New Constructs' Live Podcast: Intelligent Capital Allocation - 29 September 2023

Thanks for joining us. We are all in Nashville this week. Everybody is in the office together for a collaboration week. One of the things that we did together this week was go to Second Harvest, which is a very large food bank for Central Tennessee, and do some volunteering there. So you can see our whole group.

Yeah, it was a really great event. I think everybody really enjoyed it. I think they told us that we sorted 7,600 pounds of frozen meat.

I really liked it. We'll go ahead and get into the main portion of the podcast this week. You're here with us, New Constructs Intelligent Capital Allocation, David Trainer, Kyle Guskey, Haakon Saalt, Liam Annetta Kohler. Here's our disclosures and disclaimers. And the agenda for today. We've been getting some great input in society and we're really happy that you guys are using that community. Tons of research coming out of Kyle's team as usual. Great Danger Zone podcast link that David did. Also information on the Birkenstock IPO. The Safest Dividend Yield Model Portfolio has a featured stock for September and the Dividend Growth Stocks Model Portfolio also came out for September. There was some movement on the focus lists, both long and short, and a great long idea that Iolo wrote up this week. So please don't hesitate to check out that research. Shortly, we'll be going out to interesting headlines with David and then over to Lee for analyst updates. We'll go out to society to see what you all have been talking about and start answering some questions out there as well. Kyle will wrap it up for us doing a DCF case study on a firm. Over to David. Or interesting headlines.

It's been really, really awesome, fun, heartwarming, exciting, productive to everybody in the office. It's great. And it's such a reminder as to, to why I wanted to do New Constructs to begin. It's really amazing how many great people we have. And it's also super cool that the highlight of the week usually is our service project. It's something that I always wish I did more of every single time I do it. Other big news here, interesting headlines. I want to touch base on the Bloomberg New Constructs True Earnings Capture Index, changing the name a little bit. We now have 2 of the top 5 issuers in the world that we're having some advanced talks with and who are very interested in this. So we're excited about getting this launched pretty soon. There's still a 75-day waiting period before it can actually ever go public, but It's good to see that there's a lot of interest. I think that this is the kind of environment that's perfect for new constructs and what we do on that front. The other really cool thing I love about these meetings is that there's always a lot of interest in, well, how many other ETFs can we have? Can we have a new constructs version of the cash cows? Heck yeah, we can. We have a better measure of every fundamental metric, right? The Morningstar Wide Moat, Index, right? Could we do that better? Heck yeah. They don't even have a reverse DCF at Morningstar, so I don't even know how they measure moat. I think it's all sort of conceptual.

I'm personally looking forward to that ETF coming out and the strategy has been performing well. So we don't get updates every week or every day from Bloomberg, but I would love to have been invested in it this year.

Yeah. Yes.

It's doing well.

The show with Morgan Slade at WorldQuant, I mean, we were, you know, as a long-short index, it was outperforming by, I don't know, it was like 70% or something ridiculous this year. So when capital allocation starts to matter again, this is why this is the Society of Intelligent Investors, because intelligent investors understand the concept of capital allocation, which to me at its core is about I want to take a dollar and I want to grow it by investing it in something that creates value. That's it. And if, as long as the world is moving in the direction where they're thinking more like that, then we're going to do awesome. We should continue to do awesome because we're measuring relative value, cash flow, and all that I think as well or better than anyone else that we've ever seen. And we don't know of anyone else that can offer the hard evidence that we do have superior data. So it's good to see that grow. And on that front, 4 focus list changes. That's a lot of changes. We don't make changes to the focus list very often. That's as much as we've maybe made all year. We went back and we're kind of looking and talking about these things, and we decided to pull the plug on one and add 3 more. So we were talking internally about model portfolios and ratings and the website and And Tamara had a really great point, you know, that a model portfolio is super easy to use. We get a list of stocks, we tell you why we've picked them. There it is. You like them or you don't. The ratings on the site could potentially require a little more interpretation because of the context you bring to looking at the rating, whether it's good or bad. And so we think there's a lot of value in these model portfolios, which by the way, you can buy à la carte. on the site now. If you want to get one of those, there's low as $9.99 a month. Model portfolios, especially the focus lists, that's a lot of work. That's a lot of value add. Those lists have since inception done really well. We had a question about Valvoline and what's going on there, because that's a stock we've liked and we've written positive things on, and yet the rating is looking pretty ugly. And what's going on there is that Valvoline recently engaged in a really big divestiture and the disclosures in the most recent filings are not clear enough and we don't have enough filings post the divestiture to really put together a model that represents the new co— the new company. And so things are looking pretty weird in our model and we can't do anything about it. It's going to look a little bit ugly until we get some new Ks and Qs in there to build a model around what the new company looks like. In the meantime, We're still confident in our thesis around what that new company will look like and why it remains a good investment.

And we anticipate, by the way, David, that we'll get the annual filing for Valvoline in November, and that should give us a new annual period that should look correct. Not too far off, not tomorrow, but not too far away. Great.

Lee, I'll hand it over to you for analyst updates.

Yes, I'm glad to be back. You know, at New Constructs, we're always looking for ways to improve what we're doing on the modeling side. You know, we've got a model and ratings team whose job it is to keep up with changes in disclosure and changes in FASB rules and make sure that everything is always the best that it can possibly be. And we're also always reviewing our models for unusual situations like the one with Valvoline and others to see if there's ways that we can make our modeling better so that our customers have the best access to the best models possible. And we recently made 2 major improvements to our credit rating system that we wanted to talk about a little bit. The first is that we improved our interest coverage ratio that we use for— you can see there's the 5 component ratings that we use in our credit rating analysis. The last here on the right is the interest coverage ratio. And what we had found were that there were some companies where we weren't able to calculate an interest coverage ratio because we did not have an interest expense. And so what we were doing in those cases is making our best guess as to what we thought the creditworthiness of the company was based on their EBIT. So if they were a profitable company, we thought it was reasonably good. And if they were an unprofitable company, we thought it was maybe neutral. So we were looking at some companies where that's the case. It's generally speaking, pretty poor disclosure if companies have debt and don't tell us what their interest expense is. It's pretty unusual as well. I think there were 30-some companies in the current period where we didn't have a reported interest expense either on the income statement or in a breakout table in the notes. So we decided that what we should do is when interest expense is not available on the income statement, that we would use the cash paid for interest value from the very bottom of the cash flow statement. So in cases where we don't have interest expense, we use that value off the cash flow statement. We did some analysis to see how similar those values are. And they're generally pretty close. There's a couple of examples that we found where, you know, when companies disclose both of those things, they're not quite exactly the same, but they're very close. We're really happy about that. That gets us improved interest coverage ratios for those 35 or 36 companies in the current period, and it keeps us with a better interest coverage ratio. So that's a great improvement that we made to the credit rating system. The other thing that we did is that we improved our total debt calculation. And what we did there is we had previously looked at the fair value of debt. So companies will report an NRDC, We use the market value of debt where available. So companies will have a reported book value of debt and then a fair value of debt. And then we were using that as total debt in our credit rating calculation as well. And we decided that that didn't make sense and we should be using the book value of debt, the reported value of debt for all of these ratios that use total debt. We found that there were problems there because we were seeing companies that were approaching bankruptcy And what happens in those situations is that the market value of their debt drops precipitously, right? So maybe it drops by 90%, and then their credit rating in our system would look, by these metrics, look better, which is exactly the opposite of what we want to see happen. So we made that change as well. That did not change an enormous number of ratings. It's generally speaking a marginal difference, but it matters meaningfully for those companies that were approaching bankruptcy. We're always trying to make sure that we have the best possible models that we can. We generally speaking don't just trust the companies to tell us the truth about what's going on. We always lean towards making sure that we've included all the information available everywhere in the filing. Maybe we went too far with the adjusted debt value originally, and then we went back to using the book value. Now that value of total debt is still adjusted for operating leases, for things like variable and not yet commenced leases and other kinds of hidden debt that are also not on the balance sheet. Yeah. So those are the changes we made to credit rating improvements. We are always making improvements and changes and always taking a look at this stuff. So hopefully those things are both live and have been for a couple of weeks now, and hopefully they will help you in your analysis. If you have any questions, please ask them over in the Society of Intelligent Investors and we'll be happy to have folks talk with you about it.

This work that we're doing in our ratings is just a great example of how hard we're always working to make sure we get the best models out there. And there's so many the other firms that they would just completely— interest coverage ratio just wouldn't— there'd be no number because they didn't disclose an interest expense on the income statement. But we'll go find it somewhere else and get you a number if there is a number so that we can have a more comprehensive and reliable set of metrics. And I don't know if there are any other firms out there that do that kind of work. So it's, it's no small feat. And then to be constantly taking a look over our shoulder to make sure the assumptions we have in our models are always the best. I mean, generally market values are always better than book values when you're thinking about valuation, but in this weird corner of the universe, they're not. So we fixed it and we're always looking at fixing things or making things better. And I think that's a big part of why our models do so well. And I think it's really cool that we can be this transparent about that with our clients. I challenge you to find any other credit rating firm That will give you any kind of the level of detail that we give you. And of course, give you any kind of detail about how their methodology's been updated. Just, it's unheard of.

Yeah, no, David's absolutely right there. There's very few people publishing credit analysis like this at all anyway. And the firms that do hide their methodology, we know because we've tried to figure it out to make sure we understand what other people are doing. And it's impossible generally. And also most people aren't doing what we're doing on cover— I don't know of any other firm that's doing what we're doing here on interest coverage ratio. That's just, it just doesn't happen. They just move on.

And they hide it because they need a black box to protect what they're doing. Because if you knew how they do it, you could do it yourself just like that. And you'll notice that with all of our methodologies, all of our metrics, there is no black box.

Why?

Because the magic is not in the model. The magic is in the data, superior data. And we testify to that every day by giving you all of our models, all of our metrics, And then proving that we've got superior data. It's a new paradigm. It's a better platform for performing research. And the reason you don't see it from the other firms is because their data input, their underlying input for all the models is commoditized and not as good and not clean, which is what Harvard and MIT have proven. It's, it's a new regime that we're bringing to bear. And that's part of why Bloomberg and some of the top ETF issuers in the world want to build a fund around it.

We do have a few questions, Lee. Will the credit rating changes be applied retroactively or going forward?

So it updates the credit ratings universally through all history. So if you were looking back at past credit ratings, they will be updated to use the new methodology. We do have real point-in-time data available in the system for folks who want to do backtesting. That all exists. The way that the existing system works, if you look back at a credit rating from 5 years ago, it has been updated to use these new methodology as well.

Okay.

And then another question is, with government interest rates continuing to rise, are you updating the debt ratio more frequently than in the past? Commercial real estate comes to mind and how these empty buildings are going to affect banks holding the debt.

Sure. We update it as often as we have always updated, which is twice a month. That's as fast as we can get data about those things.

All those things get updated And then one more question there, and maybe this isn't something that we can answer now, but maybe this is something that we can get out to on Society later. Can you include one or 2 examples of those companies approaching BK for which the credit ratings changed? I don't know what BK is.

Oh, bankruptcy. The companies that we were looking at. Yeah, I don't remember offhand what they were, but we have that all well documented and we can Maybe that's something you can comment on. I don't— the examples are not ones where anyone would— it was not secret that these companies were in bankruptcy or approaching bankruptcy. That's why the market value of their debt changed so radically.

Okay.

We had the ratings suspended for those companies anyway, but they looked better. They would go from, let's say, dangerous to neutral or attractive because the company was approaching bankruptcy. We had suspended the ratings. It wasn't a secret that these companies were going bankrupt, but we wanted to make sure that we weren't just suspending the ratings in those cases, that we were making updates to our methodology to account for that appropriately. But I can find those things and we can put something in Society about it.

Real fast on the small-cap underperformance from one of our top-performing clients, Kent Seymour, in terms of questions. And we love questions.

We love them.

Is there a way to determine a true value difference between the sectors? Yeah, we have ratings on the sectors. Why don't I just share my screen and show what we're talking about there in terms of sector ratings? So let me just go over here and you can see in the sectors section, here's the ratings. So yes, I'd say we do have a, a way to show differences in value. That's the way to look at it. I would always, if I had more precision available to me, I would take advantage of it. Why invest in a larger group of stocks that would effectively always probably have more noise unless it was a perfect group, right, of all perfect stocks when you can invest in a smaller group, still be, you know, have plenty of companies or names in there and they all be good. I'd always take the more highly concentrated, high-quality approach. And that's something you hear throughout, right? We're not into sort of big themes and theme investing always. If you can do the work at the individual company level, you might as well take advantage of it.

That's what we do.

I think that answers Kent's question. If you want to follow up, do so in the society.

Lee, I'm going to hand it back to you.

Yeah, I was going to talk next about additional coverage. We've added over 100 and companies to coverage in September. We're actually at over 120 now, and we're adding more coverage every week. You know, in addition to that model and ratings team making sure that our models are always right, we've also got a team working on auto-parser and data quality or helping improve our technology. The speed of our new coverage additions has increased dramatically. We were in the past adding sometimes 10 companies to coverage a month, and I think we're at 10x that, more than 10x that now. The technology's improving so quickly that we are, you know, straining some of our other processes, which is great. But, you know, the technology really— we're dedicated to accurate data and models. The technology really helps us get there and get there faster. Machines don't make the same kinds of mistakes people make, and we're very good at using them, taking the expertise of our analyst team and turning it into additional models and data. There's that weekly new coverage email that you can get every week that tells you about what's coming out. We also want to note that, you know, if you had to hire an analyst at $100,000 a year to build these models, it would take about $8,000 to build one of the new models that we're building. The models that we've added have on average 26 or more filings, some more, some less, but that's about the average. So just in September alone, we've saved our clients over $800,000 on analyst salaries if they would've had to build those models on their own. It doesn't take us as long with technology to be able to do it. So you're much better off joining us and letting us do that work for you. And building models for 1,000 new companies would cost you over $8 million in salary if you wanted to get that done. And we are headed in that direction very quickly. And our speed is regularly increasing. It's really exciting to be a part of it. It's really exciting to get to do.

It's really cool to see the enormous amount of progress that we've made in a short amount of time with a very small group of people. The automation that we have going on right now is huge, and we're doing all of this with a team of like 6 or 8 people on the analyst side and 3 engineers, 3 and a half engineers. New Constructs is an example of an extremely efficient business. You know, we're not this extravagantly funded Silicon Valley, here's $5 billion, go make something happen. And then we'll go public at a $10 billion valuation and then we'll just go, you know, ride around on our yachts for the rest of our lives. We're actually creating real value and, and there's a discipline here and a focus that I think is special and it's really awesome to see it emerge the way we're seeing it.

It's really fun to do. I think it's the same kind of approach that we see whenever we go to Second Harvest and sort food. I think the people there regularly say things like, you guys can really come in here and like, you're very efficient, you get a lot of work done. Proud of the team, proud of it. It's really fun to see. So continue to expect more new coverage every week. Sign up for that email.

We're ready to head out to society. David, would you take us out there? I know we have a couple of topics we want to make sure to hit on. Some covered calls, equity REITs, uh, reverse DCF request for MPW and VFC.

So we had some good activity out there. We want to continue to encourage folks to ask questions here, put them in the society, and you're going to maybe get a lot of good, good answers, better answers than we could provide. Like, so for example, this question about covered calls, really at New Constructs, we don't really do— we don't do anything with covered calls as a company, right? And I don't really know much about covered calls. I do remember studying back in the day when I had to take the Series 7 exam, you know, calls and covered calls and straddles and blah, blah, blah. But as for the math and how that works now, way over our head. But I think you got some excellent feedback from our community here. And that's happened a few times where even before I have a chance to come in and make a comment ourselves or someone from our team, we get way better answers from other members of the community than we would've provided on our own. We also had a question about equity REITs that I thought we wanted to talk about too. You know, the REITs have looked pretty bad for a while. It's a very capital-intensive business. And then as the cost of capital's going up, that's not going to help when you've got effectively low returns. What did Cody say here? 95% of our equity ratings are currently rated unattractive or worse. They're value-destroying businesses. So we do have different categories for these, Lee. We just don't always talk about it.

We do.

The models are different. We parse the data differently on our side. The rating we think is still good, but we are making those distinctions. And there are, as Cody says, 5% get good ratings, just not many. You know, I think the REIT space got crowded. It's almost like the housing space, right? Like we know housing in general, if you were to try to buy stock in like the housing market in general, those stocks would all look expensive, right? I mean, we know houses are getting expensive. And then on the commercial side, non-residential, we know that's all even worse, right? So equity REITs are mostly around commercial investments. So the residential is going to look expensive. The commercial's going to look expensive because at super low interest rates for 20 years, you've just had a lot of capital flowing into that. And it's not just individual capital, like institutional capital, right? There are going to be loopholes and some people are going to take advantage of loopholes. We, we're standing up here at New Constructs to try and close the loopholes in the equity markets. REITs are expensive. I don't know if there's much we can do about that. Reverse DCF questions. Okay, this might go down as perhaps the best post of all time by anybody in society. Panaki, congratulations. These are, these are detailed, I think each 25-minute-plus videos. On Panaki's view on VFC. And Kyle, do you happen to remember off the top of your head? I hate to put you on the spot like this. Didn't we write a report on VFC at some point?

I think it was on a model portfolio at one point, but I don't think it was ever— it was a peer to some other reports we've put.

This is, this is amazing work done by Panaki, and I encourage you guys all to chime in here and take a look for some really cool Work, and he put a lot of time into, into making that happen.

We should move over to Kyle so that we give him a little bit—

Oh yes.

Time to do Affirm.

Yes.

This is the main attraction. Go for it.

I'll take the screen share here. So we're talking Affirm today. It's a Danger Zone for quite a while. We originally featured it in October of 2021. It's since down 80%. So it's been a great Danger Zone pick, but It is up over 115% year to date, I believe, is the tally as of yesterday's close. So obviously gaining some interest, and we wanted to revisit it and take a look at the rating and then what the DCF says about the stock price based on the fundamentals of the business. As you can see from the jump, the rating doesn't look good. We got some dark red up top here, unattractive overall rating. And when we go to the rating breakdown, we can really see what each of these metrics, how they're trending, what they look like, and why they look so very unattractive. On the economic earnings, we can see things aren't moving in the right direction. We've got economic earnings worse than reported earnings, although they are moving in the same direction for the most part. But we've still got growing losses at the business. Return on invested capital, similar story here. ROIC trending from a -12% down to negative 34, 39%. We're seeing a huge deterioration there, largely on the margin side. We've seen margins go from negative 15 down to negative 69%, which is a huge deterioration there. Invested capital turns a little bit different, but still down from that peak of 0.8, now sitting around 0.56, 0.6, slight improvement, but still a big drop from that. We can see the free cash flow the business, highly negative in every year, even worse in 2023, their fiscal year compared to fiscal 2022. And so we've got deteriorating ROIC, deteriorating margins, invested capital turns down from their highs, even though slight improvement. And then we see, you know, stock price has come way down, but it has kicked up in the TTM from the end of their fiscal year there. And so we've seen a, again, deterioration in the overall business, Which gives that unattractive rating there. And what we can do is really see with our DCF how we can quantify those expectations in the current stock price and really model out what is baked into the stock price and why this company does get the rating that it does. So let me jump over to the DCF. We're trading Affirm right around $21 a share. So we build out a few different scenarios here, starting with our optimistic scenario, which is What does the company have to do to justify that $21 a share? In this case, we put together a scenario here of 11% margins, which is equal to Goldman Sachs in the TTM. Again, compared to negative 69% margins for Affirm in their latest period. And then they have to grow revenue by 28% compounded annually for the next, I think it was out through fiscal 2031. And we can see in those scenarios. down in the kind of results reference points, ROIC jumps up in the 30s and then immediately after that up into the 80s almost percentage in the ROIC range. So we've got huge improvement in ROIC, huge improvement in margins, and then with that revenue growth, it ends up equaling out to, I believe, 20-something in revenue. Let me take a look here on the DCF review page. What is baked into the current price in the optimistic scenario. Sorry, $11.4 billion in revenue, $1.3 billion in NOPAT. Again, these are all NOPAT currently negative, ROIC way lower, gets you to that, you know, $22 a share. One of the key things we like to look at with a firm is because they're only taking a percentage of what is spent on their platform as actual revenue, we can really look at what this $11.4 billion equals in gross merchandise volume for them. And right now they're in fiscal '22 and '23, they take about 8% of sales on their platform as revenue. And so if we, you know, apply that same percentage rate, basically a firm has to have a GMV of, it was $145 billion in 2031 here, which is about half of Amazon's US business. And so simply to justify the current price of Affirm, Affirm has to be half of Amazon, essentially, the retail business. So huge expectations. If you want to bet that company will be half of Amazon while Amazon can also, you know, get into the same business if they wanted to, or offer any of the other competitors, you know, buy now, pay later offerings, it's a strong bet to make and one that we wouldn't see as being very probable. So With that, we can then look at 2 other scenarios. Big difference here, you know, margins get to 6% or 4% in sort of a neutral and pessimistic. 4% might also be maybe optimistic. It's Block's highest ever NOPAT margin. Block obviously is Square prior to renaming Block, so they've got their own payment platform as well. Revenue growth consensus in the first 3 years, and then 26% in the neutral scenario and 20% in the sort of pessimistic scenario. We can see what that entails for both of those on the review page. And so with 6% margins, basically 26% revenue growth out, which is the projected industry rate, we can see that we've got a shareholder value of around $9 a share, down from $21. And that's still on a company earning, you know, $9— generating $9 billion in revenue and $550 million in profits. with margins up in the 6% compared to, was it negative 69% right now? And so when we look at that last scenario, which was the highest ever for block margins, revenue growing at 20% after consensus, we can see out in fiscal 2031 looking at $4 a share, which that again could prove optimistic, which is why this company was added to our zombie stock list. I think around a year ago. We've got economic book value negative, which is the no growth value. So high expectations, huge downside risk in Affirm, especially after their 100-plus percent year-to-date return. We've got betting on them becoming half of Amazon, and if they do anything less, they're worth way less than that.

And it's half of Amazon at Goldman Sachs' margins.

Yes.

Okay.

Yeah. Yep.

It's just absurd, really high expectations. I'm looking forward to seeing how well this is going to help our zombie stock and focus list short portfolios outperform.

Yep. I, I took a look back at our, our credit rating update and we were, someone was asking what companies we were looking at who were going into bankruptcy. And the biggest example that we used was Revlon, which went bankrupt about a year ago.

There we go.

There you go.

Ask and you shall receive.

I've got you covered.

Yeah. And one more question. Any thoughts on Williams-Sonoma as a takeover for Affirm? You know, I just don't, I don't see any reason why they'd want to take on a business so unprofitable. And if they really wanted to do it, they could do it themselves. Like, why buy it when they'll give you the service for free? Right? You think Amazon pays these guys for providing buy now, pay later? They got 3 or 4 of them. So yeah, I don't see it. You know, crazier things have happened. We call it stupid money risk in the danger zone. I mean, we've— the craziest one I'll never forget, Mattress Firm, which is literally totally headed towards bankruptcy. And it was a great danger zone pick until some random firm in South Africa decided to pay like a couple hundred million dollars over market value for the stock. And they subsequently wrote it all down. It was a terrible move, but they did it. So I'm not ruling out that that can't happen. But yeah, I don't think so.

Looks like update to that comment. It was WSM as a takeout target.

Oh, someone would buy them? Oh, okay. Sorry about that. Yeah, that's much more likely if I'm going to be, you know, from my perspective, like capital allocation perspective, I'd much rather buy a very attractive stock as a takeout than a very unattractive. So yes, likely, you know, I have no idea, but that would make sense, a lot more sense than a firm. All right, folks, have a great weekend, everybody.

Take care.