🏊 Taking the Plunge

Happy Sunday to everyone on The Street. 

Does anyone else read quarterly hedge fund letters for fun? We were flipping through Oaktree's most recent overview last night and a few things stuck out. 

First, Howard Marks' insistence on “'second-level thinking' – i.e., asking complex questions, eschewing simple answers, and challenging conventional thinking." Modern day media is filled with first-level thinking: easy answers for complex questions and no one that challenges the status quo of their echo chamber. Be a second-level thinker.

Secondly, their thoughts on the Federal Reserve will be extremely interesting to watch. Essentially, they're saying if Jerome Powell fails to thread the needle, and there isn't a "soft landing" then "a rising number of companies will likely require restructuring and other liquidity solutions." This means "US public credit – high yield bonds and leveraged loans" are worth watching. Oaktree says they've "already grown more attractive in recent months, as markets have weakened." Just some interesting stuff. Here's the full letter if you want to read it yourself. 

Review

US stocks fell Friday as investors studied a fresh round of earnings data that paints an increasingly grim picture of the state of the economy. Throughout the past week, Goldman Sachs said it was cutting jobs while General Electric noted ongoing supply chain issues. These worrying signs from major US firms, in addition to the Fed’s tightening monetary policy, have exacerbated recessionary fears.

The market is also bracing for this week’s central bank policy meeting, at which a rate hike of at least 75 basis points is expected. The yield on the 2-Year US Treasury climbed to end the week, hovering near its 2007 high water mark. Zooming out, last week’s August CPI indicated inflation remains stubbornly entrenched. That has weighed on investor sentiment, dashing hopes of a more accommodative Fed later this year.

Oil prices rose Friday but slipped for the week as a whole as a protracted economic slowdown would hurt demand. That said, winter’s colder temperatures and concerns tied to supply also factor into energy prices.

On the economic data front, the University of Michigan released its September consumer sentiment report, which rose by a less-than-expected amount. Inflation expectations eased further.

In company-specific news, Kanye West is ending his business relationship with Gap after saying the clothing retailer failed to meet the terms of their agreement. The artist’s attorney sent a letter on behalf of West’s company Yeezy, saying Gap failed to properly distribute products or create dedicated YZY Gap stores.

Elsewhere, Intuitive Machines, a lunar-focused space technology company, is planning to go public via a SPAC at a valuation of around $1 billion. The deal is expected to close in the first quarter at which time shares will trade on the Nasdaq.

For the week as a whole, the Dow Jones Industrial Average lost 4.3%. The S&P 500 slipped 4.77%, and the Nasdaq Composite fell 5.48%.

Preview

Tomorrow the September NAHB Home Builders' Index is due. Last month, builder confidence tumbled for the eight straight month. The negative sentiment is mostly related to ongoing supply chain issues, high home prices, and elevated interest rates.

On Tuesday, August Building Permits and Housing Starts are due, which will shine additional light on the real estate sector. Permits for homebuilding slipped 1.3% in July, again largely due to higher mortgage rates and increased costs of materials.

August Existing Home Sales are due Wednesday, but investors will mostly be focusing on a statement from the Federal Reserve at 2 pm ET and then a news conference from Fed Chair Jerome Powell shortly after. Wall Street wants to know how much the central bank is planning to hike rates, and for how much longer they plan to do so to tame inflation.

Initial Jobless Claims and Continuing Jobless Claims are due on Thursday. Last week, initial jobless claims fell for the fifth-straight week, highlighting the relatively robust labor market.

Finally, on Friday flash PMI readings for Manufacturing and services are due for September. Again, the story here is really about inflation. Investors want to know how much price increases are impacting businesses in both the manufacturing and service sectors.

On the earnings front Autozone reports tomorrow and Stitch Fix is up on Tuesday. Both KB Home (KBH) and Lennar (LEN) report earnings on Wednesday and Thursday, respectively. These calls, along with the real estate focused economic reports, will provide a well-rounded update for the real estate market. Costco is also live on Thursday. Food costs continue to climb, which is putting pressure on consumers. Investors want to understand how that is helping or hurting the company.

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Should Investors Take the Plunge?

Pool’s Stock Sell-Off May be Overdone 

Pandemic-driven demand for backyard pools may have tanked but that doesn’t mean the water should be let out of Pool Corp.’s (POOL) stock just yet. Yes, year-to-date shares of the company are down 41%. People are spending their money elsewhere, and so are investors, but this sell-off might be slightly overdone. Here’s why. 

All those new swimming pools need to be maintained and, as luck would have it, 80% of Pool’s revenue comes from servicing pools not installing them. Moreover, as the biggest wholesale distributor of parts and supplies, Pool Corp. should continue to benefit even if it's selling fewer units. 

More Laps Left

Now, we understand some investors feel trapped in the deep end. A second-quarter revenue miss sent shares down 10% in July. Since then the stock has been bouncing around near its 52-week low. It doesn’t help that analysts expect the company to post growth of only 2% per year for the next 24 months. A full-blown recession between now and then would not be ideal for this discretionary item either. 

With that said, growth is expected to return in 2024, with earnings forecast to increase 6%. Even now margins are doing better, driven by higher prices and supply chain improvements. 

Shares Look Cheap 

Bargain-hunting investors will also take solace in the fact that Pool Corp. is relatively cheap compared to historic levels and the S&P 500. Shares are trading around 18 times 2023 estimated earnings, which is a 13% premium to the S&P 500. Typically, Pool trades at a 50% premium to the broader market. The last time Pool was trading at this price was during the 2008 housing crisis. Investors who bought shares at that time outperformed the S&P for the following decade. 

Homeowners aren’t installing pools at record numbers anymore, but they will need to take care of them. As the biggest supplier and servicer of pools, Pool Corp. might not be completely underwater. It all depends if investors are ready to plunge in again.

Popping the Hood on Volkswagen

Rough Roads

It’s been a bit of a bumpy road for Volkswagen (VWAGY). Shares of the iconic car company are trading 33% below where they started the year. Besides Tesla (TSLA), investors have been largely shunning automobile stocks. The transition to EVs over the next decade is going to be costly and it'll be tough to maintain high profitability heading into a deeper downturn.

With that said, Volkswagen has a spare tire of sorts. Later this month, or in early October, it's planning to IPO a 25% stake of its Porsche unit. This may give Volkswagen the gas it needs to get back on track in 2023. 

The Gold Standard

Porsche is expected to be valued between $60-$85 billion when it goes public. Of Volkswagen’s brands, Porsche is the most valuable given its leadership position in the luxury car market. Roughly 300,000 vehicles are made each year with the average selling price hovering around $100,000. Porsche’s operating profit margin of 20% is the gold standard. 

During the first six months of the year, Volkswagen’s operating profit came in at $13 billion, 25% of which came from Porsche. Once it goes public the unit could be valued between 15-20 times net earnings which is better than the single-digit multiples most vehicle makers command. 

One Potential Headache

In addition to the impending Porsche IPO, investors have other reasons to be optimistic about Volkswagen’s prospects. Yes, the transition to EVs is going to be costly and difficult for many carmakers. However, excluding Tesla, VW is in the lead when it comes to creating electric vehicles and building battery factories. The company is targeting production of one million EVs in 2023 and potentially two million in 2025. It also has $28 billion in cash on its balance sheet. 

Now, VWs corporate and governance structure is highly complex and quite frankly a nightmare. It has a supervisory board of 20 members like other big German firms. 10 are elected by shareholders and the other 10 are elected by labor. Without going too deep into the details two of the shareholder representatives tend to back labor, therefore cutting labor costs has been difficult. As the industry shifts to less labor-intensive EVs, this could create massive headaches.

Nevertheless, if any legacy auto manufacturer can pull this transition off, it’s Volkswagen. That's in the long term. In the near term keep an eye on the Porsche IPO. It could give VW stock that classic Porsche pop.

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Frugal Consumers Elevate Kroger's Stock

Food At Home is Trending Again 

Eating at home is trending again with soaring inflation causing consumers to rein in discretionary spending. That benefits Kroger Co. (KR), the Ohio supermarket chain, which owns Dillons, Frys, and King Soopers among other grocery stores. With a private label line of goods and a robust digital coupon offering Kroger has been able to grow sales and profits even as consumers cut back. So much so that it blew past Wall Street’s earnings estimate for the second quarter. 

Even Kroger’s stock, which is up about 4% year-to-date, appears to have more upside left, all of which presents a potential buying opportunity for investors.

Sales and Margins Growing 

Take Kroger’s sales growth for starters. In the second quarter same-store sales, excluding fuel, increased 5.8% year-over-year. That’s up from 4.1% in the first quarter. Wall Street was looking for sales growth of 4.5%. Meanwhile, sales of Kroger’s private label products increased 10.2% year-over-year. In the first quarter, that segment rose 6.3%. 

Consumers’ desire to save is also increasing engagement with Kroger’s digital offerings. In the second quarter customers downloaded 750 million coupons, saving about $1 billion. Despite that, gross margins inched higher compared to a year ago. Kroger is also feeling optimistic, raising its fiscal year 2023 guidance for both sales and operating profits. It marks the second quarter in a row. More of that may happen in the coming quarters as well. 

Should You Take a Bite? 

Then there’s Kroger’s stock price. Sure, it's up 4% year-to-date at a time when almost everything is gasping for air. Even though Kroger’s stock is up it's only trading at a slight premium to historic levels. That means there’s room for upside if it keeps improving margins and growing sales.  

Food prices are soaring but that isn’t hurting Kroger as much as investors feared. With a wide variety of private label goods, this grocery store operator has been able to weather the inflationary headwinds. Investors have to decide if it's worth snacking on at current levels.

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