The Rational Cloning: Weekly Ideas #55
The Great Demographic Reversal, Kuppy on OPEC's Counterattack, Macro Ops' Value Investing Letter Recaps, Substacks & Tweets That Make You Go… Hmm 🤔
Welcome to the 55th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Review of The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival
We have known for a long time that the population of developed countries is aging. This is set in stone because of the decline in fertility rate and rise in longevity that occurred during the 20th century. The result will be an age structure diagram, or population pyramid, that is heretofore unknown in history (and which is not a pyramid).
We used to think, we now realize mistakenly, that having an inverted (aging) population pyramid would be deflationary. After all, have you ever visited a house owned by (or vacated by) an octogenarian? One of the things you notice is that they have not bought anything in years - their houses are time capsules from an earlier decade, the decade of that person's peak consumption of home furnishings. So we figured that an aging population would decrease the demand for all sorts of goods: deflationary.
Except that is not quite right. Sure, the retired and elderly probably buy fewer jet skis, couches, and cars. But they eat the same amount and they consume much more health care and living assistance. And, most importantly, they do not produce anything. From a monetarist perspective, having an aging population producing fewer goods but with money supply remaining the same (or higher) should cause inflation.
Economists Charles Goodhart and Manon Pradhan have come to the same conclusion, that an aging population is inherently inflationary, and they wrote a book before the pandemic to make the case: The Great Demographic Reversal: Ageing Societies, Waning Inequality, and an Inflation Revival. A summary of their key points:
"The rise of China, globalisation, and the reincorporation of Eastern Europe in to the world trading system, together with the demographic forces, the arrival of the baby boomers into the labour force and the improvement in the dependency ratio, together with greater women's employment, produced the largest ever, massive positive labour supply shock. The effective labour supply force for the world's advanced economy trading system more than doubled over these 27 years, from 1991 to 2018."
"We are in a debt trap. Debt ratios are so high that increases in interest rates, especially at a time in low growth, may drive exposed borrowers into an unsustainable state. As a result, the monetary authorities cannot raise interest rates, either sharply or quickly, without running into the danger of provoking another recession, which itself would make everything worse. But that will leave interest rates, and the accompanying flood of liquidity, sufficiently expansionary (accommodating, in Central Bank speak) that debt ratios are likely to increase even further."
"The basic problem is that ageing is going to require increasing amounts of labour to be redirected towards elderly care at exactly the time that the labour force starts shrinking. [...the] portion of the labour force looking after the elderly will produce service for immediate use rather than durable consumption. These services [...] are unlikely to be replaced by automation [and] cannot be offshored the way the lowest value-added activities in manufacturing were offshored."
"Ageing is inflationary empirically, too. Juselius and Takats (2016) uncover an empirical relationship - 'a puzzling link between low-frequency inflation and population-age structure: the young and old (dependents) are inflationary whereas the working age population is disinflationary'."
"If the growth rate of workers in the economy outweighs that of dependents (as was the case during the demographic sweet spot), the world will go through a period of disinflation as it has for the last few decades. Over the next few decades, [however] the rate of growth of dependents will outstrip that of workers."
"[The] Great Reversal of demography and globalisation will lead to more inflation. When this takes hold, though it may be a few years from now, and expectations adjust, then nominal interest rates will rise. Of that, we are confident. But the more difficult and interesting question is whether nominal interest rates will rise by more than inflation, i.e. whether real interest rates will rise, or whether the reverse will happen and real interest rates will fall."
"[G]rowing inequality within countries has been mainly caused by the unprecedented surge in labour availability, caused by globalisation and demography, leading to a dramatic decline in labour's bargaining strength. If so, Piketty is history. But we could, of course, be wrong."
"But what will then happen as the lock-down gets lifted and recovery ensues, following a period of massive fiscal and monetary expansion? The answer, as in the aftermaths of many wars, will be a surge in inflation, quite likely more than 5%, or even on the order of 10% in 2021..."
"What will the response of the authorities then be? First, and foremost, they will claim that this is a temporary, and once-for-all blip. Second, the monetary authorities will state that this is a , quite desirable, counterbalance to the years of prior undershooting of [inflation] targets, entirely consistent with average inflation, or price-level targeting. Third, the disruption will have been so great that it will take time to bring unemployment back down towards 2019 levels and large swathes of industry, (airlines, cruise ships, hotels, etc.), may still be in difficulties. Does it make any sense, having propped up industry in such a widespread manner in 2020, to let much of that same industry go to the wall in 2021 as a result to rising interest rates and fiscal retrenchment? In any case, the borrowing lobby (government, industry, those with mortgages) is much more politically powerful than the savings lobby."
"The balance of bargaining power is now swinging back to workers, away from employers; current, more socialist political trends are reinforcing that. Following the recovery, whenever that happens, wage trends will change. The likelihood is that wage demands will then match, or perhaps even exceed, current inflation, despite the inevitable pleas for moderation in the context of a 'temporary blip' in inflation. The coronavirus pandemic, and the supply shock that it has induced, will mark the dividing line between the deflationary forces of the last 30/40 years, and the resurgent inflation of the next two decades."
"The losers will be savers, pension funds, insurance companies, and those whose main financial assets take the form of cash."
"Inflation will rise considerably above the level of nominal interest rates that our political masters can tolerate. The excessive debt, amongst non-financial corporates and government will get inflated away. The negative real interest rates that may well be necessary to equilibrate the system, as real growth slows in the face of a reversal of globalisation and falling working populations, will happen. Even if central banks feel uncomfortable with such higher inflation, they will be aware that the continuing high levels of debt make our economies still very fragile. And if they try to raise interest rates in such a context, they will face political ire to a point that might threaten their 'independence'. Only when indebtedness has been restored to viable levels can an assault on inflation be mounted.""
(2) Kuppy: OPEC’s Counterattack…
The Federal Reserve has been attacking inflation. The problem is that after printing trillions of dollars, they’re ill-equipped to succeed at their task. Partly, this is because all that cash has to go somewhere and partly this is because their mandate does not extend into ensuring that global energy production expands. While Owners’ Equivalent Rent and wages have remained elevated, those are often seen as the “good” sort of inflation—or at least the benign sort. Meanwhile, all other forms of inflation tend to be characterized as “bad” and frequently the “bad” inflation is caused by elevated energy prices, which then increase the costs of producing and transporting everything else. Therefore, despite the Fed ignoring the inflation they caused for well over a year, when oil cleared $100 a barrel, the Fed finally felt that they had no choice but to do something.
The problem is that the only ways to reduce the price of oil are to produce more of it or consume less of it. It’s hard to produce more when the President and many of his powerful oligarch buddies are aggressively intervening to ensure that it’s difficult to expand or finance production. Meanwhile, no one wants to invest when there are constant threats of excess profits taxes, carbon taxes, expropriation and price caps. Since the obvious solution has been made so impossible, the Fed has been forced to embark on a plan to reduce global energy consumption.
How do you reduce oil consumption?? Well, it seems that their plan is to create a global depression. So, after a decade of paying lip-service to “inclusive economics” and “closing the wealth gap,” the Fed has been forced to pivot and destroy the finances of the world’s poor, in the hopes that they’ll consume less oil.
Naturally, most global citizens do not want a lower standard of living so that US consumers can continue their orgy of excess. In fact, many global citizens owe their current standard of living due to elevated energy prices. Hence, after watching Biden liquidate the Strategic Petroleum Reserve in order to improve his polling numbers, while watching the Fed directly target their standard of living and that of their customers, OPEC has had enough. They’re going to do something about the Fed and its war on oil. OPEC has finally launched a counterattack. Last month, they agreed to cut output by 100,000 bbl/d. It was meant as a warning that went unheeded.
No one knows how big the cuts will be and frankly, it doesn’t matter how large they are. Instead, the message is clear—the Fed can crash global GDP in their fight against oil, but OPEC wields a much larger stick and will cut production even faster. In fact, OPEC will DO WHATEVER IT TAKES if the Fed continues on this path. OPEC has drawn a line under the price of oil and told the Fed that it’s wasting its time. OPEC controls the price of oil and oil is the world’s Central Banker, not the Fed.
No one knows how big the cuts will be and frankly, it doesn’t matter how large they are. Instead, the message is clear—the Fed can crash global GDP in their fight against oil, but OPEC wields a much larger stick and will cut production even faster. In fact, OPEC will DO WHATEVER IT TAKES if the Fed continues on this path. OPEC has drawn a line under the price of oil and told the Fed that it’s wasting its time. OPEC controls the price of oil and oil is the world’s Central Banker, not the Fed.
In 2023, energy will be the only thing that matters to investors. Everything else, including the Fed will be a side-show. Who’s ready for the insanity wave?? Ever since Monday, I’ve been maxing it all out in energy. I’ve been ripping right-tails all over the screen. Oil is going to wreck all the other CUSIPS. The S&P is partying this week because the Fed is cornered by OPEC, but that’s only because speculators don’t realize what this means for the price of oil.
(3) Value Investing Letter Recaps: FERG, CDMO, EVBG
Right Tail Capital: Ferguson PLC (FERG)
Jeremy Kokemor runs Right Tail Capital and in his latest letter pitches FERG, which you can read here. Let’s run FERG through our four main questions (emphasis added).
What does FERG do?
“Ferguson is a leading, primarily US-based distributor ($23B mkt cap) of plumbing and HVAC supplies that is split roughly evenly between non-residential (44%) and residential (56%) as well as repair/remodel (60%) and new construction (40%).”
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Why is it a good bet?
“Ferguson benefits from a prime spot in its value chain – fragmented suppliers (over 30,000), many customers (~1 million), and small competitors (75% of revenue comes from #1 or 2 market positions where the primary competitors are mom and pops). By providing great service and parts availability, Ferguson can help guide its customers to the parts they want and supply them in a timely fashion.
The contractors who buy from Ferguson certainly care about price, but price is likely not as big of a concern for most of them as getting the correct part on time and on budget. While prices going up too high too fast may lead to demand destruction, Ferguson and contractors can often pass-through increases in prices due to the company’s great service, parts availability, and that in many cases the parts are needed.
Ferguson trades at a significant discount to other high quality industrial distributors (for example, FAST, POOL, and WSO trade at 17x P/E or higher) despite having economics that look more similar than different. ”
Why does the mispricing exist?
“Investors are questioning Ferguson’s near term fundamentals partially due to increases in interest rates and the impact that may have on construction. I do not know what will happen to business fundamentals though I recognize that this business has historically done a good job of holding onto price after prices have risen. The 60% of revenues that comes from repair/remodel should provide some protection against any potential cyclical headwinds in new housing starts and commercial construction.
There has likely [also] been some forced selling from European passive investors now that the business is no longer primarily listed in London. Management estimates that as Ferguson gets added to US indices (possibly the S&P 500) over the next year or so, there could be demand for twice as many shares.
What is the prize if you’re right?
If the economy holds up and FERG’s earnings are flat to growing over the next several years (Ferguson usually grows earnings at a mid-teens rate), then the stock could potentially double in the next 3-5 years. If there’s a more severe pullback in business fundamentals, then Ferguson’s earnings could decline further (perhaps 25%) and our potential returns as shareholders may take longer to realize – even in this case, Ferguson’s earnings multiple would still be trading at a discount to the broader stock market despite being an above average business.”
Further Research Material
Laughing Water Capital: AvidBiosciences (CDMO)
Matt Sweeney at Laughing Water Capital outlined his thesis for CDMO 0.00%↑ his latest Q2 investor letter, which you can read here. Let’s run it through our four main questions.
What does the business do?
“CDMO is a large molecule, small batch Contract Drug Manufacturing Organization.”
Via TIKR: CDMO is a contract development and manufacturing organization, provides process development and current good manufacturing practices (CGMP) clinical and commercial manufacturing services focused on biopharmaceutical drug substances derived from mammalian cell culture.
Why is it a good bet?
“You don’t have to make any blind assumptions about total addressable market (TAM), customer acquisition costs (CAC), or churn. There is very little risk of “garbage in, garbage out” when modeling Avid’s future. Rather, Avid’s assumed growth is tied to building additional manufacturing capacity …
The company is in the process of expanding its manufacturing footprint, having announced plans to have revenue generating capacity of $370M within the next ~12 months, vs. revenues of $119.6M in fiscal 2022 (YE April 30) …
CDMOs are largely recession proof businesses. Patients still need their drugs regardless of what is happening in the real economy …
Lastly, once the facilities are built out, they are relatively capital light, and maintenance cap-ex should be 3-3.5% of revenue. Thus, at the prices we were buying our shares, CDMO was perhaps 3 or 4 years away from trading at 7x-8x steady state free cash flow.”
Why does the mispricing exist?
“I want to stress again that things can go wrong with our investment in Avid Bioservices; there is no such thing as a perfect investment. In particular, the obvious risk here is that industry capacity expansion becomes less rational than it has been historically. To be clear other industry participants are also adding capacity, although much of this expansion has been international, and focused on larger scale (20,000+ liter) capacity drug substance, while Avid plays in the smaller scale (2,000 liter and smaller) arena, and I believe domestic capacity is highly valued due to supply chain concerns …
Avid also has a concentrated customer base, although capacity expansion should dilute this potential problem, and their largest customer Halozyme Therapeutics (HALO) is guiding to more than double revenues over the next few years, which is likely a big reason that Avid Bio is expanding.”
What’s the prize if you’re right?
“At a multiple of 15x my estimate of FCF, which seems punitive for fast growing, recession proof free cash flow with strategic flexibility, shares would trade hands at $25, or a 20%-28% CAGR from our purchase price, assuming all else equal.”
Further Research Material
Alta Fox Capital: Everbridge (EVBG)
Connor Haley’s Alta Fox letters are some of my favorite quarterly reads. He finds and invests in unique business globally, and I always learn something new when reading his thoughts. You can check out his latest letter here.
Let’s dissect one of his latest pitches, EVBG 0.00%↑ .
What does the business do?
“Everbridge is an enterprise SaaS business that provides mass notification and critical event management (CEM) software in a world with increasing risks (natural disasters/weather, civil unrest, pandemic, active shooters, etc). The software allows large corporates to better manage employees and assets during times of disruption.”
Why is it a good bet?
“Everbridge serves 47 of the Fortune 50, has 110%+ net revenue retention, gross margins approaching 80%, and EBITDA margins that are beginning to meaningfully inflect higher.”
Why does the opportunity exist?
“The stock has always been far too expensive for us to underwrite to acceptable IRR thresholds within a reasonable valuation framework …
The sudden departure of the company’s CEO in December 2021 as well as forward guidance below the Street’s lofty expectations, prompted a precipitous fall in EVBG’s share price. In December, when Everbridge’s former CEO left to take the CEO role at a large PE-backed cloud business, he likely knew that EVBG trading at 14x revenue with slowing growth meant limited upside ahead (and limited personal wealth creation).
We believe the CEO departure, two disappointing 2022 guides, and broader market volatility have put Everbridge into the penalty box.”
What is the prize if you’re right?
“While we believe a sale of the company is in the best interest of all stakeholders, even if the company stays public, we estimate investors can achieve a ~30% IRR over the next several years as Everbridge’s EBITDA margins expand to the mid-30s and assuming a modest 13x EBITDA multiple.”
Substacks That Make You Go… Hmm 🤔
(1) The Last Bear Standing: When It Rains It Pours
By incorporating the covariance of revenue growth and exit multiples, the dynamic sensitivity shows a convex line with far more upside and downside. The two curves intersect on the base case assumption. If the company outperforms on growth, multiple expansion juices returns. If the company underperforms though, multiple compression leads to much lower returns. When it rains, it pours.
Investment decision are analyzed and iterated ad nauseum. A deal team will present pages of detailed model outputs, backed by endless assumptions, inputs, and calculations from overflowing excel files. Yet, the end result is always the same - the Base Case looks good, the Upside Case is a bit better, and the Worst Case Scenario is not all that bad.
Never will you see a 10-bagger or a complete donut in a memo, yet both these outcomes happen regularly. One key failure is the tendency to think about assumptions as independent (and often counterbalancing), when in reality they row in the same direction, compounding moves in good and bad directions. Better models incorporate covariance and convexity and the volatility each brings.
Tweets That Make You Go… Hmm 🤔
