The Difficulty of Short Selling

The usual way to invest in the stock market is to buy stocks. One can open up a brokerage account (at say E*Trade or Interactive Brokers), put in cash, and use that cash to buy stocks. There a few details behind this, but the general idea is that an individual can use dollars to buy shares in a company at the current price in the market. He/she can then sell when, hopefully, the market price is higher.

Selling price - Buying price = Profit per share

A lesser well-known method is "short selling". In this process, the order is reversed; an individual can first sell the stock and then buy back the stock at a lower price to make money. There are even more complexities behind this than buying stock, namely that one must borrow stock from someone else before he/she can sell it. However, the above equation still holds. One must sell at a higher price than you buy to make money.

Short-selling is known as a tough technique in the financial markets. Traditionally, it has been accepted as the counterpoint to long positions (buyers of stock), but the risks are even more nuanced;

1) A stock grow without bound (see aapl stock), but can only go to zero. Percentage-wise, you can only make 100% while long positions can make 100%+.

2) The ability to borrow to stock is not guaranteed. Depending on the broker and security of interest, one can might even have to pay a running fee to borrow (i.e. for hard-to-borrow stock). This is often the case when interest rates are low and there are many others who want to borrow. In fact, the business of borrowing shares at institutions is a division onto itself (e.g. securities lending).

3). many, many more...

Now, the upside is that short-selling can hedge other positions in an investment portfolio. Suppose you want to buy more stock but don't want to be long the "market" as a whole. Short selling can possibly hedge this (though this adds a different, basis risk). In addition, in a protracted bear market short selling is intuitively a good way to make money (vs. fighting the tide as a long-only investor)

But in the long run, is it worth it? Up until recently, I thought definitely so - there are plenty of over-hyped, expensive, and/or poor businesses which should not be highly valued.  However, even I have underestimated just how difficult to make money in the long run:

(Source: http://www.valuewalk.com/wp-content/uploads/2013/12/Chanos-Performance1.pdf)

Above is the performance of the most well-known and perhaps the few surviving short-sellers in finance today. Jim Chanos survived multiple bull markets and even the technology bubble of the late 90s.

However, even he has only had an aggregate return of 2.1% vs. 12.7% for the s&p from the 80s to 2005. Keep in mind, this is the best of the best, the Buffett of short selling. Sure, on a relative basis he has done well (12.7- - 2.1 = 14.8% of outperformance vs. just shorting the S&P 500). But that's not problem - the problem is multiple 40% drawdowns in 93 and and 95.

If the best of the best can't beat treasuries but has far more drawdowns, it makes the entire method tough to justify.

Careful investing to all,

Admitting when I'm Wrong

Earlier this year, I said that Winter was Coming. Given the continued rally in equities, I was proven wrong. Risk assets continue to rally despite rising calls of overvaluation, whether it is Shiller P/E, market cap to GDP, etc. Indeed, the mantra that valuation is no timing tool continues to hold true and those who use statistical averages at a macro level underperform. I've underperformed because the catalyst (taper) I was looking for happened, and markets continued to rally. As a result, I have covered all short positions and maintain unlevered positions in the companies I continue to like in the long term.

This is the closing of a trading view - there are views/positions which are short term (dependent on market psychology) and long-term (supported by fundamental productivity of assets). I lowered overall exposure and maintained short positions earlier in the year because of the former, but chose the individual positions on the basis of the latter.

The question now, is where to from here? Given that psychology (and price) drives behavior in the short term, I now focus on the continued hate of the market. The AAII sentiment survey as of 7/30/2014 shows a lack of enthusiasm for equities even as they rally. In the short term, this is a net positive as investing is not crowded. I therefore remain mostly invested.

Careful investing to all,
-Stanley

On Growth

A common question given during consulting interviews is the guesstimation question - e.g. how many ping-pong balls fit in a 747? Like many such questions, the point is not the answer but the process the candidate gives. For this one, one approach would be to start with the size of a ping pong ball, dimensions of the plane and make assumptions about the width of the wings.

Market-sizing is indeed a similar problem, and like most things in business are highly dependent on assumptions. For many of the high-flying momentum names (TSLA, FB, TWTR, FEYE, etc.), assumptions of a large market opportunity support the buyers (though I'd argue many supporters depend on price momentum more so). However, the does fast growth make a stock (and business) worth buying? 

Most of the time, I don't think so because 1) psychology has shown that people are easily overoptimistic about future growth and so 2) the price for such businesses are highly expensive compared to normally valued businesses. What happens when momentum falters?

(Source)

Schadenfreude aside, many have asked what is driving the sell-off. I believe the better question is, why were these securities priced so highly in the first place? Take FireEye (FEYE) for example: it is a next generation IT security provider selling at nearly 20x ttm revenues and has a return on equity of -32.85%. Let's be clear, if you had actually invested capital/equity in the business seeking $ return from operations, you would have lost nearly a third of your capital in one year. Nevermind growth 5 years ahead, at this rate you will have no capital left!

When investors are valuing eyeballs (2000, 2014) and startups are having to cold-call journalists to sell ipo shares, it is hard to justifying buying.  

Careful investing to all,

-Stanley

MSRs Redux (HLSS, OCN, ASPS)

The new year did not start out so well for one segment of my portfolio - those related to mortgage servicing rights (MSRs). Beginning with a general sell-off in January, non-bank servicing companies took a beating:

I was far from immune, though my risk-management stops did force some reduction late in January. However, the value in ASPS and OCN in particular led to me to slowly re-add in early February. This was premature:

• New York Department of Financial Services blocks Wells Fargo sale of MSRs to Ocwen
• Ocwen may be sued by multiple large investors

If the above were short-seller reports, this would have been a classic "bear-raid", especially given the black-out period prior to earnings (Feb 27/13th,  for OCN/ASPS). The first news item came out in the middle of the HLSS earnings call (Feb 6th), requiring management to deflect questions until the upcoming Ocwen call. Rumors of the above may indeed have been circulating previously, though the exact reason for the market reevaluation may be tough to see and moot at this time.

However, how does this affect Ocwen (OCN) and its related entities as a whole?  Buffett describes value as simply the discounted cash flows of a company, so the question, does this materially change those cashflows?

1) OCN's future prospects remain bright - New York's regulatory action should be temporary because OCN's best-in-class cure rate and delinquency trends make it the best for both investors and homeowners.

The principal reason for the growth of Ocwen is the competitive disadvantage that bank servicers now have in light of Basel 3. I detailed this in a previous post and showed how banks take capital charges if they service mortgages themselves.

This fundamental fact (which shows no signs of changing) has not changed - what may have is the rate of portfolio growth for OCN and others. The principal reason behind the government block is concern over the ability of OCN to service the mortgage. OCN, which outsources most of the work to india, has indeed be dogged by consumer complaints about improper/slow processing and related errors which may lead to excess fees and delayed payments. Given the sub-prime focus that OCN has, it can be difficult to figure out how much of this is simply from the sub-prime consumers' own mistakes and how much is legitimately OCN's fault. It may indeed be more of the latter, but industry data suggest that out of other servicers, OCN remains first-in-class when it comes to final outcomes.

OCN's cure rate - the rate at which it turns delinquent loans into current ones, remain the best in the industry. A higher metric for benefits both investors and homeowners, as it means that fewer foreclosures occur and more principal is repaid.

Source: December 2013 presentation by Ocwen

2) Investor lawsuits by PIMCO/BlackRock are also temporary and on weak footing. Both pushed for the ResCap's sale to OCN and have only recently turned against it. I believe that they are upset possible errors which occurred during the on-boarding process and/or lower investor returns than they anticipated due to foreclosures, etc. The above arguments apply to this as well, although detailed rebuttals will depend on the actual lawsuits filed.

--

Portfolio-wise, I've focused on the highest conviction names and have therefore exited less direct exposure to this trend, namely HLSS.

Disclosure: long OCN/ASPS 

-Stanley

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