JUSTINE UNDERHILL: Welcome to Real Vision's Trade Ideas. Today, we're sitting down with the Jay Van Sciver of Hedgeye. It is great to have you back.

JAY VAN SCIVER: Great. Thank you so much for having me here.

JUSTINE UNDERHILL: So what is your trade idea today?

JAY VAN SCIVER: Well, last time we were here, we did Rollins and Tesla shorts and lest people think we're perma bears. We're going to talk about a long, we're going to talk about Mohawk and residential construction in general.

JUSTINE UNDERHILL: Okay, so this is a little bit of a contrarian bet in some ways, because a lot of these building product stocks have been beaten down pretty hard over the past year. Before we get to the bull case for those stocks, could you talk to us about why this area has struggled over the past year or so?

JAY VAN SCIVER: No, I think it's a great question. So, you had a series of really unusual and exceptional events happen to the building products and construction material space. First, you had tax reform, tax reform, generally, major house and even the most optimistic view, less of a tax shelter a lot. Fewer people are taking advantage of the tax benefits as afforded to residential housing. Second, in 125 years, you've never had more rain than you had in the first half of 2019.

So, I think is a stat that people haven't quite internalized. But it was the wettest year in the period that was measured over the last 12 months. They've been doing that for a long time since like 1895. And it's very hard to do certain construction activities in the rain. And then construction projects get delayed, things get pushed out, even interior work gets pushed out because buildings aren't finished. So, I think it has a much more significant impact than a lot of people recognize in the first half.

You see it in farms as you see tractors stuck in the mud. But I think it's been less focused on in the construction space, in part because it's been going on for a while. We've had rain for a long time, we've had record rainfall over the last 12 months in April, record rainfall in May and June, but finally, it didn't rain in July and we're seeing some of those hours for construction equipment and other metrics pick up a bit.

And another thing is we had a spike of interest rates in the middle of 2018. And interest rates are now down. And we tend to see on average construction spending respond to lower interest rates with about a seven-month lag. So we should, as we enter 2020, at least on a relative basis have a better environment for residential construction, buildings, product suppliers, like Mohawk.

JUSTINE UNDERHILL: And what about things like tariffs and other factors like that?

JAY VAN SCIVER: That's a great one, I forgot that one as well, like tariffs had the effect of creating a pre-buy. And for example, foam which we import from China. So ahead of tariffs going to place, distributors will tend to inventory product to get a discount ahead of these higher prices. So we see this in import data spike in imports, and then we see it come back down as tariffs actually go into place.

JUSTINE UNDERHILL: So right now, we're in that lag area because there was an over-purchasing before?

JAY VAN SCIVER: Exactly, we have too much inventory from tariffs, we have too much inventory from lower than expected demand. So, people are building for certain residential construction spending growth and you end up with less raise interest rates, you end up with too much inventory. And then they have to cut production, margins go down. And that's the typical cycle we go through. And we see a pretty clear path to better demand, basically following lower interest rates and easier comps.

JUSTINE UNDERHILL: Okay, so yes. So, you mentioned lower mortgage rates. So, the 30-Year is now below 4%. It's been that way for about two months now. And we've seen a pickup in mortgage applications. But we haven't seen that pickup in construction and spending. And you were saying that there's about a seven-month lag or so, where are we right now in terms of that cycle? And when do you see that coming to fruition?

JAY VAN SCIVER: So as we described it to our clients, we think investors lined up at least on a relative basis chasing these names into the first quarter of 2020 when we start to see residential construction spending pick up a year of your basis, the comps just get easier. Basically, if you get up, you buy a house, it takes a while to actually plan and make renovations or whatever it is you're going to do. It isn't an instantaneous, get a mortgage, and suddenly, spending goes up in the same month.

And interestingly, two things that happen on the Mohawk call this quarter. One is that they didn't mention weather, which I found shocking, because it was extremely unusual then. And secondly, they seem surprised that the spending on their products was in coincident with lower mortgage rates, it says like a three-month lag. And it's longer than that. It takes a little while for it to filter through. It didn't perfectly in seven months. It's just the best R squared that you get as you do the incredibly flawed statistics on it, but it clearly is on a lag.

JUSTINE UNDERHILL: And then in terms of your view on the overall economy, are you bullish on specifically construction stocks? Are you also bullish on the housing sector overall? Where does this fit into your thesis?

JAY VAN SCIVER: So, I think we're in a classic industrial deceleration. So we're seeing GDP growth, slow, or macro changes a great job of laying out how that echoes through the economy. And in that environment, we get a lot of what we would call a classic cyclical value traps. So, we have Cummins for example, as a short idea that we had at the end of last quarter, because as you get fewer orders for trucks, you fewer engines, you get fewer engines, you get less volume of your factory, margins compress, volumes come down. Pricing is under pressure. It's a classic downturn.

It's always surprising how much typical earnings go up. It's always surprising how much cyclical earnings can go down. And I think when we look at our long list, there are a couple of idiosyncratic names, things of some exposure-type defense, some unusual fleet dynamics, but for the most part, we don't have as many longs in industrial sectors, we have shorts. I think it's a more period of time when the industrial sector and cyclicals, materials tend to underperform on a relative basis. We call it Quad 4 when we have, in this quarter, growth decelerating and inflation decelerating. We transfer, next quarter what we call Quad 3, we have growth acceleration and inflation picking up. None of those environments are great for most cyclical companies.

JUSTINE UNDERHILL: So then how would this play for builders? Would you be concerned in a slowing growth environment that building stocks might not perform so well?

JAY VAN SCIVER: So, one of the things we like to think about is like, what is the long cycle doing? So, we usually describe that fleet in terms of the ship building cycle, because it's a great cycle, like after World War II, you had a ton of ships that get converted to commercial fleet. So you have the spike in tonnage additions but you get a 30-year cycle in that. So 30 years later, you get this big replacement cycle in the peaks out. In late '70s, those ships get replaced actually peaks out in 2011.

Our launch for Samsung Heavy as the best short in 2012. And the reality is it doesn't matter what the economy does, everybody bought a ship. If the ships have been replaced, there's going to be very little demand until you should buy Chinese shipbuilders. You mark your calendar in like 2038, or whatever it is. It'll work. Those ships will meet saltwater and they will need to be replaced. And so we'd like to long cycle dynamics. If you get that right, it becomes very obvious that if you're long high PE cyclicals at the beginning of replacement cycle, it's almost certain to work. And if you're short low PE, value traps on the other side, it's almost certain to also underperform.

What we see in construction is from a long cycle perspective, the stock of residential housing is aging. We're spending below replacement demand on residential construction. We're also spending below replacement demand on nonresidential construction, and probably the worst one, not to get politics involved, but is infrastructure where we are severely underspending, we actually see the average age of streets, roads and bridges aging exponentially. So when we look across the industrial universe, like what's the most dollar value, cyclically depressed market, it tends to be construction across different verticals.

And that gives us- if you enter a cyclical downturn, if you enter a slowdown first for residential construction, you get the tail end of weaker growth means lower interest rates, you tend to get lower mortgage rates, which is at the margin, helpful. But you also, I think from a longer term perspective, are entering a period where you have better demographics, millennials are entering their early 30s, where they tend to buy first houses. We're entering a period where you have to start to deal with some of these aging assets even if residential construction spending picked up, say 25%, 30%, you'd still be only at normal levels of construction activity, you wouldn't be cyclically inflated, you'd finally maybe have your assets stop aging as quickly as they've been aging. So that already being below cyclical norms, provides a bit of a buffer into any kind of broader economic slowdown.

JUSTINE UNDERHILL: Got you. So then, could you talk about the stocks that you're looking at in the space?

JAY VAN SCIVER: So, we look at Mohawk. And I think one thing that's interesting about cyclicals is what we call the narrative or the story that gets built up around them. So in the case of Mohawk, there is a structural problem where there's this stuff called luxury vinyl tile, which sounds like an oxymoron at a product name. Like how could vinyl tile be a luxury? But it has taken a lot of share and Mohawk doesn't have as much capacity to produce it. And the reality is that that's happening. And that's basically capacity adjustment that Mohawk will have to make over time.

That is an issue I think that gets blown out of proportion, that becomes like the fixation for investors when the stock is down 60%. It already is down as much roughly as it went down in the financial crisis like it's down. Investors clearly think whatever is going on is structural. So in the case of Cummins, electric vehicles could become that on the short side. So, these narratives get out of control and create these exceptional value opportunities. And I think that's what's happened in Mohawk. I think it's pretty cheap here. I think it's positioned for cyclical rebound. It rained, and people think it's LVT, it's basically the problem with the narratives.

JUSTINE UNDERHILL: Looking at Mohawk, that stock dropped pretty dramatically in the past few weeks after it released earnings. And the CEO said that there were concerns over volume and pricing. Is that something that resonates with you? Is that something that you're a little bit hesitant about with the stock? Or are you still- you see upside from here no matter what?

JAY VAN SCIVER: I think one of the problems of cyclicals is you have to buy when the CEO is telling you, things aren't great. You don't want to buy a cyclical and margins are at- this isn't Google in 2002, it's not going to have a huge endless market. Housing is like a GDP plus or minus business, it's not going to get- as people would say, whenever and trees don't grow to the sky, it's going to be a contained story. So you generally want to buy cyclicals when there's something wrong, you're always getting something with a bit of hair on it, or when you know it feels bad. Usually the earnings are down, the multiples high. And it doesn't seem like it makes a lot of sense. And that's when you have to buy like when you see the inflection.

And I think mortgage rates give some visibility to inflection in residential rates. I think it would be shocking. If you really step back and think about if the CEO of a building products company coming out of the rainiest first half in 125 years, which impacts construction activity didn't find that they had too much inventory that they were planning for a 125-year record rainfall, the wettest period basically now as measured, that would be a surprise, that would probably mean that they were under-producing for what would be a normal environment. So the fact that we're coming out of tax reform tariffs, and this record rain, it would be surprising if in fact, they didn't have too much inventory in the channel that there wasn't pressure on pricing that they didn't feel like they need to reduce production to match demand. It would be amazing.

JUSTINE UNDERHILL: How much potential upside do you see in a stock like Mohawk?

JAY VAN SCIVER: I think that's always an interesting question in a cyclical and I think that they can be remarkably- seemed remarkably expensive when they're down and remarkably cheap when they're up. And it really looks that way, as a person who looks at cyclicals all the time. Like, that's my job for decades. They actually look expensive, because they tend to be when they're down, earnings are decelerating problematic.

But for that as a framework, I think Mohawk probably earns more than $10. And it's probably a better than average growth, earnings growth name as we enter recovery and housing activity. So, I think something like 200 is a perfectly reasonable expectation, and it's a whatever it is, 114, 115. So, I think it offers a good deal of upside as a pretty straightforward catalyst in recovering residential construction spending from lower interest rates.

JUSTINE UNDERHILL: And would you enter at current levels? Would you say now is the time?

JAY VAN SCIVER: We have it as the best idea is long? So yeah, we did a deck, putting this thesis out last Friday. For doing a deck on a Friday on August, we feel good about the thesis, which may be in it's totally wrong, like we can be certainly wrong. We say what we think and I think that's a name where I have a pretty clear visibility to at least a better environment.

JUSTINE UNDERHILL: In terms of backing out of the stock if you are wrong, is there a certain level that you'd be looking at or a certain narrative that would have to shift for you to step away?

JAY VAN SCIVER: Yeah. There are. I guess, if you saw real new problems with construction in some way, interest rates, inflation, things that we don't necessarily see could become problems. I think there are concerns around LVT that I guess if they played out differently would be a problem. I think one of the just as a problem with that story of imports is that things that that weight and price don't generally get imported because they're heavy and once we get domestic capacity in place, we'll see fewer imports. But if we had some problem with domestic capacity ramping up, that could be an issue, where in fact, we're going to be stuck on importing flooring.

That would be a potential issue. But I think the problem with longs in general is that they are more boring. I think residential construction gets a little better and the stock does pretty well, because it's down lot. It's already down as much as roughly it went down in the financial crisis. So, I think the asymmetric setup and flooring companies attract terrible puns on valuation, like the floor is in, whatever, flooring security was the joke we needed. But playing on Elon Musk, but the reality is that it's already down roughly as much as it went down in the global financial crisis, which is also known as the housing crisis. Like it's probably a reasonably valued name here. And I think that sets up in asymmetric.

JUSTINE UNDERHILL: Okay. Jay, thank you so much for joining us.

JAY VAN SCIVER: Thank you very much.

JUSTINE UNDERHILL: So Jay is bullish on building material stocks. Specifically, he likes buying Mohawk Industries, ticker symbol MHK, at current levels with upside potential of $200 over the next 12 months.

Just remember, this is a trade idea and not investment advice. Make sure to do your own research, consider your risk tolerance and invest accordingly. For Real Vision, I'm Justine Underhill.