home Depot sells. Recently, I purchased an anode rod from my local Home Depot for $25. I later checked and saw it was $17 on Amazon, so I plan to return it. On July 20th, Sears and Amazon announced a partnership where Kenmore appliances will now be sold on Amazon. This will increase transparency and consumer confidence in buying a key Home Depot category online. Finally, it is worth noting in the most recent quarter that Home Depot reported that while purchases above $900 comped up 15%, those below $50 were flat. I believe that lower ticket purchases are an early indication that Home Depot is in fact vulnerable to Amazon and Amazon pricing which could pressure Home Depot’s robust margins over time. At the moment, this is being masked by a strong cycle in housing related spending and most fund managers are hiding in Home Depot as they believe it to be “Amazon-proof.”
Google (~$650BN market cap) and Facebook ($500BN market cap) together essentially comprise a duopoly (with shares priced to remain so) in terms of online ad spend, garnering the vast majority of the domestic and global digital ad markets. Growth has been explosive in recent years, but is destined to slow, perhaps materially. Recently, a newspaper trade group that represents more than 2,000 American newspapers has asked Congress for an antitrust safe harbor against Facebook and Google , which it considers a “duopoly,” according to an article published by Axios. In a front-page story in July, the Wall Street Journal reported that Google has a program that has paid between $5,000 and $400,000 each to hundreds of research papers that bolster defenses against regulators investigating its market dominance.
Apple (~$820BN market cap) is an amazing brand, and it is valued as such as the most valuable company on earth. Apple generates gross margins in the 40%+ range. In the history of consumer electronics (pre-iPhone cell phones, PCs, TVs, cameras), there has virtually always been price deflation resulting from mass production and competition and there is scarcely a case of maintaining margins anywhere close to Apple’s current levels. Yet, with Apple, price inflation and massive gross margins are anticipated with the starting price for the new premium iPhone rumored to be $1,000+. By comparison, the Samsung Galaxy S8 starts at $725. One would think an entity generating nearly a quarter billion in annual sales would begin to attract some competition, either from established players or from the venture capital realm, given the deep interest and funding available for new concepts of nearly any type.
While not as large in market cap, many other disruptive momentum and story stocks exist (and often are highly correlated with the names above). One such name is Domino’s Pizza (~$9.2BN). Domino’s trades at nearly 21x EBITDA and is leveraged with debt/EBITDA at 4x. This has been a strong global brand and business experiencing rapid growth in recent years due to an early adoption of mobile and digital technology and strong positioning in a growing industry. However, technology is changing with Uber Eats now being advertised at McDonald’s locations and aggressively on the Uber app. Furthermore, with the coming advent of self-driving and driverless vehicles, the cost and efficiency of food delivery should drop materially, expanding ordering options and eroding Domino’s first mover advantage. We may be seeing early signs of this in the United Kingdom, considered to be a leading market for delivered food. Domino’s UK franchisee recently reported a material deceleration in comparable sales despite a booming delivery industry. Management suggested in July that U.K. delivered pizza market growth will be 4% in 2017 (vs. 9% CAGR over 2014-2016), materially below the delivered food market at 11%. While the company continues to gain share in the pizza category (up 400bps since 2014), the pizza market appears to be slipping as there is “wider choice available for customers” for delivery in the U.K.
Pizza is low-end and competition is getting more intense with a desperate grocery sector expanding take home offerings and Amazon buying Whole Foods, which is another major threat to traditional food delivery. Given the nosebleed valuation of Domino’s and strong comp expectations, it will not take much competitive impact to see a marginal deceleration in the business which would likely adversely impact the high valuation. Fortunately, we had been scaling a DPZ short position prior to the disappointing earnings on July 25th which saw a poor market reaction to disappointing international comparable sales. We believe fair value is materially lower.
At the risk of sounding like a Cassandra or a Jeremiah, the extreme one-sided views the market has taken of these businesses combined with their sheer size and influence on the overall market should be looked at objectively and viewed with a healthy level of skepticism.
I cannot in good conscience buy into many of the overpriced, crowded consensus names that have driven markets to record highs, at least not anywhere close to these prices. Yet, most investors are materially exposed to them given the popularity of index funds, ETFs and long-only funds. My contention is that given how crowded these names have become, there is an imbalance of marginal sellers to buyers.
I noted the fund has been running net-short since early 2016, but we aren’t a short biased fund, but an opportunistic one. We will be long-biased at some point. But the following headlines from July are telling and give us confidence that it is actually a pretty compelling time to be short biased.
“Short Sellers Give Up as Stocks Run to New Records” Wall Street Journal July 21, 2017
Central bank market manipulation (zero to negative rates, quantitative easing, and hypersensitivity to market sell-offs) has distorted market signals, misallocated capital and created excesses that elevate values of companies such as those above. All of this has the potential to come undone in a quick and violent fashion. Markets are adaptive and they have adapted to the perception that central banks will always be there to support them and always be stimulative. That becomes priced in and leveraged strategies are built upon it. So much so that further upward market moves need incremental “juice” from central banks. It may not even be the case that central banks must talk hawkish in terms of policy. It may simply be that a lack of incremental stimulus is no longer coming which could set off an unwind.
Evan Lorenz, Deputy Editor at Grant’s Interest Rate Observer, summed up the challenge for value investors up well in a recent Barron’s interview. “The difficulty we and a lot of value investors have is that when market valuations get stretched and the economic cycles get long in the tooth, value investors go for what is cheap and get their faces ripped off. That’s because they buy the cheap thing at the exact wrong time. The market looks rich to me. I’m not calling for a crash in the next 18 months, but we’re not finding as many cheap, defensible longs with good balance sheets that we can with good conscience recommend. So, we have been recommending more shorts.”
Barron’s… July 1, 2017
We feel fortunate to have partners that give us the flexibility to only play when we see fat pitches as opposed to trying to beat an index every quarter, particularly when trying to do so places our partners at risk of a material permanent impairment of capital. This has been an exhausting environment for a fundamental stock picker, but, we believe it is unlikely to last forever and are positioning ourselves accordingly. We have more shorts than longs, yet our gross exposure remains conservative at the current time as many securities are too expensive to buy while the most compelling long-term shorts have a powerful momentum, thus making them harder to scale and press. We believe that before too long, we will have the opportunity to materially profit from this crowded excessive sentiment and bubbly valuations. We are watching and waiting for material catalysts to arise before we press bets.
We welcomed several new investors this year. As always, we appreciate each of our investors’ confidence, trust, and loyalty. We also welcome referrals and introductions as we continue to work hard to grow the business.
Mathew T. Klody, CFA
MCN Capital Management, LLC
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