Motley Fool Hidden Gems Investing - 2 Short 2 Furious

Episode Date: August 15, 2023

Michael Burry, the investor featured in “The Big Short,” made a major bet against market indexes. Are investors due for a sequel of the Great Financial Crisis? (00:13) Ricky Mulvey and Asit Sharma discuss: A sales slowdown The Home Depot. Why the home retailer has “an incredibly high” return on invested capital. Credit downgrades for regional banks. Michael Burry’s bearish option bet against the S&P 500 and NASDAQ, worth $1.6 billion in notional value. Companies discussed: HD, MTB Host: Ricky Mulvey Guest: Asit Sharma Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

Let's check in on regional banks, shall we? You're listening to Motley Fool Money. I'm Ricky Mulvey, joined today by Asit Sharma. Asit, good to see you. Ricky, good to see you. Let's dive into Home Depot earnings. The Home Depot reported this morning on their second quarter, they beat sales and earnings expectations, but those sales dropped 2% from the prior year. Looks like they had some pressure from a drop in spending on those big-ticket purchases. We'll also note a drop in lumber prices. This shouldn't be a surprise for the Home Depot shareholders as this is a cyclical business and a lot of people bought washing machines

as the pandemic trailed off. Totally, Ricky. People have spent the big portions of their free income during COVID. Now we're coming back into a situation where there's still some money on the table for consumers, but those big-ticket items are behind people for the most part, of course, things always break down. There's always going to be a component of replacement there. The other thing you mentioned, though, lumber prices, I think we forget how much they soared during the 2021 period. Lumber prices are still elevated, but they are coming down from those extremes that we saw when we had so much of supply chain snarls and just trouble with all types of commodity increases. That drop in lumber prices, of

course, how it affects Home Depot, that's part of their average ticket. When they sell lumber, if the price is going down, that's a smaller sale that they're recording. Two other notes that I thought were interesting. One is that there was a small dip in gross margin. The CFO attributed most of that to shrink. For a lot of these retailers, they're still dealing with the problem of organized retail crime. They are not delighted to talk about that on earnings calls for obvious reasons. Then the second, where you're really seeing this business keep on chugging is that it has more than 40% return on invested capital, which is huge for a retailer asset. Let's take that first thought first. The mention of shrink, you were chatting with

me before we started taping, was very brief, right? The CFO didn't want to go into any details. Of course, you don't want to incentivize any bad actors who happen to listen to earnings conference calls and get a bright idea. But it is something that is increasingly a worry for these massive retailers shrink encompasses a lot of things. It encompasses spoilage, it encompasses damage during transit. But what's been really visible to anyone who watches the news is this organized retail theft, where gangs may come in and just grab stuff out of stores. On a less visible level, it can mean stealing stuff in the supply chain. We saw Union Pacific having some problems with some of their freight on rails that was getting

broken into and goods stolen. This is something that causes enormous amount of consternation for the big retailers because it's expensive to manage. The amount that you have to put into security systems, both in the transit chain and then onsite, is tough. It also begins to de-incentivize customers. If you have to lock up your valuable goods, it actually makes it less pleasant to go into a store and buy. Retailers hate to deal with this, but the problem hasn't gone away. In fact, it's getting a little bit bigger and bigger. Although we should mention, the dip in gross margin was only eight basis points year-over-year. While they attributed that all to shrink, not a big issue there.

Asit, stop adding context. Let's give them some big headlines. This is a company, For me, it's a sleep number stock. It trades at about a market average, but it has been a tremendous capital allocator. I think that shows up with the return on invested capital number. This is true, Ricky. It's one of my pet peeves about Home Depot. When you look at that number, you think, wow, they're just so efficient with their capital. They're better than any technology company I follow. What do these guys do? What's in their breakfast cereal? But actually, the major thing that they've been doing for a number of years is buying back shares. In their accounting, of course, when you retire those shares, it reduces your

invested capital base. If you're taking a large part of your cash earnings, decreasing the denominator of that ROIC equation, sure, your ROIC is going to keep growing and growing and growing, even if your economic returns aren't growing that much. That's what's been going on with Home Depot. Now, let me just give you the counter. I will insist on some context here. If they didn't have all that cash to throw around, if they weren't really efficient on their bottom line, then they couldn't reduce the invested capital base. There is a comeback to my pet peeve in that, dude, they're generating the cash, let them do what they want with it. They opened up two stores this quarter.

This is a very mature business. If you want to give me, the shareholder, a little bit of that money, go ahead. The board authorized $15 billion in share repurchases going forward. It seems they spend about the same money on share repurchases as they do on dividends. The other growth story is that they have professionals spending more on hardware, decking, and plumbing. Maybe it's not going to be a skyrocketing revenue story, or in fact, it's a little bit of a dip, but if you're a shareholder, hey, return it to me however you want. Yeah. I don't disagree with that. A few quarters ago, Home Depot had the argument that it had earnings momentum at its side. We know that part of that story was big-ticket items.

They were investing in their distribution system so they could sell more big appliances. Now, that's tapered away, but they still have that core generation of cash. They can put that to good use, shareholders are happy. This is one big signal to the market with that $15 billion authorization you're talking about. I noticed the stock is up-to-date despite these flattish results. One other interesting note is just seeing the macro economy through the lens of Home Depot. Retail sales data came out today, which basically found that folks are spending a little bit less on furniture, which is the big-ticket purchase, and then spending a little bit more on online retailers and restaurants.

This lipstick effect was also in action at the Home Depot, where you're seeing those appliance sales go down, but more on smaller projects, let's say gardening. Asit, as you think about your investable universe, are you seeing that lipstick effect where people spend more on smaller indulgences? You're still going to wear lipstick in a recession. Well, maybe not you personally, but some folks. Where are you seeing that lipstick effect in action? It's totally in that macro picture to begin with, Ricky. We saw U.S. household debt crossed $17 trillion recently. Consumer credit card debt crossed $1 trillion for the first time. When you think about the firepower people have, it's still there. The job market

is tight, people are getting back to work, but the amount that we have to spend on large stuff has decreased. We're getting closer and closer to being tapped out on our credit, those of us who use our credit more than we should. Our savings rate has been in decline, so we don't have as much in the bank. But as a society, we still like to spend. And I think there is some element of retail therapy here that's involved. We've had a rough stretch of years with so much of geopolitical disruption, climate change, the pandemic. I think we're still buying those little things to feel better. I certainly am. I'd be lying if I said I wasn't making some small purchases and indulging in a bit of that retail therapy. But across

the board, when we look at retailers, we see, I think, less and less of the big items in movement quarter-to-quarter. Makes sense. A few weeks ago, Asit, we recorded and we talked about Schwab. You said, you know what, when we get back together, let's check in on some regional banks. Since we had that conversation, a little bit has One big one was Moody's. The credit rating agency has downgraded 10 regional banks. They include Commerce Bank Shares, Bach Financial, and the largest M&T Bank. Before we get into the implications of this, what does it mean for a bank's credit rating to be downgraded? Ricky, it's similar to other corporations whose credit is downgraded.

right? You've got a picture of creditworthiness. Outside companies, third parties will assess you as a business and say, okay, you're very creditworthy, you can issue debt, and it's pretty safe. The market looks closely at these investment ratings, especially the difference between investment grade and the next step down, which is junk rating. There's not a a lot of in-between. This has a direct effect on the borrowing costs for businesses. If you get downgraded multiple times, let's say, out of the investment grade category into junk, it's going to cost you a lot of money to borrow. Banks borrow. Their funding costs are already on the rise because interest rates have been on the march. It's more expensive

in the first place. There's a circular effect going on here. Moody's is basically saying, look, the funding cost for banks is rising, then we're putting them on watch. If they do ultimately get downgraded, it will be automatic that those funding costs are going to increase even more. In some ways, it can be a no-win situation for companies in a high-interest rate environment when they get put on credit watch. But it's something that I think investors should be paying more attention to, this story in general. Well, if you're listening, you may be wondering why their funding costs are rising. I'll pick on M&T Bank for just a moment, although this is not unique to them. If you have a checking and

savings account there, you will receive 0.01% in interest or one basis point if we're on an earnings call. The federal funds rate is more than 5%. You could give someone a mortgage for more than 5%. What I don't understand is why this wouldn't be a boom time or what a listener may may not understand is why this wouldn't be a boom time for some of these banks. Well, it is a boom time in some ways for banks that can hold the line, but those are few and far between. I will note here that M&T Bank is making this decision not to go after those deposits, unlike some of its competitors, who are now raising the amount that they pay to customers for funds on deposit and making less money themselves in doing so.

If you take a look at M&T Bank's non-interest-bearing deposits, they're sort of static from year to year. Actually, the non-interest-bearing deposits, Ricky, have gone down from about $72 billion this time last year to $55 billion. Folks have been moving that money out to get some more yield elsewhere. Now, they've been able to make it up a little bit in some of the interest-bearing deposits, but those aren't as competitive, as you point out, so the whole number of static year-over-year. What that means is that this bank, M&T, has lost out on some opportunity, potentially. But they are a rare bank, and they don't have a lot of long-term government securities on their books that they've used for funding. Maybe

that's good for them. Of course, there is a vulnerability here when I look at their balance sheet, which is, they've got a lot of commercial loans on their books. This is something Moody cited when it talked about these 10 banks and others that have gone on its watch list. Look, there's this huge amount of commercial real estate debt that's coming due in the next few years, and banks are holding a lot of this debt. There's yet another risk portion of this investment grade rating that's at risk for many of these banks. Yeah. M&T has about $45 billion in its commercial real estate portfolio. I will note that 12% of that debt is in office properties. It will be very interesting. I think a lot of the

bank investors are still trying to weigh how this will play out, because a lot of this office debt is not coming due immediately, but who knows if folks will default before then, and then what happens after it comes due in a few years as the remote work environment shakes out. Totally. Let's say you're a bank investor and you've seen that one of the banks you've invested in has been notched down one grade by Moody's. How should they take this news? Is this ultimately meaningful for them? It's case by case, Ricky. I don't think that it means a heck of a lot if you see your bank get taken down a notch. This is about macro risk in the economy, and it's also about

the amount of capital these banks have on their books. When Moody's and other rating services start really scrutinizing the balance sheets, they understand, just like the average Depositor understands that, look, if there's a bank run, there's hardly a bank in the U.S. that can really withstand a huge bank run. That's not how banks are set up. But in this day and age where thousands of people can instantaneously demand their deposits online fueled by social media, it's a model that we'll have to examine. Now, why shouldn't you be as concerned as maybe in March? Because the Federal Reserve, the U.S. Treasury, they both signaled that they're going to keep

depositors whole. In the case of SIVB, actually, the government insured deposits beyond the FDIC insurance. It was a signal that we're not going to let the system fail. Now, I wouldn't go out and start speculating in banks. They are trading at cheap multiples. We've recommended a few in some of the services at The Motley Fool on a speculative basis. I'd be really careful here. There is concern about these business models. At the end of the day, I I think the models will evolve and some more regulation is going to come in to make these banks a bit stronger as we go forward. Well, Asit, while you are preaching caution, one investor is completely out of those regional banks. Michael Burry, who was

made famous by the big short, has liquidated his stakes in six banks. Those include PacWest and Huntington. But what's grabbing bigger headlines is that he has made a massive bet against the market. That includes put options against the NASDAQ and the Standard & Poor's 500 with a notional value of $1.6 billion. I think I first want to break down that headline asset because that does not necessarily mean that Burry has put down $1.6 billion on these stock indices collapsing. Right. That's the amount of market value that the options are implying. Now, what he paid for the options, what his firm paid for the options may be substantially less. Nonetheless, it is a big bet. There's some substantial

dollars involved here. So, the bigger question is, hey, this guy's had a hit before. It was called the Great Recession. Are we gearing up for the Big Short 2 now? I mean, you can call it whatever you want. The Big Short 2 Judgment Day, Too Short, Too Furious, The Big Short 2 Stay Put. Asit, do we need to get ready for the sequel? Look, Michael Burry seems to be saying that there's a sequel in the works. I think he's also trying to make good on that tweet. He had that tweet that just said, sell. And this was much talked about, no timeframe, but he was implying that the market was going to crash.

It didn't crash. In fact, the market went up. This is also a redux. Forget that one tweet that said sell. Here's just one big number for the market, $1.6 billion. How do you like them apples? he's short the market. I don't want to trash this guy's track record because he has made a tremendous call in the past, but there have been other calls against the market that haven't worked out so well for Burry. I think it might not be a case where another great recession is imminent. Now, I may eat my words, I hope I don't,

but I think it's worth noting not just that event, but also some of the other calls that Burry has made. Let's actually do the due diligence on this call. What does it mean? There are some things we can understand that are implied by this. If you look at the regulatory filings, of course, you can't know, because it's not disclosed, the length of those options, exactly how long are they, what are the amounts allocated to the different time series. But there are a few things we can deduce. No. 1, he was wrong with that market call earlier. I doubt he's making a really short-term call here with a bet of such magnitude. It's going to be a little further out. My guess is

that these are options that are spaced anywhere from nine months to a year apart. Why that is, if you examine what's going on with the VIX, which is an index that really gives you the measure of expected volatility in the near term, that's really declined since its peak in the fall of 2022. The VIX is low. And that also shows you that the implied volatility of call and put options is low. Why does that matter? Well, it's a cheap time to buy options, either call or put options, because volatility is one of the components of pricing. So, Michael Burry is looking at this commish market and he's saying, hey, these options are sort of cheap right now. I should snap some of these up because I'm bearish. We don't think they're short-term, because such a magnitude

of bet in a very short period could be disastrous, but they're not very long-dated either. Why is that? Because once you get out past a year or two years and get into longer-term leaps, so longer-term options, you have to pay for the time value. They're not cheap anymore, you're paying for a lot of time value. There's a sweet spot. I think he's making a call that within the next nine months to a year, we're going to see a correction of enough magnitude for him to pocket some handsome profits from this trade. I don't think he's saying anything or any less or any more. I think this is still directional, but maybe he's backed off the idea of a recession. You don't need that. You just need a good correction in the markets

with this trade to make some pretty decent money. Yeah, Asit, I was going to ask you to speculate on his thesis, but you have already answered that question in the previous explanation. We'll call it there. Asit Sharma, always appreciate your time and your insight. Always a lot of fun, Ricky. Thanks. As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Ricky Mulvey. Thanks for listening. We'll be back tomorrow. Thank you.