Friday File: The Dark and Ugly Start of 2016

by Travis Johnson, Stock Gumshoe | January 8, 2016 4:48 pm

Checking in on some big picture themes, and a few stop losses and one buy this week.

So has this recent weakness been a dip, or is it the beginning of real downward bear market or years of stagnation? Trick question. I Dunno, and neither does anyone else. But I still need to invest to grow my savings over the next 10-20 years or maybe more, so I’m still willing to buy stocks when they look attractively priced.

It’s been a year plus of oil and China panic, so I thought I’d share my thoughts on those quickly so you have some idea of my perspective… and it so happens that a few of the stocks I’ve covered for you (and own personally) fall into these categories and I do have some decisions to make about those, so I’ve got some sells and other updates to share this week as well.

Oil is still on our minds as investors, as is China, but I think it’s worth remembering that oil is a smaller part of the real economy than it is of the US stock market (even though the differential has narrowed over the last 18 months). The direct business of energy and mineral extraction (including mining for coal and iron ore, not just oil and gas), which is where the most commodity sensitivity is (refiners don’t necessarily process less oil when it’s cheaper), is substantially less than 5% of the US economy, maybe as low as 2%, and low energy prices are a real negative primarily for energy producers and their service companies (they’re generally a positive for most others, and for the economy as a whole). The energy sector is about 7% of the broad stock market in the US, down from about 17% at the peak before the 2008 crash (back when oil was spiking to $140).

The market, in my opinion, tends to overreact to energy prices — partly because they are so volatile and so widely followed, and because oil has created so many compelling fortunes in past decades. The rising dollar’s impact on industrial production and exports is a bigger deal than oil prices, I think, and energy prices will probably recover at some point if and when OPEC gets its act together and feels it’s taken back enough market share — not many folks outside of OPEC can make a profit at $20-30 oil.

In the middle of that, of course, we got the gift of laughter: One of the few things that I’ve scanned in passing in a headline and just started laughing so hard that I had to go back and read the whole article: Saudi Aramco, the Saudi state oil company, is floating trial balloons about going public.

Why laughing? Not only because this is the worst possible time for an oil company to go public in the last six years (2008 might have been a little worse), but also because this is coming from a famously secretive family-controlled firm that says it has the biggest, nearly inexhaustible reserves in the world but won’t actually let anyone see their real data. This could be the largest company in the world if they go public, but they’d make Rosneft and Gazprom look like open, shareholder-friendly stocks. Hard to imagine any non-Saudi exchange letting them list without huge disclosures, and it’s even harder to see the Saudi royals making those huge disclosures.

In oil-related stocks, we have TGS Nopec (TGS.OL in Norway, TGSGY OTC in the US) to contend with. This is the seismic data company that I featured a couple years ago and still own personally, though we hit a stop loss on the shares back in August at $19+ and I sold half my position then. I’ve been reluctant to fully get out of the energy sector, and have considered this company to be one of the ones least vulnerable to “permanent loss of capital” as the low prices wash out competitors and cut their business. They can handle it, thanks to an asset-light business model and active and cost-cutting management, so my argument has been that when oil exploration does heat back up again and exploration budgets increase at the big oil companies (and animal spirits return and create lots of new little companies), they’ll recover well.

And I think that’s still true, they will come out of this better than other seismic companies and better than most oil services companies. But that’s like saying two broken legs is better than two broken legs and a broken arm… so is it worth sticking with this? Do I stay with that discipline that tells me I should have some energy exposure because it should come back and there’s nothing fundamentally wrong with the company’s assets, balance sheet or management, or do I go with the discipline of the capital allocator and cut my losses to make sure the stock doesn’t lose me another 50-80% from this position before it recovers? In this case, I’m honestly torn, so I looked in more detail at the report they released about their 2015 year-end and their 2016 projections (the report came out just this week[1], helping the stock fall to a 5-year low of about 103 Kroner on Thursday morning (it bounced back slightly).

This is what management said about their prospects after a year when revenues fell by about a third (and the fourth quarter was worse than that):

“TGS’ 2016 operational multi-client investments will be reduced by more than 50% compared to 2015. This is partly a result of lower cost of acquiring seismic data as average vessel day rates will be substantially lower than in 2015. Furthermore, the activity level will be reduced as oil companies have become less willing to prefund new surveys. As a result of the weak market conditions there is higher uncertainty than usual with respect to late sales of seismic data. Late sales are normally heavily dependent on oil companies’ E&P spending. This relationship will continue in 2016 and as a result, TGS expects late sales to move in line with or slightly better than general E&P spending trends. However, the significant reduction in investments combined with the effect from the cost cutting measures implemented last year should support positive cash flow development despite the challenging environment.”

Data acquisition is the conducting of new seismic surveys, usually funded about half by the oil companies, half by TGS, with the data owned by TGS and accessible by the funding oil companies. Late sales are where the real gravy comes into this business model, that’s the selling of “old” data collected either in recent years or, in some cases, decades old. Data is written down quickly on their books so it appears to be worth nothing after five years or so, but in reality it creates a substantial amount of cash flow from sales because some of that data remains valuable for a long time. Those sales are lumpy and unpredictable, and they don’t come if oil companies aren’t investing in exploration — so they’ll be low this year, and new data collection will be low.

But still, TGS has a solid cash balance and it will continue to own that data library even if the rest of the world considers it less valuable while oil is at $40 or $30 or $20 (if it gets there) than it does when oil is at $80 or $100. They should survive and, they say, even have positive cash flow during what they expect will be a weak year. They even have some fairly large projects ongoing, mostly in the Gulf of Mexico to get ready for Mexico’s opening up of their offshore blocks to foreign investors.

They have about $160 million in cash as of December 31, and they expect to invest less than half what they did last year while still building the library (much of the cut in investment is just lack of oil company interest in doing new surveys, but they are also seeing much lower costs so each survey will be less expensive to run), so even if “late sales” fall by 30% or more as they’re anticipating (because of lower investment in exploration by oil companies) they should eke out a break-even on cash flow. They will almost certainly report a substantial loss in 2016, but that’s partly because of the (noncash) amortization of seismic investments they’ve made in the past four years (those investments will be amortized in a straight line over four years now, a change from past accounting practice).

On the back of all of this, my inclination is to hold on to my remaining shares as a contrarian investment… but my brain is telling me that there’s almost no chance of “animal spirits” or exploration investments picking up rapidly in offshore oil, and while TGS should do fine with their cost cutting and their valuable assets, it will probably keep going down first as they’re faced with an overwhelming lack of investor interest in oil service companies. So I’m selling, somewhat reluctantly, and will clear this one from my books at about a 40% loss on this tranche, but I’ll keep an eye on it — I’m putting it back on the watchlist, and if we see a continued downward spiral in these shares and they fall below the obvious value of their library (for me that would mean a drop of about 30% from here), or see any indications of business recovery, I’ll think about getting back in.

Now that I’ve said this and jettisoned the rest of my shares, presumably this will be the bottom.

If you look at any other seismic companies, do be careful — the reason TGS remains somewhat attractive to me is that, unlike most of the big seismic companies, they don’t have capital assets. They don’t own their own seismic ships and rigs, they contract out for that, and therefore they don’t have debt to support those assets, that’s why there is a sliver of blue sky in their ability to invest during downturns like this and buy up more data when costs are low (when the seismic vessel owners and crews are available on the cheap).

And, of course, China is freaking out. Apparently that’s what happens when you have a billion people who are pushed away from investing in real estate because it’s been driven by a credit bubble, and who are afraid of the value of the Yuan and who follow their leaders’ advice and put their money in the stock market. The Chinese market is cheap, of course, if you go by the standard PE valuations or other common metrics, but too many big global institutional investors don’t trust those numbers, and the Chinese stock market is dominated by individual “retail” investors who are, on the whole, a bit jumpy.

With the market continuing to hit the “circuit breakers” at 7% losses as they started that “circuit breaker” experiment this year, there wasn’t enough of a washout crash for value hunters to get excited… partly because all the folks who are panicking and trying to sell their shares couldn’t sell them. This seems to be working itself out a little bit now that the circuit breakers have been changed and the market has been given more latitude by the government regulators, but it’s hard to seriously contemplate a big position in Chinese stocks these days even if you do trust the numbers the companies are filing or the data the regulators are putting out about GDP and trade. It’s a mystery, and investing in mysteries is more like plain old gambling. Yes, sometimes people win when they gamble — but don’t bring your credit card to the casino with you.

On the China front, I think it’s also likely that they’ll continue devaluing the Yuan (or, more fairly, to de-peg it from the US dollar and keep it more in range with the other, weaker major currencies) — it’s been bumped down pretty significantly already over the last year (against the dollar, that is), and will probably come down more, which makes Chinese businesses less valuable to US investors (though it does make Chinese exports cheaper and more competitive globally, which supports the internal Chinese economy).

So those who are fretting about the “end of the dollar” as the Yuan rises and enters into the global reserve currency discussion have quite a bit more time to fret before that sentiment works its way into the real world (if it ever does). The Yuan might do reasonably well against the Euro, Yen and Pound… and it should, if China continues to open up, continue to squeeze into a spot at the table of reserve currencies and get more respect and more widespread acceptance in trade, but these stock market panics and hamfisted responses seem unlikely to make the Chinese government go as far as would be needed to fully open their economy and their currency to global exchange. It’s hard for a command economy to create a reliable and stable currency that sovereign banks and huge institutions would want to rely on, partly because it is hard for that command economy to give up control. If you continue to devalue your currency in surprise announcements (as opposed to trying to gradually and softly devalue it through overprinting, inflation and borrowing like the US has done for decades), folks lose interest in relying on it as a large part of their reserves. Stability matters, even if the stability comes from global consensus and reputation rather than “real” economic strength, and that favors the dollar still… by a wide margin.

I’d assume that the Chinese Yuan will gradually supplant the Yen and the Pound as the years go by, particularly if Japan continues to shrink, and it may continue to take a bite out of the Euro as the Euro area continues to wrestle with its own governance and growth… but any bet against the dollar continues to be a losing bet so far and my guess is that’s likely to continue for at least a couple years — despite all the worries and the political rhetoric and the genuine economic weakness here (largely, in my opinion, due to health care costs, an aging population, insufficient legal immigration, and energy prices displacing some of the same folks who were previously displaced by the decline in manufacturing), there are no major economies that are in better shape than the US… and the flight to safety will probably continue to favor the dollar.

Surprisingly enough to many (including me), even gold is not proving to be a “safe haven” in any real way as of yet — the Chinese, arguably the most gold-inclined people on earth after the Indians (by history and tradition), have been told that they’re facing a debt bubble partly due to a real estate speculative bubble (remember those? They end well, right?) and overinvestment in infrastructure, and that their currency is being devalued, and that graft investigations are snapping up executives right and left, and they’ve seen their stock market continually bump down in daily increments and have a couple ugly drops in a year… and even with all of that and new nuclear posturing from North Korea and a hugely important new standoff in the Middle East between Iran and Saudi Arabia, the price of gold has still only gone up 4% this week… from what was within a whisper of being the five-year low in gold prices at the end of last week. If that doesn’t make people stash gold in their sock drawer, what is it going to take? I still do hold some physical gold that I consider to be a currency hedge, but hedging against the US dollar has sure not been terribly helpful over the past five years.

So those are some of my big picture thoughts, which you’re probably better off ignoring. I try not to make big investing decisions based on broad macro forecasts because they’re usually wrong (especially mine, but everyone else’s too)… but that’s the perspective I’m coming from.

In other news, and speaking of China and my only real Chinese investment, Fosun (656.HK, FOSUF OTC in the US) has another executive being looked at by the Chinese government in their anti-graft investigations — that particular move doesn’t seem critical to me, I was much more worried about the “disappearance” of CEO Guo a few weeks back, but the whole environment (and indeed, the whole Chinese market) is wild and wooly enough that I don’t want to invest more in Fosun even at what are fairly compelling prices now.

They do still own a lot of domestic businesses in China, and investments in industrial and infrastructure-related firms, and all of those are becoming less valuable, at least temporarily, as the Chinese economy slows a bit, the currency bumps downward, and the investorate panics. Many of their most valuable assets, to my mind, are overseas, insurance companies and other investments in Europe and the US, but that doesn’t mean they can’t trade lower. I’m not selling Fosun as the panic hits China hard this week, but neither am I jumping in to buy more, in the parlance of gambling that seems most apt to China investing these days, I’m “letting it ride” for a little while to see how things settle down. Fosun is a valuable company with visionary management and substantial growth potential, but it’s also highly levered and, clearly, quite exposed to the Chinese economy and stock market .

Here’s what I’ve done this week with my money, other than that sale of TGS Nopec shares noted above:

As will not surprise you, given the weakness in the market over the last five months since I embraced a “test” of stop losses in earnest[2] for my personal holdings, I would have been better off rigidly following the stop loss alerts from in almost every case. I have held back some positions from stop losses or ignored the stop alert when I didn’t intend to expose a core position to this test or was convinced it was a quick blip down that would recover within days, and in most cases (the only strong exceptions are Markel and Verizon so far) I would have been better off following the stop alert religiously. Much better, given the lousy performance of the market since August (assuming, of course, that I held the cash and didn’t put it back into something worse).

I’m keeping an open mind. I still don’t like automatic stop losses because they go against my bargain-hunting mentality and I hate selling when everyone else is selling in a panic, but I like that they call attention to stocks I should seriously reconsider or re-evaluate… and it might be that the discipline of selling is needed for capital preservation and to keep the mind refreshed (it’s hard to worry about the same falling stock each day). It would have been better for my portfolio to follow those sell alerts so far, but we have also the key “what to do with that money” quandary, particularly if the stock is one that is of long-term interest: Do you buy back in? If so, when? Tradestops also has a “rebuy” alert for stocks that regain some positive momentum, but that’s a high hurdle and none of those have come close to triggering the “rebuy” yet.

The stop loss alerts also helped me by banging me over the head with a hammer about the risk of the reinsurance hedge fund holdings I’ve often liked over the years — both Greenlight Re (GLRE) and Third Point Re (TPRE) have now hit stops (I’ll decide what to do with the balance of my TPRE in the coming weeks, but, as I noted a few days ago, I sold about half on the alert… and so far would have been better off selling all of it), and that helped me to think again about the structural problems in reinsurance.

So that’s good, and it saved me some pain in GLRE, which I probably would have been inclined to hold through Einhorn’s portfolio implosion otherwise because of my belief that he’s likely to recover as a manager. Sometimes belief is not enough, even if you’ve got a very good long-term investing track record like Einhorn does — these aren’t mutual funds, they’re built on an increasingly fragile reinsurance business and have high embedded costs when reinsurance isn’t profitable. I’ve not made a full about face, and obviously still hold some stocks who have meaningful reinsurance businesses, including Markel and Berkshire Hathaway (and, of course, some TPRE), but I’ve been forced by these losses to look at them under an alternate microscope… so that’s good.

And I’ve also had a stop loss hit for my position in Expeditors International (EXPD), which I don’t often write about but have owned for several years. I’ve sold covered call positions against the stock in the past, and, all told, I end up closing this one out at a 32% gain… I would have been better off selling near the $50 peak when I thought it was pricey enough to sell covered calls most recently, of course (I sold between $42-43), but that’s not how stop losses work and I can probably count my past successful “sell the peak” decisions on one hand. I held the stock for close to 3-1/2 years, so that’s about a 9.5% annualized return (including the small dividend, which I reinvested along the way)… not bad, but not sexy either.

I also sold my shares in the PureFunds Cyber Security ETF (HACK) on a Tradestops stop loss alert today (I sold the whole position). I’ll continuing to watch this, since I think the sector should be strong but I still don’t really have a handle on why I’d buy one cybersecurity stock over another in many cases — some of the components have been spectacular performers, others dramatic washouts, and that doesn’t necessarily bode well for a sector bet… you’d rather not see half of the stocks in an ETF be total disasters even as spending in the industry increases.

On the profit taking side, I sold my warrants on Grenville Strategic Royalty (GRC.WT in Canada) — they’re showing a nice profit and this was always going to be a short term bet that Grenville’s valuation would bounce back in the second half of 2015, since the warrants expire in mid-February.

I put much of the profit from selling those warrants into additional regular shares of Grenville (GRC.V in Canada, GRVFF OTC in the US), so there, at least, is one buy to counter all those sells — I have increased my position marginally. Grenville shares are priced probably about where they should be to reflect the risk level in this young financier right now. The effective yield is now close to 10%, and they’re still making deals and they report their fourth quarter early in February, so while I’m willing to ride this with a fair amount of volatility since each news item could move the stock by 10%+ quite easily (it’s very small and illiquid, only a C$75 million or so market cap) I didn’t want to hold my warrants through that earnings release on the very real chance that a 10% drop in the shares would bring a 30% drop in the value of the warrant with no remaining time to recover.

My Grenville equity position is just about flat now, my returns at this point have come almost entirely from the dividend (well, and this warrant speculation). The valuation seems cheap in the abstract, but is be based on where the market perceives the risk level to be for Grenville now — the market thinks it’s riskier than I do, so if perceptions improve, it would be entirely reasonable to see the stock trade at a 7% yield, closer to the much larger Alaris (which does similar deals with much bigger companies)… that would mean a gain of about 30% from these levels, but it is a long, long way from being certain that Grenville will attain that status anytime soon. The market often disagrees with me, sometimes severely and for long periods of time.

And I’ve mentioned that I’d keep checking in on Input Capital (INP.V, INPCF) because of the odd reaction that stock had to their ill-timed announcement of a few contract cancellations with farmers. That “odd reaction” was what made the stock inexpensive enough to seriously consider an investment[3], and I bought shares and continue to look for any commentary about those cancellations… but so far, nothing. They haven’t released anything further, either in filings or by press release, and I’ve seen no news coverage, so my presumption is that this is, really, just a one-time thing: They got rid of some contracts that weren’t working, and they’ll look to replace those with others during the prime winter season when a lot of their deals are made. Canola prices are largely unchanged, and futures trading isn’t indicating any expectation that they’ll go dramatically up or down in the coming year, so… still just holding this one. It’s reasonably priced, still, and an attractive model, but it’s not so cheap that I’d be thrilled to load up and make it a major holding… they’ll report again in the first week of February, so we’ll hopefully learn a little more then.

And I noted a while back that I’ve begun to experiment with Lending Club as a lender, as an investment (not the stock, which I’m not crazy about, but putting some of my capital into their distributed lending platform).

There have been still no losses/defaults so far in my LendingClub portfolio, which is the main area of risk, but it’s very early days. I continue to think of this investment as a small proxy for high-yield bonds in my portfolio — my hypothesis is that I’ll get similar yields to high yield bonds with lower default risk (because of much broader diversification of borrowers — I can lend to 50-100 or more individuals instead of a dozen companies), and I won’t have to watch the ticker every day and see fluctuations in the current value of each specific loan, which will probably be good for my soul.

This remains a small experiment, and it’s worth noting a few things:

I’ve made that point in past comments about Lending Club, and it remains my primary concern. If consumer loan defaults rise rapidly, my guess is that LendingClub loans will have higher default rates than mortgages and credit cards and car loans. I’m not worried about individuals defaulting for individual reasons, since broad diversification with hundreds or thousands of $25 loans is designed to account for that, particularly because rates are higher for higher-risk borrowers, but I am worried about systemic mass defaults. That remains the most substantial risk I see with LendingClub and the other peer-to-peer lenders, and we won’t really know more until the system is tested — the first time these systems were tested was in 2008/2009, and the peer to peer lenders were dramatically smaller then but believe they learned a lot from that baptism by fire… we’ll see.

My current net annualized return, as LendingClub reports it, is 9%, which is well above the historical range (4.8-7.2%) for accounts with similar risk characteristics to mine. My loans are heavily weighted toward the most credit-worthy borrowers, I chose Lending Club’s most conservative automated allocation system and am actually a bit more conservative than that right now, with about 80% of my account lent to A and B grade borrowers who mostly pay 5-9%. So it’s starting out well but, as I said, we’ve not had a real “stress test” for these kinds of personal loans in the past seven years.

Because each loan fully amortizes and the terms are fairly short (3 and 5 years are the loan terms they offer), I’m not terribly worried about interest rates — each payment that comes in on an amortizing loan can be reinvested at whatever the current lending rate is (“amortizing,” for our purposes just means that they pay the interest plus 1/60th of the principal for 5 years, or 1/36th for three years, each month — you get your principal back in tiny chunks along the way, there’s no repayment of principal at the end like there would be for a bond).

So… no great wisdom to impart on Lending Club, but readers have been asking and, well, so far it’s working like it’s supposed to work. That’s mostly because I haven’t had the bad luck to have one of my notes hit the grace period or a late payment or default, since it doesn’t take many of those to eat into returns when your portfolio is less than a few hundred $25 notes (my portfolio is tiny still, 71 notes and building as I develop some trust for this system). It’s not surprising that I haven’t had a “bad egg” yet, since it’s very early on yet and none of these notes are much more than three months old, but it’s at least not bad news, and a return of anywhere from 5-9% still seems compelling as long as it’s not closely correlated with the stock market and it’s not riskier than I think it is. We’ll see.

That’s a darn sight more blather than I intended to throw at you this week, but there you have it — my thoughts of chilly January Friday. I hope you have a wonderful weekend, and we’ll be back with more teaser solutions (and hopefully some bright and happy thoughts) next week. And since it’s January, I’ll be making sure to update my thoughts on each company in our little “Universe” over the next couple weeks… so strap in, the blather’s just getting started!

  1. the report came out just this week:
  2. I embraced a “test” of stop losses in earnest:
  3. seriously consider an investment:

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