Dislocation: Shipping Thesis - Update

A long update on shipping as Our Man took advantage of the pullback in product and crude tankers, and the increasing proximity of IMO 2020, to increase his Shipping position to 15% at the end of Q3. 

Unless IMO 2020 proves to be a completely damp squib (think Y2K!), it’s a position that Our Man doesn’t expect to trade much for the next year or so. However, should tanker companies start to trade at multiples of NAV or you hear people mention them as “high dividend” stocks let Our Man know, as it will definitely be time to get out of dodge! 

An update to the broad rationale for the thesis is below, though OM will spend less time talking about IMO 2020 and its impacts (see this piece for more on that).

Also, while the thesis holds broadly true for shipping generally, OM’s investment is in Crude Tankers and Clean Product Tankers** and so the below is focused on those.

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MASSIVE CAVEAT EMPTOR

Shipping is a terrible industry to invest in!

It is a cyclical business with high fixed costs and low operating costs that leads to ugly economics.  Where else could you lever up to buy an asset that has a 20-year life but which is only profitable for 6-8 quarters of that life cycle!  Historically, this has been compounded by largely untrustworthy management teams who have engaged in all kinds of self-dealing transactions!  Meanwhile, in shipping’s rare moments of profitability, lenders have been foolish enough to loan ship-owners more money and ship-owners have ordered yet more vessels.  This has led to an excess supply of vessels that destroys the industry’s future profitability!

So, what is OM doing and why now??

Well, the thesis is a fairly prototypical example of the type of dislocation OM likes; beaten-down stock prices, investor disinterest, attractive valuations and fundamental trends, and something that will change the narrative.

Shipping is a terrible business that’s been oversupplied for years leading to collapsing share prices, investors ignoring it and attractive valuations. This excess supply and subsequent losses led to bankruptcies/restructurings which saw lenders taking losses and equity issuance from the surviving companies and no capital to finance new vessels. Meanwhile, a major regulatory change (IMO 2020) is being enacted on January 1st, 2020 and will potentially cause further disruption to both supply and demand.

Our Man has discussed the attractiveness of optionality in investments before. In Shipping, the operational and financial leverage means that for all of the sector’s many warts, in those 6-8 quarters that a vessel is profitable you make so much $$$ that it pays for the entire vessel!  Our Man believes we are at one of those inflection points due to the combination of the companies already being around break-even, the constrained supply of new vessels, attractive pricing and trends, and the potentially disruptive impact of IMO 2020.

Background since the financial crisis

Since Great Recession, shipping has been a story of oversupply and bad rates! Whenever there were brief respites and shipping rates increased, investors lent money, ship owners ordered more ships, and rates got crushed as this new supply entered the market. Unsurprisingly, this led to falling stock prices, defaults and massive dilution for equity holders. It has also meant that many of the lenders to shipping companies (especially German banks/retail investors!!!) have exited the market.

OM’s largest position is Scorpio Tankers (STNG); this is what its stock price has done since its IPO in early 2010...

Source: Koyfin

Yup, that’s a fall from the $130 (split adjusted) IPO price to a low of $15 in late 2018!

Valuation

Unsurprisingly, after restructurings that saw debt holders suffer meaningful haircuts and further equity raises, investors have not been too keen on the shipping sector! Valuation reached an extreme in late 2018 and early 2019, when crude and product shipping companies traded for about 50-70% of their book value despite seeing stronger rates and with IMO 2020 on the horizon. Though the stocks have risen meaningfully since the start of the year, they still trade at a discount to book value. This is with rates still stronger than prior years and IMO 2020 only now starting to penetrate generalist investors’ consciousness.

Supply, Demand and Rates

As the chart below suggests, the order book for Crude tankers is near the lows of the last ~25 years and this dynamic is further improved by the increasing age of the fleet*. The story is the same for Product tankers, where the order book is the lowest (as % of the fleet) since March 2000. This discipline has largely been driven by shell-shocked management teams following the (often multiple) restructurings coupled with the limited new capital available to the sector.

Source: Clarksons, from Euronav October Presentation (Pg. 18)

On the demand-side, oil demand has grown incrementally by a couple of percent per annum over the last 2 decades and is projected to continue its slow growth for the next few years (the IEA predicts a plateau in 2030!).  More importantly there is a major structural change in the marginal exporter of crude and petroleum products, with the US taking over this role from the Middle East. The discovery of shale oil has led to the US being responsible for up to 85% of the global increase in oil production. This has seen US exports of crude oil double since the start of 2018.  Petroleum products show a similar story and should accelerate in 2020 as new pipeline capacity to refiners comes online. 

This transition to US exports really matters to shipping companies.
Why?  Geography! 
The key for crude and product companies is where supply is sourced.  It takes about twice as long for tankers to travel from the US to Asia, compared to from the Middle East and it requires twice as many tankers. As a ship-owner, that’s a meaningful increase in demand!  With the supply of vessels fixed in the short-term, and limited new vessels on order, even small changes in demand can have major impacts on rates.  Examples of this can clearly be seen historically;

Source:  Clarksons Research Services Ltd, Clarksons Platou Securities Inc.  From Marine Money presentation (slide 7)

The impact of these changes on rates has a material impact on profitability given the operating leverage (high fixed costs, low operating costs) inherent in the business model. For an example, take the example of the crude tanker company Euronav.  The chart below, from Euronav’s October investor presentation, shows management’s guidance on the impact on EBITA (a measure of profitability) of an increase in rates. OM will spare you the math, but the middle scenario below (with VLCC rates of $40K) would lead to earnings of ~$1.40/share on a stock that’s trading at $11 today. 

Source: Euronav October 2019 presentation (slide 8)

Given the tightness of the market, and the impact on rates, could rates go much higher than $40K for VLCC's??  Take a look at that rates chart above!

Something to Change the Narrative: IMO 2020

The improvements in the supply/demand, and the valuation support, make the shipping thesis interesting but it’s the possible disruption from and investor attention caused by the IMO 2020 regulations that leads to the outsized position.   What is IMO 2020? 

• Well, it’s a new regulatory regime that prohibits vessels from using high-sulfur fuel oil (HSFO) unless they can capture the pollution causing materials.  The allowed sulfur content is falling dramatically from 3.5% to 0.5%.
• There is no ease-in or adjustment period.  Jan 1st, 2020 is the drop-dead date for compliance.
• Ship operators have a limited number of choices: Use low-sulfur marine gas oil (MGO), retrofit their ships to use liquefied natural gas, slow-steam (i.e. take longer to do a route, effectively reducing supply) or install scrubbers (to capture the pollution causing materials).
• Scrubbers are a popular choice but are expensive ($1-10mn/ship) and vessels have to be dry-docked, and removed from service, for them to be fitted.   This temporarily reduces supply.
• Given the costs of the various options for IMO 2020 compliance a number of older ships are expected to be retired, reducing the supply of vessels.

For crude and product tankers, in addition to the likely supply side impacts above, OM thinks that there will also be positive demand-side impacts!  There’s now a price on sulfur content in oil and this will likely cause changes in refinery demand, and oil trade routes.  If you want to read more on OM’s IMO 2020 thoughts, you can right here!

Some Risks To the Thesis:

A far from extensive list includes:

• It’s shipping!  Did you not read the caveat emptor – it’s a terrible, horrible, no good, very bad industry.
• A global slowdown could impact oil demand, meaning headwinds for both the companies and the stocks.
• IMO 2020’s impact could be more akin to Y2K, meaning that rates wander around current levels.
• Common perception is that an escalation in the 'trade war' between the US and China would be bad.  Our Man is a little more sanguine on that as trade wars mean the disrupting of old trade routes, and the creation of new and less efficient ones.

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* Vessels over 15yrs old have to be surveyed more frequently (2.5yrs vs. 5yrs) and the cost of this increases with the age of the vessel (~$4mn for a 20yr old ship vs. ~$2mn for a 10yr old vessel)

** Crude Tankers transport unrefined crude oil to refineries, and Product Tankers move the refined oil products (e.g. light petroleum products) to points near consuming markets.

Disclaimer:  As noted above Our Man holds positions in crude and product tanker companies, specifically he has positions in Scorpio Tankers (STNG), Euronav (EUR) and Diamond S Shipping (DSSI).

2019: Third Quarter Update

Portfolio Update

- Added to Greece (Dislocation):  Greece is the Word…and OM took advantage of the pullback in Q3 to add yet more.

- Added to Shipping (Disruption):  OM sized up the positions in Product Tankers and Crude Tankers as we came towards the seasonally strong fourth quarter and the IMO 2020 regulations going into effect at year-end.  Expect to hear a LOT about Shipping!

- Reduced Uranium (Dislocation):  OM reduced the Uranium dislocation position, but trimming the ETF holding (URA).  While the medium-term prospects remain attractive, the expected catalysts have done nothing to change the narrative.  Though there are discussions for various long-term contracts underway, OM decided he’d prefer to wait with a smaller position until something starts to change the narrative.

- Sold Argentina (Theme): As discussed here, Our Man exited the entire Argentina position.

- Sold Blockchain (Theme):  Our Man exited the position in Overstock.  The key for this position was the “execution"; Overstock selling its retail business and for a decent price leaving a pure blockchain focused company, without the CEO Patrick Byrne’s ‘interesting’ side getting in the way.   Well, Byrne was full of surprises including stepping down as CEO and selling his stake, and when the new CEO almost immediately demurred on selling the retail business, OM didn’t hang around!   For all the investment’s volatility over the last ~9mos, it ended flat (almost to the dollar).

Performance and Review

The second quarter saw the portfolio fall -4.0%, which underperformed both the S&P 500 Total Return (+1.7%) and the MSCI World (Total Return, Net Dividends) (+0.5%).   For the year, this leaves the portfolio at +13.3%, which is trailing both the S&P 500 Total Return (+20.6%) and the MSCI World (Total Return, Net Dividends) (+17.6%).

Thematic

The substantial majority of the losses in the Thematic investments came from the positions in Argentina (-152bps).  This was discussed in depth here, and the positions exited during the quarter. 

The Overstock position, which saw the Blockchain theme contribute +57bps, was also exited during the quarter.   True to form, CEO Patrick Byrne proved ‘interesting’ – his claim that he was involved in assisting the FBI led to the stock to fall 30% in 2-days during August, before it rallied strongly following his resignation.  That resignation letter discussed a personal relationship with a Russian agent, assisting the FBI, and referred to “the deep state”.  When the new CEO indicated that Overstock were happy with the retail business and were continuing with the plan to pay a ‘digital dividend’, Our Man decided to use the run-up in price to  leave the drama behind.

The Fourth Industrial Revolution (-40bps) positions fell back, primarily in the early part of September as the market reconsidered the premium valuations it was offering to growth (especially software) name.  The various thematic country positions - Brazil (-18bps), Vietnam (+11bps), and India (-46bps) – were a mixed bag though there was no major news.

Dislocation

Early July saw the Greek elections, which New Legacy won as expected.  After rallying following the second quarter’s European elections, the market sold the news though New Legacy’s securing of an outright majority was a promising surprise.   New PM Kyriakos Mitsotakis laid out his plans for tax cuts and structural reforms in 2020, and began the process of getting the European Commission to sign-off on his plans.  The Greek positions (-60bps) were a small drag on performance though it created the opportunity to further add to them late in the quarter.

The seasonally weak third quarter saw day rates hold up well, meaning the Shipping positions (-14bps) posted a marginal loss.  OM’s holdings continue to trade at a discount to NAV, but with numerous positive trends on the horizon including the seasonally strong fourth quarter, a better supply/demand balance than in many years, refineries coming back online, and the move towards the US becoming an oil exporter well underway.   This is without even mentioning IMO 2020, which goes into effect on January 1st and has the potential to create a major dislocation. 

The Uranium positions continued to disappoint costing -99bps over the quarter; as noted above, there is limited traction in the names and it seems we will need to see long-term contracts signed at materially higher prices before the stocks move.

Idiosyncratic & Technical

Texas Pacific Land Trust (TPL, -63bps) fell despite the company settling its proxy fight with some major shareholders.  It appointed three people from the shareholder group to the exploratory committee looking at whether the company should convert to a C-Corp, and will come to a recommendation by year-end.  There wasn’t much else to report, with the Funds (-3bps) falling slightly caused by the non-US exposure, and the Technical Book (+18bps) participating in the market’s rise.

Portfolio (as at 09/30/19 - all delta and leverage adjusted, as appropriate)

Dislocations: 45.4%

23.9% - Greece (GREK, ALBKY, and EGFEY)

15.1% - Shipping (STNG, NVGS, DSSI and EURN)

6.4% - Uranium (URA, CCJ and NXE)

Thematic: 24.2%

6.5% - Tech: 4th Industrial Revolution (JD & IGV)

6.1% - India (INDA and SCIF)

6.6% - Vietnam (VNM)

5.0% - Brazil (EWZ)

0.0% - Blockchain (no positions)

Technical: 21.6%

21.6% - OEW Technical positions (DDM, SSO, and QLD)

Idiosyncratic: 13.0%

10.0% - Funds (CWS, GVAL, and CAPE)

3.1% - Equities (TPL)

Shorts/Hedges: 0.0%

Cash: 6.6%

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc

Things from my Newsblur; 2019 Part 4

A surprisingly timely Things from my Newsblur covering a broad array of topics.   Given that, why not start with everyone’s least favorite – Brexit!

Dominic Cummings: The Machiavel in Downing Street

While the political realignment in the U.S. is taking place within the political parties, in the UK it’s happening across the parties with Brexit as the central catalyst.  PM Boris Johnson and Dominic Cummings, his chief strategist and the guy who lead the Vote Leave campaign, have been the accelerant with their all-in approach and the hard-lining of October 31st as THE date.  Since becoming PM over the summer, PM Johnson has lost his majority, every meaningful parliamentary vote, unanimously in the Supreme Court and is testing political norms/conventions.  Yet, his Conservative party has jumped to a meaningful lead in the polls and he has cemented “No Deal” as the default option to the consternation of the Opposition whose fears and frantic reactions ratchet higher as the deadline approaches.  Cummings is central to the escalating tension.  Is he a fool that has thrown it all away and put the nation at risk?  Or is he a visionary that has realized that politicians and media in the “Westminster bubble” is out of touch with the country, and by keeping his eye on the ‘prize’ of achieving Brexit created a situation where the Opposition and the EU are trapped amidst multiple prisoner’s dilemmas and faced with making a Hobson’s choice.  So what is Cummings, fool or visionary? Or is he both?

(Harry Lambert, The New Statesman)

Bonus Cummings edition: This 2018 video, of Cummings talking about Why Leave Won the Referendum, is well worth watching.

Washington Should Tax Capital Inflows

Long-time readers will know that Our Man is a huge fan of Michael Pettis and his take on both China and economics.   This timely article, from a couple of months ago, talks about how taxing capital inflows is a far better way to balance trade than imposing tariffs. The article discusses how it addresses the root causes of the problem, and shifts most of the adjustment costs onto banks and speculators.   The idea was amongst the smorgasbord of things that the Trump Administration threatened last week; even a blind squirrel finds a nut! 

(Michael Pettis, China Financial Markets)

Neither & New: Lessons from Uber and Vision Fund

The spectacular collapse of the WeWork IPO has cast a spotlight on the valuation of companies in the private markets.  In particular, it is on a group of capital burning companies that use technology to facilitate real world services.  They are neither pure technology companies (e.g. Enterprise SaaS cos) nor are they old world companies.  It’s yet to be determined if they will grow to profitability or if, like the late 1800s Steel technological revolution, it’s all profitless prosperity.  Who better to explain the nuances than Ben Thompson!  Anyone remotely interested in technology should at least read his (free) weekly article!  (Ben Thompson, Stratechery)

The Streaming Wars: Ride or Die

With Netflix, Hulu, Apple, Amazon, Disney et al all streaming their content libraries, which ones should you watch?   What’s the difference between their offerings, their business models and their goals?  Which might survive? The excellent Matthew Ball breaks it all down in this comprehensive guide!  (Matthew Ball, Redef)

Why are Autoimmune Diseases on the Rise?

While genetics explain a good portion of autoimmune disease prevalence, changing environments (including stress) are helping lead to sharp increase in the number of cases.  For anyone who has, or knows someone who has, an autoimmune disease much of this article will feel familiar.  It touches on the increased prevalence, the lack of a central database for autoimmune disorders (of which there are over 100) which contributes to the long and hard process of identifying them, and the difficulty in treating them.  (Tessa Love, Medium Elemental)

Alberto Salazar: The inside story of Nike Oregon Project founder's downfall

An inside look from BBC reporter Mark Daly whose Panorama program sparked the USADA’s investigation, which led to one of athletics' most successful coaches being found guilty of doping violations.  That Salazar was a long-time friend of Phil Knight (Nike founder), founded and ran the Nike Oregon Project, and even after the story broke was supported by Nike Ambassador’s including his “good friend” the IAAF President, Seb Coe, only adds to the intrigue.  UK Athletics, which found “no reason to be concerned” despite taking evidence from whistleblowers and the BBC, comes out with no credit either!   It also shows how long these investigative pieces take to come to fruition.  The initial work began in 2013, to Panorama’s “Catch Me if you Can” program aired in 2015, USADA charging Salazar in 2017, and it took a secretive 2-year court battle to get justice! 

(Mark Daly, BBC Panorama)

Rap Battle Debate: Hamilton vs. Satoshi

Want to know about that Bitcoin thing but don’t want to read long dull pieces on it?   Well, here are the key arguments in a far more digestible 21st century format! (Rhyme Combinator, Youtube)

Ptf Update: Don't cry for me (over) Argentina

Argentina fell under the same thematic umbrella as the positions in Brazil, India and Vietnam; a relatively ‘young’ nation that had moved towards capitalism.

The position was originally a dislocation idea after the election of President Macri in late 2014 ended the long populist (and incompetent, etc.) rule of President Cristina Fernandez de Kirchner.  While President Macri did a fine job of cultivating the low hanging fruit (independent Central Bank, removing capital controls, settling with bond holdouts, etc.), Argentina’s macroeconomic fragility meant he was always walking a fine line.  His government’s management of the more complex reforms was far less impressive, and this combined with the weak macro conditions eventually forced the agreement of a $57bn deal with the IMF in 2018.  This deal provided a much needed capital buffer for the country to stabilize the currency, but came with the IMF’s strict conditions (austerity!) leaving Macri with limited options to boost the economy.   With an election rematch expected in late 2019, and Macri’s position weakening, OM reduced the position size in the first quarter of this year.

The second quarter saw surprises as new political alliances formed; firstly, Mrs. Kirchner decided to run as Vice President inviting her former Chief of Staff, Alberto Fernandez, to lead the ticket.  Then, a third candidate Roberto Lavagna, a former Finance Minister under Mrs. Kirchner’s husband in the early 2000s, formed an alternative option to the polarized Marci-Kirchner battle.  Finally, Macri shocked everyone by naming the Senate Majority (and Opposition) Leader, Miguel Pichetto as his VP candidate!   With all the Presidential tickets announced, Macri’s position improved, Argentinean stocks rallied and OM hung around with his smaller position.

 

However, Macri suffered a huge defeat in the primary polling to get into the general election. Though Macri had no problem getting onto the general election ballot, trailing your opponent by 15 points and doing far worse than even the most pessimistic estimates doesn’t fill people with confidence.   The market’s reaction made clear how little confidence…

Add in an 11% fall in the peso, and the S&P Merval fell 48% on the day; the second largest single day drop globally since 1950!  For comparison, the Dow Jones dropped 22.6% on Black Monday in 1987!   OM managed a pyrrhic victory, with the portfolio’s Argentinean exposure falling a mere ~26% on the day! 

So what now? 

Well, the uncertainty surrounding a Fernandez/Kirchner government makes Argentina uninvestable and hence OM exited his Argentinean positions.  They certainly didn’t help in Q3, though since the start of 2016 Argentina has added ~400 basis points to performance.  As for the future, if Macri should somehow overturn the long and increasing odds to get a second term, then perhaps the situation would be similar to the original dislocation opportunity in 2015.  

The Argentina position was one that’s provided OM with many lessons.  Initially, it helped spur the research that cemented the Dislocation strategies’ rule of typically holding 18-24 months (and 30 months maximum) from the narrative changing event (in this case Macri winning in late-2014).  This time, it served as a reminder that emerging markets are never boring and the downside skew is always worse than you think!  OM would have been better trimming on the IMF deal which reduced Macri’s degrees of freedom and exiting in full back in March.  In both cases, the upside on a Macri victory was so great that missing the first 20-30% wouldn’t matter.  Remind OM of that, if Vietnam, Brazil or India start to go off the rails…


Disclaimer: Our Man held the above positions (GLOB, AGRO, GGAL and DESP) in Argentina.

Ptf Update: Themes – Vietnam, India, and Brazil

Our Man began an update on the thematic positions but it quickly got rather wordy and overly complicated.  Fortunately he stumbled across the below AT Kearney chart, that helped him tie things together more simply.

 
Three of Our Man’s Thematic positions fit the same broad template; relatively young countries that are moving towards capitalism!   Vietnam, Brazil and India all have relatively large millennial cohort (in size and as a % of the population), currently aged 23-27, who are currently entering and driving the work force.

 

Source: AT Kearney

While this is interesting, when combined with an economic move from socialism towards capitalism and supplemented by an attractive long-term chart/technical set-up then OM is interested!  It will not always work, the moves towards capitalism are incremental and these are emerging markets so the absolutes (politics, economics, etc.) are largely in the darker shades of grey.  However, while the move from darkgray to silver is but a modest step away from darkness, the delta - or rate of change - for stock markets is meaningful.  Finally, OM suspects that the technological changes that we are seeing will speed up the process, when compared to historical examples.

Vietnam
One Sentence Thesis:  Young Confucian country following the mercantilist path of predecessors (Korea, Thailand, China, etc.) as it slowly opens to capitalism.
Vietnam is one of the clearest examples of the above traits.  It is following the mercantilist path previously trodden by Asian countries including Korea, Thailand and China, of focusing on securing foreign corporate investment to help develop into a manufacturing hub while slowly opening up to global trade.  While this began last decade, Samsung’s decision to build a second Vietnamese smartphone factory in 2014 helped accelerate the process.  Today Vietnamese subsidiaries are Samsung’s biggest production base responsible for 30% of its revenue, and Samsung represents over 25% of Vietnam’s GDP! 
 

To help solidify its attractiveness within manufacturing supply chains, and secure further foreign investment (such as for Google’s hardware), Vietnam has slowly been opening its markets to trade and moving from Communism to a China-like capitalism/communism hybrid.   Examples include the recent agreement with the EU on a trade deal and an aggressive schedule of privatizations.  Finally, Vietnam has been a beneficiary of the US trade war with China, which has provided further incentive for multinational firms to invest in the country.
 

However, like all things emerging markets this will be a slow and lumpy process. Vietnam is not China; it is size constrained (100mn people) and supply chains take a long time to be built.  Despite this, unless there is a significant change (such as in the trend to becoming a more open economy, or valuations get too crazy, or increased likelihood of a major economic downturn, etc.), Vietnam appears to be in that most virtuous part of circle where the benefits from becoming a manufacturing hub start to spill over into other sectors.  As such, expect it to be to be a 4% to 8% position in the portfolio for a looooooong time, and that the small incremental changes mean that OM will  talk about it far too little!
 

Brazil
One Sentence Thesis:  An economic and market collapse coupled with a massive political/business elite scandal opened the door for unlikely President and his key minister’s Chicago-school economics approach. 

Brazil was originally a dislocation investment and was once the largest investment in the portfolio!   Our Man won’t rehash the entire story for you but the cliff notes are; one of the country's longest and worst recessions, a stock market collapse (80% in USD terms) and a massive corruption scandal the enveloped the ‘elite’ business and political class, all of which culminated in the successful impeachment of President Rousseff.

 
While OM could have managed the dislocation investment better, the 2018 election and the appointment of Paulo Guedes – a Chicago-trained economist – as economic tsar helped confirm Brazil as a thematic investment.  Guedes’ economic plan is what you’d expect from a neoliberal economist – deregulation, privatization and pension reform.  Pension reform is the most important in Brazil; for the last 20-years various forms have been in the works as a necessary component to shoring up the government’s finances and none has succeeded.  However, Brazil’s lower house of National Congress approved a pension reform bill last month, which will now head through committee and the Senate with final approval of the legislation likely in October.

 
The success of pension reform should be a good first step – investment has remained weak in Brazil, with international businesses viewing pension reform as a litmus test of the economic team’s ability to pass its agenda.  OM’s expectation is that successful passage of pension reform will prove a strong first step in restoring the market’s confidence in the economy and the political stability in Brazil.  While Brazil is unlikely to be held for as long as Vietnam, and OM is more sensitive to the medium-term charts/technical picture, it is still likely a multi-year holding in that same 4-8% NAV range.
 
 

India
One Sentence Thesis: Modi’s re-election with another large majority likely means continued steps towards his version of national capitalism and reduced bureaucracy.
Back in 2014, when Narendra Modi swept to power to become Prime Minister of India it was a time when many believed in hope and change for India.  This partially reflected a Modi campaign, and his reputation as Chief Minister of Gujarat, that was focused on economics and cutting bureaucracy.  It also took advantage of a decade of Congress party rule that collapsed under disappointing economic conditions and a multitude of corruption allegations. 

Like all things emerging markets, it wasn’t so simple.  While PM Modi has made strides to reduce bureaucracy, he has also introduced his version of state or national capitalism and in so doing failed to live up to some of the high expectations the market held for him.  However, 2019 saw PM Modi re-elected in a landslide and OM is quite aware that it is often in the second term that the largest economic changes can be made (from US/UK history, think Reagan’s second term or Thatcher post-1983 election victory).  There have already been suggestions of wide-reaching changes to the civil service and we are likely to see further expansions of Modi’s national capitalism.  While much of Modi’s platform and approach is far from perfect, as noted previously investing in emerging markets is often about incremental progress.   Our Man increased the India position in early 2019, as it became clear that Modi was going to comfortably win re-election, and it is in the midst of its 4-8% range.


Disclosure: OM is (obviously) long all of the themes mentioned above.

4th Ind. Revolution Theme: Enterprise SaaS (Part II)

As this theme is a little complex, and more speculative than most of OM’s positions, I thought I would invert this post by starting with the conclusion and then walk through some of the underlying valuation parameters and rationale.   There’s a small bonus for readers who make it to the end…

Conclusion

Our Man has taken a small(ish) position in the iShares Expanded Tech-Software Index (IGV), a broad US software index.  In time it will be replaced with the recently launched Global X Cloud Computing Index (CLOU), which better represents the Enterprise SaaS market.  OM took this position, despite the high valuations in the Enterprise SaaS market, as it reflects:

• OM’s flaws as an investor; he is better at following and adding to positions when already invested as opposed to just tracking it.  In this case, OM believes it’s a multi-year secular theme and so is comfortable with a small position that he will add to at lower prices.
• It is a more speculative position.  In short, despite the moves of recent days, OM believes that there’s a significantly underappreciated chance of a melt-up market (think S&P 4,000 within 18 mos), and in such a scenario software is likely at the epicenter of it*.  This would see valuations go from the current expensive to ridiculous!

However, as noted this is on the speculative end of OM’s positions and at these valuations…caveat emptor!  Our Man has expressed his queasiness at stocks, let alone an entire industry, trading at over 10x revenue; it’s rarified air, for only those stocks that have (or will have) BOTH good revenue growth and great margins.   The margin for error in these stocks is small, as this 2002 quote from Scott McNealy, the former CEO of Sun Microsystems (which traded at 10x revenue in 2000) reminds us. 

“At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”

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SaaS Valuation
Rather than inundate you with excerpts from my crappy badly formatted spreadsheets, I will let the below chart from the HighPeak Financial blog succinctly tells the story of SaaS valuations (~51 cos) over the last half-decade.

Source: High Peak Financial - Cloud/SaaS Public Company Valuation - Q2 2019

The chart shows a very visible step-change in valuations since the start of 2018; before this date, the group had rarely traded over 8x sales and since it, they’ve rarely traded below 8x.  This is not something that’s gone unnoticed with numerous newspapers (e.g. WSJ) and finance sites commenting on the high valuations.

The justification from public investors has largely been as follows;
- The Q4-18 swoon had no major impact on the businesses of market leading/best in class SaaS companies, providing further evidence of the resilience of the SaaS model.  This is a further sign that the business model is proving out.

- The largest SaaS companies - especially Salesforce (CRM) and ServiceNow (NOW) – continue to show strong growth and meet the ‘Rule of 40%’.  The Rule of 40%, is an industry rule of thumb for a healthy software company that states your Growth Rate + Profit (typically EBITDA is used, but that’s a whole separate debate!) should add up to 40%.  As a rule of thumb it is of course imperfect (the trade-off between growth/profit is not linear, unit economics are vital but not included, etc.) but nonetheless the spirit is a good one.  The strength of the growth/profitability of ServiceNow and Salesforce, which are $50bn+ enterprise companies that are 15+ years old,  is viewed as particularly given data shows the difficulty of meeting the Rule of 40% as companies age and grow.
However, this less impressive than it seems.   Visa is the poster child of a company that has traded at more than 10x Sales, it has done so for the last half dozen years and is currently at 17.7x Sales.  It’s Revenue Growth (12%) and EBITDA Margins (67.4%) come in at over 79%, rather higher than the Rule of 40%!

- Recent M&A is used to justify current multiples, such as the recent deal where Salesforce acquired Tableau Software at 11.2x TTM Sales.

- Low interest rates and limited growth, means companies with real organic growth deserve a premium valuation.

- Finally, the number of recent IPOs means that only a small portion of the shares are available to be traded (as some investors remain locked up, and unable to sell).  As such, demand to own these stocks is outstripping supply (available shares) leading to higher valuations and in the medium-run this will likely moderate as locked-up shares become available for sale.
However, in the short-run there is the possibility that SaaS stocks might act like Giffen goods.  That is that the high stock prices from the current excess demand will lead to an increase in the float (shares available for sale, as investors sell them and crystallize these valuations after the post-IPO lock-up ends) AND increased demand from programmatic or rules-based buyers (e.g. ETFs) that automatically increase demand as the float increases and the stocks became eligible for inclusion (or larger position sizes) within indices.

How to Express the Enterprise SaaS Theme?
There are approximately 100 Enterprise SaaS companies in the US, of which just over 50 are publicly listed.  This makes gaining exposure to the theme via public markets relatively easy.

a). The optimal way is a concentrated portfolio of 5-8 well-researched positions, utilizing the liquidity of the public markets to adjust position sizes, and buy/sell positions with a long-term (i.e. multi-year) horizon.  Professional friends will recognize this as a fairly typical hedge fund co-investment strategy, where a skilled manager can take advantage of a secular trend, in-depth research, concentration and a longer-term horizon to outperform an index.  The difficulty of such co-investments is that the best managers for it are ‘true believers’ and so the decision to exit lies entirely with the allocator.  Typically, this is the most difficult decision professional allocators face as there's no perfect answer and most decisions lead to job risk as they entail:
(i) The allocator admitting they got the theme wrong (i.e. should never have been in Enterprise SaaS), which is embarrassing and job threatening (especially when there are committees and boards involved, which were likely initially skeptical).
(ii) The allocator getting the theme right, but picking the wrong manager (i.e. would have been better going with a passive option).  This is frustrating but not typically job threatening; making good money is better than no money!
(iii) Dealing with the consequences of being right and choosing the right time to redeem a successful investment is, ironically the hardest and most risky proposition for the allocator.  This is as it is emotionally difficult and likely heretical since most people find it hard to sell things that have made them a LOT of money.  To get it right requires both a clarity of thought and a certain ruthlessness.  It also will almost certainly lead to the professional investor getting marginalized or fired.  Why?  Nobody remembers that the allocator was right to exit the investment unless the theme performs just averagely post-redemption, and things that do exceptionally well rarely then perform just averagely!  If the theme collapses after the exit then it was just “lucky timing”, and if it continues to rise rapidly then the investor was overly conservative/foolish/scared and cost the firm $X by redeeming when nobody else wanted to.  Generally, Our Man hopes to be lucky often, but will settle for being called conservative/foolish/scared.

b). There is an index just for SaaS companies, the Bessemer Venture Partners Nasdaq Emerging Cloud Index which tracks the performance of ~51 SaaS companies.  Sadly, there’s no ETF based on this index though that’s not for OM’s want of trying (he was politely told ‘interesting idea, now go away’ by more than one ETF provider when he suggested it)

c). Sadly this only leaves imperfect solutions of which two standout.  The  iShares Expanded Tech-Software Index (IGV) is a $2.8bn broad software ETF where SaaS companies make up around 1/3 of the exposure.   Secondly, Global X launched a Cloud Computing ETF in mid-April 2019, in which SaaS companies make up around 2/3 of the exposure.

* Well done for reading all the way down here!  If it does come to pass that software is the epicenter of a melt-up in the markets, then the savvy investors amongst you will recognize that cryptocurrency (i.e. software-as-a-currency?  Software as money?) will likely be at the whip end of that move.  Who knows, in that environment we might even see Tim Draper prices for bitcoin in the next year or two! 

Disclaimer: OM holds crypto assets outside of this portfolio, and IGV in this portfolio (obviously!).

2019: Second Quarter Update

Portfolio Update

- 4th Industrial Revolution:  OM added a small position in the iShares Technology-Software ETF (IGV) at the very end of the quarter, as a way to gain exposure to Enterprise SaaS companies.

Performance and Review

The second quarter saw the portfolio rise +6.80%, which outperformed both the S&P 500 Total Return (+4.30%) and the MSCI World (Total Return, Net Dividends) (+4.01%).   For the year, this leaves the portfolio at +17.93%, which is nestling in between the S&P 500 Total Return (+18.54%) and the MSCI World (Total Return, Net Dividends) (+16.98%).

As the table intimates, performance was driven by the Dislocation positions and in particular those in Greece (+398bps) and Shipping (+216bps). 

Greece rallied strongly in the final weeks of the month after New Democracy, the opposition party, comfortably won the European elections.  This led to Prime Minister Tsipras calling an early election, and investors began to think about Greece’s future under a pro-business New Democracy government.   Subsequent to quarter-end, New Democracy successfully won a majority in the snap Greek election.  New Democracy has been talking to investors for the last two years, and immediately presented a financial bill including tax cuts that it hopes will help spur growth.

Within the context of OM’s approach to dislocations, the election is the catalyst that OM believes will change the narrative around Greece and get other investors to look at it.  What does that mean for OM’s holding? Empirically, the most attractive risk/reward in dislocations is the 12-24months after the catalyst – the honeymoon period, where there’s low hanging fruit and investors want to believe the story.   Thus expect Greece to almost certainly remain in the portfolio for the next 12-24mos, with the caveat that price movement should justify this – seeing May’s lows ($7.80 for GREK) revisited would be concerning and the position would be exited if we returned to December 2018’s low ($6.75).  On the other hand, don’t expect OM to take profits for at least the first 12 months – setups like this are rare, and the compounding impact to performance is worth the residual volatility.

The Shipping (+216bps) dislocation was driven by its exposure to product tankers, which benefited from Clean Tanker rates holding up well.  The sub-sector continues to see favorable supply/demand characteristics and OM believes it is best placed to benefit from IMO 2020.  The Uranium dislocation (-60bps) fell back slightly during the quarter.

The Thematic positions were a wash during the quarter; gains in Argentina (+75bps) and Brazil (+38bps), offset by losses in Vietnam (-33bps), India (-21bps) and Blockchain (-41bps).  The 4th Industrial Revolution positions made no great contribution (+2bps) in the second quarter.

Elsewhere, the portfolio benefited from the positive trend in markets with the Technical positions (+61bps) buoyed by rising markets, which also helped the Funds (+43bps) in the idiosyncratic book.  Finally, Texas Pacific Land Trust (+8bps) was largely flat for the quarter, despite machinations between management and a group of activist shareholders.

Longer-term Chartology

With the portfolio having been run in this form for 3+ years, Our Man thought he’d throw in a rotating cast of “interesting” charts/statistics on the portfolio’s performance, drawdowns, losses, etc.   The chart below is a simple one, showing what would have happened if OM had put his money in a couple of other instruments.  As you can see, he’d have been better off (so far) putting it into US equities, Global Equities or even a simple 60% Equity/40% Bond.  Obviously, OM expects this to change …

Portfolio (as at 6/30/19 - all delta and leverage adjusted, as appropriate)

Dislocations: 42.1%

21.9% - Greece (GREK, ALBKY, and EGFEY)

11.4% - Shipping (STNG, NVGS, DSSI and EURN)

8.7% - Uranium (URA, CCJ and NXE)

Thematic: 30.4%

6.5% - Tech: 4th Industrial Revolution (JD & IGV)

6.3% - India (INDA and SCIF)

6.2% - Vietnam (VNM)

5.0% - Brazil (EWZ)

4.6% - Argentina (DESP, GLOB, GGAL and AGRO)

1.9% - Blockchain (OSTK)

Technical: 20.4%

20.4% - OEW Technical positions (DDM, SSO, and QLD)

Idiosyncratic: 13.2%

9.6% - Funds (CWS, GVAL, and CAPE)

3.6% - Equities (TPL)

Shorts/Hedges: 0.0%

Cash: 4.1%

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a few other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc. 

Portfolio Update: New Position - 4th Ind. Revolution Theme: Enterprise SaaS (Part I)

Our Man has talked a lot about software over the last 12mos+, yet the theme is not in the portfolio.  This was due to professional considerations; he was researching and allocating to a Software-as-a-Service (“SaaS”) focused fund for a client portfolio as well as writing an insight piece into Unicorns and software.  With both complete, Software can be added to the portfolio and the rationale is below.   Much of OM’s early drafts of this piece were subsumed into the second half of the aforementioned Unicorn paper (let OM know if you want a copy!), so what follows is a shortened version. 

The rise of software is not new, it was foreshadowed in Marc Andreesen’s seminal Wall Street Journal article - “Software is Eating the World " - in August 2011.  Software, and its key role in the 4th Technological Revolution, is also one of the drivers of Our Man’s bullish long-term view (more on that another time!).

The Rise of Software

Over the last dozen years, the world has transitioned online driven by increased computing power, cloud storage and mobile usage. This has increased accessibility and vastly reduced delivery costs (i.e. an internet download, or app).  This transition provides a secular tailwind for software companies, allowing them to scale and quickly generate substantial revenues, and to become entrenched in consumer’s lives and companies’ business.  These same technological transitions have also enabled many software-driven companies to change their business models from a traditional product sales/licensing (i.e. remember those floppy disks/CDs) to a cloud-based subscription model that generates recurring revenues.  Though the subscription model sees a smaller monthly fee, it leads to both higher recurring revenues and higher retention rates for the company.  Finally, the smaller regular subscription cost increases the size of the potential market and helps margins, as the marginal cost of providing a new cloud-based software product approaches 0% as the customer base grows (e.g. imagine the marginal cost of the 10,000th stream of TV show, or the millionth download of a song, etc.). 

Enterprise or Consumer?

Our Man has a strong preference for enterprise (i.e. business) focused companies rather than those that focus on the consumer.  It is only natural that the consumer market developed first, given the speed of the different decision-making process - you making a decision vs. your firm making one – and that in consumer-world the limiting factor was marketing and distribution.   Before the Internet almost all consumer business was either (i) local or (ii) space-constrained (shelf-space, channels on your TV, etc.).  The Internet resolved this - websites are accessible across the country/world, Amazon has unlimited shelf-space and cloud-based product is infinitely divisible (Netflix can let you watch everything and anything on its menu at any time, irrespective of how many others are watching it). 

The approaches to data in the consumer and enterprise environments are necessarily different, which impacts the business models.   For a company, its internal client data is a key part of its business (and often covered by regulations) which means it cannot have its software partners collect and share that information.  This contrasts with the consumer-side, where collating personal data is often key to the business model whether the data is used to help target advertising or to try and create network effects.   This difference in approach to data has further driven enterprise software towards a paid subscription model, whereas the consumer side remains a mixture of different models, including advertising driven (Google, Facebook, Pinterest, etc.), subscription (Spotify, Netflix, etc.) or models focused on the delivery of a physical good/service (Uber, Lyft, Amazon, etc.).

The value proposition to the client of the subscription model is centered on the greater flexibility that it provides. This flexibility comes in many forms;

• Easier Administration: The client can better control and match the number of licenses that are used. Since the subscription model is a pay-as-you-go system, subscriptions can be increased/decreased as required.
• Greater Compatibility & Security: As the software is hosted in the cloud, all users are using the same version of the software, ensuring compatibility across a firm. Furthermore, the software provider is responsible for updating, patching, and security, and these are done automatically rather than on a user-by-user basis.
• Cost affordability: The steady price and recurrent nature of subscriptions means that they can be budgeted for more easily.
• Global Accessibility: Users can access their software from any device as it is hosted in the cloud. This has increased in importance as the prevalence of mobile has expanded.
• Integration & Scalability: Most SaaS applications are designed to support some level of customization, and vendors allow connections to both internal applications, but also other external SaaS applications. This means that information is available in a more accurate and timelier fashion than before, which has notable impacts on productivity. For example, sales people in the field can immediately check real-time data (via an application on a mobile device) on inventories before committing to a sale, rather than going through a longer and more manual process of speaking to head office directly to get the information.

The biggest benefit of this increased flexibility for clients is that using a cloud based SaaS solution leads to increased productivity, as the clients can focus on their core businesses.

Companies’ transition to subscription models has also led to significant benefits for investors;

• Higher Recurring Revenues: The subscription model means that the firm’s revenue stream is more predictable due to the steady income from subscriptions, which helps management in planning and investors to value the business.
• Higher Retention Rate: The model changes the nature of the sales process from one where the firm is looking to complete a solitary transaction (e.g. sell X number of licenses) to one where it’s selling a long-term relationship with the client. The model also changes the nature of the client’s behavior; clients must make the decision to leave a provider rather than make a new purchase. The behavioral nature of this change has been important for software providers as it has led to increased client retention.
• Increases Total Addressable Market: As the recurring subscription cost is small (relative to the prior cost of purchase under the licensing model), the SaaS model helps increase the market size through greater accessibility for small businesses and non-core usage within large firms.
• Uniformity of Updates: As the implementation of updates is driven by the provider, not the client, and is done in the cloud, this helps ensure that updates tend to be done more frequently and that all users are utilizing the same version of the software.

For investors, the first three of these benefits - higher recurring revenues, higher client retention, and a larger market - has changed the long-term profitability of software companies, making them a more attractive long-term business. In addition to improving profitability, it has also meant that SaaS companies are less prone to changes in the economic cycle. This is a function of the productivity benefits that the SaaS model offers customers, which results in higher client retention. Given these productivity benefits and the substantial switching costs of changing software providers – including retraining employees and linking the new software into existing systems – SaaS companies often enjoy a “sticky” customer base. Typical retention rates for successful SaaS companies have been around 90% of annual revenues. This strong retention rate reflects the benefits of the SaaS business model; software subscriptions are now targeted (rather than company-wide) and at an affordable recurring cost (rather than substantial one-off license fees), which means that customers are more willing to retain subscriptions during any softening in the market.

While software is indeed eating the world, OM thinks we’re still in the earlier innings on the enterprise side.  In part II, we’ll talk a little about valuation and how to invest….

Things from my Newsblur; 2019 Part 3

Time for the latest edition of “Things from my Newsblur”, which is a little tech heavy.  As usual, the most investment-related stuff is at the end.

The Battle of Winterfell: A Tactical Analysis

With GoT’s final season having ended a couple of weeks ago, Our Man thinks he’s probably safe to post this without spoiling anyone's enjoyment.  OM watched the Battle of Winterfell and had questions, so many questions, about Team Living’s plan.  Questions like…wait, you’re going to just charge your cavalry into the darkness without scouting?  Or your fire trenches are behind your army - how are you going to retreat?   Or you might want to use those dragons rather than chilling out on a hill?   Or does Brann want to do anything – you know, like use his ravens to check out the Dead’s army or be helpful, in any way?  Well, here’s an army officer’s tactical analysis of the Battle, which confirms that Team Living were borderline inept.  (Angry Staff Officer, Wired)

Florence Nightingale: The Pioneering Statistician

The Crimean War was the first major conflict of the industrial age that utilized railways, armored ships, telegraph wires and was fought with high explosive shells.  It’s also the first war that saw its after-effects recorded through photography.  Amidst it all, Florence Nightingale (and her team) ran hospitals for the wounded soldiers, and through this work she became known as the founder of modern nursing and became an icon of British culture, especially in the persona of “The Lady with the Lamp”.   Part of her success came from the rigorous collection of data and its subsequent statistical analysis, through which she uncovered that more soldiers were killed by preventable diseases caused by unsanitary healthcare than as a result of battlefield wounds.  Through portraying this visually – and bringing the pie chart and its cousin the polar area diagram to the fore – she helped lead to reform health care in the Army and through the Public Health Acts of 1874 and 1875 in the entire UK.  This short article goes through some of the background on Nightingale’s approach, and how it was so revolutionary for the time.  (The Science Museum)

Artificial General Intelligence Has Been Delayed

For all the talk of autonomous driving and the driverless car, which underpins the valuation of many of the ‘mobility’ companies (be it Tesla, Uber or Lyft), Professor Rodney Brooks discusses how artificial general intelligence, and with it autonomous driving, is going to take a lot longer than people realize.  He’s not alone, with folks like Chris Umson (former head of Google’s self-driving project) suggesting that driverless cars will be slowly integrated onto our roads “over the next 30 to 50 years.”  (Professor Rodney Brooks, his blog)

The Aldi Effect: How One Discount Supermarket Changed the Way Britain Shops

This excellent article charts the rise of German supermarket Aldi in the UK; while it was initially looked down upon, it has taken share consistently since the Financial Crisis and grown from 2% to 8% of the market.  Like many disruptors, the tale is a mix of providing a customer with something they didn’t yet know they wanted, a completely different culture and cost structure from the lazy incumbents, and a willingness to make decisions with a longer-term horizon in mind.   For my fellow Brooklyn-ites, who don’t think Aldi has yet encroached on their shopping habits, you might want to think about who own Trader Joe’s the next time you’re purchasing your Mandarin Orange Chicken or Everything But the Bagel Seasoning! (Xan Rice, the Guardian)

Breaking Smart: Season 1 – How Software is Eating the World

Our Man’s very interested in software, especially enterprise software as a multi-year investment theme.   It hasn’t yet made it to the portfolio as Our Man spent the tail-end of Q4 researching the broader software/unicorn landscape for a recent thought piece and potential investment ideas for clients.  However, expect something on it soon as colleagues prefer to focus on the private market options.  One of the benefits of the project was that OM re-read Breaking Smart, which was the result of author Venkatesh Rao being invited to spend the year 2014 in the offices of Andreessen Horowitz (leading VC firm).    This is a long read – 30,000 words – but it’s broken down into 20 bite size essays that touch upon the impact of the technological changes on our lives and societies.  It holds up well, so make the time to slowly work your way through it!  (Venkatesh Rao, Breaking Smart)

Tsipras faces fight to stay in power after EU elections mauling

As regular readers know, OM’s highest conviction position is Greece and it is out sized at 20% of the portfolio.  A key part of the thesis is that a change in government at the next elections, will change the narrative and draw investors back to Greece.  Well, the opposition New Democracy party have been meeting those investors who’ve been to Greece for much of the last two years in the hope that investors will know them and their plan, and be ready to invest if/when they come to power.  That judgment day was brought forwards to early July, after Greek PM Tsipras called a snap election following his party’s defeat in last week’s European elections.  Now, we’ll see if the thesis holds.  (Guardian)

Portfolio Update: Greece is the Word!!

With OM’s position in Greece having been sized up to 20% of the portfolio (start of Q2), it deserves a post of its own!    While OM  has provided updates on his Greek thesis before, which can be found here and here, the entirety of the thesis is not available in a single place.  This post, will rectify that. 

Our Man’s Greek exposure is primarily held through the Greece ETF (GREK) as well as smaller positions in two Greek Banks – Alpha Bank (ALBKY) and Eurobank Ergasias (EFGEY).

OM believes that the public markets reward contrarianism, especially when it’s tied to common sense, and his playbook for a dislocation is:

1. An investment that has had abysmal performance.  Ideally, investors will have been burned badly and/or are fatigued by the situation, which means it is likely overlooked.
2. Valuations are cheap and the fundamentals are turning, yet very few people care, and the stocks should at least suggest that they have found a bottom.
3. A change in narrative that provides an excuse or all-clear sign for investors to consider the area investable once more.

From OM’s research, the most attractive part of the investment is the ~24 months after the narrative has changed.  While the situation may continue to be attractive, potentially for many years, once it gets beyond a couple of years it will fall into OM’s Thematic portion of the portfolio and be evaluated and sized on that basis.

1) It All Goes Wrong for Greece

For Greece, the Global Financial Crisis was followed by a starring role in the European sovereign debt crisis.  While most people are largely aware of the Greek debt problems and the associated economic problems, the severity isn’t fully appreciated.  The crisis saw a 45% decline in GDP and unemployment top 27% in Greece – similar to what the US saw during Great Depression!

Greek GDP

Unsurprisingly, this saw Greek equity markets get decimated; down over 90% from their 2007 peak, over 80% from their post-08 highs, and over 70% from their 2014-highs.  The fall from 2014 is particularly important as ‘sophisticated’ investors helped recapitalize the Greek banks in 2013 and 2015, with the expectation that the crisis was largely over.  It was not!!

(click to enlarge)

Well for Greece, the opportunity is pretty clear; economic disaster and collapsing equity prices, over a prolonged period means that even ‘sophisticated’ money has been scared off.  

2). Valuations Become Attractive, and Things Turn Around

However, take another look at that chart of economic growth – things have turned around, and stabilized over the last couple of years.  Those aren’t the only signs though; the country passed over 450 reforms under the conditions of its IMF/European Central Bank/European Commission (the “Troika”) bailout deals and under those deals it is financed through 2033, when its debt amortizations start.  In exchange for this financing to help build a cash buffer, Greece had to agree to remain in a post-program surveillance program.  This helps guarantee the Greek government continues to deliver on its already enacted reforms.  Finally, for a country where people don’t pay their taxes and has historically spent recklessly, times are changing!  Greece has had one of the largest turnaround in public finances in history; it posted a budget surplus for the last couple of years and is committed to running one for years to come! 

Greek Government Budget Deficit

The same is true in equity markets, which bottomed back in 2016.  As a sense of the broad value in stocks, the CAPE ratio – an inflation adjusted 10-year price-earnings ratio – is negative!   With regards to the banks; Alpha Bank and Eurobank Ergasias ended 2018 trading at ~0.25x their estimated 2019 book value compared to European peers that traded at just under 1.0x.  Now, OM gets it…investors are rightly skeptical – after all there have been three bank recapitalizations this decade (2010, 2013 and 2015) that have seen investors lose almost all of their money.  However, OM would note that at this point regulators have been insiders on Greek banks for a decade (so book value really should be book value), vetted capital levels in continent-wide stress tests last year, and that Alpha and Eurobank both have 15%+ Tier 1 capital and are profitable!

Fundamentally, the banks continue to improve their non-performing exposures (NPEs) which have fallen 20% from the 2016 peak, with the ECB monitoring and acting as ‘big brother’ to help ensure this.  Last November, saw reasonable new NPE targets set by the ECB, working in conjunction with the Greek banks.  The ECB, the Bank and the Greek government all know that the banks must continue to reduce NPEs in order to be able to lend again, and help the economy grow.  This is why you’re seeing NPE sales by individual banks and various government plans being floated by the Central Bank  and Ministry of Finance to help speed up the process.  These combined with the recent Katseli law that makes it harder for people to strategically default, and the banks’ self-help (cost-cutting, etc.) are all  positive signs, and give the banks substantial operating leverage to improved conditions.

3) What will draw others back in

Which brings us to the change in narrative! Last year saw some steps in this direction, with Greece exiting its official bail-out program and raising money from the bond markets. Those bond markets, seem pretty sanguine on Greek risk.

The Greek government further took advantage of these low yields, to raise money and prepay $4bn+ of higher-interest IMF loans.  Further steps like this, and the banks continuing to fix themselves, will help but they won’t draw most investors back in.  That will require political change, and Greece is having elections in 2019! 

SYRIZA and their leader Alex Tsipras, who came to power in 2015, are broadly viewed as crazy leftists.   Yes, it’s in their name…SYRIZA being the syllabic abbreviation for The Coalition of the Radical Left.  Despite this, SYRIZA agreed to the Troika’s demands, passed bankruptcy laws, generated budget surpluses and helped the economy start to climb out of the abyss.  Irrespective, they are not a government that investors (especially US-ones) feel comfortable investing alongside.  However, 2019 is an election year in Greece and what if the country elected a leader that comes out of Western investors’ central casting?   You know, the kind that went to Stanford and Harvard, had spent time working for well-known US banks and consultancy firms before becoming a PE/VC investor, was pro-markets and business and came across as more efficient technocrat than ideologue.   Well, that’s the resume of Kyriakos Mitsotakis, the leader of the New Democracy party that’s currently comfortably ahead in the polls.   Should they seem likely to win as the election approaches, and eventually do so, I think it will remove a key obstacle for investors – Greece will no longer be scary, nobody will be fired for looking at it again, and it might even become the latest ‘unique idea’ for hedge funds.   This isn't to underplay all the good that Mr. Mitzotakis and a new government could do, just a reflection on what investors respond to.

Some Risks

While the above all suggest how Greece is setting up to be very attractive, under no circumstances should anyone think that it is even close to a risk-free investment.  As such, here are some of the key risks for OM.

• An important risk to the thesis is if global, and especially European, growth materially slowed down or became recessionary.  The most immediate impacts to the thesis would be to weaken the economic fundamentals in Greece and to increase the stress on the banks.  Additionally, stock markets and risk appetite would likely be weak in such a recessionary environment.  That wouldn’t spur anyone to invest in Greece.  In such a situation Our Man’s position should be vastly smaller.

• An obvious risk is that SYRIZA returns to power, hamstringing the change in narrative and remaining an impediment to investor interest rekindling.  A SYRIZA victory would also remove the optionality that a more business-friendly government could increase economic growth.  As such, Our Man’s position would be smaller, though it should be noted with the Troika continuing to monitor Greece’s compliance to its economic agreements, the fundamentals likely wouldn’t change substantially. 

• A final important risk is that the position, especially in the Banks, is dependent on regulatory forbearance.  The ECB has worked with the banks as a ‘big brother’ to set NPE reduction targets, and those most recently agreed for the period 2018 to 2021 were firm but fair.  Should the ECB change its approach it would likely mean further write downs and recapitalization for the banks that would negatively impact both investor and economic confidence.  While the ECB’s current plan is working well and the ECB is an independent central bank, the President is appointed by the leaders of the countries that have adopted the euro.  ECB President Draghi’s term ends in late 2019, and a new President (and team) may choose to take a different approach to Greek banks for their own political reasons.  This is something to continue to monitor, and much like investors the ECB decisions may be tied to the election result.

Disclaimer:  Nothing above represents a recommendation in any way, shape or form so please don’t even think of trying to take the above that way.  For added clarity, while Our Man is invested in all of the securities mentioned – Alpha Bank (ALBKY), Eurobank Egrasias (EFGEY) and the Greece ETF (GREK) - that’s a terrible reason for anyone else to do so.  Our Man also holds some cash and a many other securities (of negligible value).  You should not buy any of these securities because Our Man has mentioned them, but should do your own work and decide what’s best for you given your own circumstances/risk tolerance/etc.