What Rates Mean for META, Amazon & Oil | Value Options Letter

During their recent episode of the Acquirers Podcast, Travis and Carlisle discussed:

• AI Is Making It Easier Than Ever to Start a Business
• How Cash-Secured Puts Add a Margin of Safety
• Are REITs a Better Investment Than Bonds at 5% Interest Rates?
• Could AI Bring Inflation and Interest Rates Down?
• Is Amazon Stock Cheap Compared With Its History?
• Why Market Volatility Can Mean Higher Options Premiums

TRANSCRIPT

[Tobias] Hi, I’m Tobias Carlisle, joined as always by Tim Travis. This is the new Value Options Letter podcast. We’re going to talk about value options and the macro, the micro, and everything else in between.

Tim, just before we get started, let’s just define value options for folks.

[Tim] Yeah, so value options are when you take a undervalued stock based on thorough fundamental analysis like cash flows, balance sheet, capital structure, and then you’re intertwining conservative income generating strategies with that stock to generate income and reduce risk. So, for instance, covered calls are one way that you do that when you have a stock that’s already undervalued, but maybe you sell a call at a price that you’d be willing to sell the stock at. That’s a great way to add additional income and kind of instil a discipline of actually selling at your target price.

And another strategy is selling the cash secured puts where you’re selling a put at a price that you’d be willing to own the stock at, where you think it’s got good upside potential, and it creates a heads or tails situation where heads, the stock expires above your strike price and you keep the whole premium that you collected. We target double digits almost always. And tails, your so-called worst case scenario is you end up getting exercised because the stock expires below the strike price, you end up owning it, and then you can just hold the stock, or you could implement what we call the wheel strategy when you own it and you sell covered calls at that point.

[Tobias] Yeah, so the way I like to think about it is if you like a stock, and so that’s the first part, that’s the crucial part, and you like it at a particular price. If you sell a put, that’s a little bit of a hard thing to wrap your head around, but selling a put puts you into the same downside risk as being long the stock, because you’re taking the downside risk. And the compensation that you receive up front is the premium.

And because these are cash secured, you put up the cash, then you receive a premium. So you want to make sure that you’re getting enough premium relative to the amount of cash that you put up to justify the position. And so if the option expires worthless, you get the premium on the cash secured put, and that’s hopefully what we set to make that double-digit internal rate of return.

And on the other side, if the stock moves, and stocks are volatile in the short term, you don’t know which direction they’re going to go. They take a random walk. It can be up or down.

So if it takes a random walk down, then you’ve got a little bit of premium buffer.

How Cash-Secured Puts Add a Margin of Safety

So you’re already buying with a margin of safety. It adds an additional margin of safety.

So the stock is put to you. You should be excited to get it at that very discounted price. And so the two outcomes should be good outcomes, even though nobody likes a stock when it goes down.

But if you like it long, and you get it at a very good price, and your timeline is long enough, then that should be a good outcome. So we’ve sort of discussed what we’re looking for. But let’s just talk a little bit about the context, the backdrop at the moment, the macro backdrop.

Perhaps it’s always a little bit uncertain, but it seems a little bit more negative, perhaps, than it ordinarily is. And two reasons for that. One is that rates are cranking up everywhere around the world in all the developed markets, Japan, Europe, and America.

The 10-year in America has gone over 5%, which we haven’t seen 5% since 2007. I don’t want to raise 2007 like it’s a boogeyman, like that was the precursor to the big crash. We’ve been normalising rates for a few years now.

So to get to the 2007 level, that’s really just close. 5% is not really a high rate. The long-run average of the 10-year is closer to 6%.

So we’re certainly not, by any means, in a particularly high rate environment. We’re just in an increasing rate environment. And that makes people a little bit nervous.

And Buffett’s also got that great line about interest rates acting like gravity on stock prices. So as rates go up, prices go down because you have an alternative. And so one of the things we were talking about before we came on is the 5% 10-year treasury yield.

Why buy a REIT with a 5% yield?

Are REITs a Better Investment Than Bonds at 5% Interest Rates?

[Tim] Well, because when you have a shorter-term treasury, like let’s say the 5-year at 5%, your upside is limited, right? Because it’s not a super long-duration bond. So you don’t have that convexity that you have on the longer-duration-type bonds.

What’s convexity, just for folks who aren’t deep in the market? It’s kind of the impact of interest rates. I’m not a mathematician, but it’s the impact of interest rates.

[Tobias] How much it moves, right?

[Tim] Relative to the movement. Exactly. And so with a lot of the real estate investment trust, for instance, you’re buying them right now at like…

I mean, like Vichy Properties, for instance, has a yield of 7.5%, a starting dividend yield of that. And then the actual cash flow yield is substantially higher than that. It’s around double digits, close to that.

And then you also have CPI escalators on their leases. And this is the case for most REITs, CPI, contractual. So those yields are going to keep going up.

And then you also have more inflation protection, Toby, because real estate tends to go up in value over time. And the cost to build something like the Bellagio now, can you even imagine? I mean, can you imagine what it would cost to build the Bellagio?

The Venetian, Caesar’s Palace right now, relative to when they were built. So there’s a few tailwinds there. It doesn’t mean that you shouldn’t own bonds.

I think that if you’re a buyer of bonds, there’s probably more opportunities now than there has been in quite some time. But that’s kind of why. It’s not an apples to apples comparison.

There’s much more growth potential. Because a lot of that real estate, commercial real estate, or even residential, is more long duration in nature. I mean, they have 30-year leases for Vechey, for instance.

If REITs do move down, I think it’s very likely you see a huge run in some of these names. I mean, I saw that realty incomes trading at a really, really low level, one of the lowest valuations that’s been at a long time, which is probably the biggest name in the real estate space. So I think that you could be like, if you’re buying now, Toby, into the face of a very significant adversity with the headlines that you referenced, you might be setting the stage for a 10, 15-year cycle for some of these REITs, like you saw in the early 2000s, for instance, where, yeah, you’re going to have some volatility, especially when you get the financial crisis, but the returns were quite good.

[Tobias] There’s been some carnage in bonds, clearly when they were issuing bonds at very low rates. If interest rates went up, that was going to impact bonds negatively. If folks who are not deep in it might not know, but bonds trade inverse to interest rates because the coupon on the bond is fixed.

So as the rate goes up, the coupon becomes less attractive. To make the coupon equivalently attractive to the rate, the face value of the bond or the market price of the bond has to come down. Sorry, not the face value, the market price of the bond comes down.

So because REITs have been up very substantially since 2020 or 21, I forget when the exact low was, but there’s been this enormous drawdown in TLT, which is the ETF that tracks the bonds. They’re off like 50%. I don’t know where clearly rates can go much higher.

In the 70s and 80s, we saw rates that were in the teens. And if that happens, then all bets are off. Bonds will trade much, much lower.

And so will equities at the same time. Everything will trade much, much lower. I wonder how much flexibility the Fed has there because you’ve got on one hand, you’ve got the federal government, $40 trillion in debt.

The interest rate is something like, or the interest expense on it is something like $2 trillion a year. That’s a very substantial portion of tax revenues and government revenues. And so there’s sort of a limit to how low they can get rates.

They’re a little bit caught on that side. And then at the same time, we’ve had inflation running pretty hot. The inflation is the rate of change.

I think this is this thing that everybody’s sort of relearned recently that inflation is a rate of change. So when they say that inflation has come down, they don’t mean that prices have come down. They just mean the rate of change.

So it’s not accelerating as fast as it was, but it’s still going up pretty fast. I notice things that I have bought, things that I don’t buy regularly, but I bought some protein, whey protein powder through Shopify. And Shopify records the last price that you paid for it.

And so I bought some in December last year and I paid a hundred bucks for one of those big tubs. And then I recently repurchased it. So it’s like 10 months later and it was $144.

And I checked it before then, it had been pretty steady because I was so shocked at how much it was. And it’s been pretty steady before then, but that’s a gigantic leap. And then you can see those charts that show inflation may not be running as hot as it was, but the price level is still very high.

And I think that a lot of folks are really feeling that, but it makes it hard to cut rates in that environment. They’re really, really stuck. So I think that some of that uncertainty weighs on equity prices as well, because as I said earlier, equity prices tend to be, interest rates act like gravity on equity prices.

And I think that we’ve seen that in the market, something like 60% of stocks are trading down below their 50 day moving average, even though the index is up, it’s just because there’s this extreme concentration in a handful of these very large tech stocks that have been doing pretty well, but now they seem to be free cashflow sort of diminishing because they’re spending so much on the AI CapEx buildup. What do you make of all of that?

[Tim] A lot to unpack there. So I would agree that the market, like the NASDAQ hit a new high yesterday, but most people aren’t really seeing that unless like really overweight semiconductors. Because even like Amazon, for instance, is down over the last couple of months, but a lot of people are very heavy in semiconductors right now.

So if you’re in that trade, that’s where the momentum is. There’s a few things to talk about. So you talked about inflation, and I agree with you, inflation is quite high right now and it’s concerning, but I think we know the biggest culprit.

And the biggest culprit is clearly oil prices, which is a direct result of the war. And then that war has escalated. So I mean, you have now the Houthis capturing that pipeline in Saudi Arabia, and I know there’s been some changes on that.

But it’s a situation where, you know, everyone knows that this war is not in our best interest, you know, as far as the economy, at least, let’s say. And there isn’t an easy way to stop it in the near term. Could a resolution occur?

Yes, it could. And I think it will happen sooner than later. But I think it’s a surprise people.

But once you do resolve that issue, the Strait of Hormuz specifically, there is ample oil production. I mean, there’s the ability to ramp that up quickly. And we have seen that historically, how producers are likely to respond to this, to these prices that they’re getting.

They’re going to pump more and they’re going to drill more. And I mean, there’s going to be huge, huge pent-up demand for that and pent-up supply once it can actually be transported. So I think that that’s a potential way to resolve a big part of the inflation issue.

The second issue, which I think you also touched on or alluded to, is how AI could potentially impact inflation. And, you know, let’s talk about what the hot story of this week really is, is Meta, you know, releasing kind of their consumer-orientated Muse AI product. And for some of us, you know, we’ve been using Claude, we’ve been using ChatGBT, you know, extensively.

And so we kind of have a feeling for what this stuff does. And it’s so powerful. I mean, I’ve said it on this, you know, and other podcasts that I think the transformation is as significant as the Internet.

I really do. And so now, though, people like, you know, maybe my dad doesn’t have Facebook, but his generation, you know, the baby boomer generation, I think that the ones that do have Facebook and Instagram, Toby, they’re going to use this. They’re going to try it.

And they’re going to see for simple things like haggling, you know, haggling prices down on Verizon or their cable bills or something like that. You know, they’re going to save $10, $5, $20. And it’s going to be awesome.

And they’re going to get the scale of what AI can do on kind of that small micro level. And so I think that the efficiency gains, I mean, that’s a very marginal utilisation. It’ll still have big impacts on companies, of course, but that’s a small use issue.

Could AI Bring Inflation and Interest Rates Down?

The capabilities for companies, I mean, unfortunately, to streamline their workforce, you know, the impact, also create new jobs in different avenues. I think there’s the potential, Toby, for it to be deflationary. And I’ve heard some other pretty smart people saying that as well.

And so that’s something where I think, okay, if you can solve the oil transportation issue, and if AI just kind of keeps doing what it’s doing, you know, I think that there’s a case to be made that interest rates go the other way. And going into this year, Toby, everyone thought rates were going down because the Fed said so. You know, that was their forecast.

And so, yeah, a friend of mine told me, you know, all you do is buy bonds here, you get double digit returns. Like, no, no, you don’t. So we’ll see.

[Tobias] Well, Walsh was supposed to be the dovish Fed governor, but he was confronted with, I mean, I like tracking the two-year as a proxy for maybe inflation, but it also tracks where the Fed seems to set the Fed funds rate. And it’s been a pretty good proxy when it’s trading north of where the Fed funds rate is. They tend to raise when it trades south.

They tend to cut, not immediately, but roughly over time. There’s a couple of data sets on the Alfred site that you can see. I track them pretty closely just to see it.

And it’s had a pretty good track record of, in recent times, I don’t really care. There’s nothing that you can do when rates go up or down. You just sort of have to deal with it as it comes.

I just use it out of interest to sort of set my own expectations. But it’s been trading well north of the Fed funds rate. The yield on the two-year has been well north of the Fed funds rate.

So I’ve been expecting a raise. And I think that Walsh was just sort of, if you’re data dependent, if you’re following, a raise is probably what’s coming on. And then it’s still a little bit north of where it is.

There was quite a margin there for a while. And so my expectation is probably that they raise again. And I think that some of those betting sites have a second raise this year is pretty good odds.

I mean, it’s all fluid. It can change at any point in time. But it certainly seems to me that’s possible.

[Tim] Sorry to interrupt you. The way it impacts the long term, Toby, is what’s really important. So the short-term Fed funds rate is important, but how it impacts the long end.

So some people think that, hey, he said he wasn’t going to want to raise rates. The big reason why they wanted Powell out was because he was raising rates. But if he went to raise rates, I think it’s very likely that you would have seen long interest rates go up that much more because you’re basically accelerating inflationary expectations because you’re not meeting the problem that’s here.

And so it might take a reset to get inflation expectations down. So no, those are good points. And it’s interesting, Toby, just how quickly things change.

So whether it’s interest rates, the forecast was interest rates going down. Or if it’s like the AI stuff where it wasn’t that long ago that Gemini and Google rose to huge prominence and saw big stock gains because the Gemini product was becoming so popular. And then ChatGPT and, of course, Anthropic had all the enormous momentum.

And they still do. They still have fantastic momentum. But now you have this Muse product, which for I think most tiers is free currently, and they’re trying to get consumers into it.

And Zuckerberg’s pretty damn good at that. And you’re seeing kind of an impact on like Amazon, for instance, because Amazon blocked Muse from shopping, I guess, and on its site. And so markets are reacting to that.

So it’s interesting how it’s like a racehorse or a horse race, excuse me, where the lead’s constantly changing. And you got to think about how you want to play that.

[Tobias] I think in Mag 7, it’s been interesting to watch Mag 7 because they don’t really trade as a single entity anymore. I think they did for a little while there. But there seems to be quite a lot of dispersion among them, as you point out.

At the moment, Apple was regarded as the laggard, and then Apple’s trading at these absolute nosebleed multiples at the moment. And Amazon, on the other hand, now, because they’re just not really participating in that part of the race, and they seem to have blocked the Muse app from accessing them. They can access the Walmart site.

Is Amazon Stock Cheap Compared With Its History?

So it’s a simple matter, just directing it to the Walmart site. Amazon currently trading at EV EBIT of 22 times, which is as low as it’s been in 25 years. So that’s one of the metrics that I like to track, just because it takes out that impact of the free cash flow spending on the CapEx.

It sort of normalises for all of that sort of stuff. You have to assume that all of those executives in there are pretty smart guys, and they’ll figure it out eventually. But what that indicates is in the short term, Amazon might be a pretty good opportunity.

What do you think about that?

[Tim] Oh, I mean, I agree. As you know, Toby, on the site, we’ve done trades on Amazon, we’ve done trades on Meta, we’ve done trades on Microsoft, and we’ve done trades on Google. And as of this recording, they’ve all been successful thus far.

And what’s interesting is they’ve had different glide paths. So since we started a couple of months ago, Facebook, I mean, Meta just recently has had this huge run. I mean, they’ve had their huge run like really the last couple of weeks.

But Amazon’s actually down a little bit from when we started. But selling puts has been successful. And there was even one trade where we sold a put at $250.

We got exercised. I think the stock was at like $246-ish at expiration. So we collected a premium when we sold the put initially, got exercised.

And then we sold a call at $260. And so we ended up owning the stock at a break even of like $246, $247. And then we were able to ride the stock up to $260.

And now it’s below again. So there actually today, there was a trade recommended suggestion on Amazon, selling a put at a lower price. So absolutely, Toby.

I think that’s one of the benefits of the options element is that I don’t know that with, I don’t know with extreme confidence that you or I would say we know which AI model is going to win, right? But I think we both believe in the business models of an Amazon and a Meta. And when you can buy them at valuations that are far more attractive than historical averages.

And if you believe that the ultimate ROIC, return on invested capital on these massive CapEx is going to be decent. And I think that Bill Ackman did a good job making that argument. What was his argument?

Well, just that, look, I mean, they’re meeting demand with this. I mean, this is not like just building- Yeah, the demand exists. Yeah, yeah.

So, I mean, they’re getting contracts for this stuff that are spaced out and stuff like that. So, I mean, if you get a decent ROIC, you’re going to see those earnings and those free cash flows ramp up once we get to kind of the other side of the CapEx cycle and they can afford it. And yeah, their yield might go up a little bit, but I mean, obviously the ROIC that they’re targeting is substantially higher.

[Tobias] Yeah. Return on invested capital, just for folks who are not tracking it as closely. So, I can see, look, I think a good analogy is Amazon through 2020, they built out a lot of capacity.

And I think the argument was that they slightly overbuilt capacity through 2020, because there was that everybody was locked at home. They were using all those services a little bit more. Amazon may have like overestimated the forward demand at that point.

And so, they built out a little bit ahead and they’ll punish for that in the short term because it crushes your free cash flow, just spending on CapEx in that short term. But because there’s so much demand and demand is growing so quickly, over the next few years, they’ve used all of that capacity and now they’re building more. And I think that that’s really what happens here, even if they overestimate the demand in the short term, ultimately demand catches up to that spend.

I do think that all of that spending is also a little bit inflationary because it’s this huge stimulus going on. The biggest companies in the market all competing for, I think they view it as like a singular land grab that they might miss out on. I don’t know if it’s going to be…

I mean, maybe you get a little bit of lock-in with… I know that I’m locked in probably too. Although I use four different AIs simultaneously and I have them all running little bots and doing little functions and things like that.

And it’s a hassle to transfer one of those little bot functions to another one. You’d probably need to take a day to transfer them all up.

[Tim] So, it’s not… Lock-in is not that bad.

[Tobias] Yeah, it’s manageable. Exactly right. But there is a little bit of lock-in.

And certainly if I got a much better deal from another one, I would shift over. Interestingly, Muse runs on an older, less powerful version of the AI. So, it feels to me like every day they bring out a new…

One of them brings out a new model that’s more powerful than the last model. There are a few tweets that did around sort of like, congrats on the new model, much better than the old model. Looking forward to the next model.

[Tim] We haven’t even mentioned China. China’s the wild card too. So, if they can beat everybody on cost, there’s going to be a lot.

So, I mean, yeah. I mean, I don’t… Like investing in Anthropic or ChatGBT at the valuations that they’re expected to go public at probably is a risky proposition.

It doesn’t mean it won’t work. But for the computer, the demand, the data service demand and the computing power demand, I think that that’s the safer bet than the actual AI language model. And I also wonder like, okay, Amazon’s got all of these capabilities.

Could they not replicate Muse? Could they not replicate that? It doesn’t seem like it’s that advanced relative to some of the other ones that I’ve used.

I mean, it’s fine. But yeah. So, I mean, I don’t think that Amazon’s shown all of its cards either.

[Tobias] Yeah. It’s rapid incremental change and we’re all sort of adapting to it as it comes along. But it’s certainly not clear if there’s going to be one winner or…

I think it’s more likely that there are many winners. One interesting thing to consider, this is something that Jake Taylor and I talk a little about is the consumer surplus. So, producer surplus is when they build out and then they capture, you know, like Microsoft captures huge producer surplus from its office suite.

But there is a consumer surplus there as well, which is why people continue to use it. But these LLMs, it’s possible that there’s just a huge consumer surplus. It’s a huge benefit for consumers because they’re also competitive.

The models are pretty comparable. If you find one that does what you need it to do, you maybe just stick with it and use it. And the only reason that you switch is because the pricing is so vastly different.

[Tim] I mean, absolutely. I mean, I don’t see that much pricing power as of the way things stand now. So, it’s tough to imagine, you know, a lot of pricing power there.

But it’s interesting. You never know. You never know what the longer term elements are.

But because it’s… I was worried initially that they were going to raise the price of tokens so much that it was going to dramatically reduce the utilisation of it. Remember the Uber thing where they had used so much of the AI, like on every project basically, that they hit like their limit for the year in like a couple of months.

And so, they had to downgrade it. And so, companies have learned to adopt. But now the competition is so fierce that I think that ultimately that’s going to make more utilisation of it and we’ll see how it all unfurls.

The model is going to get better.

AI Is Making It Easier Than Ever to Start a Business

[Tobias] The model is going to get more efficient. There’ll be people who figure out how to optimise. I think it is very exciting.

It is going to get better rapidly. But not clear. And as you point out, those Chinese models, when Jake and I were in China last year, we went and visited some VCs who were tracking.

And their view at the time was that ChatGPT had the superior… The scene has changed so vastly since then. This is almost useless information.

I just sort of provide it for a little bit of context. Their view was that ChatGPT was sort of the best. But then you had that deep seek, which was just behind and free.

And so for many, many applications, you’re not going to need the bleeding edge LLM. You’ll be able to find something that’s very cheap or even free that does sort of 80% of what you need. And maybe it does it more slowly and it does it more inefficiently, but it doesn’t matter because it does what you need.

[Tim] And that’s going to be like… So while you talk about there’s going to be job losses with this, but then you have like, businesses helping companies understand how to get the best ROI on their spend on the AI. Which utilizations can they use the cheaper Chinese models for?

Which do they have to upgrade for? And that sort of thing. So it’s exciting.

For an entrepreneur, it’s an exciting time. I mean, I see the risks for sure. There’s a lot of risks in every capacity imaginable.

Like there’s elements that definitely worry me, but I think that there’s also tremendous opportunity. And I think it’s easier than ever to start a business if you have a good idea. And that’s exciting.

You know how, I mean, you were a young entrepreneur too. I mean, you knew like putting a website together and creating a company. It was a challenging process if you didn’t have a really strong tech background.

But it’s really liberalised it for folks out there to be able to do more. So it’s exciting.

[Tobias] Tim, we’re kind of coming up on time. You got anything else on your mind?

[Tim] No, I mean, we’ll be back next week with the same thing. And just a reminder, we’ve got the free trial. And so the monthly price is 99 bucks.

You can sign up for the year at 999 or $999. And yeah, we’ve got some exciting trades. And I think that the volatility we’re seeing, Toby, which we related to interest rates and with AI, ultimately that’s good for options prices, right?

Why Market Volatility Can Mean Higher Options Premiums

Because the more volatility you get, the higher the premiums you get when you’re selling the options. So I think ultimately it’s going to open up some good opportunities.

[Tobias] And that’s particularly useful if you’re an… Basically, we’re equity guys focused on the underlying equities and we use the options as when there’s good option volatility, that just gives you a lower price, a lower implied price for your entry point, a little bit more of a margin of safety. And if you’re not exercised, then it gives you a better return on the cash that you use to secure.

So that’s why we sort of make this value options report to demystify it a little bit. It can be a little bit complex. It’s complex to understand the first instance.

I think that it’s actually a pretty simple idea once you understand what’s going on. And that’s what we’re going to do this podcast for a long time to come. Just so we can get the message out there.

[Tim] Thanks, Phil. We appreciate it and see you next week, my friend.

[Tobias] Sounds good.

[Tim] Thanks, Tim. Thanks, Flix.

[Tobias] We’ll see you then.