New Constructs' Live Podcast: Intelligent Capital Allocation - 3 November 2023

Welcome to New Constructs Live Podcast. This is Intelligent Capital Allocation hosted by our CEO, David Trainer, folks from our analyst and content team, Hakan Salt and Kyle Guskey II. And also with you today, you have me, Tamara Pesek. So we're excited to welcome you and dive into our agenda. Right after we spend a second on the disclosures and disclaimers. Our agenda for today, let's see, some great research came out this week. Kyle was on the Danger Zone podcast. We then did a Danger Zone report on the same topic, most dangerous and most attractive stocks. The model portfolio came out for the month, and then the featured stock in the dividend growth model portfolio also came out. And that's open to the public. So if you're not a member, that is a piece of research that you do have access to on the website. And then the long idea was focused on a shale company this week, which with the discussion of ESG last week is timely. We're going to head out with David to Society. A lot of great discussion happened out there, really wide range of topics to review. And then Kyle is going to talk about ICL for the reverse DCF case study, and then end with stock picks. And in there somewhere, we will do a quick overview of the new Stock Tracker 50 as well.

You wanna jump into that right now real fast?

Yeah, absolutely. Let me change my screen sharing.

This is an example of you asked and we listened. A lot of people said they Wanted something that was a little more affordable to access new constructs. And so we put that together. We feel this is really the best entry-level product for all types of investors, institution advisors, retail, people who want to take advantage of our awesome ratings, but aren't really ready to pay or to have access to that additional data. And so we're going to give you access now. You're going to get ratings on an unlimited number of companies. You can type in a ticker. For as many companies as you want, as many times a day, and you're going to get an answer. Green is good, red is bad.

And that's also true for all of the ETFs and mutual funds that are covered as well. So you can type in anything. A great tool is the coverage link here where you can go through the entire coverage universe. If you can't remember the ticker for the mutual fund, you can search it here. And it'll actually search the name, which I find very useful sometimes because I can't remember all of the tickers all of the time. So that's their ratings page. And then the portfolios page, similarly, you can add tickers more than one at a time by simply putting spaces in between the tickers and the add box, and those will add for you. And then you can expand to see the extended rating. You can have up to 50 tickers in your portfolio at a time, and you have an unlimited number of changes. So you can have 50 today and take away 10 tomorrow and add another 10. You're not limited in the same way that our previous memberships have been. You can tell the number of tickers in your portfolio. And the last thing I wanted to point out was the alert emails. This is incredibly helpful if you're a set it and forget it sort of investor, you can say, hey, let me know with a weekly review or a daily change when things are changing in my portfolios. You can also send that to different email addresses and you can also get alerts for new coverage. Anything else, David, do you wanna make sure that we are saying for Stock Tracker 50?

That's it.

That's it. Unlimited ratings and you can track up to 50 companies and you can change this stuff around as much as you want and you get access from the same due diligence that goes in everything we do. You're getting the takeaway, you're getting the answer. You just don't get all the back paperwork, all the working papers. And that's, I think, something that makes sense for professional, institutional, more serious investors. But for folks who just want the answers and don't need more details, this is an amazing subscription. This is doing it right. I wish we'd done our old Gold and Platinum and Pro this way. This is getting things right as an entry level.

And then as you're interested in adding research to that, you can do that singly buying the individual reports.

You can buy model portfolios à la carte. We're going to make that easier, but you can still do that on our site. You'll see on the research page, there's a buy reports thing there for you to check out. So let's talk about the big questions in the society this week. There's sometimes a disconnect between the price-to-economic book value ratio and the market implied growth appreciation period. This is a great question. One of the things you find when you do this kind of work is that there's an exception to just about every rule. Things don't fit the way they're supposed to fit. There are disclosure anomalies, there are financial anomalies, there's modeling anomalies. I don't know how to put it except to say anything that can happen There's always a good explanation here, to be quite honest with you. And the example that Alejandro pulled up here was LPG. And he's right. You've got a 0.5 price-to-economic book value. You all know from our reports and from hearing us talk about it that that means the stock price is implying profits will permanently decline by 50%. Well, then you normally assume when the price-to-economic book value is between 0 and 1, That the market implied growth appreciation period would be zero or less than 1. If the stock price is implying negative profit growth, then why would you need a growth appreciation period? This situation with Doran occurs typically when the NOPAT in the current period is anomalous. It's too high. It's not sustainable or around the margins a lot of times. And so when we put in what is a more reasonable margin, Well, then you can't get to the stock price in the DCF model. You'll see that that's the case here. That's what you're seeing in this shape of a chart. If we go to the forecast page, we're going to see that the default scenario's got 43% in here when the last year was 53%. And that 43% is based on a weighted average of the last 3 years with the most recent year getting the most. Basically what we're saying here is that we think this 53% is probably anomalous and is not going to sustain. And in which case, when you build a model with the lower margin assumption, 43% instead of 53%, you can't get to the current stock price. So that's one of the things that makes our rating systems robust. If you were to just look at one of these criteria, you'd say, oh, Great stock, super cheap, high return on capital, rising profits, decent free cash flow yield. But if you're looking to be sure that the kind of value creation we've seen from Dorian is sustainable, you'd want to look at a little bit longer history. And if you do that, well then it looks a little more risky. That's the answer. And the same thing happens on the flip side in terms of a high price-to-economic book value and a low market implied gap. You get a little bit of that on both sides. Let's talk about the state of the market. Great question. And the answer is, if anybody's got a subscription, the answer's actually really simple. We have a rating on the S&P in almost all of our, in any of our ratings. So you get the sector and then there's the S&P rating. So it's neutral. You want to look at the small-cap market? It gets, it's a neutral as well. Or you type in SPY. I think the S&P, even though it tends to be more influenced by some of the larger mega-cap stocks, it's telling a good story. Profits are good. Companies have been doing well for a while. You got a really high return on capital. Is the trend so great? Eh, not awesome, but not terrible. It's the valuation that we're seeing alarms. Valuations are tough. Free cash flows are still pretty good. But valuation in general is tough in that the expectations for future cash flows are really high across a lot of stocks in the majority of the market. So that's what I would say about the state of the market. Depending on what your proxy for the market is, it's hard to say. And we don't do a lot of this technical stuff, but if you want to know how to use ratings to determine the overall risk-reward in the market, SPY or any other ETF that is Representative of a larger market. But again, that could be— you want to look at small cap? There it is. Not too different. Not quite as expensive. And then the ability to look at sectors. You can see overall there and drill down into a sector and get a sense of what its rating is. But for the overall market, you can start with all sectors. And then you look at an index. I think it's the best way to do it. Anybody know what an all-cap index is off the top of their head? Like the whole market?

The Wilshire.

Yeah, here we go. Wilshire 5000, WFIVX. That's the, that's the 5,000 stocks in the market. So that's the rating on that. A lot like the S&P 500. Pretty much anything that contains the S&P 500. will probably look like the S&P 500 because its market cap will be the large lion's share of whatever market you look at. I mean, you've got 7 stocks that make up some 25% of the S&P. The S&P makes up, I don't know what, 92, 93, 94% of the world market. Something crazy. Maybe it's 80-something, but it's a big number. All right. New Financial Conditions Index. This is awesome. I love comments from Julio here. This is a super cool thing. We're all trying to figure out what's going on. I saw a great tweet today from a data scientist we work with at Bloomberg, Stephen Howe. And yeah, there's all kinds of ways to measure liquidity. There's all kinds of ways to talk about financial conditions. And I feel like when we look at all these stats, it's the old analogy, the 10 blind men touching different parts of the elephant. You guys know what I'm talking about? They all think they got different things. One guy's holding the tail, thinks he's got a rope. One guy's holding an ear, he thinks he's got a big palm leaf. One guy's touching the leg, he thinks he's got a tree. Anyway, tough to say what's the best, but I love what Julia has here in terms of a new stat. They're always trying to get a better sense of what's going on because if they can have a better sense of what's going on, they got a better way to manage monetary policy. And this one's pretty interesting and it's looking, things are getting pretty tight compared to what we saw in the Great Financial Crisis. And we've seen definitely a big swing from COVID period and the headwinds are coming down a little bit, possibly. So that would make you think that rates are going to have to stay higher for longer. But fascinating topic. And I invite folks to read what what Julia writes and to comment on that for sure. Let's talk about Allbirds. We get a lot of questions about Allbirds. There we go. Any feedback, bird? Appreciate it. Not really sure what you're asking for there, but the takeaway is we call that as a zombie stock or danger zone stock from before the IPO. Still looks like a terrible stock, but anytime it goes under a dollar, all bets are off.

I don't know what to say.

Yeah, I don't know what to say. What was the IPO value? $2 billion. And we're down to $138 million.

Boom.

That's a lot, a lot of value creation, a lot of value destruction. Don't worry. Wall Street guys still got paid. The executives still got paid. The private equity guys still got paid. So unfortunately, those who bought the stock and subsidized this IPO are the ones who lost the most, which is terrible. We do what we try to do to warn people about that. I don't know what else to say except that we did our best to try to warn. But yeah, Allbirds under a dollar. In terms of zombie stocks, we're going to be publishing an update pretty soon on some of these zombie stocks that have gone down under a dollar. Because at this point in time, you've got to think stupid money risk gets higher. Stock fluctuation on the margin is, is really high. 5 cents change here is a 5% move or more. We think we basically, it's getting close to time, time to claim victory on Arbers and other stocks.

A couple of questions back on the index topic.

Yes.

A comment from Kent. RSP is the equal weight S&P 500 index, if folks are looking for that. And then Roger had a question on Wilshire. How can the entire market be in the top quintile for ROIC? If it includes all stocks, shouldn't it be in the 3rd quintile?

It's a market weighting thing. I gotta believe that's why, because the S&P's so high. Here's the RSP, which is an equal weight index for the S&P 500. You can see it's a little bit different from SPY. The valuation isn't so bad. So that's showing you that the big cap stocks, it's the same as SPY here. It's not as high on return on invested capital. Same on free cash flow. And better on price-to-economic book value and market-applied growth appreciation period, which is saying that the big-cap stocks are pretty overvalued. So good questions. And thanks, Ken, on RSP. It's an equal weighted. Do we know an equal weighted, have an equal weighted ticker for the whole market? Like the Wilshire? Is there a 5,000 equal weighted? Because that'd be interesting. We'll wait and see. In the meantime, we had a question about PayPal on Circle as well.

Lots of good comments on this one.

Yeah. So earnings implied volatility is really high. PayPal, we're waiting for a new Q, so we're gonna get some new data here. This stock looks attractive. It's in a competitive space. It's ahead of the curve. There are a lot of payment systems out there and those are growing all the time. It's becoming an increasingly commoditized service. And from my position, me speaking personally and not giving any advice to anybody, You know, I think there's a fair amount of growth baked in here. We have a hard time really getting behind a business that's, albeit very profitable, got a lot of competition coming at it. I don't think the moat is all that wide. So those are thoughts on PayPal, but we should be getting a new Q probably today. Kasey's going to talk a little bit about how many Qs we're analyzing. But first I want to talk about Panaki's awesome post here about fraud and dealing with stocks versus investments that have real collateral backing them. Love the comments from Panaki. If you guys don't get a chance to look at what he writes, you should definitely take a look on a regular basis. Panaki, this speaks to the heart of what New Constructs is about, which is giving people the truth. And when we look at a situation like Allbirds, was that a fraud? Technically by the letter of the law? Probably not, because somewhere in that S-1 filing and in that financial filing, they said there's the risk for you to lose everything. And that's the needle in the haystack of noise around why people should get into that IPO. Is it technically fraud? No. Is it generally ethically fraud? I'd say so. I'd absolutely say so. And the only way to avoid that and protect yourself in a world where technically it's legal to be fraudulent, Is to do your homework. You got to go look at what's going on with respect to the fundamentals and the valuation, or you end up owning a stock like Allbirds, which practically goes to zero, or Oatly, another zombie stock that's down below a dollar and may go below a penny. But down below a dollar is pretty much the end of the road for stock. When it's below a dollar, people can't trade it. I remember when we had a hedge fund, we couldn't even put money in dollar stocks. When it comes to a universal valuation, Panagia, it's easier again on the collateral-backed securities, but that's what we are doing at New Constructs. Every analyst that goes through our training program, Akon just went through, the first thing I say is, well, it's the second thing. The first thing I say is, would you rather be a fortune teller or a critic of a fortune teller? Second thing I say is that our goal when analyzing companies is to make the models or the understanding of profitability more accurate and more comparable. Apples to apples. In order for us to put together rating systems on any particular company or the whole market, those rating systems would be worthless if the models weren't apples to apples. If we weren't measuring return on invested capital in a way that best represents the economics for every company in every sector, we couldn't say this. We couldn't say what we say about the Wilshire Mutual 1000. We couldn't say that about any pair, any group of stocks. Comparability is essential because investing is at its core a relative exercise. I'm not going to just work on one stock and understand it so well and make an investment decision, yes or no, based on what I think about that one stock. No, no, you need to go pick the best stocks and avoid the worst stocks. You don't know how good a stock is unless you know how good it is relative to all the other stocks. So that's what we're looking to do. And the bottom line is fraud is legal in so many ways in the stock market. I mean, you look at all the things that some of these people say. I mean, I was joking with a friend a couple weekends ago talking about some of the stuff that Cathie Wood and Elon Musk publicly say about their stocks or their funds. And when I was on Wall Street, those people would've been perp walked. Perp walked was when the FBI or the Justice Department went into their office, put them in cuffs, and escorted them to the patrol car with the cameras rolling. That was what they used to do when people said stuff half as crazy as what, as what Cathie Wood and Elon Musk has said. Forward-looking statements are illegal. I don't know how they get away with it. It's unbelievable. Part of it might be they say all kinds of different crazy things on social media. That you can't take any one of them at face value because they contradict themselves 20 times over. So they can say something great and the media runs with that. But what the media doesn't run with is that they contradicted themselves 2 minutes later or 2 weeks before saying the opposite, in which case no one can technically claim fraud because they didn't hear the whole story. That said, it's nutty. And that's why we say, don't believe the narrative. Don't believe the narratives from Wall Street. Believe the numbers, believe the things you can control and you can measure and start with that. And then go to the narrative, but do not trust the narrative because they will take you away on a wild goose chase.

Let's get into this filing season. What have we done and how much value the filing season brings? First, we'll look at what staff would you need to replicate the work that New Construct does? How many full-time employees? Would you need in that specific day to go through the amount of filings? To give an example, on the Wednesday, you, you would need 43 full-time employees to do 38 filings, assuming it takes 9 hours per filing to get it right and update the company models accordingly. And assuming you can do this at $100 per hour. per worker, that would cost you almost $12,000 that day. And that's the amount of value we bring during filing seasons. And the last column there is the cumulative savings. That's from the start of filing season to this day, how much value we saved to you, our clients. And I want to point out the— Today specifically, it's a special day. Today we're going to go through 410 filings and that's going to be a company high record for one day in a filing season. And today alone, we're going to be creating $126,000 of value. When we say this, we're being conservative because this analysis doesn't take into account somebody building the model, people keeping the models up to date. on new accounting rules and also the technology and website we use to distribute this data.

Part of the value of the system and the technology we have is that we can do this at that speed. If you're trying to do this manually, you don't have the benefit of all that. This is what we think it would cost. I think it's fair. $100 an hour is probably pretty low in terms of the expertise you would need for someone to really go through the footnotes and know what to do with that data. In a consistent way across all companies.

Kyle and I were talking to, to someone earlier this week who has been trying to build out his own model in Excel and is so desperately unhappy. It's something that maybe you want to do once in grad school, but then never, ever, ever again.

That's part of why we started New Constructs.

Thank you, Hakan. Oh, and Kyle, I have one more comment. The danger zone this week It was a little bit different. It was about an ETF or a mutual fund.

Yeah, ETF. We like to look at ETFs during the beginning of the quarter, like when we put out our sector and style ratings and everything. We did a recent long idea ETF as well as a danger zone ETF.

Yeah, that's a great, great benefit. Thank you.

Our ETF and mutual fund model portfolios are very impressive. And this work, what we do on how to avoid the worst sector ETFs is No one else is doing that. No one else is doing this diligence on so many holdings that we now have a rating on the ETF. So you can go and find, you know, for example, we do the work on the expenses too. Look at the most expensive, least expensive.

As a person that doesn't want to play with individual stocks because I just feel like I'm not there yet, this is huge.

1,000%. 1,000%. And I feel like that's kind of the value add too, with respect to the Stock Tracker 50, you don't want to necessarily deal with all those details, but you need to know the answer. You need to know the risk reward. We're giving that to you. And it's built on all the same machine learning, artificial intelligence diligence, all that parsing that Hakan is talking about. All that work is still going into what you get. As I said before, investing in stocks and analyzing stocks is a relative exercise. You need to know what's green and what's red. relative to all the other stocks, and we're giving you that at Stock Trekker 50. So it's an amazing value and a limited number of ratings and tracking is amazing value.

I agree.

All right, Kyle, we're headed over to you for the DCF. This was a little bit of an odd one this week. How did you find ICL?

So ICL came through a request through SocietyIQ. It was one of the requests in there. I believe it was by Pinaki, David mentioned earlier. And then I did a search and they actually came up in Society, I believe back in May or June of this year. Some other people were asking and commenting about the company as well. So we'll take a look and dive in. This is a great example of how the DCF can help quantify different assumptions on growth and margins, because when you look at ICL at the face, you've got very attractive rating. Looks super cheap, 0.3 price to book value, less than 1-year market implied gap. David was talking about those earlier. So at its face, this would look like a super cheap stock. And then you want to dig in and say, okay, what is baked into the price? And then under some reasonable growth scenarios, what could that stock be worth? And that can really give you insights into that valuation. ICL's unique in that it is in e-basing materials and they had a huge increase in a lot of the pricing of their materials in the beginning of 2022. So we've seen a huge increase in profitability. And you look at NOPAT back in the $600s, it fell in 2020, but then 2022 jumped up to $2.4 billion, which is multiples higher than anything the company's achieved in the past. So that price to economic book value on the TTM there on high profits might not be reflective of future growth or future profitability. We can come in and build some scenarios on what we're really looking at there. With that said, I'll start with what's baked into the stock price. Trading right around $5 a share, and we can look at the forecast here. I built that out and named it for the pessimistic scenario because we're— what is the worst case in the current stock price? Consensus revenue growth rates for the first 2 years, negative 23% and 1% in the next year. For the revenue growth, I went with 5%, which is in between its 5-year compound annual growth rate and since 2014, which is as far back as our model goes. It's a bit of in between on the historical growth ranges of the company. On the margin front, 6.4% in the pessimistic scenario, which is the lowest in company history, was back in 2020. It was 8.8% on a pretax. 6.4% on an after-tax basis. When we look at that, we can go to our DCF review and look at the pessimistic scenario and see what's baked in the current stock price. Record low margins or kind of company history low margins, 6.4% NOPAT margin, right to that almost $5 a share. And you're looking at, that would imply revenue growth of 1.5% compounded annually, and NOPAT would be falling 11% compounded annually. In this scenario, this NOPAT of $744 million is, let me see here, 14% lower than 2021. So before the big jump in 2022 and about half the TTM levels. So we've got a scenario where huge profit decline is baked into the current stock price, but a lot of that is because those margins are, are much higher than they've been in the past. We can see on our forecast page that pre-tax margin, 13, 14, 8, and 17 to 35. So we've seen a huge increase in margins. So if those margins were to come back down at all, put together a neutral scenario. I'm actually going to update the tax rate here. I left this one out so I don't have to calculate pre-tax and post-tax. We can actually look at a neutral scenario where Growth is consensus revenue in the first 2 years, 4% each year after that, which is the company's average since 2014, and then 0.2%, which is actually the company's average from 2014 to 2021. So before the big jump in 2022, this is really a scenario of if margins fall back to historical averages from the last 2 years and growth equals out at historical rate, what would the stock price be worth in that scenario? Because I updated the tax rate, I'll go ahead and save these. And this is where you can really see that margins are impacting the valuation of this company a lot. So we go to that neutral scenario, we've got that 10.2% margin revenue growth rate, $8, $9 a share. So if margins fall back to that 10.2% historical average, revenue grows Less than 1%, NOPAT still falls from record highs. And looking at a stock that could be worth around $9 a share today, if they could achieve that margin decline from record highs, but still maintain those historical averages, we've got a scenario where a little bit of upside, but if you think margins might come back even further, some of that historical average might not be sustainable. You could be where, again, the stock could look a little more fairly valued than that 0.3 PBV initially implies. This is a great scenario to show how you can really manage and analyze margin sensitivity, some revenue growth sensitivity in some of these scenarios when you're building out in the DCF model to see what is baked into the stock price and what it could be worth under a bunch of different scenarios. I did put together one more, which is a bit more optimistic, so we'll jump into that one real quick. This one I wanted to really test that margin sensitivity. I kept the growth rates the same as the neutral one I just talked about. So we've got consensus in 4%, but instead of that 10% margin, looking at 18%, which is actually the current TTM margin. This is likely to go down because the company has almost said as much, you know, prices have fallen a bit since the 2022 highs. But let's be super optimistic and see what the company could be worth in that scenario. So we have a range of possibilities here. So if we had margins up at 18% equal to the TTM growth, Leveling off to 40, and we do that for 10 years, you'd be looking at a stock that is worth $18 a share, more than triple the current stock price. So this one is a lot about margins and how those can level off and what is actually a sustainable margin. 2022 had huge price increases that look so far unsustainable as margins have come back down in the TTM. It's a question of what level of margin can be sustained and And as you can see, that can give you a range of stock prices from as high as $18 to possibly $8 or $9, or if their margins were to fall even further, you could be looking at, you know, $5 a share where it currently trades.

We'll go ahead and wrap up. Thank you so much for joining us this week. We'll see you out on Society. Please don't hesitate to bring us your questions out there.

Have a great weekend.