Value Options: Small Value is Back. Is Mag 7 Finally Rolling Over?

[Tobias]

Welcome to the Value Options Letter Podcast. I'm Tobias Carlisle joined as always by my co-host, Tim Travis. How are you, Tim?

[Tim]

Good, Toby. How are you, my friend?

[Tobias]

I can't complain.

October was pretty good after a pretty miserable September, August. I feel like there was a little turnaround sometime. It's been a pretty good year for small value, mid-cap value on the whole, but there was a little bit of a wobble.

September, August, but October small value came back pretty strongly and the market had a little bit of a stumble. So not that I like to see the market have a stumble, but I enjoy small value working and outperforming. How about you?

[Tim]

Yeah. What sectors are you seeing value in small value? Like what are some of the industries that you've kind of been focused on there?

Small-Cap Value Stocks Rebound as the Magnificent 7 Dominate

[Tobias]

Yeah, I think consumer discretionary has been one that really stands out to me. And I think that the reason is that the consumer has been very squeezed. So I think that I saw energy inflation is like 20% year over year, which is a big number.

And then that feeds into everything else. But like the headline number in the CPI, I don't know how accurate that is. If anything, it underestimates a little bit, right?

But like 5.7% is not out of the question. I follow a guy on Twitter and his metric is he goes and buys a slice of pizza, a slice of handmade pizza, and he just records the price every year. And so in 2020, it was $2.50. And the last one he bought was $3.49, which is pretty substantial inflation over six years. And that's where he gets the 5.7% annual inflation number. It's not a robust study, but I just think it's kind of interesting because it certainly matches the more real world examples without all of the silliness, all of the adjustments that BLS makes to the numbers.

[Tim]

I mean, I think it could be higher. It's funny you say pizza though, because I remember Home Alone was like 1992 or something like that. And they order all the pizzas before their trip.

And I remember the pizzas are pretty expensive. They're not that much differently priced than they are now, surprisingly. I don't feel like the inflation is as apparent in pizza of all things.

That's one example. I've heard it talked about before. That's why I brought it up.

But it's something I've noticed before, but that's funny. And then of course, we had the election results. I don't know.

I didn't really expect to see this type of market reaction. No, me either. What are your thoughts on why?

[Tobias]

Yeah. So what I see is that the big end of town has done really well. Mag7 has done really well out of the very first reaction.

This is the day after the election. I've said this before. I've seen this lots and lots of times where there are two possible outcomes to an event, like there's a takeover.

I always think about when the health insurers all got, they were going through the Obamacare before that had been enacted. And there were two that were trying to tie up together. And together, they would have become the second biggest.

And United, I think was the biggest at the time. And they were being blocked by the DOJ. It was before the DOJ for consideration.

And so the spread on that takeover was very, very wide. And I had that position on because I thought they were cheap. And I also thought that the spread would likely close.

And there was probably a chance for a near-term catalyst. As it happens, the DOJ ultimately blocked that merger. And the day that they blocked it, both stocks were up huge amounts, which makes no sense because beforehand, there's two outcomes.

There's a good outcome and a bad outcome. And the market's sort of guessing which one's going to happen. And so it's uncertainty about which could happen, but it must include both outcomes.

And then you get the bad outcome and you get a rally on the bad outcome. And all that sort of illustrates to me is that the market really hates uncertainty more than even the worst case outcome. And so I think that there's a lot of uncertainty.

There was a lot of uncertainty yesterday. And so even though this might be, I think that the blue state governors are going to be anti-data centre, which is probably, I don't know, maybe that's good for the hyperscalers because they're already big enough- That's what I was thinking actually.

[Tim]

I was thinking that because if there is pressure and if some of these projects don't get built, potentially you could see chip prices and the memory prices go down a little bit, which would be beneficial for those companies because they're such big consumers of them. But I mean, making a lot out of a day's market reaction is obviously not really our expertise or anyone's, I don't think, but it's interesting to say the least. And sometimes it's just a matter of like, I remember after September, we were talking and just saying, there's a lot of these prices just don't make sense on stocks.

And we talked about like Vichy Properties, for instance, with an 8% dividend and MGM Properties that went from almost getting bought out around 50, and then it dropped to the high 20s. You had some things that didn't make sense. And Mr. Marka has a way of kind of adjusting those things over time. So I think you're getting a little bit of normalisation on some of these prices. And then you have an earning season coming out and stuff like that. So definitely an interesting time.

AI Spending Boom: Can Big Tech Justify Trillions in Investment?

[Tobias]

Yeah, it's been a very bifurcated market. It's really been only the top end of town, the hyperscalers and the ones that are CapEx beneficiaries like Nvidia, Micron, SK Hynix, those kinds of names that collect all the money that the hyperscalers are spending. I think that it's a little, I'm always in two minds.

We've talked about this before, but on one hand, I think that AI is an incredible tool that is going to be absolutely transformative for the entire economy in ways that just we cannot possibly imagine. On the other hand, the numbers that they're spending are just staggering. The numbers that they're talking about, like 7 trillion in CapEx, that was one of the numbers that I saw floated over the next few years.

And then to justify 7 trillion in CapEx, you need 2 trillion in revenue on that, say. And where's that going to come from? Well, maybe that comes out of labour.

So labour share of the global economy is 40 trillion. So you need to carve out, I saw John Hampton said they need probably a reasonable improvement over the 2 trillion in spending that they're getting out of labour. So they need 4 trillion.

So you're going to carve out 10% of the global workforce to justify the revenues on this. It's just not going to happen in a short period of time, which is why I think you see that phenomenon in the early 2000s where clearly fibre optic cable was crucial to the build out of the internet. And we continue to use it to this day.

The stuff that was laid, probably it's got a useful life of at least 25 years. We're still using that stuff today. But the ones that built out all of that fibre optic cable went bust for the most part, even though the internet is, we use more of it now than we did way more than we were going to use at that point in time.

Be the same for AI. I think we're going to use way more than we can possibly imagine, but it doesn't mean that today's AI sellers are going to be the ones that benefit from it.

[Tim]

Agreed. I think there's been some interesting commentary. I believe it was Andy Jassy, the CEO of Amazon who broke it down, or maybe this AWS chairman or whatever.

But he was saying, okay, there's the spending in the data centres, which has kind of like a 30 year span that they'll be operating. And it's a longer lead time into that. But the ROI is actually pretty good once you get it built, but it's obviously high.

And then you've got the other spending on the chips and the memory and the servers, which you buy kind of right before you implement them. You already have kind of the contract in hand. You know how it's going to be.

And then those don't last as long, but the ROI is much quicker and there's going to be multiple iterations in each data centre with updated equipment, of course. And the ROI should improve on each sequence of that, because you're only doing the heavy data centre spending one time. So I definitely agree with you.

I don't know everything about CoreWeave or Nebius or whatever that is. I don't know everything about their businesses, but I don't know that their path to profitability and the multiple pillars of capitalising on AI are as powerful as it is for the Amazons and the Metas and the Alphabets of the world. And so I think that if you see breakdowns or defaults, they're the more likely ones.

And even Oracle's on that spectrum. I bought some Oracle bonds recently. I think they were yielding like 9%, which I thought was interesting.

Even Facebook, I want to say like 6.8 or close to 7. And they're long-term bonds, but I thought it was interesting because I could see if you get a recession at some point and rates go down, you could see those bonds appreciating potentially. And Toby, I had the chance.

Bill Ackman, my respect for him, I think has grown over time. I think he's a little less pompous in my opinion than he used to be. And he writes some really good stuff.

And him and his team, they were writing about the hyperscalers and they were also writing about Uber, which I thought was interesting. So you've got a stock trading at 16 times earnings and they're growing their profitability by about 25% per year. And that's expected to stick over the next couple of years.

And the fear on the company is that you have the Waymos and the Teslas that are going to produce their own automated vehicle fleets. And so much of the profits made in the big cities, right? The big cities.

And so if they get strong market share in some of those key cities, that could hurt Uber. But I mean, it seems like, I don't know, even if you're a Tesla fan, you might already have a Tesla, first of all. So it's not really that exciting to get picked up by one, but it's going to come down to convenience.

And I think that the opportunity for Uber and some of the things that they're doing, like with Uber Eats and Uber One and different types of cars, like Uber Black, Uber, they have the wait and save feature now, where if you want to spend as little money as possible and you don't care if you get picked up in 25 minutes, they have these different tiers. And so I thought he did a really good job of articulating the opportunity in Uber from a valuation standpoint. And so, I don't know, did you have a chance to look at that letter at all or not yet?

[Tobias]

I haven't, but I've followed Uber pretty closely. I remember when it flipped cashflow positive. And I think I've looked at its financials a few times.

I think it's an impressive looking business and it's not a heroic valuation that you're paying for. It's a pretty reasonable valuation. So I think it's a pretty good opportunity too.

The question is how quickly, I mean, I don't know if you've seen that, the rate at which the Tesla cyber cab scaled in Austin, where Waymo's have been building out incrementally for a few years now, and the cyber cab launched in January and it's just gone vertical and it's bypassed Waymo in a very short period of time for rides. And I was talking about this the other day on podcast and somebody said, I don't know if you feel comfortable putting your family in a self-driven car, but then you're perfectly comfortable just getting some random dude off the internet to come and drive you around in the car. That's equally dangerous, right?

Bill Ackman's Investment Strategy: Uber, Howard Hughes and Berkshire Hathaway

[Tim]

Yeah. No kidding. I mean, yeah, I think you could make the argument either way.

I mean, honestly, people look at their phones. I probably would be okay with it to tell you the truth. But yeah, Tesla, I mean, I don't discount that they'll be strong.

And I mean, that's why the Uber stock is compressed. And another thing I liked in the article is it's similar to how Warren Buffett and Charlie Munger articulate things where basically the stock follows the earnings growth over time. So even if you pay a little higher multiple, if the earnings growth is there, you should get a pretty good return on the stock.

And with some of the Pershing Square vehicles where they're kind of permanent capital vehicles, it's interesting hearing his philosophy on that and their goals to compound at 20% a year. And the Howard Hughes thing's interesting because Howard Hughes was a spinoff of General Growth Properties long ago. And I remember investing in General Growth Properties and following that whole story.

And so they have a huge real estate holdings, including key assets in Summerlin, Las Vegas, and Arizona, and Hawaii.

[Tobias]

Los Angeles.

[Tim]

Yep. And what they're doing is they acquired an insurance company that is relatively small. And essentially they've hired a really great team to manage the insurance company.

And the idea is to kind of sell off the real estate over time and invest it in the insurance company, and then kind of follow the Berkshire playbook where they've already sold off their fixed income investments. And now they're switching a lot of that to common stock, but with pretty conservative leverage ratios. And they think that they can get a 20% return on equity.

That's aggressive. I mean, most insurance companies don't get that, but that's the goal there. So look, I own some Howard Hughes.

I think it'll be interesting. I think it's cheap with real estate where it is. And then I think there's a lot of upside to what Ackman's doing there.

[Tobias]

I think that's an interesting situation. And I agree with you. I like the way Ackman moves.

And I've followed General Growth. And I remember when it became Howard Hughes, it was one of the most extraordinary runs out of the 2009 bottom. I don't know what he's, is he a 30 bag or a hundred bag on that?

[Tim]

It just could be- Oh, at least 30. Because I mean- It was 30 early. Yeah.

Because Toby, I mean, remember it was trading at pennies on the dollar, General Growth properties. So the issue was for folks that don't remember, they were the second largest mall REIT in the United States after Simon Property Group. And they went bankrupt.

And I mean, the rule of thumb basically is that equity is wiped out in a bankruptcy. But the issue with General Growth properties was that it was a liquidity issue because you couldn't really refinance debt in that market in the financial crisis. And so it was much more of a liquidity issue and Ackman grasped that.

And so in that default, the fulcrum security was actually the equity. And so he bought the equity for pennies on the dollar. And a lot of people thought he was crazy to do so.

And they kind of worked through it a little bit, got some liquidity in there. And then ultimately I believe Simon Property Groups and I believe Brookfield, if my memory is correct, they both made acquisition offers for General Growth properties after things had kind of settled a little bit. I remember because I was selling puts on General Growth properties.

It had already rallied past the pennies and I was selling puts on it. And the puts were far below the offers that they had gotten. It was an interesting time.

And so then ultimately they spun out Howard Hughes and yeah, that was a transformative investment for sure.

[Tobias]

I think insurance is a tough business. I don't know if you've ever gone back and read all of the early Buffett letters where he talks about buying the early insurers and the struggles that they had. Even Buffett, who's a pretty good assessor of risk reward, they really struggled to make those insurance companies work out of the gate.

And I don't think they could really get it going until they got Ajit Jain or maybe somebody else in there who was running the insurance rather than just the reinsurance. And then I think about, they seem to have mastered it and figured it out and they'd run it in a completely different manner to the way that every other insurance company has run. They don't write as many policies as they could given their asset base, but then they tend to put their assets into equities, which are more volatile rather than bonds.

So that's the quid pro quo for the way that they run that asset liability match. But then even though they seem to have mastered it, you look at the struggles that Geico's had over the last decade or so. And I understand that that's because they didn't progressively got pretty good at getting folks to put the little monitors into the cars that give you the data on how they drive.

And so then you can craft the insurance policy to give better drivers, better rates. And so they stick around and then you charge worse drivers, higher rates, and hopefully you kick them out and they go to a cheaper insurer somewhere else. And so you can run a pretty profitable business that way.

And I think that they were a little bit late to that. And so as a result, they stumbled. And I don't know if they've ever really regained their footing.

Maybe they're treading water at the moment. Have you followed that closely?

[Tim]

Yeah. No, I agree with you. I believe Daniel Loeb and David Einhorn, two historically good investors, especially Loeb for a long-term track record, they had their insurance vehicles too, and I believe they still do.

And that's it. They weren't necessarily the best underwriters there. It is a scale business.

One company I follow very closely is AIG. And so you have the Hank Greenberg years. And then after that, you still had really valuable assets and a really low valuation.

But their underwriting was just atrocious and their combined ratios were above a hundred and then they'd always have to revise it based on previous years. And it was just a mess. And so they ended up doing a big reinsurance deal with Berkshire Hathaway, which I believe was quite lucrative for Berkshire naturally.

And then they got a dream team together and they had a fantastic track record of underwriting and they did it. They reinsure a lot of it. And then now they're starting to leverage their scale to where they can get good written premiums, but they're not taking the same size risks.

And now their combined ratios are in the low 90s, high 80s. So you're not only underwriting at a profit, but your investment's on top of that. And the stock is still relatively cheap relative to book value if those results can continue.

So you're right, Toby, it's not an easy game. It's not a sure thing. I think leaning into management is good, but Ackman there has a mixed record on it, Toby.

And I'll never forget Ron Johnson at JCPenney, man. That was one of the biggest disasters in history. They bought the whiz kid from Apple's retail operations and he just destroyed JCPenney for all that it had.

[Tobias]

Good investors seem to be drawn into two types of businesses that they seem to struggle with. One is insurance and the other one is retail. We saw that a few times.

Remember Eddie Lampert?

[Tim]

Oh yeah. Similar concept, honestly, as Johnson. I'm writing a book actually, and those are two of the examples that I give on it.

And Lampert had a good run for a while. I mean, Sears was a really good performing stock for quite some time and the assets were clear. So especially if you looked at the real estate that Sears had versus competitors like Simon Property Group or General Growth Properties, you could see the value was tremendous.

But what the big difference is, is that you had an underlying retail business that was not profitable and you had tens of thousands, if not hundreds of thousands of employees that you can't really just get rid of them. And there's labour laws and there's things like that and just the morality of it, of course. And it became just like a really sad story for everybody.

It was like a slow death and then it picked up speed and then basically Lampert's hedge fund was loaning money to Sears at pretty high rates to keep them afloat. And I mean, it was a nightmare, man. Not a good example.

I made money on Sears and I lost money on Sears.

Deep Value Investing: How Stock Buybacks Create Shareholder Returns

[Tobias]

Yeah. I've done all right in Dillard's, which is one of those... I don't think it's a great retailer either.

It's just they've been quite good at sort of managing the decline, which is one of the things that as a deep value guy, that's one of the things that I do that probably a lot of more modern growthy type investors don't do. But I don't mind companies that are sort of in a gentle decline or where they're sort of being run, they're running in a sort of form of liquidation by buying back stocks. So if they're in that cash cow or like slight decline phase of the business, and I always think of AutoZone and O'Reilly's as two really good examples of this, but my portfolios are always filled with these kinds of businesses that basically they're too cheap because everybody can see that the end of the line is not here yet, but there's some point where it's not going to work anymore.

And so they just buy back stock hand over fist. And you can have a look at the stock price charts on these things. They're extraordinary.

All of them do very well over time. Dillard's is no exception to that, even though everybody knows what's wrong. They're just throwing off cash and buying back stock.

It's a really simple playbook, but it's very, very effective. And it's one that I like a lot. And it's one that I tend to participate in.

So Dillard's has sort of worked out, but retail is tough. And I've seen a lot of Buffett's written about that a little bit too, about the retail concept, the department store concept has changed over time. At one point, the most important thing was that you were near like a railway stop or a station where everybody got off and they went to you first and he's bought those sort of ones.

And then the railway moves or the retail concept changes. So Amazon is obviously the reason why a lot of these companies have struggled where previously you might've gone into the store to get one thing and then you get other stuff while you're in there. And now you just get that from Amazon and you never need to go in there.

And so you don't make those ancillary purchases, which is the thing that they're really relying on. So retail is tough and I would never size anything retail too big in the portfolio for that reason. But I do think it's an interesting, the two areas that there's a huge amount of risk, but there's also a lot of opportunity, as long as you know what you're doing, insurance, retail, they can be quite profitable.

[Tim]

A hundred percent. And you can get them at low valuations. So yeah, I mean, I think Assured Guarantee, the municipal bond insurer, I think they're another example of that where it's nice, especially for small caps or mid caps, Toby, like if you trust the capital allocation and if you trust that management team to act in your best interest, that's such a big part of it because you at least know, okay, if this stock gets cheap enough, I know damn well, they're just going to buy back stock. I mean, even if they have some other corporate priorities that maybe they're focused on in the short term, at some point it's just like, okay, if you're going to give me my company for 30% of the intrinsic value, I'm going to take advantage of that.

So, but then I've had other investments where I remember one was a Kennedy Wilson, which is a Los Angeles based real estate company and really interesting assets. They were early in a lot of markets, almost most of their big investments in apartments, offices, hotels, they were early, even in like the Idaho movements or the Sunbelt, they were just really early on it. But the problem was all the money went to the management team.

It was just like the incentive pay was so out of whack and you just didn't see any of the profits as a shareholder and the stock did not do well. Ultimately, Fairfax Financial bought it out at a very low price. They're going to do extremely well with it, in my opinion.

But yeah, it's just, that was a management team that didn't really prioritise the shareholders, in my opinion.

[Tobias]

You've done very well with AGO. That was one that you brought to my attention, must be more than a decade ago now. And I've followed that pretty closely over the years, just reading the quarterlies, not anything more than that.

But you should tell us, how do you interpret the financial statements of AGO and how important is the CEO, Dom Federico in there?

[Tim]

Yeah. I mean, so what I look at is I look at the insured portfolio and, okay, they show they're below investment grade assets. So those are the ones that could potentially cause losses down the line.

And they had huge exposures to Puerto Rico, for instance, that's been worked out. Almost all of those are done. Now they have Brightline, which is a railroad in Florida, who's the holding company is bankrupt.

AGO insures the secured, the senior first lien loans of the operating company, which is very different. And then you have like, it's also backed by the rail cars, the land, all this stuff. And it's not the one that went bankrupt.

Then you also have Thames Water up in the UK, which has just been a very mismanaged municipal utility, but it's water, right? So normally, even in Puerto Rico, for instance, the water and sewage was 100% recovery. So then you look at, they put their tangible book value, their operating book value, and their adjusted book values.

And there's just differences in how that they're accounted. And you can see the discount that it trades at now relative to historical times. And right now it's trading at one of the cheapest levels other than like the financial crisis, or maybe even the peak of COVID.

And so I think it is a pretty compelling value. They'll probably come out with earnings tomorrow. And the big thing I'll be watching is buybacks.

And also because that Brightline, one of their biggest exposures, because the holding company went bankrupt, what additional reserves they might add on that and any commentary there. But I mean, look, if you own an insurance company, you're going to have claims. And people get hyper-focused on that for that company just because they see it in the news, but any insurance company is going to have claims.

And so you're just part of the business.

[Tobias]

Do you see that as a business in permanent runoff, or do you think that there's a possibility that they grow that business again in the right kind of market?

[Tim]

I don't think it is. I don't think it's in permanent runoff. It's not as good as it was when you had like AAAs and you could ensure the whole spectrum of bond issuances.

But they've been growing into infrastructure and to some structured debt that they've done really well on. And you just never really know what the future will bring. I mean, the reality is there's not a lot of competition there.

And I remember having a conversation. This was not long after the financial crisis. This was probably 2011, 2012 with the CEO.

And I remember telling him, I'm like, why not use some of your excess capital and start a mortgage insurance company? Because at that time, mortgage insurance was destroyed after the financial crisis. And so you had some really smart investors.

I believe Paulson got involved, John Paulson, really smart investors in private equity. They started capitalising some mortgage insurers because there was this huge need for it. But there just wasn't companies that had ample capital and free balance sheets.

So I'm like, you guys would be perfect for this. And I think I was right, honestly. If you look at what happened with the mortgage insurers, almost all of them trade at substantial premiums to book value now.

And they've earned return on equities in the teens, even in the high teens. So that would have been a nice move for them. And they easily could have done it.

But whatever. I mean, it's not easier said than done sometimes.

Undervalued Stocks: Why Nike, Lululemon and Deckers Are Trading at Discounts

[Tobias]

But- I think you made an interesting point a little bit earlier when you said that you thought AGO was trading close to one of its lowest valuations ever. That's not... I think that AGO is particularly undervalued, but that's not unique to...

I sort of feel like there's vast swathes of the market that for whatever reason are trading as if they're in this terrible bear market. And it's lots of very high profile names that have had some extraordinary falls from like 80% off the peak. I'm thinking about something like Nike.

Every single one of the names that I mentioned, like Lululemon, Deckers, they're all... They have idiosyncratic problems. They have their own issues and that's the reason why they're down so much.

But it's such of... It's like there's so many of these companies with their own individual issues that it starts looking a little bit systemic, that there is this... And I think that part of it is that bifurcated market where you have the hyperscalers and those AI CapEx beneficiaries doing one thing.

And then everything else that's not those companies has got really, really cheap. And I looked across the portfolio and I thought my portfolios were as cheap as they were at the end of 22, except Q3, Q4 22, which was that... 22 was that bear market that there was never really any big sell-off.

It was just this grinding bear market that was just miserable every day for a whole year until right at the end of the year, everything looked pretty cheap. I thought the forward returns, even if we didn't have any multiple expansion at the end of 22 was sort of approaching 20%, which is in the portfolio, that's a huge return. I don't think we're quite at that level yet, but I think we're approaching high teens without any multiple expansion.

But then we saw October, there was a little bit of a turnaround. And then I think the hyperscalers stumbled a little bit. I've got no idea why the market decided to do that in October.

Maybe they were looking ahead to the election. What is the sandpile fall over?

[Tim]

Yeah. It's tough to say. I can tell you that I added aggressively to most of the hyperscalers, Meta, Google, Amazon.

I thought that they're extremely, extremely compelling. Google's cloud business grew by a hundred percent. They grew their revenues.

I mean, think of it, this is out in the net. That company is huge, 25% revenue growth. And you look at Meta too.

And I mean, Amazon is, I think there's not many companies I'd rather own than Amazon in the world. So I think that those are really compelling. And you mentioned, it's funny you mentioned the retailers.

So we just on the value options letter, we just sold, we just sold puts on Decker. I believe that was yesterday, Deckers. And like you said, there's idiosyncratic reasons.

So they've got, their big things are UGG and the Hoka. It's the Hoka, right? The shoes, the running shoes that are popular.

I don't wear them myself. But the growth on the running shoes has kind of slowed down a little bit. And so the market- It's still pretty good.

Still pretty good. Yeah. And so the market has some trepidation there, but the stock's trading at like 11 times earnings with a really good balance sheet.

And that's one of the benefits of using the put options. So you take advantage of that volatility from these stocks crashing from such substantial levels. And then you sell a put, you capture that attractive premium.

And like, for instance, we were put on a Lululemon put not long ago. And so I think we ended up owning the stock probably at a break even of like 96, 95, something like that. The strike was at 100.

And last I looked, Lululemon was trading at like 107. And so we actually did a covered call at 105. So that calls in the money, but that'll end, if that expires where it's at, that's a perfect scenario for that strategy.

That's called the wheel where you sell a put, you're exercised. So you keep that premium, then you end up owning the stock and then you sell a call and you benefit from the recovery. So, I mean, it's better in like an IRA or a qualified company where you don't have to worry about kind of the tax implications on that.

But definitely one of the things I like about options is that you can kind of take advantage of the volatility that's in there.

[Tobias]

Yeah. Very attractive part of that. Yeah.

So I think it's been interesting to watch those consumer-facing names. The consumer's clearly struggling, higher rates, higher gas prices at the pump. Even the oil prices up at this, the crack spread is very, very wide to the distillers that will be making lots of money.

So the customers are really feeling that, I think. And then inflation's running, like whatever number that the CPI is putting out just doesn't reflect what people are experiencing. And certainly that's just the rate of change over the course of a year.

It doesn't talk about the level and the level is up substantially 40 or 50% over a very short period of time, five or six years, according to the pizza index that I like to track. And all of those things bite on the consumer. And so anything that's consumer-facing, restaurants, most retail, all that apparel, they all are struggling as a result.

And you get slightly depressed earnings or just a lower growth. And then you get very depressed multiples. And so all of that together, I think, makes some good opportunities in there.

And I've been trying to pick some of those up for the accounts that I manage. But I do think that we... I'm not saying the worst of it, but I think that we passed the best valuations that we're going to see at the beginning of October.

And so there's been a little bit of a recovery across that complex. At the same time, there's been a little bit of a swoon at the top end of town. So it'd be interesting to see if where at some point those relative valuations give way.

And I understand why folks struggle a little bit with that. On one hand, there's the best businesses in the market. They're growing very rapidly and deploying these astronomical amounts of money and earning astronomical rates of growth on that very big deployment of capital.

But you've got to pay very high multiples for them. And at the other end of town, there's this stuff that's struggling and doesn't look like it's that mission critical, but it's very, very cheap. And that's the deep value portfolios.

And at some point, the valuation becomes more important than the rate of growth. And there's a few little statistics that I like to throw out. One of them is the biggest companies in the market have tended to underperform the market.

That's a very long got a hundred plus years of data showing that. And that's not been true for the last 10 years, but that is a cyclical phenomenon that occurs around these booms in the market where the biggest companies tend to outperform. It doesn't really tend to last for very long.

And then you have the fastest growers also, the ones that are deploying the most capital. They also tend to underperform, which doesn't really make intuitive sense, but statistically, that's the case. And it's been a pretty good signal.

Again, it hasn't really applied over the last 10 years. And so the question is, are these businesses so different from everything that's gone before that they're just going to shrug off all of this statistical sort of the implications of being very big and growing very fast and deploying a lot of capital? Or will they just be like every other business that ultimately competes in a way?

And I can see two arguments. One is that AI internet businesses are different businesses in kind because they're sort of one to one experiences spread across scale. We haven't been able to do that before.

But then on the other hand, there's also many examples of technological revolutions where the competition between the hyperscalers or the businesses that are leading at the time leads to lower returns because they just compete with each other so violently, so viciously. Great for the consumer, massive consumer surplus, but not so great for those companies making the investment.

[Tim]

It could be. That'll be the thing to follow. Do you follow, I think his name's like Thierry Drv or something like that?

[Tobias]

I do, yeah. Yeah.

[Tim]

I believe he said that about 50% of the S&P 500 is trading at over 10 times sales, which would be market cap weighted. So that makes a lot of sense, honestly. With the concentration of market, it seems very likely that that's accurate.

And of course, there's that famous quote by the former CEO, Scott McNeely of Sun Microsystems. The profitability dynamics are very different. And so while a lot of those companies are trading at very high multiples to sales, the margins are so darn high that like Nvidia and Micron, look, I mean, if it wasn't cyclical, I'm in the camp that it's cyclical.

But if it wasn't cyclical, you could see how you could get suckered into, and maybe they're not suckered in, into the low multiple and the growth rates and they look really attractive. But I think it's somewhat analogous to like home builders where not as good of a business as chips, of course, but you get these eras where they're printing money because it's supply demand. And then you get too much supply out there and that could happen.

Magnificent 7 Valuations: Could the AI Chip Boom Turn Into a Bust?

So that's why you could say, okay, well, the Democrats swept and maybe Texas and some of these states aren't building some of these data centres, less approvals, less demand for the chips maybe. And so that's kind of why you see the Nvidia is kind of selling off today. And some of these electric companies like Vistra Energy is down like 14% and they're a big Texas utility.

So they were expecting huge power demand from those data centres. And so we'll have to watch what happens there.

[Tobias]

I agree with that. I agree with all of that. I think that the cyclicality of those formerly cyclical businesses is the ultimate question that folks are going to have to answer.

For mine, I think they're probably still cyclical because what we're seeing is that sort of bullwhip effect where you have a lot of demand in the very short term, allowing them to charge unheard of prices, which is where their margins come from, which is why they're earning so much, earning so unusually. Does that demand persist at that level, like that frantic demand for chips? Does that persist for that level for an extended period of time?

I just can't see how it can, because they're all just overspending. And at the moment it's coming from the hyperscalers spending more than they're taking in. They're borrowing and they're raising equity capital and their free cash flows are massively negative.

So they can't sustain that without the revenues on top, which is the thing that we were talking about right at the very top. Unless the revenue show up, ultimately the tail end of that bullwhip is going to continue to be cyclical. And I think that we're probably, which is not to say they're not great businesses, they're funny businesses to buy.

You don't buy them when they're super profitable and optically cheap, because the market knows that profitability is short term and you buy them when they're expensive and loss-making for the most part. Well, it's probably time, Tim. Folks want to get in contact.

What do you recommend they do?

[Tim]

You can sign up for the valueoptionsletter.com. We have a free trial, seven days. You can try the service, no obligation there.

So there's recommendations just about every day. We shoot for three to five a week on there. You can see the full track record of every trade that's ever been on there.

And we have an active Discord and discussion and stuff like that. So if you're interested, feel free to join us.

[Tobias]

Good one. Thanks, folks. We'll see you all next week.

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