Annual Review: CY2019

Annual Review: CY2019

I began investing again at the end of September this year. I published an interim investment update last month to get some thoughts on paper, but you can consider this a formal investment update and a record date of the portfolio for a return to performance tracking in future quarters. (Performance until April 2019 was disclosed here for reference).

There are two things to discuss; firstly, performance over the past quarter and second, current positions and performance tracking going forwards. Performance from “this quarter” includes part of one position, STNG, that has been held for a little over a year (and also contributed to performance in my April 2019 update). As a result this is not a “formal” review and scorekeeping exercise; rather I am recording the portfolio at this point in time to have a base from which to measure future performance.

~90% of the portfolio has been purchased since the start of September 2019 and so these numbers reflect very early days for almost every position.

Performance over the past quarter

As of 31 December 2019, total performance since the start of September was around +20% (excluding currency movements),  approximately doubling the major world index returns during this period. The ASX200 Total Return index (ASX:XNT) rose approximately 2% during this quarter.

The numbers are a little vague because I have not been diligent about record returns in my second broker, Stake. Interactive Brokers (accounting for a majority of the portfolio) provides accurate performance tracking and returns there are +21% since 30 September.  In an ideal world I would consolidate brokers, but I occasionally receive gift cards through work which I am able to load into Stake (but not IBKR), providing a reason for keeping that broker.

A quick note on gift cards

Finding a broker or other investment option that lets you load small amounts of funds from a debit Mastercard/Visa is a very effective way of using generic gift cards, despite the small load fees incurred.  Furthermore, when you invariably have residual dollars left on the gift card, if you have a US Amazon.com account, you can load any residual amount over US$0.50 onto your Amazon account, draining the card. (I have not tested this with AUD denominated gift cards).

The gift cards idea is interesting because it touches on the other half of the investment equation:  savings rate.  Broadly speaking, wealth creation is your savings rate (the amount of money you save to invest) multiplied by returns on those investments, minus fees and tax. For most ordinary people starting from a small base, the savings rate is at least as important as the rate of return.  For example, if you invest $10,000 per year every year, and achieve a cumulative 10% return on that investment every year, in about 25 years you will have more than one million dollars. By the end, of course, investment earnings far outweigh the savings rate, but that’s not the case at the start. A 4% annual escalation in savings rate (only $400 a year extra at the start), for example, can shave years off the time to reach $1 million.

So you can see that relatively small sums combined with decent investment returns adds up very quickly. Many investment writers talk about the returns but neglect to discuss savings rate.  (I digress slightly, but you might also be surprised to learn that many big-name investors started a fund with less than $50k in savings).

Now, the above gift card approach and other “alternative savings methods” like apps that round your expenses to the nearest dollar and invest the excess into ETFs are often criticised for high fees. For example, I lose around $3 in fees for loading a $50 gift card into Stake. However I believe the fee-focused criticism in this particular case is incorrect, because the purpose of alternative savings approaches is to increase your savings rate.

If you save $100 a year by rounding all transactions to the nearest dollar, and you lose $10 in fees, your savings are $90 better off. You might be poorer in total dollar terms, but this is not true if you would not otherwise have been able to save that money.  My choices with a $50 gift card are either a) spend it on consumption, or b) pay a ~6% fee and invest it. Yes the investment fees are high but that is not the metric by which we are judging the benefits of this transaction. The fees let me make a contribution to my wealth that would otherwise not be possible. To give an example, offhand I think I spent around $80 on gift card load fees in the past two years. But I added over $600 to my brokerage account.

I think that certain apps and approaches (like loading gift cards into your brokerage account) can add a modest but positive contribution to your wealth over time that would otherwise not be achievable or be very hard to achieve. As a result, I believe it is worth keeping an eye out for ways to improve your savings rate, just as much as ways to improve your investment returns.

With today’s sermon out of the way….

We return to our original programming:

The reason for the strong portfolio performance was predominantly a strong weighting to low quality businesses, although all of my stocks went up. Approximately 43% of the portfolio is currently allocated to shipping, with a further 4% (Cresud) invested in beef land in South America, and another 4% (undisclosed) in a distressed oil producer. My worst performer is Transportadora (TGS) in Argentina, down 20% since purchase on a 1.5% position. One stock is flat, and every other stock has risen in price, most of them substantially.

There were several other attractive commodity businesses that I avoided purchasing including US-listed Warrior Met Coal and Arch Coal (both down LTM) that I feel have attractive risk-reward tradeoffs at today’s prices.  However I didn’t pull the trigger and I’m still not sure what the discriminating factor is that would determine whether the stocks are a buy or an avoid. Simply; they are too hard. Previously I have written about a shareholding in NGE Capital (ASX:NGE) which has heavy commodity exposures (coal, gas, aluminium) and I have historically preferred to let NGE make these types of investments for me. Given that I no longer hold NGE, I simply have not been making any large investments in energy or mineral producers. (That should not be considered a view on NGE, which I still like and consider to be interesting at today’s prices).

A substantial amount of the performance benefit is potentially market noise; when all of the stocks you own go up at the same time in three months, it is typically not prudent to assign credit to your investing genius.

Later on I have an overview of every stock including purchase price, position size, current price, and my thoughts on it. For now, here is an overview of my current positions:

The largest performance contributors have been Scorpio Tankers, Altria, British American Tobacco, my basket of shipping stocks, Sony, Datadog, and Entercom.

Previously I had around 5 shipping stocks in my shipping basket (excluding Scorpio).  I have since expanded this to 8 stocks, mostly by reducing position sizes. Capital invested in shipping is approximately 32% (now ~42% of the portfolio after gains). The reason for further diversifying shipping is that basically all shipping stocks have governance problems ranging from moderate to serious, and I preferred a broader basket of smaller positions. The Scorpio Tankers position is too large under this criteria (noting some governance risk via the Scorpio Bulkers (SALT) bailout of STNG a while back) but I felt that Scorpio Tankers was also by far the best positioned business to survive the downturn, which is why it was the first shipping stock I purchased in 2018. I am inclined to back Scorpio management more for their foresight. In essence, the Scorpio investment reflects a stock-specific bet (inspired by improving industry fundamentals) whereas the shipping basket reflects more of an industry-specific bet, while trying to minimise the risks of bankruptcy or governance problems in individual stocks.

Shipping

The shipping industry may or may not be in the middle of a mega upswing. If current prices persist, a large number of stocks in the industry that operates ships LR1 size or above (crude oil or product tankers) will earn over 50% of their current market cap in free cash flow in the next 12 months. My shipping positions are split approximately half and half between product tankers (oil products) and VLCCs (crude oil). I originally purchased Scorpio Tankers (product) a year ago on the IMO2020 thesis combined with potential increased demand for oil products.

Since then, the removal of COSCO (China VLCC shipping co) from global trade via US sanctions has effectively reduced VLCC supply by 7% and caused a massive spike in rates. Here is a chart of shipping spot rates courtesy of Twitter:

In a business where costs are relatively fixed and rates go parabolic, the implied earnings power improvement is off the chart. There are a couple of things to take away from the COSCO sanctions.

First, the market was already tight or tightening. For rates to go up 3x on a 7% reduction in supply, suggests to me there is not much excess supply available. Some academic papers in shipping seem to illustrate essentially (my very rough paraphrase) a roughly exponential change in pricing from reduction of supply as a market gets closer to equilibrium.  I.e. when you are crossing the threshold from oversupplied to undersupplied, a 2% reduction in supply could lead to a 4% increase in pricing, 3% = 9% increase in price, 4% = 16%, and so on. This “exponential” relationship I imagine would be approximately capped both on the upside by the ability of supply to enter or remain in the market, and the downside by the cost of operating a ship relative to the demand for freight.   For rates to have gone from $30k to >$100k says to me that the VLCC market is now likely moderately undersupplied. The volatility in rates also suggests that supply is presently tight, and the potential for rates to fall quickly if COSCO returns to the market should not be overlooked.

Second, some product tankers are switching to carrying crude oil, which may alleviate rates pressure (albeit tightening the product market). Third, the word “sanctions” invites an investor to pre-pend the adjective “temporary”. A restoration of COSCO supply would crush rates (more on that in a sec). Fourth, all of this is happening even before IMO 2020 comes into force. IMO2020 is expected to accelerate fleet scrapping, tighten supply and increase rates. Fifth, the uptick in rates greatly changes the economics of ship operation.

All of this is rosy. However there are a number of key risks that could quickly normalise rates or otherwise lead to shipping stocks not being a slam dunk. Here is a brief list:

• COSCO ships return to trade, decreasing supply and rates
• There is an ordinary bankruptcy or implosion among one or another of the shipping co’s (investment risk, although this would be bullish for remaining operators)
• Shipping magnates rob shareholders (one way or another). One scenario that was suggested to me was putting a company in bankruptcy, wiping out equity and buying the bonds cheap.
• Shipping companies seize the opportunity to raise more capital at a discount to book (depends on what the capital is used for)
• Companies make large outlays for new ships (reinvesting in capex instead of distributing profits)
• High rates greatly lengthen ship life and usability. During previous booms in late 1990s and 2007, ship lives were up to 28 years. Recent estimates from industry participants suggest ships above 15 years of age would be at risk of scrapping due to IMO2020 (this was pre- the massive increase in rates). Due to vastly higher rates, the rate of decrease of industry supply is likely to slow or stop as old ships stay in service, which will act to place a cap on further upside in rates.
• Industry participant/s standardise a fuel, reducing the spread between HSFO and LSFO fuel / increasing the supply of LSFO, neutering the reward of owning scrubbers and reducing the pressure to scrap old ships as compliant fuel becomes affordable and readily available.

 

In theory the companies with the oldest fleets and lowest leverage (equity funded; having paid off fleets purchased during the previous boom) are best placed to weather a downturn because they don’t have as much of a financing cost burden. For example, financing costs can approximately double the “functional” daily operating cost of a ship; new fleets need less maintenance but adjusted operating costs (including debt) are much higher if they were debt funded, and financial costs are certainly not flexible.

This is an interesting tradeoff because new fleets are cheaper and more economical to operate, need less maintenance and probably have less downtime (higher utilization) albeit a larger chunk of the profits are shared with the banks. Older, equity-funded ships need more maintenance but are much lower cost and can survive lower operating rates – as long as there is work – in the downturn. In practice however I have not seen much of a difference; while leverage varies, almost all shipping co’s have very risky balance sheets, probably reflecting the lower cost of debt versus equity.

Some thoughts on idea generation and ownership

I’ve written previously that it was important for me to “own” the ideas I generated for the 10foot portfolio. It was important to test whether I could generate ideas, investigate them, and come to appropriate conclusions with no external input . The way that I look at investing is as essentially a conglomerate of individual skills that need to be mastered. You need to be able to research a stock in depth, you need to be able to position size appropriately, you need to be able to generate ideas, and so on. My approach is simply to attack each of these skills one by one, attain enough competence to get to a point where I can self-teach, and move on to the next skill.

I’m 95% confident in my ability to do deep-dive research on stocks, looking for the key elements of an investment thesis. I’m about 70-90% confident in my ability to identify the key driver of value creation. I’m substantially less confident, maybe 50-70% confident in my ability to draw the appropriate conclusions from my research based on the state of the universe at the time I look at a situation. I for example wrote a post about EML Payments (ASX:EML) almost two years ago  highlighting concerns with its accounting.  I think my criticism was correct as far as it goes in terms of the accounting policies and management remuneration (and I note that breakage income is now being recorded even further in advance than it was at the time) but I missed the broader picture which was that the stock was undervalued due to improvements in its business. In other words I underrated business prospects and overrated the risks I saw in the business. Unfortunately, getting better at stock-specific calls requires a lot of experience, which is hard to acquire if you are a low-activity investor. This is one of the reasons I have begun keeping a paper long-short portfolio in order to increase the frequency with which I iterate on ideas.

In any event, I no longer feel the need to intellectually “own” the ideas in my portfolio.

For the past 12 months or so my skill development has focused almost entirely on situation selection (identifying winning/losing situations), along with some portfolio management. It’s likely this, combined with portfolio management, will continue to be my primary focus 2020 as well.

Here are the individual stocks I hold:

• Cresud  (3.4% position, bought at $6.09 in Aug 19 , trading at $7.19, up 18%)

I’ve written previously that Cresud is probably one of the cheapest stocks in the world due to its large combination of South American and Israeli business interests. It has a substantial tailwind due to global demand for beef (Cresud owns an enormous amount of beef land, which it leases to farmers). On the downside it has substantial risks associated with the Argentine economy and political environment.  Cresud shares have rebounded since the election and I’m up somewhat on the stock, versus substantial losses previously (no change in capital invested since my previous update).

• Transportadora de Gas del Sur (1.4% position, purchased at $9.04 in Sep 19, last traded $7.24,  down 20%)

Transportadora is a gas pipeline covering approximately 57% of Argentina. Like Cresud it is one of the cheapest stocks in the world. Unlike Cresud, it is a regulated utility and faces substantially greater risk due to government regulation. The previous government recently permitted the company to begin implementing inflation-adjusted tariff increases biannually, which would have resulted in a reasonable return to shareholders. The risk is that the new government may revoke these increases and could for example mandate Transportadora to conduct its business without profit. It is a cheap stock but in my view probably the second or third most risky stock I hold – the risks are extremely high and the position size will remain modest.

Sony (4.8% position, purchased $58.49 in Sep 19, last traded $67.72, up 16%)

I have nothing to add on Sony beyond saying that business performance overall looks credible.

British American Tobacco  (12.1% position, purchased at 28.7, last traded 32.3, up 12%)

Altria (14.1% position, purchased at 40.3, last traded 49.9, up 24%)

The tobacco theses are unchanged, although stock prices have risen somewhat since purchasing. Unlike other theses which can rely on more on a change in the state of the universe, I think these companies are a perfect fit for the “intrinsic value is the present value of all future cash that these businesses generate” mental model, and in both cases I think the present value of that cash exceeds the current stock price.

Both companies take what I mentally refer to as “discontinuous risk”, in this case that the pace of regulatory change rapidly accelerates, or the rate of decline in smoking reaches a critical mass and rapidly accelerates (leading to functional obsolescence of tobacco).  I think both are pretty unlikely but not impossible.

Entercom (2% position, purchased $3.38, last traded $4.64, up 37% – some sold at $4.80)

The largest radio operator in the USA, Entercom shares rose +50% recently when the company reported moderate growth in a recent quarter – revenues rose 3%. That will give you some idea of how pessimistic the market is over the future of radio. There are some prospects for growth, as Entercom owns the largest group of sports radio stations in the USA, which may benefit from the legalisation of sports betting in many states. This is a family-owned business and the founder and Chairman has bought millions and millions of dollars worth of stock over the past year.

I get a valuation for Entercom somewhere between $5 and $7 depending on how optimistic I feel; I lean towards $5 due to the high debt burden and mediocre performance of the recent large acquisition. However, there is also a blue sky scenario if the industry consolidates (e.g. due to bankruptcies or deregulation) where the stock could be worth $10 or more. The bankruptcies are not improbable but it’s not clear to me yet what would happen to licensing regime (many markets can have 6-8 competing stations) as the industry shrinks. As a result I recently sold half of my position above current prices.

Datadog (3.2% position, purchased 28.5, last traded 37.7, sold some at $40)

I have little to add on Datadog given the recent IPO which was so widely covered. There are some very good analytical pieces on Medium and other forums analysing the company. I found its prospectus provided enough information to make an investment decision.

Misc Shipping Basket  (25.6% position, average 11% gain)

I hold 8 shipping stocks and have little to add.  I was attracted to the idea of options on shipping stocks as these could still have an asymmetric payoff – even at today’s prices – if you believe current rates are here to stay. However options are still broadly outside my area of competence and I’m not sure now is the right time (or that shipping is the right kind of business) to be expanding the circle.

Scorpio Tankers (16.7% position,  avg price $23.4, purchased from Dec 18 onwards, last traded $39.3, up 68%)

Nothing to add.

Undisclosed 1 (4.3% position, up 6%)

UK-listed LIC with a specific strategy. Performance has been strong but only in line with the primary benchmark index. However, risk is likely to be somewhat lower than the index average.

Unrelated: In line with my comments on idea generation above, I have begun including in my portfolio ideas sourced from other people. I learn of the ideas after they finish buying, so there is no sensitive information. However it does not feel right to publicly advertise “my” positions on the back of others’ hard work. I intend to keep these positions undisclosed for the foreseeable future (1-2 years) until the idea “matures” publicly and then I can disclose, with credit where possible.

Undisclosed 2 (3.8% position, up 3%)

A highly distressed resource producer. Net debt is well over 6 times EBITDA and the market cap is less than EBITDA. It’s either a multi-bagger or a zero, and I’m not sure which yet, although I believe the risk and reward tradeoff to be favourable. Pray for higher commodity prices!

I believe its industry faces substantial historical underinvestment and looming undersupply, but whether the business can survive the several years required to benefit from a cyclical upswing is an open question.

Undisclosed 3 (3% position,  up 3%)

An emerging markets resource producer with a very clean balance sheet and surprisingly low valuation. There are a couple of really ugly reasons for this company to be mispriced. Still, the business has solid infrastructure and a very attractive cost of production/value of product proposition, and short of a political collapse (not improbable) or outright theft, it’s probable the investment will perform decently. Yet, again there is a meaningful chance it is a zero.

Undisclosed 4 (1% position, flat on purchase price)

A foreign-listed video game development company. The company has very attractive IP and a history of producing big hits, as well as some interesting side bets in distribution that are not widely appreciated. It is generally very well regarded in its industry, however all of its potential and more are baked into the valuation.

The business looks attractive on an estimate of next year’s earnings, however this coincides with new releases (i.e. a peak earnings year) and the development cycle is several years long. Much depends on the company’s ability to repeatedly monetise its new title, such as via online subscription (or microtransaction) -based multiplayer.

As a result I have a modest position that I consider essentially a “watching” position which I may sell with no notice. Over the long term, if newly developed IP is successful, it’s likely that the company creates substantial value from here. However over the next 3-4 years, I have a hard time envisioning a substantially higher share price. This business has so far steered clear of aggressive monetisation (both SaaS-style subscription, and microtransactions), so I am currently of the view that today’s prices probably overvalue the company for the foreseeable future.

The Future

I intend to return to publishing quarterly reviews. I need to set up my spreadsheet again to start tracking benchmark values. Benchmarks are an open question. I will probably keep the ASX200 XNT as the primary benchmark because I am Australian and that is my local universe, although the returns on picking global stocks would need to exceed Australian returns plus franking credits – otherwise I should just buy a local index. Beyond that, I am thinking something like the MSCI All Country World Index, the S&P500 or NASDAQ, and/or an 8% absolute return benchmark would be appropriate as secondary benchmarks.

There has been no change to the overall investment strategy, which revolves around finding stocks at compelling valuations. I try to be as agnostic as possible on the growth and value ideologies of investing. A loss-making stock trading at 12x revenues can be very good value, as can a commoditised business trading at 2x free cash flow. The inverse of both ideas is also true.

Food for thought.

At the time of publication I hold positions in every stock disclosed in the above chart. I intend to make no change to any position for the next 7 calendar days. This is a disclosure and not a recommendation.