Winter is Coming

While my focus is individual companies, I've been positive on the US and negative on China (and really emerging markets as a whole) for the last 2 years. That was shown roughly correct last year in a resurgent rally in the S&P 500 which outpaced most equity rallies worldwide. I was fortunate in removing most (valuation) shorts while holding on to most long ideas/companies. I now believe the tide is reversing, and even the United States will not be immune to weakness. In short:

(Source: Game of Thrones, http://www.ifc.com/fix/2011/04/game-of-thrones-premieres)

Contagion is the reason why this sell-off is different (and similar to Europe in 2011) because losses are contagious even though they seem unrelated at first glance. From the Argentinian peso/Turkish lira devaluation to China credit contraction and Brazil slowdown, global markets have started falling in tandem again - the Fed taper is simply the catalyst. Animal spirits are rising again, and levered funds I believe have started to cover en masse, creating a self-fulling cross-asset linkage across the world. Cash (USD) remains the only true safe haven.

My hypothesis is that (US) investors are waiting for the Fed decision (Wednesday) to reduce more, hoping not to miss the post-fed pop.  However, given the weak pre-Fed price action, consensus on yearly gains by market professionals and rally into the New Year, I believe markets have already priced in the best scenario. As such, reducing risk going forward is my position.

Fund-wise, I've dramatically reduced long exposure while maintaining the China-related (e.g. levered commodity company) shorts from last year. I still hold my highest conviction domestic longs, but believe there are better prices ahead.

Disclosure: reduced NEU, IBTX and sold out of HLSS to get cash.

Stay warm,

-Stanley

NewMarket Corporation (NEU) - An Efficient Way to Capitalize on Oil

NewMarket Corporation (NYSE:NEU) is a chemical manufacturing company which specializes in petroleum additives. With pricing power on the product side and cost-advantages stemming from increased usa oil/gas production and refining, NEU is the prototypical "great company at a fair price."

1) Pricing power - NEU's relationships with customers allow them to raise prices to pass on costs of raw materials. There is, however, no requirement to lower prices. Given the oligopolistic nature of the petroleum additives business (NEU is top 4), NEU has the chance to participate as prices continue to rise, even in 2013. The (minor) competitor listed, Chemtura, cited raw material price increases. If smaller players are able to raise prices, what does that say about market leaders such as NEU?

That doesn't necessarily show the full story, however: gross margins have been increasing steadily in the past decade:

 (Source: Morningstar)

Price don't necessary follow costs, usually to NEU's benefit! The four top producers (90% total market share) form an oligopoly which compete on services/value-add versus price. Industry competition and pricing power with customers/suppliers all favor NEU. However, this is just the beginning, in my opinion.

2) Cost advantage due to USA oil & gas renaissance. In the past few year years, raw material prices for NEU have been rising, yet cost of goods sold have remained consistent (see 10-k pg 28). NEU's relationships and market allow them to pass on cost increases. Now, what if those costs decrease?

NEU lists "base oil (byproduct oil refining), polyisobutylene (isobutylene component is of component of nat gas/crude oil refining), antioxidants, alcohols, solvents, sulfonates, friction modifiers, olefins (byproduct of oil refining), and copolymers" (parentheses mine) as the inputs needed.

Most of these inputs are the result of oil/gas production, and oil output/refining capacity has been increasing dramatically:

Should those oil/gas products lower in price, NEU and the market leaders are not pressured to lower prices to compete because of the oligopoly. They might lower, but after a lag and usually conservatively. This scenario may not last forever, but as long as competitors focus on service rather than price, NEU will continue to earn economic profits.

Now, how does NEU protect itself from new entrants who would undercut? Customization and the same customer relationships above ("oil companies and refineries to original equipment manufacturers (OEMs) and other specialty chemical companies" from 10-k pg. 3) preclude an easy switch. A customer-stickiness combined with technological know-how (from the limitless types of additives) will at least severely delay new entrants. New entrants or substitutes would therefore be difficult to make.


3) Steady secular growth - requirements from the US government for increased fuel mileage force continued reliance on additives for that extra boost of efficiency. Because of sufficient barriers to entry from 2), NEU and its competitors can participate in the steady (albeit slow) growth.


4) ROC-focused management - from reasonable buybacks, special dividends (e.g. in 2012) and a conservative capitalization, NEU is run by management-like owners because they are, in large part owners (13%/$550mm of equity owned by insiders, per Morningstar). That is how NEU manages double-digit ROA/ROIC for past 5 years, even in 2008 when many firms were trying to stay solvent.


Risks:  the main risks to this thesis include 1) the beginnings of price competition given years of solid profits 2) lack of growth from end-user demand related either to engine/machinery usage and/or regulatory changes. If, for example, government lowered fuel mileage/composition requirements, then NEU's products would not be as useful. This is not a fast-growing market, so revenue growth even in the best cases would not be high and decreases could definitely re-rate NEU and its peers lower on a multiples' basis.    

These risks, however, I believe are mitigated by the above four points, and as such I have added more to NEU.

Careful investing to all,
 -Stanley

Is Capital a Barrier to Entry? (Property Catastrophe)

Greenwald's Competition Demystified focuses on the barrier to entry as the key competitive advantage. That is, the difficulty of new entrants to enter is the main factor to focus on when determining if a company can earn excess returns (i.e. high roic/return on invested capital).  

Given current investments in a variety of (re)insurers and experience in catastrophe modeling. I was struck by the stampede into reinsurance by traditional investors. Reinsurance as an industry may be losing its competitive advantage.

Estimates now show up to 15% of the industry as from traditional capital markets and thereby push rates on line lower. That is, the premium rates paid by primary insurers to reinsurers are coming under pressure by new investors. It seems like in age driven by low interest rates generally, investors are seeking yield again in areas - namely the relatively stable catastrophe reinsurance. As a result, a flood of money has broken through industry barriers. This, to me, is an ominous sign for reinsurers. Given the stable recent returns of catastrophe (ILS) indices, investors believe that stability and consistent 5-year performance means similar thoughts going forward.

The above graph, in my opinion, is exactly what has the capital markets salivating. It breezed through 2008 with problem! The catch? It is missing 2005's Katrina+ losses, 1992 insurer-busting Andrew hurricane. As a result, fund managers may be blindly running into this arena and are unfortunately supported by 2 erroneous beliefs:

1) Price volatility = risk. I already disagree with this for equities, but for property catastrophe reinsurance (the most popular) it is even crazier. Why would a hurricane care about previous price trends made by humans? The fact that many of indices quoted don't even reach back before 2002 show the lack of data that investors are using. Hurricanes rates are not stable even over decades, yet investors believe the returns from just one.

2) Models are accurate and precise. Catastrophe modeling as a quantitative industry has really only grown in the last decade as well. Major commercial vendors such as RMS, AIR, EQE produce very deep models with 100,000+ simulated events and output losses to the dollar. Most industry veterans recognize that this is just the starting point, but new investors can easily look at results such as standard deviation and expected value/loss to make decisions. 

More specifically, the problem is that most of the risk for higher layers happen in the 100+ year return periods, that is once every hundred years. Veterans use say TVAR 99% (tail value at risk, that is the expected value of the tail beyond 100-yr (1-1/100=99%) events). Even they are wrong.



Bottom line - oversupply in reinsurance (especially property catastrophe) will probably lead to subpar returns going forward. On the other hand, for the first few years (or shorter), primary insurers will get cheap protection and may get an additional boost in earnings.


Careful investing to all,
-Stanley