Edmund Simms

Originally published in Valuabl on February 3rd, 2023.

> Mexico’s biggest poultry producer is expanding into new markets, including pork production. The spread of avian flu and a trade spat over corn between Mexican and American lawmakers threaten to hurt the business in the short term. Still, the firm’s economies of scale and efficient operations will help them serve the growing demand for chicken. I rate the shares a Buy as they offer an 89% upside, 16% IRR, and have over half the market capitalisation in cash.

Industrias Bachoco (Bachoco) is a vertically integrated Mexican chicken and pig company. The firm owns and manages 1,212 farms, 22 hatcheries, 23 feed mills, 20 processing plants, and 80 distribution centres across Mexico and the US. Bachoco is the biggest chicken producer in Mexico, accounting for 35% of the Mexican market, and the sixth largest in the world, processing almost 15m chickens per week.

Three-quarters of the firm’s sales come from Mexico, while the remaining quarter comes from the US. While the company also produces eggs and animal feed, most sales come from chicken.

The Mexican chicken market has grown at 6% per year since 2014, and Statista, a market forecaster, reckons it will continue to grow at 10% per year until 2027. They estimate over Ps300bn will be spent on chicken in the country by 2026, up from the Ps198bn spent last year.

Mexican chicken consumption has grown at 3% per year, and analysts expect that trend will continue. Mexican households, like their American and European counterparts, have started to prefer chicken to beef as it’s more affordable, higher in protein, and lower in fat.

International meat prices have surged recently as meat demand outpaced supply coming out of the covid19 crisis. But as consumption and production trends come back into balance, economists expect the price of chicken in Mexican pesos to keep going up. The per kilo price of chicken has risen 7% per year since 2014, faster than the 4% rate of Mexican inflation. Thanks to the relative demand for chicken, producers have been able to raise prices, and diners have had to swallow them.

Bachoco’s yearly sales have grown consistently. For the past 20 years, the company’s top line has grown at twice the 6% growth rate of the Mexican chicken market. Bachoco’s sales have grown from Ps12bn in 2003 to Ps97bn in the past year at 12% per year. But, over the past three years, the annual growth rate accelerated to 18%, above the 11% growth rate for the median company in my sample of 150 public food companies across the Americas.

The number of chickens the firm processes each week has gone from 7m in 2002 to almost 15m in 2021, a 4% per year production growth rate. The most significant jump was in 2011 when the firm bought O.K. Industries, an American poultry company.

While still volatile, the company’s net operating profit margins have become steadier over time and are converging towards 8%, their long-term average. The poultry industry is naturally cyclical as higher prices and profits are followed by overproduction, leading to periods of lower prices and profits.

The most considerable cost for poultry producers is chicken feed, and the most significant component of that is corn. In Mexico, domestic crops are limited. Therefore, poultry companies import a large proportion of corn used to feed chooks from the US. In 2021, Bachoco imported 80% of its grain from North of the border. Corn’s price is volatile because of weather, harvest size, transport and storage costs, regulatory policies, and currency exchange rates. As a result, the firm’s cost of goods moves around a lot. But, to offset this, the firm hedges feed prices.

Despite this, Mexican companies importing corn have to pay more than American companies because of the additional trucking expense—which rose rapidly during the pandemic. The price of US corn was about $200 a tonne in 2017, while the cost of Mexican white corn was about $300 a tonne.

Over the past three years, the firm’s margins have been average compared to its peer set. Both gross profit and EBIT margins hovered around the median.

As the firm grew, fixed costs declined as a proportion of overall costs, and the operating leverage ratio came down. That helped steady profit margins as fluctuations in gross profit have less impact on operating profit.

The company has benefitted from economies of scale and has become more efficient the bigger it is. It now produces Ps2.70 in sales for every peso of capital invested in operations. That is up from the 1.4x ratio two decades ago. Bachoco is more efficient than 80% of its peer set and is in the top quartile of working capital turnover, the ratio of sales to working capital.

Over the past three years, the firm has produced a pre-tax return on invested capital (ROIC), excluding goodwill, of 20%. That is above the 12% median of the peer set and puts it in the top quartile of food-producing firms. Its after-tax ROIC of 15% is above its cost of capital, suggesting the firm creates value.

The firm’s competitive advantage comes from its economies of scale. Because of its size within the Mexican poultry industry, the firm’s fixed cost base, as a proportion of total costs, is lower than its competitors. As it’s so big, vertically integrated, and operationally efficient, the company can produce more chickens than other companies, sell them for less, and deliver them faster than other food businesses. Its high revenue-to-capital ratios evidence that. The company doesn’t produce higher profit margins, but it does a lot more business, helping it make large profits.

> Story: Mexico’s largest poultry producer will grow as demand for chicken does. The firm’s economies of scale will help them keep costs down while they increase production and expand into the pork market. The company’s size and efficiency will help keep margins in line with its peers, while the low operating leverage helps de-risk cash flows. But with most of the firm’s operations in Mexico, it’s exposed to substantial country risk, increasing the cost of equity.

Bachoco’s share price is below the first percentile on the Monte Carlo distribution and, as a result, has a Buy rating. The Mexican listed (BMV: BACHOCOB) shares are uncorrelated enough with what I own for me to start buying.

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Stock prices fell last fortnight. The S&P 500, an index of big American companies, dropped 1% to 3,892. The market continues to rise from its October lows but is still 9% below where it was last year. Fears of a crisis after the collapse of SVB and Signature Bank have spooked investors.

I value the S&P 500 at 3,982, which suggests it is fair value. My valuation has thrashed back and forth in recent months. Significant movements in bond yields and consensus estimates are to blame. Traders and analysts are uncertain about the future, which has shown up in estimates.

The companies in the index earned $1,627bn in the past year. They paid out $516bn in dividends, bought back $981bn worth of shares, and issued $72bn of equity.

The forward price-earnings (PE) ratio shrunk to 16.9x. My 12-month forward earnings per share (EPS) estimate for the index climbed from 229 to 230.

Government bond prices rose as investors sought safety. Yields, which move the opposite way to prices, fell. The ten-year Treasury yield, a critical financial variable, dropped 37 basis points (bp) to 3.6%. Investors expect inflation to average 2.3% over the next decade, down 55bp in the past year.

The real interest rate, the gap between yields and expected inflation, shrunk by 22bp to 1.3%. Still, these inflation-adjusted rates are up over two percentage points in the past year.

Corporate bond prices also went up. Credit spreads, the extra return creditors demand to lend to a company instead of the government, shot up 24bp to 1.8%. While the cost of debt, the annual return lenders expect when lending to these companies, fell 13bp to 5.5%.

Refinancing costs are up 1.5 percentage points in the past year. The ruckus caused by SVB and Signature banks’ collapse has pushed up the price of risk.

The equity risk premium (ERP), the extra return investors want to buy stocks instead of bonds, lept 33bp to 5.3%. It’s now about the same as it was a year ago. The cost of equity, the total annual return these investors expect, fell 4bp to 8.9%. These expected returns are a little above their long-term average.

The Federal Reserve buys and sells securities and sets interest rates. It targets borrowing costs, money creation, price stability, and productivity.

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Latest data: March 15th 2023

TLDR: Last week, the Fed trimmed $969m net from its Treasury security holdings and trimmed $186m net from its mortgage-backed security (MBS) holdings. The Fed also lent $142bn to banks to sure up their liquidity.

I also share this weekly update as a Twitter thread if you prefer.

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Silicon Valley Bank (SVB), the bank for Bay Area tech startups, took a punt on interest rates staying low. They bought long-term bonds and hoped to profit. But interest rate hikes crippled the bank's capital base and left them almost insolvent. The firm's customers, most of whom had more than the $250,000 guarantee limit on deposit, panicked. They fled and tried to pull their money before others did.

It was an old-fashioned bank run, accelerated by the speed of digital banking. At the peak of the run, customers were pulling $500,000 per second, and the bank didn't have the money. This forced the regulator to step in and shut the bank. Within hours, the suits from the Federal Deposit Insurance Corporation (FDIC) had taken over.

The collapse wiped out shareholders, and bondholders will take buzzcuts. But that is not a failure of the financial system. Instead, the bank's bosses botched it, and a mismanaged business has gone bust.

Herein lies the problem. The bank had enough assets to cover deposits, but that process would have taken a long time. Many tech firms couldn't pay staff or suppliers, and sackings would have followed. Lawmakers feared the panic would spread and depositors would run on other banks. As a result, on March 12th, the government announced it would guarantee all SVB's deposits. Further, they said if asset sales don't cover costs, the gap will come from the FDIC fund, into which banks have paid.

SVB's collapse was chaotic because the bank had been exempt from some parts of the Dodd-Frank Act, a series of regulations designed to prevent these kinds of improvised bailouts. As part of the rules, banks with more than $50bn in assets would have to hold more capital and pass stress tests. They would also have to have an orderly handover plan ready for if the bank failed. Finally, should a crisis hit and the bank need capital, bonds would automatically convert to equity. The idea was that fat layers of capital would prevent these big banks from dragging everyone else down if they collapsed. Share-and-bondholders, not depositors or the taxpayer, would pay the price.

But in 2018, the government diluted the regulations and raised the $50bn limit to $250bn. A group of banks, including SVB, lobbied for this and won. As a result, the bank could hold less capital, avoid stress tests, and couldn't get the emergency capital it needed. Instead of bonds converting to equity, the bank tried and failed to sell shares into a sinking market. Regulators were flying by the seat of their pants.

Emergency loans from the Federal Reserve should have been available to SVB earlier. The bank had plenty of good collateral, including Treasuries and mortgage-backed securities (MBS). But the Fed was a day late and a dollar short. The central bank's job is to maintain financial stability, but they were too slow. If they had lent to SVB sooner, they could have averted the crisis and prevented the collapse of a major bank.

Walter Bagehot, the godfather of central banking, is spinning in his grave. Bagehot's dictum says that to avert panic, the central bank should not hesitate. It should lend early and without limit to solvent firms with good collateral. But it should also lend with punitive terms. That is almost what the Fed will now do to shore up other banks—but what it didn't do for SVB.

A new program will let banks borrow against government bonds and MBSs. Exactly like the ones SVB had mountains of. But, a facility like this would usually impose a price cut on the bonds used as collateral. This one won't. Instead, it will recognise the face value of the bonds—hair extensions as opposed to hair cuts. This generous support for banks is undue. It is a handout for bank shareholders. Although it will stop a crisis, subsidising banks for lousy interest rate bets is crummy.

The lesson lawmakers must learn is that banks are different from other businesses. They are public-private partnerships. The government gives them the right to create money, a public monopoly, but keep the profits. As such, bank regulation must serve the public purpose. Policymakers must realise this and fix it soon.

The Federal Reserve buys and sells securities and sets interest rates. It targets borrowing costs, money creation, price stability, and productivity.

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Latest data: March 8th 2023

TLDR: Last week, the Fed trimmed $20bn net from its Treasury security holdings and trimmed $6bn net from its mortgage-backed security (MBS) holdings. The total amount of Reserve Bank credit shrank by $28bn net.

I also share this weekly update as a Twitter thread if you prefer.

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The global number of active oil rigs has almost recovered to pre-covid levels. More supply will continue to relieve inflationary pressures.

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Stock prices fell last fortnight. The S&P 500, an index of big American companies, dropped 4% to 3,970. The market continues to rise from its October lows but is still 8% below where it was last year.

I value the S&P 500 at 3,788, which suggests it is fair value. My valuation has thrashed back and forth in recent months. Significant movements in bond yields and consensus estimates are to blame. Traders and analysts are uncertain about the future, which has shown up in estimates.

The companies in the index earned $1,627bn in the past year, down $31bn from last fortnight. They paid out $506bn in dividends, bought back $986bn worth of shares, and issued $71bn of equity.

The forward price-earnings (PE) ratio rose to 17.3x. My 12-month forward earnings per share (EPS) estimate for the index dropped from 244 to 229.

Government bond prices dropped. Yields, which move the opposite way to prices, rose with inflation expectations. The ten-year Treasury yield, a critical financial variable, climbed 11 basis points (bp) to 3.9%. Investors expect inflation to average 2.4% over the next decade. That's 9bp higher than the rate they expected last fortnight.

The real interest rate, the gap between yields and expected inflation, increased by 2bp to 1.5%. These inflation-adjusted rates are up over two percentage points in the past year.

Corporate bond prices also went down. Credit spreads, the extra return creditors demand to lend to a company instead of the government, rose by 6bp to 1.6%. The cost of debt, the annual return lenders expect when lending to these companies, jumped 17bp to 5.5%.

Refinancing costs have almost doubled, up 2.2 percentage points, in the past year. But they’ve been declining since they peaked in October above 6%.

The equity risk premium (ERP), the extra return investors want to buy stocks instead of bonds, fell 29bp to 4.9%. It’s now about the same as it was a year ago. The cost of equity, the total annual return these investors expect, also fell 18bp to 8.8%. These expected returns are a little above their long-term average.

Supply chains, not government spending, caused inflation.

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As the pandemic raged, governments had to find ways to keep their economies afloat. Lockdowns meant businesses would collapse as they didn't have customers, supplies, or workers. That is unless they got support. Countries had to spend big to support companies and households or face calamity.

But some economists and pundits opine that this stimulus caused inflation. They argue that more spending meant higher prices. They're wrong. Lockdowns and supply chain problems, not deficits, made prices rise. And treating a supply-side problem with a demand-side solution won't work.

According to International Monetary Fund data, countries targeted different types and levels of stimulus. Some countries focused on spending more and taxing less. Others supported liquidity with loans, guarantees and asset purchases. Combining those shows that rich countries did more stimulus as a percentage of GDP than poor ones. America, for example, spent an extra 28% of its GDP to support individuals and firms. Germany spent 43%. While Pakistan and Zambia only spent 2%.

If stimulus had caused inflation, the more a country spent, the higher its inflation would be. There should be a correlation. But, plotting each country's stimulus against inflation reveals no relationship. The result is the same regardless of whether you use 2021 or 2022's inflation data.

This dot plot may hide causality and omit other variables that cause both outcomes. But as the stimulus was discretionary, it measures the government's spending policies. Further, although this analysis is simple, it would be hard to argue a link between the two in the face of this.

So why is there no connection here? The answer lies in understanding the nature of inflation.

There are two types of inflation: demand-pull and cost-push. The first occurs when there is too much money—the government spends more than the economy's productive capacity can handle. While cost-push inflation happens when production costs rise, leading to price increases.

Cost-push inflation caused the recent price hikes we see. The pandemic disrupted global supply chains, which led to shortages and higher costs. That, in turn, drove prices up. Stimulus measures, like job-retention payments, supported spending. But they didn't cause the price jumps. During lockdowns, the global economy was underutilising labour and productive resources. That meant there was productive capacity waiting to come online when lockdowns finished.

Lawmakers are tackling the wrong problem. They want to hit demand by targeting a higher interest rate. But demand wasn't the problem. Supply was. Higher interest rates and less money don't create barrels of oil.

But the good news is that cost-push inflation is temporary. It tends to self-correct. Higher prices drive higher profits and more investment. This supply increase has already happened in some sectors like energy and materials. Prices there have come down as supply chains have expanded and stabilised.

By slaying the stimulus scare-bug, regulators put themselves in a better position to fix future inflation. We have the money to support the vulnerable without making prices spiral. But the longer we stick our heads in the sand, the worse.