Is cyclical bad?
Why I am invested in 4 highly cyclical stocks
Disclaimer: This article is for informational and educational purposes only. Do not interpret anything below as financial advice. Always do your own research & speak to a financial professional before making investment decisions.
In today's post, I thought I'd run through the holdings of a portfolio I manage that doesn't have anything to do with the Magic Formula. While a primary focus of mine is indeed my take on Greenblatt's systematic investing strategy, I also enjoy dabbling in individual stocks in a separately managed portfolio.
Cyclical stocks have a bad rep. With 4 holdings across two highly cyclical industries, shipping and coal, one might wonder how such a portfolio comes to be and what is the rationale behind constructing it in this way. My goal with this post is not to repeat the excellent analyses that are already out there covering each of the stocks that we'll discuss. Rather, the objective is to understand why an investor might want to consider investing in these out-of-favour industries that are subject to various economic and geopolitical factors, including global trade patterns, economic activity, energy demand, commodity prices and government regulations, to name a few.
As of 6 May, I am invested in 3 coal businesses from the United States: Alpha Metallurgical Resources Inc (Ticker: AMR), Warrior Met Coal Inc (Ticker: HCC) and CONSOL Energy Inc (Ticker: CEIX). I am also invested in Danaos Corp (Ticker: DAC), a Greek shipping company.
Buyback Monsters
Alpha Metallurgical Resources and Warrior Met Coal are both coal mining companies that specialise in producing metallurgical coal, primarily used in steelmaking. Alpha operates mines in the Central Appalachian region, while Warrior operates mines in Alabama's Warrior Coal Basin. Both companies benefit from their strategic locations in coal-rich regions known for producing high-quality metallurgical coal. Both Alpha and Warrior are exposed to the global steel market, which drives demand for metallurgical coal. With a focus on high-quality coal production and efficient operations, both companies may offer potential upside as steel demand grows, particularly in emerging markets. CONSOL Energy is a Pennsylvania-based producer and exporter of thermal coal and metallurgical coal (to a lesser extent). As energy demand evolves and commodity prices fluctuate, CONSOL is attractive as the low-cost provider of thermal coal.
While the above may be interesting, it probably isn't enough for most investors to really consider delving deeper into these coal players. What really attracted me about Alpha and CONSOL was their approach to capital allocation. Specifically share buybacks. These things are what Mohnish Pabrai would call "Uber Cannibals". These describe companies that return capital to shareholders via aggressive share buybacks instead of other means such as dividends. Both Alpha and CONSOL print cash and have a reputation of returning large amounts (75%+) of FCF to shareholders in the form of buybacks.
Alpha currently has a buyback yield of ~20%. This is calculated simply by taking (shares before - shares now) / shares before * 100. Assuming a) Alpha's operating earnings stayed constant at ~$852m, b) its unassuming EV/EBIT multiple remained at 5x (where it is trading at currently) and c) the company continued to aggressively buy back shares each year at the same 20% clip, that would equate to a 25% IRR over the next 3 years. This is all hypothetical of course and many things can happen to ensure that the above scenario does not play out. Earlier in the year, for example, Alpha announced plans to reduce the cadence of its buybacks and potentially pause them while it builds up a cash pile. But for a company with almost no debt and a prudent management team with a reputation to reward patient shareholders through repurchases, I am willing to stay the course and wait for the buyback engine to be resumed.
Alpha 2.0?
Warrior, another met coal player has a slightly different appeal. This company isn't known so much for buybacks like Alpha and CONSOL (it does pay a regular and special dividend). What excites me about this one is Blue Creek, a mine which is set to go live during the next couple of years. The company is already a cash printing machine having generated ~$700m in operating cash flow in 2023. When Blue Creek goes live, this figure is expected to increase dramatically. Many investors, including myself, believe there's a good chance that management will turn on the buyback engine once Blue Creek is up and running and follow the Alpha playbook. And we know what happens when that goes well, with Alpha going up over 100x since the pandemic. Even if Warrior don't buy back shares, the return potential just from Blue Creek’s earnings growth alone is compelling. Any sign of special dividends, buybacks or multiple expansion and you've got another multibagger scenario.
Can't Contain-er
Danaos Corporation is one of the world's leading independent owners of container ships. The company leases its vessels primarily to liner companies on a long-term basis. Danaos operates a modern fleet of container ships, providing global shipping services. Danaos benefits from its modern and diversified fleet of container ships, which are leased out on long-term contracts to reputable liner companies. While I don't claim to be any kind of expert on the shipping industry, this one really appealed to me for the following simple reasons:
Danaos is almost net cash positive with ~$132m in net debt, a figure that has reduced from ~$2.9b in 2014. This is due to the combination of a rising cash balance and decreasing debt load over the last decade thanks to prudent management
Danaos made some smart decisions during the pandemic and locked in several long-term contracts with liner companies during the pandemic. Per their most recent filing, Danaos has $2.4b of total contracted cash revenues through 2028 with 90% of revenues locked in for 2024 and a further 60% locked in for 2025
Analysts project $70 EPS during 2024-2026 which seems attractive given the current stock price which floats around $78 at the time of writing.
Danaos has high insider ownership, 49% according to finviz.com. This is typically a good sign as it shows management have skin in the game and their interests are aligned with shareholders
Danaos pays an attractive dividend with a starting yield in the 4% range which has grown steadily since 2021. The dividend payout ratio stands at ~11% suggesting that it can be easily paid using cash flow
Despite dividends playing a major role in Danaos' capital allocation strategy, management has also started buying back shares. While the buybacks look minimal compared to the coal players mentioned already, if management continues repurchasing shares at the current buyback yield of ~3% that’s a useful extra tailwind
Danaos is trading at 1/2 tangible book value and will earn its entire market cap through 2025. This looks like a classic 50 cent dollar type deal with a decent margin of safety built-in from the locked contracts as well as the discount to assets
Get Paid First
Despite the obvious similarity in these companies all being cyclical, there's something else that stands out for me about my current holdings. In a recent podcast, David Einhorn said that stock markets are 'fundamentally broken' and described how his fund now places a much higher emphasis on companies that pay shareholders directly through capital allocation decisions, rather than waiting for the market to put a worthy valuation multiple on the stock. According to Einhorn, he no longer relies on valuation multiples being assigned properly due to the rise of index funds and less people paying attention to valuations.
While Einhorn’s commentary is interesting, I don’t pay too much attention to valuation multiples in my valuations anyway. In other words, I don’t rely on a bigger valuation multiple when calculating my potential return. If the multiple re-rates and expands, fantastic. But it isn’t my main focus. When calculating return, I look at earnings growth (the result of ROIC * Reinvestment Rate) plus the Shareholder Yield (buybacks yield + dividend yield). Tobias Carlisle pointed out in a recent podcast that he’d actually prefer the multiple remained compressed so that if management are repurchasing shares, those buybacks are more effective in the long run.
Regardless, it is interesting that all 4 companies discussed (with the possible exception of Warrior) place an extremely strong emphasis on returning capital to shareholders through buybacks or dividends. Alpha and CONSOL, for example, virtually use all the FCF they generate to repurchase stock. Danaos pays an attractive, growing dividend and management has recently approved a $100m of buyback program. While the main attraction of Warrior is the earnings growth potential that Blue Creek offers, it would be inaccurate to assume that capital returns are totally ignored or won't be ramped up in the future once the new mine goes live.
I guess the takeaway is never discard a company simply for being cyclical. If debt is in check, earnings are solid and capital allocation decisions are sound and relatively predictable - it might be worth exploring!