Pembridgecap

A Wealth Creation Journal

Small cap value works, especially when controlling for quality

Recently I read an excellent Cliff Asness (AQR founder) paper Size Matters, if you Control your Junk.  It is very comprehensive research on the size effect. Highly recommended.

First popularized by Fama & French, the size effect says small companies outperform large by a few percentage points per annum.

After Fama & French, the size effect got a lot of criticism from new empirical research however for not being statistically significant or being the result of data mining. The main pain points that make the size effect appear less statistically significant – than for example value or momentum – are basically:

  • small caps do not outperform consistently
    • over time (in the ’80-’00 period they underperformed)
    • globally
    • over certain stock characteristics (value vs growth, positive vs negative momentum)
  • small caps outperformance seem to be concentrated in
    • January
    • illiquid stocks
    • the most extreme size deciles (smallest companies and largest companies): the size effect does not exhibit “monotonicity”. In other words, the best performing decile might be the smallest companies’ decile, but the remaining deciles do not have monotonically decreasing returns toward the last decile

The authors then surgically show that all these criticisms are trumped by the size effect if you control for “quality” (defined by high profit margin, low leverage, high sales growth, good quality of earnings). In other words, small caps have not significantly outperformed globally, over time, over certain stock characteristics, in Feb to Dec, etc. because stocks in the smaller company universe tend to be more “junky”.

If you buy small companies that are on average as high quality as large companies, you actually get size outperformance that is consistent over all the above metrics (time, geographically, value and growth, liquidity, all year) and  the effect becomes monotonically decreasing with the size decile.

Now that we can rest assured the size effect is significant and robust over all these variables when we make an apples-to-apples comparison with large stocks in terms of quality, the cherry on top is that the value effect much larger in small caps. This great paper shows how much.

TC

Thoughts on great shopping malls

Given the threat of e-commerce making inroads on convenience/time-spend of shopping (innovations such as augmented reality improve online shopping experience further), what makes a shopping mall’s future relatively bright?

On some counts, offline has advantages, on the other hand there’s weak points that need to be minimized. I make a distinction on this basis and call them “pulls to offline” and “lack of push to online”.

Pulls to offline

  • Having a “great experience”
    • Beautiful and clean mall
    • Meeting friends
    • “M’as tu vu” (requires mall to be frequented by many shoppers, ideally local)
    • Day trip allure of a mall: a whole family can enjoy a day off in one place
  • For buying apparel: human advice
    • In-store advice and advice from friends. As online is making in-roads on human advice, I believe friends’ advice is more of a selling point

Lack of push to online

As buying online is efficient w.r.t time spent, this is a weak point for some offline shop. Mitigators:

  1. Easy-to-reach
    • great location close to population with disposable income: an outlet might be a pain to reach in the middle of nowhere versus a shopping centre next to a train/tube station, or simply on the way for tourists walking by
    • population density in the neighbourhood (think city centres)
  2. Access to multiple shops at once
    • Large shopping malls offer time-efficient access to many shops
    • High occupancy rate is a win for consumers as well in this respect
  3. Access to non-shopping stores that consumers need to visit anyway
    • Mall with gyms/restaurants/grocery/barbers
      • the sunk cost of getting to these places near other stores might even make shopping before/after more time-efficient than online shopping. These places might be the next shopping mall “anchors

The points in green are arguments for large shopping malls with many tenants from diverse categories such as gyms that cannot be done online.

If some shopping malls are indeed able to offer a “great experience”, this might even pull more footfall to these outfits over time as leisure time rises around the world.

The best shopping malls are aggregators of great brands for the best consumers. As such, there are some winner-take-all dynamics at play in this weak two-sided network (weak because the network is very local, but luxury brands and shoppers compound the network effect through increased possibility of building long-term relationship).

On property management

Best property managements are therefore long-term thinkers: willing to invest in renovations / repurposing to keep footfall and tenant quality high. For example, buying back shares at 8% current yield might optically look better than making a 7% ROI renovation, while the renovation can avoid atrophy in the type of customers, tenant base indirectly for years ahead.

It seems that the number of retail shops will certainly grow slower versus the growth in retail sales as the weaker brick-and-mortar links get shut out. The highest quality shopping malls meanwhile will still see a change in tenant base as tenants with products that are great to sell online disappear (uniform products with long-tail offerings such as books, films). Experience in managing tenant base is another important treat.

Brand advertising

Some companies such as Apple (Stratechery, Scott Galloway podcast), BMW use beautiful retail stores to raise brand awareness and customer experience. Some other functions that these stores serve besides selling products:

  • advertise brand (a superior physical impression is superior to an ad on a screen; what is in particular interesting is that the human brain better memorizes physical as opposed to digital impressions example 1, example 2). The superior physical interior, product design, aroma can convince the consumer that Louis Vuitton is for example superior to Zara in a way that digital ads cannot.
  • high-end product feature awareness, customer education
  • Genius bars in themselves are a point of differentiation as competitors do not offer this service

In short, these stores are but one piece in a consumer’s product experience. In Apple’s case, an iPhone is not only hardware, but also software (iOS) and experiences such as customer support and trying out new launches of features in Apple stores, underlying again how experience is becoming more important for shopping centres.

Conclusion

The economics of growing sales for brands is permanently changed because of a growing online sales share. Whereas in the past brands grew by growing quantity of offline presence because of the fixed link with sales, today, brands will want to occupy the best offline spots and rather not want to be associated with inferior malls. A “flight to quality” malls seems plausible.

To remain competitive, shopping malls have to pull consumers through strengths and avoid a push to online by remaining competitive on the strong counts of online (convenience, price). Multiple factors require malls to be

  1. In the vicinity of high-density affluent population or transport anchors (metro, train, highway) (time-saver, social aspect)
  2. Beautiful and well-kept (experience)
  3. Diverse tenant base with anchors such as gyms, restaurants that will largely remain offline experiences (time saver)
  4. Big (experience for a whole family)

The advantage that offline offers in terms of branding seems most relevant for luxury brands and hence luxury malls.

As malls ideally aggregate the best brands with local consumers, it is in a sense similar to the newspaper business: you want to own the number one mall in each city.

A major risk concerning e-commerce is that luxury brands themselves might become less important in an increasingly online sales world. We see this with Amazon trying to sell white-labels as consumers increasingly weigh functionality and price over brand as information asymmetry is smaller online (driven by e.g. customer reviews).

TC

Book Summary: The Energy World is Flat by Parilla

I read this book because its author proved to be correct on oil.  This is a non-exhaustive book summary I made last year. In the meantime, other events prove another call in the book: the book predicts convergence of global energy prices: oil has come down and the cheapest natural gas in the world (American) is rising.

The Energy World is Flat offers a refreshing view on the oil market. I found it through one of the better Real Vision interviews with Diego Parilla two years ago. The title is a variation to Tom Friedman’s best-selling book on globalization The World is Flat. Lastly, Diego Parilla and I are alumni from the same oil & gas business school.

I only read the book now as I realized that the author’s first call on the flattening of oil call has already proven profitable. These are the main calls the book makes:

  1. the term curve of oil will flatten
  2. geographic spreads will flatten
  3. spreads between energy equivalent prices of fossil fuels will flatten
  4. oil price volatility will lessen

If we compare the oil term curve between the publishing date (1/1/15) and now, we find that it has flattened considerably.

Chapter 1: the Flattening and Globalization of the Energy World

In the oil shock of the ’70s, oil was displaced for power generation and industrial uses in favour of coal, natural gas, nuclear and others because the primary consideration is price in these industries.

Today, oil still reigns over other fossil fuels for transport purposes despite its higher price (e.g. oil was 10X more expensive per energy equivalent than natural gas in the US in 2012). The main is reason is that oil is exceptionally compact both in terms of volume and weight per energy equivalent. Over the short-term, transport is very price inelastic.

Geopolitical events that created volatility sowed the seeds for more buffers ‘flatteners’: storage, demand destruction, new technologies and discoveries. A result can be found in 2014 when the exceptional combination of the below supply disruptions failed to make the oil price spike (the move was limited to 10$/barrel from bottom to peak).

  1. the arab spring (e.g. disruptions in Libya)
  2. oil sanctions in Iran,
  3. conflicts and disruptions in Sudan, Syria and Iraq

Chapter 2: Lessons from the Dotcom bubble

The tech revolution (and bust) created huge capital inflows that led to miserable investor returns over the cycle. The big winners were consumers that benefited from stranded assets such as fiber-optic broadband.

The revolution of fracking and horizontal drilling is similar. Although there is still a lot of skepticism towards shale for environmental reasons, Parilla draws a parallel with ultra-deep-water drilling that faced critics in the early ’90s but developed into a very safe technology. Peak oil sentiment similarities to the tech revolution includes huge capital investment into:

  1. LNG terminals (requires huge upfront capex)
  2. pipelines (see European and Asian projects)
  3. E&P
  4. demand efficiency

One trap for energy investors is to follow consensus according to Parilla. The sector is driven by extremely optimistic assumptions of demand growth. Every year, demand growth estimates are revised down an average of 15-20% from the January estimates (IEA, OPEC). Since 1998, only one year, 2012, has seen meaningful upward revisions. Main reasons are

  1. optimistic GDP growth estimates
  2. using the rear-view mirror correlation between GDP and energy demand that has been breaking down since 1998

Another parallel with the dotcom boom is the diversified ‘venture capital’ approach. In the energy world a lot of capex is being made in new technologies, with a lot of losers. The mentality for

  • big integrated O&G company boards is to ‘be’ invested in new areas as it looks better on paper
  • investors to be invested in all new areas as “you only need one winner”

Examples in the transportation world are:

  1. compressed natural gas (CNG)
  2. LNG for trucks, trains and ships
  3. electric and hybrid vehicles (EV’s and HV’s)

Note: according to Parilla, governments have delayed EV’s by subsidizing combustion-engine car sales (and bailing out the companies) post-recession by a 6-to-1 investment factor to EV subsidies.

Last parallel: the bubble accelerates the impact of the revolution. The runaway oil price in 2007 set in motion a huge supply response by oil producing and oil consuming countries alike.

Diego warns that a sum-of-the-parts valuation for companies that invest in many fashionable new technologies can be very dangerous with bad capital allocators, as the good parts might subsidize loss-making ones, and that focused companies should be welcomed.

Chapter 3: The 10 Flatteners of the Energy World

Interesting excerpt:

During the super-cyclical run up in corn prices in the 2000s, most commodities were making historical highs, from crude oil, to coal and natural gas, to copper and corn. Correlations had notably increased, which was often used as an argument to justify that speculators were driving prices. And of course, high fuel and food prices were generating inflation and increasing the risk of financial stability. One again, politicians and regulators were quick to blame the speculators. “Food inflation, how dare they?” Corn was considered too expensive and would impact the poor the most and increase inequality. How cynical.

The main reason why corn prices were going up was the surge in demand for corn-based ethanol in response to both high energy prices and the regulated mandates. Corn, which had traditionally been “food and feed”, had become “food,feed, and fuel”. [..] In 2012, following an acute drought in North America, the prices of corn reached historical highs, 400% of 2005 prices. “The speculators are taking advantage of the situation.” Yet, that year over 40% of the physical harvest went to ethanol to “feed” the car. The quantities were mandated by the government as “fuel” forced the demand destruction of “food and feed” via high prices. It was the cattle and hogs who had to change their diet, not the car. By mandate.

Do spot prices converge to futures prices, or is it the other way around? A causality study by Merill Lynch, and Parilla, say futures converge toward the physical fundamentals of the spot market. Speculators will discount future fundamentals in the price. If they improperly discount future risk factors into prices, they will lose money as the future prices converge toward the in-the-future-prevailing spot fundamentals.

TC

Should you invest in franchises or managements? It depends.

Note we wrote this post last year.

Many investors categorize themselves and either say

  • they make judgment call on management or
  • rather focus on the franchise or business (it’s rather cool for some in the value investing church to say not getting to know management is a good thing)

Should we focus on the horse or the jockey?

Investor Robert Vinall is known to focus a lot on management. He believes it’s a hard but important question. Important, because it is difficult to quantify, and therefore there’s less competition from conventional investors and quant funds.

Guy Spier, on the other hand, likes to think of himself as a merely good investor, with lots of limitations, such as judging management. He therefore avoids talking to management. Getting to know managements opens us up to get manipulated by their – often perfect – act.

On bad business turnarounds Warren Buffett has said this:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

While we definitely think there’s great arguments for both point of views, we think the relative importance of analyzing franchises versus managements changes a lot with one critical variable: growth.

Focus on the racehorse and on the show jumping jockey

As the entrepreneurial HBS author of the book Buying a small business often repeats

With revenue growth comes new customers, and with new customers come new (types of) problems

In other words, growth brings change. While changing companies are not necessarily growing (e.g. turnarounds in the above Buffett quote), growing companies are always changing.

Another recent observation I had redrafting this post one year later is that venture capitalists tend to focus much more on the founder or team.

From the above, we make a case for focusing on the franchise in mature companies in markets with stable competitive dynamics.

In fast-growing companies, management becomes much more important as they need to make a lot of judgment calls in execution and capital allocation of growth investments.

In show jumping, the horse needs the jockey.

Lastly, the only competitive differentiator in commodity companies is management (companies with fast-changing circumstances).

We believe there is an opportunity in looking at jockeys in commodity industries as 

  1. investors hate commodity/capital intensive industries
  2. investors are focusing on “great franchises” right now (peak quality?) while growing more sceptical of looking at management 
  3. we believe management can be the (non-durable) competitive advantage for these businesses

While media attention tends to go to the folklore of billionaire jockeys of once-fast-growing start-ups, some examples of great commodity Jockeys: 

  1. Philip Meeson in Dart Group plc
  2. Belgian owner-operator Luc Tack in Picanol and Tessenderlo
  3. Buffett overseeing (mostly incentives) in (re-)insurance operations

We’d love to hear your under-the-radar commodity jockeys and thoughts!

MC & TC

Notes on IBKR’s November results and Peterffy at the ’18 Goldman Sachs conference

Disclosure: both a happy investor and client of Interactive Brokers.

Improve your net returns by massively saving on costs (i.e. the only thing you have 100% control over as an investor) now and become an Interactive Brokers client.

It is a well-known human bias to neglect large absolute trading commissions because we look at them relatively to the even bigger amount of money we invest. I am a big believer in minimizing any friction in the investment process (trading less which lessens commissions and frees up time to think long term; paying less for trades by being an IBKR client, although the cheapness creates a “casino effect” of wanting to trade more frequently).

Intro

We will cover IBKR’s November month results that were released this week. Founder Mr. Peterffy had interesting comments about them on the Goldman Sachs 2018 conference that took place yesterday.

First I’ll explain how I go about thinking about the IBKR’s monthly metrics in general.

Executive summary

  • most important monthly KPI to track: user account growth (it drives LT equity growth which is IBKR’s most important value driver)
  • November user account growth was “disappointing”, yet still in line with the last 10 year historical pace of 18% CAGR. The disappointment was driven by China curbing remittances to stellar grower – and intro broker to IBKR – Tiger Brokers
  • IBKR will start paying interest on smaller accounts
  • Israel markets will be added to IBKR
  • important question for the thesis: will exchange volumes keep on losing share to internalizers?

Let’s get started…

IBKR’s monthly metrics mental model*

*Hate using this snobby term but it made for the shortest title.

Although equity growth is the value driver for IB going forward (driving interest income) , account growth is the most useful reported number to gauge future LT equity growth, as

  • monthly equity growth numbers are affected by short term stock market movements
  • equity growth lags account growth because people only start depositing large chunks of money into their account once they are familiar with the platform (i.e. half of end-of-first-12-months money only arrives after >6 months)

Commission growth is also very noisy ( ~f(volatility)) and only 1/3rd of earnings.

In short, closely track MoM account growth to know if IB is on pace for LT equity growth.

Account growth + (ST NOISY= Clients adding deposits + asset inflation) = LT Equity growth

So I observe account growth and know that (ST NOISY) was historically 10% and should be at least 4% on avg. going forward, i.e. observed account growth + 4% =  conservative LT equity growth.

Let’s discuss the latest results and the interesting conference.

November numbers & Peterffy on the GS Conference

  • On the November numbers, IB swung up 8% intraday & ended slightly down on the day
  • I agree with the directional close-to-closing price given the numbers
    • Short-term value driver commissions were great (market volatility) while
    • accounts growth disappointed at +1.3% MoM (vs huge growth last months of course, even the annualized disappointing MoM pace is still 17%, +- on par with the 10-year CAGR of 18%)
      • Peterffy revealed on the GS conference that MoM account growth was affected by special measures by Chinese govt that constrained mainland Chinese customers to deposit money into their Beijing-based intro-broker Tiger Broker app accounts (i.e. IB bank accounts in Hong Kong). Probable reason: Yuan is under pressure and growing money outflows put further pressure on Yuan
        • Tiger Brokers grew at a stellar rate last years (now processing >200BUSD in trading volume p.a.) & has a great app with local support, advertising and investors in the mainland (the Robinhood of China but with a smarter client base as unsophisticated Chinese retail investors are not interested in global investing) but back-end of the app is 100% IBKR and the bank account is with IBKR HK
        • My take: a yuan devaluation event should be positive as the restraint can be more easily lifted afterwards & as more Chinese would consider investing outside China after a deval

Notwithstanding current market correction, IB’s LT equity growth (main value driver) should be at least 4% p.a. above account growth as clients deposit more money into their existing accounts and asset prices rise in long haul. In fact, historically the equity CAGR was 10 %-points above account CAGR. As interest rates rise and IB pays even more interest on client cash than competition, there is no reason the pace of client deposits should slow so 4% seems very conservative.

Even annualizing these disappointing MoM numbers gives us 17% account growth or in my view 21% conservative LT client equity growth, which is still 2 pp above my model of LT equity growth at 19%.

Recent additions to the platform Peterffy discussed:

  • Israel markets (next week)
  • New screening functions for IB’s bond platform (direct electronic access)
  • IB features in recent past makes them more & more of a bank:  IB is now considering getting banking license abroad & US. In US, broker-dealers can do almost anything but  limitations abroad are generally more extensive
  • Effective 1st of Jan IB will start paying interest for small clients with total equity lower than 100k (previously 0%). The rate these clients will get will be linearly ramping from 0% to benchmark minus 0.5% with account size from 0 to 100k, e.g. 60k client would get 60%*(bench-0.5%) on his cash

Recent SEC action on the payment for order flow “PFOF” competitor broker’s practice

  • Competitors burdened with more disclosure requirements to clients

Peterffy voiced his concern that brokers who’re accepting PFOF (the vast majority) are routing their orders increasingly to “internalizers” that execute customer orders against their private “parallel” market (e.g.  HFT arm of Citadel, public firm Virtu Financial):

  • This means less and less retail orders are going to the exchanges
    • Because retail orders are the lifeblood of market makers as they are viewed as profitable “noise”, there’s less incentive for market makers to provide liquidity-adding orders limit orders to the exchanges
  • thinks the decreasing real liquidity on exchanges is a “disaster waiting to happen”

I read the Virtu Financial prospectus, and the story is not that simple it seems: exchanges are monopolies and they have been inflating their commissions and data fees over the last years at higher than inflation. IBKR IR themselves complained about that to me when I asked about that cost item. Customers using internalizers save exchange fees that could theoretically be shared amongst client, broker and internalizer. In practice however, this windfall (and slightly worse execution when using an internalizer) goes to internalizer and broker. I still think the internalizer model is a threat to IB’s 100% direct-exchange model as this ongoing exchange trading substitution may continue. This is mitigated by IB’s tiny market share that can grow much bigger in 3 or 4 out of 5 client types (prop shops is saturated &  sophisticated individuals is saturated but only in the US).

Somewhat distressing is Peterffy exaggerating JPMorgan’s new “free trading app” clients being patsies:

Well, obviously, businesses have to make a profit or at least break even. So one day advertise no commissions. They may have to make it up somehow, and so that is partly in selling the orders, partly not paying interest on the deposits, partly charging higher margin rates. I understand that Robinhood does this, and that’s okay. But to the extent JPMorgan is doing this, I think it’s a big mistake. People don’t like to be taken for a patsy, and it’s going to be — they will regret this, I think.

There are huge differences among brokers how much they take as PFOF as they negotiate how good the client execution should be. Fidelity and Schwab have ~10x better price execution than RobinHood and earn less from PFOF. As stated above, theoretically PFOF could be compatible with great execution as exchange fees are saved.  The difference between IB’s price execution and the more established brokers is really a few basis points (insignificant for individuals), while for Robinhood it’s >20bp.

Growth

Interesting point was that not only Asian intro broker clients are growing fast. A lot of European private banks are becoming intro brokers too as they can’t keep up technologically.

TC

Great presentation by Ben Evans

https://youtu.be/RF5VIwDYIJk

Some great points and examples being made. We are indeed still in the early phase of tech. Marketing is indeed unrightfully being forgotten when looking at digital advertising as a percentage of total ad spend. Online shopping curation – as opposed to logistics – is just getting started.

Investing implications/call to action: which public companies should capture some of the value of this opportunity, parts which are often forgotten such as shopping curation and marketing spend (largely confined to offline today)?

It seems this is a simple bull argument for digital ad duopolists FB, GOOG: well positioned with undemanding valuations.

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