SA Interview: Investing In Asymmetric Opportunities Across Global Markets With Brian Kapp, CFA

Sep. 17, 2022 7:30 AM ETGOLD, AEM, SLB
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Summary

  • Brian Kapp, CFA is the co-founder and CEO of stoxdox, Inc. and has 26 years of experience across global markets as an analyst and portfolio manager.
  • The value of diversification across investing styles, the bullish outlook for aluminum and copper, and how to play the secular growth of electric vehicles are topics discussed.
  • Brian Kapp, CFA shares a long thesis on Barrick Gold, Agnico Eagle Mines and Schlumberger.

Feature interview

Brian Kapp, CFA is the co-founder and CEO of stoxdox, Inc. and has 26 years of experience across global markets as an analyst and portfolio manager. Brian is a CFA charterholder and earned a BS in Industrial Management and a BS in Economics at Carnegie Mellon University. To learn more about my research and our services, you may visit the stoxdox Membership page on the SA Marketplace. Please feel free to contact me directly should anyone have questions. We discussed an under the radar "recession resistant" stock trading at a low multiple, the benefit of adding technical analysis to fundamental analysis, and cryptocurrencies.

Seeking Alpha: Walk us through your investment decision making process. What area of the market do you focus on and what strategies do you employ?

Brian Kapp, CFA: Everyone's investment decision making process is unique and personal to them. I can speak to what I look for and my process. Given my background as a portfolio manager, my process has evolved in a way that can be utilized by any type of investor and implemented with any number of strategies. The optimal strategy for each situation differs materially, thus I select the best fit for any given opportunity.

My focus is on identifying the most asymmetric, timely, and relevant risk/reward opportunities at any given moment. I keep the opportunity set wide open across the global markets, the more diversified the opportunities the better. Diversification is the only free lunch available in the markets, offering less risk for the same or higher expected return.

For example, cyclical stocks lend themselves to more quantifiable entry and exit points. Additionally, they often entail shorter holding periods as they gravitate toward trading ranges, generally speaking. Conversely, secular growth opportunities require more of a buy and hold approach unless the valuation becomes extreme. Meaning, for a secular growth opportunity, one must be prepared to accept higher valuations which often involves being comfortable with momentum investing and letting winners run.

I am comfortable with the entire spectrum from current income through extraordinary growth opportunities. The cyclic nature of the market dictates that the best opportunities and the greatest risks at any given moment will rotate throughout the spectrum of features (growth, value, income, etc.). In every case, I'm most concerned with the asymmetry of the risk/reward profile rather than the particular features such as current yield. High yielding investments can produce extraordinary losses just the same as those that offer no current income.

SA: Does the selloff in commodities equities result in a lot of value (or contrarian) opportunities or are these value traps? Are there any factors that point to structural upside (rather than just cyclical) for certain commodities? If so, what are they and which commodities stand to benefit?

Brian Kapp, CFA: That's a tough question given the velocity of the recent commodity bull market and subsequent reversal. The supply and demand disruptions resulting from COVID amplified the price signals, first down then up. This dynamic created a lot of price noise with low information value. As a result, there are certainly many value traps out there.

My approach is to step back and observe the fundamental economic shifts to determine if a commodity opportunity is shorter cycle or longer cycle. At the moment, the energy transition stands as the primary secular driver for commodities. There is no doubt in my mind that the world is on the brink of this transition at scale. As a result, there is likely to be a longer than normal upcycle for certain commodities that could certainly last into the next decade. Meaning, while commodities are volatile, there should be a structural uplift for the energy transition beneficiaries.

Copper is likely to have a secular tailwind into the 2030s. The thesis is quite simple, electrification requires copper. If society is broadly transitioning to electrification and away from hydrocarbons, copper is the "new oil" as they say. For those interested, in several of my recent reports, I covered the structural shifts for key commodities in some detail.

In Rio Tinto: Asymmetric Global Growth Opportunity, I reviewed Citigroup's outlook for key metals and the additional demand that is projected to result from decarbonization efforts between 2020 and 2050. Incremental copper demand from decarbonization is expected to be roughly 0.4 billion tons. Over thirty years this averages out to roughly 13 million tons annually under the full decarbonization effort scenario.

Copper production is in the neighborhood of 21 million tons today. With production expected to grow at a 3% annual rate through 2030 and reach roughly 27 million tons, there looks to be a structural and material copper supply shortfall in relation to the world's preferred decarbonization plans.

I covered the projected supply shortfalls through 2040 in Freeport-McMoRan: Doctor Copper Makes A House Call. With supply shortfalls forecasted for mid-decade onward as the energy transition progresses, and the difficulty of bringing new supply online, copper prices should remain well supported at generally higher price levels than has been the case in recent times.

In the two reports above, I also cover the China effect in some detail which the market may be mispricing. In the Freeport report, I reviewed the primary risk to Chinese demand that the market fears, a deep real estate recession. Interestingly, the market may be overestimating the negative effects of China's real estate correction on commodity demand.

China operates on 5-year plus plans that lend themselves to reasonable estimates of the future. The study reviewed in the Freeport report projects copper demand by end use in China through 2050. The conclusion from the report, Chinese real estate is in the rear-view mirror in terms of copper demand. On the other hand, the energy transition is well ingrained in China's long-term plans and will dwarf any demand reduction from the real estate sector.

The Rio Tinto report highlights the fact that China, and Asia generally, will remain by far the largest influence on commodity demand and pricing. While we hear little about China's Belt and Road Initiative today, I have no doubt that some version of this plan will materialize. It is likely to feature China as the primary infrastructure builder in Asia during the coming energy transition.

This is China's competitive advantage, the ability to build infrastructure at scale in a condensed period of time. It is clearly on display in the yearly offshore wind installation chart in the Freeport report. China's ability to ramp energy infrastructure is unmatched and will be needed to execute the energy transition on a global scale. The wind example also highlights the robust demand outlook for other commodities, such as steel or iron ore.

Steel will play an important role in all renewables, including and especially solar and wind. Each new MW of solar power requires between 35 to 45 tons of steel, and each new MW of wind power requires 120 to 180 tons of steel. In fact, the Citigroup commodity demand estimates in the Rio Tinto report project that steel will account for 69% of the incremental commodity tonnage demand from decarbonization efforts and 23% of the total dollar value.

For comparison, copper is expected to account for 28% of the total dollar value of incremental commodity demand resulting from decarbonization plans. Interestingly, aluminum is projected to account for 14% of the total dollar value.

The secular thesis for aluminum is light weighting. This too is quite simple, lighter materials require less energy for production, transportation, and subsequent use. Aluminum also has the benefit, if you will, of being dirty to produce. With China agreeing to carbon reduction targets, the country has capped its aluminum production in recent years, which I covered in the Rio Tinto report. This looks to be a structural or secular shift which should support aluminum prices into the 2030s.

Of note, Rio Tinto has arguably the highest quality aluminum business in the world and may be the single best positioned company to capture the commodity growth opportunity resulting from decarbonization. Demand for all three of these primary commodities (copper, iron ore, and aluminum) should remain robust.

SA: As the electric vehicle space has a number of battleground stocks - are there any names you are particularly bullish or bearish on? If so, which ones and why? What is the other side missing about your thesis and what is going to change their mind to cause a re-rating higher or lower?

Brian Kapp, CFA: The electric vehicle space offers asymmetry in spades. As a preface, I view the space as simply automobile manufacturers, parts, and services rather than as a separate industry segment. The reason for this is that the entire industry is going to EVs which will increasingly render the electric qualifier obsolete. I believe this is the correct perspective or framework within which to view the EV opportunity.

If one accepts that we are really viewing investment options in the automobile industry, the opportunity set and risk/reward setup crystalizes quite nicely. One thing is certain about auto stocks, they trade at low valuation multiples. This feature is consistent across the entire group with the exception of Tesla, ignoring the speculative EV startups. The key question, is Tesla fundamentally different than other auto makers?

I have seen nothing structural that sets Tesla apart from the automotive group. Tesla's first mover advantage created a window into the illusion that Tesla was fundamentally different. It was able to reach profitability during a unique moment or phase of extraordinarily rapid growth along its S curve. This moment is quickly receding into the rearview mirror. Looking forward, Tesla faces an entire global automotive industry ramping EV production at scale while being well behind the pack in the secular automotive growth opportunity, autonomous driving.

The underlying structural problem is that automobile manufacturing is not a high margin, scalable business. For example, to increase sales volumes, you need to build more factories. These factories are capital intensive with little margin for error in that they need to run very efficiently and near full capacity to generate attractive returns. This is exceedingly difficult in the automotive business through a full business cycle and is a primary reason for the automotive stocks receiving low valuation multiples.

In two of my reports, Pair Trade: Short Tesla, Long GM And A Call Option On EV Growth and Will Ford Surpass Tesla By 2025? , I cover the EV opportunity set in some detail. The thesis is straightforward using the above automotive framework.

For example, GM trades at 6x the 2022 consensus earnings estimate while Tesla trades at 68x 2022 and 26x the 2030 earnings estimate. Consensus growth estimates for Tesla post 2025 are in the mid-single digit growth area. This is not materially different from expectations for most major automotive manufacturers. As a result, Tesla's valuation multiple should converge with that of the rest of the automotive industry. If so, there is extraordinary risk embedded in Tesla's valuation.

Both GM and Ford are well ahead of Tesla on the autonomous driving front and are going to market today. To my knowledge, Tesla is not actively qualifying its FSD as an autonomous system. Rather, Tesla has structured its FSD as more of a consumer entertainment system. The big unknown is whether Tesla can charge a material number of customers a significant amount of money for such a system. I don't see a large market opportunity at Tesla's FSD price point, but I remain open to the possibility.

A final note on the pair trade report above. I offered Aspen Aerogels as a high-risk, high-reward kicker. The Aspen opportunity offers a direct play on EV unit volume growth at the traditional auto manufacturers. Extraordinary EV volume growth is a certainty across the entire automobile industry. Both GM and Toyota are major clients of Aspen. Essentially, Aspen's primary products protect against EV battery fires. There are additional and substantial opportunities for Aspen's technology and a clear pathway to extraordinary growth potential through 2030 if the company can execute on its plan.

SA: Speaking of battleground ideas, what is your outlook for cryptocurrencies (including Bitcoin, Ethereum, Stablecoins, Altcoins, etc.)? How do you determine which coins have staying power and which ones do not? Which of the related equities (miners, brokers, etc.) have the best or worst outlook and why?

Brian Kapp, CFA: I don't have an outlook per se regarding cryptocurrencies. Meaning, to date, the primary use case appears to be speculation on price changes. This is problematic as there is generally no underlying cash flow support for said prices. The lack of underlying cash flow points to the primary problem for the crypto industry, there is no real economic purpose underlying them at the moment. Generally speaking, they remain a product created for speculation in search of use cases.

Furthermore, as things stand today, I do not see them accomplishing anything that is not handled much more efficiently by existing technologies. This is not to say there will not be economic use cases, there undoubtedly will be, however they will just be less exciting and will serve the real economy as opposed to the speculation use cases that dominate the landscape today.

For those that are interested in the space, I have covered the brokers, Coinbase and Robinhood, as they are where the rubber meets the road for the existing speculative use case. With price alone as the core feature, the brokers are the ultimate distribution end point for cryptocurrencies, which is to retail investors. Brokerage business models are highly cyclical and universally receive low valuation multiples. As a result, as Coinbase and Robinhood stand today, they are operating very unattractive business models with mediocre to low valuation potential.

SA: Everyone reading this can probably name popular low volatility stocks that do well in a recession - the problem is often they trade at high valuations to reflect this stability - are there any under the radar "recession resistant" stocks trading at low multiples?

Brian Kapp, CFA: That is a timely question and highlights a real challenge today for investors, valuation. Off the top of my head, ignoring valuation, the top four recession stocks would be Procter & Gamble, Colgate Palmolive, Clorox, and Church & Dwight. Another obvious choice is utility stocks, generally.

The valuation of each company above on the 2022 consensus earnings estimate is 24x, 26x, 34x, and 28x, respectively. On the 2026 consensus estimate, the valuations are 20x, 18x, 16x, and 22x, respectively. The valuation of the Dow Jones Utility Index stands at 27x the 2022 consensus estimate. I think most people would agree that these valuation levels present a heightened risk of multiple contraction.

I wrote BWX Technologies Is A Perfect Recession Stock with just this quandary in mind. With elevated valuations in place, BWX Technologies is a creative solution. Its business is mostly US government-related serving the Department of Defense and Department of Energy. The US government accounts for roughly 80% of sales. BWXT's core is in nuclear propulsion for the US Navy. The Department of Defense provides long-term visibility into demand.

For the core defense business, the Russian war and geopolitical tensions in the Pacific are a natural catalyst and should offer enhanced growth opportunities with US allies. Outside of defense, BWX Technologies is a market leader in the Canadian commercial nuclear reactor market, which is experiencing a renaissance of sorts. On the growth front, BWX Technologies is fast becoming a leader in nuclear medicine, nuclear propulsion, advanced nuclear fuel, and advanced microreactor design.

Importantly, the growth opportunities are substantial in relation to BWXT's market capitalization near $5 billion. With the core defense business offering utility-like investment characteristics and substantial growth opportunities in various stages of active development, BWX offers an enticing combination of stability and growth. Valued at 17x the consensus estimate for 2022 and 12x that for 2026, BWXT trades at a substantial discount to the utility sector overall and the traditional recession stocks. BWX Technologies may be the perfect recession stock today.

SA: Can you discuss how you add technical analysis to your in-depth fundamental analysis and give an example? Which technical indicators are most/least useful?

Brian Kapp, CFA: I have used technical analysis to various degrees over the course of my career. One thing that I have learned is not to read too much into it. What I mean by that, when you boil it down, is that technical analysis is all about price behavior, no more no less. My favorite example for explaining how I use technical analysis is the case of buying a primary home.

Nearly everyone I know chooses to buy a primary home based on the fundamentals. These include location, neighborhood, school district, crime, local government, climate, tax regime, employment opportunities, recreation, etc. While the fundamentals are the primary considerations underlying a home purchase, the price trends provide indispensable context for the ultimate decision.

For example, most would prefer to avoid purchasing a home in a neighborhood that has just appreciated 50% in a short period of time. Such a purchase would likely leave one exposed to the extreme risk of being underwater for the foreseeable future. Real estate fundamentals simply do not change that quickly. In this example, technical analysis would serve as a valuable decision support tool by allowing one to narrow the home purchase decision to the best risk/reward opportunities available at a given moment.

In essence, when buying a house, everyone studies historical pricing trends, volumes, and price comps (technicals) while the ultimate choice of a home is rooted in the fundamentals. This is the essence of technical analysis for me, a decision support tool. When combined with the fundamental mosaic, it is invaluable for timing investment decisions.

You could say that I take the KISS approach to technical analysis, Keep It Simple Stupid. As a result, I do not have a preferred technical indicator. Rather, each fundamental situation is different and demands emphasis be placed on what is most relevant to the particular opportunity. The technical analysis section of my reports only becomes animated when combined with the fundamental analysis which precedes it.

Salesforce is a great example of my use of technical analysis. At the time of my last Salesforce report in June 2021, the stock had just experienced a golden cross. This is when the 50-day moving average crosses above the 200-day moving average. From a pure technical perspective, this is a bullish development. Furthermore, it occurred after a long sideways consolidation, which is normally an ideal technical setup for a breakout higher.

A common error many make is to view only fundamentals or only technicals when weighing an investment opportunity. For example, the technical backdrop described above was quite bullish for Salesforce in isolation. When combined with the fundamental analysis that preceded it, a decidedly negative risk/reward asymmetry was revealed. In short, fundamentals are for investing while technicals are for timing.

SA: What's one of your highest conviction ideas right now?

Brian Kapp, CFA: In our last interview in December 2021, I mentioned gold and more specifically gold miners as a high conviction idea, from a portfolio perspective. Following that interview, Barrick Gold rallied 46% into April 2022 and served one of its primary roles in a portfolio, diversification. For those taking a portfolio perspective, as luck would have it, the gold miners have sold off brutally since April of 2022.

For example, Barrick is now back beneath its levels of December 2021 and is sitting on what should be an extraordinarily strong long-term support level. Agnico Eagle Mines, a blue-chip gold miner, is in a similar position. As two of the highest quality miners in the world, they are natural high conviction choices today for a diversified portfolio to gain high beta exposure to gold.

I have run many Monte Carlo simulations over my career in order to view optimal portfolio allocations under various assumptions. What I can say with certainty is that the most efficient portfolio allocation to gold is almost always vastly higher than what is implemented in practice.

Today, I see studies showing that institutions have a 0.5% exposure to gold in their portfolios, on average. Portfolio optimization points toward something many multiples of this. To me, the relative underinvestment represents a source of energy should traditional asset returns continue to revert to the mean. Additionally, we have entered a higher volatility regime than has been the case in some time, which further supports fund flows toward greater diversification. Gold is a top choice for diversification, hence my Barrick report title: Barrick Gold Is On The Efficient Frontier.

The technical setup for gold is one of the more bullish long-term setups in the market today. When combined with the fundamentals of likely strengthening investment demand, increasing geopolitical tensions, and discounted stock prices, the risk/reward setup for the gold miners is decidedly positive. The added benefit of materially increasing portfolio diversification is a unique and undervalued feature.

Moving to a more idiosyncratic opportunity, one of my highest conviction ideas is Schlumberger, which I covered in the following reports: Schlumberger: An Asymmetric Opportunity With Supercycle Potential and Schlumberger: A Top Choice For Cyclical Growth Through 2023.

A look at forward earnings growth rates and the PE multiple on each, points to a growth company trading at a discounted price. The consensus growth rate for each year through 2025 is 57%, 39%, 18%, and 12%, respectively. This is exceptional growth in today's environment. The PE multiple at each growth rate through 2025 is 19x, 14x, 12x, and 10X, respectively. There is a substantial multiple expansion opportunity as is evidenced by Schlumberger's 5-year average PE multiple of 32x.

It is likely that supply capacity in the energy service industry will be inelastic nearer term. The industry will most likely add capacity with a lag given the prolonged recessionary conditions faced before the recent cyclical upturn. As a result, the energy services sector looks ideally positioned for margin expansion, which could add material upside potential to consensus growth estimates.

Finally, there are extraordinary growth opportunities looking across the broad energy services sector. Schlumberger's active growth programs include lithium mining technology, nickel-hydrogen battery technology, electrolyzer technology for hydrogen production, and building-scale geothermal energy technology, to name a few. The broad energy service sector looks to be entering a secular growth phase in response to the aforementioned global energy transition planned through 2050. Schlumberger's valuation places little to no value on these growth opportunities.

***

Thanks to Brian for the interview.

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