The Collapse of Common Sense II – Exploiting the EBITDA/Net Debt Error Among the Durable & Fragile

Introduction: Revisiting the Collapse Using Kailash’s Models to Exploit Mispriced Capital Structures S&P500 Russell 1000 Small & Mid Cap Conclusion Exhibits Introduction: Revisiting the Collapse In our last paper, The Collapse of Common Sense, Kailash noted that the world seemed to have suffered some sort of Fed-induced intellectual decay where the relationship between fundamentals and perceived risk had inverted. Specifically, we quintiled the universe by EBITDA/net debt ratios1 and dubbed those with the highest coverage ratios “Durable” and those with the weakest financial structures “Fragile.” The partitioning using these characteristics proved practical as there was substantial autocorrelation between margins, leverage, free cash flow yields and returns profiles across the cohorts. For convenience, Kailash has reprinted the primary conclusion from that paper in Fig. 1 below with Fragile firms in red, Durable firms represented by the dark blue bars in the middle and the universe values represented by the light blue bars on the right of each group2. https://kailashconcepts.com/wp-content/uploads/2021/11/icons8-vertical-line-50.pnghttps://kailashconcepts.com/wp-content/uploads/2021/11/icons8-lock-50.pngSubscribe now to unlock the full content 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YOU ARE NOW READING PREMIUM MEMBER LEVEL CONTENT Looking at Fig. 2 below (also reprinted from The Collapse of Common Sense), we were amazed to see that starting in mid-2013 the Durable firms, with their negligible net-debt, substantial free cash flows and above-market ROAs, had price action creating Betas that were higher than the Fragile firms! https://kailashconcepts.com/wp-content/uploads/2021/11/icons8-vertical-line-50.pnghttps://kailashconcepts.com/wp-content/uploads/2021/11/icons8-lock-50.pngUpgrade your subscription now to unlock the full content Looking at Fig. 2 below (also reprinted from The Collapse of Common Sense), we were amazed to see that starting in mid-2013 the Durable firms, with their negligible net-debt, substantial free cash flows and above-market ROAs, had price action creating Betas that were higher than the Fragile firms! Using The Kailash Models to Exploit Mispriced Capital Structures S&P500 After reading The Collapse of Common Sense, several partners of the Kailash products asked: could we identify the best and worst firms in both Durable and Fragile cohorts? In researching that question we did find that while Durable firms were more likely to be higher in our rankings, enough consistently showed up in the Bottom 100 Aggregate Ranks that we could consistently form portfolios of “Top Agg Durable” and “Bottom Agg Durable” firms. Similarly, we found that while Fragile firms were more likely to show up lower in the Aggregate Ranks, enough of them consistently showed up in the Top 100 ranked firms that we could form portfolios of “Top Agg Fragile” and “Bottom Agg Fragile” firms. Unlike most quantitative processes, the Kailash models have little if any weighting on momentum and are primarily predicated on identifying mispriced fundamental merit. Figures 3 and 4 below show that the rankings have brought yet more surprises to Kailash’s original finding above. Betas currently seem to be at odds with what we consider to represent fundamental merit. The market believes the Durable Firms we like (Fig. 3, blue line) are over 30% riskier than the Durable Firms we dislike (Fig. 3, red line). Similarly, the market believes the Fragile Firms we like (Fig.4, light blue line) are over 50% riskier than the Fragile Firms we dislike (Fig. 4, green line)! Studying the S&P500 fundamentals below, Kailash finds the mechanical risk assessment rendered by Beta difficult to digest. Durable Firms: Looking at Fig. 5 below we show the fundamental characteristics of Durable firms we favor, “Top Agg Durable,” and those we fear will underperform, “Bottom Agg Durable.” Simplistically, the Top Agg firms offer nearly triple the FCF yield and double the ROEs while still providing investors significant discounts on Price to Sales and Price to Earnings Ratios. Looking at the 1 Year Sales Growth, this opportunity may stem from what we believe is potentially investors’ misplaced “revenue growth at any price” approach to stock selection. Fragile Firms: Kailash believes the comparison between the Fragile firms we like vs. dislike in Fig. 6 below seems particularly unforgiving. A reader should note the net debt ratios of our Top Agg firms are materially higher than those we dislike. Yet Kailash believes it is common sense that if you are going to traffic in firms with low EBITDA/net debt ratios it is better to have a bit more leverage and a 4% FCF yield, which is scaled to include said leverage, than less leverage and be burning cash! We would also note that the Fragile firms we are fond of (Top Agg Fragile) trade at enormous discounts on both Price to Sales and Price to Earnings ratios despite offering nearly 10x higher ROEs compared to Fragile firms we dislike (Bottom Agg Fragile). In Fig. 7 below we contrast the DURABLE firms we like with the FRAGILE firms we dislike. To note the obvious: the near-debt-free durable firms we like with tremendous cash flows, powerful ROAs and ROEs trade at immense discounts to the leveraged, loss-making Fragile firms we fear. Kailash finds it borderline incredible that despite these fundamental spreads between Durable firms we like and Fragile firms we dislike, the Durable firms sport higher Betas. Do the Kailash Rankings Matter? History indicates that our ability to discern between Durable and Fragile firms worthy of incremental fundamental research for both longs and shorts is compelling. The two left bars in Fig. 8 below show that for Durable and Fragile alike, if you are in the Top 100 Agg Score, the batting averages3 vs. the benchmark are impressive at just ~70%. This hit rate is further amplified by the payoff structures which can be seen in the first two groups of bars in Fig. 9. Not only do the portfolios of Durable and Fragile firms we like (Top Agg Durable, Top Agg Fragile) put up substantial hit rates, when they win, they tend to do far better than when they lose. Compare that to the batting averages and payoff structures of the Durable and Fragile firms that are in the Bottom Agg scores (right two bars in Fig. 8 & 9) and you can see that the story is much the same here. Barely batting 30%, these Bottom Agg portfolios struggle horribly to outperform. For long managers and short-sellers alike these companies also have beneficial payoff structures where not only do they lose to the market far more often than they win, but when they lose they lose by significantly greater amounts than the rare times they outperform. Simply put: regardless of your interest in capital structure as defined by EBITDA/Net debt, looking at the Beta spreads between the Top Agg and Bottom Agg picks in the Durable and Fragile universes, we believe the fundamentals tell us that the market has the risk mispriced and the history around Kailash’s batting averages and payoffs would seem to agree with us. Using Kailash’s Models to Exploit Mispriced Capital Structures Russell 1000 The remainder of this paper will follow the exact same layout as the S&P500 above for the respective universes. Summarily, we find here, post interaction with the ranking files, conclusions similar to those above. Namely that in both Fragile and Durable firms in both the S&P500 and Russell 1000 universes risk as measured by Beta has become wholly detached from fundamentals. Figures 10 and 11 below show the Betas for the Durable and Fragile firms we like vs. those we dislike for the R1000. As with the S&P500 above, in both cases, firms that the Kailash fundamental-driven ranking tools like are viewed as riskier than those it dislikes. Durable Firms: Examining the durable firms in Fig. 12 below, the Top Agg firms have over double the FCF yields of the Bottom Agg Durable firms we dislike despite offering nearly 3x higher ROEs and substantial valuation discounts based on price to earnings and price to sales ratios. Despite this, Beta has marked Durable Firms we like with aggregate Betas of 1.15 and those we dislike with a sub-1 beta of 0.90! Fragile Firms: Looking at the Top Agg Fragile firms vs. the Bottom Agg Fragile group in Fig. 13 below, we find the distribution in Betas borderline comical. The Fragile firms we like do have higher net debt ratios, but again, their FCF yields are 4.6% while the Fragile firms we dislike are burning cash and diluting shareholders to the tune of -3.1% with all the associated spreads one would expect in ROEs, P/E and P/S ratios. Staring at Fig. 14 Kailash cannot help but look at the DURABLE firms we like (top row) and the FRAGILE firms we dislike (bottom row) and note that they both have nearly the same beta! This begs the question: how can any rational reader believe a heavily indebted firm that burns cash and dilutes shareholders with abandon is as risky as a firm with virtually no net debt, massive ROEs and shareholder yields north of 4%? We simply cannot make sense of such data. Figures 15 and 16 are nearly identical to what we found in the S&P500 universe. For the Russell 1000, regardless of what Beta tells you, Kailash’s fundamentally driven ranking models have historically done an excellent job identifying the Durable and Fragile firms an investor wants to be long and short (or avoid). Looking at the left two bars in Fig. 15 and the left two groups in Fig. 16, Kailash’s partners can see that Top Aggregate ranked firms in both the Durable and Fragile universes historically outperformed reliably with asymmetrical payoff ratios. Similarly, looking at the right two bars in Fig. 15 and the right two groups in Fig. 16, Kailash’s partners can see that the Durable and Fragile firms in the Bottom Aggregate rank rarely outperform the market and when they do it is by much smaller amounts than when they underperform. Using Kailash’s Models to Exploit Mispriced Capital Structures Small & Mid Cap Universe In the Small & Mid Cap universe, we find our first exception to the “rule” that Beta is at odds with our fundamental assessment of firms that has been ubiquitous across the S&P500 and Russell 1000 universes. Figure 17 shows that this perverse concept, that more expensive and less financially sound firms are less risky than cheaper and healthier firms (fundamentally speaking!) still holds in the Durable sphere. Yet finally, in Fig. 18, Kailash’s partners can see consonance between Beta’s view of firm risk and the Kailash ranking model’s fundamental view. Figure 18 is the only instance across the Top and Bottom Aggregate scores in three universes where the ranking engines’ fundamental view of firm health is in sync with Beta’s assessment of firm health. Durable Firms: Figure 19 below shows that the Top Aggregate ranked firms carry little nominal net debt relative to price, trade at a 50% discount on P/E and P/S all while generating over 3x the FCF yields of the Durable firms we dislike. Overall, the Durables we like appear to offer a “free lunch” when compared to the Durable firms we dislike. Fragile Firms: Figure 20 below requires us to again acknowledge that the Fragile firms we like tend to have elevated levels of debt compared to the Fragile peers we dislike. With that said, Top Agg firms we prefer have 4.1% FCF yields with shareholder distributions that point to deleveraging – a potentially powerful amplifier to returns as explained in Kailash’s earlier work Activism Lite. Contrast that with the Bottom Agg Fragile firms which carry less debt but are hemorrhaging cash relative to EV at a 4.3% rate and are systematically diluting shareholders to the tune of 5% and the rationale behind the ranking engine’s dispersion seems beyond obvious. As we mentioned before, the Small & Mid Cap universe is the first exception to the “rule” that Beta is at odds with our fundamental assessment of firms. The chart below seems to indicate that Beta is finally making a (semi!) rational measurement in our view. In Small & Mid Cap, Beta agrees that the fragile firms we dislike are riskier than the durable firms we like. Looking at the fundamental dispersion in Fig. 21 below Kailash still thinks that while Beta is now at least directionally agreeing with our fundamental view, the magnitude of dispersion between the two groups’ Betas still seems conspicuously low. Looking at the batting averages and payoff structures of the Top Agg and Bottom Agg portfolios in the Durable and Fragile world Kailash wants to be transparent and would highlight a significant divergence from our results in the S&P500 and Russell 1000 work. As you can see in Fig. 22, like the S&P500 and Russell 1000, the SMID portfolio batting averages speak to a powerful advantage in parsing out opportunities within the most Durable and Fragile capital structures using the Kailash ranking engines. Similarly, the payoff structures are asymmetrical in a manner that benefits partners of our product with the exception of Top Agg Fragile. Looking closely at Fig. 23 you can see that in Small & Mid Cap, when we like a fragile firm, when it wins or loses the magnitude is the same. To the degree our partners in the business are going to work in the Fragile Firms we like (Top Agg), they need to be aware that they are leaning exclusively on batting averages for a better outcome, unlike the other groups where both batting averages and payoff structures are tipped in investors’ favor. Conclusion: Interacting Kailash’s fundamentally driven Rankings with both Durable and Fragile firms in this work has merely amplified Kailash’s conviction in our conclusion from our previous work The Collapse of Common Sense. We believe there is a profound disconnect between Beta as a measurement of idiosyncratic risk when compared to actual underlying fundamental firm health – particularly among larger cap firms. As demonstrated above, Kailash’s rankings methodologies have historically done a solid job identifying mispriced Durable and Fragile firms alike. Overall we believe The Collapse of Common Sense Part I and Part II are merely more evidence that in the post-2013 world, stock selection has come to be dominated by processes that are fundamentally agnostic in allocating capital to equities. As the media has not been afraid to annotate, this has been a challenging period for fundamentally oriented investors prone to studying firm and industry health and trying to find mispricings in a disciplined fashion. Reviewing this paper and the several that have preceded it, Kailash cannot help but conclude that fundamental spreads measured numerous ways have become substantial and unsustainable. History tells us that eventually algebra always intervenes and that valuations and intelligent capital allocation go from ignored in moments of ebullience, like today, to all that matters with blinding speed. Kailash makes no claims to timing but feel the payoffs available to the patient are substantial and all but inevitable. On the next page, please find exhibits for Durable Firms in the Kailash Top 100 and Bottom 100 Aggregate Rankings and Fragile Firms in the Kailash Top 100 and Bottom 100 Aggregate Rankings for both the Small & Mid Cap and R1000 Universes. If you would like to receive the four lists for the limited distribution S&P500 universe, please contact your Kailash Concepts representative. Exhibits As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded. For the sake of simplicity we used only firms with net-debt We chose to reproduce the data for the S&P500 here for optical clarity but the concepts flowed into the R1000 universe as well Batting averages are historical months the specified portfolios outperformed the reference benchmark Disclaimer The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. 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