Research Notes: Six Weeks In (Part I)
A look at our coverage so far, after six dizzying weeks in the equity markets
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This week, my mother asked me why the stock market had to crash. Surely, it wouldn’t trade in a straight line, but why couldn’t it just stay relatively stable? Why the need for these dramatic rises and falls every few years?
I gave some of the typical answers: investor (and human) psychology; the particularly unusual nature of the gains from the March 2020 lows; the Benjamin Graham quote about the market being a voting machine in the short-term, and a weighing machine in the long-term.
But as I was driving home (and thinking through the plans for this update), I realized I’d left out an important answer, one that I probably knew but to that point perhaps hadn’t quite crystallized in my own mind: incentives. Nearly every participant in the equity market, and in the industry surrounding that market, is incentivized to be in the market at all times, and almost always incentivized to be long the market.
Long-only institutional money can’t go anywhere. A pension fund manager can’t say to his superiors, “eh, we don’t like this market, we’re going to cash until there’s a 20% pullback in the S&P. Hopefully 2023 but we’ll see how it goes.” Long-only funds have the same problem with their investors. Long/short funds can get somewhere between net short and 100% short, but usually don’t. Even with the “hedge” in the “hedge fund” name, those investors still need to have the stones to potentially risk their existence on properly timing the market.
When we decided to launch this project, we had some doubts about the market ourselves. Indeed, there was an email exchange in which I wrote, only half-jokingly, that maybe we should just do a short idea-only Substack instead.
Our first post highlighted many of those concerns. But we were incentivized, like so many others, to find ideas — and, like many investors, that means mostly (though not solely) long ideas. To be blunt, so far, those long ideas haven’t played out as hoped.
That said, we’re still (generally) happy with those ideas, and, as we wrote upon our launch, we eat our own cooking. Owing to our discomfort with the market, we recommended small, careful positions — and took small, careful positions. Perhaps we should have waited a few weeks; perhaps we should have gone short-only; perhaps should have started 32 Substacks and done the probably-apocryphal 50/50 trick.1
But here we are, and we do think the long ideas presented here so far still offer promise going forward. As for the market? It seems likely we’re nearing the end of this phase, with great uncertainty as to what comes next. In the meantime, here’s the first of a two-part update on our ideas and our commentary.
Figuring Out This Market
At the end of March, we launched this project by highlighting the stupidity that had dominated the 2020-2021 bull market, and argued that it was precisely that stupidity that highlighted the broader risk to U.S. equities. And I pointed to two key lessons of market history:
Equity markets don’t bottom until the novices are gone2.
It’s difficult, if not impossible, to escape the collateral damage caused by those novices.
The novices weren’t gone. And, indeed, the contagion of what I’ve elsewhere called the “quiet bubble” — in de-SPACs, EV stocks, clean energy, online gambling, etc. — over the past few weeks has made its way into more quality names. At the Mar. 30 close, the S&P 500 was less than 5% off all-time highs. That index is down 14.4% since; the NASDAQ 100 has fallen more than 20% over the same period.
Are the novices gone yet? Well…
Data from ETF.com shows net flows remain positive this week as well.
Based on the same ‘feel’ argument that rang so many alarm bells in late March — to the point, that as I’ve heard many Tweet and say since, the best reason to be bullish then was precisely that so many people seemed bearish — we’re probably not done. It’s trite to say the market needs to capitulate, but it still seems like an awful lot of investors are hoping for a Q4 2018-style bottom and V-shaped rebound. And it certainly still seems like the novices who crushed the market for the 11 months following March 2020 haven’t run off yet.
A big near-term bounce still seems unlikely. Factors like the collapse of the Terra “stablecoin”, continuing sell-offs in crypto, and the accelerating plunges in so many retail favorites suggest more collateral damage going forward. Tesla (TSLA) alone wiped out $275 billion in paper value in seventeen calendar days. Those losses don’t occur in a vacuum; they ripple out to the rest of the market.
Meanwhile, fundamentally it’s not that easy to find bargains out there, even via a casual screen. Sort the 30 stocks in the Dow Jones Industrial Average by forward P/E and look; the list seems reasonable, perhaps, but honestly mostly about right. (The stocks are cheap on a forward P/E basis, but it’s easy to forget how many challenged companies are in that index now.) But screens of any kind in March 2010, let alone March 2009, showed so many opportunities that seemed worthy of further research3. Fundamentally speaking, we don’t yet seem to have that much in the way of low-hanging fruit.
As for the bubble stocks? Lucid Motors (LCID) still has a market cap of $23 billion. I think that stock is getting intriguing — the Air seems like a legit competitor to any vehicle out there — but it is a slam-dunk steal at that valuation? Of course not. Beyond Meat (BYND) just posted a hilarious gross margin of 0.2% (OK, 9.6% if you exclude launch costs for Beyond Meat Jerky, an equally hilarious product) — and even with an after-hours plunge has a market cap over $1 billion. As we’ll discuss below, there are plenty of other stocks that have sold off huge yet don’t look oversold.
The S&P 500 is back where it was in March 2021; the NASDAQ 100 has returned to November 2020 levels. Had there been choppy trading in each index over the same period, instead of big gains and the recent crashes, would the opportunity now, amid inflation, war, political strife, etc. seem compelling? Or would we say, “The market should be trading flat, it’s been a mess out there.” It certainly seems like the latter.
We’re probably getting in range of a bit more normalcy in terms of trading, and certainly at the point where it’s time to get shopping lists together. But, at least in my humble opinion, there is absolutely no rush. The near-term declines probably aren’t over, and once they are, there is no shortage of mid- to long-term risks to contend with. Caution still seems the order of the day.
A Big Quarter From AppLovin (APP)
On the topic of being early, our first long idea was on adtech play AppLovin (APP), a recommendation (and purchase) we made at $55. APP stock closed Wednesday at $27.28.
But Thursday morning the stock is up 38%, after a Q1 report that seems to validate the original thesis here. AppLovin raised EBITDA guidance for the year as it plans to de-emphasize, and pull back spending in, its games business (the Apps segment). A new disclosure suggests its platform for mobile game publishers generates EBITDA margins of 65-70% — nicely above the 50%-plus I estimated as a floor at the time. Indeed, AppLovin is targeting ~50% free cash flow margins, given further estimates of ~70% flow-through of FCF from EBITDA.
There still seems to be some skepticism. The big risk to AppLovin remains changing privacy policies from both Apple (AAPL) and Alphabet (GOOG) (GOOGL) unit Google, and that in turn leaves some investors concerned that AppLovin’s strong performance and full-year guidance still don’t capture a looming slowdown in its industry.
It’s clear that some investors see the change in Apps strategy too as possible weakness. AppLovin has talked up the value of the data coming from its first-party games, leading one analyst to ask on the call, “What differentiates AppLovin’s ad network now?” Another asked how much of the quarter’s strength came from the misstep at AppLovin competitor Unity Software (U), after a performance described elsewhere as a “terrible quarter”.
But while Unity was talking repeatedly about how it hadn’t quite anticipated the impact of Apple’s ATT, AppLovin management sounded as confident as ever. Guidance for the software business of $2 billion in revenue next year suggests free cash flow should near $1 billion. Even with the 38% gain, APP has a market cap around $16 billion.
It’s still possible that AppLovin management simply is wrong, and that the slowdown in the business will happen in the coming quarters. But the potential upside here if management is right remains enormous; there’s a legitimate scenario in from here which APP stock triples by the end of 2023. (I’d argue, in fact, that if management is right, the stock almost certainly will double.)
I dipped my toe into the stock last month, but I bought heavily at the open, and I think this stock is a clear candidate to snapback to $50-plus. This is precisely the kind of quarter that can, and should, change the narrative here.
More Fun With De-SPACs
Our first Research Notes piece looked at the 291 de-SPACs that had closed since the beginning of 2020. Five weeks later, the change is dramatic:
Then, the average de-SPAC was down 32% (including one acquisition); now, the average fall is a stunning 53% (including two acquisitions4).
Then, the median de-SPAC traded at $5.52; now $3.77.
Then, 50 de-SPACs traded above $10 (including one acquired at $10.05); now, 23. 7.9% — seven point nine percent! — of the 291 de-SPACs are above their reference price.
Then, 48 de-SPACs had dropped 75% from their merger price. The number has exactly doubled since.
Let’s review the last two points again. 8% of de-SPACs trade positive. 33% have fallen by more than three-quarters. It’s been an incredible track record of value destruction.
To our earlier point, however, de-SPAC performance does perhaps give some hope for the market. The dead wood continues to get cleared out. Three particularly inane rallies in the space are faltering. Yet another attempt to make Redbox (RDBX) a ‘meme stock’ has failed, with that stock down 43% on Wednesday. Digital World Acquisition (DWAC) continues to reprice. And BRC (BRCC), operator of Black Rifle Coffee, is back to $105.
In that piece, we highlighted five potential shorts (admittedly with thin due diligence). Unsurprisingly, given market performance, all five are down big. The names cited as potentially interesting longs all have gotten cheaper as well — but there might be an opportunity or two in there at some point. The de-SPAC universe is mostly, but not completely, garbage. We hope to return to that universe in coming weeks.
To that point, DraftKings stock closed Wednesday at $10.27. It’s been an incredible round-trip for a stock that went public via a SPAC at $10, cleared $70 last year and was above $60 as recently as September.
In that piece on de-SPACs, I wrote that:
…there’s going to be a quarter when DraftKings posts bottom-line numbers that shock a lot of investors who have written the company off. I don’t think that quarter is that far away.
A week later, in our coverage of online sports betting stocks, I noted still-present valuation concerns with DKNG at ~$13, but noted sharply lower promotional spending across the industry. Given that pullback, I added:
I’d bet at thin odds that there’s a quarter this year where DKNG stock is up 10%-plus after earnings. The biggest risk right now is that those gains come off a far lower base than the current ~$13.
For a moment, DraftKings’ Q1 last week seemed like it might validate that projection. Full-year guidance for EBITDA loss was better than analysts projected. The stock actually opened +4% after earnings.
But the bigger problem was that the stock, even down 80%-plus, still was too expensive. We’re getting in range, though. A ~2x multiple to FY22 revenue is at least in the range of reasonable.
The case for DKNG stock is that it’s another Snap (SNAP), a company initially written off as structurally unprofitable that, over time, proves to be an important (and profitable) part of its industry. There are serious concerns about management and execution, admittedly. DraftKings completely blew its market share edge in daily fantasy against Flutter Entertainment (PDYPY) unit FanDuel, and CEO Jason Robins is one of the best at writing Tweets that make readers want to short the stock. (Shopify (SHOP) CEO Tobi Lütke is hot on his tail at the moment.)
Still, DraftKings almost certainly is going to be profitable at some point, even though it won’t be nearly as profitable as bulls once believed. A ~$4 billion enterprise value is starting to suggest that the long-term case is getting intriguing, even if the market at the moment suggests short-term trading is likely to be rough.
Tomorrow, part 2 will cover our more recent longs, a successful short, and more thoughts on earnings.
Vince Martin is long shares of AppLovin (APP) in his personal account.
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Supposedly, in the pre-Internet age, a broker would get 16,000 names off a direct mail/cold-call list. He would call 8,000 names, pick a volatile stock, and tell them to buy the stock. He’d tell the other 8,000 to sell it.
Whichever direction the stock went, he now had a list of 8,000 names to whom he’d delivered a market-beating trade. He’d take that group of 8,000, find another volatile name, and tell half to buy and half to sell. At this point, he had 4,000 investors who’d he given back-to-back gainers. By the end, he’d have 500 names to whom he had given five consecutive winners, and to whom he thus appeared like a genius.
Is the story true? There are some holes; people didn’t always answer phones or read letters in the 1980s, so of the final 500 many likely wouldn’t have seen or heard all, or any, of the recommendations. There’s a timing problem as well (the whole process would seem to require at least four months to play out, during which time a past winner could quickly become a big loser). But I hope it’s true, and I hope whoever pioneered it is happily retired in a tropical paradise somewhere. There’s also probably an idea for a new crypto coin in here somewhere, but I digress.
I followed that with a parenthetical: “Yes, that’s an incredibly condescending point, and an unfortunate one as well. I stand by it regardless.” It’s still condescending and unfortunate, and still valid.
I distinctly remember thinking the 2009 sell-off had gotten ridiculous on the day the S&P posted its intraday low of 666 on Mar. 6. The core reason: General Electric (GE) had a $6 handle — a split-adjusted price of $50 or so. GE stock at $6.xx seemed a generational bargain. Incredibly, the stock is now down from its close on Mar. 12 of that year.
PAE Inc. was bought out at $10.05, and SOC Telemed at $3.00. Pick the two SPACs that got acquired and you’re still down 34%.
BRC isn’t a bad business, necessarily, but it’s one of the many de-SPACs that had a curious run after a merger close despite a high redemption rate (in this case, about 50%.) There’s not much logical reason to pay more than $10 a week after a merger close when the stock could have been owned at that price for months before that.
Clearly, there were some investors playing games with these low-float de-SPACs. The end of those games is a good sign for the market returning to some semblance of health.