Q3 2023
Kinsman Oak Investor Letter Q3 2023
October 30, 2023
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COMMENT ON PERFORMANCE
The Fund performed relatively well this quarter. Our performance lagged the upside in July, posted a slight gain in August, but then declined in value alongside the rest of the market during the sell-off in September. The Fund’s underlying holdings experienced two negative earnings announcements and one positive report. The one contributor partially offset the two detractors, while the rest of the other holdings were slightly down.
We have decided to maintain our positions in both detractors. Both businesses face near-term headwinds, but the long-term theses remain intact. While it’s difficult to gauge exactly when external headwinds will dissipate given an uncertain macroeconomic backdrop, both management teams have a proven track record of strong execution, and we believe each business will be in a better competitive position when conditions become favourable.
MARKET COMMENTARY
The upward momentum from the first half of the year continued in July before abruptly reversing throughout August and September. Bond yields, especially at the back end of the yield curve, rapidly drove higher while equities sold off. Last quarter we discussed how unusual the yield curve inversion was. As of now, that inversion is collapsing, but it is because long rates are rising rather than short rates are falling (Appendix A). Typically, most of the carnage tends to happen after the yield curve renormalizes.
Looking at the bigger picture, it is quite possible we have entered a new interest rate era, in which the cost of capital remains non-zero. Interest rates experienced lower-lows and lower-highs since the late 1980s, and any gyrations during that time occurred in a relatively orderly fashion. Now that may no longer be the case. Perhaps we have entered a new paradigm, and we potentially find ourselves at a multi-decade turning point (Appendix B).
The stock market remains extremely concentrated with only a handful of stocks doing the heavy lifting. While the S&P 500 Index has gained 13.1% over the first nine months of this year, the S&P 500 Equal Weighted Index has only gained 1.8% (!) by comparison, including dividends. This massive discrepancy is more than two standard deviations below historical average (Appendix C). Further, the top five holdings by weight in the S&P 500 combine for ~23% of the total index. Most mutual funds with that kind of concentration would be considered high risk.
As of today, the S&P 500 Index trades at ~17.1x FY24E Adj. EPS which appears expensive given long-term interest rates are pushing 5%. However, the S&P 500 Equal Weighted Index trades at only ~13.7x FY24E Adj. EPS by comparison, which suggests certain pockets of the market are reasonably priced. The valuation gap between the top seven stocks in the index and the other 493 constituents illustrates how lopsided things are beneath the surface.
Economic data continues to remain all over the map. Leading economic indicators are decelerating but resilient. Housing prices and mortgage rates are both rising simultaneously. Long-term interest rates are going parabolic like we have double digit inflation, yet gold prices are falling as if disinflation were imminent. Investors can basically find ample supporting evidence to support any preconceived notion or preferred narrative for which direction they think the market is heading next. Said differently, the risk of confirmation bias is quite high.
STICKING THE LANDING
The 2023 World Artistic Gymnastics Championships were held in Antwerp, Belgium earlier this month. Simone Biles was widely considered the best gymnast of all time heading into the event and then cemented her legacy by becoming the most decorated medalist in the history of women’s gymnastics. Before this event, her and another gymnast named Larisa Latynina were tied with 32 medals each in the World Championships and Olympics combined. Biles then earned an addition 5 medals this month to break the record which was previously set in 1966.
Dominating an international sport at the highest level for over a decade by accumulating 37 medals, including 27 gold medals, and breaking a 57-year-old record is a profound accomplishment. After an impressive performance at the Rio de Janeiro Olympics in 2016, Biles was invited to appear on The Late Show with Stephen Colbert. During the short segment, the two of them discuss a few different topics and she mentions when she tumbles, she can launch herself two times her body height into the air. At the end, Biles demonstrates how to properly stick the landing and teaches Colbert how to perform the correct technique.
We do not consider ourselves gymnastics enthusiasts by any stretch of the imagination. However, we couldn’t help but appreciate the conceptual similarities between tumbling and macroeconomics. Presumably, the difficulty of sticking the landing is a function of two factors: 1) height/duration of time spent in the air and 2) the complexity of the movement while the gymnast is airborne.
Investors are still pricing in a soft landing, in our view. We can gauge the likelihood of that happening given our current macroeconomic backdrop by using the same two factors. First, after a decade of ZIRP, interest rates have been abruptly launched into the stratosphere and have stayed elevated for quite some time. To put it in perspective, the Bloomberg U.S. Aggregate Bond Index is experiencing its longest and deepest drawdown since 1979.
Second, the complex conditions immediately prior to this upcoming landing have been truly unprecedented. The pandemic and, specifically, the lockdown response to the pandemic have occurred at a scale we have never seen before. Enormous fiscal spending, stimulus payments, supply chain disruptions, commercial real estate carnage, etc. are all significant shocks to the economic engine occurring simultaneously. It is impossible to ascertain how and when things will normalize, and what levels they will settle in at.
For these reasons, we believe it will be extremely difficult for policy makers to engineer anything close to a soft landing. Recalibration will likely be a lengthy process, possibly taking years to burn off exorbitant excesses from, not only the past few years, but also the decade of easy money preceding that. In short, although we think a soft landing is still theoretically possible, we think it is highly improbable.
ONE-TWO PUNCH
We believe this bear market will likely experience a “one-two punch.” The first punch, associated with rising short-term interest rates, is rapid valuation contraction. Behaviour preceding the market peak in early 2022 can be characterized as a speculative mania with excessive valuations. Qualitatively, we experienced phenomenon such as intense gamma squeezes, the creation of meme stocks, a bonanza in worthless SPACs, a frenzy in short-dated out of the money options, and so forth. Quantitatively, the S&P 500 multiple peaked at ~28.9x forward EPS which is reminiscent of the dot-com bubble which peaked at ~30.1x forward EPS.
In our view, most of the damage from the first punch occurred last year. Numerous stock market darlings with uneconomical business models and nosebleed valuations saw their share prices decline by 50-95%. Other long duration assets were under tremendous downward pressure and started this year completed washed out as well. Many high-flying stocks became extremely oversold and experienced strong reflexive bounces off their bottom so, while year-to-date performance looks strong in a vacuum, the majority remain way below all-time highs.
The second proverbial punch is a prolonged period of downward EPS revisions. Rising long-term interest rates are way more problematic for the real economy and the negative impact of past rate hikes occur with a lag. Businesses may take multiple quarters (or years) to adjust to a higher cost of capital environment. Customer spending patterns and cost structures change gradually but the trend can be quite persistent when momentum begins. Eventually, we can expect deterioration in economic indicators, earnings disappointments, and a recession.
This partially explains why bear market rallies are common in between these two punches. The damage from the first punch is like ripping off a band-aid. What follows is a brief period where valuations have come down, but the economic outlook hasn’t yet materially changed. Market participants believe multiples are reasonable since their base case is a soft landing. The combination makes prospective returns enticing and fuels further optimism. However, bear market rallies begin to exhaust themselves when it becomes clear a recession cannot be avoided.
Each punch poses different implications for the stock market and the economy. The first punch impacts all risk assets simultaneously based on the egregiousness of their respective valuations. For instance, expensive stocks with long duration factors get disproportionately hit harder than their counterparts, but all securities are affected at the same point in time, just to different degrees.
By comparison, the second punch can be more nuanced. The lagged negative impact of higher-for-longer monetary policy is less uniform, meaning the implications are generally sector/company dependent. Different sectors will be affected at different times by varying degrees as tighter credit conditions work their way through the real economy. Broadly speaking, we expect this to create an economic environment with many puts and takes. With respect to equity markets, we continue to believe prices will be volatile and rangebound as fundamentals recalibrate.
A Long Volatile Trip to Nowhere
A volatile trip to nowhere would present an interesting backdrop for bottom-up stock-pickers. Performance should be largely dictated by fundamentals rather than an overwhelming reliance on rising tide tailwinds. In our view, the difference between great management teams and bad ones will be more pronounced over the coming years. We expect high-quality businesses with economic moats, recurring revenues, high returns on invested capital, effective capital allocation, etc. to emerge as market share gainers and compound earnings through a full cycle.
Other the hand, low return on invested capital businesses with overleveraged balance sheets are vulnerable and become increasingly so over time. Management teams will find it more difficult to secure new financing and will settle for more disadvantageous terms when rolling existing debt. Lenders will require some combination of higher coupons, wider spreads, stricter covenants, etc. to compensate for the additional risk profile.
We remain selectively optimistic even if the immediate macroeconomic future remains uncertain and price action continues to be choppy. Once the second punch works its way through the real economy and the financial markets, investors will have an opportunity to buy the index at trough valuations and trough EPS, which is typically the foundation for multi-year bull markets. But certain companies and sectors have already been significantly impacted by higher long-term interest rates and appear relatively cheap even if forward estimates come down further. It’s difficult to gauge how much more pain awaits ahead but we believe there are individual stocks which likely provide adequate risk-adjusted returns over the next three-to-five-year time horizon.
THE UNSUSTAINABILITY OF BALLOONING DEFICITS
Rising long-term interest rates arguably pose an even bigger problem for the public sector. On the surface, the U.S. budget deficit was a whopping $1.7 trillion (6.3% of GDP) for the fiscal year that ended September 30, 2023 (versus $1.4 trillion last year). To put this in perspective, this is the 3rd largest annual budget deficit in history, but it’s even worse than that for two reasons.
First, the normalized budget deficit is much higher than officially reported: ~$2 trillion (~7.4% of GDP) compared to ~$1 trillion last year. In 2022, the Treasury recorded a cost of ~$300 billion associated with Biden’s student loan forgiveness program, which was ultimately struck down by the Supreme Court and never happened. After reversing the accounting effects of this failed initiative, the year-over-year contrast between the annual budget deficits is impossible to ignore as it effectively doubled in size.
Second, this explosion is taking place when the economy is stubbornly resilient and labour markets remain extremely tight. Consider this. The U.S. just ran the 3rd largest annual budget deficit in history, it doubled in size compared to the prior year, and the pending recession has yet to even begin. What will the deficits look like when an economic downturn inevitably occurs? We’re almost afraid to ask.
Rising interest rates on all that additional debt will eventually pose serious fiscal and geopolitical risks. As of now, 15% of tax receipts are already going towards interest payment costs ($689 billion) and the CBO expects that number to rise to 20% by 2033, which seems overly optimistic, in our opinion. We aren’t Nobel Prize winning economists but we’re capable of doing some simple back-of-the-envelope math.
The U.S. national debt is almost $34 trillion dollars (~$26 trillion held by the public) and the weighted average interest rate for the total debt outstanding was 3% as of the end of September (compared to 2% last year). By our calculations, if nothing changed, the current annual run rate net interest cost would ballpark ~$800 billion. However, one-third of that $34 trillion in debt is set to refinance sometime this calendar year, two-thirds of which is short-term debt rolling over with Treasury yields now at ~5%.
Another ~20% of the national debt is set to mature in 2024-25. Refinancing ~50% of the debt outstanding at higher interest rates quickly becomes a significant amount of money. We wouldn’t be surprised if the net interest cost rises from $689 last year to ~$1.2 trillion by 2025, excluding the effects of any additional annual fiscal deficits incurred between now and then. To be clear, these numbers are not meant to be exact, and this is not a projection or a forecast. We’re just illustrating how unsustainable the current trajectory really is.
Consider this. Let’s imagine a recession starts next year with a budget deficit equal to ~7.4% of GDP as a baseline. Add increased fiscal spending that occurs during every recession. Next, reduce the amount of tax receipts collected. Then, factor in higher net interest costs as the cherry on top. We could easily envision budget deficits hitting mid-teens percentage of GDP. At some point, something has got to give. Anybody with a basic calculator and grade school math skills can recognize this is an unsustainable situation with no obvious path back to normalcy.
Canadian Real Estate
Speaking of things that appear unsustainable given higher long-term interest rates, the Canadian housing market finds itself under significant stress. We have privately referred to this as the most unshortable bubble of all time, but cracks are beginning to surface. Exact numbers are difficult to obtain but, according to regulatory filings, there is currently ~$250 billion worth of mortgage debt in negative amortization and that number is growing quickly. As of the end of the quarter, ~20% of mortgages held on the books at BMO, TD, and CIBC were in negative amortization territory and ~25% of mortgages on the books at RBC are amortized for more than 35 years. For comparison, Canada has more private sector debt and household debt as a percentage of GDP than Japan did during their asset bubble in the late 1980s-early 1990s prior to their generation-crippling “Lost Decade”.
The crux of the problem is, unlike mortgages in the United States, borrowers are unable to lock in an interest rate for the life of the mortgage. Instead, the maximum term in Canada is only 5 years. This means at least 20% of outstanding mortgages will reset at higher interest rates, and higher monthly payments, every year (Appendix D). Canada is experiencing 40-year highs in inflation which makes rate cuts difficult, especially as the Fed continues to hike and any modicum of fiscal restraint remains off-limits. Eventually policymakers will find themselves at a crossroads where they will be forced to choose between the housing market and the currency. In the words of Herbert Stein, “If something cannot go on forever, it will stop.”
CANNIBALS - SHARE REPURCHASE MACHINES
Last quarter we wrote about the value destruction from ill-timed and/or poorly reasoned share repurchase programs. Over the past few months, we are beginning to see potential opportunities in “cannibals” – companies that consistently shrink their share count over long stretches of time. Worth noting, these repurchase programs must result in a meaningful reduction in net shares outstanding and cannot exist for the sole purpose of offsetting excessive share-based compensation, which has unfortunately become far too common.
Cannibals generally fall into two buckets. Bucket #1 are companies that incrementally shrink their share count consistently year-in, year-out. These businesses usually generate stable revenue and free cash flow, and experience predictable fundamental performance throughout an entire cycle. Valuation multiples tend to remain in a relatively tight range and don’t fluctuate to the extremes.
Bucket #2 are companies that conduct large repurchase programs sporadically at opportunistic times, sometimes funded by incurring substantial debt. Management teams shrink their share count in meaningful chunks only when they feel their stock is materially undervalued. The first bucket is usually more common and less risky than the second. We feel both buckets present a compelling opportunity right now and strongly prefer situations where share repurchases are funded with cash on hand rather than additional leverage, for obvious reasons.
LOOKING AHEAD
We believe the rapid valuation crunch is mostly in the rearview mirror and now we’re looking forward to how the lagged effects of rising long-term yields might work their way through different parts of the economy. We expect stocks to be volatile and visibility to remain low, with data all over the map for the foreseeable future. But all of that means potential for mispricing opportunities which can potentially be taken advantage of. In our view, this backdrop combined with negative sentiment is an interesting set-up for bottom-up stock pickers.
Sincerely,
APPENDIX
Appendix A - Bloomberg
Appendix B – Bloomberg
Appendix C – Bloomberg
Appendix C – Barclays U.S. Equity Strategy – Food for Thought: Dissecting the AI Rally – June 23, 2023
Appendix D – Bloomberg; STCA – Statistics Canada
https://www150.statcan.gc.ca/t1/tbl1/en/tv.action?pid=1110006501
