Broad picture thoughts – Post-Covid investing

This is going to be a rambling post.

My investing thesis post Covid-19 is simple – invest in companies producing real stuff, with the sweet spot being primary and secondary industries. I am sure there will also be tertiary winners (e.g. technology) but there is a lot of competition in this space and I am unlikely to pick out the winners relative to current market valuations (for instance, if it turns out that Microsoft is the winner in cloud computing, on their current US$1.6 trillion market capitalization, it might not turn out to be very profitable).

In terms of real stuff, somebody has to keep pulling the raw commodities out of the ground in order to fuel the real (not digital) economy. Companies will incur costs to do so, but ultimately the commodity itself will have value. In a depreciating dollar scenario, these commodities will organically exhibit price increases, all other variables being equal. This is a well known process.

However, ultimately commodity pricing is a function of supply and demand. In many industries, there was an assumption with most producing companies that they did not want to hold inventories during Covid, and took actions to streamline. This is quite apparent in the lumber industry, and it was not generally expected that people would be using their CERB or US-equivalent to improve their homes, build fences, and so forth. The result is that lumber prices have skyrocketed.

Other commodities that have exhibited forced price cuts (e.g. oil) are now being bidded up because liquid energy consumption is clearly headed toward normalization (an examination of the Google Map traffic is enough to be said here, but I am sure the economic engineering department of Google makes much better usage of the data than we can from our consumer perspectives).

Gold is also going crazy right now. I have encountered some friends inquiring about gold, and also people with gains on precious metal funds, and inquiries about how to obtain physical gold, and so forth. It is to the point where it is feeling frothy. Just because things are frothy does not mean they will become more frothy.

The underlying basis of demand is likely a combination of a natural increase from the recovery of Covid-19, coupled with a fright of dollar devaluation. In light of the US Government (and world governments in general) blowing out deficits in record magnitude, it is reasonable to think that joint devaluation of currencies will result in increased prices for everything, starting with commodities, but in general, the price of energy is the core to it all.

The quantity of energy consumed is generally a barometer of the health of civilization – this goes back for millennia. Our lifestyle is inevitably linked to the consumption of energy. Don’t get me started on the production economics of mining bitcoins!

Fossil fuels have been shunned upon for various reasons (carbon emissions) and renewable sources have been promoted, but there is a scale limit to how much renewables can be introduced before you incur significant tradeoffs – either significantly higher costs, or reduced reliability (the higher percentage of intermittent sources you have, the more you need to buffer them with dispatch-able energy).

Despite this, renewable sources have been deemed politically correct and have received sky-high valuations and subsidies.

I will make the claim that in terms of industrial levels of power generation, in North America we are reaching a scale limit to intermittent energy production. This will certainly not be a popular opinion or claim. The short story is that renewable energy cannot scale to high percentages in all jurisdictions on an individual grid. In California, for example, during mid-day it produces a ton of energy from solar sources (on a day like today, 11.8 gigawatts!), but broadly speaking, the following are very relevant questions:

a) How much did it cost to get those solar arrays up and going, and to maintain them;
b) How do you buffer the amount of energy on days where it is no longer sunny, or off-peak times?

Question (a) tells you the trade-off economics of building one type of power generation vs. another. Incomplete accounting makes intermittent power look cheaper both from a raw cost perspective (for instance, you do not have to include the cost of a backup source of power when the wind dies down, or the sun isn’t shining), but also with subsidies and omitting environmental costs of production.

The question of (b) is not trivial, but typically it involves a combination of natural gas, hydro, load-following base power (e.g. coal, but not in California!), storage (very expensive in industrial quantities) or imported electricity.

Essentially, somebody has to produce the supply to meet the electricity demand – this is why the more intermittent supply that is added to the power grid, the better it will be for fossil fuels – either you consume a ton of energy up-front to build up your solar arrays or storage solutions, or you consume it in natural gas. Jurisdictions with ample hydroelectric power (such as British Columbia) are also blessed with dispatch-able power, but building dams is a very expensive endeavour, both in raw costs and significantly increased political costs (permanently flooding land is not popular). In other words, for each incremental addition of intermittent energy sources that you rely on to fuel demand, you need a unit of dispatch-able power from somewhere.

The logical course of increasing intermittent resources can be seen in a place like Germany, where the cost of power has skyrocketed as they have removed coal and nuclear energy from their power grid, and attempted to replace it with solar, wind and tidal power. This is not viable without relying on others in the power grid.

One major event that will occur in the future (a matter of when, not if) will be a significant power grid failure that will have been instigated by having too much intermittent energy sources on the grid, without available backup from domestic or external grid sources. This may be caused by a freak transmission failure (cutting an intermittent-heavy grid from a dispatch-able heavy grid) or some other ‘black swan’ event. When this occurs, there will likely be a dramatic shift in power generation policy to increase the robustness of a domestic power grid.

The preceding few paragraphs lead to very political issues regarding energy production. Many will not agree.

This leaves me to my last point of nuclear energy. It has been shunned for a very long time (the documentary Chernobyl was great to watch although it did embellish in some scenes for dramatic purposes, the Fukashima reactor, etc. are all stories that are in the public consciousness), but this is going to change, for no other reason simply because to expand power generation capacity in a carbonless manner there isn’t much room to go other than nuclear.

This is not a call that Uranium commodity pricing will increase (it is a relatively abundant resource at present), but rather that an exploitable avenue is a resurgence of nuclear power in general. I do not know how that will take place, but if de-carbonization continues to be popular, it would be a logical conclusion to replace base load coal, and natural gas plants with nuclear energy. Reactor technology has significantly improved in safety, where Chernobyl-type disasters have no way of happening.

The other issue is that nuclear technology is (for obvious reasons) highly secretive and countries that have competitive advantages in nuclear energy will tend to keep them, in addition to competitive advantages associated with domestic-only production. In the USA, this means companies like BWX Technologies (NYSE: BWXT), who are more or less the sole-source provider for nuclear engines for naval vessels. I bought them post-COVID.

Finally, we have the nuclear materials themselves. While Uranium is a hyped up commodity, and domestically there is only one Canada/USA credible stable large-cap company specializing in its production (Cameco, TSX: CCO), there are also a bunch of other smaller cap companies, including Energy Fuels (TSX: EFR), Denison Mines (TSX: DML), Laramide Resources (TSX: LAM), NexGen (TSX: NXE). Even further down are a bunch of TSXV companies which I won’t bother listing.

However, the commodity itself faces considerable cost competition from central Asian companies, which makes uranium production in North America relatively uncompetitive unless if you believe that geopolitical constraints (e.g. trade embargoes) will then put North American producers on a level cost playing field. In that case, I would be much more interested.

The refinement of Uranium, however, is a much less competitive space (just ask the government of Iran how their attempts on Uranium enrichment is going for it), and a company that I took a modest position post-Covid was Centrus Energy (AMEX: LEU), which has had its stock take off to the point where I can now freely write about it. Be careful – it is very thinly traded and has a small float in absolute numbers (it is heavily insider owned). A case can be made that in an ideal scenario they will trade for much higher than their current price, which has more than tripled since their Covid lows. I’m sure now that I’ve written about it, they have peaked – the downside scenario is that the next generation of nuclear won’t move from the planning stages.

Tailored Brands (Men’s Warehouse, Moores) does Chapter 11

As predicted earlier, Tailored Brands filed Chapter 11 today. Another retailer bites the dust.

This is not surprising, but when reading the fine print (8-K):

The RSA contemplates a restructuring process that will establish a financially sustainable operating company (“Reorganized Tailored”). The contemplated restructuring process includes (i) the commencement by the Debtors of voluntary cases under chapter 11 of the Bankruptcy Code, (ii) the acquisition of the DIP ABL Facility (as defined below) from the Debtors’ current ABL lenders, (iii) the Consenting Term Loan Lenders agreeing to compromise their prepetition claims in exchange for, among other things, exit debt and 100% of the new common stock of Reorganized Tailored; (iv) the Consenting Term Loan Lenders agreeing to the consensual use of cash collateral; and (v) the implementation of exit financing for Reorganized Tailored (which is described below), each on the terms set forth in the RSA.

The first-lien debt holders will get 100% of the common stock of the reformed entity. The senior bondholders will receive nothing unless if they are thrown a few last second bones (warrants to buy common?) to expedite the restructuring. They last traded at 3 cents on the dollar today.

Take-under – Stuart Olson

Shareholders of Stuart Olson (TSX: SOX) got a surprise today when they woke up to the following headline: Bird And Stuart Olson Join Forces To Create A Leading Canadian Construction Company.

This was a takeover proposal from Bird Construction (TSX: BDT). After cutting through all of the self-congratulatory sentences, the salient terms and details are the following:

$40 million cash and $30 million in BDT stock (valued at $6.32/share) will go to the senior secured creditors;
$22.5 million in BDT stock goes to the unsecured debentureholders;
$4 million in BDT stock (0.02006051 BDT per SOX) goes to the shareholders.

Notably, this works out to 13 cents of value per SOX share.

Something was definitely off when SOX announced last month they would pay the semi-annual interest to debentureholders with 10.6% of the company (equity) instead of cash. Now we know – they were in the middle of a negotiation to sell shareholders out.

Not to say that SOX was in a good financial position – indeed, SOX was in a poor position (they were likely to blow their covenants which had been relaxed for COVID-19), and Covid was not making matters better.

SOX apparently got 31% of shareholders to agree to this take-under, and they need a 2/3rds vote in favour to approve this. The market right now is trading SOX at 39 cents, which can only mean that either stock is hard to borrow (it is) and/or they anticipate some sweetening to get over the 2/3rds threshold.

Bird Construction, however, is in better financial shape. Operationally, however, they will still be suffering from the effects of Covid and margins are quite thin.

No positions in any of these companies, but just following this financially interesting story.

Miscellaneous notes

I took a few days out in a remote area (i.e. away from major urban centres) to do some reflection and avoiding the airwaves for the most part. It allows for mental digestion without dealing with the day to day distractions. Also, due to Covid-19, the tourism sector for the most part is decimated, which is why it is the perfect time to go out to places that would otherwise be swamped with tourists.

Covid

It’s pretty evident that nomenclature has made this much more difficult than it should be. The virus that causes COVID-19 is SARS-CoV-2. An analogy is that HIV is the virus that causes AIDS. Unfortunately, in everyday conversation, the words “COVID-19” refer to the disease and are conflated with the virus. There is ample evidence that even if you have the virus, there is a very good chance that you don’t get the disease, but the reports are still such that you are “COVID-positive”.

There are plenty of viruses out there that people are completely asymptomatic to. A good example is the Herpes Simplex virus, where it is estimated that 2/3rds of the world population has it. The disease that the virus causes is called Herpes simplex (same name as the virus).

Until people make a proper distinction between the virus and the disease, I generally believe public policy will be quite irrational in circumstances. Specifically, efforts to contain the virus by caging people and restricting various activities are effective in the short term, but pay very little to the fact that in the longer run, there will be re-infections. Jurisdictions that have claimed victory (e.g. New Zealand, Atlantic Canada, Hong Kong) will discover that the virus will re-emerge despite all efforts to contain it. This is ultimately a futile battle.

If I was pulling the public policy levers, it would be to focus on those obviously vulnerable to the disease and not the virus. As the age cohort is the dominant variable that correlates with mortality and severe symptoms, these people should continue to take extra precaution – both due to SARS-CoV-2, but also because there are a boatload of other viruses out there that also correlate positively with age in terms of mortality.

But in the meantime, we have long since passed the point where COVID-19 is used for rent-seeking and other political purposes. This is obvious in places like Hong Kong, which authorities are claiming to cite as the reason why they should shut down again (real reason – legislative elections are coming up and they won’t be good for the establishment), but also here in Canada, where incessant “mask or no mask” polarization completely misses the point – people that get the virus don’t necessarily get the disease.

This search for a vaccination is also a huge red herring, but it will serve a psychological purpose – a light at the end of the tunnel. However, my deep suspicion is that this will be similar to attempts to vaccinate against the common cold (Rhinoviruses and other Coronaviruses) and the annual “flu season vaccination” which protects against certain strains of flus (H1N1, H5N1, etc.). There is evidence to show such vaccinations do have effectiveness, but it is never a “black or white” situation – the flu vaccination, for instance, ranges in effectiveness from 10% to 50% (if you believe the evidence!), but it is impossible to measure after the fact – for ethical reasons, you can’t run a double-blind test where you purposefully infect people in one arm. Measuring something that does not happen is much more difficult – if you took the flu vaccine, but didn’t catch the disease, who is to say that you just simply never would have gotten it anyway?

So here is my prediction on the COVID-19 vaccination – there will be something released, it will be ‘proven’ to be effective, but its effectiveness will be diffuse (let’s call it a statistically significant 10% success rate). Victory will be claimed, and a whole bunch of people will take it (which will spark another public controversy over mandatory vaccinations vs. not taking them) and the world will move on.

Fundamentally, what is going on is much more simpler – we all have immune systems. Some of us are much better at fighting certain classes of viruses than others. There are some of us that have very good immune systems, and some of us that get sick all of the time. Statistically speaking, if you are young, treat your body well and have had general exposure to other amounts of viruses in your past life, your body will be well adapted to fighting SARS-CoV-2. Some will be much more vulnerable. A simple analogy is that happened to when the European explorers introduced smallpox to the native populations in North America – the natives didn’t stand a chance since their immune systems were not trained at all to fight the classification of viruses that had brewed up in the filthy urban centres of Europe over the prior centuries (prior to the advent of urbanized sewage systems, it made Chinese wet markets look very sanitary by comparison).

Another analogy is physical fitness – if you are asked to run 5km in a 75th percentile time and you haven’t done it before with zero athletic training, chances are if you actually forced do it, it would probably cause severe damage (shin splints to name the least, but it would probably cause severe cardiovascular damage). Recall the first recorded instance of a person running a marathon died after completing his mission (Pheidippides)! However, if your body is trained, you will be adapted to the stress that heavy physical activity incurs. While this simplifies matters with regards to immunology, the body that has faced a variety of viruses in the past will likely do better dealing with SARS-CoV-2 than those that are inherently sensitive.

Finally, if this virus is anything like other viruses, there will be subtle mutations that will increase and decrease the prevalence of disease – just like how you can get a “light” cold and a “bad” cold.

I really think it’s time we move on.

Investments in Markets

It is evident to me that investing in ‘stuff’ rather than ‘dollars’ is going to be the right decision. Other than some (rapidly depreciating) cash, I hold nothing financial in my portfolio. No banks, no insurers, etc.

There is currently a boom in technology-related issuers and I am content to let this segment of the market figure itself out with their high valuations. The rush to liquidity to largecap issuers (the FANGS, and throw in Tesla in there while you’re at it) are also a result of passive indexation – you throw a dollar into an S&P 500 index fund, and 20 cents of your investment automatically get forced into the top 5 or 6 companies – who’s going to sell it to you? As a result, prices rise when liquidity rises. The major indicies will likely continue rising.

It will eventually implode (analogy is year 2000) and when it does, the survivors left standing will be the ones that are actually producing real stuff. This means primary industry participants (that can actually produce such products at competitive costs as primary industries are quite competitive), but secondary industry participants that produce viable products from primary industry participants will also do quite well. I realize this is quite abstract, but I do have some names in mind.

Commodity investing

Gold is going crazy right now (and rightfully so – why bother speculating on negative interest rates with government bonds that are effectively yielding zero, when you can just get your hands on the shiny yellow metal?). I do not like any of the gold mining companies – they are all capital pits.  Their market value will go up on the basis of reserves, rather than having efficient operations and capital management.  Perhaps I’m a little too dismissive and throwing out the baby with the bathwater, but I think there are too many eyeballs on gold producers (despite most of these producers not being very well represented on the indicies). If you believe in gold, just buy the futures contracts and get price exposure that way.

Oil is a more interesting space, at least in Canada. Canadian SAGD producers (and more conventional low-decline producers) are going to be in shockingly decent shape – most of the capital has been spent and it requires relatively less maintenance capital to keep the production flowing. Contrast this to capital-intense shale producers which is now financially nonviable (and institutions are now smart to how this pricing model is no longer functional). Especially in Canada, environmental laws are incumbency protection for the major producers, and now that US shale has peaked (Q4-2019), they are going to be more reliant on imports once demand gets back up again. With Trans-Mountain continuing, Coastal Gaslink proceeding and Keystone probably continuing to fruition (maybe), it actually bodes quite well for Canada. Teck not getting into the oil sands game was probably the death knell for further oil production in Canada in the foreseeable future, which means the Suncor, CNQ and Cenovuses are going to be reaping the rewards.

My guess is we will see a triple digit oil price in a couple years. Other fossil fuels (gas, coal) will follow. It will be considered a massive surprise from market participants that thought the days of fossil fuels were done.

Again, just like gold stocks, probably investing in futures contracts are the easier method, although in Canada, most of the companies have been hacked so badly in the past decade that they are lean operations and you can pick and choose from them to get sufficient leverage (in addition to being registered account eligible).

Finally, the outlook for Coal companies right now feels like how the market felt about tobacco investing in the late 1990’s. The highest returns are to be made when an entire sector is shunned without any hint of contrarianism (which is what you see now in the airline and cruise ship industry).

Election Politics – USA

It is tough to believe the US Presidential Election is just over three months away.  Four years ago the election felt like it lasted a year.  This time around it feels like it hasn’t even started yet.

The most credible gambling site where you can throw a bunch of money at and not get defrauded (they respect wagers from people that actually are winning clients) is Pinnacle Sports.  They have Trump at +156 (39% to win) and Biden at -184 (65% to win) (note that the excess of 4% of the total of 104% is the “bid/ask spread”).  Another credible site (Betfair, but not available for Canadians) has Trump at 9/5 odds.  The basis for this is likely the litany of polling showing that Trump is down by about 9% across the country, which in most ordinary circumstances would result in a slaughter.

However, this is not any ordinary election, and the winner is determined from the electoral college and not the popular vote.  Just like in 2016, Trump is going to get slaughtered by significant margins in California and New York, but it doesn’t matter whether he loses by 40% or 20% in those states – the outcome is already pre-determined.  The question is how he does in MI, OH, FL, NC, PA.

The other question is if polling data is reliable.  In both Canada and the USA, elections are determined by who turns out to vote, and polling typically does not capture this data very well.  If I were to guess at present, I would say the odds are reversed.

Election Politics – Canada

There is a non-trivial chance of Justin Trudeau calling an election for October.  Be warned.