most of an email from Wednesday night

 I think we won’t really begin to know how bad things are going to be before we see companies report earnings for 1Q20 over the next few weeks.  And it may not be until we get well into 2Q20 that we’ll have a solid grip on what the situation is.  That’s when we’ll be able to assess whether the market has already discounted all the possible bad news.
We can already figure out stuff that should be avoided–cruise ships, department stores, airlines, the Detroit auto companies…
If a professional manager has to remain close to fully invested, meaning no more than 10% in cash (for a pension manager, the maximum cash percent will typically be stipulated in a contract), just avoiding the losers will probably be enough to do better than the market.
For me, I think the investment focus should be narrower.  I find techy businesses with worldwide appeal and little investment in physical plant and equipment are especially attractive.   This is partly because technological change is very rapid, partly because I think the Trump back-to-the-Fifties economic strategy is already doing huge long-term harm to the US economy.  If he or someone like him continues in office, I think the ability of a company to pick up roots quickly and move to, say, Canada will be a distinct plus.  I also think this flight capital idea is already being factored into stock prices (look at NASDAQ  +50.8% vs Russell 2000 -13.6% since Trump has been in office).  I wouldn’t just distribute money across the board in the -non-losers.  I’d emphasize what I think are the long-term winners.
I’m sure that there are some people buying NVDA, NFLX and ATVI not because they believe in them or even know much about them but purely to defend themselves from the possibility that conventional consumer names will have hugely bad earnings performance over the next couple of quarters.  They may not be table to quantify how bad but they’re convinced that there won’t be any positive surprises, only potential negative ones.
Assuming I’m right in what I’ve written so far, the key question for me is when/how does this market situation reverse itself.
Reversal typically comes in one of two forms: the price difference between the good stocks and the bad stocks will get so extreme that, purely on valuation, the bad stocks will start to catch up with the good ones–this is a “counter-trend rally” and tends to be short; or the economy will begin to improve and there will be a genuine reversal of relative economic momentum toward business cycle recovery stocks.  I agree we’re a long way off from that.  At some point, though, it will be right to shift holdings to more traditional cyclical names in anticipation.
To some degree, the first thing has happened already.   MAR, for example was $150 in mid-December, then $46 a few weeks ago, and is now $80.  So it’s up by almost 75% from the low.  I don’t know what will happen from here but I might be tempted at $60 to buy a little bit.  Generally speaking, though, I think this kind of stock will be lucky to go sideways between now and the time, late this year?, that we get signs that business is recovering.  I’m really not accustomed to thinking about ETFs but a hotel ETF might be the better way to go.

oil below $20 a barrel

The Energy sector of the S&P 500 makes up 2.8% of the index, according to the S&P website.  This is another way of saying that none of us as investors need to have an opinion about oil and gas production, which makes up the lion’s share of the sector.

Last weekend Saudi Arabia and Russia, with a fig leaf provided by the US for Mexico’s non-participation, led an oil producers’ agreement to cut production by around 10 million barrels daily.

Prior to the meeting, crude had rallied from just over $20 to around $23.  Right after, however, the Saudis announced price discounts reported to be around $4 barrel for buyers in Asia.  Prices were reduced by a smaller amount in Europe but went up for US customers–apparently at the Trump administration’s request.  That sent crude prices into the high teens.

Why is this the best strategy for Saudi Arabia?

The commonsense answer is that Riyadh thinks it’s more important to secure sales volumes than it is to be picky on price.  This is at least partly because the world output cuts reduce, but by no means eliminate, the oversupply.  So there are still going to be plenty of barrels looking for a buyer.  Another reason is that since demand has dried up the Russian ruble has dropped by 20%.  That’s like a 25% local currency price increase for Russian crude, meaning lots of room for Moscow to undercut rivals.

investment implications

The most leveraged play to changes in oil prices is oilfield services.  Companies that specialize in exploration–seismic services, drilling rig firms–are the highest beta, firms that service existing wells less so.  During the oil price crash of the early 1980s, however,  drilling rigs were stacked for a decade or so.  On the other hand, oilfield services firms are the ultimate stock market call on rising oil prices.

Given that US hydrocarbon output and usage are roughly equal, the country as a whole should be indifferent to price changes (yes, it’s more complicated, but at this point we want only the general lay of the land) rather than the net winner it was 15 years ago.  However, within the country oil consumers normally come out ahead, while oil producers are losers.

Typically, the resulting low gasoline prices would be a boon to truckers and to commuting drivers.  The first is probably still the case, the second not so much.

The bigger issue, I think, is the fate of the Big Three Detroit auto producers, who are being kept afloat by federal government policies that encourage oil consumption and protect high-profit US-made light trucks from foreign competition.  While nothing can explain the wild gyrations of Tesla (TSLA) shares, one reasonable interpretation of the stock’s resilience is the idea that the current downturn will weaken makers of combustion engines and accelerate the turn toward electric vehicles.

Personally, I’m in no rush to buy TSLA shares–which I do own indirectly through an ARK ETF.  But it’s possible both that Americans won’t buy new cars for a while (if gasoline prices stay low, greater fuel economy won’t be a big motivator).  And the rest of the world is going electric, reducing the attractiveness of Detroit cars abroad, and probably making foreign-made electrics superior products.

If there’s any practical investment question in this, it’s:  if the driving culture in the US remains but the internal combustion engine disappears, who are the winners and losers?

 

 

 

 

 

 

 

 

Tesla and the efficient markets hypothesis

The Efficient Markets Hypothesis is an academic theory that posits that the optimal portfolio is an index fund.  There are different flavors of EMH but the general idea is that all relevant information about all stocks is virtually instantaneously factored into prices.  Therefore, it’s impossible for any investor to beat the index return.

The evidence in support of the theory is that almost no one who manages money for others and publishes legitimate results has an index-beating record.  Of course, the traditional brokerage strategy has been to build a strong sales force to gather fee-generating assets and to hope that performance takes care of itself.  So beating the market has never been a top goal.  I think that strategy is changing now, as younger and more savvy clients appear on the scene.

It seems to me that year-to-date performance of any US stock provides a counterexample to EMH.  I’ve been particularly impressed, if that’s the right word, about Tesla (TSLA).

 

On January 24th, TSLA closed at $564

By February 19th, 18 trading days later, the stock rose by 61% to $917

On March 18th, 20 trading days later, TSLA had fallen by 61% to $361.

By yesterday, another 20 trading days had passed and TSLA was up by 104% to $734.

So in the space of three months, a buyer at the close on 1/24 would have been:  up 61%, then down by 35% and is now up by 30%.

 

One side effect of EMH–its real purpose?–is that it legitimizes having tenured university finance faculties totally devoid of any practical investing, or even general capital markets, experience.  Other than the lack of respect, this suits professional investors fine.  Who needs extra competition.

 

 

 

 

 

energy: oil

history

–oil began replacing coal as fuel of choice in the early 20th century, but that loss was mostly offset by substitution of coal for wood, until…

…at the end of WWII, Saudi Arabia, having lost its primary source of revenue, Hajj pilgrims, in the prior decade-plus, opened its oil deposits to foreign development.  

–Third-world producing countries formed OPEC in 1960 as a political organization to battle exploitation by oil-consuming countries.  In the 1970s, OPEC “shocked” the world by raising the price of crude oil in two stages from $1 barrel to $7.  In the panic that ensued after the second increase the price spiked to over $30 before collapsing and staying low for years.

–During the 1970s oil crisis, every major consuming nation other than the US acted decisively to decrease dependence on oil.  If anything, the US did the opposite.  One result of our misguided policy (to protect domestic auto firms) has been that although the US represents 6% of the world’s population it consumes 20% of global oil output.  Another, despite this + trade protection of domestic carmakers, has been loss of half the domestic auto market to better-made, more fuel-efficient imports.  (In most cases this is what happens–protection weakens the protected sector.)

supply/demand

price dynamics

Pre-pandemic, the world was producing about 100 million barrels of oil daily.  It consumed about the same.  Oil supply is relatively inflexible.  In over-simple terms, once a large underground pool of oil start to flow toward a well, it’s difficult to stop without harming its ability to start up again.  Because of this, even small supply excesses and shortfalls can induce sharp price changes.

supply

The biggest oil producers are:

US          19.5 million barrels/day (includes natural gas liquids.  crude alone = 12.7 million)

Saudi Arabia          12 million

Russia          11.5 million

Canada, China, UAE, Iraq, Iran      each 4 – 5 million

demand

The biggest oil consuming countries are:

US          20 million barrels/day

EU          15 million

China          13.5 million

India, Japan, Russia      each about 4 million

my stab at production costs (which is at least directionally correct)

Saudi Arabia        less than $5/barrel

Russia          $30/barrel

US fracking          $40/barrel

where we stand toady

The coronavirus outbreak appears to have reduced world oil demand by about 15 million barrels a day.  Enough surplus oil is building up that global storage capacity will soon be completely full.  Also, a spat broke out between Saudi Arabia and Russia over production cutbacks to support prices.  When the two couldn’t agree, the Saudis began to dump extra oil on the market.

West Texas Intermediate, which closed last year just above $60 a barrel, plunged to just above $20 a barrel in late March.  It goes for about $24 as I’m writing this late Sunday night, despite Moscow and Riyadh seemingly paving patched up their differences last week and agreeing to cut their output by 10 million barrels between them.  The market was not impresses, as the Friday WTI quote shows.

fracking

The US is in a peculiar position:

–the administration in Washington appears to have two conflicting energy goals:  to keep use of fossil fuels as high as possible; and to keep the world oil price high enough to make fracking profitable.  The first argues for lower prices, the second for higher.

–according to the Energy Information Administration, fracking accounted for 7.7 million barrels of daily crude oil liftings in the US last year, or 63% of the national crude total.   If the cost numbers above are anywhere near accurate, domestic frackers are in deep trouble at today’s oil price  

This doesn’t mean production will come to a screeching halt. 

The industry has two problems:  excessive debt and high total costs.  According to the Wall Street Journal, Whiting Petroleum, a fracker who recently declared bankruptcy, prepared for pulling the plug by drawing its full $600 million credit line, swapping stock in the reorganized company to retire $2 billion in junk bonds and paying top executives a total of $14.5 million.  That solves problem number one. 

As to number two, total costs break out into capital costs (leases, drilling…) and operating costs.  I have no idea what the split is for Whiting and I have no interest in trying to figure it out.  My guess is that the company can generate positive cash flow even at today’s prices.  Almost certainly the reorganized company can.  It may choose to shut its existing wells in the hope of higher prices down the road.  But it could equally well opt to continue to operate just to keep experienced crews together.  However, new field development is likely off the table for now.

my take

When I was an oil analyst almost (gulp!) a generation ago, the ground level misunderstanding the investment world had about OPEC was the belief that it was an economic organization, a cartel, not the political entity that it actually was.  The difference?–economic cartels invariably fail as members cheat on quotas; political groups have much more solidarity.  Today’s OPEC, I think, is much more an economic cartel than previously.  In other words, it can no longer control prices.  And despite the fact that Putin and MSB have extraordinary sway over the administration in Washington, my guess is this won’t help, either.

There’s some risk that investing in oil today is like investing in firewood in 1900 or coal in 1960.

Despite this, for experts in smaller US oil exploration companies, I think there will be a lot of money to be made after a possible wave of bankruptcies has crested.  Personally, I’d rather be making videos.

 

 

 

 

 

 

 

 

negative working capital

Working capital is all about the inventory cycle–meaning the journey from cash in the bank to production materials to finished goods to sales and back to cash.  For pharma distributors the cycle may take two weeks, for a scotch distillery six years.  Conventionally, however, working capital is defined as assets and liabilities being used over a 12-month period.

Manufacturers typically have lots of working capital, much of it tied up in inventory.  Retailers of consumer durables and jewelry do, too.

There’s another class of companies, however, like utilities, restaurants, hotels…that typically have negative working capital, meaning the company doesn’t need to feed cash into the production process to keep it going.  Instead, operations generate cash, at least for a time.   And the amount of cash grows as the business expands.

Why is this?

–A restaurant is an easy example.  In the US, sales happen either in cash or by credit card, where the funds are available for use almost immediately.  So it has no receivables on the asset side of the balance sheet and it has an inventory of maybe a couple of days’ food.  On the liabilities side, rent, utilities, salaries and food ingredients are paid for an average of, say, two weeks after their inputs are used.  So once it gets going, the restaurant has many more current liabilities than current assets and it has the use of the upfront payments for about 14 days.  If the restaurant prospers, the gap between liabilities and assets may expand in percentage terms, but even if not the cash “float” will grow in the absolute.

–An online service charging a monthly or yearly subscription fee–music, books, news, Adobe Cloud–works the same way.  People pay in advance for services provided bit by bit over the term of the subscription.

–hotels, cruise ships and public utilities, too.

There’s a temptation for negative working capital companies, seeing apparently idle cash of $100,000, then $125,000, then $175,000 (much bigger figures for publicly-traded companies) just lying on the balance sheet for years, to use this money to, say, open a second restaurant that would potentially double the size of the firm, create economies of scale…  In fact, the only company I can think of that steadfastly refused to touch any portion of its cash buildup was Dell in its heyday as a PC manufacturer.

The problem:  suppose a negative working capital company takes a risk with its “float” money and stumbles.   In our restaurant example, let’s say the company takes $50,000 out of its cash balance, uses it to set up a second location and the second restaurant flops.  All of a sudden, salaries, utilities, rent, food bills come due and there isn’t enough money.  Whoops.

Suppose the business begins to shrink.  If so, so too does the cash pile.  But at least initially the liabilities remain the same.  Potential trouble, unless the company adjusts very quickly.

More relevant today, suppose there’s a quarantine and incoming cash dries up completely.  In the restaurant case, in less than a month, the cash is all gone!   And the owner has to decide whether to inject more capital into the business, close its doors, or not pay the bills and see what happens.

CCL

A case in point is cruise line Carnival (CCL), which raised about $6 billion last week in a stock/bond sale, shortly after drawing down much, if not all, of its $3 billion bank credit lines.  Three entries on the balance sheet explain these moves to me.  As of last November CCL had $518 million in cash on the asset side:  liabilities:  $4.7 billion in customer deposits + $1.8 billion in accrued liabilities (= other stuff).