September 3, 2019—Argentina Flirts With Default as it Looks to Restructure Over $100 Billion of Debt. What Happened to Argentine Bonds?

Tobacco Companies Philip Morris and Altria Confirm Merger Talks. What’s the Catalyst Behind This Deal?

Cycling Equipment Company Peloton Reveals Plans for IPO. Should Investors Buy it?

China De-Escalates Trade War as it Indicates it won’t Retaliate on New U.S. Tariffs. What Happens Next?

A Discussion on the Underperformance of Small Cap Stocks.

Subscribe: Podbean | YouTubeStitcher | Overcast


Welcome investors to the Absolute Return Podcast. Your source for stock market analysis, global macro musings and hedge fund investment strategies. Your hosts Julian Klymochko and Michael Kesslering aim to bring you the knowledge and analysis you need to become a more intelligent and wealthier investor. This episode is brought to you by accelerate financial technologies. Accelerate because performance matters. Find out more at www.Accelerateshares.Com.

Julian Klymochko: Hey, everybody, welcome to Episode 29 of The Absolute Return Podcast. I am your host, Julian Klymochko.

Michael Kesslering: And I am Michael Kesslering.

Julian Klymochko: Today is Friday, August 30th. We are into the tail end of the dog days of summer. Nonetheless, there is a lot of really interesting market action that we want to keep you guys up to date on. This week off the top:

    • Argentina flirts with default as it looks to restructure over 100 billion of debt. We are going to chat about what happened to the trading in its bonds and the bond price.
    • A big tobacco deal potentially, as Philip Morris and Altria confirm they are in merger talks. What is the catalyst behind this potential deal?
    • Cycling equipment company and hot silicon valley company Peloton reveals plans for an IPO. Should investors buy it?
    • Update on the trade war with China de-escalating as it indicates it won’t retaliate on the most recent U.S. tariffs. What happens next?
    • Lastly, we are going to chat about a recent blog post we put out. It is a discussion on the underperformance of small cap stocks.

Big news in the sovereign bond space. As we have discussed ad nauseum on this podcast over the last number of months here, we are having a big bond market rally year to date and treasuries up well into the double digits, I believe north of 20 percent. But not all bonds globally are rallying specifically in Argentina. Those bonds are getting crushed as the country looks to default and restructure over 100 billion in debt.  Argentina’s government is asking creditors such as the IMF, The International Monetary Fund, to push back debt payments and extend maturities on a total of 101 billion of debt. The country’s finance minister is looking for financial relief as Argentina faces a worsening economy and a potential debt default prior to upcoming elections in October. These measures that they are asking for, they would postpone payments on a total of one hundred billion in debt, including a large part of a previous 57 billion bailout package agreed to by the IMF just last year, which was the largest in its history.

This attempt at debt restructuring comes amidst really a crisis that was recently triggered just this month when President Mauricio Macri, he suffered an unexpectedly heavy defeat in a primary election that all but wiped out his chances of re-election in October. In addition, a recent auction of government that failed to attract enough demand from investors, forcing the government to take action. Basically Argentina’s economy right now is very fragile. Inflation is accelerating; I believe it is above 50 percent, unemployment is rising. The economy is being throttled by very high interest rates, and we will talk about the currency. The Argentine peso has lost a quarter of its value since the August 11th primary. This unexpected political event and investors are worried that prolonged political instability ahead of this upcoming presidential election in October could trigger the kind of market meltdown that we’ve seen over and over in Argentina.

Specifically, they have defaulted on their debt already eight times in their history. The most recently just five years ago in 2014, but certainly Argentina does have quite the history of debt defaults. As for its bonds, they have obviously plunged in value here in recent weeks amidst fears of a default. They are trading below 40 cents on the dollar. I believe they are currently bid around 38 cents on the dollar. Bond investors definitely taking some pain there, and ironically, Argentina issued a 100-year bond just in the last couple of years.  Obviously, the price of that has just been absolutely crushed. S&P, the bond-rating agency, moved Argentine debt to the selective default category, which is obviously pretty bad. Analysts estimating that bonds are likely only to recoup about 40 cents on the dollar if Argentina defaults and goes through restructuring. What do you think of this potential Argentina default?

Michael Kesslering: Yeah. I guess the question isn’t if the bonds will be written down. It is a question of how much. This is the point in time where creditors will kind of band together and negotiate how much value they can recover. What is known as distressed debt investing, and so a good example of how sovereign distressed debt investing works is the experience of Elliott Management, one of the last times that Argentina defaulted, which is in 2001. At that point, in time, the country tried to offer the creditors 30 cents on the dollar. Which most accepted. You had mentioned that the IMF is one of their creditors; they are someone who would be more agreeable to accepting an offer.

Julian Klymochko: Because they are not a financial investor. They are not looking to make money. They are more so giving them money to help the stability of the country.

Michael Kesslering: Absolutely, and in this case, Elliot did not accept this.

Julian Klymochko: Right, a bit of background on Elliot now. Elliot is a massive hedge fund they are in I think 30 to 40 billion. There are definitely known as one of the most feared activist and distressed debt investors out there.

Michael Kesslering: Absolutely. Very well known for their activism and really sharp elbowed approach, not only to their negotiations with sovereign nations, but also companies where there’s a lot of interesting stories that have gone on throughout the years with Elliot. Going back to this particular situation, although they won in multiple court cases, they really had no ability to collect any of the amount of money that they were owed.

Julian Klymochko: So, Elliot in this case?

Michael Kesslering: Yes, then in 2012. We are looking at 11 years later, they arranged for an Argentine naval vessel to be seized in Ghana. They convinced the Ghana government to do their bidding, which they were going to use to pay the one point three billion dollars in awards that the courts had awarded to Elliott.

Julian Klymochko: Basically Elliott trying to grab any Argentine assets that they could in order to recover some value.

Michael Kesslering: Basically looking to liquidate a naval vessel, which is pretty crazy. This only further politicize the issue. In 2014, as they were still in the courts, the court appointed a mediator and then eventually in 2012, that mediator, through negotiations with the Argentine government, ordered Elliott, among other holdout creditors. There were some other ones, but Elliott itself got two point four billion dollars. Now, based on their original investment, that is three hundred ninety two percent return, which sounds great, although that is over 15 years. So their annualized return was only in the 11 percent range, and when you factor in legal expenses and just overall firm resources used in this legal battle, as well as the publicity, there was a public relations nightmare for Elliott. This really is not an outstanding return. I would be very interested to see if funds that have been doing sovereign distressed debt investing such as Elliott, Baupost which is run by Seth Klarman. Whether they will be involved in this potential restructuring.

Julian Klymochko: Yes, certainly. I would not be surprised to see some aggressive hedge funds show up in the holders list of these soon to be defaulted Argentine bonds.

Big news in the M&A space with a big potential merger in the mix. Philip Morris International and Altria, two of the largest tobacco companies, they confirmed that they are in discussions for an all stock, 200 billion merger of equals. By merger of equals, this is basically a no premium, all stock deal. This deal would bring back the companies together. They used to be part of the same company when Altria spun out Philip Morris back in 2008. They separated eleven years ago, now they are trying to get back together. The companies are considering this merger to help withstand the decline in demand for tobacco. And that’s their main strategic rationale behind the deal, is that the tobacco business has really gone downhill and you’re seeing declining demand, especially internationally. Demand certainly has been declining in North American developed markets for a while already. But they were seeing international growth, but that is starting to tick down and turn negative. They are looking to alternatives such as cannabis, such as vaping and other sorts of, you know, electronic cigarettes.

Combining Altria and PMI, Philip Morris would create a global tobacco powerhouse with investments in e-cigarettes and cannabis. Now this deal has really long been speculated by the market. Both companies have really been struggling, just declining cigarette consumption. They have faced a pretty tremendous new competitor in Juul Labs, which makes vaping, which seem to be a healthier alternative to traditional tobacco based nicotine. Altria actually invested nearly 13 billion dollars to take a large stake in Juul labs just last year, so that is Altria’s strategy there.

As for merger consideration, as I said, all stock, they are weighing 59 to 41 percent split in which Philip Morris would own 59 percent. Altria own 41 percent. So basically PMI worth nearly one hundred twenty billion. Altria, almost a 90 billion. That is kind of looking at how the cards will be cut here. But like I said, this deal is not definitive. They are still in discussions. If a deal is announced, it could come within weeks. We are seeing a lot of scepticism in the market, which certainly increases risk that this deal does not happen.

Got a quote here from the Citi analyst, he stated. So far, we have not spoken to one PMI shareholders who supports it. We are unconvinced of the benefits of combining. A quote from the Stifel analyst. He is stated while U.S. litigation risk was sufficient to break these companies apart back in 2008, U.S. regulatory risk is on the same plane now, in our view. Certainly shareholders in the market not liking this. Shareholders not impressed. PMI shares lost nearly 8 percent on Tuesday when the story was confirmed. Closing at less than 72 bucks a share while Altria’s stock fell about 4 percent, closing around 45. But so, you know, a lot of negativity around this deal, a lot of scepticism. The strategic rationale does not really seem all that logical, but certainly notable, just the massive size of it – two hundred billion dollar deal. I mean, you don’t see those every day. What are your thoughts on it?

Michael Kesslering: One thing that you mentioned is that back in 2007, 2008, when they had originally done the spinoff, is that one of the things was the declining U.S. market while international growth was reasonably strong. Then the really litigious environment in the U.S. with regards to all the lawsuits that were coming at coming at them. One thing that has changed now is that the international market is actually slowing its growth as well, so it is coming back closer to the U.S. So that is one thing that has changed, but I just wanted to highlight some of the reasons why they would want to combine. From PMI’s perspective, from Philip Morris International’s perspective, Altria with their 35 percent stake in Juul, as you had mentioned, as well as they have the 10 percent stake in of Anheuser-Busch and the 45 percent stake in Cronos. Those are viewed as high growth verticals for Altria.

Julian Klymochko:  Right, and specifically, Cronos was their big cannabis investment.

Michael Kesslering: Yes, and in terms of the ideal on Philip Morris side as well, they do have their own heated tobacco product, which contains tobacco vapour, basically just heats the tobacco. So very similar to what Juul is offering that they are marketing. From Altria side, what they would view as positive is the international exposure that Philip Morris, has to further market for Juul, so that could be interesting in any sort of combination here. As you mentioned, it really just confuses investors on this strategy. It really is like the issues that were present at the time of the spin off still here for the most part. It does seem like a little bit of confusion from a strategic standpoint as well I would like to point out that although volumes are decreasing in the U.S., the cigarette companies do have a significant amount of pricing power where they have been able to offset some of the volume decrease with regular pricing increases. Just because this is an addictive product. In that sense, I think for better or worse, they do have a very captive audience.

Julian Klymochko:  But thus far, investors not liking it. You are seeing about 10 billion-dollar decline in value for both the companies around this story. We’ll see what happens, whether or not they get a definitive deal, but should be an interest one to watch.

Interesting news in the IPO space with cycling equipment company Peloton revealing its plans for an initial public offering. What they did is they filed their prospectus for their much-anticipated initial public offering or IPO. Now, the company Peloton, which is known for its two thousand dollar exercise bikes. You heard that right, two grand. They were actually last valued at four point one five billion in the private markets last year when they raised over 500 million in venture capital funding. So that just happened a year ago back in August 2018. In addition to these exercise bikes, Peloton offers subscription-cycling classes that can be streamed live or on demand into homes. They said that they have more than half a million connected fitness subscribers, which is double the year prior. And its prospectus, it showed that it’s burnt through a ton of cash, which is a recent trend we have seen in most IPOs. It’s burning cash at the fastest clip since it was founded with revenue doubling from the previous year to over 900 million. Revenue is almost a billion dollars, but losses are climbing even faster. They went up for four X to almost 200 million dollars over the past year. Interesting quote from the Peloton, co-founder and CEO. He pitched the company as so much more than, a maker of fitness equipment. “It is no secret that exercise makes us feel good. It is simple science, exercising creates endorphins and endorphins make us happy. On the most basic level, Peloton sells happiness.” Your thoughts on this interesting IPO? To say the least.

Michael Kesslering: Yeah. Despite them selling happiness, what they are selling is a luxury good package together with a subscription service. Looking at a business like this, so in a subscription business, it is important to look at the unit economics of really what is the lifetime value of any new and incremental new customer. There are three main parts of this, so the first being customer acquisition cost. Really, what this is; is just sales and marketing. What their sales and marketing is per new customer over the last year is about twelve hundred dollars, which is very high. That is on par with financial services, certain areas of financial services, which is known as a really high customer acquisition costs business. But you can reduce this because of the gross profit that they do get on the sale of the bike. The positive thing with this 2000-dollar bike is that they actually realize around 42 percent gross margins. You can reduce the customer acquisition costs by about eight hundred forty dollars to three hundred eighty dollars in that range, which is still a high customer, acquisition costs but a little bit more bearable with regards to what their subscription price is.

Julian Klymochko:  Right, and it is interesting on that gross margin, I believe that is similar to the level of an iPhone.

Michael Kesslering: Absolutely. Which is pointing to the fact that it is a pretty reasonable business model. Then moving to the next point in the lifetime value equation is the monthly churn. This is where things get really interesting with the company is what they report is a point eight percent monthly churn.

Julian Klymochko:  And by churn. You mean how many subscribers are leaving and not paying the money anymore.

Michael Kesslering: Yes, and so with a point eight. They reported churn rate, it averages to an average customer lifetime of ten point four years. The important thing to remember is that what the LTV formula for an additional customer, the unit economics, is really sensitive to the churn metric. If you increase this just to 1 percent, the average customer lifetime is eight point three years down from ten point four, and if you further increase that to one point five percent, that reduces it down to five point six years. So you can see how this becomes really important what these churn metrics are. The fact is, is that their churn metric has actually been artificially low for the last couple of years as they have aggressively marketed their bikes. What they have done is offer them for zero dollars upfront on a payment plan over thirty-nine months. But the thing is, that these subscriptions are rolling off in the next couple of years. So we really don’t understand how these new cohorts or those original contract were sign if those customers are actually going to continue subscribing.

Julian Klymochko: Right or even the original customers, those perhaps would be the most keen on the product and the service, are the new subscribers as likely to have the same sort of lifetime value to them?

Michael Kesslering:  Absolutely, and what would really make this a lot easier, which some other subscription business model companies do, is they really show the cohort analysis, which Peloton really doesn’t do, which just makes this churn metric a little bit harder to justify. If you do take their reported value and then moving on from there, you have your gross revenue, gross profit per user. It is a thirty-nine dollars subscription, their gross margins on that are about 42 percent as well. And why it is so low? You would think that this would be a higher margin on the subscription side, but it really comes down to the music licensing is they do have to pay a significant amount of money to license the music, and music is a really important part of the Peloton experience. I believe music is mentioned one hundred and seventy four times in the S1. It is a very important part of the business model.  Any of you can do your own LTV calculations on your own with an appropriate discount rate; typically, it is in the 10 percent range. But when I go through the math here, it does look like if you use there reported monthly churn, you do get a positive value for a customer. That is great in and of itself, but what becomes really important is what is the total addressable market? Now, you had mentioned iPhones with Apple. Well, pretty much everybody in North America at least needs a cell phone or wants a cell phone.

Julian Klymochko:  Right.

Michael Kesslering: Not every person in North America is interested in a Peloton in a very expensive luxury good like a peloton bike.

Julian Klymochko:  Sure.

Michael Kesslering: I have not done any strong analysis into what their addressable market is. But that would be very integral in deciding on whether this is actually worth a valuation of 5-7 billion dollars.

Julian Klymochko:  Right and I think if we were to boil this down to a real simple way of thinking about this. Now, you mentioned there are historical metrics, which look attractive, and I believe that the stock could work if they continue on that path of steady, profitable unit economic growth. But my main concern is that of business model risk. We see history littered with failed or faddish fitness trends. My main concern here is Peloton Netflix or Bowflex. Obviously, Netflix has low churn, they have a huge addressable market where customers continue to pay the monthly fees and they have pricing power. They raise prices, customers continue to pay, and they grow their subscribers, and they have been for, you know, over a decade. Then Bowflex was kind of like a flash in the pan. It was hot for a while and then decline. Now you are seeing a bunch of dusty old Bowflex equipment sitting in basements and for sale at garage sales. That is kind of a major concern here, which kind of gives me pause. The other thing is, you know, the competitive angle to it. I know Peloton competitors SoulCycle, they actually tried to go public in May 2018, but they backed off due to lack of demand blaming market conditions. But that could temper some demand behind this IPO. In addition to that, earlier this month, SoulCycle actually announced an exact competitor to Peloton. Some seem to think that perhaps that this business model, maybe they be able to replicate it. Nonetheless, I think there is bad risk here. I think that stock market is littered with failed fitness concepts that come out with massive growth numbers and then are proven to be a fad trail off and then crash and burn the stock prices. I certainly think investors should keep that in mind. In my opinion, I put this one in the too hard pile. It is kind of hard to judge whether or not it is a fad and at what point that will change.

Michael Kesslering: Absolutely, and just to address the main point of whether it is a fad is that currently they actually do have a very engaged user base. Now, that is currently the company has only been around for about four years developing like with their selling their actual product. I don’t know if that’s long enough to be a very strong sample size, but in terms of their customers, now, 92 percent of their customers who have purchased equipment are still subscribers by the end of their fiscal year 20 19, which was the end of June. Which is a pretty impressive number on its own. When looking at the churn metrics, but you do have to consider that people were buying these at aides with zero money down. With that, you were given the subscription, and so once those are all off, it will be really interesting to look at how those customer engagement are looking moving forward. The other interesting aspect is that they have added a little bit of gamification to their business model because you can just buy a subscription without the bike but in that you are not allowed to go for the leader board on your cycle. Other things like that they have added a level of gamification used in the gambling industry. As well as I think that there is a psychological effect of having skin in the game, when once you do make the decision to put two thousand dollars down on a bike, that you’re unlikely to cancel your thirty nine dollars a month membership just because you already view that you have this two thousand dollar investment. That you don’t want to admit to yourself that 2000 dollar investment was a bad was a bad decision.

Julian Klymochko: Yeah. So how do you play it? Buy, short or on the side lines?

Michael Kesslering: As of right now, I’m on the side lines just in terms of I really don’t have a strong grasp of the both the churn and the customer acquisition costs moving forward, because as I mentioned before, the lifetime value of the customer is very, very sensitive to the churn rate. And as well, they’re marketing a ton, they would have to bring that down on a per user basis for me to be comfortable with it.

Julian Klymochko: Wanted to touch on a quick update on the ongoing U.S. China trade war. Now, China’s Ministry of Commerce, this week they offered conciliatory remarks, hoping that the U.S. can cancel the planned additional tariffs to avoid further escalating the ongoing trade war. Now, China indicated that although it had ample countermeasures to retaliate to these most recent tariff increases by the U.S., they indicated that they thought discussions should focus on whether previously implemented tariffs can be cancelled. China has hit back against each previous tariff increase by the U.S. It has been a tit for tat battle. Up until this week. So not responding in kind this time may finally signal a change in their strategy. We certainly saw a bit of a market rally based off this news. Ministry of Commerce spokesman Zong Shan, he stated escalation of the trade war won’t benefit China nor the US nor the world. The most important thing is to create the necessary conditions for continuing negotiations. The other really interesting aspect of what China has done recently with respect to its currency, now its currency has dropped three point seven percent. And China controls its currency, the value of its currency pretty tightly, so China allowed its currency to drop three point seven percent in August, which makes it the largest currency decline in more than 25 years. Analysts are expecting further weakness in the months ahead as policy seekers in China seek to make exports, Chinese exports more competitive as to partly blunt the effects of U.S. tariffs.

Economists see that a 10 percent fall of the yuan against the dollar would boost Chinese economic growth by about zero point two percent. This helps to offset a cumulative drag of almost 1 percent from the planned and existing U.S. tariff. Like we talked about before, what China is doing in devaluing their currency is really to try to stem some of the effects of this ongoing trade war. What are your thoughts on the recent news? I mean, we saw some interesting market action the day that this news came out. S&P rallied one point three percent. So certainly investors liking it.

Michael Kesslering: Absolutely, and in terms of the negotiations, I believe they will begin on Sunday. It will be really interesting to follow those, but I guess just a question of do you think that this is China admitting that the U.S. had more leverage over them than they were letting on to begin with? Or is it just simply a move that is rational, that isn’t necessarily a sign of weakness.

Julian Klymochko: Perhaps, they met the end of their ability to inflict further economic damage onto the U.S. China imports a lot less from the US than the U.S. does from China. Therefore, naturally the U.S. has significantly more power in that trade relationship. I think China just kind of cannot do much else. Right. And we’re saying perhaps that the Chinese economic growth numbers and, the negative currency effects are really starting to affect them. I mean, they would never admit that, but that is certainly a decent thesis to carry. I think that they could be taking that into account in their most recent action of not escalating the trade war, not doing that tit for tat action as we have seen up until this point, and ultimately seeking more talks.

Michael Kesslering: Absolutely and what I’m looking at is kind of the signalling effect of that and what that could potentially mean for their GDP numbers that are coming up to see what sort of effect. Maybe, there is very poor GDP numbers coming up. You really don’t know, but I guess there is speculation abound.

Julian Klymochko: We put out a blog post this week entitled does size still matter, a fresh look at the size premium. What the size premium refers to is the notion that historically small cap stocks or those stocks with the smallest market capitalization tend to outperform large cap stocks on average. There had been a popular study released about 30 years ago that indicated it studied the performance of stocks between 1926 and 1975 and determined that being long a portfolio of the smallest stocks while being short, a portfolio of the largest stocks generated a return of nearly 20 percent annualized, which is pretty exceptional.

We ran a similar study on Canadian and U.S. stocks for the 20 years from 1999 to present. We segmented stocks based on their market cap decile and this portfolios rebalanced on a monthly basis. Most of what we determined on Canadian stocks is that over the past 20 years, the smallest Canadian stocks returned eight point nine percent annually, while the largest Canadian stocks compounded at a slightly lower eight point three percent annually. In this 20-year simulation, there was no discernible evidence that supports the notion that smaller stocks outperform larger ones. We put some money into the simulation after 20 years, one hundred thousand dollars invested in the small stock portfolio turned into about $550,000. While the large stock portfolio turned into about four hundred and ninety thousand. But what’s notable about the 20 year simulation is that, you know, all those small stocks did outperform significantly between 1999 and 2011. Since then, over the past eight years, they have materially underperformed large cap stocks. The portfolio of small cap stocks is actually down 15 percent since 2011.

So eight years and negative double digit performance while the portfolio of large cap stocks over this time period gained almost 50 percent. So significantly adverse relative performance between small cap stocks and large cap Canadian stocks over the past eight years. Now, if we look into the U.S., the evidence of the size is premium it’s even worse. Since 1999, the decile small stocks actually underperformed large stocks.

The small portfolio compounded at seven point three percent annualized, while the large stock portfolio not just slightly higher, seven point four percent annualized return again in the U.S. Really no discernible evidence that smaller stocks have outperformed large stocks over the past two decades.

Looking at the simulation of these two portfolios, we are seeing similarly interesting dynamics that we saw in Canada. That is a material recent underperformance of small cap stocks. The U.S. small cap stocks are actually in a bear market. They are down 25 percent over the past year. Not to mention that they have had a negative return over the past five years, and this is amidst basically a large cap rally. Large cap stocks have only been going up since then and they are really, within a couple percent of their all-time high. Basically our study shows that if there is a small cap effect or if there was, there really isn’t much evidence that there is anymore. So take that into account with your allocating to different strategies exclusively based on size. What we are saying is perhaps that is not a robust investment strategy to allocate capital.

And that’s it ladies and gents, for episode twenty nine of The Absolute Return podcast, as always, you can check out more episodes at if you like it leave us a review and we’ll chat with you next week. Have a good one, cheers.

Thanks for tuning in to the Absolute Return Podcast. This episode was brought to you by Accelerate Financial Technologies. Accelerate, because performance matters. Find out more at The views expressed in this podcast to the personal views of the participants and do not reflect the views of Accelerate. No aspect of this podcast constitutes investment legal or tax advice. Opinions expressed in this podcast should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information and opinions in this podcast are based on current market conditions and may fluctuate and change in the future. No representation or warranty expressed or implied is made on behalf of Accelerate as to the accuracy or completeness of the information contained in this podcast. Accelerate does not accept any liability for any direct indirect or consequential loss or damage suffered by any person as a result relying on all or any part of this podcast and any liability is expressly disclaimed.

Book a Meeting

Schedule a meeting, call or virtual
appointment with Julian Klymochko,
Maury Krupp or Sean Murray
Book a Meeting!