And I think I found it.

Here are the results for the WSG picks for 2024:

Again I view this with a long-term time horizon and to be honest, any performance under 12 months to me is not much more than noise. I will be more interested to see how these mature in about 3 more years.

So let’s get into it, here is my pick for December and my last paid pick for now.

(See my most recent subscriber update for more details)

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

The act of charging for the picks gave me enough incentive to stick to the schedule and put my ass in the seat to come up with an idea ~every 4 weeks, which was exactly the goal of this small business experiment. But there was a little problem.

Trying to monetize my writing killed the creative desire within me.

Most months I had to push myself to sit down and write. It became a chore, which was something I never wanted for my writing. This is why I have decided to pause the paid segment of WSG and bring it back to a free publication starting in January.

For those who have committed to an annual membership, I will be reaching out through email to refund you the difference between the month you signed up and the appropriate amount remaining in your subscription after the last pick is sent in December.

This decision also rests on the fact that I have made some particular progress within my career that has demanded more time and I have been happy to give it. My life and pursuits are moving in a direction that I wish to give more attention to and having a paid newsletter doesn’t allow me to commit to the level I wish.

I plan to still write about stock picks and investing musings but for enjoyment, not commerce. There is more clarity now when defining the activities I wish to do for work and those I wish to do for no other reason than love. Writing for me falls into the latter category and thus it’s time to readjust.

For those of you who did sign up for the paid subscription it means the world to me to know my content was worth your hard-earned money so a sincere thank you, the next and final pick will be in your inbox on December 8^th.

I appreciate all of the support I have received this far and look forward to continuing to meet new people and collaborate on ideas.

I wish you all a wonderful holiday season.

-Michael

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

This idea is embodied in my November pick, I already own it, it’s gone higher, and I am going to put some more chips on the table.

Of course, here is the table for my picks up until this month.

Like always, I make these picks with a long-term time horizon and each of them is not a big position in the portfolio so take them with a grain of salt and keep this in mind when reading ahead.

Here is my pick for November

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

1) Because this month has been crazy and 2) the reasons I find this name attractive are simple and don’t need a long complex post to explain.

Here is how the previous picks have stacked up since I began this newsletter in January:

As always I make these picks with a long-term mentality. I have an analogy of whiskey barrels in my mind for each, they will take years to age and we really won’t know how they “taste” until time has passed.

The goal of course is to be a good enough distiller that when the time comes you have enough solid barrels to build a legacy. For me, I hope to have enough good picks to have some nice wealth into my old age.

Here is my newest barrel for October.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

Well, a certain other investor bought the name and the news sent the stock up ~10%. Lucky for me after the most recent earnings have sent the price back down a little.

Well, we will find out if this is actually “good” for me or not.

I am attracted to this business due to the fundamentals and the capital allocation strategy. It’s a simple business in a not-so-easy industry but has shown it can not only compete but also produce excellent financial metrics at the same time.

Before we dive in here is the scorecard through the last 9 months:

Like always, I make these picks with a long-term time horizon and each of them is not a big position in the portfolio so take them with a grain of salt and keep this in mind when reading ahead.

Here is my pick for September.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

For the common investor, the most exciting portion of the journey occurs when they see their positions starting to run to the upside. They spent hours pouring over annual reports, digging into the proxies, and talking about the company with their buddies. It is a ton of work, and when you are “right” it’s an amazing feeling.

This is a feeling I love too, but there is something I love more. The smell of blood.

The rush for me comes when a company that I have told myself, “I would love to own one day” gets something wrong and their share price gets hammered. A sinking share price gets me way more juiced up than a rising one.

I handle it with more grace now.

When I was younger I would do a fire drill. A sinking share price led to manic-like research, which was only confirmation bias, and I would end up loading up on as many shares as I could. My subconscious would rationalize these actions by reverberating all of the famous Buffett and Munger quotes about buying as much as you can when you find a good thing.

Well, this has caused plenty of pain. My hands are still torn up from all the falling knives.

After touching enough hot stoves I have learned to tamper the dopamine rush when I see a name I like to be “one sale”. I am much more skeptical now and know what it feels like to buy and own companies that go from “Hated” to “Loved”. It seems that the shift happens instantly and for me happened almost in sync with my sell orders.

The stock market gods have a sick sense of humor.

When I have been able to stomach the continued downturn after my initial purchase, maintain a long time horizon, and trust that the business fundamentals win in the long run I have been rewarded on enough occasions to trust the process. I have also watched plenty of the names I bought plummet, sell my shares, and then watch the thesis play out with me on the sidelines.

Nothing teaches you better than real money mistakes.

I won’t say I am cured of my problem, but I still bristle when a company I like falls through the floor (as long as I don’t already own it). My starting sizes are much smaller and I no longer expect to time “the bottom”. I go in with the expectation that it is going to get worse before it gets better.

So, if I like the company, the economics, the track record, and the management, I hold my nose and buy a small enough position to matter but not big enough that I feel like I need to watch it every day.

I have found this process to be the one that fits me and that’s just fine.

With that being said, August’s pick is a name that is down 50% from all-time highs, just had a huge product flop, and has nothing to do with the AI wave of the future. I have been watching this company for years now and now the price is finally at a point where I am comfortable taking an initial position.

But before we get into it, let’s see how we are doing so far:

Like always, I make these picks with a long-term time horizon and each of them is not a big position in the portfolio so take them with a grain of salt and keep this in mind when reading ahead.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investment decisions. Thank you.

Read more

But as I survey my picks throughout my life I have lost more money trying to buy things I think are a “bargain” than stretching a little for a business I knew had a high-quality standard to it.

If you’re looking for a screaming buy trading at single-digit multiples this one isn’t for you.

However, if you are looking for a dependable name that has produced tremendous returns for shareholders and is the leader in market share in their industry, then this name might be for you.

Before we get into July’s pick though let’s check in on the track record for this year.

As always, I make these picks with a time frame of years and since the oldest one on here is 7 months, take all of the results, good and bad, with a grain of salt.

Alright, let’s get into July’s pick.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

But before we get into it, here are the results so far of the WSG pick tracker.

After 5 months of doing this, we are only in the early stages and all of these should be viewed with an owner’s mentality which embodies a multi-year time frame.

Short-term price movements are nothing but a distraction so until these picks mature for a few years, you won’t see me resulting in them.

With that being said, here is my pick for June of 2024.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

Over the next two months, my posting schedule will be a tad different. I have some big life events coming down the pipe demanding my full a…

Read more

They are one of the largest manufacturers and distributors of a critical component in a home and derive 80-85% of their annual revenues from replacement. Their balance sheet is strong and they return a large majority of FCF to owners through dividends and buybacks.

The business is boring but the execution of a shareholder-friendly playbook is like few others. If I had to pick a coffee can stock, this would qualify.

As always here is how the picks from 2024 have faired so far:

The disclaimer that these picks are so new I won’t be taking results from them for a few years so I suggest you view them in the same lens.

Alright let’s get into my pick for May 2024

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

It also trades for a <6x EBITDA/EV using a 3-YR earnings average.

Given the risk-to-reward ratio this is going to be a smaller bet with an optionality to add more in the future.

Here is how the prior picks have been so far.

As always these picks have only had a few months to work since the start so take the returns with a grain of salt. I won’t be resulting any of these until a few years pass.

You should view each pick for what it is, a monthly pick, some will grow into winners and some will fall by the wayside but if the ideas are good over time, the winners will pay for the losers.

Here is my pick for April.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

Here is the simple framework that explains the meteoric rise.

A Consolidation of Distribution Networks

Since the name was released out of the hands of private equity in 2005, BLDR has been on an ever-expanding path of industry consolidation in a highly fragmented space.

The homebuilding suppliers were left for dead post-GFC, and if we have learned anything from the Robbotti investment philosophy, the seeds of success are sown during the period when no one wants to touch it

Since then we have seen two waves of consolidation among the major players.

One came in 2015 when the 4 biggest players became two and in 2021 the two biggest became one when BMC merged with Builders First Source. And even though they are the largest in the space with a presence in 89 of the top 100 MSAs, they only have ~2.6% market share.

This is to say, there is still a ton of room for consolidation in an industry where larger scales translate to increasing returns.

The building supply industry is a local business. The big products that go into home building such as lumber, plywood, drywall, flooring, windows, doors, and shingles do not travel well over long distances.

For professional homebuilders, deciding on a supplier comes down to two things, proximity and selection. If a supplier is close to the job site and stocks all the supplies you need, they become your first call, and if you fulfill the needs, rarely do they go elsewhere. These are sticky relationships.

As a way to make sure this relationship is not lost, BLDR takes the extra initiative to go the extra mile making the building process easier for builders through their value-added offerings and digital platforms.

The value offerings such as truss systems and millwork, are built to fit off-site and require only installation in the field. Manufacturing these components in a shop instead of the field is much more efficient and makes the overall process a little bit easier.

When you add all of these together, proximity, selection, and value-add services it creates a wide moat unlike many others in the building supply space.

This competitive position is illustrated by the growth in revenue from ~$1B in 2012 to over $17B in 2023.

What makes the story even more interesting is they have been able to push up margins over time too.

The simple understanding comes down to this:

BLDR through a series of acquisitions and mergers has achieved a national scale in a local business.

This has allowed them to become the strongest competitor in the markets they serve. The scale allows them to negotiate for better pricing on supply and produce efficiencies that others can not replicate due to their smaller size. This leads to an ability to pass on better pricing to their customers and attract more in the process. Attaching national purchasing power to a local business is a huge competitive advantage.

This wheel will continue to turn as the company continues to grow through more consolidation. It also helps to have a major tailwind.

Tailwind

BLDR’s business is directly tied to the number of homes built and we are going to need more homes.

The best explanation I have heard came from Ed Wacheneim when he was discussing DR Horton on the Business Breakdowns Podcast. (He gets into it around the 23-minute mark).

Here are the big things you need to know from this discussion:

• The US has a basic demand for about 1.5M new housing units a year. 1.1M comes from population growth and ~400K comes from replacing homes that are torn down or damaged beyond repair from fire or flood

• For the past 12 years, we have substantially underbuilt and as a result, there is a shortage between 3-4M.

• The situation today is much different than 12 years ago as we have a shortage of labor and some materials so, in Ed’s opinion, we don’t have te building capacity to keep up with demand. He thinks there really is only the capacity to build between 1.6 to 1.7M units each year including apartments.

• With a 3-4M shortage, an annual demand of 1.5M more, and the capacity to build 1.7M you will be chipping away at the deficit by ~200K a year. Which means it will take between 15-20 years to erase the deficit.

I will be the first to jump out in front of the bulls and scream, this will not be a straight line.

Housing is cyclical and there will be ups and downs to the cycle but for a company like BLDR, even if these numbers are slightly off, there is a massive tailwind pushing the demand. When you sell picks and shovels, it helps to have rising gold prices.

Proven Capital Allocators

Since the combination of BMC and BLDR in 2021, FCF has not been scarce. An above-average year in 2022 helped but on a 3-year average, they bring in about ~$2B a year in FCF.

The part I find more interesting is how they have taken the cash, used it to decrease the leverage in the business, and used the buyback machine to shrink the share count by ~41% since August of 2021 when they merged with BMC.

They like to use the term “fortress balance sheet” to describe their financing profile and aim to keep the debt load between 1-2x EBITDA which I think is conservative enough.

From 2022 through 2023 the company deployed a total of ~$6.1B.

• $4.4B went to buybacks

• $900M was used to make 13 acquisitions

• $800M went to organic investment in their business.

During their investor day in 2023, they outlined their goal to deploy between $5.5-$8.5B between 2024 and 2026 through a combination of all 3 buckets, buybacks, M&A, and organic investments.

Something else I found interesting was their incentive structure.

50% of the long-term comp package for NEOs is based on ROIC goals and a TSR modifier compared to an industry index. It’s a good sign to see ROIC and not just a fixture on the earnings profile. This tells me they are both focused on growing the earning power of the company and making smart investments with their capital.

In Closing

It’s hard not to sit back and admire the success BLDR has had over the past decade. Yes, the stock produced eye-popping returns. But, it is the fundamental execution that I admire more.

Over the last decade, they have been able to complete two large acquisitions/mergers, grow both the revenue base while simultaneously increasing the margin profile, and have the conviction in their own plan to buy back a huge amount of stock when the market had a different opinion. It is an impressive track record and deserves attention.

I am not ready to give an opinion on the stock price as I am a beginner at understanding the company.

After a price run like we have seen over the last two years, it’s hard to argue the bullish nature of the situation isn’t already priced in. It’s safe to say there is a tailwind but with a price run-up like this the question becomes, “How strong?” and I don’t feel comfortable yet to give an opinion.

Subscribe now

Disclosure: I do not own BLDR shares at the time of this writing.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Since then, they have been executing the build-out and are now the #3 largest fiber network in the country behind AT&T and Verizon with ~6.5M passings and ~2M fiber customers.

This change from copper to fiber has been and continues to be transformational for the company. The margin profile of a fiber sub-base is far superior to its legacy business.

In the fiscal year of 2023, overall EBITDA grew for the first time in a decade.

This turnaround might work.

Financial Results ’23 vs ’22

• Passings: 6.5M vs 5.2M

• Fiber Customers: 2M vs 1.69M

• Copper Customers: 936K vs 1.17M

• Fiber Revenue: $2.99B vs $2.77B

• Fiber EBITDA: $1.33B vs $1.16B

• TTM EBITDA: $2.13B vs $2.08B

• Leverage Ratio: 4.3x vs 3.4x

Let’s not kid ourselves, what they are trying to do is hard and expensive. Although emerging from bankruptcy has given them a “fresh start” they have wasted no time investing a ton of capital into their fiber build.

Over the past 3 years, capex has totaled ~$7.6B, spending $3.2B in 2023 alone. Although management has guided to lower capex for ’24, they still plan on spending $3-3.2B.

The past two years have been the heaviest in terms of capex and should be coming down as they get to their goal of 10M passings.

This has been a “bet the farm” play for Fronteir.

Execution

Fiber subs are growing, Fiber EBITDA is pulling the majority of the weight, penetration is in line with guidance, and ARPUs are up. This transition, so far, is working.

But, they did start with a bit of an advantage.

Instead of having to build from nothing, they walked into their new fiber plan with a fresh balance sheet and an existing network on copper lines. Their legacy business provided the infastructure, think tubes, poles, and lines to the house. All they had to do was repalce the copper with fiber.

We are in the early days of seeing the fruits of the labor.

The Fiber segment became the breadwinner in 3Q of 2021 but didn’t push overall EBITDA up until this year.

When it comes to inflection points, this was a big one.

Not only is the fiber rollout working, but it’s also fundamentally changing the margin profile of the company.

“Investors should be expecting us to deliver margin expansion, particularly as we shift a greater proportion of our business on to fiber.” - John Stratton, UBS Global Media and Communications Conference

As the fiber numbers continue to become a larger and larger piece of the pie, the overall margin structure will begin to reflect the company's current state. Right now, there is still enough cover from the copper to hide what is going on.

The Destination

“Our ultimate goal is to get to that point where we're generating $4 billion of EBITDA, we're kicking out $3 billion-plus of free cash flow. We're decreasing our leverage and we're returning cash to shareholders. This is a great outcome” - John Stratton, UBS Global Media and Communications Conference

This outcome will come down to two variables, ARPU and Penetration.

Consumer ARPU has been steadily climbing over the last 12 quarters. Management has guided towards ARPU growth between 3-4% a year, in line with the current industry practice.

And, they have been able to hit their targets for penetration.

Management believes the end state for penetration rates sits around 45% and they have evidence to back up their thinking.

Before the big fiber rollout, Fronteir had ~3.2M fiber passings. This group is what they refer to as their “base fiber network”. This network has had time to mature and currently sits with a penetration rate of 44%.

This gives them confidence to see a path to 45% in other markets as well.

“What we find is that in 86% of our footprint, we have either one or no gigabit-plus capable competitors. And that competitive dynamic is in play, both in the fiber base, the base fiber networks as well as in the expansion network. So very, very similar in terms of the competitive set.

And then the markets themselves, the market characteristics, all the things that we look at in terms of the attractiveness of our service look very, very similar in the remaining 7 million as they do in the first 3. So this is what gives us great confidence in our ability to get to 45%.”- John Stratton, UBS Global Media and Communications Conference

Based on 2023 numbers hitting 45% penetration on 10M passings would translate to ~$3B in EBITDA ($665 per sub). APRU growth and what is left over from copper will likely make up the remaining $1B between the above estimate and their goal.

Let’s not try to pinpoint this with accuracy but $3B in FCF on 250 shares outstanding gets you $12 a share which would be a P/FCF of ~2x today’s price. (Assuming the share count stays around the same levels)

The Path Remaining

FYBR sits today with about ~3.5M passings remaining on their “fiber expansion” plan. This will translate to ~$3.5B in build capex assuming the costs stay in line with expectations.

One of the initial concerns I had about FYBR was their ability to fund this entire build-out without diluting the shareholders. This meant funding would come from debt and push the leverage ratio higher.

Right now it’s up to 4 turns of EBITDA and it’s probably going higher this year.

I wouldn’t be comfortable with this if there were not strong evidence supporting growth in EBIDTA ahead.

As we move into ’25 and beyond, I expect it to begin to come down as the built network matures into a more terminal state and margins expand as fiber becomes a larger piece of the pie. This transition will lead to a natural deleverage as John spoke about.

But this takes time and I wouldn’t expect much over the next year in terms of delevering.

Closing Thoughts

In December, Jana Partners sent a letter to the Board of Directors stating,

“As we have expressed publicly and in direct conversations with the Company, we believe Frontier's equity is grossly undervalued and that it will continue to underperform if the Board maintains the status quo.”

Jana then stated they would like the company to conduct a strategic review that would create the best possible outcome for shareholders. This could include a joint venture, shedding the non-strategic copper assets, or even a sale of the company.

When asked about the letter the next day at the UBS media conference, John Stratton responded,

John Stratton: I would tell you is this, our Board is very much focused on the opportunities that are right in front of us. And what I would say also is that we are very willing to explore all alternatives that may be present for us to achieve our #1 objective, which, of course, is to achieve maximum value creation for our shareholders.

Interviewer: Okay. Everything is on the table?

John Stratton: Everything is on the table.

As of right now, they are conducting the strategic review and on February 5^th, the company added Woody Young to their Board of Directors. Mr. Young has more than 30 years of experience in telecommunications M&A.

Right now it’s all talk. I share Jana’s opinion that the company is undervalued, and any move from management to unlock the value I welcome. But for now, I am going to stay focused on the fundamentals.

Here is what I am looking to see from FYBR over the next year:

• Add ~250-300K fiber subscribers

• Grow EBITDA by ~10%

• Keep penetration rates in line with guidance

• Fiber ARPU to grow ~3-4%

They will probably do another capital raise in a similar fashion to the one they did last summer and end the year with a leverage ratio between 4.5-5x.

The KPI I focus on the most is the growth in fiber subs.

This will be driving all of the value creation for the company. The leverage is getting a little high for my liking but if they can keep adding fiber subscribers, it will come down as the network matures.

Investing is not about where you are now but rather where you are going. With Frontier, they are continuing to execute their transformation from a sleepy copper provider to a high-speed fiber company.

Their earning power comes from their fiber but it’s still valued at a copper multiple. As long as they continue to execute I am sure the market will come around.

Disclaimer: At the the time of this writing I am long Frontier

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

This article is an attempt to synthesize the thesis into a written form. For myself, it is only Chauffeur's knowledge but I put this together so others can hear about the idea too.

Here is the full presentation if you are interested, which I strongly encourage you to listen to:

LSB Industries manufactures chemical products for the agricultural, industrial, and mining markets. Their main products are ammonia, ammonium nitrate (AN), urea ammonium nitrate solutions (UAN), and nitric acid with an annual production capacity of ~900K metric tons. They operate 4 plants located in Alabama, Arkansas, Oklahoma, and Texas.

It is one of the smaller “pure-play” names in the space.

When you think ammonia, you think fertilizer. Right now most of the demand for the chemical comes from agriculture and LSB is no different.

However, the demand profile could be shifting.

As the world works to transition out of fossil fuels something has to fill the gaps. Solar, wind, and hydro only go so far. Ammonia has emerged as a possible candidate to help in the areas where the others might not be feasible.

Here are the 3 big areas where ammonia could aid in the energy transition;

Maritime Shipping

Right now several companies are working to develop a maritime engine that burns ammonia.

This advancing technology could unlock an enormous end market for the chemical. It is still in development and would require the shipping industry to retrofit or build new vessels. This could take a while. However, even a ship that has an engine that burns ammonia and traditional fuel would be a move in the right direction.

Power and Electricity Generation

Japan and South Korea are blending ammonia in with their coal fire plants reducing the CO2 output from coal burning. Both countries have signaled a bigger move to incorporate the blending to a larger degree.

This implementation requires no retrofitting and the adoption curve can be much quicker.

For what it’s worth, LSB is in talks with INPEX, Japan’s largest E&P company, to develop and construct a production and export facility on the Houston Ship Channel that would have an annual capacity of 1.1M MT of low-carbon ammonia. Right now INPEX is pursuing offtake agreements and the final investment decision to be made at the end of 2025. We wouldn’t see production from this hypothetical asset until 2029. Discount appropriately.

Storage and Transportation for Hydrogen

Hydrogen is one of the fuels we are looking for for a clean transition, the problem is the lack of infrastructure. Ammonia, although still difficult to move, has an infrastructure in place and when blended with hydrogen can move the chemical more easily.

Here is a chart from Yara, one of the world’s largest Ammonia producers, which outlines the potential growth in the ammonia market should these demand cases materialize

The Competitive Advantage for LSB

In a commodity environment, the lowest-cost producer wins and no one in the world has a better cost profile for ammonia production than those who have operations in the US.

The reason we can produce it so cheaply is our incredible supply of natural gas, which is the main ingredient in the production of ammonia.

Having their plants located in North America is the biggest competitive advantage for LSB.

The cost savings are so great that international producers have begun projects in the US with most of them not being complete until 2025. Should the demand case come full circle, this oncoming supply will still be dwarfed by the potential demand.

They also got lucky.

On top of being located on the right continent, LSB’s largest production facility (El Darado) sits on top of a cavern where it can sequester CO2 permanently without having to truck it out.

The passage of the IRA has created economic incentives to capture this CO2 and LSB has teamed up with Lapis Energy to conduct the sequestering.

Lapis expects to capture and sequester >450,000 MT of CO2. Lapis will then receive a tax credit (45Q from the IRA) and pay a fee to LSB for each MT captured. This project has the potential to produce an extra $15-20M in incremental EBITDA for the company.

CF industries highlighted the benefit of the 45Q Tax Credit during their 2023 roadshow.

These structural competitive advantages give LSB the ability to earn outsized returns, which we saw in 2022. Bob admitted in his presentation they probably “over earned” then and he forecasts normalized earning power to be ~$200M a year range but it will be lumpy.

As the prices for both Corn and Ammonia came back down from 10-year highs, the earnings readjusted to a more normal level in 2023 even though the results look awful compared YoY.

2023 vs 2022

• Sales: $594M vs $902M

• EBITDA: $120 vs $380

• EBITDA Margin: 20% vs 42%

• Diluted EPS: $0.37 vs $2.68

But this lumpiness and possible underearning in 2022 has put the stock around ~$7.50 compared to $28 in 2022.

Bob sees this as a huge opportunity.

Priced Well Below Replacement Cost

One of the main pillars of the Robotti investing philosophy is to find the survivors of a creative destruction cycle. It is the belief that after the destruction has taken place, the survivors can capitalize on the next upcycle with higher market share and even greater earning power.

Ammonia has been at the center of one of these cycles over the last 5-6 years. Returns on capital were low and in LSB’s case negative. No one wanted to be in the ammonia market. But, it seems that we are on the other side of that cycle.

Except no one cares.

The current price for LSB is less than half of what Bob estimates it would cost to build the same amount of capacity today. Based on 2023 M&A, he isn’t far off.

• CF Industries bought the Waggaman Ammonia Facility (880,000 MT capacity) for $1.67B.

• Koch Ag and Energy Solutions bought the Iowa Fertilizer (850,000 MT) for $3.6B.

These prices translate to ~$2K-$4K per MT of capacity, which would give LXU a value of $1.8-$3.6B. If we subtract the net debt of $276M we get an implied market cap between ~$1.5-$3.3B. Today the market cap is ~$500M.

Even if these prices are off, there is a significant margin of safety when compared to the price that LSB is trading for today.

Overall there are 3 things Bob stresses about LSB:

• It’s priced well below replacement cost

• There are structural advantages in place to generate outsized earnings

• The change in demand profile for ammonia turns this into a growth company.

I enjoyed this pitch and will be diving into LXU more to shed the chauffeur knowledge. It does seem like an interesting play on a company that is trading at a serious discount to IV with the potential for growth ahead.

There is plenty of work to do before I am comfortable enough to give an opinion, but it does intrigue me.

Subscribe now

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

This company has been one I have passed on more than once only to watch the price continue to rise due to continued execution, with help from a change in opinion from the market.

The value side of me doesn't want to pay a higher price but as I pitched the idea to a friend yesterday he reminded me that if the price was lower after continued execution, "You're probably wrong."

Today's price feels "fair" and because of the track record, runway for growth, and a business model that lends itself to high returns on capital (>20%), I am comfortable putting some skin in the game.

The WSG picks are not off to a hot start after two months. I have a time frame of years and one should view these picks with the same timeline. Monthly movements are just noise.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

Read more

The words, “Our revenue growth has slowed considerably” sent investors to the exits.

At the time, the stock was down ~73% from all-time highs and traded at an EBIT multiple of ~15x. New entrants were banging at the door with billions in their pockets. This new supply would, “Kill the streaming business”.

But, the moat stood strong and the same shares today are ~$600.

Now the investors who bought in the face of uncertainty have a new question to ponder, "Is it time to take some money off the table?"

At the start of this investment, there was no optimism. Today, there's plenty. Although, it doesn’t feel like there’s too much.

Don’t get me wrong, it’s not cheap. But it doesn't scream overvalued to me either. It feels full. Should the multiple expand of another 10 points, I might get scared of heights.

But we are not there yet.

Underwriting a name at 15x EBIT differs greatly from owning a name at 27x 2024 eEBIT. (If they can hit their revenue targets of double digits and operating margins of ~24%). Topics like competitive position, TAM, and growth are much more top of mind now.

To own at these levels means I have to be comfortable with the direction of all 3. So let’s dive in.

TAM

Ted Sarandos likes to throw around $600B as the TAM for NFLX. This number includes Paid TV, Games, and Advertising.

By those standards, NFLX captures only 5% of the market, but as much as I like Ted, I am going to apply a discount. Asking a CEO for a TAM is like asking the barber if you need a haircut.

Let’s cut it in half, this might be too much but call it a margin of safety. Using this NFLX currently sits with a 5-10% market share based on both numbers. The big questions become:

Will the TAM for streaming companies be bigger in the future and can Netflix take a bigger share of the market?

Let’s address the first one.

Yes, I do think the TAM for streaming companies will expand over time.

In May of 2021, Nielsen reported that streaming-only accounted for ~26% of total TV viewing. In the most recent report, it was ~36% of total TV viewing. In under 3 years, streaming has been able to grab an extra 10 points of market share from cable and broadcast.

Will this continue? I like the odds.

From a consumption perspective, streaming is a better mouse trap for entertainment.

Will we become a streaming-only world anytime soon? No, but the introduction of ad tiers has only made it harder for legacy cable and broadcast to compete for eyeballs.

As the eyes migrate, so will the dollars. With less ad revenue C&B will have to pull back on spending only making the offer less and less attractive.

Warren Buffett said in newspapers, “It’s survival of the fattest”. In this circumstance, this sounds like it rhymes.

Competitive Positioning

The answer to the second question, “Can Netflix take more share of the TAM?”, will be a direct result of their competitive position.

When we look at the playing field right now they lead the pack in most of the key metrics and not by a small margin either.

I am not saying the other ones won’t work. This is not a winner-take-all market. But it might be winner take most and NFLX is the lead dog.

It helps they have one focus.

For Disney, Warner Brothers, or Comcast streaming is a part of the entire business. Although it’s top of mind, they can't devote 100% of their resources to it, and this comes with a cost. Please don’t ask me to put value on it, I would say go look at the numbers and they don’t lie.

Chasing someone who has reached critical mass, in a hard business, is not the premier position to be in. It also doesn't help they have been able to build a platform that enhances the long-term value of content.

As a recent example, look at what has happened with Suits.

“The example on Suits, that was the show that didn't make a lot of noise in USA. It was certainly available on Peacock and on Amazon for 2 years before it came on Netflix.

And that power that comes from that recommendation engine and that distribution platform, they can get a lot of people talking about and then the compounding benefit of everyone is talking about this show. And then everyone is using Netflix, so you got this powerful self-reinforcing cycle.

And where that comes out is for the last several years, the guy who created Suits had a spin-off show he was trying to sell everywhere in town. Everybody passed, including us and including NBC. And now they're making it. It was a huge, new interest in Suits. And I would probably argue that next year, you'll probably see a bunch of lawyer shows.” - Ted Sarandos, UBS Global TMT Conference Interview

This ability to strengthen value will make Netflix the first call for owners of IP.

To answer the question above, I would say yes, Netflix will own a bigger piece of the streaming pie over time.

As the industry continues to play out, others will reach profitability and break even. But, it will be a battle for second place. All the while, Netflix continues to focus on widening the gap.

They Still Need Growth

For the current valuation to make sense, they are going to need to continue their revenue growth. It's naive to expect the next 10 years to look like the past. But, they should be able to grow at a mature clip. They forecast mid-teens, which is reasonable to me.

The majority of their growth going forward will come from three variables:

1) Ads

The advertising tier for the service is still young but now accounts for over 40% of new signups. As it scales, the audience size and targeting will improve attracting more ad dollars.

The introduction of an ad tier pulls both levers increasing subscribers with a lower-priced offering and giving ARPU room to grow from both small price increases and more Ad spend per user.

2) Paid Sharing

The success of their password crackdowns would not have been as effective if they didn’t have the ad tier to offer at a lower price. Now, this is the normal course of business and has expanded their reach opportunity.

“At this stage, paid sharing is our normal course of business — creating a much bigger base from which we can grow and enabling us to more effectively penetrate the near term addressable market of ~500M connected TV households (excluding China and Russia), which should increase over time as broadband penetration rises.” - 4Q23 Shareholder Letter

Although you can’t beat free, $7 a month is a pretty good price-to-value trade-off if you ask me. With this effort now the company will be able to get more juice from the squeeze.

3) International Expansion

In Q1 of 2017, the international segment of Netflix only had 47.89M subscribers bringing in $5.3B in Revenue. At the end of 2023, they had ~180M subscribers bringing in ~$18.6B.

During the same period, the UCAN segment went from ~50M subs with $5B in revenue to ~80M subs doing ~$14.9B.

Netflix is not looking to be the most entertaining company in America. They seek to become the most entertaining company in the world. This has led them to build out content libraries for each local market and cater to local tastes.

This attention to local detail has shown to work.

But, with >50% of their market tapped (as defined by the ~500M connected TVs) the incremental sub-gains from here will be small.

But I am not worried.

The average ARPU in these international markets is lower than the UCAN. If they mature similarly these should trend up over time. It will take years to close the gap but it is a trend in the right direction.

When you stack all three of these (Ads, Paid Sharing, and International) it’s reasonable to believe there is still room for revenue growth. It won’t be as large but it will still be positive.

In Closing

The current multiple feels full but not crazy so I’m holding onto my shares.

When my mind begins to wander down the road of trimming or selling a quote from Chris Cerrone comes to mind about the attempt to optimize a portfolio.

“In some ways, optimizing is insatiable and I think there's a certain amount of humility that comes into play where you say, "I'm taking money out of this business that's doing really well, and I'm reallocating it over here to something that hasn't done as well, and I'm right in both of these instances” - Chris on The Business Brew

Trimming the position would be an effort to optimize and I hold it with a sense of humility.

We have a leading company with a strong position in a growing industry. With their moat under attack, they have grown revenue, subscribers, and expanded margins. They introduced a whole new offering and asked non-paying customers for money. The last three years have been some of the best execution I have ever seen.

If this isn’t a stock worth holding I don’t know what is. It has earned the right to stay in the portfolio.

As I look into the future I will be assessing the company based on the normal KPIs (Subs, Revenue, and Operating Margins). I will be paying closer attention to the international ARPU growth but I  don’t expect huge gains over a short period.

Over the next year, I would like to see them execute on their guidance of revenue growth of ~13% and hit their operating margin target of 24%. If they can deliver, consider me a happy shareholder.

Disclosure: At the time of this writing I do own shares of Netflix.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

His calm prose has always been something I return to when I seek to deepen an understadning of a concept. His book, The Most Important Thing Illuminated, includes 20 chapters on these “concepts”. All 20 being “The Most Important Thing”.

I make it a goal to reread the book once a year as a way to remind myself of the principles I need to beat into my head if I want to be a solid investor.

Over the past two years, I have taken a keen interest in his chapters on risk.

You could say I was primed for the information. During this time frame there has been a few mistakes that have caused me to comb over my process and work to improve it.

This work has translated into taking a more humble approach to my “conviction” and a deeper appreciation for risk and all it entails.

I went back through his chapters on the concept and thought I’d share the big points for two reasons:

1. It will only ingrain the lessons into myself further.

2. Serve a reminder for those who have read the book and an introduction for those who have not (Thought it should be a must-read for all investors).

I hope it’s helpful.

Risk

“Investing consists of exactly one thing: dealing with the future. And because none of us can know the future with certainty, risk is inescapable.” - Howard. Marks

As an investor, your success in the short term will be determined by the winners you pick but your long-term success will be determined by your ability to deal with risk.

Before we can learn to deal with it we must be able to:

• Understand it

• Recognize it

• Control it

Most level-headed individuals, especially investors, want to do their best to avoid it or minimize it. It can never be extinguished completely as it works in tandem with its better-known brother, returns.

You can’t have one without the other. This is why a deep understanding of the concept of risk is imperative for investment success.

Understanding Risk

If we were to ask the Academics for their definition of risk their response would land in the range of the word volatility. Howard takes great issue with this because it doesn’t represent the actual desires of the investor.

“I think people decline to make investments primarily because they're worried about a loss of capital or an unacceptably low return. To me, "I need more upside potential because I'm afraid I could lose money" makes an awful lot more sense than "I need more upside potential because I'm afraid the  price may fluctuate."

For an investor, the only definition is the possibility of permanent capital loss.

How do we measure it?

The short answer: You can’t.

There is no mathematical formula. The hidden, subjective, and unquantifiable nature of risk is what makes it so elusive and thus, hard to deal with.

You might not be able to put a number on it but it can be judged.

“A skillful investor has the ability to get a sense of the amount of risk in a given situation by looking at two factors:

1. The stability and dependability of value

2. The relationship between price and value”

These won’t give an exact amount, but they will tell you if the water is hot or cold.

Keep in mind the difference between probability and outcomes.

As much as we would like to hope, we do not live in a world that fits under a “normal” bell curve of probability.

There will be people who unknowingly subject themselves to a real risk, have it never show up, and look like a genius. Nassim Taleb calls these people “Lucky Idiots”. The other side will also be true, you can take every measure to protect your portfolio from 99% of all “worst-case scenarios” but the 1% left over can happen.

Even though the investor was extremely cautious, they can still look like a loser.

“The key to understanding risk: It’s largely a matter of opinion. It’s hard to be definitive about risk even after the fact” - Howard Marks

Returns alone tell you little about the quality of the decision made. The other side must be given attention. It can not be measured, but it can be judged based on the probable outcomes at a given point in time.

There will be those who run through a dynamite factory with a match and survive. But this doesn’t mean you should do it again.

Recognizing it

Now that we understand what risk is and what it isn’t. To get to the final step of controlling it, we first have to learn how to recognize it.

It’s our job to defend against permanent capital loss.

The largest amounts of this risk tend to show up where it is perceived to be the lowest by the masses. The problem is the crowd is as often wrong about risk as it is about return and we tend to:

• Overestimate our ability to recognize when risk is at its greatest. (When everything is going great and we don’t want the party to end)

• Underestimate what it takes to avoid it. (Leaving the party early and looking like a loser)

Thus we should do our best to work contrary to the crowd, stay away from environments that lend themselves to higher risk, and dive in head first when the opposite is true.

To give you an idea of what a risky environment looks like, here is an excerpt from Howard’s memo, It’s All Good, in July of 2007.

“Where do we stand today [mid-2007]?

In my opinion, there's little mystery. I see low levels of skepticism, fear and risk aversion. Most people are willing to undertake risky investments, often because the promised returns from traditional, safe investments seem so meager. This is true even though the lack of interest in safe investments and the acceptance of risky investments have rendered the  slope of the risk/return line quite flat. Risk premiums are generally the skimpiest I've ever seen, but few people are responding by refusing to accept incremental risk….”

Another helpful guide is a checklist Howard prepared in another chapter that I have reproduced here:

Staying away from permanent capital loss means staying away from situations where everyone thinks there is no chance of it.

Controlling Risk

“Outstanding investors, in my opinion, are distinguished at least as much for their ability to control risk as they are for generating return.

High absolute return is much more recognizable and titillating than superior risk adjusted performance. That's why it's high-returning investors who get their pictures in the papers.” - Howard Marks

There are two ways to be an above-average investor 1) achieve returns that are higher than average or 2) achieve average returns but take less risk to do so.

Most shoot for the first but forget about the second.

Why?

Because risk control is one of the least sexy things an investor can do.

The fruits are losses that do not materialize and when you take prudent steps to control your risk it means you are likely to underperform in bull markets.

Nobody likes to be that guy.

But the greats are that guy.

The impressive thing about individuals like Buffett and Klarman is their long track record of success that comes with no huge blow-ups. Yes, they have had a bad year or two but they have been able to produce a tremendous amount of outperformance by staying away from disasters rather than working to shoot the lights out.

The alpha comes during downturns because they focus on risk control, not return optimization.

We should work to do the same.

Investing is bearing risk for profit. But to do so intelligently means to work hard to ensure the risk you bear is controlled. To do this we need to do 4 things well:

1. Be aware of the risk we are taking: What is going to lead me to a permanent capital loss?

2. Be able to analyze it: Can I analyze these variables that lead me down this potential path?

3. Diversify away from it: How can I size this position to make sure if I am wrong I’m not dead?

4. Be compensated for it: How much return am I going to demand to bear this risk?

Mastering these 4 is what separates the best from the best.

In Closing

“Clearly, Oaktree doesn’t run from risk. We welcome it at the right time, in the right instances, and at the right price” - Howard Marks

This is the process for a successful investor. You can’t run away from risk completely but you can decide the time, instances, and price at which you are willing to bear it.

Each investment comes with two sides, the potential IRRs into the future and the risk to achieve those. Although one is much easier to calculate than the other, the latter will have a larger effect on your long-term outcome than the former.

The best way to string together a career of compounding is to partake in the simple act of first looking to avoid situations where the risk to return is backward.

High-risk situations are usually filled with over-optimism and high prices when compared to current fundamentals.

If it is loved by the crowd. Run.

“The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors' results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners.”

The best investors look down, not up.

I hope this little piece reemphasizes the importance of risk and how intertwined it is in the investment world. If you have not taken the time to read Howard’s book, I strongly encourage you to do so. It’s required reading for any investor.

It’s one thing to find an idea trading below intrinsic value. It’s another when the name is trading at a discount with a runway of growth ahead of it.

This is a special situation set up with a hidden asset that hasn’t shown up on the income statement (Full effects will be shown in Q1 2024), in a terrible corporate structure (Which is going away), and there is a possibility of a lalapalooza-type outcome if the situation evolves in a certain way.

Of course, this world is anything but certain but I like the odds of a positive outcome.

Here is the table I will be showing every month of all the picks so far with their returns compared to the SPY at inception which will be tracked over time.

We are not off to a hot start but I have a time frame of years and one should view these picks with the same timeline. Monthly movements are just noise.

Read more

This runs counter to the school of thought in the investing world where one should sit still and wait for their fat pitch and then swing with all their might and capital. I worked to invest like this however, I am starting to wonder if the act has hindered my personal growth as an investor.

Like most self-taught, my education came from the material I chose to consume. It was the search for a simple answer, “Who is the best investor, and how did they do it?”

This led me into the world of Berkshire, Buffett, and Munger. Which, to someone who knew nothing, was like drinking from a firehose.

In the early years, I attempted to copy everything. I could parrot back their mantras and tried to integrate these staples into my investing process. For a beginner, this was probably the right path to follow.

But eventually, you have to leave the nest.

As we work towards mastery there comes a time when you shed away some of the training wheels to create a style that works for you. This means you begin to think for yourself.

Looking back, I think I kept a specific set of training wheels on for too long.

“You only need a few ideas a year”

My initial understanding of this principle was to go big on your “best” ideas and then do nothing. The issue with this is for someone in the early innings of their investing journey, this “do nothing” approach leads to a lack of stress testing and a neglected research habit.

Because of this, my “best” ideas came from a small pile.

For someone with decades of experience, a small pile is fine. But for someone who has less than 10 years under their belt, 5 of which I would say are “less” serious years, this can be detrimental to a learning curve.

You can’t make up for a lack of reps.

Our opportunity set is defined by the ideas we are familiar with, and within this list sits a circle of competence. For the beginner, the goal should be to get familiar with as many opportunities as possible and then work to define the circle of competence with deeper thought as time passes.

Writing this feels like swallowing glass but I used the “best” ideas mantra as a crutch for laziness and an excuse to stop looking for new ideas.

This is unacceptable.

A Newish Approach

The mantra still reigns true. One needs only a handful of good ideas over a lifetime to make an impactful difference. The part where I stumbled was defining the timeline in which you can place the label “good” on an idea.

In a recent interview, before he passed (Long live the 🐐), Charlie Munger gave an interesting answer to this kind of question posed by Ben at Acquired:

Ben: As you reflect back on one of these few great companies in a lifetime that you should bet big on, what advice would you have for David and I as young partners looking for a few of these in our lifetime? Things to look out for?

Charlie: You may find it five years after you bought it. These things may work into it or your own understanding may get better. But when you know you have an edge, you should bet heavily. When you know you're right. Most people don't teach that in business school. It's insane. Of course you got to bet heavily on your best bets.

I heard the last point loud and clear but I disregarded the first for many years and this dog has bitten me numerous times.

Had I been more patient with my ideas from the start, allowing the conviction to grow with incremental information. Then sizing my position into confirming evidence instead of lower prices, I would have fared better both financially and mentally.

This year I am permitting myself to take smaller bites if I like the idea and the “odds”.

The “tracking /research” position approach is one I used to roll my eyes at. I thought it was only for people who didn’t know what they were doing with no conviction. This is a naive stance one has when they don’t understand the full reality of how hard this game is and it gives no admission that there are many ways up the mountain.

It was an immature and closed-minded way of thinking.

My Definition of “More Active”

I recently disclosed that I’m starting a paid portion of the website where I will send out my best stock idea each month. For someone who thought having 1-2 good ideas a year was a productive year, putting out at least 6 ideas (I can re-up an idea only after 6 months) is a level of activity that runs in the face of my prior beliefs.

This is intentional.

By putting myself on the hook to come up with a respectable, well-researched, idea a month I will be sifting through plenty of names to come to the one I like the most at the given moment. It will force me to look at more ideas which will increase my pile of “familiarity”. I like to think of this as deliberate practice.

Each idea is not a pound on the table but a hand I find attractive that I want to play.

Time will tell as to whether my initial thesis is right and I hope that as more incremental information comes out, I will be able to adjust my position sizing accordingly.

I want to lean into my winners and let the losers die away.

By allowing myself a small budget to find new ideas I will hopefully, 1) stay away from touching the larger portions that are working, 2) give the positions that are still proving out time to work, 3) keep my edge sharp so when the environment is ripe with higher than average future returns, I am ready to go.

With any craft, there are a number of reps one needs to complete to reach a level of competency. It seems obvious to me that I have been lacking. This decision to look more will hopefully make up for some lost time.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.

So let’s get into the idea I like the most this month.

When deciding which name I wanted to highlight, my mind kept wandering back to the idea that I have recently participated in, plus will be participating in after this is sent to everyone. (I always buy the name or in this case, names, after I send out the pick each month.)

It stuck out to me because I see a risk-reward return profile that I find attractive. It will bore most of the growth investors as it deals with an asset-heavy business and IRRs that are not eye-popping.

But R/R works on a sliding scale and if I can achieve these satisfactory rates of return with a below-average risk profile, I will take the bet every time.

This month my picks are a small basket of Multifamily REITs, more specifically:

1. Mid-America Apartment Communities

2. Camden Property Trust

3. Equity Residential

This is the basket I own and these are the horses I’m betting on.

You should know as the reader I am return agnostic. If I feel confident in my ability to analyze the cash flows, it can come from a portfolio of Real Estate or an Oil well. The money is green either way and if the price is attractive enough, I am willing to look at anything I feel I can understand.

I feel comfortable with these.

I can’t take credit for the originality of this pick, Bill Chen of Rhizome Partners, introduced me to the idea when he did a podcast with Bill Brewster. At first, it didn’t stick out to me but as time went on it began to age in my mind and I began to find it more and more attractive for a few reasons.

Why I Like It

1) An Asset like Multifamily Real Estate comes with a different risk-to-reward profile than a normal “Stock”

One of the first questions I like to ask myself when thinking about an idea is, “How durable are the assets and the cash flows”.

You don’t get much more durable than owning real estate. In exchange for this enhanced durability, you have to be willing to give up some returns.

Bill likes to call these REITs your “left tackle” of the portfolio and I fall in line with that assessment. Making an investment like this is not going to give you Hall of Fame returns but from where they trade today, I think they offer the ability to put money to work in one of the more durable asset classes and achieve acceptable rates of return.

This could also be known as a satisfactory return like the great Mr. Graham has instructed us all to seek. You are not going to shoot the lights out but you are also not going to shoot your foot off.

With this opportunity set, I believe you could build a solid backbone of a portfolio.

What gives me the confidence?

2) These REITs own hard assets in popular cities where long-term supply is falling off.

Real Estate is an asset that comes with inflation protection as the buildings were built in yesterday’s dollars, so it is normal for the value of real estate, in most cases, to drift in an upward movement with time.

If you are lucky enough to own property in a place where the demand to live there is outpacing the new supply, then you have a serious appreciation in the asset value over time. (We will get to the bear’s point on new supply killing demand later on)

You don’t need to venture far to run into the biggest determination of value: Location, Location, Location

Here are the top 5 cities for each name in the basket

Here is a population migration chart from that I found helpful.

It would be easy to make this more complicated but I keep coming back to the simplicity of the idea of owning Class A buildings in high-demand cities is something I find very attractive, throw in the embedded inflation protection and natural appreciation of value, and it’s a cherry on top.

But it’s not the only thing that gives me confidence

3) They have a long track record of FFO growth.

Here are the 11-year FFO CAGRs for each.

If we use the simple, Yield plus growth formula this basket would produce an annual IRR of ~12% before any multiple expansion.

Which I think is a nice kicker

4) Right now these are cheap from both a replacement and historical perspective.

Here are the current cap rates for each name in the basket:

One of the points above spoke to the inflation-protection nature of these assets and how they were built in yesterday’s dollars. Right now these REITs are priced below what it would cost to rebuild them in their locations. Why?

The IRRs for ground-up development have changed dramatically since the rise in interest rates began in 2022.

From what I have been able to gather, developers aim for an exit cap rate of 6%. Two years ago, in a ZIRP world, the returns of developing ground-up were large enough to compensate for the inherent risk that comes from developing.

But the borrowing environment has changed.

The rise in interest rates has pushed both the borrowing cost up and has brought down exit multiples. for example traded at a 3% yield ~2 years ago and now trades closer to 7%, which is over a 50% cut in multiple.

If I am a developer now, my speculative returns have decreased dramatically and it’s much harder to raise money for the same amount of risk with a forecast of lower returns.

From a historical perspective, these REITs are cheap too. Cap rates on multifamily REITs on average have traded in a range of 100-200bps above the 10-YR, over the past few months we have seen the spread widen to 300-400 bps.

With this information I am betting that the odds weigh in favor of these assets trading on the cheaper side than not, giving me a comfortable margin of safety.

5) A rising tide of demand for apartments

It is much easier to invest in situations where the wind is at your back for the demand.

In this case, we have two gusts, one with the population migration into the cities that the basket represents, and two with the ongoing demand for rental properties instead of occupants choosing home ownership.

I will leave some charts here for you to ponder but the conclusion remains the same. Along with other large life events such as marriage and deciding to have a family, becoming a homeowner is one of those events individuals are willing to push off. Creating more rental demand.

I think this small detail only strengthens the argument for the premium value these assets can show in a few years.

But, this doesn’t come risk-free.

The Bear Case

From where I see things 2 huge risks come along with these.

•Overwhleming New Supply

•Increasing interest rates

Let’s start with supply.

The rent market for these REITs has turned a bit soft and in 2023, new multifamily deliveries totaled over 565K which is the highest level the industry has seen since 1980. In 2024, Co-Star expects deliveries to pull back to around 444K.

Nobody wants to stand in front of this oncoming supply and the softening rent market, which is why these trade at historically low valuations.

Supply by itself isn’t scary, it is only when the supply overshoots demand to a point of suffocation. I don’t think that is what will happen here.

If we reflect on the chart above and compare it to the top 5 cities for each of our REITs there is a minimal amount of overlap in the highest areas of new supply but we should also remember that the companies themselves only have a portion of their FFO come from these cities.

Even if they experience oversupply and softer rents in certain markets the diversification of their portfolio will hold them up.

Plus, if we reflect on the migration trends I believe the new supply will not have trouble being absorbed. Will it cause some short-term rent pain? Probably. But when we stretch the timeline out past the current supply wave, I don’t think it destroys long-term FFO growth.

I wouldn’t be surprised if the basket above has flat FFO growth over the next two years but what happens after this supply is worked through the system?

New development, as measured by multifamily starts, has fallen off since rates have begun to increase.

These assets take 3-4 years to build, giving us a runway to about the middle of ‘27 if interest rates fell today. The longer the rate stays up here the longer this timeline stretches out only enhancing the competitive position of these REITs once this new wave of supply passes.

Rents might stay flattish over the near term but once this supply is worked through, these premier assets, in strong cities, will likely have some pricing power and it is in these later years that this basket grows in value as they can raise rents.

Interest Rates

I am not naive to the reality that Real Estate is an asset class that is extremely sensitive to interest rate movements. I am not an economist and I have no view on the direction of rates but here is how I see the range of outcomes for this basket if rates move in either direction.

If They Move Up

The cap rates on these assets continue to increase and, likely, the price continues downward.

However, the effects of this increase will only make it a stronger reason to cut off more supply and thus lengthen the timeline for new supply to enter the market only putting these current assets in a stronger position.

If They Move Down:

These assets likely re-rate to a higher multiple and we get nice price appreciation in the short term.

We have a strong amount of loosening to go before development becomes attractive again but if rates fall to that level then these REITs do not trade where they stand today and we still have a good runway before new development hits the market again.

If They Stay the Same:

Supply continues to stay on the sideline and let’s say the price of these don’t move, we collect a 4%+ dividend and wait through the new supply wave. Each passing month keeps new supply off the field and only lengthens the amount of time these assets have pricing power in the later years.

Even if FFO stagnates or decreases, we have a strong 6.5-7% yield today, which is a strong return given the R/R here.

In Closing

I put my initial REIT position on about a month and a half ago but still find the opportunity set to be attractive even after a small price appreciation.

I will be buying at the higher prices because I will never write about a name I won’t buy myself.

If rates increase and these prices come down I would be open to adding more as it only strengthens the competitive position over the long term. This basket of REITs represents a portfolio of quality apartments in some of the most popular cities in America that are trading below replacement cost.

To me, this is a simple proposition where I am forcing myself not to make it complicated.

Over the next 5 years, I wouldn’t be surprised to see mid-teen to high-teen IRRs at the current prices.

I expect to see flattish rent stability over the next 18 months based on a blended rate, (new rents combine with renewal rates) then see pricing power come through in about 2-3 years as new supply thins out.

Based on a yield plus growth formula I think you can hit a mid-teens IRR, multiple expansion would be the cherry on top. If cap rates move back to 5 instead of ~7% where they are today, that is like going from a 14x to a 20x multiple on earnings, a nice tailwind.

I chose a small basket approach here because I believe multifamily apartments as a whole are on the cheaper side and it gives me an added layer of protection on incentives for each management team.

I am confident that I can say this pack of “horses” is fast but less confident in my ability to pick the one who will win the race. In this scenario, I don’t feel the need to, they will all likely trade in the same return range anyway.

I would not have come across this idea if Bill Chen had not introduced me to it. Please look at his work on the space and listen to the podcasts he did with Andrew Walker and Bill Brewster.

And check out this small “memo” he published on Twitter a few days ago on this exact topic, which I thought was great timing.

If you are looking for an idea that can give your portfolio a solid foundation to build on, this could work for you. Don’t expect it to get you on the cover of Forbes but you have the chance to put money to work at attractive IRRs in a highly durable asset class.

Please be advised, Wall St Gunslinger is not an investment adviser and does not give personal investment advice. All content is for educational and entertainment purposes only and should not be interpreted as anything other than such. Investing entails a lot of risks and should be managed appropriately. Please do your own research and consult with an investment professional before making any investing decisions. Thank you.