To summarize our outlook and positioning, we see great opportunity in “risky” equities and great risk in “safe” equities – because price determines one’s margin of safety.
The Triple-C Crown
The “risky” names we’ll focus on below have some commonality – equity prices have been under pressure for any one of (or a combination of) these three themes. To the contrary, “safe” names have been beneficiaries of these themes:
- Commodities – The decline of crude oil and other commodity prices or end markets
- Currency – Impact of a strong dollar
- Credit – Sensitivity to widening spreads as a function of leverage (or lack thereof) and liquidity
Why did crude oil prices decline over 80% from its 2014 peak? A supply glut? Saudis defending market share? Iran production coming back online? The headlines would suggest so, but as the chart illustrates, it was not just oil. We certainly can’t ignore the Chinese demand factor, but we think there’s more to the story.
We think the simplest explanation is the most likely. Commodity prices are simply an inverse of the U.S. dollar. Since bottoming in July 2011, the trade-weighted U.S. dollar had appreciated over 37% in 4.5 years, as rapid a rise in that amount of time as we’ve seen in the last 20 years, only rivaled by the’96-’02 move (+35% over the course of 6 years). This single factor cannot be over-emphasized. Just as we believe that the confluence of the currency, commodity and credit headwinds that have pressured risk assets for several years are likely to abate, they will also have a negative impact on the beneficiaries.
Safety in Risk
Over the last 18-24 moths, “risky” stocks were considered so for good reason – valuations were stretched and the Triple-C headwinds proved meaningful. That was then.
Here’s the question: If there is some marker of a floor on valuation and the prior macro headwinds become tailwinds, are risk equities still “risky”? In our view, that’s when risky assets become safe assets.
We’ll focus on just few examples today to illustrate our point, but similar situations are unfolding throughout our portfolio – both long and short.
Kirby Corp (KEX – Long): KEX has a virtual monopoly on the domestic inland marine barge business. Certainly KEX was impacted by the crude/credit/currency trifecta, but the company has continued to grow shareholder value. Investors have only been able to buy KEX at these P/B levels 4 times over the last 20 years and we expect chemical transport volumes to increase in 2017-18.
Genesee & Wyoming (GWR – Long): GWR is a short line railroad operator and also has virtual monopoly in the regions it operates. Except for a poorly timed acquisition of Australian assets, the shareholder return profile and historically low valuation levels are similar to KEX.
Quanta Service (PWR – Long): PWR is a pipeline and utility contractor. The company has used FCF from backlog to reduce share count by 33% since Jun 2014 (green line) at trough valuations.
Industrial Metals Risk Bucket (Long – X, CENX, TMST): The Chinese have been dumping excess steel and aluminum on the U.S. market, which has pressured pricing for last 12-18 months, but in December 2015, the U.S. imposed 300% tariffs. Plus, metals prices appear to have troughed in China.
Risk in Safety
Just as the Triple-C Crown has weighed on “risky” equities, it has been a boon for “safe” equities. Declining commodity (input) costs have been a significant tailwind for Consumer Staples. Flows into the sector (as well as Utilities, REITS and Telecom) have been exacerbated by “Flight to Safety” and “Reach for Yield”. The stocks have worked well, driving complacency and record high valuations. This is also the case for a number of other sectors and industries. We have only seen this dynamic one other time in the last 20 years. We highlight several examples below.
In conclusion, we think the divergences in equity markets that have unfolded over the last 18-24 months have created an environment where Active Management can perform quite well in the coming years. We also think that smaller Funds may have an additional advantage due to their agility to invest where larger Funds may be constrained. We will remain prudent and thoughtful in our approach, hedge ourselves, and concentrate in our best opportunities when and where appropriate.
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ABOUT THE AUTHOR
Ryan Thibodeaux is President / Portfolio Manager of Goodwood Capital Management.
Ryan founded Goodwood Capital Management, LLC in March, 2012 and serves as a Portfolio Manager. Prior to starting Goodwood, Ryan was a Partner and Senior Equity Research Analyst with Maple Leaf Partners, LP. Maple Leaf Partners is a long short equity hedge fund started in New York by Dane Andreeff in 1996. In 2003, Julian Robertson’s Tiger Management seeded Maple Leaf and it became what is commonly referred to as a “Tiger Seed.” The firm eventually grew to over $2 billion in assets under management.
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