Kinsale Capital Group is a mid-cap specialty insurer operating in the Excess and Surplus (“E&S”) lines subsegment of the broader Property and Casualty (“P&C”) insurance industry. The company has generated an ample, “mid-teens” return on equity, and grown revenue at an annual CAGR of 34% over the past three years. That success, together with a float-limiting insider ownership of 7.31% of the outstanding shares, has engendered a committed shareholder base of long-only, “true believers” who have held Kinsale as it has earned inclusion in the S&P Small Cap 600 Index, and rocketed to a valuation in excess of 9x tangible book on the back of new passive shareholder ownership amounting to 27% of the float. This “single stock valuation bubble” has come about just as the coronavirus pandemic and lockdown-induced recession threaten to produce decelerating revenue growth, adverse reserve development, and investment portfolio losses.
December 31st, 2019 seems a disproportionately long time ago. When David McCullough and Ken Burns finally get together to decide just exactly what happened over the past six months, I doubt that the formation of Antrim Investment Research, LLC or the publication of my coverage initiation on Despegar.com will rank among the defining events of the first half of the year. Nor will I merit a musical number in Lin-Manuel Miranda's next production. Nevertheless, Antrim has taken over a tremendous amount of my energy and focus over the past six months, and the developments of the past few weeks have been significant milestones for myself, and for the company. In progress, then, is an update for my readers on where Antrim stands today, and where we're going (for now).
In June, I completed the process of registering Antrim as an Investment Advisory in the State of Virginia. Despite a growing number of blogs, newsletters and podcasts that disclaim, "nothing you read in these pages constitutes investment advice, even the investment advice," and despite that RobinHood "Snacks" has ushered in a new era of "broker-produced-blogs-not-research," (admittedly, they're not researched) I interpret that the ethics of my profession require me to call my content what it is, which is to say: I publish security recommendations, dated and timed to coincide with specific market events and meant to provide professional investors with actionable, diligently researched, and independently formulated ideas. Despite delays brought about by the novel coronavirus pandemic, the efforts of my attorneys and Virginia state regulators bore fruit early last month, and Antrim is now legally able to accept payment in exchange for my work. Prospective clients and subscribers can find Antrim's Form ADV part 2A and 2B "Brochure" as they sign up for my research (you're required to read it, actually, despite that it's boring) and linked in the footer of my website, next to the Privacy Policy disclosures.
In June, the broker research division of Refinitiv (formerly Thompson Reuters Financial & Risk division) approved Antrim Investment Research to distribute its work on the Refinitiv broker research platform, and on Friday, July 3rd, my coverage initiations for Michaels Companies (Nasdaq:MIK) and Despegar.com (NYSE:DESP) were published for subscribers to Refinitiv's research feed.
In June, I discovered that it was actually equally difficult to get Antrim set up with a merchant account and payment gateway so that I might accept credit card payments in exchange for research access for my subscribers. As it turns out, web-based subscription services with recurring credit card payments are considered the highest risk category of payments for payment processors, and Antrim's request for a new merchant account coincided with Fed Stress tests that indicated to a number of banks reviewing Antrim's application that they didn't have enough regulatory capital set aside to weather the ongoing economic impact of the coronavirus. Antrim's application for a merchant account was auto-denied by most.
It turns out that Stripe is an excellent solution for web-based start ups. Their prices are lower (at least in the high risk payments category I find myself in), they offer a useful dashboard for payments and subscriber analytics that's modern and intuitive, and their sales team and customer support people work on weekends. I learned all that because I needed them to get my application approved on the weekend of June 27-28, and the Stripe people came through. I've covered merchant acquirers in the past but I've never really seen the business from this angle. It was an illuminating process. But as a result, Antrim's payment gateway is live, as of the evening of June 30, and my subscription based equity research product is now LIVE, for $100/month, or an annual subscription of $1,000/year.
Currently, Antrim finds itself in something of a "soft launch" mode - currently accepting payment from subscribers, but also still in process of building out my coverage universe. Initiations on long positions: Michaels and Despegar have already been published. Initiations on Cabot Oil & Gas, AGNC Investment Corp., Annaly Capital Management, PNC Financial Services, and Lemonade Inc. are in process. Initiations of short positions in Kinsale Capital Group, Skyworks Solutions, Transdigm Group, Tesla, GSX, Restaurant Brands International, Micron, and Lancaster Colony are in process. I hope to publish many, or all, of those initiations for subscribers over the coming months.
So too are changes coming for the monthly newsletter, Idiosyncratic Risk. While it still comes out on the first of every month, and it's still offered for free, I do plan to start charging for Idiosyncratic Risk subscriptions. At some point in the fall/winter, IR will become a subscription based newsletter, offered at the price of $20/month or $200/year. Ultimately, the "Antrim Vision" is to provide, for $1,200 annually, a compelling investment newsletter PLUS ongoing institutional coverage of the ideas contained within its pages. Antrim seeks to differentiate its coverage by focusing on special situations and short idea generation, and all for less than the annual cost of a subscription to Grant's. (Don't cancel Grant's though, they're great, too.)
This post is intended to be somewhat of an announcement to my readers about where we are and where we're going. Also a bit of a celebration of what I've accomplished with Antrim over the past weeks and months. But it's also a reminder that I'm going to be very busy over the next few months, and that there's a lot of wood left to chop. For those of you that are interested, sign up on the equity research tab. For those of you who are curious, get in touch! I can be reached by email at ejensen@antrimresearch.com and I'm happy to talk stocks, talk Antrim, or just make new friends.
The first six months of 2020 have been interesting, to say the least. I'm an optimist at heart, and I'm excited, despite it all, for what the next six months could bring. If you've made it this far, thanks. If you're still here for radical common sense and thoughtful, independent stock analysis, like, share and subscribe!
Since coming public in 2017, Despegar shares have been under near constant pressure due to a variety of exogenous shocks and macroeconomic factors outside of the company’s control. Lackluster GDP growth in Latin America has pressured demand, dramatic currency devaluations have destroyed customer purchasing power and hampered translation of Despegar’s results into U.S. Dollars. Sharply increased interbank lending rates have restricted profitability, and the coronavirus pandemic has resulted in government-imposed lockdown and the restriction of non-essential travel. For these reasons, DESP has been summarily ignored by the market, and presently offers investors who can tolerate elevated volatility the opportunity to purchase an extremely high ROIC business with local currency bookings growth in excess of 20%, negative working capital, and a fragmented base of local competitors and suppliers, all at a bargain basement valuation.
The Michaels Companies is a struggling big-box specialty retailer, specializing in the general arts & crafts category. The shares trade at $7.07 as of Tuesday’s market close, down nearly 80% from a peak of over $30 per share in May of 2016. Despite negative same store sales growth in six of the company’s last eight reported quarters and substantial financial leverage, we believe the market price of MIK dramatically overstates the distress in which the company finds itself, and that current prices offer investors the chance to buy a solvent national retailer specializing in a relatively attractive product category at 3.5x earnings per share, and 4.8x adjusted EV/EBITDAR.
If you are wondering what mental health theory and practice have to do with investment management, you’ve probably never managed client assets. I’ve spent nearly 11 years on the buy-side managing assets for individuals and institutional investors, and it took me all of that time and then some to begin realizing the full importance of recognizing and regulating my emotional response to the fluctuations of the market, or the relative success or failure of my recommendations. I won’t ever master it.
Of course, everyone is familiar with the concept of “Behavioral Finance.” Daniel Kahneman was awarded a Nobel Prize in 2002 for his work recognizing and quantifying the bounds of rationality for economic decision makers. But, while academic economists have been having a statistical debate about the bounds to rational decision making for decades, and mental health professionals have been honing their understanding of irregular emotional responses to stimuli for decades, investors (who are generally not practicing academic economists or mental health professionals) have too often reduced the tenets of behavioral finance to a set of trite and contradictory aphorisms and tautologies that substitute the appearance of profundity for practical, actionable advice.
Who isn’t familiar with Warren Buffet’s famous advice, “be fearful when others are greedy, and greedy when others are fearful.”? Behavioral finance would tell you that the Oracle of Omaha has done an exemplary job over a long and illustrious career at avoiding “herd instinct,” which is a rather obvious behavioral bias which stems from the evolution of human beings as social creatures, who frequently must use cooperation and the accumulated intelligence and instinct of the herd to survive when confronted with predators who are faster and stronger.
Behavioral finance would tell you that asset prices tend to over-value consensus thinking and undervalue data points that challenge the consensus, because on average, it’s too easy for market participants to give into their base instinct and follow the herd, rather than making a hyper-rational decision.
But behavioral finance would also tell you that investors frequently exhibit a dangerous overconfidence bias stemming from a self-serving mental heuristic which falsely attributes outcomes to your own analysis as opposed to market forces, or the illusion of superiority, which is evident in surveys that demonstrate the vast majority of market participants believe they exhibit above average skill (I shouldn’t have to explain how that could not be possible).
For most of my career I have dismissed the insights of behavioral finance because I’ve felt that there was a tenuous link between the theory and its practical application. Have courage in your conviction, but don’t be overconfident sounds more like something an emotionally overwhelmed parent tells a child heading off to college than something like useful advice for financial professionals. But I have discovered better tools to explore my emotional responses to market forces in the field of dialectical behavioral therapy.
In dialectical behavioral therapy (“DBT”), therapists use the concept of a reasonable, emotional, and “wise” mind in order to guide patients towards more regulated decision making and consistent outcomes. In this framework, the reasonable mind is the home of rational thought. (Most investors think they live here all the time, but all Star Trek fans understand there are limits to the practical application of hyper-rationality) The emotional mind is the home of emotional responses, which provide our cerebral cortex with evolutionarily useful signals that may or may not be better suited to the Serengeti than the New York Stock Exchange. By recognizing both mind states for what they are, and sitting with both rational and emotional reactions, the patient is able to access a third mental state, the so called, “wise mind,” which represents a useful and productive reconciliation of the strengths and weaknesses of both other states.
The therapist’s subject is encouraged to map their thoughts and feelings onto a literal venn diagram – feelings go into the emotional mind circle, and data goes into the reasonable or rational mind circle. It is, perhaps the practice of writing things down, or maybe just the pause inherent in the study itself that allows the patient to sit with their feelings for a moment and recognize them for what they are. By taking time and inventory of emotional responses, the patient becomes able to differentiate useful signals from noise.
How is this any better than our starting point? I’ll give you two practical examples.
I’ve recently been publishing security analysis on Seeking Alpha, where commenters frequently weigh in on your work with their own opinions. Almost every time I receive a notification that a commenter has posted on my article, my heart rate quickens, my breath gets short, and I feel tension deep in my abdomen. It’s honestly terrifying. It’s a pure, physical expression of fear. My identity is wrapped up in the success or failure of my recommendations, and I perceive that the public’s perception of my abilities in the investment arena are relevant to my career and my ability to put food on the table. When you post that I’m an idiot on Seeking Alpha, I literally “feel” threatened. Of course I am not. But after recognizing this insight, it’s easier for me to differentiate between two commenters: One told me I was an idiot (he’s entitled to his opinion, but I retain courage in my convictions); another told me that I was wrong about the date Michaels’ Companies’ term loan matured (I was). In the second instance, I was able to recognize that the fear I felt was useful in motivating me both to correct my notes, but also to reevaluate my entire investment thesis given that I had previously been using incorrect information. That doesn’t mean I lack the courage of my conviction, it means that my fear response is useful professional motivation.
Another example: The markets have been extremely volatile. Michaels Companies’ reported strong May same store sales comps last Thursday, during a week when almost every highly levered business with substantial short interest was rallying, and the stock popped, like I had said it would. I thought to trim my position, and add to relative underperformers in my portfolio, and while I was logging into my brokerage account, I felt very calm. My posture was better than average, my breathing was slower. This comfort is overconfidence bias. It’s a form of self-attribution or illusory superiority. Michaels’ hardly rallied any more than any other junk retailer last week, and I wasn’t making a profound adjustment to my portfolio construction by selling shares and buying something else, I was executing a simple rebalancing algorithm. I don’t do that as well or as often as a computer can, so, there’s that.
I ended up trimming anyway and I’m glad I did, because we were approaching a near term top in a market that had become overwhelmed by speculative fervor. But I think it’s important to notice here, I didn’t do anything profound, and I need to understand that the actions I’m taking aren’t profound. Am I taking profits after a successful recommendation and running a victory lap, or am I executing a simple portfolio rebalancing? If it’s the latter, is this the time to rebalance the portfolio, or am I only doing it because I feel as though it’s a victory lap?
Honestly, I can’t say for sure. But I can say that I have taken an inventory of the emotional responses I have to my trades, and I can reconcile that inventory with my own self assessments and the lessons of behavioral finance.
I’m not sure if I have a new appreciation for behavioral finance or not. But I’ve definitely arrived at an appreciation for dialectical behavioral therapy techniques. I’d recommend them to anyone challenged with frequent decision making in a professional capacity.
Disclosure: I am long MIK. I do not have a business relationship with any company mentioned in this blog.
This will be a quick blog post insofar as it represents a departure from the intended purpose of this space, which is to discuss my investment philosophy and practice in a general, informative sense.
As the week has worn on, I've been increasingly focused on two particular news stories, both of which represent watershed moments for the capital markets. It is not surprising, if it is a little frustrating, that while neither has gone unnoticed, the headlines have been buried somewhat by the ongoing coverage of the Covid-19 pandemic, the U.S. Presidential twitter feed, and the literal, tragic watershed moment experienced by Michiganders on Wednesday. Candidly, I don't have all the answers, so I'll keep my editorial commentary and analysis brief, but I felt it would be well received if I call my readers' attention to a couple items that might loom much larger in retrospect than they seem to at present.
(1) Below the fold on page B1 of Thursday's Wall Street Journal: Bill Would Force China Firms to Cede Listings ... wait what?
On Wednesday, the Senate actually passed, UNANIMOUSLY, a bill co-authored by Sen. John Kennedy (R., La.), and Sen. Chris Van Hollen (D., Md.), which would require any firms listed (via American Depository Receipt or ordinary shares) on an American stock exchange to be audited by an auditor subject to the oversight of the Public Company Accounting Oversight Board. Since the U.S. Auditing firms are subject to such oversight already, and public companies are required to file audited financials, this might seem redundant, but it's not. It has become commonplace for Chinese companies to skirt their home country's restrictions on foreign direct investment in order to list shares on U.S. exchanges by creating Cayman Islands-based holding companies which maintain a variable interest in actual Chinese corporations through contractual obligations of questionable legal enforce-ability. These companies are universally audited by Chinese auditors or the Chinese branch of American big four auditing firms, which are NOT subject to PCAOB oversight, and fraudulent activity has run rampant (See: Luckin Coffee Inc., $LK).
There are numerous Chinese-company ADRs which present investors with a credibility question, to a greater or lesser degree. Fresh off their successful $LK expose, Muddy Waters Research (@MuddyWatersResearch on twitter) has put out a piece calling into question the veracity of GSX's revenue growth claims and financial reporting. One recent Cayman ADR-IPO, Kingsoft Cloud Holdings lists explicitly in its prospectus that investors should be aware that they assume the risk that financial statements are reviewed by an auditor who is not subject to PCAOB oversight, and that short sellers may attempt to discredit management or impugn the credibility of their financial statements, to the detriment of equity holders. But even the equity of extremely large, well known, and widely held companies like Alibaba ($BABA) fail to meet the criteria for exchange listing under the terms of the bill passed in the Senate yesterday. This represents a substantial risk to current shareholders of Chinese corporate equity in the form of ADRs listed on U.S. exchanges, and could put a damper on $1.8T of market cap currently listed in the U.S. that would theoretically be in violation of the law under this regime. To my knowledge, there is, as yet, no bill in the House of Representatives coinciding with the one passed by the Senate yesterday, so it's not clear that it will get any further down the road to becoming law. That said, the administration appears willing to engage in political fisticuffs with the Chinese political and socio-economic elites, and the bill that went to the Senate floor shared unanimous, bi-partisan support. Stay tuned.
I came across this podcast by Quoth the Raven (@QTRResearch on twitter) wherein he interviews Carson Block of Muddy Waters on all things investing, short selling, and China (including China short selling): https://quoththeraven.podbean.com/e/quoth-the-raven-185-carson-block/ I will warn, the podcast is rated "M:Mature," primarily for profanity, which is a bit "off brand" for Antrim Research. But I would say I have a great deal of respect for the work Mr. Block has done on this space. His commentary about the impact of (potentially) de-listing Chinese equities starts shortly after the 1h 15m mark.
(2) On Monday, May 18th, German Chancellor Angela Merkel and French President Emmanuel Macron announced a joint plan to set up a $500B coronavirus pandemic relief fund to be administered by the ECB.
It doesn't require uniquely penetrating insight to understand that the European Union is a tenuous one. After all, Britain left on January 31st of this year (more than three years after the referendum that set Brexit in motion). I've long simplified (in my own mind) the complexities of Eurozone fiscal and monetary policy by interpreting almost everything through the lens of the central monetary disagreement in the region: Germany is a fiscally responsible, monetarily conservative government, overseeing a strong, export driven economy, fundamentally at odds with a number of fiscally irresponsible, monetarily undisciplined, democratic socialist countries with weaker economies, and a general inability to meet their fiscal obligations through tax revenue. Greece, for example, has been in technical default on its financial obligations for over 50% of the time it has existed as an independent country. It's hard to say how much better Potugal, Italy, and Spain are doing. And lest it be forgotten, there's a bit of lingering animosity between Germany and France.
All of that seems pretty self explanatory. Common sense would suggest that Germany, having been responsible with their policy decisions since World War 2, is loathe to bail out neighbors who they view as irresponsible younger siblings. BUT, Germany is an export driven economy, which implies that insofar as they benefit from a weak Euro relative to other global currencies, they've been stealth beneficiaries of the profligate spending by weaker Euro member nations. If that's an A-Ha! moment for you, it was for me too. They kinda WANT to bail out the little guys, they just want to moan about it for a bit while they do because they like a little inflation and a little irresponsible money printing and debt issuance, but if they don't continue to be the voice of reason, confidence in the whole region could collapse. It might appear to be a bit of a high-wire act if you look at it this way.
So what gives now, and why would they cooperate with the French? Well. (1) The pandemic is really, really, bad. Like, it's bad, and everyone, Germany included, knows it - and everyone, Germany included, knows the stimulus announced to date won't be enough, so let's get more stimulus. (2) The U.S. Fed has opened the checkbook in a BIG way. It's been enough that many analysts (your humble author included) have begun recommending investors to precious metals and warning of coming USD inflation. Well... that's not good for an Export Economy, which generally desires that US Dollars increase their purchasing power in Euro terms. (3) If the economic collapse is too severe for the weaker members of the Eurozone, the whole union could collapse, which would take away ALL the benefits Germany has enjoyed as a Euro member, overnight. So... the answer is simple - there's plenty of room to stimulate and bail out by issuing Euro debt and subsidizing weaker member nations. The $545B (US, 500B Euro) facility announced is a FRACTION of the fiscal and monetary stimulus offered in the United States. And, Germany definitely doesn't want deflation. And, Germany wants to instill confidence in the region.
What could instill more confidence in the authority of the ECB to govern the Eurozone through another economic crisis than cooperation between Germany and France on a bail out initiative operated by the ECB, and a bilateral willingness to accept the bank's policy decisions?
At the risk of overdosing on confirmation bias - I think this is a big moment for the Euro, which instills a level of post-Brexit confidence in the longevity of the Union that was by no means guaranteed heretofore. I think that it will prevent runaway deflation in the Euro, and that it represents yet another round of fiscal and/or monetary stimulus, globally, that can't help but provide support to precious metals prices. But I think it is unlikely to substantially weaken the currency vs. the U.S. Dollar. And lastly, I think it means that the European political elite is really, really, worried about the depth and duration of this economic crisis, and we should be too.
I hope this was a welcome distraction from the ongoing twitter debate between Cliff Asness and Nassim Nicholas Taleb.
Disclosure: I am short GSX, and long the gold miners' ETF, GDX. This is but a humble blog post, and as such, is not intended as investment advice.
Braggadocio.
And Gold all in the portfolio.
I realize I'm not that funny, but there is a relevant and interesting investment point I can make that is related to that joke. For the past several - well - for a while now, we've been witnessing a steady normalization of the gold bug's investment philosophy among even the most esteemed professional investors. Historically, gold bugs have not exactly been ignored; but, I would argue they've drawn frequent comparisons to Chicken Little for constantly predicting the demise of the U.S. Dollar all the while "inflation" is conspicuously absent and the dollar is, well, fine. Is the sky falling, now? Let's ask Fred Hickey, who writes the fantastic investment newsletter "High Tech Strategist" that used to be about Fred's portfolio of tech stocks - these days it's about gold:
If you're interested in investing, you should at least follow Fred on twitter. And if my newsletter isn't enough monthly investment content for you, consider subscribing to HTS.
The logic actually is really simple. Almost everybody understands it. The Fed (and the Treasury) are printing money as fast as they can and we have (roughly) the same amount of actual stuff today that we had yesterday, so it would stand to reason that it will take more money tomorrow to buy the same amount of stuff you bought yesterday. But this has been true for as long as I can remember. So what has changed, today? Why are all of these investment luminaries buying gold now, when before they were concerned about deflation (Dalio), or focused on individual companies and security analysis (Einhorn), or short bonds and long agricultural land (Hendry), or ... long China (Druckenmiller - and then short China, and then long China again)?
And what of inflation? The government has been printing money since the press was invented. Where is inflation? Today's wsj.com headline would imply it's not here, yet: Consumer Prices Fall 0.8%, Most Since 2008 (on a year over year basis, prices are still up 0.3%, supposedly). I'm going to quote Fred again, from this month's issue of "High Tech Strategist," as it turns out the devil is in the details:
"Last month the BLS reported the CPI index for March increased 1.5% year-over-year, but the number was depressed by a sharp drop (10.5%) in the gasoline index (doesn't help much as people currently aren't driving), airfares (people aren't flying), lodging away from home (people aren't traveling), and apparel (people aren't visiting retail stores). All these category drops held the CPI down, while the things Americans are spending money on including medical care, food, auto insurance and education all rose more sharply." You really can't eat an iPad.
If you're prone to exasperation you're probably thinking this, too, is not exactly a NEW phenomenon. The "I can't eat an iPad" movement actually started in 2011. So I'll add a little color of my own.
Since the great financial crisis and great ("Terrible, yes, but great." - Garrick Ollivander) recession inflation has been absent because the supply of money actually hasn't been increasing as fast as the government press has been running. This is because of something known as, "the moneyness of credit." Or - "debt is money. Money is debt." As in, when I take out a loan (debt) to buy a house, and buy your house, you deposit the proceeds (money) in the bank and they lend your deposits out to someone else (debt) who uses the proceeds (money) to - well you get it. When the banks lend, they actually create money out of thin air. So how much money is there? Well how much debt is there?
In 2008, when "QE" first became a household term, the federal government started issuing debt in record numbers. Unprecedented indebtedness that repeatedly made headlines, and continued to for a decade, as it continues to today. But TOTAL debt has been falling, at least as a % of GDP, look:
Pink is bigger than ever before, but we're no more indebted today than we were in 2009 (or we weren't, three months ago), because we've been resolving and restructuring and eliminating mortgage debt this whole time. The money the federal government printed over the last decade was little more than a formal recognition of the money the banks had already printed during the housing bubble.
What's CHANGED, then, is the government's printing press has finally lapped the American households' persistent, and beautiful (to quote this post's titular investment idol), deleveraging. In a little less than 3 months we've taken total indebtedness from ~ 180% of GDP to over 250%. Households can't tighten their belts anymore, and the government printing is in overdrive. The Committee for a Responsible Federal Budget projects that the nominal amount of Federal Debt (the pink alone) will exceed GDP in 2020 for the first time since World War 2. It's clear that the slope of the Debt-to-GDP graph is no longer negative. Does that mean that this is a decade for inflation, even as last decade was a decade of deleveraging?
I try not to make a habit of making macroeconomic prognostications, but yeah, that's what it means. The last time that this happened, when total indebtedness grew from 2002-2010, gold went from $400/oz. to $2,000. That might be what's convinced Ray Dalio, Stanley Druckenmiller, Paul Tudor Jones, David Einhorn, Seth Klarman, Paul Elliot Singer, Jeffery Gundlach, Sam Zell, Fred Hickey, Hugh Hendry, Mark Mobius, and Trinidad James.
I am long GDX, the VanEck Vectors Gold Miners ETF.
Since launching my website and publishing my first newsletter on April 1st, I've received a fair amount of feedback, a bit of casual curiosity, and several fairly serious investment related questions. Two of those concerned the price of oil, and one came from a friend, yesterday, who was wondering how the price of oil could possibly be negative.
Up until yesterday, I could've said that the price of oil had never been negative before and left it at that. Today that would still be true, sort of, but it comes with a caveat. Yesterday, the May futures contract for West Texas light crude oil did, indeed, go negative. That contract expired today, and everyone who "bought" one yesterday, receives a barrel of crude oil and a $10 bill (at least). The money is for nothing and the oil is free, to put a modern spin on the Dire Straits song.
The reason the contract went negative is because, technically, the money is not for nothing. The money was in exchange for the promise to take delivery of a barrel of light, sweet crude oil in Cushing, Oklahoma, today. As you might expect, not everyone can actually do that. What you might not know is that quite a few people who have made that promise cannot actually do that. You'll hear the term "speculators" used to describe these folks. They are financially motivated buyers of commodity contracts, who purchase a contract in the hope that prices will rise, and they can sell it at a higher price. And it's not all gambling. The presence of financial buyers and sellers in the market for physical commodities provides a tremendous amount of liquidity to those contracts and makes it much easier for actual oil producers and refiners to "lock in" the prices at which they will sell (or buy) their raw material at a later date. And at the end of the day, the price of the contract can only really diverge slightly from the value of the underlying commodity, otherwise one of those actual producers or refiners would buy a barrel and leave it in their tank for a few days until they can sell it to somebody for what it's actually worth. The problem yesterday was that, with the contract near expiry, we essentially ran out of real world storage. There weren't any legitimate places able or willing to take another barrel of crude, and there was no shortage of desperate financial holders of the May contract who were absolutely required to dispose of them, at ANY price. As it turns out, they had to pay for the privilege. A stock or an option can only go to zero, but a real world commitment must be honored or otherwise paid for.
When I got the question yesterday, I remembered something about crude oil speculation and futures that I had hypothesized early in my career and never put to the test. I remembered that one of the primary ETFs investors use to track the spot price of crude oil, the USO ($2.81 as of today's close) invests 100% of its portfolio in the front month oil futures contract, and sells the entire portfolio to buy the following month's contract every four weeks. Its sister fund, the USL ($10.14 as of today's close) spreads its bets out equally over contracts spanning the next 12 months, and rolls only the front month into the 13th month every four weeks. When the oil futures curve is in contango (meaning that future oil costs more than now oil), both of these funds are forced to buy fewer contracts every time they "roll" the front month contract into the next one. This negatively impacts the net asset value of the funds, which maintain a financial interest in fewer barrels of oil after the roll than they did before. It's called "roll yield," and it's a cost of doing business for those investors who maintain a long position in a commodity using futures contracts. USO and USL pay the roll yield with their investors' capital, but the USO pays a lot more, because it's rolling 100% of its portfolio every month, while the USL is rolling only 8% of it. In 2009, when the oil futures curve was in fairly severe contango, I hypothesized that you could short the USO, buy the USL, and earn the roll yield without any exposure to the volatile price of the underlying commodity.
I was correct, but I did realize after a few minutes that it's not a "risk free" trade. The problem, of course, is that the oil market has to actually STAY in contango to keep benefiting from the roll yield every month. Whenever it finally snaps back - which is to say, whenever the front month contract actually increases in value and starts to approximate the 2nd month contract, the USO could snap back with a vengeance while basically nothing happens over at the USL. The "roll yield," trade is basically a short volatility trade, where you collect a small fee every month to have the position on and you hope that the USO never snaps back and wipes you out. As a result, I had never put the trade on, until yesterday when I put 20% of my portfolio into it.
There are a lot of reasons to hate ETFs, and I do hate them. As an active investor and investment management professional I've long believed that indexing is not the panacea for individual investors that the academics would have you believe. But that's a different rant. The worst thing about ETFs and the relevant characteristic to this blog post, is that they market what they "track," as opposed to what they "own," and most investors don't really understand the difference. They buy the USO because they want to "track" the price of oil. They own the front month oil futures contract in size. The USO actually owned, as of close yesterday - about 25% of the outstanding June futures contract. The USO, which CANNOT TAKE DELIVERY OF OIL, has PROMISED TO TAKE DELIVERY OF 25% OF ALL THE OIL IN TEXAS AND OKLAHOMA THIS JUNE. The prospectus uses different language, but that's (more or less) what it means. The investors who punt a few hundred dollars at the USO don't understand the difference. They think they're buying the price of oil, and they aren't. It breaks my heart to see that individual investors are buying USO in record numbers (https://robintrack.net/symbol/USO) because I know that few of those understand that the USO will destroy a tremendous amount of value when they try to roll a full 25% of the outstanding June contract into July. And unfortunately, I know that it's those investors who are supporting the price of the USO at levels well above it's actual NAV and creating what basically does amount to an opportunity to make a profitable trade, without assuming any risk.
These are odd times, and odd things are happening. Even one month ago I didn't think the front month contract could go negative. But it did. When I looked into the roll yield trade again yesterday I quickly calculated what would happen if the USO were to roll it's 100% long June Oil position into July at prevailing prices. They were originally scheduled to do that over the course of three days, May 5th to May 8th. Spoiler alert - it would destroy quite a bit of value - so I was about ready to hit the sell button and put the trade on, but there's more. The folks at USCF (the guys who sponsor the USO and USL ETFs) aren't completely oblivious. They read the wall street journal, too, so when this article was posted on Friday, they filed with the SEC to notify their shareholders that no longer would the USO track solely the front month futures contract, but it would own 80% of the June contract and 20% of the 2nd month, July. I wondered what would happen if they made that change in it's entirety yesterday around midday, (the June contract was acting poorly yesterday, too) and I came up with a back-of-the-napkin NAV estimate around $3.55 for the fund, which was still trading north of $3.80. Again, all of this is public information, but the individuals buying USO on Robinhood cannot reasonably be expected to get notified every time USCF files an 8-k saying they've DRAMATICALLY ALTERED THE MAKEUP OF THEIR FUTURES PORTFOLIO IN ORDER TO MAKE A FRAGILE GUARANTEE OF THEIR FUND'S SURVIVAL.
Long story short (ha.), I sold USO at $3.80 thinking I was selling $3.55 for $3.80, and I bought USL in roughly the same amount, so that I wouldn't have any exposure to general price movements across the curve. It turns out that USO ended the day with a NAV of $3.46. I made money, but I don't feel great about that. Unfortunately, the real test is still to come - USO destroyed almost $0.30 (or more, depending on how much of the June contract blood you think is on USO hands) of fund value yesterday, trying to move 20% of its portfolio one month into the future, so what will happen on May 5th, 6th, and 7th, when the other 80% of the portfolio was to get rolled? An already bad situation can only be made worse by the fact that USO actually publishes its trading schedule, and has promised to buy and sell its oil promises on specific dates. So - while I would normally not recommend trying to "arbitrage" the roll yield disparity between the USO and the USL, I felt that the fund found itself in such an abnormal and dire situation that there was sufficiently little risk it could extricate itself before the curve returns to normal.
They felt so too. Last night, the USO suspended new creation baskets for shares in the ETF. Meaning, they finally admitted, "owning 25% of the June contract is too much, we can't really buy more to support new investors, anymore." Refreshing, but a little late. The June contract got hammered today. It ended the day at $13.12, down from $20.43. At first I thought other investors and speculators were doing what I was doing, and maybe they were. But towards the end of the afternoon, the USCF made another announcement on behalf of the fund. They sold half the June position in order to put 5% of the portfolio into the August contract, and another 35% of the portfolio into the July contract. Unfortunately, that means they're paying the roll yield TODAY. And it's no small number. A $3.46 portfolio of 80% June WTI Crude and 20% July WTI crude should've closed today with a NAV around $2.28. If they rolled the full 40% of assets they intended to roll at today's closing prices, that would cost the fund another $0.50, and they could report a NAV at day's end of $1.78. The USO closed at $2.81. I'm still short, and I still don't feel good about it. Actually I had to short more today to keep the hedge in place; USL did not decline anywhere near as much. And I don't even have to care if the curve stays in contango, the roll is happening NOW.
The good news (depending on how you look at it) is that I think they've "saved" the fund by rolling it all today. They've paid more than a pound of flesh to diversify into 40% front month, 55% second month, and 5% third month contracts, but they've created a sturdier portfolio and set the precedent that they will act nimbly in times of crisis to prevent a situation where the fund finds it cannot roll a front month contract that's effectively worthless. In other words, I don't think that USO will be de-listed. But I will caution anyone who holds a few shares - if you think that USO will "snap back" to $10 or higher because, well hey, that's where it was when we all stopped driving at the beginning of March and created this mess, you'd be wrong. In order to survive the fund has re-configured its portfolio and it tracks a financial interest in far fewer barrels of oil, now, than it did at the beginning of March. Then, a 10% increase in the price of oil was $1 in value to USO shareholders. Today it will be a little less than $0.20. And if you're hoping that contango will end and the USO will roar back, well, they've dramatically reduced their exposure to that, too. They had to.
Several of you will be wondering what to do, today? What to do if you own USO? Well... it's complicated. I'm not going to keep this position on forever (or even very long for that matter), but the troubles aren't over yet. Certainly I do not think that the supply glut can be ameliorated before May 8th, but the administration and everyone else in the world is trying. The Texas railway authority is convening to try to mandate a production cut across the state. Saudi Arabia has already agreed not to send as much oil our way in June and July as they did in May. The administration has opened the strategic petroleum reserve to take on excess supply. So - I don't think that the USO fund will collapse. But I think it's worth less than $2, and it closed today at $2.81. Unfortunately, the situation is so bizarre and it's unfolding so fast that I can't really recommend selling USO tomorrow morning until I know what price USO is trading at tomorrow morning and how much of their portfolio they were able to roll today. What I can say is this: If you aren't involved yet, please, please, please, don't just buy USO because it seems like oil has to go higher.
For now, I guess I agree with this guy. Stay away from USO.
Disclosure: I am short USO, and long USL. I wrote this blog post myself, and it reflects my personal opinions. I am not being compensated for it, and I have no professional relationship with the funds' sponsor, USCF, or their parent company.
When I first decided that I would launch Antrim Investment Research, I wrote a blog post entitled, "Investment Philosophy: The Local Rock Pit," that meanders through some of my thoughts about the philosophy of security selection as well as my reaction to Peter Lynch's folksy-investment-guru styling from "One Up on Wall Street." Candidly, at that time I hardly knew the difference between Squarespace and WordPress, and my goal was merely to explore the capabilities of my new investment advice pulpit. But today I felt that I should revisit that post, because I had committed the rather egregious sin of teasing my audience with a skeptical take on Tesla Inc. (TSLA 147.05 -2.88 -1.92%) while disclosing only that I had no position in the name either way. That feels rather cowardly, so I'll endeavor to rectify the situation today.
Those who have worked with me in the past (or spoken to me a few times) will be aware that I am rather bearish on TSLA, the stock (I do think the cars are cool). I might as well have said so in the aforementioned blog post - I did indicate that I did not share the market's optimism. But all of that has been true since TSLA crossed $200 in 2014. It was trading near $750 when I wrote that blog, and it's closed today at $745.21. I wasn't short then, and I'm not short today - but I did make a mistake in the interim. I shorted TSLA in some size towards the end of March, and covered that position at a loss in mid-April. I'm not going to go into much detail about TSLA's fundamentals or valuation in a quick blog post (though I will likely do so at some point in the future), but I would like to take this opportunity to talk about something you don't usually hear about from investment professionals: my mistake, how I made it, and why, so that you might gain some insight into my investment process, or learn something about short selling and risk management.
I am, at heart, a value investor. I'm a bottom-up stock picker; an old-school security analyst versed in the art of qualitative fundamental analysis. I relish in the knowledge that the market is inefficient and provides me with mis-priced investment opportunities on a daily basis. I endeavor to identify them, and I invest in those securities with the conviction that my diligence is adequate to inure my portfolio against the risk of permanent capital impairment. In fact, I hold only one professional belief with greater conviction than that I reserve for my precious investment portfolio, which is: I have been, and will frequently continue to be, wrong. It presents something of a paradox for the self assured professional.
In the end, the resolution of this paradox is rather simple. You have to install some type of risk management or mitigation into your investment process, because betting the house every single time is guaranteed to end in ruin for anyone who runs the risk of being wrong one time. Most investors will be familiar with the concept of diversification as a risk management strategy. I like diversification, to a point. Eventually I do believe that diversification dilutes my time and attention away from my best ideas, but I, like any responsible professional, understand the need to have at least 5-7 uncorrelated ideas in the portfolio at all times. At an even more fundamental level, though, one must practice self-reflection and self evaluation. The successful investor must constantly re-evaluate their thesis anew, re-testing assumptions and modeling ever more potential scenarios in order to constantly reassure themselves of the validity of their initial analysis. Armed with this knowledge and a desire to be intellectually honest with myself throughout the investment process, I confidently tolerate even extreme volatility in my long investments while I await the rewards I know that patient, long term investors reap.
Short sellers do not have this luxury.
The very nature of the short sale does not afford the investor the ability - no matter how patient and self assured they may be - to wait out any and all volatility, secure in the knowledge that their analysis is sound. The short seller, quite simply, has sold something that does not belong to them. It doesn't matter whether it's old or new, or whether it's blue. What we can say for certain is, it's been borrowed, and the short seller has sold it. This can present a problem when its owner wants it back, and it does present a problem for the security analyst awaiting the encounter between price and intrinsic value.
David Einhorn said it best in, "Fooling Some of the People All the Time: A Long, Short Story," when he wrote, "Twice a silly valuation is not twice as silly." Let's imagine we've sold short a company that we believe is a total fraud. If it is, it's worth $0. It's no more rational for it to trade at $10 than $100 if it's not worth anything. Which is to say, if it's at $100, it could go to $1000. Who's going to stop it?
When you sell a stock short, your risk management process cannot consist solely of re-evaluating your thesis and re-testing your assumptions, because you do not have the luxury of outlasting any and all volatility. But neither is the short sale a rare and mysterious thing that must be approached with unprecedented caution and treated with fear and reverence. It's really just a bet that a stock will go down and it requires a bit of risk management. For whatever reason, probably because I'm a simple guy, I've always preferred simple solutions to my difficulties, and I've resolved this one by adhering to just about the simplest system I've ever heard of: the same one prescribed by the character, "Old Turkey," in "Reminiscences of a Stock Operator." When asked for investment advice, Old Turkey would only ever say one of two things, "It's a bull market, you know," or, "It's a bear market, you know." If it seems controversial that you could distill all the investment advice accumulated over the course of a successful career in the markets down to one pithy aphorism, it's because most people seem to think things are a sight more complicated than that. But as far as I'm concerned, it's a pretty good place to start. The lesson, such as it is, is that you shouldn't spend a lot of energy fighting the general trend, since trends tend to persist.
All of which brings me back to Tesla. I am willing to say that I do not believe that Tesla is properly valued by the market, and I am willing to express my skepticism about their ability to service their debts without raising additional dilutive equity by selling the shares short. What I am not willing to do is stand directly in opposition to an ongoing, exuberant, speculative fervor in TSLA shares. It might seem simple, but it saved me a lot of money simply NOT being short from around $200 to wherever TSLA peaked ($917.42!).
In Q1 of this year, however, two things changed. First - we entered a bear market and TSLA stock stopped going up. That's not enough to short the shares, but that's another essay for another day. Second - the Covid-19 pandemic and enforced social isolation measures resulted in the closure of TSLA's Fremont, CA manufacturing facility. Together, I saw a catalyst that directly (and negatively) impacted TSLA's ability to service their debt, and a shift in the prevailing market sentiment that favored the short seller, and I initiated a position.
I patiently endured a (typically) violent bear market rally in late March and early April, until the sentiment shifted again. While the S&P remains (in my opinion) comfortably in bear-territory, TSLA has begun to revisit its over-exuberant speculative fervor phase on the strength of a new thesis. Investors have started to believe that long-feared competition from the legacy auto-OEMs in fully electric vehicles will be scrapped or delayed as those companies struggle to re-open shuttered factories in the wake of the pandemic (to me this sounds a bit like a tacit admission that competition would've been a challenge for TSLA, but hey, the punch is already spiked, drink up!). TSLA bulls, assured of TSLA's survival, are equally assured of the demise of the traditional auto OEMs. And, it being the case that those same OEMs are, in fact, heavily indebted, enough credibility is lent this new wrinkle on the TSLA bull case that we're back off to the races. While my opinion on TSLA's fundamentals has not changed, I am forced to admit we are back in a bull market (as far as TSLA is concerned, anyway).
So for now: I covered my position, at a loss. I'm confident that when the time is right I'll get my money back. With interest.
Disclosure: I have no positions in any of the stocks mentioned herein, and no plans to initiate a position in any of those stocks in the next 72 hours. I have no business relationship with any company mentioned in this post, and I am not being compensated for its publication.
This is a blog post, and it is not intended as a recommendation to buy or sell any of the securities to which it refers.
On Wednesday, April 1st, I published the very first issue of my investment ideas newsletter, Idiosyncratic Risk, which can be found on my website, https://antrimresearch.com/newsletter/ featuring a "long Despegar" recommendation (DESP 12.59 +0.37 +3.03%). As a result, over the ensuing news cycle I was hyper-aware of a constant refrain from pundits and guest commentators alike on CNBC that went something like this:
"You have to be selective in this market. You can't just own the index, because the index owns travel stocks, and the index owns highly levered companies, and while you can look for buying opportunities right now, you cannot own travel stocks, and you cannot own heavily indebted companies." To which I would haughtily reply, "I can do whatever I like, thank you very much!" but I do understand the sentiment, and I do challenge myself not to be contrarian merely for the sake of becoming an iconoclast, without better reasoning and rationale. In addition, I received some interesting questions and feedback from those who did read my newsletter, so I felt it would be appropriate to follow up and explain exactly why it is that I own Despegar.com in the middle of a global pandemic and travel lock down, and to whom, precisely, I would recommend purchasing shares.
One of the core beliefs I hold that inform my investment style and philosophy is that it is far easier to predict the general arc of the future than it is to predict the specifics. As an example, I could not presume to guess what the price of a barrel of oil will be at the end of Q3 this year. But I can say with moderate conviction that global dependency on fossil fuels as the predominant source of energy will be significantly reduced over the upcoming decade. Without getting into politics, I would imagine most meteorologists would tell you that they have greater confidence in the IPCC global climate model's predictions about average temperatures five years from now than they do in predicting the likelihood and amount of local precipitation in one week's time. And if I might attempt to circle back to the topic at hand, which is travel, travel related stocks, and Despegar.com, I cannot tell you precisely when the U.S. and Mexico will ease international travel restrictions and border controls, but I do believe that Cabo and Cancun will remain popular vacation destinations for U.S. travelers 3 years hence - and 5, and 7, and 10 years from now for that matter.
Honestly, none of that is really very controversial. The problem, as the "you-can't-own-travel-stocks-right-now" crowd sees it, is the opportunity cost of capital. Most professional investors, try as they might to maintain a long term investment horizon and benefit from the "easy" predictions like, "Cancun isn't going away," are beholden to mark-to-market accounting and short term performance reporting requirements. Their clients are free to redeem their investment and fund a manager with better near term performance. The CNBC pundits are similarly aware that their audience has a great short term memory, and that they are only ever as smart as their most recent recommendation. Where we might all agree that DESP is worth more than its current price, and will likely trade higher over the next 5 to 7 years, we will find no agreement or certainty as to what the next 6 to 9 months hold. It is highly likely, in fact, that Despegar will not be the best performing stock on the NYSE over the next six months. In all probability, it will not be anywhere close. Capital parked in DESP over that time period is no more likely to outperform the S&P than in any other stock a blind monkey could hit with a dart. And THAT is the cost that most are unwilling or unable to pay. The opportunity cost of missing out on today's hottest issues is simply too great, and many or most would prefer to pay a higher price for DESP, later, armed with the certain knowledge that travel restrictions are easing and vacationers are emerging from self isolation. To most, it feels smarter to attempt to invest in near term certainty, despite the utter lack of evidence that there is profit to be made in certainty, and the plethora of evidence that would suggest long term market inefficiencies like, "low P/E ratios," persistently outperform.
There are those, however, who do manage to fight the current of popular opinion and ignore mark-to-market volatility. Investors like Seth Klarman at Baupost, who enjoy a more-or-less permanent base of investor capital or Warren Buffet at Berkshire who enjoys a permanent base of capital. And private equity. Private equity requires investors to agree to a lock up period of 7-10 years during which their illiquid investments in whole companies are allowed to mature largely free of a mark-to-market performance reporting requirement. And while some under-perform, it is rare to see a private equity fund actually squander investor capital and produce negative returns. Your author counts himself amongst those who enjoy a permanent capital base - I invest only my own money, and I don't have to worry about clients redeeming. I need only satisfy my own investment goals to continue employing myself. As a result, I try to think like private equity as much as I can.
In the case of Despegar (DESP 12.59 +0.37 +3.03%), it is plainly obvious that Despegar is a company of the caliber that long term investors should find attractive. Despegar is the leading online travel agency in Latin America by both market share and brand awareness. Statistically speaking: Despegar increased gross bookings +26% in 2019 in local currencies, despite -3.5% GDP growth in their second largest market, Argentina. In 2015 and 2016 they reported USD revenue growth in excess of 30% despite -3% annual y/y GDP in their largest market Brazil, in both years, and overall LatAm GDP growth of -0.5% in 2016. As recently as 2017, the company generated $40M of free cash flow ($0.58 per share), and they remained cash flow positive even during a difficult 2019. The company has grown revenue in USD at almost an 8.5% CAGR over the past three years, despite macro-economic weakness in Latin America and difficult currency translation headwinds into their reporting currency, USD. They generated, at peak (2017), $0.61 of earnings per share, and 13.6% operating margins. As of their December 2019 investor day, they expected the company to double in size over the next five years. And why not? Euromonitor estimates that the LatAm travel market is growing at over 9% annually, with the online travel market growing even faster, and Despegar continually taking share from a fragmented base of local travel agencies.
But at what cost comes this growth? Surprisingly little, in fact. Despegar operates with negative working capital as a result of the fact that they take cash from customers up front, and pay hotels (in most cases) 45 days after their customers check out. The company has over $300M in cash on its balance sheet at its most recent reporting date (12/31/19) and only $19M in debt. They have one material liability, which is $261M in accounts payable that represents, for the most part, future payments to hotels that will not be made due to the current global pandemic, and instead turned into one-time cash refunds to their customers. But DESP has enough cash on their balance sheet to refund 100% of their current payables balance, with money left to spare. They have agreed to make an up front payment to acquire the Mexican travel agency "Best Day" of $88M during 2020, but I strongly suspect that the material adverse change clause of their merger agreement will allow Despegar to renegotiate either the price or the terms of the deal, or walk away entirely, should such a need arise.
In Despegar, we find a late-stage growth company, self funding its own investment in local currency revenue growth in excess of 25%, with net cash on the balance sheet, trading at barely 10x 2017 EPS, and taking market share of a fragmented growth industry. If I allow myself to think like a private equity investor, or a late stage venture investor, I find that I am absolutely salivating at the prospect of taking a stake in DESP today, to be valued 5 to 7 years hence, when the global Covid-19 pandemic is naught but a sour memory. If I can't escape the need to generate near term mark to market performance, I would, however, be unable to "get in front of" the company's customer refund liability and the uncertainty regarding the timetable for a resumption of so-called "normal" travel demand. Therein lies the opportunity, as I see it, for investors with a sufficiently long term horizon and the ability to ignore near term price fluctuations. You can expect above average 5-7 year returns, with greater-than-average conviction.
But I must give my readers one important caveat: you do have to be honest with yourself about your capital needs over the next 5 to 7 years, and your ability to stomach mark-to-market volatility in your investments. It's not clear that we will see ANY travel demand in 2020, let alone "normal demand." It's not clear that things will be "normal" even in 2021. We simply don't know. What I believe is that we will get back there, in time. And I believe that DESP shareholders today will be the beneficiaries.
Disclosures: I am long shares of DESP in my own account and the Antrim Investment Research portfolio, of which I am the sole beneficiary. Neither Antrim or myself have any professional relationship with Despegar or any other company mentioned in this blog, and I am not being compensated for its publication.
