Initiatd on the 4th of April 2025, this position was closed on the 8th of April 2025, from a sense that the market had baked in the likelihood of China’s non-compliance with President Donald Trump’s ultimatum to lift sanctions. The position closed with a return of 34.11%.

Turning and turning in the widening gyre   

The falcon cannot hear the falconer;

Things fall apart; the centre cannot hold;

Mere anarchy is loosed upon the world,

The blood-dimmed tide is loosed, and everywhere   

The ceremony of innocence is drowned;

The best lack all conviction, while the worst   

Are full of passionate intensity.

William Butler Yeats

One of the great puzzles of the economics of risk is the insurance paradox: assuming a world of expected value maximisation, why does a market for insurance exist if the price at which insurers are willing to provide it is higher than the price at which consumers are willing to pay for it? A solution suggested as early as the eighteenth century by Daniel Bernoulli in my favourite mathematics/finance paper of all, “Exposition of a New Theory on the Measurement of Risk”, gives a powerful answer: in a world where , in the long run, catastrophe is certain, one needs insurance to emerge from catastrophe wealthier than one would without it. Insurance makes the insurer and the insured wealthier. 

This is not a long-term thesis, but a short-term, tactical thesis to help navigate the risks of the coming days, and weeks. One of the great realisations I had when I wrote my as yet unpublished Masters’ thesis, “The Nature of Risk”, is that losses have a greater impact on portfolios than gains. In a sketch of an idea, named after my masters thesis, I explained that,

Losses impact portfolios more profoundly than corresponding gains. In truth, although perhaps controversial, this can be shown with very elementary arithmetic: a decay in wealth of 10% requires an 11.11% gain just for an investor to break even, while a 20% decline requires a 25% gain, a 50% decline demands a 100% gain, and a 99% decline requires a miracle. As losses mount, the gains needed just to break even escalate asymmetrically. Whether these losses come in one fell swoop, or in dribs and drabs over time, the demands on a portfolio to earn asymmetrically greater returns soar. Managers and investors are rationally obliged to avoid risk, investing only when they have an edge, and, when doing so, investing in concentrated portfolios, while diversifying across time.

For many investors, this will be a period of escalating losses requiring asymmetrically greater gains just to break even. I see this period as, at a minimum, analogous to the COVID-19 crash, as a period of systemic downturns, an idea that informed my thesis on gold and gold miners. Here, I argue for a tactical, short-term deployment of the ProShares Ultra VIX Short-Term Futures ETF (UVXY) over a holding period of one week to one month. The aim is to not only capture upside potential in hedging volatility but also to protect a concentrated 10-stock portfolio, where 30 to 40% of the value is exposed to steep downturns -such as my position on Meta Platforms-, against tail risk. I suspect I will start off at a loss, and this will carry on till Monday, but as the trade war intensifies and apocalyptic nightmares stalk investors, the UVXY will storm forward.

Downside Volatility Will Be Sustained

At one point, the Wall Street Journal reported that April 3 experienced the second biggest daily loss in U.S. stock market value, with an estimated $3.1 trillion dollars wiped off the market. The WSJ quoted Rob Citrone, a tariff-skeptical hedge fund manager who had bet that the early rally was “crazy”, as saying, “I should have sold more”. I think that that feeling is widespread. When the debris has cleared, there will be a lot of value to be had. I suspect I acted too early with Meta Platforms: the thesis was sound, the timing was terrible. Some investors, citing Warren Buffett’s famous axiom, “Be fearful when others are greedy and greedy when others are fearful”, may swoop in, but that only works if the losses incurred are not so great that one needs a miraculous Covid-sized bounce. Some stocks may not recover for years. The Financial Times later reported that the final losses were $2.1 trillion. My arguments from my gold and gold miners piece remain: we have entered a period of such uncertainty wherein selling will beget more selling, as market participant’s rational fears and their deleveraging and de-risking act to make the market more risky for holders of stocks, a moment of negative momentum, and capital outflows from stocks into gold and other perceived safe haven assets. Furthermore, we await the counter moves of the U.S.’ major trade partners, all of whom have promised strong, carefully considered reactions. This season of mutual blood-letting will send markets into a death spiral until the trade war is called off, or, until there is a sense that a grand bargain can be achieved. 

Although value will likely outperform growth, the typical value investor will still return very low returns because of the gravitational pull of this market mayhem. Moreover, because, at 52%, U.S. portfolios were allocated to equities at their highest levels since the Federal Reserve started collecting data in Q1 1951, there were already rational reasons for the aggregate portfolio to exit stocks. This is an era of rational panic. That means, for the next few days to a month, downside volatility will define the market. 

The UVXY inversely correlates with the S&P 500 so that during periods of systemic distress, it benefits from these cycles. As the fund sheet explains,

ProShares Ultra VIX Short-Term Futures ETF seeks daily investment results, before fees and expenses, that correspond to one and one-half times (1.5x) the performance of the S&P 500® VIX®Short-Term Futures Index.

However, the dear reader should note that trading such instruments incurs significant transaction costs, with the UVXY having a gross expense ratio of 0.95% compared to 0.0945 for the SPDR S&P 500 ETF Trust. Insurance is expensive. One has to believe that downside volatility will be deep and sustained enough for this to make sense. One must balance the expected gains from hedging with these costs, especially over short holding periods.

Past Analogies

While I suspect that this crash will end up greater than the Covid-19 crash, one can use it as a way of benchmarking expectations. Between March 1 and April 1 2020, the S&P 500 slumped some 16.4%, compared to a rise of 187.7% for the UVXY. 

When the UVXY first entered the market October 31 2011, in the wake of the August 2011 stock markets fall, the S&P 500 fell 4.64%, while it gained 21.75%, between October 31 and November 29. 

The final analogy is indirect: during the 2008 financial crisis, specifically between 1 August 2008 and 30 July 2009, the CBOE Volatility Index (^VIX) gained 27.6%, while the S&P 500 declined 28.3%. 

These are the results of a simple buy-and-hold strategy of an instrument that is typically deployed for very short periods. The results are even greater when the VIX is deployed for shorter periods, before decay sets in as the market recovers. At a base value, I expect to gain 20% over the next month from the UVXY, and higher than that in short bursts.

Execution and its Risks

The reader will have to work out the appropriate position sizing and risk management tactics based to offset potential losses. My guess is that losses could be as large as 30% for the year for this period and by extension, for my risk-exposed positions. To sketch out how to think about it, let V denote the portfolio value and H the hedge allocation. My goal is to choose H such that:

H = (L⋅V)/ΔP_ETF

where:

• L is the maximum acceptable loss (targeting a reduction in risk exposure by at least 30%),
• ΔP_ETF is the expected percentage move in the ETF during a crash event.

That allocation can be dynamically adjusted using Bayesian posterior estimates.

The instrument is itself volatile, so a stop-loss order is crucial to preventing a market rally adverse events from exacerbating losses. I recommend setting a stop-loss at a level where losses exceed a predetermined fraction of the hedge position (typically 20 to 30% of H). The UVXY is designed such that it suffers a decay due to futures roll costs, especially in a contango environment. This can erode returns if the market remains volatile without a sustained crash. There is also the issue of timing uncertainty. Miss-estimations are the norm, and can lead to over-or-under-hedging. I could go on. Simply: this is not a guarantee of a gain, either because a sustained crash does not happen, and the fees incurred leave the investor at a net loss, or because the UVXY may not hedge against such a  sustained crash in the expected fashion.

Conclusion

Nevertheless, with the commencement of a global trade war, the prospect of stagflation, geopolitical uncertainties fast-emerging, and the possibility of tighter monetary policy, the probability of a sustained market downturn has increased. What is proposed is a tactical, short-term position in the UVXY as a hedge against systemic market crashes. By combining Bayesian probability with quantitative models for position sizing and risk management, and by accounting for transaction costs and market microstructure, the proposed strategy offers a robust framework for preserving portfolio value in these turbulent times. Nevertheless, there are inherent weaknesses, such as the leveraged decay, liquidity risk, and model uncertainty, and these must be closely monitored.

This investment thesis also appeared on the investment platform, SumZero. The thesis was closed on 24 April 2025, with a pair return of 8.15%.

There are decades when nothing happens; and there are weeks when decades happen.

Vladimir Lenin

There is an old Russian novel, A Hero of Our Time, by the great Mikhail Lermontov, whose title alone is delicious. It is the story of Pechorin, a Byronic figure representative of an age when, to quote Lord Macaulay, a man aspired to be “proud, moody, cynical, with defiance on his brow, and misery in his heart, a scorner of his kind, implacable in revenge, yet capable of deep and strong affection”. I often tell my friends that President Donald Trump is, like Pechorin, “a hero of our time”: regardless of whether one lauds him or loathes him, he is the great totem of the age, and his “Liberation Day” policies of global tariffs represent the greatest reordering of the global economic order since the end of the Second World War. 

Warren Buffett, the second greatest investor of all time -after Jim Simons, of course-, famously does not incorporate political concerns into his investment thinking. For decades, he has been correct to do so. Research has shown that the U.S. president has far less sway over the economy than the typical voter believes. However, all presidents since the end of the Second World War worked within a conventional understanding of the benefits of what has come to be called the “liberal order” of which free trade was an important component. The old order is dead, the new order is in the making. 

In an epoch of fear and trembling, uncertainty reigns, and, in response, investors have and will continue to invest in gold and gold miners. Though the consensus opinion is that tariffs will lead to recession and general immiseration, the White House has marshalled scholarly arguments in favour of tariffs, and some economists, such as Oren Cass, have argued that tariffs have unappreciated benefits that outweigh their costs. For investors, I do not think it matters who is right and who is wrong. Having published a review of 2,000 years of literature on money, I am well aware that sometimes history defies economic theory more often than economists like to admit. What one can say is that investors, influenced by the echoes of the Smoot-Hawley Tariff Act of 1930 and its reputed causation of the Great Depression, and U.S.-China Trade War of 2018 to 2019, know that gold did well in both periods. Indeed, gold is negatively correlated to the US dollar, and outperforms equities during periods of volatility.

Market Perceptions Are Driving a Reallocation of Capital Toward Gold and Gold Miners

What concerns investors is this: the defining feature of the present moment, until some grand bargain is achieved, if ever, or at least analytical clarity is gained, is that investors are fearful and uncertain, and the reaction to that spurs investment flows. In The Alchemy of Finance, George Soros proposed a theory of reflexivity, saying,

Buy and sell decisions are based on expectations about future prices, and future prices, in turn, are contingent on present buy and sell decisions. To speak of supply and demand as if they were determined by forces that are independent of the market participants’ expectations is quite misleading. The situation is not quite so clear-cut in the case of commodities, where supply is largely dependent on production and demand on consumption. But the price that determines the amounts produced and consumed is not necessarily the present price. On the contrary, market participants are more likely to be guided by future prices, either as expressed in futures markets or as anticipated by themselves. In either case, it is inappropriate to speak of independently given supply and demand curves because both curves incorporate the participants’ expectations about future prices.

He suggested that market dynamics are governed by the interaction of two equations:

1. y = f (x),
2. x = φ(y),

where f is the cognitive function in which “the participants’ perceptions depend on the situation” and φ is the manipulative function in which “the situation is influenced by the participants’ perceptions”. The interested reader is encouraged to read the Journal of Economic Methodology’s 2013 series on his theory, in which economists reacted to his ideas. The interaction of these equations leads to feedback loops that drive market trends. Applying his theory to the present moment, one sees how investor expectations of economic malaise have led to capital flowing out of stock markets and U.S. Treasuries and into perceived safe haven assets such as gold and the producers of those safe haven assets, exacerbating the perception of the riskiness of US markets and fueling more outflows to safe haven assets, in a positive feedback loop. The perception of risk, because of the manipulative function, leads to a flight into safe haven assets, creating more risk, ad infinitum. This is analogous to Hyman Minsky’s financial instability hypothesis:

The readily observed empirical aspect is that, from time to time, capitalist economies exhibit inflations and debt deflations which seem to have the potential to spin out of control. In such processes the economic system’s reactions to a movement of the economy amplify the movement–inflation feeds upon inflation and debt-deflation feeds upon debt-deflation.

…

Expectations of profits depend upon investment in the future, and realized profits are determined by investment: thus, whether or not liabilities are validated depends upon investment. Investment takes place now because businessmen and their bankers expect investment to take place in the future.

…

The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

In the year-to-date (YTD), the SPDR Gold Shares ETF (GLD) is up nearly 19%, and the iShares MSCI Global Gold Miners ETF (RING) is up just over 37%, compared to a decline of 8.61% for the SPDR S&P 500 ETF (SPY), and 1.5% for the iShares MSCI World ETF (URTH). It is likely that at the end of this year, gold and gold miners will outperform the S&P 500 and many other market indices. Some may respond that surely gold and gold miners are in a bubble, yet, as Soros (and I) would point out, buying into a bubble is rational if that bubble is sustainable. The investor who bought bitcoin is better off than the investor who put his money with 99% of investors across the world. The question is of the sustainability of that bubble.

It is clear that the European Union (EU), the People’s Republic of China (PRC), and other major economies will respond to the US’ protectionism, creating escalatory rounds of retaliation, even if the ultimate goal for those countries, and possibly the Trump Administration, may be to achieve a grand bargain, the so-called Mar-a-Lago Accord. In Bill Bishop’s Sinocism issue today, he writes on the PRC, whose effective tariffs now stand at 70%, that though the PRC’s “reaction is unlikely to be weak, and I doubt Xi and his team will just roll over and do nothing while trying to negotiate”, there are signs of a desire for a grand bargain in the future. He goes on to say that,

People’s Daily commentator Zhong Sheng has launched a new series – Fully Understanding the Win-Win Nature of China-US Relations 充分认识中美关系互利共赢的本质. As of April 2nd there are two installments. This first one is from March 31st and is titled “Moving Towards Each Other, Letting Investments Better Benefit the People of Both Countries.

Excerpt:

‘The logic of China-US investment cooperation is clear. While there is competition between the industries of the two countries, there is even more complementarity. By leveraging their respective advantages and strengthening investment cooperation, China and the US can fully achieve mutual benefits and win-win results.

The expected tit-for-tat response to the US’s protectionist policies will likely go on for at least a year. The Trump Administration will want tangible results by the mid-terms, and it is in the PRC’s interests to negotiate, but from a position of strength, and that means trying to get to near the mid-terms when they will be able to get a more favourable deal, especially as the PRC does not have the scope to make the fundamental reforms that the United States seeks. If a one-to-two year trade war is the bare minimum in terms of the duration of a trade war, the subsequent decline in trade volumes and build-up of economic inefficiencies will make gold and possibly gold miners, more attractive, as investors hedge against the risks of escalating trade conflicts.​

Even without Trump’s revolution, it is notable that the aggregate investor’s allocation of their portfolio to equities, a measure I call, “equity preference” was at 52% at the end of Q4 2024, its highest level since the Federal Reserve started continuously collecting the component data in Q4 1951. As I explained last year, equity preference is inversely correlated with future 10-year returns, in other words, as the demand for the limited supply of future returns increases, the supply of those future returns declines. the investor who bought the S&P 500 in December and holds it for the next decade, will earn low-single digit returns. Investor portfolios, excessively allocated toward stocks, are now under forced rebalancing, and gold miners are, because of gold prices, one of the few exceptions to the gravitational pull that stocks are feeling. In many ways, this thesis is a thesis contra stock market indices, a put against the S&P 500.

Stable Supply, Supports Elevated Gold Prices

In his book, Capital Returns, Edward Chancellor told the story of Marathon Asset Management LLP, a UK firm that uses what they call a “capital cycle” framework to analyse markets. Chancellor explained,

…high returns tend to attract capital, just as low returns repel it. The resulting ebb and flow of capital affects the competitive environment of industries in often predictable ways – what we like to call the capital cycle. Our job has been to analyze the dynamics of this cycle: to see when it is working and when it is broken, and how we can profit from it on behalf of our clients.

That framework has been subsequently backed up by what economists now call the “asset growth anomaly”: in general, low asset growth stocks outperform high-asset growth stocks, and this explains stock market returns far more than any other factor such as value, size and momentum. Commodities are difficult to invest in because their production cycle follows the “cobweb model”, which means that management makes production decisions with long lead-times, long before they can observe the prices at which their products will be sold, leading to overshooting or undershooting in supply and price fluctuations. For example, according to the World gold Council, the typical time between exploration and first output is 15 years. My first job was running a small gold miner in Zimbabwe in 2007. it was, appropriately, named “Scallywag”. Many of the older gold miners had spent the majority of their careers not actually mining gold, but treating “dumps”, or the tailings from gold processing, because for decades, the price of gold was so low that gold mining was not worth it. Firms such as DRDGOLD Limited (JSE:DRD) in South Africa, who primarily engage in the treatment of tailings, have a longer history of profitability than conventional gold miners. The devastation felt by gold miners in former times was the consequence of excess supply leading to a collapse in prices that made gold mining unprofitable. The entry of capital and subsequent expansion in production portended a collapse in profitability and exit of capital. A joke told to me was, “It takes a small fortune to make a large fortune in gold mining”. A report in Reuters captures the history of the industry:

Anyone acquainted with the industry might find that hard to believe. Historically, gold miners have offered remarkably poor protection against rising prices. Over the past three decades the index of U.S. consumer prices more than doubled and the price of gold rose sixfold. Over the same period, the Philadelphia Gold and Silver Index of listed miners climbed by about 40%. The mining benchmark remains well below its peak in 2011. Since that date U.S. prices and bullion have risen by 33% and 55%, respectively.

Few industries have a more dismal record of allocating capital. After the gold price took off in the early 2000s, miners pursued growth at any cost. They borrowed freely, splurged on new developments, and pushed up costs by extracting gold from low quality mines – what’s known in the business as low-grading. Debt levels at the four senior miners – Newmont (NEM.N), Barrick Gold (ABX.TO), Agnico Eagle Mines (AEM.TO),  and Kinross Gold (K.TO)  – rose to an average 50% of net assets. After the gold price dropped in 2011, the miners were left stranded. Barrick, the world’s largest miner at the time, announced some $23 billion of asset writedowns between 2012 and 2015.

That era is, for now, a thing of the past. Today, gold prices are so high that gold miners can comfortably pay their all-in sustaining costs and all-in costs. Although the gold price has shot up to dizzying heights, part of a run that began around 2002, thereabouts, capex has actually fallen from its peak in 2012. In fact, capex for the top miners globally, across all commodities, has not recovered from the 2012-2013 heights, despite the temptations posed by the commodities boom. The economic result is clear: since 2010, supply has risen from 4,316.9 tonnes in 2010 to 4,974 tonnes in 2024, compounding at just 1% a year. Although demand is currently below supply, on balance, demand is more likely to rise quickly than supply is, pushing prices up. I try to avoid demand forecasts. What is essential is the realisation that the excesses of previous cycles have been avoided, supporting high gold prices. 

A recent discussion in the Financial Times shows the extent to which capital allocation has improved in the industry. Not only have miners shunned capex expansion, but M&A deals are far more conservative. As prices have risen, gold miners have become free cash flow (FCF) spigots. The FT cites a report by TD Securities which shows that, at current prices, Barrick Gold Corporation (GOLD) will earn an FCF yield of 9.5% and the Newmont Corporation (NEM) will enjoy an FCF yield of 7.5%. Kinross has doubled its FCF to $1.3 billion year-over-year. Gold miners have also become better about returning capital to shareholders. Barrick Gold, on the back of doubling its FCF in Q4 2024, announced a $1 billion share buyback. AngloGold Ashanti plc (JSE:ANG) declared a final dividend of $0.91 per share, five times the previous year’s dividend, having said that its balance sheet is at its strongest in a decade. Gold Fields Limited (JSE:GFI) has also said it will initiate a share buyback this year, while Harmony Gold Mining Company Limited (JSE:HAR) has said it will be able to self-fund the construction of a new copper mine in Australia. 

My own research suggests that a high-cost gold miner can make $1,000/oz more than it costs to produce, while low-cost producers can earn half of the gold price in profits. Usually, gold miners do not do as well as gold in terms of returns, but as profitability has risen, the market has started to wake up to the attractive economics of gold mining. In March, gold mining ETFs experienced their first net monthly inflows in six months. We are at a moment now where, if gold continues to do well, gold miners will benefit on the market. The capital discipline within the industry is even more remarkable when one considers that gold miners did not budget for prices in excess of $3,000. They have been built for lower prices, so that they are now earning excess FCF which, based on recent history, will be allocated in a disciplined fashion.

How High Can Gold and Gold Miners Go?

The iShares MSCI Global Gold Miners ETF trades at a price-to-equity multiple of 19.11, compared to 22.3 for the iShares MSCI World ETF (URTH) and 25.02 for the SPDR S&P 500 ETF Trust (SPY). This is, of course, a crude way to look at it if one cannot value each business on its own. If a re-rating results in the iShares MSCI Global Gold Miners ETF getting to 23.66 or thereabouts, an average of the iShares MSCI World ETF and SPDR S&P 500 ETF Trust, the share price will have risen by about 25%. I think the SPDR Gold Shares ETF can match that rise, the thesis working out over the next 2 years.

I recently published an investment thesis exclusive to the investment platform, Seeking Alpha, where I will be covering recent and forthcoming initial public offerings (IPOs). The article is on the Hong Kong-based civil engineering firm, Skyline Builders. From the executive summary of the article is the following:

• Skyline Builders Group Holding Limited (SKBL) is rated Unattractive due to regulatory risks, competitive pressures, and financial instability, despite its strong growth potential and market position.
• The civil engineering industry in Hong Kong is growing but highly competitive and capital-intensive, impacting profitability and requiring significant upfront costs for labor, materials, and equipment.
• Skyline Builders’ revenue model relies on government contracts, making it vulnerable to policy shifts and economic conditions, with significant risks from regulatory changes and PCAOB inspection issues.
• The current stock price implies unrealistic growth expectations; a reverse DCF model shows a potential 97% downside if NOPAT margins and revenue growth remain at historical levels.

The rest of the article is available here.

This investment thesis also appears on the SumZero platform. Initiated on the 24th of March, I closed the position on 4 April 2024 with a total shareholder return (TSR) of -18.44%. The new tariff regime suggested that, while Meta might remain highly profitable, risks associated with its Chinese business, as well as the the rising probability of a recession, would be a drag on profitability. This remains true even if tariff rates ex-China remain at 10%, rather than the highs of the “Liberation Day” policies.

Few companies have so successfully combined growth with profitability as Meta Platforms (META: 596.25/share). A company born out of the miracle of the Internet Revolution, it is charting a path toward leadership in the AI Revolution. However, those investments have come under scrutiny as investors start to worry if Big Tech can earn a meaningful return on them. While the stock price has not quite taken a beating this year, it has not delivered the heady returns that investors have grown accustomed. This has presented investors with an opportunity to buy a firm that earns an “Attractive” rating according to my stock rating methodology.

The Advertising Cycle Is Turning

Adapting from economic structuralism, one should see Meta as a social media monopoly at the meso level and an advertising company at the macro level, where it exists in an oligopoly in which its chief competitor is Alphabet. The first port-of-call when analysing Meta should, therefore, be its advertising cycle. In my article, “Meta Platforms: Its Economics and Valuation”, I explained that,

The price of Meta’s ads is subject to the same laws of supply and demand that I recently showed govern S&P 500 returns. Ad impressions take the place of supply, and the price-per-ad that advertisers are willing to pay for user attention, is demand. Ceteris paribus, as ad impressions rise, price-per-ads decline, and vice versa. The chart below, inspired by Thompson, shows just this relationship, with year-over-year changes in ad impressions usually inversely correlated with average price per ad.

An updated version of that chart is here below:

I went on to say that,

The best time for advertisers to invest in advertising on Meta is when the supply of ad impressions is rising as, all things being equal, this pushes average price per ad down, which has the effect of improving advertising returns and making Meta more attractive to advertisers viz. its competitors, as was the case in 2022. With average price per ad growing in the last three quarters, Meta is vulnerable to more cost effective competition, because prospective advertising returns are lower. Nevertheless, the advertising business remains very strong.

Since Q2’ 2024, when I wrote that article, the supply of ad impressions has increased, softening the rate of increase in the average price per ad rising since 4Q 2023. Prospective advertising returns are not at 2022 levels, but the weakening of Meta’s competitive position in its core business has been slowed, and this hurts competitors.

Costs Discipline is Working

Since 2023, Meta’s annual report has featured a section titled, “Investment Philosophy”, which is really a declaration about their desire to embrace “cost discipline” and to continue to build things. Meta’s push to compete in artificial intelligence has led to an increase in the firm’s costs and expenses, but cost discipline does seem to be working. While costs and expenses have indeed grown, as a share of revenue, they have declined from an all-time-high of 71.2% in 2022 to 57.6% in 2024, below the historic average of 59.4%. As a result, Meta’s net operating profit after tax (NOPAT) margins, which had fallen to an historic low of 29.4% in 2022, are now at 43.2%, above the average NOPAT margin of 40.2%.

Meta’s Industrialisation

Where once software ate the world, today, AI is eating the world, with Big Tech promising to spend some $300 billion in 2025 on AI infrastructure. In an article on digital firms, “Uncertainty, Information and Digital Firms: a Framework for Understanding Meta Platforms and its Peers”, I noted that,

The impact of the internet on the economy has been to decouple matter from information and expand the production possibility frontier. New markets, industries and economic sectors have emerged and continue to emerge, as capital and entrepreneurial planning have launched toward technological infrastructure. Firms have and continue to develop new ways of capturing value, and new forms of economic transactions have emerged and continue to emerge. The possibilities flung open by the internet have also created new forms of firms, firm-types which enjoy increasing returns -the tendency of what is advantaged to gain further advantage and what is disadvantaged to to be further disadvantaged-, and which are compelled to enhance consumer welfare. The Internet Revolution is the most consequential economic transformation of the world since Johannes Guttenberg developed modern movable type printing in 1440.

Key to this was that, thanks to the decoupling of matter from information, digital firms could produce with zero marginal costs, creating a tendency toward oligopolistic and monopolistic market structures. That easy consensus is changing. AI requires investments in infrastructure that are changing the nature of digital firms in a process of industrialization, or, better yet, materialisation. The company’s 2024 capital intensity, as measured by capex/revenue, at 23.9%, is higher than the historic average of 19.2%, and has been rising for the last two years. Since 2022, it has never fallen below 20%. There are only three other years in which capex/revenue has been over 20%: 2012, 2018 and 2019. However, although Meta’s maintenance capex, which I computed using Venkat Pedireddy’s methodology, has shot up from $2 billion in 2015 to $11.5 billion in 2024, as a share of revenue, the cumulative capacity cost ratio of Meta’s infrastructure has declined from 0.11 to 0.07. Quite simply, the economic cost of Meta’s physical investments has declined as this giant firm has continued to grow at astonishing rates. This is important because some analysts have worried that these infrastructure investments could hurt profitability. So far, Meta has continued to be exceptional. The reason seems to be that its existence as a digital firm prior to the AI Revolution, allows it to grow and be profitable at such astonishing rates that it can take on such investments without hurting itself.

Profitability is a Feature

Since 2011, Meta has compounded revenue by 33.9% a year and NOPAT by 37.4% a year. The company’s 5-year compound annual growth rate (CAGR) for revenue is 18.4%. By way of comparison, according to Credit Suisse’s The Base Rate Book, the mean 5-year sales CAGR between 1950 and 2015 was 6.9%, and for firms with annual sales of over $50 billion, it was just 1%. Meta’s 5-year NOPAT CAGR is an astonishing 23.9%. Few companies can match Meta’s growth and profitability at this scale, indeed, its numbers make many small firms look decrepit. Between 2011 and 2024, its average return on invested capital (ROIC) is 31.7%, with the current ROIC being 38.7%. As with NOPAT, Meta has improved its ROIC in each of the last three years. Only four other years have ROIC-levels higher than 2024, and its NOPAT is the highest in its history.

It Matters that Meta is Founder-Led

Mark Zuckerberg remains at the helm of Meta and this is key to its extraordinary success. Not only does it tie management to shareholder interests, it also ensures that, unlike Apple, and Google, for example, Meta is led by someone with the credibility to make big changes to the company. Although the metaverse was value-destroying, Zuckerberg’s credibility allowed him to try something that Tim Cook or Sundar Pichai cannot. Zuckerberg would likely argue that AI will ultimately make the metaverse possible, and indeed, revenues for the Reality Labs division have doubled in the last three years, and if that does in fact happen, it will be because Meta has a builder at the helm with a desire to stake his place in history.

Meta is Reasonably Priced

With a stock price of $596 Meta has a price-to-economic-book-value (PEBV) of 1.98, implying that its NOPAT has a growth limit of 98% from its 2024 level, despite its stellar and exceptional returns. I used my reverse discounted cash flow (DCF) model to tease out the expectations implied by the firm’s current share price. 

In the first scenario, I quantified the expectations implied by the current price: 

• NOPAT margin remains at the present level of 39.3%.
• Revenue grows at 16.9% in 2025, 13.7% in 2026, 12.5% in 2027 and by 14.4% thereafter, in line with consensus estimates. 

In this scenario, Meta compounds NOPAT by an average of 7% a year till 2036, where shareholder value equals the current price. 

If, on the other hand, 

• NOPAT margins falls to its 3-year average of 33.3%
• While revenue grows at its 5-year CAGR of 18.4%

Meta can compound NOPAT by 8.8% a year, down from its 5-year CAGR of 23.9%, and the stock is worth $800 per share today, a 34% upside to the present price. 

While Meta is more richly priced than one would like, Warren Buffett’s observation that, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price”, seems apt at this point.

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of the accounting adjustments made to Meta’s 2024 10-K:    

Income Statement: I made $7.6 billion in adjustments to calculate NOPAT, with the net effect of adding $5 billion in non-operating expenses. The adjustments are equal to 12% of Meta’s GAAP net income.   

Balance Sheet: I made $167.7 billion in adjustments to calculate invested capital with a net decrease of $75.9 billion. One of the largest of these adjustments was $37 billion in operating, variable and not-yet commenced leases, an adjustment which, on its own, is worth 13.5% of reported assets.   

Valuation: I made $161.4 billion in adjustments with a net effect of decreasing shareholder value by $225.5 million. The largest of these adjustments was $80.5 billion in adjusted total debt, representing nearly 5.2% of Meta’s market cap.

This investment thesis also appears on the SumZero platform.

ANY Biztonsági Nyomda Nyrt.¹ (BUD:ANY: 5,960 Ft/share) is a leader in the security printing industry in Hungary and a growing player in Central and Eastern Europe (CEE) and international markets. The business is of high-quality, is possessed of strong competitive advantages, stable cash flows and expansion potential. The firm operates in a structurally attractive oligopoly, with high barriers to entry, long-term government contracts, and pricing power. The company’s rising exports, technological innovation, and strong financial performance make it an attractive investment. Given its solid growth outlook, stable dividend policy, and resilient business model, ANY is well-positioned for long-term value creation. The company earns a Very Attractive rating based on my stock rating methodology, which is itself based on the accounting adjustments I make and the reverse discounted cash flow (DCF) scenarios simulated.

A Diverse Portfolio of Products

The security printing industry is a highly specialized segment within the broader printing sector, focused on producing documents that require protection against counterfeiting, fraud, and unauthorized duplication. Customers, broadly, tend to be governments, who require them for passports, visas, tax stamps, ID cards, and election materials; financial institutions, for secure banknotes, checks, and payment cards, and corporations, for authentication labels, security seals, and event tickets. 

Four secular trends have driven the demand for security printing solutions. First, the shift towards digital identity is transforming personal ID documents, with initiatives such as the European Union’s Identification and Signature Regulations (eIDAS) regulation facilitating online identity services, particularly benefiting transition economies by improving service accessibility and tax collection. Second, private security printers (PSPs) are evolving into service providers, integrating blockchain technology and identity-as-a-service models to meet government demands for secure digital credentials. Third, tax stamps are the fastest-growing security print product, spurred by regulatory changes such as the World Health Organization’s Framework Convention on Tobacco Control, enabling better tracking of goods and counterfeit prevention. Lastly, payment methods are shifting from cash to contactless and mobile payments, with biometric-enabled payment cards and smartphone-based platforms like Apple Pay and Alipay gaining prominence. While banknote printing remains significant, its market share is expected to decline as digital transactions become more widespread. These trends collectively shape the future of security printing, pushing it toward digital and service-oriented solutions.

To meet this multifaceted demand, ANY has a diverse portfolio of products serving this market that fall under five broad categories, Security Products and Solutions; Card Production and Personalization; Form Production and Personalisation; Traditional Printing Products, and Other.

Through this diverse portfolio, ANY delivers a wide and growing range of complex solutions and complete document issuing systems, from biometric data collection, product personalisation and document verification. The company’s solutions often combine a physical product with digital security elements and verification. 

In 2024, the 24% year-over-year growth in security products and solutions revenue was thanks to an increase in sales of election ballots produced with security elements, a rise in passport sales, and other security products, and growth in roll-out tasks of passport issuing systems. The 50% increase in card production and personalisation revenues was due to growing demand for document cards in both domestic and export markets. Revenues from form production, personalisation and data processing grew by 7%, while traditional printing products saw a 1% increase.

The Export Market is Growing

Diversification comes not only from product type but from geographic market, with just over 56% of 2024 revenue emanating from exports, with the firm selling to over 60 countries in five continents. Management believes that its success in the export market is due to growing global recognition of the quality of its innovation. The company’s Document Security Laboratory is staffed by scientists, many of whom are PhD-level, who engage in research and development. In the last few years, their efforts have resulted in 9 active patents. The impact of this innovation touches the entire firm, from security graphics on documents to the security ink used across the world by printers, border control organisations, government departments and other other authorities. The company has produced the world’s only penta-fluorescent ink. 

Although Hungary remains the single largest market, with 45% of revenue in 2023², the African market³ is the second largest, with 24% of revenue. Revenues from the African market grew by 353% between 2022 and 2023, largely due to the company’s expansion into Angola. Africa could prove to be a valuable source of revenue given that, because the continent is starting from a lower base than Europe, but is getting richer, and is younger, demand for solutions such as passports and IDs will be fairly high. I anticipate that Africa will be a sustainable source of fast-growing revenue in the years ahead. Europe, Africa and South America will experience medium growth levels in the next five years, while Asia-Pacific, which ANY does not seem to have meaningful exposure to, will experience high levels of growth.

Barriers to Entry Protect Incumbents

The security printing industry is structured as an oligopoly, where a few firms control the market due to high regulatory requirements, technological barriers, and limited supplier availability. The company’s competitive landscape features firms such as the state-owned banknote printer, Pénzjegynyomda Zrt., and, in the CEE Region, De La Rue from the United Kingdom, a global leader in banknotes and security printing; Giesecke+Devrient from Germany, which specializes in security printing and biometric ID solutions, and IDEMIA from France, which focuses on passports, visas, and smart ID solutions. ANY dominates the Hungarian market and is expanding abroad, particularly in emerging markets like Angola​, as discussed in the section prior. 

The oligopolistic nature of the security printing industry is due to the high transaction costs involved in the business in order to ensure extreme quality control requirements, meet the regulatory hurdles that governments place in order to win contracts, and the limited trust between buyers and sellers, with buyers preferring proven suppliers. The credibility required to be a meaningful player in the industry demands large investments in expensive infrastructure such as printing facilities, investing in proprietary inks, fibers and security tech, and creating incentives to rival the network effects enjoyed by incumbents. 

Since buyers cannot risk supply chain failures, they consolidate their contracts with a few trusted players, reducing uncertainty and favoring large, established firms like ANY. Consequently, growth in Africa, for example, could prove crucial because the company could lock in government business for the long-run, in the world’s fastest growing market. At the same time, the company is highly unlikely to lose current contracts. 

The oligopolistic structure and transaction cost economics of the industry means that contracts tend to be long-term⁴, firms deploy a lot of money into innovating to meet the security needs of the market and firms such as ANY can build close relationships with their clients. Moreover, there are high switching costs for clients. Consider, for example, a country whose passports are produced by ANY and which decides to switch to another supplier. That country would either have to withdraw ANY’s passports, or have systems that can read ANY’s passports as well as the new supplier’s. These features result in firms earning and conserving attractive profits and having considerable pricing power and facing limited competition.

ANY Enjoys Scale Economies

Since 2019, revenue has compounded at about 15.6% a year. As revenue has increased, ANY’s operational efficiency and profitability have improved, with Total Operating Costs and Expenses as a share of Total Revenue, declining from 93.36% to 81.86%, a sign of the firm’s scale economies.

This is especially impressive given that the cost of specialized raw materials such as security paper, biometric chips, and anti-counterfeiting ink, has been on the rise, rising 21% in 2023 and 25% in 2024, due to raw material shortages and export logistics​. As the company has pricing power, it has been able to grow its margins despite rising input costs​. Three reasons seem to be responsible for this: first, the company everage its Hungarian operations to sell globally, secondly, security products, which are higher-margin, have grown grown in importance, and lastly, ANY’s R&D investments in proprietary security features allows the company to command higher prices. 

It is notable that the company’s capital intensity, as measured by the share of revenue devoted to capex, has decreased from about 8.3% in 2019 to 5.5% in 2024, in yet another sign of the company’s scale economies.

Profitability Has Shot Up

ANY’s net operating profit after tax (NOPAT) has compounded at a rate of around 43.5% a year, from approximately 1.8 billion Hungarian forints (Ft) to nearly 11 billion Ft, increasing NOPAT year-over-year in each of the last four years. The astonishing increase in NOPAT is matched by NOPAT margin expansion, which has fattened from 5.3% to almost 15.6% in that time.

In that time, ANY’s capital efficiency has improved as well, from 2.32 to 2.83 invested capital turns. The happy marriage of burgeoning NOPAT margins and invested capital turns has widened returns on invested capital (ROIC) from just over 12.3% to 44.1%.

Dividends Are Supported by Free Cash Flows

Since 2019, ANY has increased its annual dividend from 92 Ft per share to 450 Ft, with a current yield of 7.55%. The quality of dividends depends upon a firm’s long-run free cash flow (FCF) generation. The greater the gulf between FCF generation and dividend payments, the greater the ability of management to sustain and grow dividend payments. In that vein, one observes that since 2019, ANY has generated 15.2 billion Ft, some 15.3% of its enterprise value, and paid out 10.9 billion Ft in dividends. The company’s 6.3 billion Ft in FCF in 2024 has a yield of nearly 6.4%.

A Strong Balance Sheet and Attractive Credit Rating

ANY’s ability to maintain its competitive positioning and navigate any economic turmoil, is bolstered by its strong balance sheet. The company earns an Attractive credit rating based on my credit rating framework.

In addition, with 7.6 billion Ft in cash and cash equivalents as of the end of 2024, ANY has a strong cash position in the event of market distress. As of the end of 2023, the company had an overdraft limit of 4.3 billion. Assuming this remains unchanged -one awaits the overdraft discussion in the coming annual report-, ANY has 11.9 billion Ft in liquidity, with 10.3 billion Ft due in 2025.

Stock is Priced for a 30% Decline in NOPAT

Despite its impressive economics, ANY has a price-to-economic book value (PEBV) of 0.7, implying that the market expects its NOPAT to permanently fall 30% from 2024 levels. I used my reverse DCF model to tease out the expectations for future growth in cash flows implied by various scenarios for ANY. 

In the first, I quantified the expectations implied by the current price:

• NOPAT margin falls to 9.7%, its 5-year average compared to its 2024 level of 15.6%. 
• Revenue grows at 2.7% a year, the global industry’s estimated compound annual growth rate (CAGR) for the 2025 to 2030 period. 

In this scenario, NOPAT falls 1.35% a year to 7.1 billion Ft in 2026, and the stock is worth 5,859 today, roughly equal to its current price. 

If, on the other hand, we assume that ANY’s

• NOPAT margin falls to its 3-year average of 11.4%;
• Revenue grows by just 5% a year, then,

the stock is worth 7,347 Ft per share, a 23% upside from the current price. 

If ANY’s future cash flows are in line with historic performance, and,

• The current NOPAT margin of 15.6% is maintained
• While revenue grows at its 3-year CAGR of 11.6%, then,

the stock is worth 11,067 Ft today, an 86% upside to its current price.

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to ANYs’ 2024 unaudited interim report:   

Income Statement: I made 3.7 billion Ft in adjustments to calculate NOPAT, with the net effect of adding 3 billion Ft in non-operating expenses. The adjustments are equal to 47% of ANY’ IFRS net income.  

Balance Sheet: I made 24 billion Ft in adjustments to calculate invested capital with a net decrease of 23.9 billion. One of the largest of these adjustments was 4.1 billion Ft in excess cash, an adjustment which, on its own, is worth 8% of reported assets.  

Valuation: I made 20.6 billion Ft in adjustments with a net effect of decreasing shareholder value by 12.4 billion Ft. The largest of these adjustments was 13.2 billion in adjusted total debt, representing nearly 15% of ANY’s market cap.

1.  The company’s name is Hungarian for ANY Security Printing Company. ↩︎
2.  2024 revenue breakdowns by country will only be available with the coming annual report. ↩︎
3.  The company does not break the market down by country. ↩︎
4.  Passport and tax stamp contracts often last 5 to 10 years. ↩︎

This investment thesis also appears on the SumZero platform.

AS Merko Ehitus (TAL: MRK1T), the largest listed construction company and residential real estate developer in the Baltics, earns a Very Attractive rating based on my stock rating methodology, which are themselves a product of my accounting adjustments and reverse discounted cash flow (DCF) scenarios. Merko Ehitus presents a rare deep-value opportunity with asymmetric upside. Despite its dominant market position, ability to earn and grow attractive profits, and superior capital allocation, the stock remains significantly undervalued. A confluence of factors -cyclical fears, Baltic market inefficiencies, and a lack of international investor coverage- has created a mispricing that offers an attractive entry point for long-term investors. With strong secular tailwinds in infrastructure and defence spending, scale economies, favourable supply-side constraints, a fortress balance sheet, and deep undervaluation, Merko is well-positioned to deliver outsized returns.

A Vertically Integrated Business

Merko Ehitus operates a two-pronged business model comprising general construction services, which accounted for about 88% of revenue in 2024, and real estate development, which accounted for 12%. The business model is vertically integrated, so that a client can contract Merko Ehitus to execute the entire construction and real estate development process -preparation, design, construction, fittings and warranty-period service, in construction services, and planning, design development, construction, sales, and service during the warranty period in real estate development-. Whereas many construction firms are heavily reliant on subcontracting, Merko Ehitus leverages a vertically integrated model that minimises transaction costs, enhances execution efficiency, and improves quality control. This structure enables Merko Ehitus to capture higher margins across the value chain while reducing reliance on volatile external contractors.

Offerings and Geographic Diversification Lower Risk to Investors

Construction services and real estate development are inherently cyclical industries, tied to economic growth, interest rates, and government spending. However, Merko’s geographic diversification and wide range of offerings, reduce the risks inherent in being in the business. 

Merko Ehitus operates in Estonia, Latvia, and Lithuania, with a nascent presence in Norway. In terms of client location, Lithuania, with 52.6% of revenues, is the largest geographic segment, followed by Estonia with 41.7%, Latvia with 5.7% and Norway with 0.05%. In Lithuania, the firm engages in real estate development, building and infrastructure construction, and public-private partnerships (PPP) projects; while in Estonia, it engages in real estate development, building, infrastructure and road construction, and concrete works; in Latvia, in engages in real estate development and building and infrastructure construction; and in Norway, it engages in real estate development and building construction. Merko Ehitus’ geographic diversification reduces its exposure to any single country’s economic cycle and provides it with multiple pathways for growth as economic conditions change across the region. For example, while transaction volumes for apartment development have largely not recovered from the effects of Russia’s invasion of Ukraine, the rebound in the Lithuanian markets has cushioned the firm from the less robust Estonian and Latvian markets. In an environment of stabilising prices for new residential projects, Merko Ehitus has been able to grow profits, in large part thanks to Lithuania.

The wide range of construction services and products and comprehensive solutions offered by the company reduces operating risk, allowing it to respond to shifts in demand. For instance, in the 2023 annual report, the company’s chief executive officer (CEO), Ivo Volkov, noted that,

Since the real estate market will remain unstable in the near future and the pace of apartment sales is low, we are steering our developments at a pace and volume that corresponds to the new market situation. 

In the near future, we will again focus more on construction service. Our portfolio of work is in about as good condition as can be in today’s turbulent world, counterbalancing the negative impact on our construction volumes and sales from the apartment market slump.

Merko Ehitus’ Scale Advantage

Although Merko Ehitus competes with firms such as Nordecon (TAL: NCN1T) in Estonia, as well as regional Nordic construction firms in select segments, as the largest listed builder and developer in the Baltics, Merko Ehitus can leverage its relationships with its suppliers and contractors to get discounts on the volumes of business it brings. In addition, the company can scale its operating costs and expenses across the region. As the chart below shows, Merko Ehitus has been able to reduce the cost-burden its revenues bear, measured as operating costs divided by revenue, from nearly 95% in 2019 to almost 88% in 2024.

The company’s scale reduces its operational risk and further enhances the de-risking that occurs from the wide range of offerings that the firm has. 

Moreover its scale allows it to compete for long-term contracts and execute or be involved in complex, large-scale projects, such as Rail Baltica. Indeed, for the sixth year in a row, a survey by Kantar Emor found that Merko Ehitus was the most well-known and trusted brand in Estonia. The company’s buildings have earned prizes across the region. For instance, the Merks Viesturdārzs residential project earned the first place in the New Homes category at the Best Building of the Year awards in Latvia 2022, and Vilneles Skverai was declared Lithuania’s best residential project at the Sustainable Development 23. With recognition, comes the opportunity to be involved in more large-scale, and highly profitable projects.

Merko Ehitus’ recent expansion into high-margin infrastructure projects, such as wind energy and national defense facilities, positions it well for structural growth. An example of this is the large wind farm infrastructure project in Lithuania, which the company has been seized with for the last two years. In its 2024 unaudited interim report, management revealed that its Lithuanian team was,

…able to tap into the economy of scale effect and build a record 87 turbine foundations using what was effectively an industrial production process, at a consistent pace and record speed. In addition, risks were avoided, and all of it together yielded significant savings on expenses. Expenses were also reduced by the fact that work on a national defence site in Lithuania are executed ahead of schedule.

These scale advantages have really come to the fore during Estonia’s recession, and an era of interest rate growth in the Baltics and the Eurozone at large: Merko Ehitus has been able to grow despite weakening demand in construction and real estate development, because it can build cheaper than competitors, and win attractive contracts.

Supply-Side Constraints Favour Incumbents

Barriers to entry are the friend of the investor and the economics of construction and real estate development in the Baltics provide incumbents such as Merko Ehitus with a number of benefits. The region has a skilled labour shortage and has faced subsequent, though easing wage growth -except in Lithuania, where it continues to grow-. Not only are skilled labourers more likely to favour working for Merko Ehitus over its rivals, the rising hiring costs place limits on competition from both new entrants and smaller rivals. In 2023, the company ranked as the most attractive employer in Estonia, cementing this view. 

Across the Baltics, housing affordability has declined sharply since 2022, although there is some recovery. While this will and has continued to impact the company negatively, it is cushioned by the fact that, again, given its scale and brand strength, it will be able to close new contracts, and secure order books, at a faster rate than its rivals, improving its competitive position.

A History of Profitable Growth

Merko Ehitus is a highly efficient operator, combining both scale and profitability. Since 2019, Merko Ehitus has compounded revenue and net operating profit after-tax (NOPAT) by 10.5% and 31.6% a year, respectively. A key question for any construction firm is the durability of its margins. Historically, the industry has been plagued by low returns on capital due to aggressive bidding and thin margins. Merko Ehitus, however, has consistently bucked this trend, with NOPAT margin improving from 4.7% in 2019 to 11.3% in 2024, highlighting its ability to extract economic rents despite a challenging economic environment. Key to this has been the firm’s long standing reputation, which ensures it secures premium contracts with both private and public sector clients; the firm’s vertical integration and superior cost controls; a strong balance sheet position that insulates the firm from rising financing costs, providing a competitive edge over leveraged peers; and the benefits from the Baltic governments’ multi-billion-euro investments in renewable energy, infrastructure, and defense projects. From a game-theoretic perspective, Merko’s repeated interactions with public sector clients create a “reputation effect,” where reliability and execution quality lead to a reinforcing cycle of contract wins. Smaller competitors face a prisoner’s dilemma: either compete aggressively on price and risk financial distress or concede market share to Merko.

Merko Ehitus’ invested capital turns remaining unchanged, at 0.86, in that time. Rising NOPAT margins and flat invested capital turns have led to an expansion of return on invested capital (ROIC) from 4.1% in 2020 to 9.7% in 2024.

Attractive Dividends are Supported by Free Cash Flow

Merko Ehitus has increased its annual dividends from €1.00 per share in 2019 to €1.30 per share in 2024. In 2025, the annual dividend will increase to €1.90 per share, and has a yield of 7.48%. Since 2019, the firm has earned nearly €133 million in free cash flow (FCF), some 33% of enterprise value, and paid out almost €94 million in dividends, showing that the firm’s dividend payments have been supported by earned FCF.

Strong Balance Sheet and Credit Rating

Merko Ehitus’ ability to maintain its competitive position is, in part, a function of its strong balance. Merko Ehitus earns a Very Attractive credit rating, with all five criteria of my credit rating framework also scoring as Very Attractive. In the event of adverse economic conditions unfolding, Merko Ehitus’ robust financial health strengthens its ability to navigate through that.

Moreover, with €91.9 million in cash and cash equivalents as of the end of 2024, Merko Ehitus is in a strong cash position to navigate the current epoch of economic uncertainty, and invest counter-cyclically and capture distressed assets at attractive valuations. The company also has overdraft contracts with banks amounting to €51.1 million, of which €44.0 million was unused as of the end of 2024. This gives the company €135.9 million in liquidity, with just €21.3 million debt due in 2025.

In Merko Ehitus’ fourth quarter results, it spent €8.5 million in marketing, general and administrative expenses, or €2.1 million per month. In a worst-case scenario in which Merko Ehitus pays down its current debt, earns no revenue, and covers its full marketing, general and administrative expenses, Merko Ehitus could operate for 55 months without requiring any additional capital. It is, of course, unlikely in the extreme that Merko Ehitus’ revenue would be driven down to zero. Additionally, in this catastrophic scenario, Merko Ehitus would be able to pare down its marketing, general and administrative expenses.

Defense Spending Could Benefit Merko Ehitus

President Donald Trump’s urgings for the United States’ partners in the North Atlantic Treaty Organisation (NATO) to spend more of its gross domestic product (GDP) on defense, have been favourably in the Baltics, where the spectre of Russian aggression looms large. Estonia and Lithuania have both agreed to spend 5% of their GDPs on defence, with Estonia’s prime minister, Kristen Michal, remarking that,

These kind of signals probably are messages from Trump that you should take your defense very seriously — so for me it’s quite understandable. …If you are probably the wealthiest and most free region in the world, you should protect it and invest in your own defense.

This surge in defence spending would make Estonia and Lithuania the highest percentage defense spenders in NATO, ahead of Poland. This rapid escalation in military investment is expected to drive large-scale infrastructure projects, including military bases, logistics hubs, and critical defense infrastructure. Merko Ehitus is well-positioned to secure these contracts due to its proven track record in government-funded infrastructure projects; established relationships with Baltic defense ministries; and expertise in large-scale, high-security construction. This spending spree creates a multi-year tailwind for the company, boosting revenue growth and strengthening its competitive position in public-sector contracting.

Merko Ehitus’ Current Price Implies NOPAT Falls 58%

Throughout this discussion, the macroeconomic headwinds facing the Baltics have cast a shadow. The company’s stock seems, however, to have priced in a catastrophic decline in profits. At its current price of €26 per share, Merko Ehitus has a price-to-economic book value (PEBV) ratio of 0.42, implying that the market expects the company’s NOPAT to permanently decline by 58%. This seems a rather catastrophist view of the company’s prospects. In this catastrophist scenario, The company’s EBV per share is €58, a 123% upside to the present price.

The current price implies a scenario worse than the 2008 Housing Crisis. Using my reverse DCF model, I quantified the cash flow expectations implied by the current price.

Scenario 1

I used the historical revenue declines and NOPAT margins for the housing crisis from 2007 to 2011 to model the catastrophist scenario implied by Merko Ehitus’ current stock price. In this scenario, NOPAT falls by 37% in 2025, and by 5.8% compounded annually for the next five years, at which point it equals the current stock price. This scenario implies that Merko Ehitus’ 2030 NOPAT will be 65% below its 2024 NOPAT, a return to its 2020 NOPAT levels.

Scenario 2: Giveaway Valuation Gives Significant Upside

If one assumes that the Baltics will grow modestly in 2025, and that the wave of defense spending will create, in the least, a floor for Merko Ehitus’ revenue, then the company appears quite clearly undervalued. In this scenario, NOPAT falls by nearly 36% in 2025 and grows by just 0.5% till 2030, for a shareholder value per share of nearly €48, an upside of 83% from the current price. By way of comparison, as aforementioned, Merko Ehitus’ NOPAT has compounded by 31.6% a year over the last five years.

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to Merko Ehitus’ 2024 unaudited interim report:  

Income Statement: I made $4.3 million in adjustments to calculate NOPAT, with the net effect of deducting $3.71 million in non-operating income. The adjustments are equal to 6.7% of Merko Ehitus’ IFRS net income.

Balance Sheet: I made €617 million in adjustments to calculate invested capital with a net increase of €188 million. The largest of these adjustments was €402 in accumulated asset write-downs, an adjustment which, on its own, is worth 90% of reported assets.  

Valuation: I made €121 million in adjustments with a net effect of increasing shareholder value by €58 million. The largest of these adjustments was €65 million in excess cash, representing just over 14% of Merko Ehitus’ market cap.

This investment thesis also appears on the SumZero platform.

Nigeria’s largest palm oil producer, Presco plc (NGX:PRESCO) earns an attractive rating according to my stock rating methodology, driven less by price than the power of its economics and a valuation that is reasonable-enough to justify investment. Presco is uniquely positioned to benefit from a mix of favorable macroeconomic trends, regulatory barriers, and supply constraints that support elevated palm oil prices. While valuation alone does not make it an outright bargain, Presco’s superior economics, competitive positioning, and high-quality earnings suggest significant upside potential. With global palm oil demand continuing to rise due to its ubiquity in food, cosmetics, and biofuels, supply-side constraints, both in Nigeria and globally, create a compelling investment case. Presco’s deep vertical integration, geographic advantages, and strategic market positioning place it at the forefront of this high-growth industry. Investors should consider the risks of climate volatility and policy shifts, but for those with a long-term view, Presco represents a rare opportunity in the African agribusiness sector.

Restricted Supply and Burgeoning Demand Support Rising Prices

Palm oil, an edible vegetable oil extracted from the many clusters of fruit called fresh fruit bunches of oil palm (Elaeis guineensis) trees, has three main end products: crude palm oil (CPO), which is squeezed from the fruit of the oil palm trees and is mostly used as edible oil; palm kernel oil (PKO), which comes from crushing the kernel in the middle of the fruit and is used in cosmetics; and palm kernel cake, which is made from the remaining kernel after the palm oil has been extracted and is used as animal feed. According to the World Wide Fund for Nature (WWF),

Palm oil is in nearly everything – it’s in close to 50% of the packaged products we find in supermarkets, everything from pizza, doughnuts and chocolate, to deodorant, shampoo, toothpaste and lipstick. It’s also used in animal feed and as a biofuel in many parts of the world

This is due to the ease with which palm oil can be stabilized and their efficacy in maintaining flavour and consistency in ultra-processed foods. A 2015 study found that the average person consumes 7.7 kg (17 lb) of palm oil a year. The WWF found that two-thirds of palm oil consumption goes into food; nearly a third is used in industrial applications and consumer products such as cosmetics and cleaning agents, detergents, and soap; and 5% is used in biofuels, although the country-to-country mix varies. 

Fragmented markets with goods in rising demand often follow what economists call the “cobweb model”: production rises to meet demand, given the lag between production decisions and price observations, a glut emerges, causing a collapse in the price of said goods. An investor’s task then is to question if there are reliable constraints on supply that support elevated prices. Vegetable oil economics are defined by restricted supply and rising demand, which has driven a surge in vegetable oil production and prices. Since the 1960s, vegetable oil production has grown markedly, with palm oil production outstripping the rest since 1978, and global palm oil production compounding at 7.34% a year. The reason is simple: palm oil accounts for a third of the world’s vegetable oils while utilising less than a tenth of its cropland. This productivity makes it ideal for meeting the world’s rising demand for vegetable oils. On a per hectare basis, oil palm yields are 11 times greater than those of soybeans, 10 times greater than those of sunflowers, and seven times greater than those of canola.

The Food and Agricultural Organisation (FAO) estimates that 50% more food must be produced in order to achieve food security by 2050. At present, the world is already off its 2030 goals for achieving Zero Hunger. This is particularly acute in Africa, the only region in the world with a growing population, with the third largest economy in Africa by nominal GDP and set to have a population of 312.7 million by 2040, and the 14th largest economy in the world by 2050, local demand for palm oil is likely to continue to grow. At present, Nigeria is a net importer of palm oil, as it struggles to scale production to meet domestic demand. Dr Celestine Ikuenobe, the previous head of the Nigeria Institute for Oil Palm Research (NIFOR), told the Nigerian Tribune that Nigeria requires 3 million tonnes of palm oil a year and is currently only producing 1.4 million tonnes a year. 

Indeed, the government has worked to revive palm oil production since the turn of the century, making land available, and providing aid, in a bid to meet domestic demand and compete with Indonesia. Nevertheless, a combination of climate change and capacity constraints on the part of the Nigerian government have made it hard to properly grow palm oil production. Stagnating supply is not just a Nigerian story: production has fallen in Indonesia and Malaysia as well, despite rising demand, not only for food, but, crucially, for use in biofuels, as the shift from fossil fuels continues unabated. As with Nigeria, climate change and capacity constraints, not merely from the government, but from the financial sector, have made it hard to grow production.

Barriers to Entry Protect Presco

The most important of competitive advantages are barriers to entry. These barriers to entry are a function of the enormous transaction costs involved in creating a competing firm: the capital investments needed are high, with Presco’s invested capital as of 2024 being N238.67 billion, and there are regulatory constraints and land acquisition challenges that are hard to overcome. Presco’s deep relationships with local distributors and local communities place it at the head of the queue when it comes to acquiring customers and land. A rival would not only have to match Presco’s capital investments -as well as that of the other oligopolists-, it would have to break their relationships with local distributors and local communities. So, the industry dynamics not only protect Presco’s position, they tend to smooth the capital cycle. 

In terms of regulations, it should be understood that regulations are, whether they are good or bad, a transaction cost. Concerns about the impact of environmental, social and governance (ESG) impacts of palm oil production have led to regulations such as the European Union’s Regulation on Deforestation-free Products (EUDR), exact costs for producers that will discourage the emergence of market entrants and protect large producers from competition. In addition, these costs are passed through to consumers, and Isabella Weber’s work on price controls suggests that “large corporations with market power have used supply problems as an opportunity to increase prices and scoop windfall profits”. In other words, firms have the ability to profit from supply problems. Regulations are likely to grow as the world tries to control the impacts of palm oil production on the environment. 

In Indonesia, expansion has been further slowed by the number of land disputes the country’s 1,000 palm oil producers are involved in, such as those involving Astra Agro Lestari. In 2012 -I could not find later data-, 59% of Indonesia’s palm oil producers were involved in land disputes. In 2021, the country recorded 4,000 land disputes between local communities and palm oil producers.

Geographic Concentration Presents a Fertile Risk

Oil palm trees are native to west and southwest Africa, with the species name, guineensis, referring to the historic region of Guinea, as opposed to the modern-day state. In the last century, it has become naturalised in Madagascar, Sri Lanka, Malaysia, Indonesia, Central America, Cambodia, the West Indies, and several islands in the Indian and Pacific Oceans. American oil palm E. oleifera and the Attalea maripa, are also used to make palm oil. 

Although Nigeria for a long time led the production of palm oils, it was supplanted by Indonesia and Malaysia decades ago, at a time when Nigerian palm oil production was essentially moribund at the end of the twentieth century. Largely through World Bank loans and governmental support, the industry was revived. In 2021, palm oil accounted for nearly 40% of the world’s production of vegetable oils, with around 56% of production emanating from Indonesia, and approximately 26% from Malaysia, even though there are 42 producers of palm oil across the world. Nigeria is the world’s fifth largest producer, responsible for just about 2% of global production. Globally, it is cultivated on large plantations and smallholder plots.

This state of affairs presents obvious risks, risks which the world has already experienced: on April 28, 2022, President Joko Widodo announced that Indonesia was suspending “cooking oil raw materials and cooking oil” exports in order to “ensure the national availability of cooking oil” and keep it affordable.  That announcement was tempered a few weeks later, when the government exempted crude palm oil exports from the ban. Although the ban was lifted three weeks later, it revealed the risks inherent in the global production of palm oil, that any disruptions to production in Indonesia or Malaysia could send the price of palm oil soaring. Climate change and capacity constraints are likely to define the industry for the foreseeable future, making rising long-term prices more likely. Ex-Nigeria supply-side shocks will benefit Presco and the Nigerian palm oil industry as a whole.

Vertical Integration Deepens Dominance

The palm oil value chain consists of producers of varying sizes, processors, traders, consumer goods manufacturers (CGMs) and retailers. At the refining and internal trading level, the market structure is oligopolistic, whereas at the production level, supply is fragmented, with suppliers from smallholders to large plantations, and manufacturing encompasses a vast array of CGMs in a rapidly diversifying market. 

Presco’s vertical integration is a consequence of the fact that it derives a competitive advantage from controlling the entire value chain from plantation to refined products: by owning its own oil palm plantations, palm oil mills, palm kernel crushing plants and vegetable oil refining plants, it can guarantee round-the-year supply of high quality speciality fats and oils, such as Palm Fatty Acid Distillate (PFAD), Crude Palm Kernel Oil (CPKO), Stearin, Olein, Refined Bleached Deodorized Oil (RBDO), and Special Palm Oil (SPO), while bringing transaction costs down, gaining cost predictability, and reducing dependency on fragmented supply chains. Not only does vertical integration drive down costs, it gains an ineffable advantage in innovation. An example of this is Presco’s addition of a Jerry can plant to bottle palm oil and vegetable oil in 5 and 25 litre jerry cans, so that they are more accessible by households. 

Presco’s vertical integration, and scale advantages allow it to produce and sell larger amounts of palm oil with lower cost and higher quality, while spurring innovation and realizing higher NOPAT margins than the competition.

Soaring Growth with Record Profitability

Presco’s revenue has ballooned from N12.72 billion in 2019 to 198.16 billion in 2024, compounding at 58.64% a year, while its NOPAT has even more impressively ballooned, from N2.92 billion to N83.77 billion, compounding at 95.63% a year. In tandem, the company’s NOPAT margin has leapt from 14.82% to 42.28%, while its invested capital turns have improved from 0.65 to 1.04. As a consequence of rising NOPAT margins and invested capital turns, Presco’s return on invested capital (ROIC) has surged from 9.58% to 43.92%.

Owner-Operators Align Incentives for Success

Belgian agro-industrial firm, the Société d'Investissement pour l'Agriculture Tropicale or the SIAT Group has been involved with Presco since 1991, the year of Presco’s incorporation. Siat’s ownership and management of Presco, and the personal investment of its CEO, Felix Onwuchekwa Nwabuko, in Presco, mean that the interests of management and shareholders are properly aligned. 

When Siat came on board, Presco operated from 2,700 hectares on the Obaretin Estate, a palm plantation that had previously been owned by the old Bendel State Government. Siat’s involvement came at the request of Presco’s controlling company, textile manufacturer, President Industries Nigeria Limited (PINL), who valued Siat’s experience in plantation investment and management in West Africa. Siat has grown its shareholding from 33% in 1991 to 50% in 1995 and then 100% in 1997 when PINL divested its shareholding in the company. Presco listed on the Nigerian Stock Exchange in 2002, with Siat retaining a 60% shareholding. 

Under Siat’s management, Presco has obtained the 2,800 hectare Cowan Estate at Ajagbodudu from the Delta State Government; a further 6,500 hectares at Obaretin Estate, the 13,100 hectare Ologbo Estate from Edo State Government; and more recently, the 17,600 hectare Sakponba Concession in the Orhionmwon Local Government Area in Edo State, from where Presco will grow oil palm and rubber.  Moreover, until 2021, Siat fully controlled Siat Nigeria Limited (SNL), before transferring its assets to Presco in order to deepen Presco’s vertical integration. SNL’s acquisition brought with it 16,000 hectares of oil palm plantations that SNL had bought in 2011 from the River States Government’s Risonpalm operations. In total, Presco has a land bank of 40,000 hectares, of which 25,000 are fully planted. 

Rasheed Sarumi represents Siat on Presco’s board as chairman. Nwabuko serves on Presco’s board as a non-executive director and has direct and indirect interest in Presco, totalling 151,700 units. Nwabuko, who previously served as the managing director of Presco and SNL from February 2015 to March 2024, was succeeded by Reji George as Presco’s managing director. 

This alignment of interests is manifest in the growth of Presco’s ROIC -which, as aforementioned, grew from 9.58% in 2019 to 43.92% in 2024-, and economic profit. I found that Presco’s economic profits swelled from N2.45 billion to N46.96 billion between 2019 and 2024.

Presco Has Further Upside

At the present price of N750/share, Presco is trading at a 119.6% premium to its economic book value (EBV). this is hardly “attractive” as I have signaled. My stock rating methodology balances earnings quality and valuation to assign stocks into a bucket somewhere between “very unattractive” to “very attractive”, and Presco scored as attractive, thanks largely to its earnings quality and an attractive MICAP that underestimates Presco’s competitive positioning. 

The company’s price-to-EBV (PEBV) ratio of 2.27 implies that the market expects Presco to grow its NOPAT by 127% from current levels with a market-implied competitive advantage period (MICAP) of just six years. In order to grow NOPAT by 117% from current levels, over the next six years, Presco would have to grow revenue by its 3-year compound annual growth rate (CAGR) of 33.11%, while maintaining its 3-year NOPAT margin of 31.47%. As these operating hurdles are within Presco’s historical range, they are fairly achievable, even though they are aggressive.  

If Presco can grow revenue at its 5-year CAGR of 58.64% over the MICAP, while maintaining its 3-year NOPAT margin, the stock is worth N2,104/share today, an upside of 180.5% from the present price.  

One can of course foresee catastrophe: while the markets expectations are rooted in Presco’s operating achievements,  fall in revenue growth to a still-high 20%, due, say, to climate induced disruptions, while maintaining 3-year NOPAT margins, would mean that the company is worth just N227/share.

This investment thesis first appeared on SumZero on 27 December 2024, when the position was initiated. It was closed on the 4th of April 2025, with a total shareholder return (TSR) of -4.91%.

Steel Dynamics, Inc. (STLD: $117/share) proves a simple and compelling thesis: first, its alignment of shareholder and management interests have ensured that the firm has created shareholder value, and, given that these incentives remain in place, the firm can be trusted to act in the best interests of its shareholders; secondly, free cash flows (FCF) generation has been such that the firm should be viewed as a source of safe, growing dividends; lastly, the risk-reward profile of the firm, as expressed by its earnings quality and valuation, make it an attractive investment in terms of my stock rating methodology.

Vertical Integration is a Competitive Advantage

Steel Dynamics was founded in 1993 as a steel company operating one electric arc furnace (EAF) steel mill in Indiana, and has since evolved into what it describes as a “lower-carbon emissions metals solutions company, providing diversified high-quality products and enhanced supply-chain solutions”, operating seven EAF steel mills shipping, 15 flat roll steel coating lines, a copper rod and wire operation, 70+ metals recycling operations, and 9 steel processing operations, with a 16 million tonnes steel shipping capacity. It is the fifth largest steel company in the world, in terms of market capitalisation, and the fifth largest steel producer in North America. 

The company has a vertical manufacturing model connecting its metals recycling platform, and steel mills and fabrication operations, which helps it hedge against steel price volatility. Vertical integration allows Steel Dynamics to locally source scrap material; melt the recycled scrap metal into steel in its EAFs, which are more energy efficient and produce less greenhouse gas emissions than traditional blast furnace technology; roll that steel into finished steel products, fabricate them, and reclaim end-of-life steel material as feedstock for new steel products. Consequently, in periods of low steel demand, the company can source its needs internally, whereas in periods of high steel demand, it can purchase what it needs. Not only is its metals recycling platform its largest supplier of recycled ferrous scrap, it is also expected to be its largest source of recycled aluminum scrap in its planned aluminum operations. As the reader will see in the chart on Steel Dynamics’ capital allocation, a consequence of that is that there has been negative net working in three of the last five years, with a net investment in working capital of $1.3 billion between 2019 and the LTM. This vertically integrated model permits Steel Dynamics to have a higher through-cycle steel production than other steel producers, and to enjoy low, highly variable costs, industry-leading profitability.

Peer-Group Leading Profitability

Revenue has compounded by 11.3% a year from 2019 to the last twelve months (LTM) ending in 3Q 2024, from approximately $10.5 billion to $17.9 billion. By way of reference, according to Credit Suisse’s “The Base Rate Book”, the 5-year mean and median sales compound annual growth rates (CAGR) for the 1950 to 2015 period were 6.9% and 5.2% respectively. Steel Dynamics combines exceptional growth with profitability. Net operating profit after tax (NOPAT) has shot up from $720.4 million in 2019 to $1.73 billion in the LTM, compounding at 19.2% a year. In parallel, Steel Dynamics’ NOPAT margin has enlarged from 6.9% to 9.7%, while its invested capital turns declined from 1.53 to 1.38. The result of this is that, as will be further discussed further in the section, “Alignment of Shareholder and Management Interests”, that returns on invested capital (ROIC)¹ have grown from 10.6% to 13.3%. 

Steel Dynamics’ profitability compares favourably to peers such as Nucor Corp. (NUE) and CMC (CMC).

Alignment of Shareholder and Management Interests

Steel Dynamics’ long-term incentive plan (LTIP) performance awards seem geared toward achieving the firm’s financial, operational and strategic goals. In order to ameliorate the principal-agent problems that are so rife in business, 25% of the long-term incentive plan (LTIP) performance awards are tied to annual after-tax ROIC relative to a “steel selector comparator group”, composed of companies such as Nucor and the Commercial Metals Company. The rest of the awards are equally tied to revenue growth, operating margin, and cash flow from operations as a percentage of revenue. 

In its 2024 Proxy Statement, management remarked that it believes after-tax ROIC “provides an indication of the effectiveness of the company’s invested capital” explaining that it calculates after-tax ROIC as: Net Income Attributable to Steel Dynamics, Inc / (Quarterly Average Current Maturities of Long-term Debt + Long-term Debt + Total Equity). There are flaws to this measurement, one of which is that the numerator, total net income, includes non-core, non-recurring items, and another of which is that its measure of invested capital does not account for items such as after-tax accumulated asset write downs, so that management is not being properly judged for its stewardship of invested capital. Nevertheless, in 2023, the firm earned an after-tax ROIC of 32%, the highest of the S&P 500’s materials companies. According to my calculations, Steel Dynamics has grown ROIC from around 10.6% in 2019 to nearly 13.3% in the LTM. This compares favourably with peers Nucor and CMC, whose ROIC rose from 9% to 11% and 6% to 9.3% respectively.

We can assess management's performance in terms of growing shareholder value through an analysis of its economic profit². Since 2019, Steel Dynamics has compounded economic profits by 14.2% a year, from $234 million to $466.3 million³.

Tying executive compensation has a further benefit to the firm and its shareholders: in an industry whose capital cycle is historically defined by wild ebbs and flows, having leading firms such as Steel Dynamics, Nucor, CMC, and U.S. Steel tying some portion of executive compensation to either ROIC or return on capital employed (ROCE), strengthens the industry’s sense of value and helps to spread more rational industry behaviour. Firms are less prone to aggressively expand capacity in response to rising prices, aware of the dangers of industry-wide overcapacity and that growth can be value-destroying. For those firms whose executive compensation is already tied to ROIC or ROCE, the odds of their benefitting from value-destroying behaviour on the part of rivals, are higher.

Value-Creating Capital Allocation

Steel Dynamics’ capital is allocated to eight major areas: mergers & acquisitions (M&A), sporadic purchases of short-term investments, capital expenditures, dividends, debt repayment, gross buybacks and changes in net working capital.

Of these, I will discuss three elements to show management’s skill at value-creating capital allocation: dividends, gross buybacks and capital expenditures.

Dividends are Supported by FCF

Steel Dynamics has expanded its regular cash dividends from $0.24 per share in Q1 2019 to $0.46 per share in 1Q 2024, compounding annual dividends by 13.9% a year. In 2024, the firm is paying a dividend of $1.84 per share, with a yield of 1.57%. Moreover, although in that period FCF has declined from $233.4 million in 2019 to $509 million in the LTM, for a cumulative $5.7 billion, it has only paid out $1.4 billion in dividends. This gulf between FCF generation and dividend payments is an expression of the quality of the dividends and the scope which the firm has to grow them.

Gross Buybacks Reward Continuing Shareholders

According to my calculations, Steel Dynamics has traded below its economic book value (EBV) throughout the 2019-2023 period, only trading at a price-to-EBV (PEBV) ratio above 1.0 in the LTM, so it is hard to assess management’s ability to resist the temptations of buying its stock at elevated prices, especially given that the LTM PEBV of 1.22 is attractive.

What can be said is that gross buybacks have rewarded continuing shareholders, building their long-term value per share. Buybacks have also reduced Steel Dynamics’ share count from 214.5 million to 153 million. With $1.3 billion in buybacks in the LTM, the firm has a buyback yield of 7.22%, for a total shareholder yield of 8.79%.

Steel Dynamics’ Hidden Growth Capex

Investors typically use depreciation and amortisation as a proxy for a firm’s maintenance capex, however, as Venkat Ramana R. Peddireddy’s work reveals, this often leads to the costs of inflation and technological obsolescence being ignored. Calculating Steel Dynamics’ maintenance capex using Peddireddy’s method shows that in the LTM, depreciation and amortization exceed maintenance capex is $57.5 million greater than decoration & amortisation, suggesting that the firm’s growth capex is larger than investors may conclude.

Investments into Working Capital

As aforementioned, Diamond Hill’s net working capital as I calculate it is equal to its operating current assets (operating cash, which I estimate to be 5% of total revenue, operating investments -investments less Deferred Compensation Plan Investments in the Funds-, accounts receivable, and other current assets), net of its non-interest bearing current liabilities (NIBCL) (accounts payable and accrued expenses and accrued incentive compensation). Net working capital has burgeoned from $100.5 million in 2019 to $125.7 million in the LTM, or 92% of the firm’s total assets. Importantly, revenue is equal to 116% of net working capital, revealing an asset light business model. Net working capital has compounded at 4.6% per year, showing the modest incremental investments needed to grow the business. Operating investments compose 91.4% of total assets and are the largest component of net working capital. This is because, while operating current assets have risen from $135.8 million to $154.7 million in that time, the value of non-interest bearing current liabilities (NIBCL) has declined from $35.3 million to $29 million. In 2019, 2020, and 2022, net working capital has declined, making it a source of cash. This is important given that research by Robert L. Kieschnick, Mark Laplante, and Rabih Moussawi reveal that, “the incremental dollar invested in net operating working capital is worth less than the incremental dollar held in cash for the average firm”.

Steel Dynamics Has Room to Run

With a share price of $117 per share, Steel Dynamics has a price-to-EBV (PEBV) ratio of 1.22, which indicates that the market expects its NOPAT to grow NOPAT by 22% from its present levels, despite a history of compounding NOPAT by 19.2% a year. I used my reverse discounted cash flow (DCF) model to analyse the implied value of the stock based on conservative assumptions about Steel Dynamics’ future growth in cash flows. 

In the first scenario, I quantify the expectations baked into the current price, and assume that,

• Steel Dynamics maintains its current NOPAT margin of 9.67%, 
• revenue declines 3.4% in 2024, then grows 2.27% in 2025 and 7.51% in 2026, in line with consensus estimates, before growing 4.9% thereafter. 

Under this scenario, the company has a market-implied competitive advantage period (MICAP) of less than a year. 

If one assumes that:

• Steel Dynamics’ NOPAT margin rises to 13.3, its 3-year average, and,
• revenue grows by 11.3%, its 5-year CAGR

Then the stock is worth $155, an upside of 32% from the current price.

If, however, 

• NOPAT margin is 12.65%, its 5-year average, and,
• revenue grows by -0.56%, its 3-year CAGR

Steel Dynamics’ stock is worth $148, an upside of 26.5% from the current price.

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to Steel Dynamics’s quarterly reports for the LTM period:

Income Statement: I made $203 million in adjustments to calculate NOPAT, with the net effect of reversing the impact of $23.9 million in non-operating income. The adjustments are equal to 1.4% of Steel Dynamics' GAAP net income.

Balance Sheet: I made $3.1 billion in adjustments to calculate invested capital with a net decrease of $2.1 billion. The largest of these adjustments was $1.8 billion in excess cash, equal to 11.6% of Steel Dynamics' reported assets.

Valuation: I made $4.6 billion in adjustments with a net effect of decreasing shareholder value by $3.1 billion. Aside from total debt, the largest adjustment to shareholder value was $943 million in estimated deferred tax liabilities, representing nearly 5.3% of Steel Dynamics’ market cap.

1. NOPAT/Average Invested Capital ↩︎
2. Economic profit margin*invested capital, where economic profit margin refers to ROIC - weighted average cost of capital (WACC). ↩︎
3. DataWrapper does not recognise LTM as a valid date format, so "2024" in the charts really means "LTM". ↩︎

In his paper, “The Nature of the Firm”, Ronald Coase proposed that firms exist because there are transaction costs to organising economic activity through the price mechanism such that when they exceed the benefits of market transactions, it becomes cheaper to organise certain economic activities within a firm, where they are coordinated administratively, rather than in the market. One can apply this framework to understand why active asset managers have had their pricing power, in the form of fees, eroded over time.

The Steady Erosion of Pricing Power

That same logic explains why passive management funds exist: asset managers face enormous transaction costs in attempting to create a diversified portfolio of stocks that can outperform the broad market, from research costs to trading costs and commissions and the tax implications of trading. Passive management funds exist because their broad diversification, and lower trading frequency and the scale they can achieve, allows them to capture the broad market return, while eschewing the transaction costs of active management. Active managers are at a disadvantage because they have higher transaction costs and are less likely to achieve market returns for clients even before they deduct for fees.

The paradox of investing is that it is essential for the preservation and growth of wealth, and yet, most investments fail to preserve wealth or beat their benchmark. Economic losses, rather than profits, define investing, not merely because they are more probable, but also because losses impact portfolios more profoundly than gains. Indeed, such is the nature of risk that, in the long run, even in a fair game¹, wealth is destroyed. Daniel Bernoulli called this, “nature’s admonishment to avoid the dice”. I noted in a discussion on future S&P 500 (market-weighted) returns, that,

In his earthquake of a paper, “Do Stocks Outperform Treasury Bills?”, Hendrik Bessembinder found that, between 1926 and 2017, four in seven U.S. stocks had lower compound returns than one-month Treasuries. In terms of lifetime dollar wealth creation, he found that just four percent of public companies generated the net gain for the entire U.S. stock market, with the rest earning returns that merely matched Treasury bills. In “Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks”, Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, found that this positive skewness of stock returns was a global phenomenon. Between 1990 and 2020, 55.2 percent of U.S. stocks and 57.4 percent of non-U.S. stocks, had lower compound returns than one-month U.S. Treasury bills. In terms of lifetime dollar wealth creation, they found that just 2.4 percent of the 64,000 firms they studied generated all the net gain of the global stock market. Ex-U.S., just 1.41 percent of firms generated $30.7 trillion in net wealth creation. The implications seem clear: an active manager is more likely to create a portfolio that underperforms one-month Treasuries, than outperforms it. 

In a study of the cost of using active managers, “The Deadweight Loss of Active Management”, Moshe Levy studied the Sharpe ratios of U.S. active equity funds against that of the S&P 500 -as a proxy for the market-, using the CRSP Survivorship-Bias-Free Mutual Fund Database for the December 1991 to March 2021 period. The results are shocking: 92.1% of funds underperformed the S&P 500 and investors incurred total annual losses of $235 billion, due to $186 billion for inefficient portfolio allocation, and $49 billion in fees. When firms outperform the market, that outperformance is typically modest, whereas when they underperform the market, the results are often cataclysmic. So, while the S&P 500 had a Sharpe ratio of 0.288, and the average Sharpe ratio of active funds was 0.192, the best Sharpe ratio among active funds was 0.392, an outperformance of only 0.104, while the lowest Sharpe ratio among active funds was -0.475, an underperformance of -0.763. 

Yet, people must invest, and for most of the modern era, they have relied on active managers to do so. In his paper, “Exposition of a New Theory on the Measurement of Risk”, Bernoulli gave the world’s first mathematical argument for the benefits of diversification, saying that “it is advisable to divide goods which are exposed to some danger into several portions rather than to risk them all together”, so that the geometric return of the portfolio approaches its arithmetic return. For investing, nothing is a greater testimony to the power of diversification than passive funds. A mass of stocks, most of which fail to beat the humble Treasury bill, are together able to generate positive returns in excess of those of Treasury bills, and such that their geometric mean approaches its arithmetic mean. As passive funds are more diverse than active funds, with, for example, the S&P 500 holding 500 stocks, or the Russell 3000 holding 3000, their chances of capturing the excess returns available on the market are far higher than for more concentrated portfolios held by active funds. 

Since the advent of passive investing instruments, active managers have been battling two powerful forces: firstly, that they face greater information costs in attempting to find that slice of the market that generates excess returns, and secondly, that given the unlikeliness of this, they are more likely to generate inferior returns pre-fees, than passive funds, although William F. Sharpe believed that active managers can match market returns pre-fees and that it is fees that are the source of inferior active management returns. Empirically, studies of active US large cap funds have found that pre-fees, the odds of outperformance are a coin flip and post-fees, the odds crash toward zero. Data from S&P Global’s SPIVA, which measures the performance of active managers against the S&P 500 and other indices across the world, shows that in the last fifteen years, 87.98% of Large-Cap active managers have underperformed the S&P 500, and only 12.02% have outperformed it. Morningstar’s research found that real estate is the only category in which the 10-year success ratio for active managers exceeds 50%. However, outside of US large caps, Dr Alex Beath of CEM Benchmarking found that,

…the average fund in the CEM database has outperformed their benchmark by 67 basis points (bps) gross of costs and 15 bps net of costs. It is reassuring to note that the evidence shows that large institutional investors are able to add value over long periods, even if more than 75% of the gross value added is eroded through costs.

The United Kingdom’s Competitions and Market Authority (CMA) noted that 

…‘buy-rated’ products outperform their respective benchmarks on a gross of AM fees basis by approximately 23 bps per quarter, on average. These results are highly statistically significant. This is also true however for all the AM products in our sample regardless of their rating, which are also found to outperform their respective benchmarks albeit by a smaller margin (17.4 bps per quarter, on average). 

156. Once we take into account AM fees, we find that recommended products continue to outperform the market though only by 4 bps per quarter on average. These results are no longer statistically significant. In other words, because of the variability in the net active returns of ‘buy-rated’ products in the data, the observed outperformance against their benchmarks may be attributable to chance. 

²At scale, a sliver of outperformance may be enough justification for institutional investors to continue to use active managers. In fact, passive instruments make up just over half of US long-term funds, and 39% of the global funds market, and represent just 23% of global assets under management (AUM). Nevertheless, the effect of these forces is to create downward pressure on fees so that they now approach those of passive managers, a pressure that is likely to continue. 

Given that few active managers have succeeded in fundamentally reducing their information costs and earning extraordinarily high long-run returns, the typical active manager has to accept declining fees. Quite simply, active managers do not have meaningful “pricing power”. A study by McKinsey tells us that revenue-weighted pre-tax operating profit (NOPBT) margin declined three points between 2019 and 2023, while revenue compounded by 3.3% a year, and costs by 4.3% a year. Similarly, in that period, model portfolio constituent, Diamond Hill, experienced a fall in its NOPBT margin from 61.9% to 50.3%, as a result of the confluence of revenue compounding by an anemic 0.018% a year, while adjusted operating expenses compounded by a margin-eating 3.7%. 

In her 2023 letter to the shareholder, Heather Brilliant, CEO of Diamond Hill -whom I have written about here and on SumZero-, said, 

And, of course, costs have been rising for asset managers — including distribution costs, growing product suites and the related data and technology to support them, operational and IT costs, and the ability to retain top investment talent to deliver strong results for clients. At the same time, rising revenues over the last 15 years have enabled a lack of cost discipline to persist within the industry. With revenues now slowing, the industry is starting to see the implications of higher cost structures.

This is the fundamental reality and challenge facing active managers. The other reality is an opportunity and it is that, not only must people invest, but some people want to earn returns greater than those available in a passive investing instrument and will continue to be attracted by active managers. 

Conflicts of Interest Are Endemic to Active Management

In Coase’s theory of the firm, he argued that firm size is a function of rising marginal costs of organisation, so that a firm will stop growing when the marginal costs of organisation equal the marginal benefits. The active asset management industry suffers from diseconomies of scale. It is ironic, for example, that just as Warren Buffett became recognised as a kind of prophet of a secular religion, Berkshire Hathaway was approaching diseconomies of scale. Buffett himself observed that his best period was in the 1950s, when he “killed the Dow”. Increasing scale reduces the investable universe, focusing attention on larger and more widely understood opportunities -eroding any information advantage, i.e; increasing information costs-, and carries the risk that large block trading negatively impacts the strategy³. Michael Jensen’s agency theory views the firm as a “nexus of contracts” tying stakeholders together, wherein a principal delegates decision-making authority to an agent in a relationship of asymmetric information. Conflicts of interest arise when contracts and financial incentives do not align an agent’s self-interested desire for wealth and leisure with the shareholder’s need for wealth maximisation. Yet, as Chengdong Yin discovered, active fund managers are paid more as the size of fund assets increase, even at the risk of hurting fund performance. Thus, typically, there is misalignment of interests in the typical investor-fund manager relationship, with firms policing their size as much as is needed to maintain style average performance. With compensation linked to both fund performance and fund size, a manager who cannot earn market-beating returns is rationally obliged to continue to grow fund assets, because what counts is the total compensation package, not the share attributable to performance or size.

1. That is, one where one has an equal chance of winning and losing. ↩︎
2. The SPDR® S&P 500® ETF Trust has a net expense ratio of 0.0945%. ↩︎
3. Renaissance Technology, a firm that enjoys pricing power, found that in commodity markets their trading activity directly impacted market prices. ↩︎