June 2020 Macro Commentary
The Current Investment Environment Possesses Very Low Visibility
Proceed with “Instrument Flight Rules Only”
by Sanjay Khindri, CFA on July 3, 2020
Uncertainty abounds across a variety of factors that drive investment returns, e.g. the corporate earnings outlook, inflation, currencies, fiscal policy. Despite this, equity and credit markets have held up surprisingly well. The resilience can be attributed to two main elements: 1) there isn’t much of a precedent for the current economic situation, so the best “guess” of investors/analysts is that any earnings decline in 2020 is temporary, with a rebound to “normalized” earnings in 2021; 2) the Federal Reserve has provided an incredible amount of liquidity to the system, forcing that increase in money supply to find a home (see our April ‘20 Commentary here).
If valuations were in general “cheap”, investors could passively invest in markets and statistically rely on mean reversion to generate returns. But that is not the current context: low visibility plus high valuations require a different approach.
It can be difficult to remove oneself from the day-to-day of markets and objectively evaluate investment opportunities, especially when there is so much volatility. In this macro commentary, we review two examples of how we are focusing on a targeted, fundamental analysis of companies to drive portfolio allocations. The macro still matters, but gaining conviction on the details of situational opportunities is the best way to generate above average returns in the current environment.
Nuclear Propulsion and Medical Isotopes
Some may be familiar with a medical imaging procedure known as a SPECT test, in which a radioisotope is injected into the body. This radioisotope acts as a radioactive tracer which provides imaging of various parts of the body when viewed with a gamma camera. This imaging can diagnose various cardiac, neurological, and pulmonary issues. The primary medical imaging radioisotope, Tc-99m, is used globally in some 40 million procedures every year.
The more interesting aspect of Tc-99m, at least from an investment perspective, is the raw material supply chain. As of today, the only commercially viable way to produce Tc-99m is via Molybdenum-99 (Mo-99); but Mo-99 today is only created through the fission of uranium. The supply issues with Mo-99 are now obvious: nuclear proliferation is a global concern and commercial nuclear power plants (in which Mo-99 can be produced) aren’t exactly ubiquitous.
A certain company, which we hold in our portfolios, has developed a proprietary process to produce Mo-99 that bypasses the use of uranium altogether and will be capable of supplying 100% of North American demand on day 1 of commercialization1. The company’s expertise in this area derives from its primary business of developing nuclear propulsion systems and the maintenance and servicing of commercial nuclear reactors.
There are other companies which have been conducting research and development on alternative sources of Mo-99, but none have been able to create a solution which both 1) satisfies a large portion of domestic supply needs and 2) is plug-and-play for radiopharmacies (i.e. doesn’t require downstream supply chain changes). The fact that this specific company is able to immediately scale up to 100% of North American demand while also being plug-and-play implies that it can capture significant market share simply on supply consistency and price (i.e. there is an implied large production cost advantage).
Our analysis of this situation concludes by valuing this opportunity to the company while also evaluating the core business: nuclear propulsion technologies. The company’s core business is developing and supplying nuclear power systems to the U.S. Navy’s submarine and aircraft carrier fleet. One potential risk is budget cuts impacting Navy fleet development. By evaluating Department of Defense research reports delivered to Congress, one learns that the replacement of the Navy’s nuclear submarine fleet is a top priority, so any overall budget reductions will be met by cutting non-nuclear spending.
Our valuation informs potential upside while a risk assessment informs potential downside outcomes. The two together drive the portfolio weighting..
Housing and Infrastructure
One of the relative bright spots in the U.S. economy has been the residential housing market. Yes, the lock-downs kept potential buyers away which has impacted housing starts and sales; but incredibly, the Mortgage Banker’s Association purchase application index is now above pre-Covid-19 levels. This is a paradox: it seems absurd when viewed in connection with the record number of unemployed, but is plausible when viewed in connection with the wealth disparity exacerbated by this recession (see our May ’20 Commentary here).
The median age of a homebuyer is 47, while the median age of someone working in a restaurant is 292. Job losses have disproportionately impacted the younger and lower paid, and the younger and lower-paid are also more likely to be renters than homebuyers. Finish it off with the Federal Reserve keeping interest rates very low across the curve and the paradox is complete. This is all before even considering the potential acceleration in urban flight as a result of the virus.
Housing starts (construction of new homes) have never recovered to levels seen before the financial crisis of ‘08/’09, when easy financing was widely available. But today, there is also a shortage of land impacting housing supply. Homebuilders will benefit from the rebound and likely acceleration in new home demand, but the margin outlook is more cloudy due to low land inventory. We look further upstream to uncover beneficiaries: building/construction materials suppliers.
The interesting aspect of construction materials suppliers in general is excess capacity. Because housing construction has consistently been more than 30% below pre-great financial crisis levels3, building materials suppliers have meaningful excess capacity, and therefore meaningful operating leverage. The implication is better margin performance in a renewed secular upward trend in home construction.
The near-term could be challenging for construction materials suppliers, not just from the temporary dip in housing construction, but also from a pause in commercial building construction and infrastructure spending. This makes it all more important to focus on individual companies as opposed to an ETF-based investment (e.g. a sector ETF). Because of the higher operating leverage and more uncertain near-term, we rely on in-depth financial modeling to predict cash flows and leverage ratios. This modeling also allows us to hone-in on valuation and understand what the market is expecting in terms of earnings.
By straying from the mainstream homebuilders that investors generally follow, we can find opportunities with the potential to realize outsized benefits from an overall industry thesis.
1Company Management expectations
2Pantheon Macroeconomics
3In terms of total monthly private housing unit starts
Gallatin Capital Management, LLC
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