Betting Against Craft Beer
Featuring Louis Llanes
Published on: August 22nd, 2019 • Duration: 19 minutesLouis Llanes, CFA, CMT, founder of Wealthnet Investments, approaches trading by combining deep fundamental research with technical analysis. In this episode, Llanes breaks down the fundamental backdrop for the four components of a pairs trade comprised of two longs and two shorts in the brewing industry. He also analyzes the long-term chart patterns for each company, sizes the positions for market neutrality by comparing the volatility of each component, and addresses the risks to the trade. Filmed on August 19, 2019 in Denver.
LOUIS LLANES: Hi, this is Louis Llanes for Real Vision and Tech Trader. I'm going to be talking about a long/short trade, a market neutral trade. I usually don't talk about these types of trades. But I think we're in an environment where it could make some sense for us to trade like this, because we get non-diversification, trades that are just all bundled together. We have a counteraction to that. We get the ability to make money when the market goes down, and to actually take advantage of a value spread, which is what we're trying to do in the brewery market today.
And this is what I call a relative value trade. It's also known as that in the industry. And basically, what we want to do is we want to buy a couple of the stable brewers, and we want to own them. They have strong cash flow. They have solid balance sheets. They're repairing their balance sheet. So we see that as being a really good positive. And we want to short some of those, what I would consider overvalued companies, companies that everybody loves, the craft beers, the ones that everybody wants to drink right now, actually on a valuation base, they're overblown.
In this trade, it's going to be a little bit counterintuitive, it's going to be a contrarian play. And for those of you who like to follow momentum, it's not going to feel comfortable. And normally, there are times when you want to be following the trend. And I've done a segment on this before, there's times when you want to be following the trends very aggressively. And there's times when you want to start nibbling at contrarian plays.
And I think it now is the time to start nibbling at contrarian plays, because many of these trends have played themselves out on a fundamental basis. And the technicals are starting to show the beginning signs of deterioration. And that's what we're trying to do. We're trying to be early to find the beginning. Now, let me just say one thing about this, when you're doing this type of a trade, you don't want to just plunge, you don't want to just dive in, what you want to do is you want to scale your way in, and you want to give yourself smaller position sizes, and then as you become right, add more to it. So keep that in mind.
Now, one of the things that I want to talk about is just the advantages and disadvantages of using a spread trade. A spread trade is when you- again, when you buy and then you short at the same time. One of the disadvantages of that is that shorts can go up very rapidly, and they could really hurt you. So you really have to manage those shorts. And that's one of the reasons why we'll be talking about position sizing where we're going to size those shorts to be smaller, it's actually going to be a smaller percent, so that we can have that risk management built into the basket itself.
Now, when you look at the brewing industry as a whole, it's very interesting, because it's been really under pressure for a long time. We've seen a sluggish beer market, we've seen beer as a percentage of the overall alcohol industry has been shrinking. It was at 50% of the total industry a decade ago. And now, it's about 40%. So we see spirits and other drinks becoming much more popular, that overall has been hurting. That's another reason why we want to be more in a spread trade, not in a right long position.
Margins are under pressure in the entire industry. And why do we see that? We see that because it's a very fragmented industry. It's very fragmented from the standpoint that there are a lot of brewers that are out there and we see the margins being eroded by commodity prices, input costs are getting stronger. It costs more to package. It costs more to bottle. All those things are really hurting the industry.
It's also extremely competitive. Like I was saying, the craft beers are very fragmented. There's lots of them. People really enjoy the trendiness of being able to, hey, identify a smaller brewer who is privately owned, and they care about how they brew it, their brews taste great. That's really been putting a lot of pressure on the big boys.
Now the big boys are getting into the game. They have been getting into the game for quite some time. And what we see is that is actually hurting margins. In fact, when you look at the margins in the craft beers, in some cases, they've been smaller, you would think they'd be higher than your run of the mill beers, but that's actually not always the case.
Okay, now what I want to do is I want to dive into the fundamental backdrop of the four stocks we're going to be talking about in this basket. First of all, on the stocks that are most attractive, I'm looking at Anheuser Busch, and I'm looking at Molson Coors. And then primary reason is, is both of these companies have very strong distribution. They have the resources to actually get into the areas where consumers want to be in and where their tastes and preferences are going. Right now, they've been under pressure. In fact, their stocks are in downtrend, but you're starting to see the beginning signs of that downtrend to be slowing and even maybe even reversing now, which is what we're looking for.
Now, when it comes to Anheuser Busch. Anheuser Busch has very strong cost containment, they're probably the most efficient provider. They also have great international exposure. They have 62% stake in ambit, which is really amazing. They also are getting cost containment from their SABMiller acquisition. And so there's a lot of synergies that are expected there. They're paying off debt. They have a good dividend yield, solid return on capital. So Anheuser Busch is a solid long term play.
On Molson Coors, they've been really under a lot of pressure. They've been really under a lot of pressure, because they're not as strong as Anheuser Busch. But they are getting stronger, because they're making some very key changes. They're paying off debt. They're investing in faster growing product lines. They're also getting in a situation where they're increasing their dividend, which is good for investors.
And really, the list goes on and on. And we don't have enough time to go into all of the reasons. But I will say that both of these companies are relatively undervalued from a longer term investors' perspective. When we get into the charts, you'll see that I'm going to be looking at really long-term charts. We're not looking for- this is not a quick trade, this is a longer-term trade.
Now, on the relatively overvalued side, we're looking at Craft Brew Alliance. Craft Brew Alliance is a very interesting company and that they actually pull together and they look for and put together a portfolio of craft beers. And that's very trendy right now. And actually, Anheuser Busch has a stake in them. So there's a little a bit of a conflict there. However, this company is trading around $13 a share, and it is much more overvalued relative to the other two stocks we were talking about.
And the other stock that's really, really been on a roll that we're going to be looking at putting as a short position in a small position size is Boston Beer, symbol SAM. Now, this company is already reflecting all the good news. They've had a lot of good things happen with the craft beer volumes. And that's been a great thing. They have the Truly Hard Seltzer and the Twisted Tea. These are brands people love right now. And they're very trendy.
So in fact, just the other day I found here in Denver, I live in Denver, we're going to actually have a big festival with those kinds of drinks. And well, it'll be interesting to see what that looks like. But anyhow, that whole industry is very fragmented. And what's happening now is we're starting to see competition, and there's a lot more players coming in. And that's actually showing up in the numbers, we're seeing a slight deceleration in the revenue. And we also see a potential for margins to actually contract rather than continue to expand. So we're at the early stages of this.
But that's the fundamental backdrop for what we're looking at. I like to see in these trades- from a technical perspective, we want to see the technicals confirming what we're seeing with the fundamentals. And so now, what we're going to do is we're going to dive into the charts. So let's do that.
Okay, what we have here is a historical divergence in this industry. This chart actually shows over the last 5 years, the reward risk scatter plot for these investments that I just outlined. And what I mean by that, as I'm just looking at the annualized return and the annualized standard deviation, and just plotting them out. And what you could see is basically, Anheuser Busch and Molson Coors have really been underperforming these other two companies that we talked about that were going to short, Craft Brews as well as Samuel Adams or Boston Beer.
So you could really see what's happened over the last 5 years. The market has just been going after those other two companies. And now, what's happened is they're extremely overvalued. And when you look at the fundamental data, you can see this. This chart here shows various key fundamental metrics of valuation. There's price to book, price to sales, price to cash flow, and dividend yield. And what you see, the two on the left there in the green, Molson Coors and Anheuser Busch, and on every metric, they're relatively undervalued.
And on the right side, you see Boston Beer, Craft Brew, they're really expensive. For example, Boston Beer's trading at 29.8 times cash flow. For a company like this, that's extremely expensive. So the setup is there. And then when you drop down from the valuation then you look at the charts, you see that there's actually momentum shifting there. So we're going to talk a little bit about that.
But in order to build this basket, it's really important that you understand the correlation and the volatility of each one of these stocks so that you can blend them. It's almost like making a recipe. You want to blend them in a way so that you're getting what you want. And what the statistical analysis shows here on this chart is the volatility analysis of each one of these companies looking at them over a 63 trading window, that's about a quarter. We're looking at it rolling 63 days, and we're calculating the standard deviation of those returns in percentiles and analyzing it.
So basically, what all that fancy talk means is that we're looking at how volatile these instruments are relative to each other. And what you could see is that it's very, very clear that Anheuser Busch and Molson Coors have very similar volatility. You could see that on the bottom here, all across the spectrum, they have very similar volatility. And then what we have is a divergence there where we have Craft Brews and Samuel Adams are quite different. They have much higher volatility levels, especially Craft Brews, because you can see it's really, really high.
So we're going to size our positions. So that that does not become a problem. So that each constituent in that basket has a relatively similar effect on the portfolio, because we're truly trying to capture that valuation difference and a technical catalyst that can move that.
If you look at this, we're going to go through three quick stages to show how that works. The top is really showing the long/short basket itself. If you volatility adjust, what that basket looks like is we should be long. For every unit that we trade this in, we should be long 23% in Molson Coors, and we should be long 31% and Anheuser Busch and we should be short 30% Sam Adams, or Boston Beer, and minus 16% on Craft Brews. And if you put that all together, that all adds up to 100%. Now, the longs are plus 54%, shorts are minus 46%.
Now if you look at the stock price, we want to apply today's stock price right now, you basically come up with a unit size. And what I've come up with is a unit size of $20,000. Because that gives us a good enough size, we can trade that in units of $20,000. And this really shows the number of shares you would need for each particular trading unit. So we'd have 89 shares of TAP, 65 shares of BUD, 14 shares short of SAM and 229 shares short of BREW. And that is what a single basket looks like. Now, that's a lot of numbers. You can always rewind and look at these numbers and write them down. But that's going to give us a neutral positioning.
All right. Now, I want to dive into the charts and let's start off with Anheuser Busch. Anheuser Busch's chart looks pretty amazing, because what we saw was a clear, big long-term uptrend. And this is a monthly chart by the way, showing going way back to 2010 all the way till the current period here in 2019. And we saw a big uptrend in Anheuser Busch. And then we went into a downtrend. And what you'll notice now is what we see on a very long term basis, we're starting to see a breakout in relative strength.
This bottom line here shows the relative performance of Anheuser Busch compared to the S&P 500. And what you see is that we were in a downtrend in relative performance. Now, that's broken to the upside. So that's a really bullish indication. And we're also seeing a divergence here. You're seeing breakouts above moving averages. And you're seeing us right now testing that trend line. That is what we want to see. We're in the early stages, I think of having a bull market in this particular stock.
Now, if we move on to the next stock, what we have here is Molson Coors. Molson Coors, again, same scenario, big up move. And then they've been in a long term downtrend, all the way since the peak in late 2016. This has been the common theme of the big brewers, because again, we talked about how the industry was under stress.
Now, we're at the point where the valuations are attractive for many, many different reasons. And what we see in this particular stock is we see a downtrend that is now oversold. We haven't seen a reversal, like we saw in Budweiser, but we do see the starting of the slowing of the momentum, which is really what we want to see. So this is early on in the trade.
Now on the on the flip side, let's look at the two stocks that we're looking to short. Now, this is going to be counterintuitive. This is really a contrarian play. So for those traders who are normally just always following the momentum, this may feel uncomfortable. But when you put it in a basket like this, and you size it correctly, you have staying power so that you can hold on to it. And that's really what we're trying to do with this, just trying to nibble at it while we're getting into this basket trade early.
Okay, so let's look at Craft Brew Alliance. This particular company has a classic divergence pattern happening. We had big up moves, and we saw rises in relative strength, you can see the two rises there, another rise here. And then what you see is another rally that fails. So that rally is now lower than the prior rally. And we're also starting to see a downtrend occur with the relative performance.
That's what I mean about the technicals are actually starting to show signs of deteriorating and it's early on that that cycle. And the fundamentals are showing that the revenue top line is starting to slow down. On the surface, it sounds like wow, we want to be where the momentum is, which is where all the Craft Brews are and all the food drinks are. But the technicals are showing that the early signs indicate this could be a slowdown. So that's something that we're trying to capture.
Same thing with Boston Beer. Boston Beer's a little bit different though. And that it's been on a roll. This has been on our buyer list. This has been one that we've been looking for the long side. But now, what's happened is the stock is extremely overvalued in our estimation. And we've reached a measured move upside target of 429. We're right near that level.
Again, this is early type of trade here. So we want to nibble at this trade and work our way into it, you don't want to just plunge in this trade. We're at the beginning part of this cycle. And again, we want to be market neutral on this as well as sector and industry neutral. So that is really going to add some benefits of diversification to the portfolio.
Now, what this chart shows is the actual basket itself. Now earlier, I'd shown the number of shares that were in each one of the stocks. And this actually shows those actually blended together in one unit. And you can see the value of one unit along minus short. And that right now is trading right about, you can see right about $5,000. That's where it is right now, a little bit above that. So we want to enter in right around this level, we want to start nibbling our way at around $5,200 per trading unit. And we want to put a protective stop right around $4,200. So that we don't let this thing get out of control if the short start really taking off.
Now, what we see is from an upside potential, if you blend those stocks together from evaluation perspective, as well as from a technical perspective, looking at the upside target and you look at where this particular basket could go, it could go as high as $10,000 to $11,000 as an upside target per trading unit. So that's a pretty good reward risk ratio. We'll dive into the numbers a little bit more on that. But that's generally the idea. We want to take this and we want to put this trade in as a diversifying market neutral type of the trade.
Now, there are some risks of this trades. The biggest risk that I see is that there's some commodity input costs that can continue to erode the margins of these stocks, and all of them could move against us. The bear market could remain sluggish and lose share. And that could hurt the longs more than the shorts. The other thing is that value as a factor could be shunned, and the market may continue to favor growth, which could lead the shorts to rise faster than the longs. I would I would say that that's probably the biggest risk and that's what we want to manage the risk on.
But that's why I want to nibble on this trade and work your way into it. Don't just plunge in this particular trade, dollar cost average into here, this is a long term trade. Keep in mind we're looking at this on monthly chart basis. We're looking for small position size, stayability in the trade and to work ourselves into a longer term industry- this is called a convergence trade basically where you have overvalued and undervalued converging. So that's basically what this trade is all about.
Okay, what I'd like to do now is summarize this trade. We want to be long Anheuser Busch, and we want to be long Molson Coors. We want to be short Boston Beer and Craft Brews. So basically, what that does is that gives us a volatility weighted basket that will allow us to be net long the lower valuation companies, and short the higher valuation companies.
And what we want to look at is approximately entering in the basket with a value of $5,200 per unit. And we want to put a stop loss approximately at $4,200. And our profit target is going to be to make about $10,000 per unit. Our reward risk is $4,800. So we're looking at 24% upside. And we're also looking at 5% downside, and that gives us a 4:1 reward risk ratio.
The primary risks that we see is a trend that accelerates