Pembridgecap

A Wealth Creation Journal

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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

Live Portfolio – Update #2

Make two small adds to Yixin Group (1%) and AddCN (1%) respectively @ 1.64 and 230.

 

Avanza 4Q 2019 Update

Avanza reported strong results and continued to grow its customer base which is up 17% year over year from 837k to 976k in 2019 (Avanza report its customer base in terms of the number of funded customers). A growing customer base is the single most important metric for long term value creation. It demonstrates that Avanza continues to be the most attractive retail investment platform in Sweden. Avanza’s customer base is ~10% of the Swedish population but only has 4.2% market share in the Swedish savings market. Avanza announced the ambition to increase savings market share to 7% by 2025 which means a double of savings capital from SEK ~400bn to ~800bn. This should then translate into a doubling of revenue.

 

Stock brokerage is high switching cost business, especially for retail investors. The high switching cost works both ways – it protects Avanza existing customer base from poaching by other online stock brokers but also deters Avanza’s attack on incumbent financial institutions. Avanza is winning market share because it is the lowest cost broker in Sweden AND provides a user-friendly investment platform.

 

Revenue grew 14% which was mainly driven by net interest income growth. Net profit grew 28% due to lower operating cost growth of 6%. Riksbank decided to go against their peers and raise repo rates in Sweden. The repo rate in Sweden is now at 0%. This has helped to increase net interest income by 70%.

 

The new CEO, Rikard, is very ambitious and continues to build on the customer-focused culture that has driven Avanza’s success in the past.

 

My view on Avanza remains the same: the best value-for-money investment platform in Sweden that has a very user-friendly online platform. It has an incredible mind share with young professionals, and as they progress in their careers, their savings on Avanza will grow too. There are two main optionalities with Avanza:

 

1) interest rate sensitivity where every 1% increase in interest rate will lead to incremental interest income of SEK 300m (2019 net profit is SEK 447m). I don’t count on it for the investment case to work but I consider a very valuable;

 

2) Avanza might grow into an online bank and offer more services to its existing customers hence increase product per customer and then revenue per customers

 

Trading at 36x P/E, Avanza is not cheap. But the strong growth visibility and the long growth runway means that I can be patient. Since my initial purchase in 2017, the stock is up 55% and generated 14.5% annualised return albeit with huge volatility. Over a longer time period, I believe Avanza is a 10-15% annualised return investment with very limited downside risk. Maintain current position and will add if Mr Market presents attractive opportunities to do so.

Live Portfolio – Update #1

Sold all Bitatuo shares and swapped into Yixin group shares. Believe that given the probability of success is the same for two stocks, Yixin clearly offers better risk-reward. Yixin has around 10-20% upside while also offering 15% upside. Bitauto, at current prices, has less than 3% upside but more than 30% of downside.

Live Streaming My Investment Portfolio

I am not sure if there is much benefit to broadcast my portfolio online. But it certainly sounds FUN! I was born in a small village with a very auspicious sounding name which loosely translates to mean a hundred victories. I really love that name and in honour of the village, I am calling my portfolio – Invictus. I hope it also brings me many victories in the years ahead.

I have included here is a breakdown of my portfolio as of 31 Dec 2019 and Invictus’s performance since inception in 2016.

  • Invictus Gross Return is the return after trading cost, admin fees and so on…
  • Invictus Net Return is the return after I applied an artificial fee structure of 0% fixed charge + 20% of the profit above 5% return. Unfortunately, nobody is paying me any fees now but I am determined to change this!
  • While I could not care less about what the index does in any month, quarter, and year, it is the best yardstick to measure performance over the long term

Here is how I will update my portfolio on this blog:

  • Every investment action will be updated here with at most 2-3 days of delay
  • I will try to explain all of my investment decisions as much as possible but no promises here
  • Every 6 months, I will provide a comprehensive portfolio update with performance and detail portfolio breakdown as seen above
  • Every 6 months, I will write a letter to explain my thinkings in more detail

Please feel free to share any feedback/comments with me! Even better if you share an investment idea with me!

Disclaimer: All information and material presented here are based on a virtual portfolio where there might or might not be actual trading activities behind it. The information contained herein is not intended to be a source of investment advice, credit analysis and trading recommendation. The sole purpose of this document is to document general investment thoughts and reflections on different businesses.

 

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