Peak Brexit

*Credit to Google Trends as of 6/23/2016.

Contracts don't overcome economics.

Throughout this commodity down cycle, investors have often relied on contracts to justify otherwise un-economic investments:

Example: Cliffs Natural Resources (CLF) in 2014 (and earlier)

"...the company's core U.S. iron ore business has long-term supply contracts and therefore is not exposed to the volatile spot prices."

...except actual results show something different:

CLF's contracts do index worldwide iron ore prices, even if indirectly. Even if they didn't, how would their customers compete on the open market if their costs are extremely higher? They don't:

"For its part, Cliffs has responded in filings in Delaware that Essar Algoma is seeking to gain a windfall by persuading the Ontario Superior Court to force Cliffs to supply the ore on the terms the steel maker wants"

Contracts are meant to reduce swings, not a sustained trend in one direction. Customers have to try to negotiate, whether through changing terms or bankruptcy.


Now that iron ore, oil down, liquefied natural gas prices have fallen by 50%+ don't think "long-term" contracts are nearly as helpful as investors believe.


Disclosure: short LNG.

VOYA Continued

Despite reaching a ~8% return on equity and its 3rd year of profitability, Voya Financial (NYSE:VOYA) still trades at the same discount to book (0.7x book) as three years ago. Most of its revenues and income come from fee-based businesses that are recurring and sticky, allowing current purchasers to buy a reasonable business at a great price ~12x ttm earnings or less.

Voya has many positives:

1) Three segments that are well-positioned for future business:

• Retirement Services: 401(k) plans are fee-based and sticky, generating recurring revenue (2/3 of operating income, 2014 10-K ,http://www.sec.gov/Archives/edgar/data/1535929/000119312515069733/d877740d10k.htm , page 120)
• Investment management: a steady business moderately levered to growing financial markets
• Insurance solutions: life insurer that benefits from steadily increasing interest rates

For the full year 2014, operating earnings were ~800mm against a current market cap of ~10bln. (http://www.sec.gov/Archives/edgar/data/1535929/000119312515042830/d867605dex991.htm), the current quarter's earnings were even better at a ~1bln annualized net income.

2) Strong capitalization due to regulation that simultaneously provides potential runoff profits.

Voya's financial leverage (liabilities/equity) at ~15 is the lowest compared to peers such Prudential (PRU, 18), Lincoln National (LNC, 17).


The Closed Block Variable Annuity segment is a pre-financial crisis artifact that due to regulatory pressure is highly hedged and overcapitalized:

(source: 2014 10-k, page 222)

Basically, if the equity markets rally Voya will actually make money while being hedged on the downside; interest rates hedges naturally complement the business as increased rates help the life insurance side of the business while lower ones result in profit for this side of the business.

3) Alignment of incentives: of the insiders who bought in the spin-off/ipo in 2013, many including officers have not sold a share (even after a 100% gain in 3 years). There is little hurry to unload shares.



Risks:

• Market declines: This is a financial company, so overall market declines do impact results in terms of outflows (to cash), declining aum balances. However, given the fee-based nature of the business I believe the business will continue running. It is not a bank, so it is not direct affected by bank runs.
• AUM losses: more for the relatively minor investment management division, outflows from poor performance is possible; retirement services are less so given the sticky nature of institutional retirement programs. It is simply easier to stay put unless there is a significant misstep.

Nonetheless, given the extreme cheapness of the stock even an average business would suffice. A reasonably competitive business such as Voya is a bargain at current prices and in my opinion should trade at or even above book value ~ 1.15x or 75$/share.

Is it time to "go for the jugular"?

Soros taught Druckenmiller that what matters is not how often you are right, but how much you make when you are right. Given that shares of iron ore miners (such as Vale) have been falling alongside iron ore prices amidst increasing supply (and flat demand); perhaps it is almost time for crisis-mode for these share?

The catalyst here? Bans on selling. China has essentially restricted liquidity of the largest holders of shares when liquidity has become paramount.  The United States & other others instituted short selling bans that did not help in restoring confidence - now the Chinese government has learned the wrong lesson and gone all-in. If there is no way to hedge counterparty risk (cds/bond market is far smaller in China), what can investors and indeed banks do? Sell everything else - including commodities such as iron ore.

The AA Trade (MPEL)

Michael Lewis's The Big Short described one particularly effective way to short mortgages - shorting the "safer" derivatives on mortgages. There were many mortgage derivatives (e.g. senior tranches of CDOs) that were rated AA (that is, just riskier than AAA-rated US government debt). Yet, the underlying assets were of junk quality. As a result, the resulting payout was $50 to 1 invested vs. say the $10 to 1 of shorting the riskiest mortgages. Shorting Macau-based casinos such as Melco Crown Entertainment Ltd. (Nasdaq: MPEL) may be the AA trade for shorting China risk.

MPEL is a Macau-based developer & operating of casinos and entertainment resorts and makes money mostly from Chinese tourism. As Macau is the one area in China where gambling is legal, MPEL is essentially an investment in Chinese gambling. However, increasing (sticky) supply of casinos, decreasing demand from China, and a heavily leveraged capital and operating structure make a short favorable.

1) New supply comes from a near doubling of casinos from 2007 to 2013 alone:

(Source: http://www.cnbc.com/id/101258573 - not the best source, but I believe this is approximately correct). At the same time, entire new casinos are being built to be completed in 2015-2016 (http://www.wsj.com/articles/macaus-gambling-revenue-continues-to-tumble-1430718723 , http://www.nytimes.com/2014/03/26/business/international/macau-rides-high-on-new-round-of-casino-construction.html?_r=0 )

Here is the key passage:

On Wynn’s earnings conference call last week an analyst asked the company’s chairman and chief executive, Steve Wynn, why he doesn’t slow construction of the project or scale it down.

Mr. Wynn interrupted him: “Hold on. You can’t slow it down. It’s being finished and there’s bank obligations. You can’t slow it down in Macau. The building is sitting there. The skin is on. They’re getting ready to fill the lake. Staff is hired.”

This is key - increasing competition and falling revenues does not affect supply. In the face of debt and financial commitments, most developers are committed to the path.

MPEL is committed to spending its entire profits since 2005 on new projects.

They are $1.3B for Studio City Project Facility & $1B for capex related to Studio City, City of Dreams Manila and City of Dreams, against ~2B in positive gaap net income, see page 106 & F-63 of annual report with SEC:
http://www.sec.gov/Archives/edgar/data/1381640/000119312515130190/d807931d20f.htm#toc807931_76


2) Lower demand - from the Chinese government corruption crackdown, to a now falling (leveraged) stock market, the party is over (from same wsj article):

Macau’s gambling revenue fell 39% in April from a year earlier to 19.17 billion patacas ($2.41 billion), according to official data released Monday. Revenue has fallen for 11 straight months, including a record 49% drop in February, and has now declined 37% this year.

Yet, Macau is far from returning the "norm" of Las Vegas:

(http://www.asx.com.au/education/investor-update-newsletter/201404-emerging-markets-versus-developed-markets.htm)

Macau's gambling revenues can drop 90% before reaching 2004 levels. Macau was 10x Vegas even during the housing boom. Now, this is an admittedly apples-to-oranges comparison, but the key point is that Macau revenue growth has been exponential even compared to China proper. There is plenty of room at the bottom.


3) Leverage makes this highly explosive. There is operating leverage for Casinos as a whole - most costs are highly fixed in building the resort, games etc., so once a casino is built every new customer is profit (roughly). This means that when there is a flood of big gamblers from say China, casinos do well (see above graph).

There is also consumer leverage - Chinese visitors are big spenders, despite a lower per capita gdp/income in China. This is because typical vistors are VIPs, the super-rich.



http://www.statista.com/chart/1455/macau-makes-10-times-more-revenue-than-vegas-per-visitor/

What happens if this reverts to a more normal (yet more rich? USA levels)?


For MPEL, there is the operational leverage of being 100% China/Asia, as well as the financial financial leverage of taking on debt

http://financials.morningstar.com/ratios/r.html?t=MPEL&region=USA&culture=en_US


Much of this write-up was macro-focused, and that is no accident - this is a macro trade expressed through a usa equity. MPEL is simply (one of) the least diversified company, most levered casino operator I've seen. Macro investors are focused on shorting the yuan/aud, iron ore (more of a short bbb trade), equity indices in China, shibor swaps. Equity investors are focused on monthly revenue data, new casino builds, costs of new casinos etc. They see the last 3 years and hope for "normalization" (http://online.barrons.com/articles/macau-casinos-time-to-bet-on-the-house-again-1418977279).

That is the edge here.


Valuation:
$1 is a placeholder for debt-restructuring. I believe the revenue tide will (continue to) turn violently in the other direction and wipe out gaap & even ebitda margins. The equity will probably reflect this well before any covenants are actually triggered. The severity of revenue change expected by this thesis makes detailed modeling unnecessary, in my opinion.

For example, say revenue per customer gets cut in half (still much higher than Vegas), not unrealized given the 40%+ annualized drop seen in months earlier this year and revenue reverts to 2010 levels. MPEL is breakeven on a gaap basis or worse.


Catalyst:
Time & bankruptcies proceeds. As this is a macro-themed trade the psychology/reflexivity of price-action can be its own catalyst. For example, margin call selling of stocks by Chinese (retail) investors puts further pressure on stocks and finances of the Chinese populace as a whole. Fewer people go to gamble when many are wiped out by the other casino (the stock market).


Risks:

1) China double double double...downs and succeeds: stimulus even beyond current levels could possibly restart the investment engine. However, I believe the recent state-sanction equity injection (7/7/2015) in the stock market has finally shown where China's reach has exceeded its grasp. It is as if Obama asked Goldman Sachs to buy stocks, then the market falls. Regardless, the exponential growth of of MPEL/Macau makes future growth difficult to achieve - especially given that competitors are trying to grow as well (http://www.reuters.com/article/2014/03/12/us-macau-expansion-idUSBREA2B09D20140312 , http://www.wsj.com/articles/macau-gambling-continues-to-drop-1433140493)

2) Currency devaluation - part of MPEL's debt is dollar denominated (p. 24 of 20-F/annual report), so liabilities actually worse as revenue is derived from Chinese exchanging yuan into hkd.

3) Buyout - unlikely given the debt-load and that plenty of casinos are already building - why buy when you can build using cheap materials (steel)?

4) Reversal of smoking/visa restrictions. China recently eased visa restrictions to Macau, allowing Chinese to visit Macau more often. To me, this is like telling homeowners in 2008 that they get a 20% discount on flights to Vegas. Vegas still lost money.


Conclusion:

This write-up is meant to be approximately right rather than precisely so and is meant to be a hybrid investment, macro expressed as single equity. As such, it depends on hitting the overall view (China short) while expressing it in a capital efficient way (many ways to profit).

Careful investing to all

Dividends don't matter (that much)

One popular investment strategy is income investing - investing in stocks that pay a steady stream of (growing) dividends. This way, you are most likely to get some money back after investing. 

More generally, a popular argument to investing in a particular security is that it has a high dividend, etc.; but why should this matter? If the goal is maximum total return while minimizing risk (whether permanent loss or even price fluctuations), why should getting back money so quickly be a priority?

There are a few reasons that people put forward, but I don't think they are as straightforward as they might seem.

1) Stable companies have good dividend histories. Dividends are a proxy for well-run businesses with good prospects; if that is the case, why not focus on the business value in the first place? 

2) Want income for daily needs. Dividends are not guaranteed, and for any specific security can vary greatly by year; in fact, those securities with the highest dividends frequently lose prinicpal (see mortgage reits in the recent year). Once again, business value (i.e. future earnings prospects of the company) matter most.

Furthermore, dividends are taxed at least 15%+ while sales of stock (depending on tax basis) may be considerably less. 

3) Companies don't have better use for the capital and frequently misuse it, so better to give money back to shareholders. It is worth it to invest in companies that are poor capital allocators? 

More generally, whether it is distributed as dividends or reinvested in the business, the cash is there. If many companies can invest it in their business at their return on equity (mostly 10%+), does it make sense to withdraw it unless you need it? Even so, outright sales are typically more tax-efficient.

Mea Culpa - HLSS, OCN, ASPS

If it wasn't clear already, I was wrong, very wrong on Erbey's mortgage servicing companies. The analysis can go on for pages, but the key is this: Erbey's companies relied on cutting corners on costs to make their competitive advantage. As a result, they deliver an inferior product (mortgage servicing) that matters to both consumers & regulators.The MSR transfers etc. that were part of the original thesis does not work if they cannot service mortgages effectively.

Buffett once said:

When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.

In this case, I'm actually not sure if management is that skilled. Anyone can cut costs by partially ignoring the rules of the industry. Then, ASPS took on debt to buy back shares & 30x+ ttm p/e.

I actually feel like it is value-trap now, though have no position in the shares after selling them mid-year 2014.