Research Notes: Opportunity In Volatility

Looking for potential ideas amid a market-wide sell-off

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From a historical perspective, the CBOE S&P 500 Volatility Index (colloquially known as the ‘VIX’) is elevated:

source: YCharts; log scale

From a ‘feel’ perspective, that seems about correct. Since mid-2009, the VIX has cleared 25 only a handful of times. Spring 2020, Q4 2018 (the forgotten sell-off), and Q3 2011 (when bears were certain a ‘double-dip’ recession was on the way).

We talked just last week about the difficulty in fading even a shaky post-Jackson Hole market. Being long equities now doesn’t seem any easier. Between pressure on Treasuries and, as the Wall Street Journal reported today, rising defaults in high-yield loans, the credit markets don’t exactly look like a safe haven either.

Returning to the equity markets, it does seem like an enormous move is at least possible. Jump to the end of 2023: would you be shocked if the S&P 500 had fallen 50% from current levels?

Mathematically, it’s not that hard to get there. Compress earnings multiples by ~30% and earnings by ~30% and the index is halved. Well, here’s where the Shiller PE ratio sits at the moment:

source: Multpl.com

A 30% reduction there gets us to 20-21x. In the context of recent history, that would be low, but not unprecedented. Assume legitimate competition for capital from bonds (a rarity since the financial crisis) and a low-20s figure appears in play.

Meanwhile, corporate profit margins have soared:

Here, too, a 30% decline suggests a bit more than reversion to the mean. But given an energy crisis in Europe, a property bubble in China, inflation, the risk of recession, and any other not-really-black swans you want to throw in, a significant compression (plus perhaps a decline in revenue?) wouldn’t be mind-blowing.

There would be a retrospective logic to the index falling by half in 16 months. Companies were overearning thanks to flush consumers and government stimulus. A rapidly strengthening dollar eroded profit margins for U.S. companies operating overseas. Excessive optimism from investors was not, as bulls hoped, limited to ‘hot’ sectors like electric vehicles or software. Fed tightening burst what (again, looking backward) was an equity bubble.

Conversely, would it be impossible for the S&P to rise 50% from here over the next 16 months? Before the pandemic, investors talked up the “TINA” (There Is No Alternative) tailwind for U.S. equities. Is there an alternative now? Are investors going to buy international stocks amid geopolitical and economic turmoil on almost every other continent? Yes, Treasury yields are rising, but they’re still at ~3.5% and a stampede into that market (from capital both foreign and domestic) would reduce real yields to ~zero at best.

And so earnings multiples not only stay intact but rise as capital flows from around the globe into the U.S. market. Corporate profit margins don’t compress; it’s clear in retrospect that those margins should be higher than in the past, even in a recessionary scenario. The nature of U.S. corporations, and the industries driving the profits, both have changed markedly just since the 2000s.

Charting What’s Possible

To be clear, neither outcome seems particularly likely, but both are possible in a way that’s not usually the case. These broader concerns trickle down to individual stock analysis as well. Assigning appropriate multiples right now is exceptionally difficult. Was 2019 “normalized”? Is 2022?

It’s perplexing and entertaing in equal measure. And this kind of market does open up potential opportunities. We’ve all known that investor — hell, we’ve all been that investor — who says, “I like ABC, but I’d like to own it 20% cheaper.” In 2019, that kind of downside move almost certainly wasn’t coming without new information that changed the story. In 2022, -20% can happen for almost no reason at all.

After a reasonably steep sell-off, one interrupted by a rally late Wednesday, it’s worth taking a look at a few of these potential ideas: stocks that at least have become a lot more interesting thanks to volatility.

McCormick (MKC)

We’re breaking the rules here a bit at the start, because volatility has pushed MKC down of late, but volatility on its own isn’t necessarily what might create the opportunity going forward.

Before a 3.4% regular-session gain on Wednesday, MKC had plunged 11% in 13 trading sessions, and threatened a 27-month low in the process.

But MKC didn’t look cheap: shares closed Tuesday at 27x the midpoint of FY22 adjusted EPS guidance. McCormick for years now has looked expensive, receiving a decent premium (in terms of either P/E or EV/EBITDA) to peers. The core reason was a different long-term outlook. While most major packaged foods manufacturers faced risks from those crazy millennials and their anti-corporate and anti-frozen and -processed food stances, younger customers ate more spice than did their parents. (If you grew up in the U.S. in the 1980s, as I did, you know this tailwind to be true.)

But after the close on Wednesday, McCormick delivered a rather ugly earnings pre-announcement. Non-GAAP EPS guidance went from $3.03-$3.08 to $2.63-$2.68. What is particularly problematic is that McCormick had already reduced its outlook after the Q2 release at the end of June.

Two cuts in two-plus months raise some concerns about management credibility. Let’s be honest, no one wants to be grouped in with Target (TGT) and Snap (SNAP). There are two more worries, however.

The first is that McCormick is still projecting a pretty strong Q4: implied guidance for the quarter is $0.87-$0.92 against $0.84 the year before. The comp is a bit easier, yes, but McCormick posted a 20% decline y/y in the first nine months (including preliminary Q3 figures). That’s a big reversion in a relative hurry (Q4 started last week).

The second is that even if the new, lower guidance is correct, the stock still isn’t cheap. Given a surprisingly small after-hours decline (-5.9%), MKC now trades at 30x this year’s EPS. That EPS implies essentially zero growth from FY19 levels, despite a pair of acquisitions (including Cholula, the popular hot sauce) with a total cost of about $1.5 billion.

So there’s absolutely a world in which MKC plunges from here. The most worrisome part of the commentary alongside the preliminary results was an admission from CEO Lawrence Kurzius that “broad pressure…from inflation has resulted in higher price inelasticity than expected, although still below historical levels.”

The relatively inelastic demand was a key part of why investors were willing to pay up for MKC for so many years. If that premium goes, so does the stock.

Long-term, however, a plunge might well be an opportunity. This is a good company, one I owned for a few years before the pandemic. (I bought it when the company announced it was buying the food division of Reckitt Benckiser (RBGLY) in 2017, and sold it in 2019 due to the aforementioned valuation concerns.) FY22 results look ugly, but cost inflation is enormous (guided to “high teens” for the full year). Outside of trading down there isn’t much here to suggest something has changed structurally (and McCormick does have a generic business that can recapture some of those lost sales).

The relatively resilient after-hours trading suggests that maybe investors won’t let MKC fall that far. But the chart, the fundamentals, and the external environment all suggest a big leg down is on the table. Selfishly, I hope to see that come to pass.

Confluent (CFLT)

On August 3, data streaming play Confluent reported second quarter earnings. The following day, CFLT stock gained 12%.

Since then, shares have dropped 18% on no news. CFLT now trades 29% below its IPO price from last June, and has fallen 43% from its first-day close. Obviously, this is a different market than it was 15 months ago, and anchoring bias aside, the stock isn’t necessarily cheap at just under 10x EV/revenue (based on 2022 consensus).

Still, there’s a good ‘Big Data’ story here (a category that’s produced a good number of winners) and revenue is growing 47%. Even the weakness in tech could be a benefit: Confluent’s Apache Kafka is based on open-source Kafka software. Competition from in-house builds presumably is less of a problem when potential customers are letting coders go by the hundreds.

It feels early to pound the table for CFLT too hard just yet. But this is a good watchlist stock for growth investors, in particular.

monday.com (MNDY)

MNDY is almost the same story. The “Work OS” developer is down 24% from its IPO price (monday.com went public the same month as Confluent), and trades 34% below its first-day close. EV/revenue too is a bit under 10x.

Monday.com is driving better growth, including a 75% increase in Q2. But there’s more competition in the space (Asana (ASAN) and Smartsheet (SMAR)) and there’s another big red flag: Cathie Wood has been buying the stock all year.

Given Wood’s timing over the past 18 months, investors might want to wait until she’s selling. History suggests MNDY will be available at least 30% cheaper at that point.

Elanco Animal Health (ELAN)

Elanco, the manufacturer of the well-known Advantage animal parasiticide, posted soft Q2 results in early August. Guidance was cut for a second time.

But investors seemed to shrug off the lowered outlook, as well as pushed-out margin targets. Management mostly pointed to the stronger dollar and lockdowns in China as the culprits, and that explanation was well-received: ELAN closed exactly flat the day of earnings.

Since then, however, the stock has fallen 24%, touching an all-time low (the company was spun from Eli Lilly (LLY) into an IPO in 2018). The balance sheet certainly has amplified the decline: based on 2022 guidance, net leverage is over 5x EBITDA. There are competitive worries as well.

There should be some level of defensiveness, however. Based on guidance, a 14x earnings and 11x EBITDA multiple means ELAN is getting interesting. Owning a “value trap or value play?” argument at all-time lows is high-risk, but owning a leveraged, defensive play clearly is high reward as well.

Five9 (FIVN)

I’m no technical analyst, but FIVN at least looks like a trade here, no?

source: finviz.com

Five9’s Q2 report led to the Barron’s headline “Why Five9 Earnings Have Analysts So Upbeat”. Shares are now down 10% from where they closed the day of the after-hours release. The market cap of $6.5 billion is less than half what Zoom Video Communications (ZM) offered 14 months ago — a deal (admittedly all in stock) that Five9 shareholders voted down as undervaluing their company.

Valuations obviously have compressed since then, and Zoom is now a competitor in call center software. If this is a market that hasn’t quite come to terms with how crazy valuations got last year, FIVN probably has more downside ahead.

Still, can FIVN work even as a trade?

Olaplex Holdings (OLPX)

Fundamentally, Olaplex seems like a steal just above an all-time low. Based on guidance — reiterated after Q2 — the hair care product company trades at 22x this year’s net profit. Those earnings are guided to increase 35% this year. There’s a bit of debt and modest stock-based comp excluded from the adjusted guidance, but nothing to really break the fundamental case.

The market is pricing in a tremendous deceleration in earnings starting in 2023. It’s hard to see precisely why. The sector is holding up just fine: Ulta Beauty (ULTA), with which Olaplex has a strong relationship, has been one of the year’s best stocks. Inflation and recession risks are real, and their $30 (or more) shampoo probably is the bear case here.

However, given gross margins of 77% over the past twelve months, Olaplex has some room on pricing. The fact the company was founded just eight years ago, and already has a market cap of $8 billion (with TTM sales of $725 million), provides some context. Analysts are also bullish: the average target on OLPX sits above $22, and now suggests 85% upside.

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As of this writing, Vince Martin has no positions in any securities mentioned.

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