Four Industries Facing Substantial Change

"Life is pleasant. Death is peaceful. It is the transition that’s troublesome.” - Isaac Asimov, Writer (1920 to 1992)

The M2X portfolio is up +9.3% year-to-date 2017 (gross of fees, net of interest expenses, borrow costs and commissions). At this point in the market cycle, with numerous risks present, yet seemingly ignored by the market, M2X has limited overall market exposure by running an average net exposure of +14% YTD (long exposure less short exposure). Additionally, we continue to construct the portfolio in a manner designed to limit directional exposure to any one country, industry, commodity or style factor (e.g., momentum, value). Finally, to protect against outsized downward market moves, we maintain portfolio insurance in the form of options and continue to shock test the portfolio’s construction for potential large macroeconomic moves. While these risk management efforts are not always fully appreciated in a bull market, we are increasingly confident that their benefits will be evident in months to come. In the interim, we continue to focus on single-stock selection, our core competency, to generate competitive returns with as little market risk as possible.

?Change Means Opportunity

As we scour the market for mispricings, M2X frequently looks to areas of the economy undergoing a transition, or change, of some sort. These situations can present great single-stock investment opportunities, long and short, and often fall into one of the following categories:

• Cyclical Change – the recurring up and down fluctuation of an industry (e.g., auto sales)
• Secular Change – unique and longer-term trends (e.g., technology into automobiles)
• Business Model Change – financial or product-driven change (e.g., hardware to software)

Many companies are subject to more than one of these transitions. For example, Delphi Automotive is in the highly cyclical automotive sector, subject to the secular trend of technology into transportation and undergoing a transition in its business model (more software product plus a spin-out in process).

4 Industries Facing Disruption and Transformation

From the numerous industries being monitored, we list four below that are facing significant changes in the months ahead. Given space constraints, the discussion will focus on the core issues these industries face. For those that have interest in a deeper discussion, each industry dynamic and portfolio exposure can be discussed offline in more detail.

#1 – Automotive: Cyclical, secular and business model changes are all happening

M2X exposure: Long well-positioned secular winners / Short both secular and cyclical losers

The auto sector is facing unprecedented change. Cyclically, vehicle sales in the U.S. are a source of considerable debate. Low interest rates and an improved economy drove sales from an annualized rate of 9 million in early 2009 to 18 million in late 2015. Recently, sales have trended downwards causing concern about future trends. At the same time, there are big secular changes happening as electric drivetrains take share and technology content per vehicle increases. Finally, business models are transitioning and emerging. For example, a few established players are becoming more like software companies, some software companies are entering the auto sector, and certain emerging companies are offering “mobility as a service.”

This level of transformation presents numerous risks and opportunities. So-called “value traps” are present; situations where “cheap” stocks may see earnings collapse rapidly and then look to be quite expensive. Other companies trade at low valuations yet seem to be well-positioned in terms of key secular trends. Finally, the derivative impacts of these industry trends will flow to many other industries, some for the better and others for the worse (e.g., automotive technology is a driver of new demand for semiconductor capital equipment providers such as Applied Materials).

#2 – Grocery: Sleepy and stable industry no more; Big changes on the horizon

M2X exposure: Long secular technology winners / Short those with unique, unappreciated, risks

Years ago, I was a strategy consultant and worked on the operational model for one of the first online grocery companies in the United States. As I tweaked capacity utilization in my model by small amounts, the output turned from being highly profitable to bleeding cash. My not-too-valuable conclusion at the time: It is a tough business. That was then and this is now. My recent investment research combined with my past experience leads me to believe that the trend towards more grocery sales occurring online is just beginning.

Amazon’s purchase of Whole Foods was a seminal event in the industry. For those that wondered about the impact this new player might have, Amazon gave them a wake-up call with a price cut announcement to be implemented on the first day the acquisition was completed. Some analysts seemed to imply the price cuts were hyped too much by the media. They do realize this was done on day one of the acquisition, right? Those that do not appreciate the risk are akin to Conor McGregor taking the first punch from Floyd Mayweather in round one and Conor saying, “Well that wasn’t so bad, was it?”[1]

Less attention has been given to the expansion of discount European food retailers, Aldi and Lidl, into the United States. Having seen firsthand how effective these innovative formats have been in Europe, I do not believe this new competition should not be taken lightly. These changing industry dynamics make a once sleepy industry look very interesting to a stock picker. Long-time U.S. grocery executives will be working longer hours in the months to come and quant investors should think about updating their beta calculations (Kroger’s beta is 0.74).

#3 – Industrial Distribution: Pricing and margin changes looming

M2X exposure: Short bias through much of 2017 as risk level not fully appreciated

For those looking carefully, Amazon’s intentions to expand into this market were revealed in a court filing many months ago. It made perfect sense as industrial distribution is a big market with strong margins and returns on capital. Many analysts did not seem to give this changing dynamic much weight at the time – but that changed earlier this year when Grainger announced a surprising price cut on hundreds of thousands of SKUs.

How might this play out? A conversation I had with a roofing contractor provides some insight. I asked him if he bought supplies using Amazon. At first, he said he did not. Then he thought about it and said, “Actually, I do buy a few things.” He explained that his distributor was sold out of some simple, but often used, material a few months ago. He had a job in 3 days and needed it. He expressed his frustration to the distributor and went on Amazon and bought it. The cost? About 35% cheaper than he used to pay. Worse yet, he never bought that product from the distributor again.

The point is that Amazon does not have to take all your sales to materially change your business. There will be products that are “un-Amazonable” and, certainly, some distributors will compete well over time. However, when a large new competitor starts cherry-picking high-margin products from your existing customer base, the future might look quite different than the past.

#4 – Solar: The never-ending “solar coaster”

 M2X exposure: Monetized recent gains with limited current exposure; Closely monitoring the situation

Solar, all through the value chain, has been an exceptionally volatile space in which to invest since the very first public companies came to market over 10 years ago. It is a classic case of a hyper-cyclical growth sector, with over-supply and under-supply dramatically changing the relative opportunity through the value chain over short periods of time.

This year, stocks have rallied (the Guggenheim solar ETF is up 30% YTD). Yet there is a valid argument that some demand has been pulled forward, which could mean a falloff in demand is on the horizon. Worse yet, Suniva has filed a trade case for tariffs to help support U.S. production (ironically, Suniva is Chinese-owned at this point).[2] Various procedural decisions are imminent and ultimately President Trump could be the final decision. While the whole situation is a bit crazy, I’m reminded of something someone told me some time ago, “never confuse how things should turn out with how they might turn out.” The “solar coaster” will be moving sharply in the months ahead.

Final Thought: Poker as an Investing Metaphor

The game of poker provides a useful metaphor for investing. First, each poker hand presents an opportunity. Therefore, seeing more hands is a good thing if you play well. For M2X, this is part of the rationale in tracking industry transitions. As the industry changes unfold, numerous stocks will be moving, both up and down. In poker terms, the cards are being dealt and the game is on.

Second, good poker players calculate the probabilities of how much they can win versus lose on each hand. Part of that involves assessing how many “outs” – meaning cards that can lead to a good hand – are possible for a given situation. Likewise, in investing, one needs to understand how many ways an investment lead to a positive outcome versus a negative one. Also, investing provides an opportunity to change the odds a bit, if desired. For example, I recently sold two long positions that have appreciated a considerable amount. I replaced them both by selling puts as I am a willing owner down 10%. In the meantime, I’ll monetize the income from selling the option.

Third, in poker, it is important to assess who is at the table as they will influence the game. Is the other player being overly aggressive as he or she has an hour drive home to the family (very common at charity poker events)? Or are there players who seem quite good at math, playing tightly, and seem to be approaching this as the biggest event in their 28-year-old life thus far (also quite common at charity events, I might add)?

While always important, “who is at the table” has become even more interesting in public equity investing as the investor makeup is constantly shifting. Currently, index and quant funds are influencing stock prices more than ever, especially among small/mid cap companies. For example, the current portfolio has a position in a company that has sold off even though they potentially will win one of their biggest contracts in history in coming weeks. Why? The company has two very different business lines, one of which leads it to being in certain industry ETFs unrelated to the one in which the contract may be won. Also, the current ownership is dominated by passive index funds, which seemingly sold after the last quarter disappointed. Knowing these types of situations can lead to better confidence in increasing – or decreasing – positions at opportune times.

Likewise, private equity is likely a “new” player at the table as funds are flush with cash and feeling pressure to put it to work. Whether these deals ultimately prove smart or not to their investors, the public-to-private acquisition potential does change the risk/reward to public equity investors.

Fourth, poker is a competitive – and very emotional – game. Often when you win a few hands your confidence in the next hand irrationally increases. After a big loss, emotions can drive us to want to win it back faster than is prudent given the opportunities at hand. If someone at the table is irritating, you may desire to knock them out of the game and play more aggressively than you should.

Investing is even more emotional. In my humble view, fund allocators are better-served spending more time in understanding a portfolio manager’s emotional makeup and a bit less on the logic of specific investment theses. Many times, errors that are perceived to be analytical in nature are, in fact, caused by emotion.[3]

M2X runs a concentrated portfolio of mainly single-stock positions. In poker terms, we only “play” a small percentage of hands we see. Our view is that if we see a lot of hands, calculate risk/reward consistently well, understand the other players at the table and keep emotions in check, positive risk-adjusted returns will follow.

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Michael Molnar Biography

Michael Molnar is the Portfolio Manager and Managing Member at M2X Capital LLC, an asset management firm focused on investing in public equities. He has been involved in the energy, industrials, materials, agriculture and consumer sectors as a hedge fund investor, investment banker and sell-side equity analyst for over the past 15 years. In 2016, he published the book, Decoding the Energy Enigma: Improved Decision-Making on This Generation’s Most Pressing Issue, which applies systems thinking and behavioral economics to important topics in energy.

Previously, Michael was a Founding Partner and Co-Managing Member of Lorem Ipsum Partners LLC, a long/short equity hedge fund focused on the energy, industrial and agriculture sectors which grew to approximately $200 million in assets under management during his tenure.

He was also a Founding Partner of Greentech Capital Advisors where he advised clients on M&A transactions, strategic joint ventures and private capital raises. He served on the Board of Directors and the Commitments Committee, helping the firm to grow nearly 10 times, raise two rounds of capital and expand to three offices around the world.

Prior to Greentech Capital Advisors, Michael was the lead equity analyst for the U.S. alternative energy and coal sectors at Goldman Sachs. At Goldman, he also helped to start the Small and Mid-Cap Research Team and was a member of the Special Situations Research Team.

Prior to Goldman Sachs, Michael was a Visiting Research Fellow at Accenture’s Institute for High Performance Business, a company-sponsored think tank. His research focused on management techniques to most effectively maximize shareholder value and was published in both internal and external business journals. He was also a manager in Accenture’s strategy consulting practice.

He started his career as an auditor with Arthur Andersen LLP. While in university, he interned at the Federal Bureau of Investigation where he assisted in white-collar crime investigations.

Michael received an MSc in Decision Sciences with Merit from the London School of Economics, an MBA in Finance from the University of Chicago, and a B.S. in Accounting with Honors from Rutgers University. He is a CFA (Chartered Financial Analyst) charterholder and is a former CPA (Certified Public Accountant - inactive), CMA (Certified Management Accountant – inactive) and CFM (Certified in Financial Management - inactive).

Outside of work, he enjoys yoga (completed yoga teacher training), stand-up comedy (both watching and performing) and training in mixed martial arts.

He can be reached at [email protected].

Disclaimer

This report is confidential and intended only for the person to whom it has been delivered and may not be published, distributed or reproduced for any purpose without prior written consent from M2X Capital LLC. 

References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as a recommendation to purchase or sell such securities. The contents hereof should not be construed as investment, legal or other advice. Where information provided in this document contains forward-looking information including estimates, projections and subjective judgment and analysis, no representation is made as to the accuracy of such estimates or projections or that such projections will be realized.

The views and information expressed herein are solely those of M2X Capital LLC as of the date of this letter and are subject to change without notice. This is not an offer or solicitation for the purchase of interests in any investment. Past performance may not be indicative of future results.

Copyright 2017 by M2X Capital LLC. All rights reserved.

[1] On the off chance that Conor McGregor reads this, I would note that (a) this is simply an imperfect comparison which means no disrespect to him, (b) I thought he did a very respectable job in the fight and (c) I am 12.5% Irish on my mother’s side.

[2] I personally love this article title from Bloomberg: “China-Owned U.S. Solar Maker Seeks U.S. Tariffs on China Imports.”

[3] Process is important as well. See the September 2016 newsletter entitled, “Judgment: The Key to Outperformance,” for more discussion (https://www.m2xcapital.com/newsletters).