Finance – Page 16

When narrative and reality collide – ESG, politics and markets

One rewarding aspect of finance is that participants that correctly perceive reality are eventually rewarded with additional capital, provided you stay solvent longer than the market remains irrational.

As markets are an amalgamation of sentiment, there is an element to psychological timing with regards to asset prices. The prices that are currently seen represent the baked in assumptions of marginal buyers and sellers, each trading with their own motivations – some extremely short-term, some extremely long-term. Another vector is the advent of environmental, social and governance (ESG) driven investing. Formerly labelled as “socially responsible” or “ethical” investing, ESG has generalized this to refer to politically correct practices.

As the politicization of financial markets continue, it is obvious that a focus on ESG and politically sensitive institutional investors (e.g. public pension plans and the like) will take a factor in investment decision making. This has long-since been baked into certain asset prices. Political favourites, such as renewable energy initiatives, have resulted in such assets receiving premium valuations and hence low returns for current investors. Such assets are typically aided by government subsidies (in the form of attractive power purchase agreements, or in the case of Tesla, outright tax breaks and subsidies).

This sort of gaming goes on all the time in most industries, as participants jockey for position. Large entities try to assert control through rent-seeking techniques. Nothing is a better example than how various entities are reacting to COVID-19 – companies such as Amazon are cheering for continued lockdowns as they continue to eat away at conventional retail. The medical industry, both private and public, are cheering their nearly unassailable position as nobody can question the quantum of spending in relation to the overall benefit – “anything to save a life” is the current expectation. By the time it comes to pay the bills, the blame will be attributed to other factors.

On the flip side, we have the ‘enemies’ of ESG, which generally constitute a list of firms in politically incorrect industries. One of these industries that are deeply politically incorrect at present (especially in North America and Europe) is oil and gas exploration.

When looking at core valuation of the major Canadian oil and gas firms, there is a major valuation gap between what the ambient market is offering versus what cash is being generated by the companies in question.

For instance, Canadian Natural Resources (TSX: CNQ) gave out guidance on May 6, 2021 that assuming a US$60/barrel of West Texas Intermediate (right now it is US$63.50 on the spot contract), they will be able to generate around $5.7 to $6.2 billion in cash flow, and this is after their capital expenditure and dividend payout (which is another $5.4 billion). Backing out their $2.2 billion annualized dividend to zero, that’s around $8.2 billion in free cash flow (FCF).

Recall that CNQ’s enterprise value is currently around $67 billion, so a rough valuation would be an EV/FCF of 8 times. This means if things continue at current prices, CNQ could pay down all their debt and buy back all their shares outstanding (at current prices) in 8 years. This isn’t an isolated case. The other Canadian large players, Suncor, Cenovus, Tourmaline, are roughly the same (plus or minus one or two points). There are no other ‘substantially Canadian’ plays that have a market cap of above $5 billion at present (Imperial Oil is 70% owned by Exxon, and Ovintiv, the former EnCana, is now primarily a US producer).

You cannot find valuations like this anywhere else on the large-cap market. A typical utility such as Emera (TSX: EMA) trades at roughly 18 times EV/operating cash, never mind capital expenditures! Royal Bank (TSX: RY) trades at 15 times earnings. Perhaps the only outlier I can find in this respect is E-L Financial (TSX: ELF), which posted a 2020 net income of $129/share (on a current share price of $948).

Needless to say, Canadian Oil and Gas looks cheap, and one reason for this (other than the horrible regulatory climate) is the investment ineligibility due to ESG. The irony is that this creates opportunity for returns for those that want higher returns, such as international investors that do not take North American ESG into their investment consideration.

I can think of one analogy in the past which reminds me of today – the plight of tobacco companies in the late 90’s. Tobacco companies (most specifically, Philip Morris) were vilified in the 90’s for having the gall to produce a product that caused lung cancer and collectively denying it until they had lost all public support. The watershed moment was a US$200 billion settlement with the states in 1998, but in reality, this agreement secured incumbency rights for the existing players. The Philip Morris example (now known as Altria) has them earning $3.20/share in 1999, while the stock closed at $23/share for the year. They bought stock like mad during the dot-com boom and shareholders got very rich. Incidentally, Philip Morris was right up there with Microsoft in terms of generating shareholder value over decades (not really the case today anymore, although tobacco continues to remain very profitable).

I’m going to make a much looser analogy with Warren Buffett buying Apple stock in 2017 and 2018 (at his cost basis of $34/share to the tune of some 907 million shares he currently holds today) is giving him a current earnings yield of about 15%. There are of course key differences – with Apple, you have to assume they can continue selling iPhones, iPads, Macbooks and ‘iApps’ at their monstrously high margins indefinitely. With oil and gas you have to make an implicit assumption that the underlying commodity prices will stay steady. This is another argument for another post, but please humour me by granting this assumption.

Buffett, by virtue of his size and relative fame, is constrained by political considerations. The cited justification for selling off his shares in airline companies at the onset of the COVID-19 crisis was politically motivated – the chances of airlines getting public money bailout with (deep pocketed) Berkshire being a 10%+ shareholder was much less, so they had to sell (I am not sure if this is retrospective analysis that actually went on during the sale, or whether it was a simpler case of the original investment thesis being broken). This is not the only example.

In the most recent 13-HF, we had Berkshire disclose that it had sold half of its Chevron stake and all of its Suncor. Chevron is obviously going to be completely divested by next quarter. There is nothing in Berkshire’s public holdings that relate to oil and gas production going forward. This is very intentional, and I believe it is for political reasons.

Buffett is the son of a former US Congressman and should know a lot about the political dynamics that is going on with ESG currently. There were two shareholder resolutions that came up during Berkshire’s last annual meeting. One was from Calpers and the Quebec Pension Plan, two very credible institutional investors:

In order to promote the long-term success of Berkshire Hathaway Inc. (the “Company”) and so investors can understand and manage risk more effectively, shareowners request that the board of the Company publish an annual assessment addressing how the Company manages physical and transitional climate-related risks and opportunities, commencing prior to its 2022 annual shareholders’ meeting.

The other (from a generally unknown proponent) was:

Shareholders request that Berkshire Hathaway Inc.’s (“Berkshire Hathaway”) holding companies annually publish reports assessing their diversity and inclusion efforts, at reasonable expense and excluding proprietary information.

Normally such shareholder resolutions get voted down, heavily. The Board of Directors almost universally recommend a vote against such resolutions.

However, the actual results of the votes got somewhat close:

There were approx. 548,000 votes cast in the meeting (some votes are not cast due to them being held by brokers that do not vote). The directors control 272,900 of the votes (the vast majority of this is from Buffett himself). So the vote result was a foregone conclusion.

However, excluding the directors’ votes, both resolutions passed with a slim majority.

This has to be interpreted to be a warning shot across the bow to Berkshire and almost any other corporation out there with a large public presence. They are not immune from activist politics and the politics driven behind institutional shareholders.

You can imagine how Buffett might be frustrated in not being able to deploy capital into a field that is liquid enough to make an impact on Berkshire. However, with the world examining his holdings every quarter, he must take politics into his investment considerations.

ESG, just like most political interventions, cause market distortions between perception and reality that can last for years if not decades. Hundreds of billions of dollars of capital are being invested not with a return in mind, but rather with a heavier consideration to other factors, including those that are acceptable today (which may or may not be acceptable tomorrow). Pharmaceutical companies were completely vilified before COVID-19, and now they are being showered with immunity from Covid vaccinations and have a gigantic regulatory shield to work with (until they are no longer in favour again for making outlandish profits). Today’s enemies are those relating to climate change, but this may change in the future as demand for fossil fuel energy outstrips available supply.

I am not making a moral judgement on ESG and its intentions. I am claiming, however, that ESG-driven considerations are causing significant distortions in the returns of investments that would have not otherwise existed.

Ultimately for equity investors, cash flows will dictate returns. It might take some time for political fashions to turn, but just like Philip Morris investors in the late 90’s, they were very well rewarded. Eventually the paydown of debt and payments of dividends and buyback of shares trading at single digit multiples will result in higher equity pricing, no matter which trends are politically correct.

This will be interesting – Bitcoin

Bitcoin is taking a dive:

Today’s price action so far:

This looks like a margin-propelled crash with today’s 20% takedown. From peak (US$65,000) to trough today is just over a 50% haircut, and not many people have the intestinal fortitude to handle such a drop – especially when they are leveraged.

The question going on in my mind is cross-margining – have people collateralized loans with their Bitcoin holdings? If so, what else are they going to be forced to sell as a result of today’s price drop?

Always be conscious that a trade involves a swap of asset for cash; the amount of cash nor the amount of asset changes on net. Only the valuation of the asset in question changes.

Now you have the people speculating on BTC from the middle of February to yesterday all underwater; the people that speculated from the beginning of 2021 to the middle of February are roughly in a break-even position; while you still have a dedicated ‘fan base’ holding prior to that – all trading against each other in one massive zero-sum game. The only person that really doesn’t have much choice in the matter is Microstrategy (MSTR), who’s CEO cannot possibly reverse his decision as right now he appears to be willing to be the last bagholder.

The pivot out of garbage into value

The year 2000 to 2002 was a fairly good barometer of what I think is to come with respect to these high-flying companies that populate the SaaS, ‘alternate energy’ and SPAC domains (I know SPACs are a financial characterization and do not necessarily reflect the entities that emerge from SPACs, but most of these are complete garbage reminiscent of the dot-com era of 1999-2000). There is also the market for crypto-garbage which many people in their 20’s are enamored with.

The poster child for all of the equity froth is the ARKK ETF:

There will be ups and downs, but the prevailing trend will be down as valuation eventually has to settle into the equation. Even after a major period of volatility in the spring of 2000, it took a couple years for the Nasdaq to fall roughly 75% from peak to trough before it began to recover again. Think about this – a 75% drop over 30 months.

During this same time, companies that generated real cash flows and provided economically valuable goods and services did reasonably well. Berkshire was a great example of this. Warren Buffet prior to 2000 was criticized as being behind the times, just as he is today. Once again, he is going to get his revenge:

I think Warren wants to live to see the day when Berkshire Class A shares trade for US$1,000,000 a piece. He’s accelerating the process by buying back shares. Just imagine the headlines then.

In Canada, it’s actually not that bad in terms of the froth. When dredging up a list of winners over the past year, while there are a few obvious examples of “stinkers” which I will not mention here, there are many companies which are riding the resurgence of commodities and are well positioned to generate huge amounts of cash.

A good example of this is Teck, which exists in the sweet spots of being the leading metallurgical coal producer in Canada (also go look at a chart of Stelco for an idea of how the steel market is being treated currently), coupled with having a very large copper operation that will get even larger with the completion of the QB2 project in Chile – with current commodity pricing they will be minting billions in the upcoming years.

One might be fearful that a drop in the high-flying sectors of the stock market will translate into drops in valuations of “real economy” firms. While this might occur in the short term (as portfolios inevitably will de-leverage to some degree), past experience would suggest that sentiment will flow favorably to companies that can demonstrate profitability and valuations will receive a boost accordingly, especially since the alternate is much less attractive in our very low interest rate environment.

Buying is easy, selling is not – Canfor

There’s a great discussion on portfolio diversification between stusclues and Rod in the previous post. I’m appreciative of the time it takes to write these things and for the shared perspective and respect for differences. I was wondering if I was on the internet for a moment.

Going to the title of this post, I have always found the timing of my buying to be a lot better than my selling. The execution of my selling over the past decade or so has been mediocre, to the point where I’ve given it a bit of revision over the years. In general, my problem has been that I have been too eager to sell. I typically buy stocks that are considered to be ‘value’, and when the market realizes it, it tends to over-swing in the opposite direction and I’ve been trying to get a bit better at ‘playing the pendulum’. There have been failures and successes, but for example, in the case of Genworth MI, I probably bailed out a little too early and left some money that I probably shouldn’t have (especially those monstrous special dividends).

Still, one cannot be expected to claim every penny of upside, especially when looking at a stock in retrospect. It is nearly impossible to time the top, as well as being able to time the bottom. A lot of value is captured being directionally correct and not necessarily buying at the low. Also, a lot of value is captured in identifying when the basis for taking the position in the first place was wrong and taking an early small loss instead of a larger one. Finally, if an alternative position poses a better risk/reward, there may be value in diversifying the less attractive alternative – 2020 was rife with sales that today look stupid, but the transaction spreadsheet doesn’t show what was bought in substitution for those sales at that particular time (almost anything sold between March 2020 to May 2020 looked like a bad sale, unless if you take it in consideration with what was purchased at the same time).

Applying these general principles, I have recently decided to bail out my (very small) positions in Canfor (TSX: CFP) and Western Forest (TSX: WEF). These positions were tiny and taken during the Covid onslaught (there was just too much other stuff going on for me to pay more attention), but percentage-wise they were well above a 100% gain. I’ve redeployed the proceeds to companies that are exposed to crude oil prices.

The lumber commodity has been on a huge tear over the past month. The following is a chart of the July lumber futures, and note that the step-up is because on many days the future contract has been locked limit-up:

For contrast, this is the 40 year history of the commodity:

I could only imagine what it was like to be a short seller of the futures over the past month (noting that the 925 price level was already at all-time highs!).

Correspondingly, lumber companies have skyrocketed during Covid. This includes CFP, WEF, WFG, IFP.

I will talk more about Canfor. They are 51% owned by a Jimmy Pattison company (his company also controls Westshore (TSX: WTE)). They were notably in the news in 2019 (pre-Covid) when they tried to take over the 49% minority stake at CAD$16/share. This was a typical Jimmy masterstroke – if it actually passed! The vote failed to meet the passing threshold – barely. Notably, one of the directors, Barbara Hislop, who was a descendant of one of the original founders of Canfor (in addition to working her ranks up the company over a few decades herself), was against the deal. She was the sole director to ‘abstain’ from the board of directors’ vote to recommend selling out at $16/share. That ‘trade’ to not divest saved her many millions of dollars – going into 2021 she had 1.3 million shares of Canfor and has subsequently dumped nearly half of them for around $30 a piece. Talk about vindication.

It’s easy to look at this in retrospect, but even then, Canfor got as low as $6.11 during the pits of the Covid crisis. The trade to not sell out at $16 was looking bad for some time.

In the last quarter, Canfor reported a net income of $3.42/share. Annualized that’s $13.68/share, or about 2.4x earnings at the current trading price of $33. Needless to say, you are correct in questioning my mental sanity when I am selling equity at 2.4x annualized earnings. Didn’t I talk about selling out too early at the beginning of this post?

The reason for this is that lumber is very cyclical. There are boom and bust periods. Right now is the “category 5 hurricane” confluence of events that is triggering a massive demand-supply imbalance and we are in the second phase of that storm where the eye of the hurricane has passed and we are once again facing the winds. Putting a long story short, when Covid started, the assumption that wood executives made was to clear out inventory because the economy would crash and construction would come to a halt. Precisely the opposite happened (everybody decided it was a great time to start building your own deck) and we are seeing the reverberation of those March 2020 decisions today. Now we see 4’x8′ OSB plywood selling at $60/sheet at Home Depot and anything wood-based is insanely expensive.

Certain construction projects must be completed on a timeline – developers generally can’t say “forget it, I’ll wait until lumber gets cheaper to do this project” – there are running timelines that can’t be altered. Discretionary projects, however, will be delayed and this will create its own residual demand which will add to future prices – hence the January 2022 lumber futures are at around $1100. But there will be a point where the demand destruction will kick in, and lumber will hit some regression to the long-time average.

In the meantime, the surviving lumber companies will be repairing their balance sheets and prepare for a day with less profitability than present. Currently, they are pumping out lumber as quickly as they can make it.

In addition to Barbara Hislop selling out, I note that a week ago Brookfield Asset Management dumped a massive stake in West Fraser Timber. While I am not a “follow the leader” type investor, I generally do have respect for Brookfield’s investment decisions.

In terms of the market dynamics, my gut instinct says that now is a good time to cash out. Everything is rosy. It feels terrible to sell out at 2.4x and I am probably leaving 10-20% of upside, but I’m punching out the clock right now. If I had a larger position, I’d get a little more fancy and sell a chunk of it with every few percent of share appreciation (this indeed would capture more of the upside if it were to occur), but I just want this trade out of my mind to preserve my mental bandwidth for other things.

A good primer on portfolio positioning, concentration and measurement

Horizon Kinetics’ 1st quarter commentary has an excellent primer on “On Concentrated Positions, “Locking in Profits” and “Trimming”” which contains sage wisdom, well worth reading (pages 2-6).

When trying to summarize my own investment strategies in a sentence, it always amounts to maximizing the reward/risk ratio (or minimizing the risk/reward ratio). Most laymen when hearing this think it means trying to operate a conservative-as-possible portfolio, but it doesn’t preclude really swinging the bat for a home run now and then at the risk of a strikeout. However, when going into detail as to what exactly entails ‘reward’ and ‘risk’, I end up sounding like a total flake simply because my investment style is to be as amorphous as possible dealing with the cross-section of the highest probability of what I believe I know (e.g. I can’t know everything, I don’t know most of everything, I know a lot of what I do not know, and I don’t necessarily know what I think I know!) and where I think things are going in the grand scheme, and having political experience helps with this. Markets inevitably are human-driven, with all of our psychological traits deeply embedded despite most of the actual trading being driven by human-written yet computer-executed algorithms.

It is always disturbing to me that the performance I have generated over the past 15 years or so has just could have (Sacha’s note: In the original posting, I forgot to include these two words which materially alters this sentence!) been the result of dumb luck. I’d like to think otherwise, but I can’t rule it out. One great and bad thing about an “amorphous” investing strategy is you can’t backtest it to measure how much alpha you truly generate. But I do like the “if I went into a coma for the past X years, would my portfolio be better off today or had I not slipped into the coma” test, whereby you can measure your performance against yourself rather than some arbitrary index. For instance, all of us have underperformed the bitcoin index over the past decade.

If I were to characterize the markets currently, it is pretty clear that things have stabilized after Covid-19 and this is going to end up muting overall returns going forward. Q2-Q4 in 2020 was a bountiful time where farmlands were fertile, and today the crops are growing, but the harvest time is coming very soon. I’m guessing that as the more youthful participants in the markets slowly get their accounts liquidated (through SPACs, junk crypto and the like), that the remaining competitors in the market will be much more sharper with their pricings. The continuing gap of passive vs. active (another topic that Horizon has written about extensively in the past) will also be exploitable going forward.