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.