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.

Parabolic lumber

Lumber has gone nuts, especially in relation to its ambient trend over history.

Since 1978 we have the following (nominal) pricing data:

And in the past year:

Similar to crypto, nothing shows proof of work more than a sawed 2″x4″x8′ stick of wood available at Home Depot!

Not surprisingly, given the completely out-of-history price rise in lumber pricing (right up there with government bond pricing), we have seen lumber producers skyrocket in price from their Covid lows. The previous rise up in 2018 also caused a spike in lumber producers, but this time the prices are even much higher.

However, lumber is like most other commodity markets that are highly cyclical – I suspect pricing is at the point where there will be an element of demand destruction and when this occurs, watch out below. It’ll probably happen in 2021 when the current backlog of “must-construct” projects abates and supply continues to stream in.

The times are good right now – lumber companies will be posting insanely high profit numbers in Q1 and Q2, but the question remains how sustained this massive commodity boom will be. The phrase “leaving the party while people are still drinking the hard liquor” seems apt – it seems so contradictory, but you want to unload your commodity shares at a point where the historical price to earnings is the lowest (typically a mid-single digit). The market has a very good sense of being able to detect when the commodity company has reached its peak profit.

Bye-bye FLIR

I unloaded my FLIR (Nasdaq: FLIR) today at US$58.25/share. Past 10 year chart for reference before the company disappears this quarter:

I’ve been stalking this company for ages. I originally did a very short post on it from July 2011, but never got around to purchasing the stock until the Covid crisis in April 2020.

I wrote about the Teledyne acquisition here which occurred at the beginning of the new year.

I am not typically a large-cap S&P 500 company investor. I make rare exceptions now and then, but for the most part I prefer the smallcap space. FLIR investors will receive 0.0718 shares of Teledyne per FLIR share and US$28 in cash. Teledyne has had an excellent track history of integration acquisitions, although their style of acquisitions have been bolt-on and tuck-ins, and FLIR is a mammoth acquisition for them, the largest in their history. I don’t know if they can execute, although strategically given their product portfolio, it makes sense. Financially, TDY is expensive, but they are also in a business domain that is relatively stable and should continue producing stable cash flows going forward. They will also be a positive recipient of passive index money from the S&P 500 (a larger fraction given how their market capitalization will increase post-merger). But that said, they are too large for me, and hence my decision to eliminate them from my portfolio. I paid about a 30 cent merger arbitrage spread (or about 0.5%) which worked out much better than Atlantic Power!

There few decent alternatives for re-investing at the moment. I am feeling quite conflicted about things in the market, so I continue to reduce exposure.

The “proper” amount of cash allocation

How much spare change should you keep behind the couch? You need a little bit in case if you want to head out to the grocery store to pick up some beer and popcorn, but too much of it and it will be wasting away earning a zero yield, which can be more efficiently thrown into the short term treasury bill market where you can skim off a rich 25 basis points. Depending on how much you actually have in the couch, that could translate into an extra beer!

Sarcasm aside, in the case of the US government, they raised a ton of money during the COVID-19 crisis as illustrated by the following chart:

In recent history, the US treasury normally keeps $200-$400 billion in cash available for day-to-day operations (noting that the annual US deficit in recent years typically hovers around the trillion dollar range), but they raised about 5 times this much during Covid-19.

However, now that the worst of things presumably are over, they have begun to bleed away this excess cash balance, approximately half of it. This can be attributed to some factors, but I would estimate the stimulus spending bill has accelerated the distribution of this cash, coupled with the necessity of keeping a high float due to the even further elevated deficit the government is incurring (estimated $3.3 trillion in 2020).

I don’t know what to make of the implication of the US government bleeding off the cash balances, but I will also note that the Government of Canada appears to have a similar trajectory:

Balances held by auction participants have presumably been zeroed because participants could get higher yields on their capital from other areas.

My understanding is that with the BoC still engaging in a very healthy amount of quantitative easing (‘at least’ $4 billion a week) interest rates will continue to be suppressed. I will note that the 10-year yield has almost reached to the range of the pre-Covid yields and the financial overlords are probably trying to manage some fine balance between the level of QE vs. what is truly going on in the economy. However, the current course of action (accumulation of massive amounts of debt and monetary suppression of interest rates) will come at a cost of economic growth being lower than what it could be – it is sort of like strapping additional weights on the ankles of a marathon runner.

Reasons to shut the radar off IPOs and SPACs entirely

Here is a prototypical example. MDA (TSX: MDA) has gone public yet again. Most people here probably know the financial history of the firm – purchased by Maxar (TSX: MAXR), and then taken private so that Maxar could de-leverage, and then now it is taken public again with a price of CAD$14/share.

The company had its founding in the Greater Vancouver area, and continues today to perform engineering services in the space satellite domain, among other things.

The offensive thing about the public offering is page 65 of the 275 page prospectus:

The overlords of MDA knew perfectly well that they were probably going to go public again, and in the process granted themselves a ton of cheaply issued stock (noting that the right-hand table contains the applicable prices because of the 6:1 reverse split they performed before the IPO). They were looking to raising more money (at a higher share price) but had to taper it back to CAD$14 due to the tepid reception – probably partly due to this table. The other is the financial status of the company (it isn’t making that much money).

At the very minimum, I’d wait until the 180 day lockup period is over before even considering it, but knowing that space is a hype sector, I’m sure it’ll take off soon before then. Comparisons to SpaceX, however, is incredibly misguided – SpaceX has the reusable rocket technology which contains a massive competitive advantage on launch costs, while satellite construction and manufacturing is a much more competitive (and hence lower margin) industry, albeit played by a much fewer number of participants.