Transcat Can Double in 3-5 Years

Transcat (TRNS) distributes, services, and calibrates equipment for a variety of industries, particularly highly regulated industries such as life sciences. Transcat serves as a one stop shop to make sure the equipment are working properly, without customers having to schedule with each and every OEM. The link here shows the instrument types they can calibrate.

I will try to provide the outline of a long thesis as succinctly as I can. Someone has a more thorough write-up here (paywall).

Thesis Sketch

Transcat can double its EBITDA in 3-5 years, and the stock can double as well. The reasons are below:

• The company has 2 segments, one growing and one declining/stabilizing. Revenue growth is set to accelerate because the growing segment is now outpacing the declining one.
• Growth is further enhanced by a roll-up strategy in its services segment (in addition to organic growth) 
• Margins will benefit from mix (Services segment has higher margin), as well as operating leverage.

As a bonus - I'm not counting on this - the company pays 30-40% tax. A corporate tax cut to 20% would immediately boost earnings by 14-33%

Mix Shift Toward Higher Growth and Higher Margin Segment

The company has 2 segments: Services and Distribution. Right now they contribute about 50/50 in terms of revenue. The Services segment has been a steady grower (both organic and via acquisition). Distribution segment revenue declined the past few years due to the oil and gas industry downturn, but seems to have stabilized in the past few quarters.

Going forward, the growth in Services will outpace the decline in Distribution. Since Services enjoys a higher EBITDA margin (low double digits vs mid-single digits), EBITDA will grow faster than revenue.

The slide below shows the revenue and profitability crossover.

Roll-Up Strategy

The Services segment is also a rollup story, supported by reasonable debt levels (~2x Debt/EBITDA). The company is a disciplined acquirer, typically paying 4-6x EBITDA with IRR hurdle of 15%.

Calibration services is an $1bn market, split 40%/35%/25% between 3rd party services providers, in-house labs, and OEMs. Within ~the $400mm market for the 3rd party services provider, Transcat is the 2nd largest with behind Tektronix (18% share versus 22% share).

Notably, almost 40% of 3rd party providers market is serviced by smaller regional and local players. That’s a ~$160mm space that Transcat has been, and will continue to be consolidating.

I believe the company can improve its share of that 3rd party market from 18% to low 20%’s, providing a tailwind for revenue and margins.

Valuation

With TRNS stock trading at $12.4/share, the company has $89mm of market cap and ~$115mm of enterprise value.

Management is targeting $175-200mm of revenue and double digit EBITDA margin in 4-5 years. Using the midpoint of $187.5mm revenue and a 12% margin gets you to $22.5mm EBITDA. With a 10x EV/EBITDA and you have $225mm of enterprise value – almost a double from the current $115mm EV.

That is in 4-5 years. But as markets are forward looking, I expect the stock to double sooner.

Here’s my rough model on 1) how revenue and EBITDA might progress over the next few years to FY2021, and 2) what they look like if management’s goals are met.

The 2 are fairly close so I think management’s goals are reasonable. Recent financial results suggest they are well on their way.

Week ending 3/10/2017: Losing Streak

From red hot to ice cold. My major stock holdings have drifted lower. My small, speculative positions have blown up and given back their gains. In the past months I twice sold stocks (Fortress and Nimble Storage) days before they get acquired at huge premiums. Even currency trades, a barometer with which I judge my understanding of the world, went from positive to negative.

It’s a combination of bad shots and bad luck. What do you do when you keep shooting bricks and air balls? Do you keep shooting? Or do you bench yourself?

For now it’s the latter. I have cut back on losers and winners alike. Despite having a plethora of stock ideas, I’m putting them on hold until I can figure out what’s going on.

Major Stock Positions

Fidelity National Financial (FNF). Spinoffs coming 2H16 to unlock value. The core title insurance business is cheap at about 10-12x PE. This is a great business and we may be on the cusp of a wave of millennials buying their first homes.

Beijing Enterprises Holdings (0392.HK). Just too cheap.

Sallie Mae (SLM). A play on deregulation, tax cut, and higher interest rates.

Aetna (AET) and United Health (UNH). Insurers have the best bargaining power in healthcare.

Medtronics (MDT). SURTAVI trial results coming March 17th. A good read could boost the market size of TAVR heart valves and MDT’s market share.

Vipshop (VIPS). Incredibly cheap for a company with 20%+ revenue growth. The market should come around to it one day.

Most of these have done well the past 2 months but are now showing weakness. I’m actually praying for FNF, SLM, and VIPS to go lower so I can buy more. Beijing Enterprises had a nice run the past month but looks about to be beaten down again. The negative sentiment in Chinese stocks persists (this applies to Beijing Enterprises as well as VIPS) and I think part of it is the market assigning a steady decline in Chinese Yuan.

Inotek and Negative Enterprise Value Situations

2017 will be an interesting year in biotech. When “clinical stage” biotechs fail their trials and still have cash left, what do they do? These stocks can trade at below value of cash on balance sheet, so the market is basically saying management will entrench themselves and burn away cash. There’s a bunch of these companies in the market right now. Ovascience, Inotek, Ophthotech…etc. Merrimack is another one that could have negative EV soon.

I replaced my OvaScience position with another negative EV play, Inotek. This company develops eye drugs. It has one more phase 3 trial result coming up, and no more pipelines after that.

In this way Inotek is superior to OvaScience, which has multiple years of pipeline (thus excuses to burn cash and destroy shareholder value). If the trial fails, Inotek would still be sitting on cash of $2-2.5/share and no debt. The company trades at 1.6 when I bought (up to 1.8 today).

It’s hard to say what management will do. Ideally they just return cash to shareholders. But they could try to acquire some product pipeline. Or they could refuse to admit defeat and do another phase 3 trial on the same failed molecule. In short, anything to keep paying themselves.

So this is potentially an activist situation. But I’m not sure how much good that can do. The board has no investor representation and only one director is up for election in 2017.

Ophthotech is another eye drug company with negative enterprise value. They have already said they will not return cash, but will look to acquire. So Inotek could be a target.

On “M&A Valuation”

What are these “plethora of ideas” that I’m holding back from? I have one general observation about the whole IT/medtech space.

I’m seeing lots of companies like this: revenue growing fast – say 20%+ or even 100%+ a year. Stock trades at 2-4 times EV/revenue. Big net cash positions. GAAP losses but approaching cash flows break even (because of stock based comp and D&A). High gross margins. The biggest expenses tend to be sales/marketing /G&A.

From the perspective of a strategic acquirer, you can synergize and cut down SG&A by half or even more. If you do that, most of these companies are essentially valued at <10x EV/forward EBIT, maybe lower.

So if you start modeling “acquirer perspective”, they all look like slam dunks. On a standalone basis though, most of them will never be profitable (unless you literally project growth like 10 years out).

Off the top of my head, Novocure (NVCR), Atricure (ATRC), Nutanix (NTNX) are just a few that fits in this category. The list is long.

The megacaps are sitting on huge cash piles. Tax reform could add to that by allowing big tech companies to repatriate cash. This all bodes well for M&A. Of course, not every company will be bought out, but increasingly market valuations are based on perceived M&A potential.

Leaning on Currency Trades

In a bull market everyone is a genius. In the month or so I enjoyed profits in all directions – equities, currencies and commodities. The problem is that idiosyncratic contributions are wearing thin and the gains are more and more dependent on market wide movements. So I decided to do another macroeconomic review, starting with currencies.

A quick disclaimer: anytime someone tells you about a “macro trade”, it’s got a lifespan of about 3 months or less. The reason is market moves feedback to real world fundamentals and no one knows how that will play out with any certainty. The trick is to anticipate a sort of decision tree, and ride the trend when real life plays out as you expected, and be ready to do an 180 when events go down a different path. This is why macro guys like Druckenmiller can flip flop all day yet still make money.

With that out of the way, I’m long Russian ruble, Danish krone and USD, short euro, and anxiously watching the USD.JPY pair. I will explain each below.

The Ruble

I've been riding this trend since late November/early December. I actually have no great conviction on the ruble, but I love Russia’s situation –their geopolitical and economic outlooks are clearly improving.

In the 1970’s and 80’s, the U.S. and its allies opened up to China to counter the Russian threat. Now in the 2010’s it’s the reverse. The U.S. will warm up to Russia to balance against China. Trump clearly wants to work with Russia and France could elect Le Pen, who views Russia more favorably. Shinzo Abe in Japan is getting closer to Russia as well.

This all improves the probability that the current sanctions against Russia will be removed. On top of that, Russia is coming out of a recession and oil prices have stabilized. Inflation will likely subside, which can lead to the central bank cutting rates. Russia is also looking to lower its budget deficit.

The combination of lower expected rates, budget consolidation and improving sovereign credit is the best possible set up for bonds and has mixed outlook for the ruble. Unfortunately I have no access to Russian bonds, but I will settle for going long the ruble and Russian equities (which I also have positions in).

Even if the Central Bank of Russia starts cutting rates, the ruble should still be supported by a relatively high rates and portfolio inflows into the country. Once ruble strength start fading, Russian equities could be the next bull market.

Euro: short EUR/USD and EUR/DKK. Get ready to buy French companies

The dissolution of EU is on everyone’s mind but what happens to the euro is anyone’s guess. The euro could strengthen because weak countries like France and Spain would exit, leaving euro as the currency of a very strong Germany. The euro could also weaken because any dissolution requires a long transition period and the ECB will go on a quantitative easing binge while they’re at it.

At least in the next few months, I think the latter is more likely. So I’m shorting the EUR against the U.S. dollar and the Russian ruble.

I’m also shorting the euro to go long the Danish Krone. The downside is low here as I’m shorting a currency that is pegged, yet undervalued.

Denmark has one of the highest current account surpluses as percent of GDP in the world. If you think Germany has undervalued currency because it uses the euro, then the Danish krone is just as undervalued because of the peg to euro. Denmark also has zero interest rates and an overheating housing market. Does that sounds like an economy that needs more QE? If the ECB unleashes another round of QE, I doubt Denmark will want to follow suit, so they have to unpeg and let the DKK float upward.

Finally, a full dissolution of EU would be great for France. Upon completion, I expect French companies to be big beneficiaries as France would have much needed flexibility on fiscal and monetary policies. French companies will also enjoy great operating leverage with that 10% unemployment rate.

Yen: USD/JPY short in the next month could be the next pain trade

We are heading into European elections and there’s a high probability that populism will win out in Netherland and France. This could trigger a global risk-off with international funds pouring into JPY.

On the USD side, Trump's tax/trade/infrastructure plans (it’s all tied together now as you can’t have one without others and not blow up the budget) would certainly not be passed the next few months. So we can see deterioration in USD as expectations are pushed toward later dates.

Any JPY strength would catch the market by surprise. The market is still very long USD. As for yen positioning, “large specs” went from very long JPY to net short to less short (but still net short) in the past few months. This suggests more room for JPY to the upside.

I'm not going to short USD/JPY however. At the time of this writing, USD/JPY is at ~114. More likely I will wait for the pair to drop to 109.5 or even 106 and resume a long USD.JPY position.

Buying OvaScience at Negative Enterprise Value

OvaScience (OVAS) aims to improve chances of fertility. It has two products in early stage development, and one that’s already in the market outside of U.S.

I have some notes in the next section about what the company does, but the thesis is really quite simple - extreme cheapness presents attractive risk and reward.

At $1.6/share, this company has $56mm market cap, yet it has $130mm of cash and securities and no debt. There are no off-balance sheet arrangements either. Stock options are mostly way out of the money, so there’s minimal dilution risk. Taken together, the company has enterprise value of negative 70mm+.

Put another way, the market is pricing in 100% chance of OvaScience burning $70+mm of cash (more than the market cap!) and get nothing in return. Implicitly, the market judges the science behind OvaScience to be worse than worthless.

Now that’s harsh.

Let’s go through some hypothetical scenarios.

First, it goes without saying that this is a multi-bagger if the pipeline in development actually works out. Even if the pipeline doesn’t ultimately work in the long term, the stock can go higher with any positive results from clinical trials. Also, keep in mind we’re in a new era of deregulation – the FDA approval process can conceivably get easier.

But how if it does not work? What’s OvaScience without the science? Is it “game ova”?

No. On the contrary, the stock offers multiple options: a) as a target of acquisition and/or liquidation, 2) as an acquirer of another company.

The company is not majority controlled by insiders. So this is not a situation where management can destroy shareholder value with impunity. Various types of potential acquirers can take control and monetize the discount here.

Management did say they will burn cash in 2017, but not nearly as much as the stock price would imply. If clinical trials start showing bad results, an activist fund can step in, liquidate the company and realize the remaining cash hoard. A pharmaceutical/biotech company can likewise do the same. IVF clinic like Virtus Health could also be natural buyers.

OVAS can also act as an acquirer. This would remove the threat of management running cash down to 0, and thus a boon to valuation. The stock would be worth more even if management buys some snake oil with that $130mm of cash. If they buy anything worthwhile this could be a quick double.

Obviously, things have not gone well with the company thus far. But at this price the downside is minimal.

What the company does

Women are starting families later, which means their eggs are older and have lower chances of conceiving. OvaScience plans to improve fertility via operations on EggPC cells, defined as “immature egg cells found in the outer lining of the ovary, which have the potential to mature into new healthy eggs, thereby replenishing egg supply”. Here’s a picture from the company’s presentations.







Their 3 products in development represent 3 different ways of utilizing these immature egg cells.

• AUGMENT - enhances egg health by extracting mitochondria from EggPC cells and injecting them into normal eggs.
• Ovaprime - increase egg reserves by taking a woman’s own EggPC cells and injecting them into her ovaries. 
• Ovature - A woman’s own EggPC cells are matured into healthy, young fertilizable eggs outside the body.

The company currently has minimal revenue because the AUGMENT treatment has not been a commercial success.

On December 2016, OVAS stock dropped to as low as $1.3, in response to an announced restructuring, summaries of which are below:

• The company will stop expansion of AUGMENT and reduce its workforce by ~30%.
• CEO and COO both stepped down. Founder Michelle Dipp took over the firm.
• As a result of its corporate restructuring, the Company anticipates that operating cash burn will be between $45 million and $50 million in 2017, excluding one-time cash items of approximately $7 million to $8 million related to the restructuring. The Company may also incur further restructuring charges related to the restructuring plan. 
• These changes will enable the Company to extend its cash position into the first quarter of 2019 and increase its focus on the development of OvaPrimeSM and OvaTureSM. The restructuring is expected to be completed in the first half of 2017.

Post the restructuring, the new goals/milestones are shown in the below slide (from company presentation)

Don’t Know Much About VIPS, But I Do Know It’s a Buy

At this price, Vipshop (VIPS) is a situation where a short term trading approach can turn into a longer term investment. I bought at $11.1 last week. The stock is at $11.5 now but the logic still holds.

I did not spend a lot of time researching VIPS– altogether no more than 8 hours. More research will be not be productive. I already have enough information to know that:

1) Stock priced in lots of negatives already, and the upside is big if things go right.

2) The technical set up provides a high probability of a short term trading win with minimal downside.

3) I’m not ready to assess VIPS’s longer term growth prospects, at least not until revenue growth stabilizes. But the likely short term trading gains could tide me over until then, and provide the cushion to turn this into a longer term bet.

Brief Background

VIPS is an online discount retailer for apparel brands in China. Apparel brands/manufacturers often end up have excess inventory to get rid of, but they don’t want to flood their stores with big discounts. VIPS is one of the ways that manufacturers can offload inventory. VIPS would organize “flash sales” on its website, selling these items at 30% to 70% off the original retail price. Most of their inventory for now is based on consignment, meaning VIPS bear little inventory risk.

VIPSHop came from a friend who compared it to the online TJ Maxx of China. It didn’t really appeal to me at first - I’m just not much into shopping for clothes. While I was away for Christmas vacation, I watched to stock drift lower and lower, and I finally decided to take a look.

What Is The Market Saying?

Revenue has been growing more than 50%+ per year, it has slowed recently but sell-side analysts still expect revenue to grow 26% in 2017E. 2017E P/E ratio is just a little under 18x. For this type of growth VIPS is incredibly cheap.

Just to put this in context, VIPS is expected to earn about USD $0.48/share for 2016. If EPS grows at 25% CAGR for next 3 years it will earn about $0.94/share in 2019. A consumer stock growing double digits in China should easily command an 18x multiple, justifying a $17 stock price.

Clearly, the market thinks that’s not going to happen.

With VIPS trading <$12, the market is basically saying a) growth will decelerate drastically or even decline 3-5 years out, or b) there are concerns of fraud.

There were in fact accusations of fraud, but that was over a year ago and GeoInvesting actually came out defending the company. At this point I think it’s got to be a small and diminishing factor in the stock price.

So it’s more about the sustainability of growth, and by extension VIPS’s business model itself (footnote 1). You can argue both sides. I lean toward the optimistic side but honestly– anything can happen. I’m certainly not one to claim any sort of conviction here.

On the bear side, one can easily think of some risk/concerns for VIPS. The discount retailer model is far from a sure thing – the success of TJ Maxx is an exception, not the rule. There are also questions as to how the discount model can carry online. Retailers can show deep discounts on their websites directly (like some already do in the U.S.), so the need for something like VIPS is questionable.

Competition will surely be tough. The fact that revenue has decelerated in recent quarters would seem to suggest other players are taking share. It puzzles me that VIPS is expanding into the financing business (for consumers, suppliers, and even selling private wealth management). Is that really the most effective way to juice growth? If you need to finance apparel purchases to increase growth, isn’t that a sign of desperation?

On the other hand, a bull would say yes, there are many ways for manufacturers to offload inventory, but this is China we’re talking about there. The market is big enough to have all these different channels. The company’s revenue may be slowing as percentage, but it’s growing off a larger base and that growth is actually larger in dollar terms. The upside is huge if and when the negative sentiments are lifted. If VIPS could sustain double digits CAGR for a few years and then not fall off a cliff, that business could trade closer to 20x P/E

I’m not smart enough to predict how the future will play out, or even assign probabilities. But I do know that IF it works, the stock can be up 50% or even double. How if it does not work? Well the stock already reflect much of the “not work” scenario.

What’s the floor value of VIPS in the next 3 years? Again, I don’t know. In the next month or so though, the downside is low and that’s a good starting point.

Where to Cap My Downside?

Here’s a chart showing 2 year stock prices against volume moving averages. The black line is the price (left axis), the blue and green lines (right axis) are the volume moving averages. I do this to smooth out volume fluctuations and get a better sense of volume trends.

The blue line (1 month moving average of volume) shows signs of capitulation selling with volume spike during late 2015 and early 2016. This was followed by a period of lowering volumes, signaling investor disinterest. It seems that growth/momentum investors have abandoned the stock, leaving value investors with lower expectations. 

I would also note the historical demand around the $10-11 area. Each time the stock dropped to $10.3 the buyers showed up. Even after the disappointment in 3Q16, the stock seems to bottom around $11.

Finally, this stock can run up between earning releases. This happened prior to the 8/15/2016 earning, as the stock rallied some 50% from its June lows. Serious resistance doesn’t show up until ~$15-$16 range.

Game Plan – Buy the Stock < $12

There’s not going to be an earnings release for at least a month or so. In the meantime there’s unlikely any catalyst to shock the stock below its $10-11 support zone. So both the probability and severity of downside is low in the next month or so.

If the stock falls below $10 then I'm probably wrong and I'll take a small loss. If the stock doesn’t move I could cut down before earning release. I might have limited losses, or limited gains – it’s a coin toss.

There's a good chance I might even get 15-20% upswing given the low price – there’s precedent for more. In that case, those gains would allow me to hold through the earnings, as the gains will serve as a cushion for any drops from earning disappointment. If 4Q16 turn out to be good, the stock could roar higher, giving me even more cushion to hold longer term – for the real bet - that the business is sustainable after all. 

Taken altogether - my downside is 10-15%, short term upside some 15-20%, long term upside could be 50% or even double. Regardless of my doubts about the company, I have to take the trade.



Notes 

1. VIPS may not be cheap if there’s not a “mature phase” of this company. The multiple seems absurdly cheap if you think the company will grow double digits for a few years then revenue stabilizes at some level – a theoretical “steady state” for valuation purposes if you will.

That works for most companies, but an internet company? I’m not sure. It could be either you’re gaining share and growing, or your losing and dying – maybe there’s not this “steady state”. In a DCF model, revenue/cash flows would grow to some peak, slow down, then decline precipitously. That would justify the apparently low multiple. The market seems to price in some probability of this.

December 2016 update – Single Names

It’s been a while since I last wrote. Here I will just give a quick update then sketch out a couple stock ideas I’m still in. I will leave the forward looking macro view for the next post.

It’s been a good month for all investors and I’m no exception. Post the Trump win I loaded up on financials (SLM and WFC), and tripled my holdings in Sterling Constructions (STRL). These are concentrated 7%-12% positions. I also went long the US dollar against yen and euro, riding USD/JPY from 105 to 115. A week ago I cut back on STRL, exited WFC completely, then went long Russian rubles.

This series of frantic trading and macro maneuvers paid off. In the last month I did better than the S&P index even with all my large cash holdings/shorts/hedges. I started taking chips off the table as the market looks extended again.

Single Names I'm still Bullish On

I’m still very bullish on Salle Mae and Sterling Constructions over the next 3 years. FNF is another that can double. Below are a just some bullet points.

Sallie Mae (SLM)

So the stock trades at $10.8 at the time of writing. Downside is $10-$10.5. Upside could be $15+ and a highly probable one.

This is a company that was doing well even before the election – strong growth, strong ROE, and solid capital levels. Management is also trying to improving cost efficiency. The only thing that held back the stock was Democrats’ various attempts to undermine the private student loan market (free college, student loan forgiveness, and general hostility toward lenders…etc).

After November, all the sudden we have 1) decline in regulatory risk, 2) potential market size expansion as Republicans might scale back government funded student loans, 3) higher rates and steeper yield curve driving higher net interest margins, 4) a big tax cut (SLM pays a high 35-40% and their preferred dividend further leverages EPS to tax cuts). The last point alone could juice their earnings by 30%+.

Here’s how I roughly think about floor value and upside. The stock was trading in the $7-$7.5 range before election. Republican president and congress removes an existential threat to the business and should make this worth $8-$8.5. Tax cut improves earnings by 30%+, so add another $2/share and we’re already at $10-$10.5 as floor value – not far from where the stock trades now.

And that’s before factoring in better net interest margin and market size expansion! All together, there’s a high probability that SLM earns $1.5/share within 3 years. At a fair 10x multiple SLM could easily be worth $15/share.

We have a nice bet here. SLM represents 7-8% of my portfolio and I will look to add on weakness.

Sterling Construction (STRL)

Although a construction/infrastructure stock, this is not really a “Trump Trade”, as I wrote about Sterling Construction back in July here. The thesis has not changed much, but the emphasis has shifted from company specific factors to the industry and macro pictures, which has gotten much better.

The company is highly leveraged to gross margins, which was already improving back in July, but now will likely go higher due to 3 factors. First, management has stated their intention to go after higher margin, non-highway projects (commercial, airports…etc), and have in fact started to win them. Second, the local projects passed during November 9th will be supportive for industry competitive landscape and margins.

Finally, Trump’s $1 trillion infrastructure plan threatens to take margins, and by extension STRL’s stock, to a whole new level.

So both the probability and magnitude of a win are much higher now. Right before the November election, I would say STRL’s floor value is about $6.5 and ceiling about $8.5. Now I would say the floor is ~$7.5 and the upside is uncapped until the teens’ or even $20’s.

The key is to not get ahead of ourselves too much though. I’m looking for improved quarterly results, new contract wins, or legislative progress on Trump’s plan to add to my positions.

Fidelity National Financial (FNF)

This is the largest title company and the most profitable one. The company operates in an oligopoly with captive customers - title insurance is mandatory purchase. At $34 per share, the stock is acting incredibly bearish right now. But a catalyst has surfaced.

Currently there are 2 negatives holding back the stock in my opinion. First is structural complexity. FNF consist of the core FNF title insurance company, a publicly traded subsidiary Black Knight Financial (BKFS) and the FNFV tracking stock (which represent a portfolio of side bets like restaurants). The second problem is commercial title revenues are slowing down.

There's a catalyst coming next Fall. Management announced they will address the structural complexity issue by cleanly splitting out core FNF title division, BKFS, and FNFV. This would allow the core FNF business be included in indices.

The core FNF title business then has a path to double once commercial revenue stabilizes. Here's what could happen with some back of the envelope math:

• Home sales picks up. Perhaps because millenials are reaching the 30-40 age zone for peak home buying, or because Trumponomics puts more money in peoples pocket. Say home sales up 5% and housing price up 5%, that's a 10% revenue gain. With operating leverage you get to 15% gain pretax.
• 3 years from now pretax grew by 1.15^3-1 or 50%.

• Tax rate cut from 35% to 20-25%. That means EPS could be 70%+ higher in 3 years
• Just making up some numbers - right now $1 pretax get you 0.65. In 3 years you have $1.5 pretax at 25% tax rates. That results in an 70% higher EPS.

• P/E multiple of core title business re-rates from 12-15x because revenue outlook reverted to growth. Removal of structural complexity in the FNF complex also helps. That's another 25% gain.

Compounding these effects get you a double. I already have a solid position on this. But I could really go big (thinking like 20% position) if I see commercial title revenue to stabilize.

Revisiting the Big Picture

I try to hold in my mind several macroeconomic scenarios that are likely to play out, as facts come in and probabilities shift, I rethink my investments themes accordingly. The most bullish scenario (for equities and commodities) is as follows. The time frame I’m considering is next 2-5 years.

The outline of a macroeconomic progression:

1. Higher inflation expectations…

Crude oil has bottomed in the $40-50 range. As energy is a key ingredient in all other commodities, this is likely the end of the commodity deflation cycle. Indeed, other commodities sectors (particularly agriculture), looks to have trough too. If the world then starts eating into the currently very high inventory levels, that would leading to inflationary pressures.


2. …leading to higher yield in long bonds…

As inflation targets are hit, the central bankers will face pressure to hike rates. But hiking short rates would lead to a flat or inverted yield curve, damaging the banking system, so the central bankers have hinted they’ll let inflationary pressure push up longer term bond yields.

In recent weeks we have seen 5yr/5yr forward inflation breaking above 1.8%, and 10 year treasury yield going above 1.8%.

At this point the impact on US equity markets is unclear. Do we have real growth? Or do we just have stagflation? If the former, then inflation expectations lead to more investment and real growth, then equity markets could look up again. If the latter, then stock prices would take a hit because the market assigns higher discount rates with little growth to offset it.


3. …But underlying GDP growth is still weak, prompting fiscal stimulus.    

With rates around the world still near 0, central banker will have a harder time inventing new monetary tricks. But that’s missing the point. Pushing people to borrow don’t work because we have industrial overcapacity everywhere so businesses don’t want to invest. Thus government has to take the lead.

Fiscal stimulus can drive inflation up further. But this time both real and nominal GDP rises. 

 

4. We end up with (still) easy monetary policy and fiscal stimulus. 

In this world, the US dollar would be stable, commodities prices goes much higher than today, long bonds gets crushed, and US equities go through the roof into an unprecedented bubble, setting up for the next crash.

Where Are We

We seem to be at step 2 right now. But note that step 1 & 2 does not necessarily lead to 3 & 4. Alternatively, we could have just easily skipped 1-2 and go straight to fiscal stimulus in an effort to drive inflation.

My view is that inflation cannot sustain itself given the current macroeconomic regime. This is because higher inflation drives Fed rate hike expectations, which (in today's upside down world with quantitative easing) drives the US dollar up and defeats the commodity price rally.

Regardless of how the sequence plays out though, there are certain themes here for investments purposes: fiscal stimulus, commodity price recovery, steeper yield curve, companies with structural growth prospects. 

In the past month, my research have focused on the commodity front, taking a particular interest in the agriculture space. Here the key questions are 1) can price increases sustain itself or is it self-defeating? 2) what has to happen to drive a sustained increase? These will be for another post.