Friday File: Portfolio Transactions Catch-up (2 sells, 5 buys)

by Travis Johnson, Stock Gumshoe | July 13, 2018 1:01 am

Hello, dear friends — I have a few portfolio updates to start with as I get you updated on a few trades that triggered since I last wrote, so adjustments to the portfolio (including a few buys and sells) will be the focus of today’s Friday File. The latest update to the Real Money Portfolio is also available for those who want to see more detailed numbers.

Omega Healthcare (OHI) hit my profit target as optimism improved, and I sold that position. The pause in their dividend growth this year means this is not a “hold forever” kind of stock, and they continue to have some challenges with the concentration of their portfolio and the regulatory risk of medicare and medicaid as it relates to skilled nursing facilities. It’s undeniable that the demand for skilled nursing should rise, given the aging population, but it’s also undeniable that skilled nursing is a hard business without huge barriers to entry and without pricing power, given the dominance of government insurance in that marketplace. So many skilled nursing operators are skating close to the edge when it comes to sustaining their businesses, and when lots of operators are at risk that means the landlord is also at risk.

This is nothing new, that’s the reason for the shares collapsing last year — and I thought that was an overreaction. But now that we’ve recovered from that overreaction, I’m willing to sell the shares with a decent profit and move on. I think there are better ideas for long-term growth in real estate, and have moved some of that money to those ideas.

One of those is Kennedy-Wilson (KW), so I added a bit to my KW position, increasing it by about 20% with some of the proceeds of the sale of OHI — largely that’s just to keep my real estate allocation from dropping too substantially, and KW has been performing well as the market has grown more accepting of their ability to thrive even if interest rates rise a bit. I wouldn’t add dramatically to the position here at $22 or so, there may be more opportunistic price points in the future if we have another interest rate scare or a quick real estate panic, as happens from time to time (or, of course, a real estate crisis)… but adding on a bit makes sense to me and the value is still rational, if not cheap.

And another is Innovative Industrial Properties (IIPR), our little REIT that owns medical marijuana growing facilities in the US. The shares of that one dipped just below my maximum buy point of $35, so I added a little bit to the position. The stock is driven by marijuana sentiment, for sure, so it often goes a little crazy and it is even a bit on the expensive side right here, given the risks (primary risks in my mind are are customer concentration and ability to continue to make reasonably priced deals, though the industry itself is obviously all at some regulatory risk), but the financials of their deals are so favorable that they make up for a lot of that, and as long as marijuana sentiment doesn’t crash the stock could do very well as one of the “safer” players in the space that has the potential to dramatically increase its dividend over the next few years.

So both IIPR and KW are now 1% positions in the Real Money Portfolio.

But that wasn’t all — a few other transactions hit as well. I made a very small add-on investment in Clean TeQ, which has taken a big hit since they released their definitive feasibility for the Sunrise cobalt/nickel project in Australia (mostly due to the increased capital cost, I expect), and I’ll go into that in a little more detail in a moment, and I added another dumb speculation down at the bottom of the portfolio, but I also added one brand new position of substance to the portfolio this week in Starbucks (SBUX), which went onto the watchlist not long ago.

I picked up SBUX shares as it recovered from the dip below $50 a share. The reasons are fairly simple: The stock has been dead in the water over the past three years, but the business has continued to grow, which means that the value of the business has finally grown to catch up with the market price. Buying a dominant consumer brand, with large expansion possibilities still extant (particularly in China, though also in more brand extensions outside the coffee shops), with a valuation that’s arguably below the market and with a high and growing dividend (near 3% yield, with the dividend increased by 20% just this quarter), is too good to pass up.

There’s risk, of course. They will be under new management, and things fell apart a little bit the last time Howard Schultz left Starbucks… their ambitious Chinese growth plans might falter, which would put more focus on the flat sales performance of their US stores… higher coffee bean prices could pressure their margins… and there’s also political risk if Schultz really ends up running for president or something similar and generates a backlash for the company… but at this valuation, with this global brand strength, high and sustainable profitability, and fantastic balance sheet, I see a lot to like to make up for those potential risks.

They don’t have to grow very much to justify this valuation, the stock is trading at 19X next year’s expected earnings and should be growing earnings at least 10% a year, and I think investors have all but given up on the stock after three years of doing nothing. That doesn’t bother me, because I didn’t own it during those three years, but I think buying strong brands at a discount is worthwhile. Starbucks opens at about a 1% position in the Real Money Portfolio — that’s a little larger than my typical entry position, but for a large cap stock like Starbucks where I believer the risk and volatility should be a lot lower than for many of my speculations, it’s a little silly to tinker around with really teensy positions.

And together with all of these “hellos” to stock positions, we must also add a “good-bye” … Xylem (XYL), the water treatment stock I bought early this year, hit our stop-loss trigger point and I sold it from the portfolio. That was also roughly a 1% position, so in some ways Starbucks is just taking Xylem’s slot. We’ll see how it works out.

Why sell Xylem? I don’t slavishly follow stop-loss alerts, as you’ve probably noticed (we had several others hit recently that I did not act on), but I do pay special attention to stop-loss alerts for positions where I have low conviction or where the primary driver of the stock is the “bull market momentum” excitement. Stop losses are more meaningful to me if I don’t see a specific level of real fundamental support from current earnings, which usually means that it’s a growth stock that is driven by high expectations.

In this case, it’s mostly that my conviction is low and I’m therefore more willing to take my cues from the stock price. I think Xylem has a decent chance of building a strong water treatment business, and there should certainly be substantial global demand for their products and services, but they are also priced very richly as a roll up business and need to be able to acquire more companies to get meaningful growth, which means they need to keep that lofty valuation so they can use their stock as an acquiring currency, and they’re also facing cost pressures in materials. I bought it because of the potential of the roll-up strategy and because of the sector, but I could also easily imagine the stock falling 30% if optimism dips (it’s trading at a high PE relative to most of its competitors right now, 28X trailing earnings and 20X forward earnings), so I’m following the stop loss recommendations from Tradestops.com on this one. Xylem drops out of the portfolio and we record a small loss of just under 5% for that six-month hold.

If you’re wondering what those other stop losses were that have been hit since I last wrote to you, in addition to Xylem they are Altius Minerals, Berkshire Hathaway and Boston OMaha (each of which has hit stops several times recently, and which I’ve determined to hold — my opinion hasn’t changed on these), Clean TeQ Holdings, and iQiyi.

That iQiyi (IQ) stop loss triggered during this recent China-stock washout in the wake of trade war fears, which has hurt pretty much all of my speculative Chinese positions (mostly options on big tech names), but because I took profits on the options for IQ to subsidize this position, I’m giving it a little more room. The surge to the mid-$40s was ludicrously fast for a fairly large and far-from-profitability company, but they do appear to be establishing a strong brand and customer base.

On the other hand, Baidu (from which IQ was spun out via IPO earlier this year) has sold some more shares, which the market took as bad news, and all the concerns (competition from Tencent and Alibaba, lack of profitability, need to invest heavily in content) are still there… and there’s also the IPO lockup expiring in September for those institutional investors who were talked into buying when BIDU first floated the shares, so that could pressure the stock as well. Steel yourself for some volatility if you like this stock as a long-term position.

And I promised to go into more detail on Clean TeQ (CLQ.AX, CTEQF), so let’s do that now.

The definitive feasibility study for Clean TeQ’s Sunrise project did get released at the end of June, as expected, and the release put some pressure on Clean TeQ shares — mostly, as I see it, because of the increased capital cost of the project in their updated estimates. That increased cost appears primarily to be due to the plan to increase refining capacity to enable them to increase cobalt production more quickly, which seems reasonable to me given the need to meet the huge cobalt demand as early as possible, when prices are still high and before other supply hits the market (either from existing producers becoming more acceptable, perhaps through some sort of change in the Democratic Republic of the Congo, the world’s dominant cobalt producer and a political pariah to most of the world, or from increased nickel prices that help drive up cobalt production elsewhere).

The report also indicated that the final decision to proceed, called the Final Investment Decision, will now be early in 2019, so that’s another bit of disappointment for those who expected the decision to be made immediately and the funding to kick in as soon as the feasibility study was released. That adds a few months to the projected production date, most likely, but in the end it probably won’t make a meaningful difference. In truth, the final investment decision has really already been made, at least by Clean TeQ — they’ve made some massive up-front investments in equipment and site preparation, and have raised a lot of the capital they need… but they do still need additional bank funding or offtake agreements, so they can’t formally begin construction until that financing is officially in place.

So the big things now, aside from the price of nickel and cobalt which will drive the eventual profitability of the mine, are the capital costs and the timeline for construction. Capital costs are now estimated at about $1.5 billion, and the net present value of the project, given their price assumptions ($7/lb nickel plus $1 sulphate premium, $30/lb cobalt, $1,500/kg scandium oxide), is $1.39 billion, with a post-tax internal rate of return of 19.1%.

A 19% return is not outrageously exciting for a mine developer, but this is an unusually long-lived project that will likely produce for far longer than the initial 25 year estimate… assuming, of course, that there is still abundant demand for nickel and cobalt, whether for lithium ion batteries or some other purpose.

So what we’re looking at is a mine that I think should be fairly easy to finance, given that $500 million of funding has been effectively “pre-committed” by Chinese partners and that they can now sign offtake agreements with some of the folks who really need cobalt… but they do need to raise some more money, and it could be that some of that ends up being more equity, which would pressure the share price further. I’d guess that we’re likely to see the required capital come from debt, perhaps from Chinese banks or partners, or offtake agreements, given the depressed share price, but that’s just a guess — so although it’s quite possible that the stock will dip further, particularly if they surprise me by having any trouble raising funds, I did add slightly to my holdings this week. A $400 million company with strong management that has a large ownership stake is a reasonable buy when they’re sitting on a project with an estimated value of $1.4 billion. Not a no-brainer, to be sure, but a reasonable point for me to average down a bit on my position, given my level of confidence that cobalt will remain an important battery metal.

Lots of folks say you should never average down, of course, and shouldn’t chase badly performing stocks with new money… but I don’t like to use any “never” rules. Your money, your choice.

And speaking of feasibility studies…

What about Sandstorm Gold’s (SAND) PFS for what is by far their most important project, the Turkish Hod Maden project that they acquired a junior shareholding in when they bought Mariana Resources? That was released recently as well, and the weakness in the gold price and the lack of real “new” news in that PFS has helped the world to continue to ignore Sandstorm’s shares.

There looks to be no real surprise in the Hod Maden PFS, it’s still a low-cost mine to build and it will still produce a huge amount of gold. They’re planning to start their definitive feasibility study by the end of the year, which will be important because they intend to fund most of the development costs with debt (the feasibility study is to convince the bankers), but as of now the PFS puts the after-tax value of the project at $1.1 billion — which means Sandstorm’s 30% stake would theoretically be worth $330 million (they paid roughly $175 million for the stake when they bought Mariana almost exactly a year ago).

Sandstorm is expecting to be on the hook for $30 million in capital investment for their share of the equity financing for mine development, and such things are often hyper-optimistic… but we can hope. The mine is so high-grade and so large that it should be easy to justify developing the project even if gold falls 20-30%, though it wouldn’t be surprising if a weaker gold market delayed things — and we are left also with the overlying risk of “this is in Turkey” that will worry some folks, though with a well-connected operator in Lidya I don’t imagine they face any real political risk in the current environment (the world continues to turn, of course, and things change).

There’s still risk in having a lot of the value of the company tied up in a single project, and Sandstorm is still going to be weak when gold prices are weak, but there’s little downside and no debt and if gold eventually rises in value Sandstorm will become rapidly more valuable. I don’t know if that will happen or not, but I do keep a portion of my savings in gold bullion and a portion of my equity portfolio in gold-driven stocks, primarily Sandstorm and Franco-Nevada (FNV) (both are passive royalty companies), because I think gold continues to have value as “disaster insurance” against faltering currencies or other crises, and I expect that gold will hold its purchasing power over the long term as central banks continue to try to boost inflation.

Which is a long way of saying that Sandstorm is going to do exceptionally well if gold surges, and will be weak if gold falls… but unlike junior miners or riskier gold plays, they have very limited operating costs and almost no liabilities (other than that $30 million they’ll likely have to contribute to Hod Maden, which they can cover easily), so they won’t be at risk of going out of business if a mine fails, and they won’t have to dilute shareholders if gold prices fall. They should thrive in the next upturn and survive the next downturn, and they’re quite a bit cheaper than Franco-Nevada or the other major royalty companies, perhaps because there’s still some overhang of fear about that Hod Maden project. I expected gold to have a better year this year, mostly because of fears of political upheaval and continuing currency crises in Europe and elsewhere, but that certainly hasn’t been the case yet — the dollar has remained strong and has continued to be the “flight to safety” investment as interest rates rise and the world fails to worry about debt levels… but I still want this gold exposure and am likely to remain stubborn at maintaining that exposure, so for now all of my gold investments are a drag on the portfolio.

And one more note on a transaction… this one is in the “dumb speculations” category and comes in at about a one tenth of one percent position (just barely large enough to be worth telling you about — I don’t typically include positions below 0.1% in the Real Money Portfolio).

I bought Renaissance Oil warrants (ROE.WT.A is the Canadian ticker). I’m a sucker for long-term warrants, and these are highly speculative, with 2 years to expiration but in the money by about 5 cents and trading at about 10 cents. Each A series warrant entitles the owner to buy ROE shares at 20 cents anytime before the warrant expires on October 6, 2020. As of right now, ROE shares trade on the Venture exchange in Canada at 24 cents, so the warrants are “in the money” by four cents and anything beyond that is speculation about the “time value” of the warrants and whether the stock might rise in the next two years. I paid about 10 cents per warrant.

ROE could easily fail, but I don’t have much oil exposure so this is a small risk, large reward scenario. I’ve covered this one before, with some skepticism, when it was teased as an oil giant in the making thanks to their exposure to the newly privatized oil fields in Mexico — Keith Schaefer pitched it back in 2015[1], and Christian DeHaemer last year[2], and the stock is right near where it was when it was pitched in the past — but I think the story has improved a bit, with production likely to increase soon as they’ve gotten additional permits and are expanding their footprint in Mexico with additional properties, and with the oil price rising. This is likely to be an all-or-nothing investment over the next couple years — either oil keeps rising and Renaissance is able to ramp up deeper unconventional onshore production, and the production rises dramatically and the stock climbs… or they keep producing minimal amounts from their conventional wells and selling more stock to raise cash and the shares falter. Assuming, of course, that oil stays in this range above $50-60 and doesn’t collapse or skyrocket, either of which would also be likely to have a big impact on the stock.

Other questions? Here are a couple…

Why is Ligand (LGND) soaring again?

Ligand recently announced an agreement for expanding its OmniAb platform with WuXi Biologics, and that brought in more up-front cash, so they updated their guidance to forecast adjusted EPS of $6.15 for 2018.

That’s a nice boost in earnings, and helped the stock jump up above $200 per share for the first time, but it’s not something that will be recurring so it doesn’t necessarily change the future expectations much — for that future we’re still waiting to see if new “tentpole” royalties emerge to supplement Kyprolis and Promacta, and waiting to see if Promacta’s incredible sales growth continues. So far the market is very pleased, but this is a volatile stock and I’ve resolved just to give it a lot of room as long as Kyprolis and Promacta sales are rising. The next real indication we’ll get for that is when Novartis (NVS) releases its second quarter results on Wednesday — so far Promacta has been doing very well under Novartis, and I expect that to continue, but I will be watching (Amgen’s next quarter, which should include updates on Kyprolis sales, will come a week later).

What to do with Estre Ambiental (ESTR)? This is a pairs trade for me, short the stock and long the long-term warrants. It’s too illiquid to cover quickly or easily, the stock and warrants are dropping, and there’s no real news. On the other hand, there’s little carrying cost for this position, and very limited risk, so I will just let it ride. So far the profit on the short side would more than cover the cost of the warrants, so this would be a decent profit now if liquidated… but with the Brazilian Real dropping again (it has fallen 20% in just a couple months versus the US$), the stock could easily drop further (it’s priced in dollars, since it’s a US-listed company, but all of the operations, costs and income, are in Real). Just waiting to see how things develop — my most likely next step would be covering the short position and letting all or part of the warrant position ride “for free” if I think there’s a decent chance of the company establishing some revenue growth.

And a reader wrote in asking me to address Clean TeQ and Yatra Online in the Friday File… we’ve already gotten to Clean TeQ, but let’s take another look at Yatra.

If you don’t remember this one, Yatra is another of my “I’m a sucker for warrants” positions — I bought the warrants on this stock about a year and a half ago, when they were just easing into their backdoor listing (they merged with a “blank check” company, just as Estre Ambiental did, which is why there are warrants — essentially every blank check/SPAC offering includes warrants).

Yatra is an Indian online travel agency — think Expedia or Ctrip, but for India. The promise is that India has the world’s fastest-growing travel business and a huge consumer economy that’s growing quickly and increasing the demand for flights and hotels and tours and the like. The challenge is that Yatra is the second-place player in a market where the leader, MakeMyTrip (MMYT) has grown stronger (thanks partly to combining with Naspers’ Ibibo and getting a cash influx from Naspers and Ctrip last year) and is far larger… and all of the industry participants have been willing — for ten years now — to compete aggressively on price and forgo profits.

So far that has favored the bigger player — MakeMyTrip has also had trouble over the past year, given the lack of earnings and the lower level of optimism about India in general, but Yatra has done much worse than MMYT. Personally, I speculated on the Yatra warrants while also noting that the larger MakeMyTrip was a safer bet, and then when those warrants did very well in the Spring of 2017, when YTRA hit $12 or so, I sold about a third of my warrant position to cover my purchase cost and “let it ride” with the rest. I’m still doing that.

What’s going on with the actual business? Well, they’re growing faster than expected, with 40% top line growth as of the last quarter, so that’s good… and they narrowed their losses a bit, but still (like MMYT) are nowhere near making money. That was more or less OK with the market, but then they announced a share offering at $5.50 to raise cash and the stock pretty well cratered to hit that offering price. It’s near that now, in the $6 range.

I think that’s fairly appealing, honestly, though it would not surprise me if the end game was a business combination with one of the major global travel companies (like Booking.com, for example). Yatra has a strong portfolio of hotel deals, which is where more of the profit comes for these kinds of companies (commissions on hotel stays are far higher than the small fees they get from booking airline tickets, for example), and they are trading at a pretty reasonable price/sales ratio of close to 1 — so the business is at a meaningful scale, and they have a strong gross profit… it’s just that because they are so small, overhead and other operating costs are far higher and result in steady losses, and I don’t know how long it will take them to grow into profitability on their own (MakeMyTrip is more than 10X larger, trades at a far higher price/sales ratio and has better gross margins, but is also far from profitability… though MMYT is moving in the right direction, and analysts predict a profit of 27 cents per share in 2021).

So Yatra to me is still an appealing little company that’s in a sector, Indian consumer travel, where margins are negative and growth is very high. I’m not sure how it will play out, but both MakeMyTrip and Yatra should eventually be able to grow into profitability — they both have very high gross margins, and online travel is a good and scalable business, it’s just that they need Indian consumers to have a little more money, or they need to compete a little bit less with each other (and with other travel agency operations) The market is growing fast on the top line but evolving into any eventual profitability very slowly.

I still think it’s reasonable to speculate on either Yatra or MakeMyTrip if you think Indian travel and the Indian middle class will continue to expand, but both are “story” stocks without earnings to support their plans for the future. Yatra is far higher risk because they have less scale and less access to capital (as we saw when they had to go town to $5.50 a share to raise growth capital), but, unlike MakeMyTrip, it’s also trading at a substantial discount to what the business might be worth to a much larger company, whether that’s a global travel brand or an Indian consumer or online business. I have some exposure to MakeMyTrip through my Naspers position, since Naspers owns more than a third of MMYT, but don’t own the stock directly. I continue to hold those Yatra warrants, which are each for a half share and have a strike price of $5.75 (so $11.50 per full share, for our purposes, is when they are “in the money”), with an expiration date in mid-December of 2021… so we have quite a bit of time still, and I’ll watch patiently, but part of the reason I can do that is that I’ve already covered my investment with earlier profit-taking, and it remains a very small position. The assumption should be, as with any out-of-the-money derivative speculation, that it has a high likelihood of going to zero.

So that’s a lot of catch-up for you — selling Omega and Xylem, buying Starbucks and ROE Warrants, adding a bit to Kennedy-Wilson and Innovative Industrial Properties and Clean TeQ… that seems enough for a week.

And the one stock I haven’t added to this week but am tempted to buy? That’s Naspers (NPSNY), which has again gotten cheaper as it has fallen behind its major portfolio holding, Tencent, and represents a pretty good bargain — that’s on my list to add if we continue to see this price differential. As of yesterday, Naspers’ 31.2% ownership of Tencent should be worth $143 billion (they say they do not have any tax liability with this holding, which is all capital gains), while Naspers as a whole has a market cap of only $110 billion — as well as a meaningful net cash position once their sale of a little Tencent (they used to own 33.2%) and their Flipkart position (to Walmart) clears, to say nothing of billions of dollars worth of investments in other companies, including MakeMyTrip and Mail.ru and other established names as well as lots of smaller ventures). Tencent can certainly come down dramatically in price, it’s a lightning rod of a stock and faces regulatory scrutiny in China, and all things China seem to be faltering right now… but Naspers gives you a nice valuation cushion on one of the world’s most valuable (and still growing) tech companies, as well as a portfolio of other hopes and dreams.

Endnotes:
  1. Keith Schaefer pitched it back in 2015: https://www.stockgumshoe.com/reviews/oil-gas-investments-bulletin/friday-file-the-historic-opening-of-an-oil-bull-market-bigger-than-texas/
  2. Christian DeHaemer last year: https://www.stockgumshoe.com/reviews/crisis-and-opportunity/christian-dehaemers-better-than-the-bakken-mexican-oil-play/

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