Markets Bleed

Good morning to all investors.

Asset prices continue another week of bleeding as fear of rising interest rates provokes a recession in the global economy.

As a general rule, when interest rates move up, discount rates also increase and the cost of capital becomes more expensive.

When the cost of capital gets too expensive, capital allocators require a higher rate of return and push high cost projects out to later years, causing a slowdown in the economy.

The Federal Reserve’s high interest rate policies are geared towards causing a recession, to slowdown the demand for goods and services, which should lower prices and tame inflation.

Government intervention is a complex machine and when messed with the global market, will eventually end up in a disaster. Look out below when the music stops and there are not enough chairs for you to sit down on.

In this newsletter we will discuss four items that are currently on my mind

1. Domestic box office

2. Rising energy prices

3. National advertising revenues

4. Financial independence during a market downturn

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See important Reg A Disclosures 

Domestic Box Office

I am a big fan of the movie theater industry. I used to skip school all of the time and head out in one of our beaten down cars to grab the hottest flick and cover our fingers in butter salted popcorn. The experience of the box office is comparable to no other movie going experience.

During the COVID-19 selloff, movie theater companies got demolished. When your high fixed cost business is forced to close down for months, and when you eventually open up doors and only 10% of your capacity is met, a large amount of free cash flow is burnt.

I have detailed working models of movie theater companies and most of the public ones are too over-levered for me to get comfortable with. My thoughts heading into the pandemic was that most of the over-levered players would end up going bust as their balance sheets were impaired heading into the downturn.

I was grossly wrong as state and federal grants came in and saved the day. In addition, I did not think for one second the rise of AMC into a meme stock would allow that company to sell equity at the top and raise enough cash to make it through the downturn.

I was also wrong on the domestic box office jumping back to pre-pandemic levels. In 2019 the domestic box office was $11.5 billion. In 2020 it was only $2 billion. By 2021 the box office was $4.4 billion. So far in 2022, the box office is only at $2.3 billion.

Analysts are calling for a return to the domestic box office of $9-10 billion by 2022 and by 2023 they think we will be at pre-pandemic levels. I think they could be wrong and we will see some mom & pop and maybe a few over-levered larger players head for the gutters.

Stock prices on movie theater companies has been trending downwards and it is likely we see some consolidation here. My favorite little movie theater company has started to get to the point where it make senses to buy it again. There is a large amount of real estate and the balance sheet is rock solid. Alpha Letter Pro subscribers can see my original research report here. I may have to start buying again. Should I make an investment, I will put out an updated note.

In addition, there is another small-cap company in the movie theater space that controls over 75% of the advertising placements. Their capital structure is a little goofy but the business model is solid should any return of the box office happen this summer. Stay tuned on more information.

Rising Energy Prices

Energy prices across the globe continue to make new highs. Since 2014 we have been in an energy recession. Prices were low, companies underinvested and investors lost capital.

With the lack of investment in the global energy complex, in addition to investors losing a significant amount of money for almost a decade, there is now lack of supply to meet all of the demand.

If you read any energy company’s earnings call it is all verbatim. They are all focused on generating free cash flow and returning capital to investors. No one is spending anything on growth capex and consolidation has not really taken place. The only thing energy companies are doing is burning through their current reserves to build up cash on their balance sheets.

The combination of lack of investment and the war in Ukraine has created an interesting dynamic in energy companies.

The war in Ukraine has led to a chokehold on the global supply chain. Russia provides a significant amount natural resources to the global world. When the world told Russia they will not buy their goods and services, the price for energy and natural resources skyrocketed as the supply for these resources officially shut off.

And then you have the impact of energy companies focusing on free cash flow and not production growth which is a doubled edged sword leading to sky high prices at the pump.

Eventually high prices will cure high prices. The question is: when will entrepreneurial individuals start investing into production in the energy space? I follow the space pretty closely as over 20% of my portfolio is in energy stocks, and I have yet to see a large increase in production announced by the majors.

I do know that these high prices will not last forever and investors in the energy space should be aware that prices turn on a dime. Here are a few things I think could send energy prices spiraling downwards:

• Putin getting assassinated

• The war in Ukraine ending

• Major energy companies announcing the increase in production targets

• A large downturn in the global economy which in theory would cool demand for energy

Energy is still a significant part of my portfolio and I continue to monitor the global landscape closely. As of right now, it is hard for me to part with my energy companies when they are trading at 40-50% free cash flow yields.

National Advertising

I am a student of traditional media. I follow the industry closely and keep close tabs on most of the major players.

As a young analyst, one of the first sectors I covered was the traditional media space. Think radio, newspapers and television.

I was drawn to the space years ago as a few of the players were trading near the cash value on their balance sheet. Other investors left these industries for dead as tech dominated the world and digital advertising became the gorilla in the room.

I still like the traditional media space because valuations tend to get blown out from time to time. Investors hate slowly dying industries. They are melting ice cubes, hard to forecast and with interest rates historically at zero percent, it paid to buy growing businesses, not shrinking ones.

Despite all of the nasty features that come with buying into a business that shrinks year after year, these companies tend to trade in wild swings, giving opportunistic value investors like myself, and opportunity to buy assets under replacement value.

Which leads me to the point of this blurb. A lot of traditional media companies have seen a large selloff in stock prices over the past few months. A few of the bellwethers are down over 50% and counting. The main reason? National advertising is drying up.

National advertising in the media space is won by large ad agencies that typically take 15% of the gross revenue. These agencies focus on winning advertising contracts from the likes of Ford, GM, Johnson and Johnson, McDonalds, etc. Major companies with major budgets to spend.

The dynamic that I am seeing in the industry is that national advertising is beginning to slowdown, and in some cases dry up to nothing.

Investors have taken this news and sold off media companies. Valuations are down as the fixed costs to operating a media company is significant. As revenues go up you make a ton of money as your fixed costs stay fixed. As revenues go down, the fixed cost nature of the business bites and burns cash flow.

A lot of the companies in this space are levered to the tilt and any meaningful downturn could result in a large amount of capital getting burned and potential bankruptcy.

I am invested in a couple small media companies and looking to add to another one should valuations continue to get week. Stay tuned.

Financial Independence During A Downturn

The death and demise of traditional media companies brings me to my last point today. The importance of staying financially independent during all times, especially a downturn.

Financial independence gives an individual optionality to make choices that most others do not get to make. With financial independence you can work when you want to work, not stress about the mortgage, invest excess cash into capital markets and a lot of other freedom that I could list on and on.

But the best part about achieving financial independence is what you can do with during a market downturn.

As asset prices collapse, commodity prices rise, jobs are lost and budgets tighten up, the ones with financial independence can use the chaos on the street to their advantage and grab the largest bucket they can find and collect as much rain that is falling from the skies as possible.

Investing during a downturn is where real money is made. If you have real financial independence, it is time saddle up and start buying when everyone else is panicking. You have the cash reserves and ability to clean up during this period.

Nothing lasts forever and this downturn will eventually end. And if history has taught us anything, its that markets will eventually correct and go higher and higher. The ones who bought in 2008 made a killing. The ones who bought during the March 2020 COVID crash made a killing.

Will you make a killing during this downturn? Or will you sit on the sidelines with your hands in your pockets?

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