Divestor

This is taught in first year finance, but is an excellent reminder.

I will give an advance apology for the CFAs reading this, it is remedial material.

While the finance math here is simple, the applications are enormous in the realm of valuation, because your input variables have a huge determination on the output.

This math is as fundamental as the formula which drives much of accounting, which is “assets equals liabilities plus equity”. An entire professional body is driven around this very simple formula.

Likewise, in finance, learning how to capitalize a cash stream (and vice versa) is a fundamental calculation.

The value of a perpetual cash stream can be expressed as a single number in present value. You simply need a projection of cash flows, and you need to apply a rate of interest to account for the time value of money.

This is best expressed in an example.

Say you are promised $50 in two sums, $50 today and $50 in a year.

But you are offered a deal. I’ll pay you $80 today, lump sum.

If you do not care about the time value of money (an interest rate of zero), you would reject the deal. After the deal you’d have $80, but without the deal, you’d have $100 in a year. No way you’d take it.

We now bring in the concept of the interest rate, which is how much you’re willing to pay for money today versus money tomorrow.

Let’s say you think you can make 100% on your money. Clearly taking the deal is beneficial. Instead of $150 at the end of the ‘no deal’ scenario, you would instead be sitting on $160 if you took the deal.

It gets even more complicated if you think you can make 100% on your money for the first 6 months, and 25% thereafter. The rate of interest is a function of time, in addition to the cash flows. When it comes to valuations, both the cash flows and the rate of interest are never as black-and-white as these examples make them to be. There is significant uncertainty to deal with.

There is a break-even point where you would be theoretically indifferent between the two options. Your counterparty will have different interest rate expectations, and thus their break-even will be a different number and this is where markets are formed.

Implicitly when engaging in the market, we are guessing what the shape of the cash flow and interest rate function is, and trying to interpolate that into a capitalized value, which is traded in present day.

The more exciting part is the cash flows (is company XYZ going to make $$$ EPS in the next few years???) and, in general, the rate of interest is a more neglected variable.

The rate of interest has a huge impact on the temporal aspects of global decisions, whether to invest in projects, or to take deals (bird in the hand vs. two in the bush).

Let’s say you are a forestry company and your trees are growing biomass at 4%, and the interest rate is 3%. It makes sense to keep those trees in the ground. At an interest rate of 5%, it makes sense to harvest.

In general, higher interest rates force one to be more presently oriented, while lower interest rates afford the luxury of being future oriented.

This is evident in a couple examples. One is in highly inflationary economies (e.g. Argentina), hard assets are held precious. Investments in the future must have large payouts today and very short recovery periods. Commodity investing is great in high rate environments, especially if you already have a producing asset.

Another example is the (hopefully) fictitious example of a planet-killing asteroid hitting planet earth in a couple decades (there was a recent horrible movie regarding this, please erase this out of your mind when thinking of this example). Upon the discovery of the asteroid, interest rates will rise dramatically, but it wouldn’t be insane like if such a discovery was obviously an irrevocable impact in a year – the cash flow function would have some expectation after the two decade mark because we might be able to avoid the collision. Either way, the present becomes much more valuable.

Let’s fast forward to 2022, in the present.

Historically, especially since 2008, short term interest rates have been kept to a minimum, and long term interest rates have also been to record lows.

This dramatically increases the present value of future cash flows. Companies with “future promise” are valued higher as a result.

This is starting to reverse for various reasons.

It has been about 40 years since the financial markets have had to deal with a sustained amount of inflation and a rising interest rate environment.

The playbook is fundamentally different. Things that worked in the past will no longer work in the present. The monetary base itself, the measuring stick for performance, is starting to change, which creates its own layer of uncertainty.

All of this is part of “the turn” that I have alluded to. Those that do not pay attention will be investing with one eye blindfolded.

I’ve been on radio silence lately on this site, but suffice to say world events over the past month have dramatically changed the calculus. Similar to how Covid-19 (or rather the policies and psychological reaction in response to Covid-19) accelerated certain prevailing trends, the invasion of Ukraine by Russia is doing likewise.

This is a miscellaneous post. I had intended to write “The Turn” but this work is being preempted by geopolitics, and indeed it is pretty sad since I have made predictions on a draft post which is already coming to fruition, so I’ll have to strip out that spicy content.

I consider it quite instructive that my own personal calculation of an open-air nuclear detonation this year has moved from near-zero to around 2%. One such detonation will significantly transform the psychological landscape and indeed open a Pandora’s box that will accelerate trends beyond anybody’s imagination. A very long time ago in a previous life, I took a couple courses on radiation biophysics and have brushed off the dust from my memories. Better to be prepared today to interpret the Geiger Counter when it tells you you’re exposed to 10 microsieverts per hour, caused by the Cesium-137 ash blowing in your direction… is it safe to eat the food on your table or not?

I have been noticing the commodity complex has received a considerable amount of attention from speculator-types. One stock in particular that I own (ARCH) is being traded around like a dot-com company like it was 1999. Indeed it is obvious there is a rotation of demand going on, and has been going on since last December – technology/SaaS issuers into “stuff”. This trend is likely to continue as “stuff” becomes more and more precious. Electrons (aside from those generated from power plants) are not nearly as precious as they were back in November.

Readers will also note I have been diligently updating the DCOGI Index. All companies have reported their Q4-2021 results. While spot oil as I write this is about US$110/barrel, for modelling purposes I try to level each company at US$75 equivalent (not a prediction, rather a margin of safety). Even at this deflated level, these companies are trading well below a EV/FCF of 10x, which still prices in extremely negative sentiment in terms of market expectations. All of the companies have reduced the level of debt (adjusted for acquisitions) – CNQ is the leader in the group with a $7 billion reduction. All of these companies, with the exception of Peyto, are in the process of either jacking up dividends or buying back stock – the latter of which should be exceptionally accretive to existing shareholders. If you assume US$100 as your baseline, the valuation metrics become even more ridiculous.

Be warned these sorts of conditions do not last forever. But they can last longer than most people expect. Resource companies can produce commodities today and sell it at spot – and a bird in the hand today is slowly being valued more and more than the two in the bush due to the upcoming rising short term interest rate.

The Bank of Canada raised rates a quarter point last week and all indications suggest that another quarter point rise is in the cards for April 13, June 1 and July 13, which will bring the summer short term rate to 1.25%. The next meeting is September 7, after a 2.75 month break, where I think they will evaluate conditions and determine whether to continue raising rates. The question will be what happens to longer term interest rates – will the central bank invert the yield curve by year-end?

Also, it is an interesting intellectual exercise to model out M2 in Canada for the past little bit, and there is an obvious rise in the curve which does not help the inflationary situation. This M2 curve is even worse (steeper) in the United States. Both central banks will be trying to quench the creation of money supply and QT is bound to occur. Similar to 2017-2018, it will take some time for the true impact for these monetary decisions to be felt. But the punch bowl is being taken away, bit by bit. Do not be the last person at the party. It is likely not an ideal time to take on additional leverage. We might get a good rally or two from here, but definitely we’ve reached an inflection point of sorts – until the next calamity that hits.

I am going to review my writings of April 5, 2020, still a time when nearly 95% of the population was locked in their homes about fears of SARS-CoV-2. Of course, with any prognostications, you will get some right and get some wrong, but the material issues of the fallout of Covid-19 I got completely correct. There is a bit of back-patting in my current post but let’s take a look:

Oil in about nine months, maybe six or eighteen will skyrocket. The longer that oil is under $30/barrel, the further the bounce is going to be on the other end when supply/demand dynamics results in a supply imbalance. It probably wouldn’t be the worst of ideas to buy long-dated crude oil futures (December 2022 at US$38.75/barrel?).

Check! This is happening presently. By most accounts October-November 2020 was the non-panicked low for spot crude and after that it has been a pretty good ride up.

The after-effects of this [effective debt monetization] during the 2008-2009 economic crisis came in the form of asset inflation, but this time it will be different. With trade lines cut, it is pretty obvious that there is going to be some high-grade consumer inflation that will be coming. Not now, but in a year’s time, this will be a dominant message, especially with the pending increase in oil prices. Note this is not going to be Weimar Republic inflation, but it will be at rates that we will not have experienced in a long, long time. As a result, interest rates must rise.

My predicted timing was a little faster than reality, but this one is coming to roost. However! In a future post, I’ll give some colour to this.

Despite how dysfunctional the economy may seem to be, equities are going to be the only game in town, especially in a monetization situation. It will confound people that there will be such a disconnection between the stock market and the underlying economy

Check. Bonds, to put it mildly, have offered sub-par returns, and if you had invested in longer durations, you are in the red.

The statistic of “deaths” needs to differentiate between “deaths due to Covid-19” versus “deaths with Covid-19”. There is no practical way that these statistics will be obtained.

Check. The application of this has been totally manipulated for political communication purposes. Initially, it is deaths with Covid-19, and later on, some revisions of “because of Covid-19” when the message suits it. Don’t get me started on manipulations of cause-and-effect claims of vaccination statistics (efficacy and safety).

I always like to think of a “parallel world” example, where you see people lining up to get into the grocery store that are spread two meters apart, versus not having these measures in place – will the death and/or transmission rate truly be impacted in either scenario? Of course, ethics prevents double-blind testing, but I would think the effectiveness of some measures to enforce “social distancing” are completely for show – similar to some procedures that you see around airports in the name of security.

I think the (much attacked, just because the truth really hurts!) Johns Hopkins paper on non-medical interventions pretty much tells the story here. One paper does not constitute a proof, but from the spectrum of governmental responses (ranging from full-blown isolation to relatively open society), the course of the outcome inevitably is the same – you might be able to isolate in a cabin in the woods, but as soon as there is one instance of contact, good luck! (Antarctica, Kiribati Island) – SARS-CoV-2 cannot be contained in any semblance of a normal society. It’s out there, and you’ll get it eventually.

My opinion at present is that the current route that most world governments have taken on Covid-19 will cause more collective damage with stress and economic turmoil (and subsequent spinoff consequences of such) than caused by Covid-19 itself. Political pressure likely forced most democratic governments to shut down, while autocratic ones can put on a semblance of ‘back to normal’ just strictly through misinformation, like how China is basically getting back to work despite there being cases of Covid-19 (the one or two they report is just symbolic, while the actual numbers involved are likely much more). Their “confirmed case” count is likely understated by a magnitude of 10, but came to the conclusion that a lockdown was doing more harm than good.

While my prediction was completely correct that the response to Covid-19 will cause much more damage than the virus itself, the mistake I made here is the implicit assumption that governments (especially authoritarian ones) wanted to move past Covid-19 as quickly as possible. It has become a political tool in many jurisdictions.

And finally…

This might sound a little crazy, but I can see the S&P 500 heading to 4000 before the end of the year.

It was around 2500 when I posted this. Predicting a major index will rise 60% in 9 months is the definition of insanity. Indeed, this was an incorrect call, but it did get up to about 3800 by years’ end.

My main point here, other than a bit of chest-thumping, is to successfully invest you need to have some sort of idea where things are headed, and also know if this is a consensus opinion or not. My opinions in early April 2020 were very much out of consensus at the time and the logical course of action were to proceed on it with a “real world economy”-heavy portfolio.

It’s been almost two years since all of this mania has occurred, and the world is changing once again. In an upcoming post, I’m going to describe what I call “the turn”.

Will asked:

Sacha,

How do you think the oil party will play out, with 50% of lost US production has been recovered (pre covid peak of 13.1 mbbl/d to trough of 9.7 mbbl/d and now sitting at 11.5 mbbl/d) and super majors are going for the shale again. You see it over soon with another round of massive boom (volume wise, if not price)/ bust or players become better at managing prices in a goldilock where everyone makes decent money.

I don’t have much insight on what’s going on in the rest of the world. However, in the USA to maintain it will require a gigantic amount of capital investment and aside from the Permian Basin, most of the top tier geology has been tapped out. When you have 30% decay rates on 10 million barrels/day of production, each year you need to replace 3 million, and that’s a steep order.

You’re up against production declines like this:

What do I mean by “top tier geology”? When looking at a drill map that looks like the following (this is in the Bakken shale in North Dakota):

This is pretty much tapped out on the northwest of this specific map. I’ve seen other maps made elsewhere of entire regions being completely saturated like this.

Just like when picking fruit in an orchard, you go for the low hanging fruit first, and this is what happened in the resurgence of USA shale drilling over a decade ago. Now the geology has been tapped out – you can’t mine these areas again. They will still produce, but at much, much lower rates than the initial drill. Some of Peyto’s monthly reports get to this in detail.

Canada’s oil sands and in-situ (steam-assisted gravity drainage) projects have much better decline profiles. In addition, from what I can tell, our companies are being unusually conservative these days in terms of expanding capacity, especially these days when expanding capacity would be wildly profitable. While we do not have the power to move markets like OPEC, the apprehension is also faced elsewhere in the world, especially when there is gigantic amounts of ESG pressure (see: Exxon board election).

There will be a bust, but not right now. Demand is stronger than ever and the ability to meaningful ramp up supply is constrained. Any meaningful price drops in fossil fuels at this point will be on the demand side (the economic bust scenario), but even in 2020 when the world shut down for a couple months due to Covid, demand was estimated to be about 91 million barrels daily, down from about 100 in 2019.

I will also note that the measuring barometer of oil, the US dollar, should be taken into consideration. Everybody these days is forced to be a macroeconomist to properly invest in these crazy times.

Here is a good story for the “everybody wants to become a day trader” society I have been talking about during the Covid era.

If this article is to believed, some guy told his story about losing US$400k trading options on Robinhood. I will take this article at face value.

By the sounds of it, the person was in some sort of job that was synergistic with investing:

My job involves a lot of researching companies and trying to understand business and economic models. I like to read a lot, and there’s a lot of books on investing.

So the fellow got his start on investing in AMC and tripling it. Then he invested in silver and tripled that. Options are fantastic in that they can offer a degree of leverage that are only otherwise offered in casinos. Straight margin on equity only gets you at most 3x leverage (in addition to pesky interest expenses) so why not just go with the 94 octane?

Then this person took his life savings from his employment and his trading gains and wanted to make a big score, and he chose Alibaba.

Okay, I’m done with this. Now I want to buy a safe bet. And the safe bet was Alibaba. It had fallen from $330 to $245, but I had wanted to find a company where the price-earnings ratio was low, and every single analyst had a buy rating with like a 40-50% upside on it. Looking at all of TipRanks, my understanding was that this was a very, very safe bet with a limited amount of risk.

He found his vehicle: In-the-money call options (note BABA was at US$245):

Then I just went all in on this one single stock option: The $200 strike price call option on Alibaba.

Then he put everything into it, and believed his downside was limited.

I initially invested $300,000 in February, basically every single liquid asset in my account. Not retirement, but everything cash. I didn’t have anything left. My thesis was I might not make a lot of money, but I won’t lose much. The downside seemed limited, and that if worse comes to worse, it would go down to like $280,000.

It didn’t go well. But he decided to add:

Hey, this is gonna rebound. And as my salary came in, I saved another $100,000. So in July, I put in another almost $100,000.

The rest of the story is the trade going to zero and the person beating himself up for it.

It is one thing to learn lessons from your own mistakes. It is much more powerful to learn it from others. These lessons can be learned theoretically by sitting and thinking about it at a coffee shop or in bed, but in these days, thinking hurts a lot of people’s minds.

Lessons:

1) It is damaging for a beginning investor to be immediately successful, especially their first three trades. One will be convinced the game is easy and then proceed to bet more and more aggressively in their over-confidence until it blows up on them. The issue here is that a good investor should have a general sense of why their investments will move in the direction they anticipate. Getting the call itself correct is not good enough because the ‘why’ part of the question tells you what signs you need to look out for to get out.

In every investment, I have a general idea of what I’m looking for, and a general model in my head of what will cause things to rise or fall. Clearly if I’m anticipating an investment to fall, I don’t invest, but if you believe such an investment has longer-term potential, then this is an excellent way of testing your mental model of the company and what the market perceives of it. In general, if the company does something and the market reaction isn’t what you anticipated, it is important to examine why this occurs. There is no “one size fits all” prescription here – the intuition gets developed over many, many years (in my case over a couple decades) and most definitely can’t be learned in a few months of trading on Robinhood.

To summarize this – an investment requires you to get in, and there will be a price where you should be thinking about getting out. The “get out” point actually doesn’t need to be precisely calculated at the beginning – you can model a path in your mind for the company to get to some unspecified higher point – but without an idea of what to look out for throughout the course of the investment, you are flying blind. You might get lucky with a few trades just on sheer luck, but the variables that caused the trades to be successful will have just passed by your brain without being able to apply successful investment methodologies with future investments.

2) All eggs in a single basket. For low amounts of money (let’s say less than a quarter of annual income) I can accept an ‘all-in’ investment, but when dealing with 6-digit figures, then some component of diversification is required for reasons found in any first year finance textbooks. An asteroid might crash into the headquarters of the company. Natural disasters happen. Accounting fraud happens. I won’t talk about the obvious benefits of some diversification. Diversification these days is exceptionally cheap – you spend 10 commissions and can build up your own private ETF of 10 companies. If your portfolio is $10,000 then your one-shot first year MER is effectively 1% which is under most actively traded funds.

This guy put it all into BABA. Even if this guy put half of it into BABA and half of it into almost anything else, there would have been some degree of salvage.

3) Using call options. Options require people to bet against specific sets of variables other than the direction of the stock. If somebody has positive conviction on a stock to that degree, by most accounts it is better to simply buy equity on margin. One justification of using options would be if the options were offered at low volatility, but in the case of BABA this was not so. The usage of call options brings me to my next point, which is…

4) Using deeply in the money call options. If you had to use options and you were bullish on the stock, it makes sense to use out-of-the-money call options, which will result in a lesser amount invested in order to achieve the same delta. The scenario this person was prescribing used the wrong tool for his outlook. In addition, deeply in or out of the money options typically trade at much higher spreads, which increases the cost of trading significantly compared to using equity on margin.

5) Using P/E ratios, analyst price targets, and “TipRanks” as a measure of safety. A low P/E might be one clue, but all other underlying factors have to be examined. Why is the market letting you have this low P/E stock for so cheap? – this question must always be answered. Clearly in the case of Alibaba, a major variable in the valuation that was entirely missed by the person in question was the impact of Chinese government policy on technology firms at the time, and the perception of international investment in the country, rather than the P/E or what some analysts think the price target should be.

6) Adding to a losing position. There are times to add to a losing position. There are times to just leave it. There are times to just jettison the thing when it drops from your initial investment price. The lesson here is that you do not have to make up losses in the same stock you lost money from.

Hopefully these lessons can be ingrained in your investment psyche without having to experience what this fellow did, and if you must learn the lesson by losing money, do it with a much lesser sum of capital.