AI Fear Trade, Emotional Markets, Avoiding Value Traps, and Current Opportunities
Some thoughts on the recent emotional "AI Fear Trade" along with case studies; and comments on NRP, DOUG, PBI, oil, silver, and DIS
This post is going to be more of a looseleaf collection of a few different topics I’m thinking about and ideas I’m working on. I plan to flesh these out in more detail over time, but I wanted to share some of these thoughts from the investment journal.
My last post had some thoughts on AI and the general market (plus Tickle Me Elmo’s excess inventory issues). I mentioned some valuation concerns, but I also believe there is a big dichotomy between stocks that occupy most of the headlines and much of the rest of the market. I think there are lots of inefficiencies in the market. Within just the last month, we’ve seen major household names in software lose 30% or more of their value. And these fears are rolling through one industry after another, like a virus that’s spreading.
On Monday, SPGI and MCO got infected. These are two dominant moats that have been beloved by investors for over a decade (with the valuation multiples to prove it). Tuesday, it was real estate brokers (JLL, CBRE). Yesterday, it was the trucking companies that were down 15%, and even stocks like Copart (CPRT) and Ritchie Bros (RBA), salvage auctions (junk yards!) were down 7-10% on AI fears.
In recent weeks, I think there has been a lot of indiscriminate buying and indiscriminate selling (based on whether the consensus is that AI will help or hurt). There is a lot of emotion, and emotion always trumps thoughtfulness in the heat of the moment. What if some of these companies get good at using AI and it actually benefits them?
I have seen this being dubbed the “AI Fear Trade”. It reminds me of the summer of 2020 when everything related to internet, software or ecommerce was soaring and everything in the old world was tanking. Zoom captured everything about pandemic demand: video conferencing was a booming industry. The stock soared in early 2020, reaching a peak valuation of 154x sales. Today it trades around 4x. The stock is down 85% from its peak, even though profit margins have continued to grow nicely.
At the other end were the stocks that were left behind: stodgy industries like banks, manufacturers, oil refineries... Valero traded near a 20% FCF yield during this time, and is up 5x since then. There are countless others that did far better, but I chose Valero because I have a soft spot for the stock as it was one of the first stocks I bought 25 years ago when I first started investing. Refiners are cyclical, but there is a massive barrier-to-entry that gives it a durability that I like. Sadly, despite my history with VLO, I didn’t buy it in 2020 (it’s up 5x since then).
The Covid market dislocation, and many others in previous cycles before it, are caused by fear and uncertainty about the future. In the dot com bubble, internet stocks sucked up most of the incremental capital in the stock market, leaving stocks like BRK and AZO (great businesses but viewed as “old world”) left behind at 10 P/E or less. But the latter group soared over the next two years, even as the S&P 500 dropped 50%. It was a bifurcated market that is caused by mania, euphoria, erroneous extrapolation, and general emotions like greed and fear. These emotions lead to hasty decision making… Let’s sell now (or buy now) and ask questions later.
Today, hedge funds, pod shops and momentum investors pile on which tends to amplify the moves in whatever direction the stocks are moving. This creates mispricings. There are lots of opportunities during these times. This means opportunities for mistakes (I made plenty of them) and also opportunities to find some nice winners (there are always new ideas to be found).
The same type of dynamic seems to be happening now with AI. Anything related to AI infrastructure that stands to benefit from the rapid growth in demand is soaring: memory chips, datacenters, even previously sleepy companies like utilities, glass makers and fiber optic manufacturers are seeing frenzied buying in both their underlying businesses and in their stocks. On the other hand, industries that might get disrupted by AI are getting left behind.
I am not bottom fishing in most of these stocks right now, as many of them are still too expensive, but I think the stock price moves we’ve seen recently are generally an overreaction because the reality always tends to be more nuanced and more complicated than the knee-jerk market reactions might suggest. Capacity comes online and shortages get solved (and usually become gluts). Also, companies don’t sit idly by… will SBGI be disrupted by AI or will it be a beneficiary? You can substitute that ticker symbol with many other stocks and ask this same question. The world is a dynamic place and businesses adapt (and yes, some don’t and will be toast). I think the market is usually correct, but it isn’t always, and when emotions and volatility picks up, more stocks get mispriced. I think it’s a stock picker’s market once again.
Taking Advantage of Your Cheap Stock
I’ve heard from other investors that the market is broken or that passive investing has removed opportunities for stock pickers. I don’t see this as the case. In fact, even aside from the AI Fear trade victims, I see lots of cheap stocks (generally in smaller companies currently). I often get asked about value traps. For companies that understand capital allocation and value, a cheap stock is a gift.
As I covered in this post, a company with a stable business that trades at a 15% FCF yield can in effect create its own 15% ROIC reinvestment engine by buying back shares. Assuming no growth and no multiple expansion, this stock will compound at that 15% rate indefinitely. This is obviously theoretical, as companies usually have fluctuating levels of cash flows and fluctuating stock prices, but when cash flows are durable and the company is buying back stock, you have two good possible outcomes: either the valuation rises (which pulls forward returns) or the valuation stays cheap and the stock can compound capital at the rate of the FCF yield. It’s a nice either/or situation for shareholders. And it’s not just theoretical: there are real live examples of how management teams have taken advantage of this gap between price and value.
BVFL is in one of the more boring corners of the more boring industries: small community banks. BVFL is a no-growth thrift conversion that IPO’d (second step) two and a half years ago at $10. I wrote about thrift conversions in the SRBK post for those who need a quick primer. Using the excess capital from the IPO, the company took advantage of its cheap stock, buying back shares as soon as it was eligible to. Last year, they bought back 17% of the shares outstanding. The stock has risen from $10 to $19, a 29% CAGR over the last two and a half years. Not bad for a sleepy bank stock outside of Baltimore.
SRBK, PFSB, and CPKF are others on my list of sleepy banks with excess capital that are buying back shares (see SRBK writeup here). SRBK has reduced the share count by 13% since it started buying back shares on September 20th, 2024 (the 1 year anniversary of the IPO, which is when thrifts become eligible to repurchase shares).
FCNCA is the large cap version, buying back 17% of its shares over the past 6 quarters. The gameplan here is when your stock is undervalued, don’t worry about how to pitch it to investors, just use the company’s cash to acquire good value in your own shares. These stocks aren’t investment suggestions, but rather case studies on how even small companies with little to no passive flows can create great value for owners by making sensible value-based decisions. I think investing in small, cheap bank stocks might continue to be a good sub-strategy in the coming years, as there are lots of cheap banks and an incentive to consolidate within the industry. The key is finding management teams that understand value and are buying back shares. I have a post coming soon with one current example in this space.
NRP
The antidote to a value trap is a business that pays you the cash. NRP might be one such example. I believe NRP is a great business. (See full writeups here and here for more details).
The business is on the cusp of some significant increases of the cash distributions to unitholders. Here’s an overview of their cash earning power (assuming no debt, which soon will be the case):
I think 2026 will be the year that investors have been patiently waiting for: NRP should be debt free soon and will begin paying out much larger dividends. My expectation is that the dividends will be variable and should approximate 100% of the free cash flow that the company earns over time. NRP has earned $16 over the last twelve months, even in a bear market for coal and soda ash, its two primary commodities. The stock is now $124, suggesting a 13% yield on ttm FCF, and a higher yield on the average of $18 FCF/sh of the past decade.
ARLP, a comparable coal-based MLP trades at 10% yield, despite having more debt and more operational risk. NRP is a pure royalty business model without the heavy costs and the debt that ARLP has, and in my view would be worth a premium. With decades of reserves left, along with some valuable other assets that the company views as call options, I’m excited about the future cash flow potential here.
Met coal prices have been rising in recent weeks, which is a tailwind to near term cash flow. Also, demand for electricity continues to grow, which helps extend the life of coal plants which use our thermal coal. Most of our cash flow comes from met coal, but I believe thermal coal’s lifespan will last far longer than expected (it might surprise some people to note that thermal coal globally hit an all time record for consumption in 2024, likely surpassed that level again last year). I think the global economy will be using both types of coal for many decades to come.
I view this asset as a long-term holding almost like an apartment building that should throw off cash flow for many years to come. NRP is hedged nicely against inflation given the cost-free royalty business model (90%+ FCF margins). The company is run by high integrity people who care about unitholders, and I am happy to be partners with them for the long run.
Originally, I intended to write a post about current ideas that I’m working on and plan to be spending time on in 2026. I want to highlight some of these current investments below. Think of these as looseleaf notes from my investment journal. Some of these are new ideas, and some I’ve written about before. I plan to flesh out more details on some of these in future posts. Here’s a few current ideas that are on my desk at the moment: