Investment Update – Oct 2019

Investment Update – Oct 2019

After a hiatus since April I’m overdue for an update. There are a couple of things to talk about.  I’ve made a couple of mistakes, but on the plus side I have solved several problems and performance has been good – really good.

Previously in my quarterly investment updates there were two recurring issues.  Position sizing was a concern in part due to the ASX $500 minimum trade size (and partly due to poor sizing), and brokerage was an issue due to the % impact of $15 brokerage on a $500 trade.  I have more or less resolved both issues. The appropriateness of a position size I don’t think can ever be precisely calculated, but it is vitally important to get the sizing more right than wrong over time, and without ever being so wrong that you detonate the portfolio. I think I have made headway on this, both from a stock selection perspective and also on position sizing, although there is more to be done.

To reduce fees, I’ve opened accounts with Interactive Brokers and Stake, which is an Australian-based no-fee US brokerage account (a Robinhood-like).

Stake

Stake deserves a little mini-review of its own elsewhere. Suffice to say it is an adequate platform for conducting free trades, with the only fee being the 0.7% load fee when adding money to the platform.

Much is made of selling order flow and for a hundred thousand dollars worth of stock I would not disagree. However for small position sizes, the incremental drag of $10-$15 brokerage fees is substantially worse than the negative impact of having your order flow sold, especially if you use limit orders.

I am finding Stake to be a useful solution although I would be very cautious as a beginning investor as the platform is aimed to encourage short term and/or thematic trading. E.g:

https://twitter.com/10footinvestor/status/1067492869483638784

Interactive Brokers

Interactive Brokers is a very professional platform that needs no introduction. It also has comparatively cheap brokerage. The execution difference of a professional broker is really noticeable here. On small orders I routinely have orders filled below my limit price. This is unprecedented in a decade of using Commsec, Nabtrade, and Stake.

(I currently have a referral offer from Interactive Brokers – new customers will receive $1 in IBKR shares up to US$1000 worth (escrowed for 3 years) for every US$100 they contribute to the platform. It is not a standout deal, but even after just 2 months of use I’m pretty sure I will never migrate away from IBKR, so it’s a reasonable incentive to move an account. I receive no commission or benefit whatsoever from this recommendation, and I have no affiliation of any kind with IBKR. If you’re interested, please comment or email me at 10footinvestor@gmail.com so I can send the referral letter to you.)

The combination of both platforms lets me invest in a very broad range of global stocks at more cost effective rates.  It’s had an unintended side effect in that it becomes a lot easier to trade more frequently. I’ve done a couple of day trades and a couple of week-long or fortnightly trades. Partly I was curious about this type of thing, and partly there have been a few interesting events (including a large number of US tech IPOs) that seemed a reasonable opportunity, but overall it’s pretty stupid and I’ve lost about 0.2% of the portfolio on short term trades.

Idea generation and procedure – paper portfolio

Over the past year I have been dumpster diving for stock ideas. I mentioned Argentina but I also looked at a series of US mall REITs on ~1x FFO with ridiculous leverage (e.g. NYSE:CBL) among others.

I maintain a paper long-short portfolio where I add investment ideas essentially on 10 minutes research, and track the performance. The goal is to focus on situation selection, without really caring whether the results are good or bad as long as I can iterate on what I learn. So far the best long performer is Just Group plc (a former holding; up 50%) which I ran as part of a long-short pair against Prudential plc (which is up slightly).  The second best long performer is Maharashtra Scooters, a discount to sum of the parts Indian scooter company that I would never EVER invest in, but hey it’s up 43%…  I have added a large number of dumpster stocks to the paper long portfolio and performance has been reasonable, up 11% since December last year.

On the short side there have been a couple of probable frauds and earnings quality risks but the most frequent and best performing shorts have been overlevered conventional businesses run by corporate management that is focused on acquiring or cost cutting. Short performance has been really bad, with the short portfolio up 9% overall despite a couple of idiosyncratic big wins.  I shorted a bitcoin miner (never again) and a quality of earnings risk Hong Kong listed “tech” stock that doubled in my face….  The short portfolio I am kind of not surprised to find that it is bad, as I have never shorted a stock and don’t expect to start, so that is just a little bit of fun on the side. I figure the process is kind of a inverse stock picking process – tell me where to die so I don’t go there, etc.

This paper portfolio probably deserves a longer write-up elsewhere as there are some interesting ideas in there. Probably one of my favourites from a novelty perspective is a Portuguese Eucalypt forest owner and paper manufacturer.

Idea generation – actual portfolio

For a while I was procedurally confused because I had multiple competing urges (trading, buying dumpster stocks, looking at US tech IPOs, paper portfolio) and I was never sure if I was gambling or not so I spent most of the last 7 months just trying to sit on my hands.

Having continued my research, successfully talked myself out of trading, and re-entered the right mindset following opening an IBKR account, I think it is a genuinely good time to be buying ugly businesses. They are not sexy, nobody wants them, interest rates are low and financing is relatively easy (reducing default risk), and these stocks are also on the ugly end of liquidity because stocks that are going down are getting sequentially less buying interest. Of course, plenty will be distressed for a reason. Still I think over the next couple of years it will be shown that investors were able to find good bargains in the ugliest parts of the market. I don’t know for sure if stock picking (identifying idiosyncratic single investments that have better risk-reward than other distressed stocks) or a basket approach (buying five distressed stocks in the same industry) will prove the better strategy but I think both will be viable. An interesting portfolio could be something like 30-50 deeply distressed stocks at a 1-2% position size, plus whatever else you like that is better quality, and cash. Although “really promising” stocks are hard to find, there is quite a large number of businesses out there that look convincingly mispriced.

For me the intermediating factor between “low quality businesses that are a buy” and “low quality businesses that are a sell” is how much distress is already baked into the price. There are a fair few low quality and overlevered businesses like Energizer (NYSE:ENR) that are essentially fully priced. Elsewhere there are really distressed businesses (with similar leverage and business quality) trading at low single digit earnings multiples that I think could survive.

One of the advantages of lower quality businesses at this point in time is often the thesis is something like “if this business does not detonate spectacularly, I could make money”, whereas to buy a highly priced growth stock you need to have substantially more confidence about the overall market, its market position, and management.

It’s currently (in my view) much easier to find a company that will probably not detonate spectacularly, than to find a company that will grow revenue 50% a year for the next 5 years and become convincingly profitable.  For example, I think Entercom (NYSE:ETM) is a well-run but mediocre quality business, yet if all it does is tread water and pay down debt I think it is worth substantially more than the $3.30 price I purchased it at.  And on the other hand I witnessed an interesting discussion recently regarding the way that cost of sales and marketing are classified for tech stocks, and why 80% gross margins are not necessarily comparable or indicative of business quality.

Even so, I recently had a very close look at Datadog (NASDAQ:DDOG) and stayed up until midnight to buy its IPO, but the opening pricing was far too high.  A key concern I had with it was that Datadog has already pulled the price lever hard. It probably has substantial additional pricing power, and operates in a growing industry, but I don’t know how to quantify this and there are aren’t as many visibly untapped opportunities as there were at Xero in 2014/2015. As a result, Datadog might be a great company that continues to grow (I am confident that it will) but I find it pretty hard to have a confidence around valuation. I also had a look at a few other IPOs such as Cloudflare and Slack (definite no) but they were too hard. I think Datadog is a great business, but I don’t know if it’s worth $35 or $27 or $50. (Subsequent to writing this paragraph, I bought a 4% position in Datadog when it dipped to $28 recently).

In any event, following the sale of my whole portfolio earlier this year I have started rebuilding. This quarter has been extremely dynamic so there are a number of stocks that I own but have been trimming positions, and others where I have sold completely yet intend to buy back quite soon. Positions and thoughts below are current as of 19 November (date) but can and will change.  Here is what I hold at the moment.

Portfolio overview

Before I go into this I should clarify that my portfolio is very small at the moment, around $9,000. The regular reporting is a valuable discipline but I would not read too much into position sizing or other comments.

Position sizes are reported at current position size, which includes all stock price movements and any trimming of positions.

Cresud – Down 30%

I covered Cresud in my Argentina post. I think it’s a very cheap stock with a credible underlying business. It is reasonably well placed to weather Argentine inflation due to its variety of businesses, foreign and USD-denominated earnings, and ownership of large tracts of land. Its beef land can arguably do well with the devaluation of the Peso if it can export a meaningful amount. Argentina has recently signed large trade agreements to export beef to China.  On the other hand…it is Argentina.  Uncertainty is extremely high and risk is only marginally lower. The recent election has returned money-printing and allegedly corrupt former Presidente Kirchner to government.

I must confess I have day traded this stock a couple of times. I increased position size when the Argentine beef export deal was struck, for example, then reduced greatly prior to the election, for a modest loss overall.

Transportadora de Gas del Sur – Down 32%

A similar thesis to Cresud above. This is a monopoly gas pipeline supplying gas to 56% of Argentina. It is finally receiving inflation-linked tariff increases with a biannual review after years of being capped by regulation, and it pushed through substantial tariff increases last year. It is probably the cheapest pipeline in the world, offset by substantial regulatory risk. The Argentine government will definitely not permit anywhere near the exploitation (and as a result, the debt burden) of pipelines elsewhere in the world.  There is a non-zero chance the government caps tariffs following the recent election.  All these things considered I think Transportadora is likely substantially undervalued but it should be, and will remain, a tiny position size.

Both Transportadora and Cresud have been annihilated since the election, down around 30% (in addition to the 40%+ decline earlier this year). While I reduced position sizing prior to the election, in hindsight position sizes are still too large. Fortunately the small size of the current portfolio limits a lot of the risk. Objectively the difference between having a 3% position or a 1% position on $9000 is not material especially when the capital in the portfolio is growing regularly. It is not ideal but in this case it is a mistake I can live with.

Sony  Up 7% 

I have wanted to buy Sony for a while following Third Point’s activist long thesis. I don’t really have much to add other than that I found the idea compelling.

Entercom    Up 43%  

A large radio company with a substantial debt burden.  Management has purchased a significant fraction of the current market cap on-market recently.  I don’t have high confidence in this position but I think it is quite likely undervalued. There is a possible tailwind emerging with the advent of sports gambling and associated advertising (Entercom owns the best sports radio stations) in the USA. I recently trimmed this position following its run up.

Tobacco  25.3%   Up 8.2%

British American Tobacco – Up 1%  

Altria –  Up 16% 

The tobacco thesis is outlined with greater clarity by smarter people elsewhere, and I have touched on it before. I do not think much will change at these businesses and I think both trade at a substantial discount to intrinsic value. Altria I have owned previously at $52(?), in much smaller position size. I felt at $40 where I acquired it that it was substantially undervalued. The fear over tobacco regulation drives much greater volatility in stock prices than the volatility in underlying earnings power and cash flow at tobacco companies.

Scorpio Tankers  –  up 33%   / Misc shipping stock basket  

I’ve written previously about shipping.  I increased my position in Scorpio Tankers (STNG) earlier this year.  Following the recent sanctions against COSCO and the subsequent inflection in shipping rates, I purchased a basket of VLCC crude shipping stocks, and additional product tanker stocks.  Previously, my investment approach for shipping required a “safe” balance sheet and young fleet in order to survive until a nebulous future period when rates normalised. Scorpio Tankers performed the best on these metrics. Following the inflection in rates however, I purchased some lower quality businesses (although still with a bias toward young fleets) and one dumpster stock, Teekay Tankers which I previously identified (link above) as being extremely risky and unlikely to survive unless rates normalised.

As rates returned to normal following the spike, I sold the shipping basket and trimmed my Scorpio Tankers position. I made approximately 15% on these purchases (split across 4 stocks) before tax.

For those that are interested; at around current rates, shipping stocks trade on something like 4x free cash flow. At recent (admittedly ludicrous) highs, stocks traded at ~0.6x next year’s profits if those rates persisted for one year, for something like a plausible ten-bagger. The industry has high fixed costs and supply is not very flexible. I think there are favourable tailwinds playing out in shipping including an ageing fleet, lack of replacement fleet, potential ageing scrapping post- IMO 2020 (although scrapping has probably been delayed after the recent price spike), and a cost advantage for fleets like Scorpio with scrubbers. Overall I think there is some potential for a revenue increase while fixed costs stay roughly steady, multiplying profits.

I have abandoned the previously mentioned idea of finding a refinery to benefit from the spread in LSFO/HSFO fuel. The fuel mixtures are not standardized, i.e. not every LSFO is equal, and this brings substantial risks to shipping operators depending on technical factors with their machinery (which I admittedly do not fully understand).  As a result I think it is likely that one or all of the oil majors will standardize a fuel type and that breed of LSFO will be the winner, and a small refinery will be unable to compete. Large refiners are, I guesstimated, too big to see a meaningful benefit to earnings from the changeover.

I have recently been purchasing shipping stocks again. In the future I will think more closely about how I describe adjustments to position size and similar, especially if I start adding and adjusting baskets of distressed businesses. While I always lean towards full disclosure, it’s simply not very interesting to talk about how I re-weight my basket of shipping stocks every other month. This is my most active position.

Datadog (DDOG) – Up 40%

There are lots of theses on Datadog on the internet.  It is reportedly a very attractive solution from a technical perspective and its billing procedure (per volume of logs created) means that companies a) have power over how much they spend but also b) the spend will grow in line with the company, which is a favourable tailwind for the software companies Datadog supplies. It is a pricey stock whichever way you cut it, and I don’t have much new to add. Following the recent run up in stock price, I have trimmed my position.

Undisclosed –  Up 2%

I took a small position in a foreign-listed LIC with a specific offering that I feel is quite unique and undervalued. It’s a small strategy and I took the idea from a friend who is a specialist in the field, so it would not feel right to disclose the idea. Against my better judgement I purchased a position at a price around NTA, only because I feel the NTA likely substantially undervalues the holdings.

Undisclosed – no change

A recently purchased, extremely distressed resources business with essentially binary and probably extreme outcomes. The risk-reward trade-off is favourable, but this will be a good test of my newfound position sizing skills.

Cash 

I have one further purchase on the horizon but for the foreseeable future I intend to keep an elevated amount of cash.

 

It’s a short period of time but results have been very strong;  I think October (up 9%) was the strongest month I’ve ever had, performance wise. I’m up approximately 15% since opening my Interactive Brokers account in September.  What will be interesting now will be to see whether the stocks I have selected actually deliver on results. Tobacco stocks need to roughly maintain their earnings and cash flow. Shipping rates need to remain at least somewhat elevated from where they were a year ago. Datadog needs to continue growing revenue very rapidly, at an appropriate cost. Entercom needs to grow revenue modestly and keep costs contained, and so on.

As this is a mid-quarter update mainly just to keep me honest, I’ve not provided precise information on purchase prices, position sizes, or performance versus an index and it’s possible there are errors in the above numbers. Come December 31 I intend to fix position sizes and prices at then-current levels and return to performance reporting and tracking like previous 10foot posts.

I own shares in each of the companies shown in the above portfolio chart. I will make no trades in any of the mentioned stocks for 7 calendar days following this post. This is a disclosure and not a recommendation.