Q4 2018 – Orienteering in a Post-Truth World
By Julien B. Booth
September 28, 2018
I hope this note finds you doing well.
Aging has a wonderful way of making us more appreciative (or cynical I suppose) of our health, relationships and opportunities. Experience also gives perspective on where we are in a market cycle. While we do not expect any immediate calamity, orienting the compass to our current location is important.
2018 has been special to me as we have experienced intra-office highs and lows beyond my imagination. Suz Wright (18-year daughter of our smiling Karen Wright) has risen above cancer; James Barrier (intern) returned to us after the loss of his right hand, and John Michael celebrated a new baby Olive (they lost Bridget in 2016). Godspeed to each of you and your families.
“The latest trade of a security creates a dangerous illusion that its market price approximates its true value.” –Seth Klarman
Full Disclosure: We are not good at speculating on assets without underlying structural protection or supportive (margin of safety) valuation. Please note warnings at the end of this note regarding “private placement” securities. Caveat Emptor
2018 has been challenging for income-oriented investors. The Federal Reserve has raised short term rates 3x and is expected to continue in Sept. and Dec. After NINE years of near-zero rates an adjustment period should be expected. (Chart page). Higher rates put downward pressure on the lower return (lower risk) assets. Accordingly, the safest bonds have produced modest negative returns and the “junkiest” have faired far better. Assets even further along the risk spectrum (stocks) have been performing incredibly well.
This month I have asked Davis Dawson (our UNC intern in Singapore this term) for some help in deciphering our 3 main themes for the remainder of 2018 and into 2019.
Davis is a sharp young man who has been broken the intern model. He is an Eagle Scout, intrepid student of the world, and student of economic behavior, so we had to promote him into a Junior role. He “gets the joke” as we often say.
1. Inflation Peaking – Inflation expectations are the main driver on income asset pricing. Rising inflation = rising rates = downward pressure on income securities. For the trailing 9+ years we have had EPIC stimulus of the economic system: 0% interest rates, quantitative easing (money creation), and Trump’s Massive tax cuts. The fact we can only budge towards 3% growth notwithstanding, this policy creates inflationary pressures that have been finally ramping into 2018. The Federal Reserve follows the regular script and is raising rates late into the cycle. We are already seeing the negative affects of rate hikes on commodity pricing, foreign exchange, real estate lending and consumers. The best cure for higher rates is higher rates; it will slow growth. We are seeing it make many residential and commercial development projects no longer viable. This policy works on a substantial lag and the data (inflation) is the most lagging of indicators. It occurs near the end of the cycle.
2. Currency Mayhem – Rising U.S rates have sucked the air (capital) from the remainder of the world. Positive U.S. rates encourage $$$ flow back to the U.S. Emerging economies, commodity dependent nations, and those with slower growth are punished. Commodity prices (priced in U.S. Dollars) crash as U.S. rates rise. Note: Oil is an exception; it has variant factors driving its pricing.
Currency crisis become almost inevitable as those countries with debt priced in U.S. dollars, but local currency derived revenue albeit destroyed from within. We are seeing this in real time in Argentina, Turkey, and others.
3. Valuation Orienteering – Investors are paying very high historical multiples for all risk assets. (Chart page) Much of this growth has been funded by “borrowing” to buy-back stock and other corporate functions that do not create long-term intrinsic value (often deemed financial engineering). Additionally, we have seen tremendous price increases in the Internet companies since the late 1990’s.
When Facebook exceeds the value of the entirety of India’s stock market I feel confident that we have entered the “its different this time” dimension.
Investor Behavior: The longer that bull markets, economic growth, and optimism persist the greater the speculative fervor. Once again, firms without real profits are dramatically out-performing.
We have an inherent bias to value and margin of safety (disclaimer), but I believe three particular stories reflect the recklessness of the present day:
TSLA by stock valuation is the largest American car company by market value of its stock. We are not passing judgement on the underlying product.
Tesla has not generated an operating profit, has significant debt ($12Billion), and is burning around $6 Billion of cash per year. The recent DOJ/SEC investigation will make raising more $B difficult.
The bonds (the most senior security in their capital structure) trade deep into junk territory, about $0.84 cents on the dollar to yield near 8%. Junk Index yields 5.4%. #notgood
Net, net it is not an invest-able stock. A Speculator may buy the bonds and at least have some hope of value in the restructuring. Stock is at the bottom of the Capital Stack.
Since its peak pricing the market value of Bitcoin, and its cryptocurrency underlings, has dropped in excess of $640 Billion dollars in total value. The group of Doctors that lectured me on it over overpriced steaks in October 2017 does not seem to mention it anymore. The cost of production of a Bitcoin (consumes massive electricity) is close to the current pricing – about $6200/unit. It’s only down 70% YTD.
Description below. Tilray has sales in the $28 Million range but is worth more than the entire NASDAQ Inc. Company, in the range of $22+ Billion. At the time of this writing it is worth more than 50% of the companies in the S&P 500. This behavior is an extreme example of gross valuation mismatch, speculative fervor, and carelessness with ones capital (@ present prices). Already bigger than General Mills & Hershey’s, it will exceed Apple’s valuation by Christmas (at current rate of increase). Drafted this note too soon – corrected by $11+ Billion in value in the past several trading days.
Tilray is a global leader in medical cannabis research, cultivation, processing and distribution. We aspire to lead, legitimize and define the future of our industry by building the world’s most trusted cannabis company.
I entered the securities industry in 1995-1996 and had the great pleasure of witnessing and working during the Internet Bubble 1.0. Value investors seem to be born as I could never grasp the methodologies employed to value companies on metrics that did not generate revenue and operating cash flow. I assumed I just was not smart enough (Forestry/Ag School at NC State). We are all familiar with the outcomes. Net, net I bought a timber farm with Sun.com proceeds. We still grow timber there. It has even been leased for mineral exploration. Sun.com is gone. As a rule, we prefer intrinsic and durable value.
After/as the real estate market cratered in 2008-2009 I had lunch with my Uncle Dick Ranson. We agreed to “bring something of value” to discuss. In a very primitive (using real paper) way he had extrapolated the cyclical nature of real estate asset price cycles from peak-peak over more than 100 trailing years. Each complete cycle lasted around 18 years.
As we see yet another round of robust speculation in the financial markets, I often reflect on the Internet 1.0. This time seems to rhyme.
My primary intent is to help you understand where we are in this investment cycle. The nature of investors is to expect future returns to be similar to the trailing returns. When we find ourselves in this valuation range and economic cycle the opposite is more likely to be true. Future returns will likely revert to the averages over time. We continue to favor securities with underlying preference in the capital structure, predictable cash flows, and a reasonable margin of safety.
Thank you for your trust in Forest Capital and Sixty Guilders Research.
Julien B. Booth
Forest Capital Corp.