The Rational Cloning: Weekly Ideas #57
Macro Ops: Merion on SIX, Ensemble Capital on SCHW, Right Tail on CSU; Substacks/Blogs & Tweets That Make You Go… Hmm 🤔
Welcome to the 57th edition of the Rational Cloning Newsletter (Weekly Ideas Series).
Helping you discover the best ideas of others.
Happy cloning.
Weekly Investment Ideas
(1) Value Investing Letter Recaps: Q3 2022
1. Merion Road Capital: Six Flags SIX 0.00%↑
What does SIX do?
Via TIKR.com: Six Flags Entertainment Corporation owns and operates regional theme and waterparks under the Six Flags name. Its parks offer various thrill rides, water attractions, themed areas, concerts and shows, restaurants, game venues, and retail outlets. The company also sells food, beverages, merchandise, and other products and services within its parks.
Why is it a good bet?
“SIX is another turnaround situation. [The company] is backed by hard assets and has a history of stable earnings.”
Why does the opportunity exist?
“New management is looking to grow EBITDA to $700mm vs. the $525mm range over the past several years, covid aside. Their strategy is to effectively reduce traffic and increase price, while prioritizing capital spend on high return projects. Results have admittingly been mixed so far.”
What is the prize if you’re right?
“Even assuming no benefit from the new initiatives, the company is trading at a reasonable valuation of 11x EBIT.”
2. Ensemble Capital: Charles Schwab, Inc. SCHW 0.00%↑
Ensemble discusses two of their long ideas in its Q3 Letter: NVR, Inc. (NVR) and Charles Schwab (SCHW). You can read the letter here.
What does SCHW do?
“Schwab’s core value proposition is about helping its customers, both individual investors and independent registered investment advisors like Ensemble, intelligently and efficiently invest in capital markets”
Why is it a good bet?
“Schwab grew its scope of services and revenue to new more profitable levels built off its ability to drive operating costs lower with scale thereby offering excellent value and service to millions of customers relative to competitors.
This has powered its growth and profit flywheel that relies on scale and efficiency to drive costs lower, allowing it to reduce prices that attract more customers and assets even as it invests to add higher value services to cross sell, which further increases scale and efficiency opportunity. As a result, assets held at Schwab now stand at over $7 trillion from about $1 trillion in 2005 …
Today, Schwab stands in front of a large revenue opportunity not seen since before the great financial crisis, with interest rates higher than they’ve been in a decade. As mentioned earlier, Schwab’s largest revenue source is now net interest revenue, and it’s a highly profitable source too. ”
Why does the opportunity exist?
“Schwab’s business model has changed over the years as its offerings and capabilities evolved, initially being driven by trading commissions, then distribution fees on third party mutual funds, and later asset-based fees on its own proprietary mutual funds and ETFs, and more recently net interest revenue that is derived from its customers’ cash holdings sitting on Schwab’s balance sheet.”
What’s the prize if you’re right?
“Earnings grew dramatically last time this cycle played out and with an even higher base of interest earning assets today, we expect the eventual higher NIM will power much higher earnings again.
One other thing to note is that despite near record low NIM recently, Schwab was already reporting record high adjusted operating margins in 2021. Adding billions of dollars in additional interest revenue at little incremental cost over the next couple of years should drive those margins higher.”
3. Right Tail Capital: Constellation Software CSU 0.00%↑
Jeremy Kokemor is back this week with his latest Q3 Letter idea: Constellation Software (CSU). Jeremy recently joined the Value Hive Podcast to dive deep into his Q2 idea, Ferguson PLC (FERG).
You can listen to that episode here and read his latest letter here.
What does CSU do?
“Constellation Software buys and builds niche software businesses which provide mission-critical solutions. Current President Mark Leonard founded the company in 1995. He has produced a track record of incredible growth and returns on capital. Constellation is headquartered in Toronto and has an enterprise value of ~$34B.”
Why is it a good bet?
“Constellation does many little things well, which is a great source of competitive advantage. They buy and grow many “little” businesses. They remain fastidious on price, usually only relying on their own cash flow to buy businesses. They balance growth and profitability rather than solely focusing on growth at any cost like many companies over the past several years. As a result, Constellation’s return on invested capital is exceptional.”
Why does the opportunity exist?
“The risks here are organic growth declines, poor capital allocation, and a headline valuation (~4-5% earnings yield) that does not scream cheap. Organic growth declines in the more important maintenance and recurring items would be a red flag. This seems unlikely given the company’s long history of organic growth and focus on mission critical software …
Growing revenues at a 20% CAGR and free cash flow at a 25% CAGR over the past 10 years while maintaining a flat share count are exceptional results. As the business gets bigger, these growth rates will likely decelerate”
What is the prize if you’re right?
“At recent prices, I believe Constellation Software can generate a 15-25% IRR for several years (vs ~30% IRR over the past decade) even with a slower rate of growth. At a 20% IRR, Constellation Software has the potential to double in share price in the next ~4 years.”
Substacks/Blogs That Make You Go… Hmm 🤔
1. Philo: MD&A: It's Never the Subsidies (High Speed Rail, The Subsidy Narrative, and The Midwit Fallacy)
Again, the simple explanation is the correct one. High speed rail is politically popular because people far prefer it over air travel, and we know this because it almost completely displaces air travel wherever it is built.
The subsidy narrative is a good example of the Midwit Fallacy we discussed previously. The Midwit Fallacy describes our tendency to reject simple answers and accept complex answers simply because complex explanations sound smarter. We do so even when the complex answer is contradicted by the available evidence and contains logical holes.
Here is a sampling of other related areas where you sometimes see people make a contrarian midwit case that Thing X is only popular because of subsidies:
Home ownership. Yes, the US showers homeowners with subsidies, but our home ownership rate of 65% is very much in line with other countries. People want to own their homes regardless of subsidies.
Car ownership. This has a bit more truth; we subsidize car owners in a multitude of ways, while other countries tax them heavily, which leads us to drive a lot more. However, cars are unmatched for their convenience and flexibility, and so car ownership in other countries is not far below what it is here in the US: in 2022, Americans owned 868 cars per 1000 residents, while Japan and Western Europe are in the 600-750 range.
Single family homes. People also like living in suburbs and in single family homes. Yes, single family zoning does limit the construction of multifamily housing in the US, which massively inflates rents and condo prices in popular cities, but single family homes are popular everywhere. In the EU, 53% of the population lives in single family homes (not all detached), while almost 70% of housing is single-family in the US.
Here is why the subsidy narrative is generally likely to be wrong:
Politicians like to subsidize popular things. That gets them more votes than subsidizing unpopular things. The subsidy narrative usually gets the causation reversed – the Thing is not popular because it is subsidized, the Thing is subsidized because it is popular.
In most cases, to get the majority of people to switch from a vastly superior Alternative to an vastly inferior Thing, the magnitude of the subsidy required would be tremendous. Like, implausibly tremendous. A small subsidy will nudge a few fence-sitters, but that’s usually all.4
Most importantly, handing out tremendous subsidies for something that is widely popular is impossibly expensive, simply because it is widely popular.
If the country only consumes a million widgets a year, a $100 per widget subsidy is manageable – $100 times a million is only $100 million. If the country consumes ten billion widgets a year, that’s a less manageable $1 trillion per year.
You can hand out small subsidies for popular things (like mortgages), and large subsidies for less popular things (like electric cars), but it is almost impossible to afford large subsidies for popular things. Incidentally, this is the exact impossible dilemma many countries are having to confront with energy prices this winter.
2. The Last Bear Standing: Pass GO, Collect $200 (On Dollar Nationalism)
Throughout the COVID pandemic, the U.S. federal government spent $5 trillion in fiscal stimulus. As outlined in previous articles, this $5 trillion was funded by the Federal Reserve’s quantitative easing. In other words, the money distributed by the Treasury did not previously exist. Money supply exploded.
The result was a doubling of the total dollars in circulation, but the beneficiaries of this dilution were largely U.S. consumers and entities, while the losers are international entities that hold dollars or fixed income dollar assets like U.S. Treasuries.
To protect against this risk, equity investors often insist on anti-dilution provisions. But there are no anti-dilution provisions when you buy U.S. Treasuries or hold U.S. dollars from trade imbalances. Since fiat currency can be created at will by the central bank, dollar holders are constantly on risk for currency debasement - dollar dilution.
While dollar dilution means global inflation, the U.S. economy is in a far better position to withstand higher prices. Since goods and services are auctioned globally to the highest bidder, the U.S. is in a far better position to win those auctions.
The U.S. dollar is the world’s reserve currency. Other central banks hold more dollar assets (largely U.S. Treasuries) than any other currency by far and a huge proportion of global trade is denominated in dollars. In certain critical trades such as energy, the dollar has a near monopoly on trade.
This global dollar dependence gives the U.S. a unique ability to leverage its own currency to its advantage4. The more that a country’s currency is held by foreigners, the greater the ability to dilute foreigners in favor of domestic interest.
Until recently, the U.S. has managed keep dollar dilution in line with true economic development, allowing the currency to maintain most of its value. But during COVID, this assumption was upended as the U.S. Treasury gifted its economy $5 trillion and the Fed footed the bill in the midst of declining global output.
But what are the alternatives? Outside of abandoning the democratic-developed finance system and integrating with the authoritarian regimes who have been forcefully tossed from the dollar system (i.e. Russia, Iran, North Korea, etc.), there really are none. Most of the rest of the world is captive to the dollar and the U.S. policy as a result.
The U.S. possesses unique economic power through its control of the world’s most important currency. At any time, the Fed and Treasury can print and distribute dollars.
To preserve this special lever over the long-term, the U.S. must practice monetary restraint and maintain economic growth, but in an emergency it’s one hell of a safety net, global disparities notwithstanding. It brings negative repercussions for the rest of the world holding dollar assets, but those are the rules of the game. In the short term, there is little recourse.
Commodity-rich nations have long been aware of the rules, but at least have a potent counterpunch in controlling the supply of exports. Foreign countries with dollar dependence who are also reliant on critical imports, however, have far less recourse. For such countries, the past two years will be a valuable lesson in the inherent risk of fiat dilution.
Tweets That Make You Go… Hmm 🤔
