This post’s title is a wink at the book “Being Right or Making Money” (never read the book, yet like the title).
It is important, yet hard to draw correct investment lessons from experience.
I think I recently found a personal bias in the last few years. I unduly focused on finding investments with *multiple* *interesting* thesis points.
Take GOOG as a counter point. For the vast majority of time, GOOG has been an analyst’s favorite, with “buys” outnumbering “sells” by a wide margin.
Yet GOOG holders are making money hand over fist time and time again.
I believe the main investment thesis on GOOG hasn’t changed much since IPO. The main thesis point is simply the “positive feedback loop”, i.e. better AI algorithms draw in more users. Users generate useful feedback to improve those same algorithms. Rinse, repeat. In my opinion, GOOG has always been the AI and large datasets company.
I have followed GOOG for a long time. It was the first company I wanted to buy as a young engineering student (my father stopped me) after reading “The Google Story”.
Once I gained control over my savings, I always felt I did not have an edge vs consensus. Everything I know about the company is public knowledge. Most insights are scattered around.
There is nothing interesting for me to write on GOOG, everything interesting has already been written by greater investors and greater writers!
Is it possible the edge here is to understand the “positive feedback loop” thesis point, given the AI dynamic, is not “very, very important”, but instead very, very, very, very, very, very, very* important?
Assigning outsized weights to thesis points does not make for very interesting blog posts.
The above lesson was largely learned by having worked for a great portfolio manager who fostered the ability, I believe, to spot super important thesis points.
Let me know what you think.
I believe FB is in the same boat (biggest network reinforced by AI = unprecedented). There might be a larger binary risk involved, but on a risk adjusted basis the low valuation seems compelling.
Disclosure: Long GOOG, FB.
*aka high conviction on super durable long runway growth. Is this what John Huber means when he wrote on Facebook “the best business model ever created”.
As I’ve outlined before, there is no informational edge in most large-cap stocks, but there absolutely
is a time-horizon edge for those who are willing to thoughtfully analyze what most people want to
avoid out of fear of what the next year might look like.
I guess great investors who sometimes write 1 pager theses, like Mr. Huber, are telling us to focus on their thesis points as being “very, very, very, very, very, very, very important”.
This post will not be about the Corona shock itself. Rather forward looking & on knock-on effects.
Summary on the shock
I do believe this virus is in the sweet spot of characteristics between % mortality and other characteristics like incubation period to cause more simultaneous deaths (not anything like steady flow of traffic deaths) than ever before in absolute casualty cases. On the other hand, it is a mathematical certainty that consumer society will resume +- normal in a few months as the % of recovered population goes up and makes the viral reproduction multiple (R0) plummet. In simple terms: viral reproduction ability plummets as recovered population can’t infect others, nor can others infect recovered cases except for some exceptions (see most rudimentary math model in epidemics SIR model).
I personally haven’t deployed any cash/gold into stocks this week (though I do believe I should be almost always 90-100% invested in stocks as a stock picker).
while exogenous temporary shocks like COVID are +- noise for long-term investors most of the time, these shocks tend to cause recessions late in the cycle:
Consumer / business confidencecan only fall a lot if it is falling from a record high base level (e.g. not in March 2009)
Corporate debt built-up after a long cycle can cause domino effects from a short-term economic shock
the long-term indicators that correlate best with consecutive 10 year stock market returns, Shiller PE & Tobin’s Q compare the price of equities to measures of value for equities . (respectively: equity market cap vs cyclically adj. net earnings after interest costs and equity market cap/equity book value)
these indicators are far from perfect but have worked best in the past. Is today different?
blue chips balance sheets have deteriorated A LOT since ’09 : a lot of cheap debt has been added
Shiller PE, while at historically high levels, is oblivious to huge corporate debt loads when the interest cost of debt is ~0% as net earnings are ~unaffected
this is problematic for all P/E ratios, ~zero interest debt does not detract from earnings (i.e. debt is invisible), but the fact interest is ~0% does not mean the nominal debt balance is 0! the outstanding debt is still there and is highest in history
equities are residual interests in the business value after those historically high nominal debt balances that cannot be ignored
valuation measures based on enterprise value (market cap + debt) such as EV/EBIT, EV/sales have never been higher than today (for the US)
when compared to the ’09-’15 period, it seems the buy the dip mentality is deeply ingrained in my proverbial neighbors
are stocks cheap when they cross the level they were at not so long ago before the recent feverish melt-up
At this point I’m inclined to buy the low debt names in sectors that were already cheap before this shock started.
High cash yields with bond-like robustness to a recession are key.
Energy is a good example.
Huge advances in shale technology were pitched by Wall Street as a reason to pour money in shale. Ironically, technological progress was the very enemy of shale investors (stocks are down ~90%) .
Not unlike Buffett’s Berkshire textile operations, technological advances lead competing producers to pour money and invest in new technologies simultaneously. A decision that seems rational when a consultant presents it in isolation (invest 1000$ in this machine that saves you 700$ annually per factory, payback time = 1.4 years) is not rational when every competitor is doing the same. The end result is more efficient production for all producers and hence price deflation. The only winners are consumers. This is why Buffett stopped investing in the ever-efficient textile business.
Back to shale.
A widely known consequence is that this amazing technological progress (machine learning is still improving fracking efficiency) has led the US shale producers to be the new global “swing producer” of oil. Shale acts as a ceiling on the oil price as the global supply cost curve has flattened. Technological efficiencies cause the absolute cost difference in developing a cheap Permian barrel and say more difficult Bakken barrel to tighten. India needs an extra barrel? Oil price barely needs to go up to drill more. No one talks about peak oil these days.
What is not widely understood right now – with energy equities at a multi-decade record low % of total market cap – is that the corollary is also true.
In stark contrast to conventional and deep water reserves, existing shale developments have very high annual decline rates (in the second year, 40% less oil flows vs the first year; in contrast to conventional decline rates which are in the single digit % p.a.).
Since 2015, the growth of shale production has been astonishing. Today, shale oil satisfies 7% of total global consumption (the latter is ~100m barrels per day).
In the biggest recession of our lifetime, oil demand declined only a few million barrels, (low single digit %), before it resumed its upward march:
Then why was the price move so abrupt in 2009? Existing developed production does not adjust much to lower prices as the cost to develop the field is already stranded.
The marginal cost of producing developed barrels that are already flowing is much lower than the all-in cost (incl. investment cost to develop) . In the past, oil prices had to fall towards the marginal cost of developed barrels to adjust production downward, as the geological decline rates of existing reserves were so low. In the past, price had to move a lot to balance supply with small changes in demand.
In the next recession, existing shale oil production will decline immediately by virtue of huge decline rates on existing production (i.e. mother earth). New shale development will grind to a screeching halt as the oil price moves down a little, below the all-in cost of development. By the way, Wall Street has already soured on shale producers as they have proven to be cash burning machines doomed by the Red Queen effect described above + a recession will completely halt the easy money flow for new development + we are seeing this already: the rig count is already down more than 20% (incl all types of development incl gulf of mexico).
In other words, my believe is that oil prices can’t move much down in the next recession as the cost curve thanks to technological progress has flattened, and the swing producer adjusts immediately to lower oil prices thanks to mother earth’s decline rate.
Conventional & deep water reserves are long-cycle. Today’s marginal producer is fast-cycle with huge decline rates, dampening oil price volatility for a given demand increase/decrease.
Oil equities have been punished indiscriminately last week, from a low valuation base.
What about ESG/political risk?
I do believe the risk reward of investing in E&P’s with cash flow generative conventional oil reserves in non-liberal democracies (South East Asia, Africa, Russia, perhaps US) is better.
However, climate activism tends to peak with the economy: in recessions there are more pressing issues for democratically elected politicians (job losses, ballooning deficits, bank runs etc.). Abolishing oil production (this causes more job losses, deteriorates export-import balance and deficits) is the last on the bucket list.
In short, I believe political risk will be fine in a recession.
And while society can legitimately choose to curb carbon emissions trough different mechanisms on the demand side, it is a fact that society would screech to a halt when oil production stops today. Stopping O&G production is the most efficient way to propel us back to the stone ages.
Personally, I find it distasteful to look down on investors that have risked real capital (indeed lost much in the last decade) in a sector that risks capital and livelihoods to produce the energy that society (still) needs (and takes) right now. Cheap energy has always been a fundamental driver to improving quality of life for the poorest.
What am I looking at?
I looked at US shale gas producers (AR: own a small position , Range Resources, COG, CNX: probably interesting here)
why do I own a US shalegas producer?
much lower decline rates (15-20 y reserve life),
both the commodity and equities are incredibly cheap (but most producers except COG carry high debt burdens)
US nat gas is the cheapest in the world right now, trading at 10$ per energy-equivalent oil barrel (nat gas prices are not uniform across continents due to relatively high costs of LNG transport vs oil tankers)
nat gas is the cleanest fossil fuel (30-50% lower CO2 per unit of energy vs resp. oil and coal, zero particulate matter & SOx & NOx)
most importantly, I believe the -95% punished shale gas stocks (and the incredibly cheap US nat gas price itself) are counter-cyclical in this weird junction in history.
In a recession, I expect “associated gas” from shale oil wells (cheap competition to pure play nat gas) to decline rapidly, which tightens US supply a lot, while demand for natural gas is not at all volatile (residential heating, electricity demand, chemical feedstock need does not change much in a recession).
I expect nat gas prices to rise in a global recession
but honestly, continuous technological progress makes time the enemy of shale investors in the long haul (the investment they make today is stranded tomorrow due to price deflation)
while investors should be willing to pay a lot for counter cyclical assets (I am) and shale gas E&P seems undervalued, time is not your friend
Right now I am looking at low cost (high margin) cash flow generative oil producers at single digit earning multiples
Even the lowest cost shale producers have low profit margins, making them speculative.
On to more conventional producers:
Lundin Petroleum (family owned & great compounder in the space), Talos, Kosmos Energy, Vermillion, Husky energy
IPCO – spin-off from Lundin, high profit margin developed reserves, valued at ~1/3 of P2 DCF value, opportunistic management buying new reserves with quick payback time, in absence of these deals, company buys back a lot of stock with steady cash flow (good VIC write-up)
The crucial factor of course is capital allocation in the commodity space.
Any recommendations on good managements in this space are much appreciated!
How America’s most reckless billionaire created the fracking boom [Guardian] – Bethany McLean on the shale industry & Chesapeake (CHK) founder
in 2008, conventional wisdom was that 8$ was a natural gas price floor (it cratered to 2.5$)
there was a real scare of US running out of gas before the shale revolution, with even Greenspan comments
“Landmen were always the stepchild of the industry,” he later told Rolling Stone. “Geologists and engineers were the important guys – but it dawned on me pretty early that all their fancy ideas aren’t worth very much if we don’t have a lease. If you’ve got the lease and I don’t, you win.” – McClendon, Chesapeake Energy founder
In my opinion, the US natural gas industry has become an interesting pond to fish in.
That other shale phenomenon, shale oil is actually the biggest risk factor for the price of US natural gas (i.e. cheapest fossil fuel globally, and cleaner than oil & coal). US Shale oil producers make their decisions based on the oil price. As a “side effect”, they also produce associated gas. This “free” natural gas competes with cheap shale gas producers in the US. Interestingly, the US natural gas price is becoming counter-cyclical via the worldwide oil price. As the oil price suffers from an important demand shock in a recession, and shale oil producers are swing producers of oil, this growing competition of “free” associated gas is turned off (hence local nat gas supply shrinks).
In other words, while US shale gas producers are amongst the cheapest fossil fuel producers in the world, most US shale oil producers are almost the opposite (the marginal producers that turn off if oil demand retreats). As “associated gas” production of oil producers is turned off, this is very positive for US natural gas producers.
As credit markets are already shutting for natural gas producers (have a look at breathtaking multi-year plummeting share prices of AR, RR, CNX), a recession will probably put a damper on shale gas drilling (i.e. capex) growth as well. Lastly, demand growth remains underpinned by being the cheapest fossil fuel in the world. Meanwhile, US natural gas equities are very cheap compared to their prospective maintenance cash flows (20-50% yields) and SEC PV-10 reserves. Both valuation measures give 0$ credit to the huge dormant assets convexity/optionality (no costs if US nat gas prices go down, but extra profits if nat gas starts rising). Of course these are commodity businesses with the usual disadvantages, except one! This idiosyncratic group of commodity businesses can’t be criticized as “cyclical” anymore. That is a game changer. More later.
“Simply put, low prices cure low prices as consumers are motivated to consume more and producers are compelled to produce less” – McClendon
I concur the valuation is compelling but I think this is borderline too hard. In my mind there is a >70% probability BKNG stock is a home run. In the other case, BKNG loses its edge relatively quickly (measured in years while it trades around 20X earnings) as Google keeps innovating & lowering the user friction to book directly with hotels (or any other OTA bidder, aka make the bidding process for ads in the Hotel Module – which is one giant & very user-friendly meta search ad – much more competitive & hence expensive for BKNG). If the user experience becomes better (and hence the search process for hotels and travel starts) on Google, then the legacy moat of BKNG is in trouble. The post does not elaborate on potential further Google innovations such as Google Assistant sorting out a booking with a direct AI phone call to hotels, passing on the parameters the user was looking for originally (hence lowering friction to book directly & getting a birds’ eye view on). Stratechery [The Google Squeeze] focused more on the latest innovation at least.
Google makes available a direct booking API for larger chains to easily plug into. That will increasingly happen to smaller hotels too. BKNG has painful take rates of 15% on hotel revenue
Google Hotel Module is making auctions for customer attention more competitive. As the real estate of mobile phone is limited, competitors get only one shot for attention in this superior meta search tool. The highest bidder is featured on top.
general takeaway: long equities, commodities (though not energy), short long duration fixed income (he is basically long inflation)
maybe not read too much into it as he reverses positions frequently
last takeaway: bull on UK domestic economy: “never underestimate the common sense of the British people” – Thatcher via Druckenmiller. Stan is a brexiteer, biggest FX long is GBP & says UK domestic stocks are at low multiples.
2X as much KKR investment professionals in RoW vs US.
18 out of 22 investment strategy families less than 10 years old. Significant operating leverage on those (mostly) RoW people in young strategies
KKR Capital Markets: doing deals with third parties and being able to control the dealmaking and capture some fees, having a cap markets division is a competitive advantage that does not show up in typical alternative’s KPIs such as AUM, FPAUM etc
when KKR converted to C-corp, it stopped distributing 75% of distributable earnings. Today it is lower
Note I believe this is reason why KKR trades cheapish: the market prefers bird in the hand over compounding bird in the KKR stock bush, with supermajority voting stock etc.
KKR major player in Asia, biggest in terms of private equity funds, started in 2005
Most Asian investment professionals actually in India
Investing mostly in domestic consumption stories in Asia
Coming wave (next 1-2 yrs) of flagship fund raisings, chronologically:
Asia PE fund
Flagships will be additive to overall fundraising (last 3 yrs 90B of AUM raising without flagship wave, i.e. I believe only 1) and should be 30-40B USD in aggregate. Everything else equal, 120B AUM raising in 3 years is possible (bull case environment maybe).
If you buy 99 shares of Danaher through IBKR today at the US open, you’ll probably be able to tender these by the end of the business day (which is the deadline) for 5% more value in NVST shares. In two weeks you’ll get NVST shares delivered in your account.
Danaher is splitting off its 80% interest in NVST.
I am doing this unhedged, i.e. simply buying DHR and taking the volatility risk on NVST
Results may vary a lot, but 5% upside baked in is quite a high expected IRR for a few weeks of waiting.
As the book does not have a big narrative, I’ll share some interesting concepts and quotes I picked up. The book is also full of “concept boxes” that explain certain touched-upon concepts. Even for seasoned investors, you will learn a few things. I will not share these.
Interesting thoughts, resource and quotes. Unsurprisingly, as an electrical engineer myself, the “hard science” investors’ thoughts resonated most:
most investors used the bulletin boards to share info with others ADVFN (which I find useful as well for our Dart Group plc position), Fool, iii.co.uk, stockopedia.co.uk
Investing is not like Olympic diving: there are no marks for degree of difficulty
optimal betting size (i.e. Kelly Betting) is more cautious to downside risks than simply going by “expected returns” (i.e. probability-weighted return). Optimal betting uses logarithmic returns: while an investment with 50% chance of +25% return and 50% change of -20% has a 5% “expected return”, it has a 0% expected logarithmic return. Another way to see how an investor “gets” 0% and not the expected return is by continuously investing in the above 50/50 +25%/-20%-type of investments: +25%’s that are equally followed by -20% return 0% over time
Path-indendepent thinking: occupational identity can be a mental constraint. Don’t let your thinking be constrained by your identity.
I don’t seem to have very much influence on Walter. That’s one of his strengths: nobody seems to have much influence on him.
Warren Buffett on walter schloss
look for motivated sellers
better be right than consistent
The best decisions in the stock market attract no applause
structuring your investments by writing down a brief 1) thesis 2) secondary factors 3) “hygiene factors” (absence of red flags)
investing is a game with negative scoring: avoid mistakes, learn from other people’s mistakes
optimal rate of error: it is not worth knowing everything about a company, because every point investigated has a time-opportunity cost. Your aim in checking “hygiene factors” is not to find out everything, but to reduce your error rate to an acceptable level
On talking to insiders and activism:
strategic naïvety: it can help to appear less sophisicated than you are. It helps persuade insiders to open up.
manage company meetings: at AGM’s, set expectations at the start of the meeting by informing insiders you have several questions to ask. Take note of who answers which questions and how they interact.
create a paper trail: putting your communication on paper makes it harder for directors to evade their fiduciary duties and ignore you
Another interesting – and complimentary – review can be found here.
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)
over certain stock characteristics (value vs growth, positive vs negative momentum)
small caps outperformance seem to be concentrated in
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.