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Q3 Report Card / GSE Update
Kaoboy Musings 13 – 11/19/2019
Q3 Report Card
Since Q3 earnings are now mostly out of the way, I thought it would be a good time for a recap as well as a candid self-assessment on my own prognostications.
What I Got Right So Far
Since Kaoboy Musings 3 (9/27/19), I have been sharing my then-contrarian viewpoint that the U.S. economy was not about to go into recession -- notwithstanding a spate of weak economic data, an inverted yield curve, heightened trade tensions, etc. There is nothing magical about using 9/27/19 as a basis for comparison, but since that is the date I began pontificating about the economy, I will use that date in my forthcoming comparisons.
So far, this sanguine view of the economy has borne out. In Kaoboy Musings 5 (10/3/19), I predicted that the Administration would use the trade tensions as a lever to induce the Fed to shift into a dovish stance and then get a trade deal done before 2020 elections. This, too, appears to be happening. Jerome Powell has definitively shown the markets that the Fed is more likely to let the economy run hot than allow the specter of deflation to take hold. Jobs numbers have subsequently surprised to the upside, and whereas in the past “good” economic numbers may be negatively received by the markets in anticipation of hawkish Fed policy, Fed effectively negated this upside headwind.
The yield curve has steepened materially (see chart below), and not surprisingly, the XLF (ETF that tracks financials) has ripped 6.2% since then (although it surprised me that this was not much better than the S&P 500’s overall 5.4% ascent over the same period). Financial institutions, which are generally in the business of borrowing short-term and lending long-term, benefit from a steep yield curve.
On the “micro” side, the resilience of the economy is borne out by the Q3 earnings scorecard as well. As of this writing, 93% of the S&P 500 companies have reported Q3 earnings. The trend I outlined in my Mid-Earnings Season Gut-Check in Kaoboy Musings 10 (10/29/19) has largely continued. Overall, the earnings beat was a whopping 4.74% with a sales beat of 0.44%. 10 out of 10 industry groups reported earnings beats, and 6 out of 10 groups reported sales beats. The 4 groups that had negative sales surprises were: energy (-0.43%), materials (-1.48%), industrials (-1.99%), and utilities (-5.5%); it amazes me that despite these headwinds in these 4 groups, all of them still reported earnings beats, demonstrating that they’ve been able to reduce costs faster than revenue declines.
Part of my optimism about the markets and economy ironically comes from the fact that there have been almost as many “rolling recessions” within certain pockets of the economy as there have been mini-bubbles and that the overall market, while not cheap, is also not “irrationally exuberant” as it was back in 1999-2000. The weakness in the 4 industry groups above illustrate this in real-time. As long as this weakness does not metastacize into other industry groups, I would argue that this weakness actually provides our inflation-targeting Fed an even longer runway to be accommodative since at least 3 of the 4 industry groups that missed on revenues (energy, materials, industrials) seem to be directly exerting deflationary forces.
Although I think there is risk of a “melt-up” into year-end, it’s worth noting that the stock averages are all plumbing all-time highs already: the S&P 500 is up 24.6% ytd, the NASDAQ is up 29%, and even the Russell 2000 is up 18% ytd. The markets are not cheap and have now discounted a lot of good news already. I tend to get more cautious as contrarian views become more mainstream, and I believe that is happening now. I am not chasing beta here and prefer to stick to less frothy, “value” names in this tape.
Heady markets notwithstanding, I still do not believe we are on the precipice of recession simply because we are in the “longest expansion ever.” As I have opined in the past, I believe the intensity of the expansion matters more than the duration; given the somewhat flaccid recovery of most of the last decade, I believe that the duration of the expansion will exceed most people’s expectations.
What I Got Wrong So Far
In Kaoboy Musings 10 (10/29/19), I gave several reasons for why oil and oil stocks may be poised to outperform. So far, not so good. Oil is down 1.3% since then, and the XOP (an ETF for oil and gas exploration and production) is down ~8% since. Believe it or not, this 8% decline belies much more severe carnage in the sector as worries over free cash flow and scale have hammered smaller-cap players – the small-cap (TEV of $4 bn and below) basket of Permian shale developers I follow is down 10% to 72% ytd! Worse, the basket of 20 post-reorg (names that have emerged out of bankruptcy over the last several years) names that I follow in this space is down an average of 51%, with several of them down 80+% and likely to go “Chapter 22” (industry slang for Chapter 11 a second time around). Even some names that I consider to be “best in class,” like Diamondback (“FANG”) (which I own, in the name of full disclosure), have stumbled badly in this environment – down ~16% just from 10/29/19. This sector is not for the faint of heart!
Truth be told, this sector has been my personal albatross over the last several years, as the “shale miracle” that has enabled the U.S. to export more crude than Saudi Arabia has largely resulted in massive value destruction amidst lack of capital discipline and way too many players. Consolidation is happening now through mergers as well as bankruptcies, but the process of rationalization has occurred far more slowly than I thought.
In the end, the situation in U.S. shale reminds me of the cutthroat steel industry of Carnegie’s heyday, plagued by long periods of brutal commodity prices. The winners in these industries will be those with strong balance sheets who can execute with capital discipline and be the low-cost producer.
Although it’s always challenging to be a deep contrarian and look for “treasure” amidst what is being tossed out as “garbage,” other investors that are more well-known and well-capitalized than me appear to be doing the same thing:
Another name that I’ve been wrong on so far is the GSE preferred securities, which I recommended all the way back in my Kaoboy Musings debut on 9/18/19. The on-the-run benchmark that I view as the proxy for all 40 flavors of these securities is FNMAS, and this name is down 28% from 9/18/19, with 10% of it coming today. What’s even more surprising is that most of the news that has come out has been generally supportive of the thesis even if the timing is not 100% known. Therein lies the trickiness of timing markets and the importance of being patient – in the short-term, it is often impossible to ascertain what kind of expectations might be embedded in the market. In the longer-term, I might be 100% right on my thesis and potential upside target in this name, but in the short-term, I could be very wrong in knowing what market participants have embedded into the stock price. In my experience, volatility and timing uncertainty almost always accompany situations with outsized return potential. For this trade in particular, it has been an 11-year roller coaster; the difference this time, however, is not if GSE reform is happening, it’s when; given that, I’m surprised at the depth of the selloff even if timing is pushed out by a year or so (and I’m not convinced that it is). As I have previously indicated, I have owned these securities from much lower levels for 11 years now. The reasons why I continue to think these preferred securities are interesting (far more so now given the near 30% decline) can be summarized in Kaoboy Musings 1-4, 9, 12. I added to my position today for the first time in several years.
The Billion Dollar Question, however, is timing – I believe recent comments from FHFA Director Calabria have introduced some uncertainties regarding timing of the outcome, and I think this is the primary catalyst for the selloff as opposed to anything material to the thesis. On November 15th, Calabria suggested that Fannie/Freddie may not exit conservatorship until 2022-2023 but in the same breath mentioned that they would likely need to raise new capital by 2021-2022 – this suggests to me that they still have a lot of heavy lifting to do (negotiating with Treasury, settling the lawsuits, etc.) in a hurry despite Calabria’s comments about the process not being calendar dependent. On November 19th, Calabria and the FHFA announced that it will re-propose capital requirements for the GSE’s in early 2020, and since a capital raise is unlikely to happen before such capital requirements are finalized, the bearish argument I’ve heard is that this pushes out the capital raise/conservatorship exit to a date beyond the 2020 elections, which then presents political risk in that a Warren Presidency could conceivably fire Calabria and name its new FHFA Director with a different agenda entirely.
I have several problems with this bearish thesis: 1) it should not be a surprise to anyone that it will take time for the GSE’s to rebuild capital even under the partial uncapping of the Net Worth Sweep enacted on 9/30/19, 2) given the hostility Calabria/Mnuchin encountered at the 10/23/19 testimony in front of the House Financial Services Committee, I don’t think it’s a bad idea to avoid making GSE reform a political football until after the 2020 elections, 3) as I’ve opined many times, I don’t think even a Democratic Administration will ultimately risk destabilizing the mortgage markets by severely altering the trajectory of the GSE’s; if the end goal is to get them well-capitalized enough to stand on their own in the future and still preserve the 30-year mortgage, I don’t see many alternatives to the current plan, 4) I still believe that between now and the 2020 elections, the FHFA/Treasury are likely to take several steps (in addition to some of the ones already taken) that will make it difficult if not impossible for a new Administration to “unscramble the egg” without risking disruption to the housing market; as mentioned earlier, if they plan to raise capital in 2021-2022, this only gives them a year or two to accomplish a lot of milestones – almost all of which should be positive for the thesis, 5) finally, if the depth of the selloff can be truly attributed to a real chance that Warren may win the Presidency, one would think the overall markets would be correcting severely instead of plumbing new highs.
There is one more credible explanation for the severity of selloff, since I don’t believe it has to do with the fundamentals of the thesis. Two other widely-held “hedge fund” names, Pacific Gas & Electric (“PCG”) and Intelsat (“I”) have collapsed due to idiosyncratic issues (see below). My sell-side trading contacts tell me that there is significant cross-ownership of these names along with the GSE preferred securities and that heavy losses in these unrelated securities may have led to forced selling of other holdings like the GSE’s. Taken in isolation, I would be a bit skeptical of this as the proximate reason for the GSE selloff; however, taken with the concurrent Calabria comments that may have disappointed some weak-handed holders with perhaps unrealistic expectations on timing, I think it is very credible.
Interestingly, I came across a blog post from Todd Sullivan who is a fellow value investor that has been invested in these GSE preferreds for years. The following are paraphrased notes he took from a talk Craig Phillips (a Treasury official who worked extensively on GSE reform with Mnuchin before he resigned on 6/17/19) gave on 11/15/19:
He thinks the GSE’s will be privatized Administratively with “zero chance” of Congressional involvement
Treasury thinks that its warrants are potentially worth $60-$80 bn and that it wants to IPO
He thinks that Treasury must deal with junior preferred holders in order to IPO
He thinks that preferreds get equitized to common (see my “home run” scenario below)
After this equitization, he thinks the capital raise occurs
The “receivership option” mentioned in the 10/23/19 hearing was just “posturing” and “not even being considered”
The most interesting thing that Todd speculated on is that Warren Buffett was being considering to write the sizeable check required for the capital raise. I quote Todd: “Why Buffett? I’ve heard now from 3 different people that execs from Freddie were in Omaha last week. I doubt it was for steak dinner.” Indeed, as an avid Berkshire/Buffett watcher myself, I’ll note that Berkshire now has $128 bn of cash burning a hole in its pocket.
The bottom-line is that outside of timing uncertainty, I don’t think anything about my thesis has changed, except that the original upside / downside risk of 100% up / 50% down has now improved to ~180% up / 30% down based upon my original price targets for FNMAS. For certain less liquid, off-the-run issues like the ones I own, I believe the upside / downside is more like ~235% up / 15% down. I am basically modeling slightly above par (~107%) for the upside target and around ~27% of par as the downside. I believe there is very low likelihood of a zero outcome in the GSE’s, and I think that there are “home run” scenarios where the preferred gets equitized to new common, and the upside becomes uncapped and can ultimately be 300-500% in this case.
Given how long this thesis has taken to play out, I think the market is perhaps exhibiting some PTSD whenever there is any uncertainty, but I think to dismiss the very real momentum behind the push to exit conservatorship when the only real issue is timing is to miss the forest from the trees – especially when the timing of events required to occur before a 2021-2022 capital raise still suggests the likelihood of many positive catalysts within the next 12-18 months, which was the original timeframe I mentioned in Kaoboy Musings 1.
At the end of the day, anything with this kind of potential return often carries with it an enormous amount of volatility, so caveat emptor -- if it is not within your constitution to withstand this kind of volatility, I would not get involved in this name.
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Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets. I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.
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