Pembridgecap

A Wealth Creation Journal

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Live Portfolio Update – 2020 #8

The deal is finalised today and closed out all Bitauto / Yixin positions.  A cool 20% return in 6-months. I consider special situation opportunities such as this one to be perfectly reasonable investment opportunities given the generally high market valuation. Will probably participate if similarly good opportunities arise again.

However, one must recognise the real money is made with a great company that can compound over time. The special situation opportunities seem to me to have real reinvestment constrains because one cannot always find wonderful special situation investments with attractive absolute returns despite good risk-adjusted return. And not scalable after a certain capital size(not an issue for me now but hopefully it will be).

Frankly, it just feels less satisfying than owning great businesses that just keeps improving and making a real impact on the world.

Live Portfolio – Update #4

What a roller coaster journey I have had with Aimia for the past 2 years. I initially bought Aimia share around CAD 1.3 in Sep 2017. There was a lot of debate around what Aeroplan would look like once it breaks away from Air Canada. My purchase was driven mainly by the insight that the redemption liabilities originated from issuing loyalty points do not carry nearly as much economic value as its nominal value would suggest. As the issuer of your own currency, there are multiple ways to deflate the liabilities denominated in your own currency to effectively zero. Anyhow that debate got resolved when Air Canada bought back Aeroplan for a sweet CAD 450m which more than double Aimia’s market capitalisation at the time.

I sold the majority of Aimia position but kept a sizable 5% position because I believe the activists’ chance of monetising the remaining holdings (such as PLM and Cardlytics) are quite high and the discount to NAV is substantial (30-50%).

Fast forward to the current situation, the activists have taken over the board at Aimia and completed monetization of smaller stakes such as Cardlytics. However, the real value is PLM which is Aero Mexico’s loyalty program. Aimia owns 49% of PLM.

The biggest variable in Aimia’s NAV calculation is the valuation of PLM stake. This valuation is a balance of three factors:

  • The balance of negotiation power
  • How much can Aeromexico realistically afford to pay given its highly leveraged b/s
  • The intrinsic value of PLM

I ranked them in order of decreasing importance. The relative negotiation power of Aimia vs Aero Mexico is the most important driver of the actual value realisation and not the intrinsic value of PLM. It is not clear that Aimia is in a position to push for high valuation because Aeromexico can always opt for the status quo indefinitely. Yes, Aeromexico would have to share the dividend value with Aimia but it would also be very hesitant to add to its already high debt load. Of course, Aeromexico can issue equity to Aimia but this is further compounded by the current coronavirus situation.

My original expectation was that there could be a reasonable chance that Aimia can sell PLM stake at 10x EV/EBITDA multiple. I must admit that this is looking increasingly remote. I still believe that Aimia easily have 20-50% upside from its current share price. However, there is a real opportunity cost to holding Aimia shares as other companies are becoming more attractively priced.

So I have decided to sell Aimia position down to zero at the prevailing market price (CAD 2.2)

Live Portfolio – Update #3

In Feb 2020, I have added to AddCN (0.7%) @ 230 and 6% (Yixin) @ 1.69.

In addition, I have also opened a short position to BITA (-7%). I shorted BITA because of the unique characteristic where BITA’s downside in a case of deal failure is likely to be higher than Yixin. While the Yixin upside (20%) is substantially higher than BITA (~6%). So this creates an attractive situation where I can create a long/short value ratio of 10:3 (Yixin / BITA) to almost fully hedge out the downside risk of a deal failure

Sold ~20% of GAW position at GBP 61.3 because I have another opportunity in the game sector that I would like to deploy capital. Given the current market environment, I think the option value of keeping some cash is very high. So I sold some GAW to make room for the new idea while keeping a healthy cash level.

On another side note, Bill Gates published an article on Coronavirus (Link here) where he advised government around the world to assume that “Covid-19 has started behaving a lot like the once-in-a-century pathogen we’ve been worried about”.  And then he went to outline measures to combat the virus and highlighted the importance of pre-emptive measures in the emerging markets. Bill is just an amazing human being.

I am put to shame as I have been preoccupied with the opportunity to profit from the market dislocations created by this virus and have not so far thought about how I can help with the pandemic. And frankly, there is probably little I can do anyway. Nonetheless, I am very grateful to people like Bill who are fighting the virus tirelessly. Without them, there would be no recovery and nothing to profit from. So for that, I am very grateful.

With that gratefulness in mind, I will resume my work to find the best opportunities to make money from!

Corona stock hunt & why oil prices are robust to a global recession

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).

Equities: cheap? 

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).

Why?

  • 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 confidence can 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 shale gas 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!

TC

Long read on US shale gas backdrop

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

Links

  • Booking.com thesis (excellent overview) – [the 10th man BKNG thesis]
    • 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.

  • Druckenmiller 2020 Outlook [Bloomberg]
    • 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.
  • Peter Lynch in [Barron’s ]

 

 

 

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