Category: Supply chain trade ideas

• In the heaps of Producer Price Data issued by BLS, there was one curious item in September – an unusual price shift.
• Corroborated by the industry sources, the shift can become a catalyst for many changes beyond petrochemicals.
• Most of the supply chain will suffer, but there are few companies that might benefit.

Looking for change catalysts can sometimes be frustratingly difficult, particularly in the age of data abundance. In the supply chain investment process, I typically follow commodity price shifts, revenue surprises by major companies, corporate actions – most of these events create aftershocks in the supply chains that can be reliably translated into investment theses.
One such area to pay attention to is Producer Price Indices published by the Bureau of Labor Statistics. Although the purpose of data series is to follow inflation, deep industry level monthly pricing data are an excellent source of change catalysts.
The challenge is of course sifting through the hundreds of industries and finding ones with significant price change; luckily this can be automated – I use LINKS Mira for the purpose. September PPI data show a surprise price increase of 8.1% in the petrochemicals industry. Such a significant price increase cannot leave other industries in the supply chain unaffected. One of the industries that I follow – organic chemical manufacturing, for instance, shows an expected 9.8% profit loss due to the price change.
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• Earnings season provides incredible insights into global supply chains.
• Monsanto’s earnings release was by far the most insightful last week in terms of implications for many companies.
• In many ways, there is no need to forecast – the reliability of conclusions (and trades) is a necessary outcome of what Monsanto disclosed.

The earnings season has begun with its regular treasure chest of valuable gems in terms of supply chain trade ideas and insights. Of course, given the abundance of information and analyses combined with the concerted effort on part of the companies and analysts to “manage” investors, it is hard to pick the most promising (read: profitable) insights from the announcements.
While majority of analysts and market participants focus on the ever important earnings per share number, it is arguably the least informative number in a typical announcement. First, most companies “guide” analysts during the quarter with such fervor that there is little information content left in the final number (the well-documented Standardized Unexpected Earnings, for instance, has stopped working for almost a decade). Secondly, since EPS is the line at the bottom of the income statement, most companies have lines above it with sufficient and often hidden “cushions” to even out quarterly earnings. For this reasons, it is often more rewarding to focus on the top line, particularly if the point is to gain insights about other markets.
Revenue surprises in this sense are a good place to begin. Last week most large revenue surprises were on the negative side, which in itself is quite unsettling. In the table below I have added the end markets of each company to see the pattern. Weakness in the oil & gas, infrastructure and materials industries is not surprising, of course.
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• The most tangible impact of Brexit so far has been the falling sterling.
• Near 15% decline of the currency since the vote should in theory create problems for many US competitors.
• Due to the peculiar nature of the British economy, the outcome is a little more unexpected.

A few months ago, when I was asked about the potential impact of the Brexit vote by our clients, my answer turned out to be half right. I was not worried much about a “no” vote for two reasons. First, I assessed the likelihood of a “no” vote as very low – a conviction that was subconsciously biased due to the precedent of earlier Scottish independence vote of 2014. Secondly, I was not too concerned because I knew a bit about the peculiar structure of Britain’s economy and its potential impact on the rest of the world.
Fast forwarding a few months and here we are, the “no” vote has toppled a government and driven the pound to 25-year lows. But what is the impact on Britain’s key trading partners and why is the British economy so peculiar? More importantly, a large and potentially permanent shift in the exchange rate ought to have created investment opportunities?
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• Two very significant events in the week will have implications beyond their immediate markets.
• OPEC’s agreement to cut production, although ineffective in itself, is a trigger for something more significant.
• Deutsche Bank was magically saved by accommodating stance of DoJ, yet the episode highlights the vulnerabilities and the mechanism of a global financial distress.

Events that find their way to the daily headlines have direct and apparent impact on many investors. These events move stocks, indices and markets instantaneously. But there are also second and third-degree impacts that become evident only after a while. Understanding these impacts and potentially converting them into trades can help translate the daily events: anything from OPEC’s agreement to cut oil production to the troubles and then the magic rescue of Deutsche Bank (NYSE:DB), into actionable intelligence.

OPEC agreement
While oil traders, analysts and consuming industries are still coming to terms with the unexpected agreement at OPEC to limit production to 32.5 million barrels per day, the oil price is already up by ~8%.
The fact that the decision is not yet implemented and clearly lacks any implementation mechanism (suffices to say that OPEC member countries have not yet agreed an allocation of cuts – that is yet to be decided), scarcely dampened the bullish oil sentiment. Although many are inclined so, it is not wise to chuck it down to the naïve market participants – the wisdom of crowds must have picked up on lack of credibility.
Deutsche Bank
As it appears in the nick of time Deutsche Bank managed to secure a very amicable settlement with the Department of Justice (DoJ) of “only” $5.4 billion versus the earlier requested $14 billion. Good news of course and a remarkably co-operative DoJ stance, but what really just happened and what was averted, and more importantly, what to watch for going forward?
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• Managing market volumes and prices of steel with administrative resources proves difficult.
• A combination of two dilemmas is likely to result in lower steel prices.
• Car manufacturers stand to benefit from lower raw material prices, but what about other risks?

It is remarkable how telling prices in multiple commodity markets can be. Often, those markets are parts of the same supply chain or linked to several complementary or substitute products. Reading commodity prices in this connected manner yields insights into the strength of downstream industries and can be a basis for an investment strategy with competitive advantage over the market.
One little snag is, of course, the fact that markets are driven not only by the fundamental supply and demand for commodities, but also by liquidity, storage (if applicable), investment or speculation demand. Additional effort should be applied, then, to separate the wheat from the chaff.
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• Bayer’s bid for Monsanto is yet another evidence of a seismic shift in the supply chain power balance: consolidation in agrochemicals and seeds markets.
• The supply chain becomes even more unbalanced, with concentration even high both down- and upstream from farmers.
• Resulting competitive dynamic extremely bearish for farms, farm economics, and as an extension, for farm assets: farmland and equipment. The balance sheet effect here is significant.
• Farmland REITS and farm equipment makers will have to face years of earnings headwind.

Change is the biggest source of return on the stock market. It is the bona fide creator and destroyer of wealth: think of technological change that enabled Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Uber (Private:UBER) or regulatory change that mandated ethanol use in gas or free trade agreement with Canada and Mexico – all these events generated and destroyed wealth for investors at an unmatched scale.This is why when there is tremendous amount of change crammed into a short period of time, one has to take notice. Bayer’s (OTCPK:BAYRY) bid for Monsanto (NYSE:MON) is just such an event.
A large acquisition in itself is already a good indication that the balance of power and economics of businesses in the supply chain will change; more so in the agricultural supplies market, since it is already highly concentrated. Falling agricultural commodity prices have prompted deals throughout the sector, with Dow’s (NYSE:DOW) merger with DuPont (NYSE:DD) in the approval phase, ChemChina’s acquisition of Syngenta (NYSE:SYT), which in turn was a target of multiple takeover attempts by Monsanto.
Further consolidation is bound to have implications for the food/agriculture supply chain and possibly create attractive investment opportunities.
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Summary

• Using global supply network indicators it is possible to find the most favourable markets.
• Structural changes in commodity prices suggest that the ideal industry is positioned as a supplier of energy-related products and consumer of agricultural commodities.
• Ethanol producers are the best match; with a six-moth view these companies are likely to experience continuously improving margins.

Not all who wander are lost.
-JRR Tolkien

We all have to wander

Over the years I have known a great many analysts – field experts, whose in-depth knowledge of the dozen companies that they covered was surpassed only by the amount of detail in their quarterly earnings forecast models. Awesome as their knowledge was, they were as useful to me as the high-end fondue set I bought a decade ago: two out of three days that I felt like having fondue in those ten years I could not remember where I had shoved the set.
Money is made in trading and investment alike when things change – companies surprise with products, markets change requirements or tastes. Since chances that large changes can happen to a small set of companies that one specializes in are slim, one is forced to “wander” the universe of companies. But as Tolkien put it, not all who wander are lost. Especially, if we have a reliable “map” – industrial supply chains.
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