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Small Cap Hiatus

I haven’t written for a while. Summer is a hard time to find time.

This summer, that was compounded by a lack of things to write about. We rallied, the rally failed, we rallied, the rally failed again. I bought a couple stocks. I sold a couple stocks. I held nothing with a particular conviction that would compel me to write about it. My portfolio did nothing, which means, as it importantly implies, it did not go down.

The last time I wrote (mid-July) I was talking about going back to my default position. Putting back on hedges, putting back on shorts and trying to squeak out a few gains while not taking any big chances. That is pretty much what I did and pretty much where I am now.

While I remain nominally net long I am, in terms of my portfolio’s response to market moves, a little net short. Witness that on big up days during the summer I lost money (this is also due to my “natural short” of being long US stocks with a Canadian dollar account, otherwise known as my “edge”). On down days, I made a bit. Overall I am very slightly better off than where I started the summer.

The reason my portfolio acts as if it is net short is because I don’t own much in the way of small cap stocks. Yet the stocks I am short are the somewhat shitty one’s that tend to go down a lot when the market goes down (though vice versa as well).

The moves in the portfolio overall are small and the exposures are as well. That’s okay. The time will come again to take a large line. That time does not feel quite here. While many portfolios are down big double digit percentages from highs set in 2021, I am not and that is good enough for me.

I do feel like change is coming. This bear market is getting long in the tooth. Yes, there are plenty of things to worry about, but there are always plenty of things to worry about.

My approach this time around may be different. I am not looking to place bets on small-cap shooting stars.

Quite the opposite. My portfolio today (which I know I haven’t updated in a while, I will do that in the next couple days) is full of very large businesses and, for the most part, somewhat boring businesses.

My largest positions today are in stocks like Vertex Pharmaceuticals, Dole Foods, Hewlett Packard Enterprise, Verizon Communications, Meta Platforms and Alphabet.

Why the shift? Right now many very large companies trade at valuations that seem pretty reasonable to me.

In addition to these large cap names, I’ve bought some bank stocks. This is maybe crazy if we are indeed on the cusp of a recession. But I’m also short the Canadian banks, and short some other parts of the market that I believe will go down more, so I’m trying to cover my downside here.

My reasoning on a bank stock long is that if this recession is not deep, the banks have a lot going for them. What I heard on the Q2 earnings calls were banks talking excitedly (for a bank that is) about their net interest margin expansion. They were passing the floors on their variable rate loans, meaning they could hike rates on loans in concert with Fed hikes, and yet the deposit betas (meaning how much they had to raise deposit rates for their customers) was coming in muted.

Banks remain very cheap on trailing earnings that don’t reflect this expanding margin. The banks I am buying are generally below 10x PE.

But you have to be careful about what you buy right now. While the rise in interest rates has been good for income, there are some banks that have seen their book value slashed by paper losses on the securities they hold.

I am seeing some banks taking huge mark-to-market losses on treasuries and mortgage backed securities. These securities are going down as rates go up.

I’m not really sure what to make of these losses, because they are just paper losses, but they are also real in so far as they impact the banks tangible book calculation and therefore the capital ratios. Which means they will also impact the banks ability to grow.

These losses, which are called “other comprehensive income” (OCI) losses, don’t show up on the income statement. They feed through on that next page, called “Comprehensive Income”. I have noticed that most of the banks with the biggest OCI hits have kind of glossed over it like it doesn’t exist.

But they do exist and OCI losses are very big for some banks. Take Keycorp for example. I bought them and owned them for a few days until I figured out what was going on with their comprehensive income. Once I did I sold. Because Keycorp took an OCI hit of 37% of their tangible book in the first half of the year. That’s huge! They aren’t the only one – Fifth Third Bancorp, another bank I was looking seriously at until I ran into this OCI issue with them, took a hit of 31% of TBV.

Again, I don’t know what to make of these OCI hits. Do they matter? I’m not sure. They certainly make the bank look more expensive on a book value basis. Post the OCI hit, the bank is closer to running into regulatory trouble if something goes wrong with its loan book. OCI hits don’t impact earnings, though as I said they might impact the ability to grow earnings in the future.

Just to be safe, I’ve stayed away from banks with big securities portfolios that are taking big OCI hits. Funnily, its either the very small banks or very large banks that aren’t having to do that. The small banks don’t own a lot of securities. the largest one’s (like C, BAC or JPM) seem to be better at hedging their exposure.

The other big question is whether the banks will get creamed on loan losses brought on by a recession. A lot of that will depend on how bad the recession is. It will also depend on the nuances of each bank – where they made the loans, who they made them to, and what are the loan-to-values. So again, you just have to be careful.

The thing is, banks went through a pretty strict rationalization of their loan book with Covid. We are barely two years past that. It is not like there are years of excess baked in.

While I could get smacked on real credit driven downturn (I mean if credit goes south no bank is immune), if this is a mild-ish recession, I think bank stocks are going to do okay and maybe even well.

I have also done something that I never thought possible. I made the move into a few SaaS and tech names. I own Datadog, and Zoom. Pigs fly.

These stocks aren’t really “cheap”. But they are a lot cheaper than they have ever been since I’ve followed them. Take Datadog. I have followed it for a few years now. I make this little discounted cash flow model for it that I update every quarter or two. The details of that model aren’t super important, but what is important is that I always use the same assumptions.

Using the same assumptions means that I can track how Datadog is valued against my own crude valuation over time and get a sense of when it seems quite reasonable.

At $90 Datadog trades at a 20% discount to this fair value. It hasn’t traded at that level before (other than in June when it was $90). I read through the Q2 call, I read through their talk at the Goldman conference. The business still is what it is.

The thing about Datadog is that yes, its growing very fast, but it is also a free cash generating business. Their FCF margin was 18% in 2021. It probably goes about 20% this year. They are doing this while growing 60-70%. Yeah it looks expensive on a PE. But on a DCF basis with even conservative assumptions, it doesn’t.

So that’s Datadog. You can kind of make similar comments about, though they are maybe 2 years earlier on in the process and the free cash flow barrier hasn’t been cracked just yet.

Zoom is a different beast. They aren’t growing right now. They grew too much during Covid and now they have stopped. The stock is being whacked because they aren’t growing and because Teams is free.

That’s fine and it seems well-founded. My thoughts with Zoom are that A. It is hated and yet seems to be bottoming, B. It is not all that expensive at 11x EBITDA and a 5% FCF yield, C. It may start growing again some day and most importantly D. Zoom is on everybody’s desktop, everyone’s smartphone and I don’t think the value of that is priced into the stock.

But Zoom gives me the most pause. They could pull out an awful Q3 and I get stopped out of the stock.

You have to remember that my style is not to do a conviction-building deep dive into Zoom (or any other name) that most likely turns out to be wrong anyway and just keeps me from selling the stock when I should be. It works better for me to come up with a cautious, heavily caveat-ed, thesis, that has some merit and if the stock acts right I’ll assume I might be onto something.

I sold my oil stocks. I sold a lot of the gold stocks. I only own a small position in Newmont and Alamos Gold. I have been buying a couple copper stocks – Hudbay Mining and Taseko. These miners have been whacked pretty bad, they discount $3.50 copper at the current price and the longer term outlook for copper looks quite good to me. I’ve read a number of analyst reports that make the case that we don’t have enough copper for the renewables transition and that we will (eventually) need higher copper prices to get those projects built.

I also have sold almost all my biotechs. I moved up the food chain with the purchase of Vertex. Though I still own Eiger. I did sell a some of my Eiger in my less risk tolerant accounts (RRSPs) but I kept it in my own account, where I was okay having a bit more risk and also able to have more hedges via shorts (like an XBI short for example).

Eiger as a Covid play seems less likely to pan out than a few months ago. But Eiger’s stock has been surprisingly strong. The HDV results will be coming up in a month or two, which will make or break the stock. CEO David Cory also hinted at the Baird conference that they might have other countries interested.

So that is the kind of catch-up, catch-all summary. I’ll try to write something more specific about a name or two in the next few weeks.

9 Comments Post a comment
  1. concojones #

    Thanks for sharing your thoughts.
    Yardeni publishes a historical graph of valuations (“Blue Angels”) for the S&P 500 Value index which suggests we have a LOT lower to go in my view, when on his graph you draw a long-term earnings trend, and look at where valuations typically are in tumultuous times not to mention recessions. (Another sign of froth in the markets is retail sales which are still way above their multiyear trend and will have to come back to earth at some point.) This is why I’m largely in cash and my plan is to get back into the market in tranches as the bear market unfolds, using the Blue Angels chart as my guide.

    September 21, 2022
  2. concojones #

    For the Blue Angels chart, see this URL, figure 20:

    September 21, 2022
  3. concojones #

    Just to rephrase my point more clearly: on that chart, when you draw in that figure 20 a long-term earnings trend line (to smoothe out the cycles; mine does +4.8%/year since 1995 which also seems reasonable to me). And you compare to that trendline where the market has been (= the red graph in figure 20) at various points in time, it seems that the market is currently pricing in the nice economic environment of 2017-2019. Which is remarkable: in this economic environment I’d expect the market to trade more like in late 2018. And if there’s a recession, more like 2002 or 2010-2013.

    September 21, 2022
  4. If you’re not already a reader, BankRegData has good info on US bank trends and data; his periodic mailing list is helpful (the most recent one went into OCI).

    September 23, 2022
    • Thanks – any thoughts on banks yourself? Am I too soon to be buying something like BAC?

      September 24, 2022
    • Also, do you mind emailing me the OCI discussion? I don’t see it posted on their site.

      September 24, 2022
  5. Just sent it to liverless from my Yahoo account, and there’s an “add to email list” link in the email too. Likely not much there you don’t know, but interesting to read.

    I don’t have much of a thought on banks right now; I don’t have a sense on upside because the market seems very busy switching from derating to rerating on names I’d look at like CUBI. I definitely think a name like BAC is a good relative-performance bet, but I am definitely not smart enough to figure it out or handicap potential real returns.

    I recently bought MFDB when it got to $2, but that’s purely idiosyncratic: it’s a marginally-profitable tiny heavily-overcapitalized barely-traded “MHC” bank where the “real” float, as best I can make out, is around 1.15 million shares and equity is around $17 million, so purely a ridiculous-valuation/something-eventually-happening buy. Entirely possible nothing happens there, ever.

    September 24, 2022
  6. But more to your second question: gun to my head, I’d say my INSTINCT is that large, non-crazily-managed banks have pretty good prospective returns after a lost decade+ with multiple cleanups and rationalizations. Muttering about Italian banks looking good; I have not really dug into that, but it might be the same potential dynamic: shakeouts create opportunities for survivors. But this is pure (barely-examined) gut.

    September 24, 2022

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