by Travis Johnson, Stock Gumshoe | March 23, 2018 12:25 pm
I just realized that we blew through the 11-year anniversary of the launch of Stock Gumshoe just a few days ago… and forgot to have a party or light the fireworks or anything. Ooops. Guess I was distracted by this nutty stock market… so, “happy birthday to us!”
And thank you, dearest Irregular, for making it all possible with your support. We rely not just on your subscription dollars to keep the lights on, but on your keen mind as you send us appealing teaser ads, make wise comments on our discussion threads, and, yes, tell me when I’m being a bonehead — I couldn’t do this every day without you.
So what comes to mind as we enjoy another week of that favorite classic horror movie, The Return of Volatility? Will we close out the week with another wave of panic as investors fret about holding their positions through a “who’s gonna tweet what” weekend? I don’t know, but there’s some chance of real shakeup in the markets if this latest trade war panic doesn’t get accepted as a “buy the dip” moment, so hopefully we’ll see prices fall enough that there will be compelling buying opportunities under the surface.
Stock investing is based on hubris. To invest in select stocks is to puff out your chest and say that your opinion or analysis is worth more than the average person’s. Or the average investor’s, at least.
So to make that work, you have to be above average in some way. You need to be above average in your determination to identify unique ideas or perspectives. You need to be above average in your patience level. But more than anything else, you need to be above average in your ability to think independently. If you’re just going to sell everything that’s falling and buy everything that’s rising, you might as well just spend your time doing something more fun or rewarding, or indulge your gambling instincts at the casino, and invest all your important money (retirement savings, college savings, etc.) in index funds. That’s what indexes do — they own everything and make little to no value judgement, but on the margin they buy rising stocks and sell falling ones.
And there’s absolutely a place for that. Index funds and/or low-cost active funds that are widely diversified are a great place to put the majority of your equity investment capital — particularly if you don’t enjoy the hobby (sometimes torturous, sometimes euphoric) that is investing in individual companies. I’d give the edge to the strong and patient active managers at the moment, just because I think they have the potential to profit from the short-sightedness of the index funds and the “bubble” in indexing (where does a “fair” market price come from once we run out of “active” investors, after all?) … but certainly the index funds were the place to be over the past ten years, because they don’t ever overthink or overanalyze or keep some cash to buttress market moves or protect investor capital: They just buy everything, and the more popular and large it becomes, the more they buy it. That has been an extraordinarily successful strategy since the collapse of the market.
If we’re really going to be moving into a new era here, as is being telegraphed by the dip in early February and the trade war fear dip this week, then individual investors might have some advantage if they can avoid being overwhelmed by emotional response. If the market falls sharply, some asset managers will have to sell because some of their investors will pull out their capital — mutual fund and hedge fund redemptions helped to drive the last market crash, as falling begets selling which begets falling which begets more selling, so if you can just try to take a stop back and think rationally about company valuations there may be bargains in the wind if we continue to see these choppy reactions to political and regulatory nuttiness… but, of course, that’s hard to do.
That’s a big part of the reason why I invested about 1% of my portfolio in a hedge position early this year, because that allows me to get the worries about a 60% market crash out of my head and focus on what I should do if the market falls 10 or 20% or a few stocks I like fall more than that. Sometimes a hedge is important to actually protecting capital in a portfolio, either short or long term, but I find it to be particularly important to my emotional wellbeing as an active investor — if I know the downside risk and have calculated it and controlled part of it, I don’t spend hours fretting over things I can’t control.
And the simplest and cheapest hedge, of course, is cash — in a richly valued market, you don’t have to be fully invested… holding on to cash and waiting for what Warren Buffett would call a “fat pitch” doesn’t hurt, but don’t plan to buy the bottom or pull your back out trying to hit a home run as soon as the first good pitch comes — no one knows what the bottom will be, whether we’re going to have a relatively placid 10% dip or whether the market’s going to keep going down and hit a 25% correction or a quick crash or worse at some point. That means the most sensible advice I can give is to have some hedges in place either in the form of excess cash or downside protection (puts or short positions, for the most part), which will help to protect you a bit and keep your head straight… and buy in small bites when things start to look tempting. I did a bit of that today with Naspers, we’ll get to that in a moment…
So what’s going on this week?
You already know that I’ve been thinking quite a bit about my large Facebook (FB) position, I wrote about that on Wednesday in a special “early Friday File“ for you, and nothing has changed yet. It hasn’t hit my stop loss level below $157 to force a partial sale, and it hasn’t really shown signs of real recovery either. We’re all waiting to see how Zuckerberg’s painfully ham-fisted apology and Facebook’s future changes impact users, and whether regulatory pressure will become substantial enough to hit Facebook’s revenue growth or costs in a meaningful way. Lots of unanswered questions, and that will probably be true for a while… though we should probably lean toward the general tendency of “big guys win” even as we keep an eye on the exit in case we’re wrong.
What does that mean? It means that, all else being equal, harsh or even oppressive regulation or new taxes or strict new rules (like rules for handling or disposing of personal data, for example) tend, over time, to favor the incumbents — the companies that are already huge and can afford to deal with any new rules. Those companies, like Facebook in this case, might see their business hurt — but that also keeps new competitors out, because the little guys nipping at Facebook’s heels are much less prepared to handle new costs or onerous new rules. “All else being equal” is a key part of that, though, and sometimes companies do really implode or face disastrous changes, even big companies, and sometimes regulatory or legal pressure really is aimed at a single company, so keeping that one eye on the exit is important. And, of course, it doesn’t help that in this case, Facebook’s management is so far proving itself inept (or naive, if you want to be more charitable) when it comes to public and governmental relations.
I did make one small profit-taking trade in my speculative positions this week, with my Square (SQ) 2020 options having increased by close to 200% I sold off half of that option position to book profits, and will let the remaining half ride. I certainly still like Square’s prospects over the long term, but because of the risks of options I do generally like to take partial profits on the way up if I have a position that’s of meaningful size that experiences a big run-up. With a very richly valued and fairly large company like Square, that’s also fairly important — if it starts to get valued based on its current business instead of on growth hopes, the stock could easily come down sharply (Cowen just downgraded the shares to sell this week, and analysts are generally skeptical, with the average price target at $47 and change, well below the current $53 share price).
And we had some more “normal” news with portfolio companies as well…
Five Below (FIVE) had a great holiday quarter, though the stock price was anticipating that (and the company had already guided investors to expect a “beat”), so the “beat and raise” report didn’t move the stock very much… perhaps because they only raised expectations for the first quarter, and their projected earnings for the year were just in line with what analysts had been expecting.
I don’t know why we’d have any confidence now about what forecasts are for the critical holiday quarter that doesn’t start for more than six months, but you have to start somewhere — and we’re starting with analysts forecasts of $2.42 for FY2019 (which is underway now, ending next January), so FIVE currently trades at 28X forward earnings… or, if you want to go out a year, as investors will begin to do soon when they use the “forward PE”, almost exactly 20X next year’s earnings.
That’s pretty solid, still, for a company that is expected to grow earnings by at least 20% a year for the next few years (35% this year), and that is growing both store count and same-store-sales as they expand nationally. The high valuation means the stock will be volatile if expectations change, however, and FIVE is a fad-driven retailer so it’s definitely possible for them to have a terrible quarter if they misjudge or mismarket something. If they do that in a holiday quarter, the stock could easily lose half its value in a matter of days. That’s the price of high-growth speculation… but I do think the company has enough of a track record of strong store openings and strong merchandising that they deserve some level of faith on that front. And they are in a pretty strong position, they have enough scale to be very profitable but they are still quite small, pushing for national expansion and 100+ store openings a year at a time when retail vacancies are a problem and rents should be more manageable (and good locations more available).
We’ll see, but I’m still happy with my position in this speculative retail stock — they have real growth and a long runway of more growth potential if their stores are as popular in new towns as they have been in their existing areas. I don’t think any festering trade war is likely to be targeted at $5 stuffed animals and mermaid blankets, so this will probably remain a company-specific story: If they keep growing same store sales and keep opening new stores, investors will keep buying the shares. The stop loss price is about $55, so that’s where I’d rethink this one on the downside, and I’m not interested in making this a larger position just yet (it’s close to a 2% portfolio position already), so for now I’m just watching.
Altius Minerals (ALS.TO, ATUSF) again expanded its potash royalties, which are some of the longest-life mining royalties on the planet — this time they paid C$65 million to Liberty Metals and Mining, which is the insurance-funded private equity partner with whom they bought their big royalty package a few years ago, in order to buy out most of Liberty’s share of the Potash Royalty Limited Partnership… that will give Altius about 91% of that partnership, which has royalties from six producing potash mines in Saskatchewan that have an estimated 49 years of remaining production (assuming they don’t do more exploration to extend that). These mines are also ready to increase production if prices and demand warrant, most of them have invested in expansion and, as a group, could “almost double production” according to Altius’ press release.
We don’t know what the value was of these potash royalties when they were first purchased, because they were part of the large Sheritt royalty acquisition — that whole package cost Altius and Liberty (and some smaller partners) about $460 million, but the six potash royalties were somewhat less important to the full value of the deal than were the five coal royalties, which generate much more revenue (though potash has looked better lately as coal production has dropped — those potash royalties before this deal generated 16% of Altius’ revenues in the last report, versus 20% for thermal/electrical coal).
So what kind of impact might this have on Altius’ income statement, in exchange for that C$65 million? They are effectively increasing their ownership of this royalty portfolio by 75% (from 52% to 91%), so presumably their cash flow will, all else being equal (which it won’t be, but we have to start somewhere), increase by 75%. Their royalty revenue from potash over the past eight months was C$7.37 million, so we can annualize that since it was an odd 8-month fiscal year (they’re converting to a January fiscal year) and guess that a full year at that pace would generate C$11 million in Potash royalties. Adding 75% to that from this Liberty transaction would mean that we boost the total by about C$8.3 million… so the total cash flow from potash could be $19.3 million. That means they paid $65 million for a possible $8.3 million in annual royalty revenues — a pretty steep 8X revenue, but all of those royalties are on producing mines with very long reserve life and with expansion projects already underway. And, of course, the hope is that potash prices will not just stay stable but will rise. Altius won’t be incurring any extra costs, it is no more expensive to cash a $19 million check than it is to cash an $11 million check, so that additional $8 million goes right to the bottom line (well, before taxes).
The upside is time and/or pricing, as Altius thinks ahead to how much cash flow will come from this deal in 2025 and 2030 and beyond. The downside, of course, is that potash pricing could fall, and could be much lower for a long time. Potash is not that rare, and most potash mines are huge and capital intensive but also likely to be easily cash flow positive at current prices. The pricing is controlled by a few major producers, including Nutrien and Mosaic who own those mines on which Altius has royalties, as well as the Russian and Belarusian producers who also have low operating costs, and global inventories are fairly high right now… with some influence from buyers as well, particularly the Chinese, who can make large annual deals for massive amounts of potash and thus have some leverage when producers are in need of cash.
The spike on potash prices a decade ago caused a lot of investment by folks like BHP Billiton, who spent a ton of money planning the Jansen mine in Saskatchewan but might want to sell it rather than keep pouring money into development, and also caused the dissolution of the potash cartel arrangement between Belarus and Russia as they fought over who could sell how much to the Chinese. It costs a lot of money to build a potash mine, these are heavy tonnage projects (BHP might spend as much as $14 billion on the Jansen mine if they move forward with development, which has some BHP investors very antsy), so they don’t just pop up all the time… but because of those huge capital investments and the small number of major producers, the market has been dominated by either formal or informal cartels and price management for a long time. Demand is perpetual and rising, but supply is to some degree flexible as producers try to either maximize short-term revenue or maintain pricing power.
Potash pricing has been steady in the low $200s for a couple years now, so these royalties have not generated dramatic returns… but they have been solid, and this will increase the cash flow. Altius can easily afford the deal because of the investment they received from Fairfax Financial, so as long as we are indeed near a cyclical low in the potash market, as seems likely, this will work out very well over the long run — if potash returns to super-low controlled pricing like in the pre-2007 years, like iron ore, or the Russian potash cartel starts dramatically overproducing and drives prices down, then it could take a lot longer for these royalties to pay for themselves… but with 49 years of mine life on some of the biggest and most productive mines in the world, and a critical mineral that’s essential for global agriculture, they will pay for themselves eventually. It’s just a matter of time.
This means Altius’ investments over the past couple years have focused first on copper, then on iron ore and now potash, all commodities that look like they might have bottomed out near the time of Altius’ investment… at least so far. So that’s good, that’s why Altius is in my portfolio — because they try to buy commodity exposure, mostly through royalties, when prices are in the lower part of their long-term range, and sell projects when prices are bumping higher.
I’m pleased with Altius’ expansion of these potash royalties… but it looks like Liberty might be pulling back from their commodity investments in general, because they also sold their interest in Alderon to Altius this week, and that’s a less compelling (though also much smaller) deal for Altius.
If you don’t remember Alderon (IRON.TO, AXXDF), it owns what’s now known as the Kami project, which is an iron ore prospect that Altius staked back in 2004 and explored for a while, then split off into a separate company, Alderon, that was spun off and raised its own money in the public markets. Altius maintained a minority equity stake, but the real value is its 3% gross sales royalty on the Kami project, which for a while looked like it could generate massive annual cash flow in fairly short order… until the iron ore price spent a couple years falling as Chinese demand slumped (2012-2014 or so), and Alderon failed to get financing to develop the mine despite some strong early partners (also Chinese).
Alderon then tried to buy Bloom Lake in a fire sale to get access to that infrastructure (that’s a nearby mine that closed down a few years ago because of high costs and low iron ore prices), and failing that they’ve basically just been waiting for better prices… though this past year saw some reorganization at Alderon that indicates they might be getting fired up to do something active again. I’m keeping my expectations low, particularly as iron ore suffers through a weak month (perhaps pressured by worries about Chinese demand, iron prices are now back down to December levels after surging a bit earlier this year).
That fluctuation in the iron price is going to hit Altius’ cash flow as well, since they’ve invested heavily in Labrador Iron Ore over the past year (they now own roughly 5% of LIF.TO), so the metals fluctuate but Altius remains levered exposed to copper, potash, and iron ore prices, and to thermal coal sales volumes (those Alberta power plant deals are per-tonne, not price-based), in roughly that order (the only other meaningful drivers are zinc and metallurgical coal). And there are plenty of other drivers as well, including possible labor disruptions at Labrador Iron Ore (where worker contracts are about to expire), and possible mine development or prospect generation success.
So I’m not particularly thrilled that Altius is sinking more into Alderon equity, though it’s a fairly trivial amount (Alderon’s market cap is down to $30 million or so, and Altius now owns about 40% — this latest purchase was only about $5 million), and who knows, it might have been a sweetener for the Liberty Metals sale of the Potash royalty position that’s far more attractive and lower-risk… and I do like the potash investment. Those Alderon shares were bought by Liberty at much higher prices, when Kami was just completing its preliminary economic assessment and some big offtake agreements and seemed on a fast track to development… so maybe Liberty’s just happy to get those shares off their books at a 90%+ loss so they can wipe the slate clean (Liberty paid a total of about C$53 million for these shares back in 2012). Alderon is again talking about being on a “fast track”, and they brought back their old CEO earlier this year (he had left in 2015, when the project was basically put on mothballs), so who knows… if they do get going, that could be a huge leveraged win for Altius, but I suspect the odds are not great unless iron ore goes crazy again.
Altius is still doing the right things, though the nature of being a commodities investor and financier is that it might not matter if you do the right thing if those commodities don’t follow the expected cycles and eventually recover in price. If we go back to the 1950s-1990s trend of commodity deflation (mostly) or relatively flat commodity prices, this model isn’t going to work — I think that’s a fairly low risk in an increasingly globalized world with a growing population and increasing urbanization, but it’s still a risk. The world of commodity pricing was completely thrown out of wack when China went whole hog on growth in the early 2000s, and the “China Industrialization” era of the past 15 years or so really defines the expectations of most commodity speculators, so there’s plenty of risk if the future is different than the recent past.
In other news, Naspers (NPSNY) announced that it will sell about 8% of its Tencent (TCEHY) holdings, as Tencent released earnings and the shares had their worst day in a long time (down 10% or so) because of a stated focus on retaining earnings and reinvesting in growth… you know, the same stuff that makes investors love Amazon (AMZN) more, but apparently makes them now worry a bit about Tencent (not that much worry, the stock has still roughly tripled in the past three years). The Reuters story about Tencent earnings is here.
And, of course, there’s plenty of reason to be cautious with Tencent, just as there is with Amazon — it’s crazy expensive, it’s huge, it’s subject to regulatory oversight by (arguably) the most totalitarian major economy in the world, and revenue growth was lower than expected last quarter.
But, oh man, how it’s growing. Even that “lower than expected” revenue number was crazy growth — 51% growth for the year. They booked impressive profits for the year, though that was largely because of some successful spinoff/IPOs of their investments and subsidiaries, and they won’t likely replicate that this year… though they do still have Tencent Music, and they are going to invest heavily, they say, in their Weixin Pay service and in video and various cloud and AI initiatives (pretty much every big tech company says they’re investing in “cloud and AI,” though that could mean almost anything at this point).
Tencent has now given up the gains it made in the first few months of this year, with the stock back down to roughly where it was during the February dip… so it’s not being crushed, by any means, but is back down to a sub-$500 billion valuation. Analyst estimates are of questionable import here, I suppose, given the crazy-high valuation and the extent to which the share price has blown by the earnings growth, but the current estimate is for $1.35 in earnings in 2018 and $1.75 in 2019 for the OTC shares that are currently priced in the low $50s, so the current year PE is about 38 and the forward 2019 PE is just a whisker under 30. Maybe that can be justified for the dominant platform company in China when it comes to messaging, games and payments, maybe not, that’s a judgement call… but the shares are at least a little more attractive at $50 than they were at $60.
What does that mean for Naspers, which I’ve not owned recently but long favored as a way to buy Tencent at a discount? Well, Naspers fell a little bit less than Tencent on earnings — perhaps because they’ve finally decided to do something about their sharp discount to their Tencent holdings by selling that small slice. If we assume that Naspers has sold the shares, now has just 31.2% of Tencent (down from $33.2%), and has that $10 billion in cash, that would be worth about $165 billion. Naspers currently has a market capitalization of $116 billion and about $4 billion in debt, so it’s still trading at more than a 25% discount to the value of its Tencent stake.
The risk, of course, is that Naspers is valued only based on that Tencent stake, and while that may have been the best venture capital investment of all time (they paid $34 million for their now-$165 billion stake in the early 2000s), investors would like Naspers to do something else to justify themselves… so pressure is fairly high.
And some of the business is quite challenged, including the cable TV and news businesses in Africa that were the original core of the company… and given the perennial political crises in South Africa, where Naspers is headquartered, there’s an additional layer of regulatory risk. Naspers says their Tencent shares are held in offshore entities and shouldn’t be taxable, but even with the hopefully investor and economy-friendly transition of power in South Africa we probably shouldn’t count on that being the case forever. A country changing its laws because of the actions of one company wouldn’t be that unusual — particularly when that company is by far the largest in the country.
On the flip side, Naspers has also made a lot of other interesting investments over the years that have flown under the radar but could pay off, including what is now a 16% stake in Flipkart, the Indian ecommerce leader, as well as dozens of other smaller investments in technology companies around the world… and now they have another $10 billion to spend on finding more growth. The problem in judging the results of any of these investments is that the Tencent stake completely obscures everything — whether we apply a 10% discount or a 20% discount to the Tencent stake matters a LOT more to Naspers’ valuation right now than whether or not Flikart manages to hold off Amazon in India, or whether MakeMyTrip or Mail.ru makes great strides in India or Russia, among other substantial investments in the Naspers portfolio. None of those other things move the needle yet… but they might someday, and in the meantime you still have that huge Tencent position and can continue to participate in the anticipated growth of (arguably) the most dominant tech company in China.
So… will another Tencent emerge from this Naspers portfolio? Probably not, that was a once-in-a-lifetime deal, but they have had successful investments and it’s possible that their venture capital investing will find some more large winners even if they don’t generate 500,000% returns like Tencent. They’ve definitely spread the money around, so they’re not making all or nothing bets and they are applying some discipline (including cutting back on some African investments that aren’t working), but it will take patience and there will be a lot of uncertainty along the way.
Still, that discount calls to me… so although I’ve been watching the stock for a while and haven’t yet found a really tantalizing price, I’ll bite the bullet here and pick up a very small position on this 10% dip and the potential news that their $10 billion in investable cash might generate as they aim to get more attention for their non-Tencent investments. That will help me to watch it more closely… and, as always, I’ll let you know if my opinion changes.
Some readers also asked me about Alphabet/Google (GOOG) recently, so here’s my thinking there…
Alphabet (GOOG) is not dirt cheap just yet, perhaps, but it’s awfully cheap compared to the other internet giants around the world, from Facebook to Tencent to Alibaba to Amazon to whoever else you want to use in your comparisons. I think we’re continually underestimating the potential at Alphabet, mostly because it’s so huge and remains fairly opaque in describing how they’re spending their massive cash flow on venture capital-like initiatives in biotechnology and self-driving cars and whatever else.
Right now, GOOG trades at a a forward EV/EBITDA ratio of about 12 (trailing about 19)… which is certainly not the lowest that number has gotten, it was down to 9-10 on a trailing basis from the 2009 crash to 2012 or so, when Alphabet’s share price was pretty moribund and the stock was still suffering under the inscrutable leadership of founder Larry Page, before a more investor-savvy CEO took charge and started to provide some clarity and discipline regarding their “other bet” investments outside of the core search/advertising business. But it’s pretty low… if you give me a choice between GOOG at $1,000 and FB at $175, I’ll take GOOG.
Which, come to think of it, is the choice all of us face each day. I can’t trade FB today, since I wrote about the shares and initiated a stop loss order on Wednesday, and now I can’t trade GOOG either since I’m writing about it here… but I’ll keep an eye on that dichotomy in the future if it seems to me that the pressure on the industry brings GOOG down further. I bought my first Google shares when they dipped around the time the IPO lock-up period ended just over 13 years ago, so I’ve been sticking with this one for a long time and probably will continue to do so given their fantastic earnings power and (relative) diversification — though I last added to my position when it was around $800 a share back in early 2017. I’ll let you know if that changes.
And that’s where we’ll leave it today, dear friends. Have a great weekend, enjoy the first signs of Spring, and I’ll be back to blather at you next week.
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