Correlated Commodities - Part 1: E&P

Given the cheapness of the refining companies, I've tried my hardest to justify the purchase of PSX/MPC. The result has been a further refutation of my long thesis and the reverse thesis. Companies which produce crude oil and its products (e.g. gasoline) are actually in the same situation as iron ore & steel producers. Very lean times are approaching.

Let's invert and try to justify the purchase of oil producers. Most exploration & production (E&P) oil companies in the usa have grown due to the development of "tight oil" reserves. These reserves (e.g. e.g. Bakken Shale, Eagle Ford) have become viable due to the development of techniques such as hydraulic fracturing & horizontal drilling. These techniques, which have now become widespread in the United States, have led to thousands of new drilling sites and large increases in production:

Source: http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=A

Great - looks like the potential revenue is there. However, what about cost? Looking at fast growers such as CLR, we see that growth requires very high capital expenditures. In fact, CLR's free cash flow has been negative for the past four years. As a result, we can say that the growth in CLR has been essentially debt-financed. Now, it is possible that investments in tight oil require large upfront contributions which taper off, but that is not the case for fracturing, where continued production requires continued capex.

Okay, so may be E&Ps as a whole may just be break-even and not make "excess" profits. If crude oil prices rise, couldn't they make more money? In the short term, sure, but how easy is it for others to look for new wells? In short, it takes less than a month from start to production, so barriers to entry is easy for those with capital. Capital in no short supply given high levels debt issuances for energy producers. As a result, competition is high and always waiting in the wings to drive down prices quickly, similarly to gas shale. This is makes investing in E&P's a tough business, at the very least.

This is just the beginning, however. E&P's may do okay with flat to rising oil prices near $100, so what would drive a panic-driven sell-off of both futures & equities? One possible answer, which I'll dig into will be in part 2.


Disclosure: short CLR & other oil E&P company equities

"The lady doth protest too much, methinks"

After coming across this article about investors losing $1 billion+ by investing money through "secureinvestments.com", I was reminded of this quote: 

"The lady doth protest too much, methinks" -  Hamlet by William Shakespeare

The key takeaway from this quote is that the more loudly we hear an assertion, the more likely it is not so genuine. More concisely, the loudest person in the room usually has the least to say. When a business names itself "Secure Investments," one should be especially wary of how secure it is.

Now, this is very unfortunate for those affected and I do hope they are able to get some of their money back. However, it is worth noting some rules of thumb which can help investors avoid landmines such as the above:

1) Education about investments is the best protection one can pay for. Learn from many sources to see different viewpoints. For example, just reading about Buffett's annual performance of 20%+ would make a 300%+ annual return with principal guarantee sound like a fairy tale. If this company is so good, why doesn't it just trade its own money?

2) When it comes to investing money, there is virtually nothing without risk. Guarantees are only worth the honesty and business making the guarantee. More fundamentally, just calling a product guaranteed doesn't make the underling asset (in this case, currencies) any less risky.

3) There is no substitute for effect due diligence when evaluating investments or managers. The ironic thing about the examples in that article are that many investors distrusted brokers but ultimately lost it all to a business they trusted. Many read statements/web profiles from Secure Investments but didn't verify or see with third-parties about the validity of such statements.

There are many more, but the consistent theme here is that like most things, there are no shortcuts.

Synchrony Financial

Synchrony Financial (NYSE: SYF) is General Electric's former retail finance arm and presents an interesting opportunity to invest in banking/lending and private label credit cards. What first got me interested is its cheap valuation (<10 times ttm earnings) and high returns on equity/assets (30%+/3%). As a bank these are fantastic metrics, though leverage is normal.

But how is this as a business? SYF is a bank which uses its deposits/capital to lend to consumers often through private label credit cards. These are the Home Depot credit cards, etc. which are often pitched in checkout lines. The benefit to consumers are discounts (up to 5%) at that particular chain, while companies get another tool to offer brand loyalty and promotions. It is this last aspect which is useful for companies and may indeed give it some pricing power. As the largest private label credit card issuer by market share (40%+) it may indeed be the go to source for private label credit. It can therefore focus more on relationships than pricing.

However, the relatively high rates and typically lower-class clientele on consumer side may be difficult. In particular, there may be a saturation point for such credit cards because such cards are more useful at larger/diverse retailers such as Amazon.

This may indeed be one of the larger risks for SYF. Lending, while muted, is highly profitable now because lower overall interest rates are suppressing defaults and the danger is that the credit cycle is a peak. I believe this is less likely given the lack of lending overall by banks (i.e. monetary velocity) such that only the top borrowers are getting credit. SYF survived the last crisis while remaining profitable (per their prospectus), so at ~ 10 times earnings this looks to be a good price for a decent business.

Disclosure: Long SYF

Asset Allocation does Not Solve the Funding Gap

Many pension funds/endowments and many other defined-benefit plans are behind their benchmarks. 2013 helped greatly, though it was only in 2012 that funds where in big trouble. Basically, they have promised a certain amount of future payouts but their current funds are not enough to do so. Part of this reason is the Federal Reserve's QE and other rate-lowering methods. Plans can plan on 5% return from their treasury bond portfolios, but with 10-yr treasuries yielding less than 3% they fall short.

To solve this problem, investors have shifted out into the risk-curve, buying assets/funds with fewer guarantees at only marginally better yields. Is this the right call?

To answer, let's ask this: if buying higher yielding assets gets better results, why were funds just buying now? Why were they not buying in 2009/2010 when yields were substantially higher?

One answer: it's the incentives. Buying a higher yield now gives the possibility of hitting the target while pulling back guarantees under-performance. Liquidity/Fed and price-stability gives the illusion that all is good so that managers can do so. We already know the results of this; a similar bid occurred from 2001-2008 with CDOs and other yield-oriented instruments. We see that now in anything related to fixed income from MLPs (oil/gas etc.), mortgage reits, high yield bonds and of course alternative investments.

(Source: http://dealbook.nytimes.com/2014/08/14/the-signals-from-the-high-yield-bond-market/?_php=true&_type=blogs&_r=0)

The result? So far, pensions are better but it's despite their asset allocations. In the previous link, Rhode Island pension funds allocated to alternatives only to see vanilla equities outperform.

My point is that allocations should be driven by opportunities in the market, not trying to beat the benchmark every year. Just because the plan needs 5% returns does not mean one should choose the best-performing assets or those which yield the most. Investing is investing, that is, putting capital where the risk is (far) justified by the reward. Hedge funds/alternatives, bonds, equities should be judged on whether the manager/asset is priced relative to the risks they take. For example, right now activist hedge funds have been doing extremely well. Does this mean endowments should allocate more? Not unless they can get the top managers and lower-than-average fees.

Now, measuring risk/reward is a tough topic, to say the least. However, that should be the base for allocations. Using "alternatives" to "diversify" because the manager is scared of another 2008 is not. Investing in an equity manager/index when equities are cheap relative to norms; that is better.  

Short Selling Fallacies

I am big fan of Jim Chanos and other fundamental short sellers. They are the ultimate financial detectives who root out fraud, over-promotion and other excesses in the stock market. However, Chanos's recent interview paints short selling in too easy a light and does not truly refute the common risks associated with short selling.

We start with the well-known 100% profit limit on a short-sale of stock (borrowing and selling a stock, hoping to re-buy at a lower price). When you (short) sell a stock, you receive cash but also retain the obligation to buy that stock back. The profit on a full round-trip is therefore (the sale price minus the purchase price) times the number of shares. Because the sale price is set at the beginning, the lowest purchase price is 0, so the return on the original sale is  (sale price - 0)/sale price, or 100%.  

Chanos posits the ability for a short seller to sell more as a stock declines. On face, this doesn't seem to increase the position as a lower price means a lower market value on which to add. However, adding (selling more) does increase the obligation to return shares. If prices rebound after an additional short sale, the seller has both additional losses and a larger liability than before. Therefore, adding to short sales is risking more.

Secondly, Chanos discusses the unlimited possibility of loss given a short sale. He says that stop-losses and other automatic price triggers can reduce losses. This is also true for long positions, however. The key difference is that with short sales, one has to constantly monitor price and decide when/if to cover if there is an adverse move. Long and un-levered positions have the unique and key ability to wait, while shorts have to watch and are dependent on liquidity. In turbulent markets, this ability to wait is unparalleled:

(Source)

Would stop-losses help in the above? Perhaps a short seller can cover at the $300 level, but it is far from certain. Separately, what if the seller shorts more after the weakness in early October? He/she would have been serious trouble against a nearly 400% rally. Short selling can be profitable and in my opinion is highly useful to the economy at large. However, the real risks of this technique are Not easily overcome.

Alibaba and the Rule of "Law"

With the numerous articles about the upcoming Alibaba Group IPO, I'd like to focus on the rule of law and its history with the leadership at Alibaba (i.e. the Chief Executive Officer, Jack Ma). Alibaba may indeed be one of the largest and most profitable businesses in China, but does that translate to profits for investors?

For reference, Alibaba is one of the largest group of e-commerce businesses in China with over 7.5$ billion in sales in last year. Its multiple lines of business span across web portals for business to business transaction, payments services, Amazon-like search engines.  However, its focus remains in China, so why is it listing stock in the United States/New York Stock Exchange?

In short, it is because was denied listing in Hong Kong:

Alibaba considered listing its shares in Hong Kong. The company asked the Hong Kong Stock Exchange to allow a listing despite rules that permit only one shareholder vote per share; Alibaba has an unusual partnership structure that gives more sway to top executives, including Mr. Ma. After Hong Kong regulators refused to make an exception, Alibaba pursued a listing on the New York Stock Exchange, which allows more diverse ownership structures.

The "more diverse ownership" euphemism is essentially an admission that Alibaba did not want to give control with ownership and and went with the lowest denominator/least regulation. It will be using a dual-class like structure where founders' shares have more control than regular shares. Now, Google, Facebook and other internet companies have similar structures so that itself is not necessarily a damning factor. I personally believe is a huge incentive misalignment (it allows founders to risk other's capital without commensurate compensation). At worst, it allows founders to misappropriate assets without recourse (see below).

This is the least problematic of Alibaba's history with investors. When Jack Ma/Alibaba sold a large stake of itself to Yahoo, he had seller's remorse post-close and thought he undersold. He tried to buy shares back but since Yahoo refused he resorted to a transfer:

Mr. Ma transferred ownership of Alibaba’s fast-growing online payment service, Alipay, to an entity that he controlled. He didn’t get the permission of Alibaba’s board. He just went ahead and did it.

Basically, Jack did not like the terms of his sale and therefore ignored it. Yahoo/Alibaba did not get compensation for Jack's self-dealing and could do nothing about it. This is how Jack and the leadership at Alibaba treats investors that it does not get along with.

Furthermore, since Alibaba will be partially using variable-interest-entities as mandated by Chinese law, USA investors do not even own some parts of Alibaba. They have a profit participation interest via a Cayman Islands entity. Given that Jack and Alibaba's leadership do not even reside or do business in the USA, what potential recourse do investors/customers here have?

Suppose a year after the IPO Alibaba's shares have doubled, but the overall group's business is slowing down. What prevents the leadership from selling its stock, transferring the jewels of the business to themselves, and starting over?

Which Businesses can Consistently Make Money?

When buying businesses, whether in the public stock market or in private negotiated transactions, one key characteristic is the ability consistently make money. It is great if a company makes record profits one year  (for example $1/share), but what about the next?

Often, the companies and industries which are able to maintain and grow profits are the ones with durable competitive advantages. This is the "moat" that Warren Buffett refers to when he looks for companies to buy.

Example: a lemonade stand

Suppose that you are able to open a lemonade stand during the hot summer months. You buy some basic materials such as a chair, table, etc. and set up on the nearest street corner from your house. Business is good - you are able to buy lemonade in bulk from the grocery store @ say 2$/gallon and sell cups of lemonade so that the effective selling price/gallon is $4/gallon. Say you sell 1,000 gallons worth of lemonade each year so that your yearly pre-tax profit is: (4-2)*1000 = $2,000 or $2,000*(1-0.35) = $1,300 post tax.

Let's also hypothetically say it cost you $1,000 to set this business up and that you could hire someone for $300 to man the stand all year. Therefore, you could put down $1,000 and make $1,000 back in one year. A great return of 100% and full payback in a year! The is the equivalent of a 100% return on equity.

The Problem

However, next year your neighbor sees all the money you are making and decides to open an identical one himself for $1,000 and at same price point. Now, if customers only care about price you might make only $500 next year. More competitors enter until the $1,000/year reduces to almost zero. More specifically, more entrants will enter until the fantastic profits go away.

That is the nature of competition in capitalism and paradoxically is the worst for capitalists in highly competitive industries. We can see this happen in real-time with commodity or commoditized markets such as iron ore (e.g. CLF, VALE). In this case, a boom from China drove prices higher and led current incumbents in 2003 and 2008 to make record profits. This lead to increased capacity and new entrants over the next few years (the time it takes to increase capacity/enter the industry), which has led iron ore prices lower. Because iron ore is a globally traded commodity and is relatively easy to mine, it was sufficiently easy to buy another "lemonade stand".

A Solution

It is therefore the companies who can forestall competition which paradoxically benefit in capitalism. Newmarket Corporation (NEU) from my previous post may indeed be such a company because of product differentiation. NEU's customers are strongly tied to it and NEU's own 10-K focuses on the the adaptation of its own products to customer needs rather than pricing:

Competition

...

The competition among the participants in these industries is characterized by the need to provide customers with cost effective, technologically-capable products that meet or exceed industry specifications. The need to continually increase technology performance and lower cost through formulation technology and cost improvement programs is vital for success in this environment.

...

Most 10-K's competition focuses on price. NEU's does not. Instead, it is focused on service/technology. A competitor cannot easily build another NEU/"lemonade stand" because the products are highly engineered and customer specific - why would customers switch suppliers especially if cost is not the primary consideration? If a company is well-run and doesn't have to worry about price-cutting, perhaps it can survive, even flourish?