Value Investing Archives - Page 3 of 3

August 25, 2020August 25, 2020

Intro to Discounted Cash Flow Analysis, Part 1

The discounted cash flow (DCF) method is one of the more popular choices for finance professionals. I often use DCFs as a rough, back of the envelope calculation to see if the business is trading at a reasonable price. The thing I like the most about DCFs is that they factor in the growth of the business. Valuation ratios, such as price-earnings, are just a snapshot of the business at that point in time. In this post, I don’t want to get into the math, or how to make super accurate DCF models. However, I will provide an introduction to discounted cash flow analysis, by describing the four inputs to the DCF calculation.

In simple terms, a DCF approximates the value of a company based on the stream of cash flows it generates into the future, a growth rate of these cash flows, and then factors in the investors time value of money (ie their desired rate of return).

Cash Flow

The first DCF input is the amount of cash flow the businesses currently generates. Cash flows can be measured in several ways, such as net income, earnings per share, free cash flow, among others. I typically use free cash flow (FCF) because I believe it is a better measure of the earnings an owner would receive from the business than net income.

Using the latest FCF number makes sense if the business is stable and predictable. However all businesses are going to have varying cash flows year to year. Some companies are cyclical, so you don’t want to use the peak earnings for that economic cycle. Other companies produce very random earnings, complicating things as well. Instead of using the current free cash flow, in most cases it makes more sense to average the past few years value. I usually average the last three years of FCF as the input to the DCF. For companies that seem cyclical, or have an unusually high FCF figure for the current year, I will handicap it a bit to a more conservative value.

Growth

A reasonable business is going to produce a certain amount of cash flows into perpetuity. Ideally, these cash flows are growing as well. The growth rate assigned to the businesses cash flows is the next input to the DCF model. A large, stable business may grow at the rate of inflation, so about 2-3% per year. Many businesses can grow above the rate of inflation, and certain companies (like tech stocks) can grow their business at high rates. High growth rates can greatly increase the value of a company produced by a DCF.

A Note On High Growth Rates

High growth rates are why some stocks can appear expensive on a price-earnings basis, but they may be a reasonable price when you factor in high future growth. However, many times everyone is saying that a stock is The Next Big Thing, that revenue will grow a ton, and the stock price will massively increase. These stocks are too expensive even though they may have high growth rates. DCFs anchor the growth of the business to its fundamentals, allowing the investor to make sure the growth story isn’t getting ahead of a reasonable valuation.

The problem with plugging a growth rate into the DCF model is that it is an estimate since we cannot predict the future. Oftentimes narratives about a stocks high growth prospects is pumped by the financial media. It is easy for an investor to get caught up in the hype and plug in an unrealistically high growth rate when performing DCF analysis.

The other problem is that companies cannot sustain high growth rates forever. There are eventually diminishing returns, where the company’s growth will slow as it gets larger. DCFs typically use a 10 year forecasted growth value. An investor has to be careful that even though the company has grown at 10% the last few years, it will still be growing at that rate ten years from now.

Calculating Growth

There are many ways to estimate a businesses growth rate, such as historical revenue growth, net income growth, FCF growth, or the company’s return on equity. I typically use a 5 year average of revenue growth. This probably isn’t the best way to estimate growth, but this metric is easily found on the website I use to research stocks. Like with the FCF, I often handicap the revenue growth rate by lowering it a couple of percentage points just to produce a more conservative valuation.

Terminal Growth Rate

The growth rate discussed in the previous section estimates the growth in the next 10 years. Since the DCF assumes the business is going to produce cash flows in perpetuity, we need to use a growth rate from year 11 to forever. Since diminishing returns will take into effect eventually, we can assume that after a long enough time the company will just grow at the rate of inflation. For my DCF calculations, I use a terminal growth rate of 2%.

Discount Rate

The discount rate is the last input used for the discounted cash flow model. Discount rate is the hurdle rate, or the investors desired rate of return on the investment. Finance professionals and academics typically calculate the discount rate by using the businesses Weighted Average Cost of Capital (WACC). In simpler terms, calculating WACC, produces a discount rate that reflects what the market thinks is reasonable for the business. I am critical of the WACC method, but that is a discussion for a different day.

The other method of determining a discount rate is to just use a personal desired rate of return. When I perform DCF analysis, I almost always use a 10% discount rate. I figure this value is not too low, or too high, but should still beat the market.

DCF valuations are highly sensitive to the discount rate you use. A lower discount rate will increase the value of the company. This is because you are willing to pay more for this stream of cash flows and accept a lower return. This can create a tricky dynamic because I am a young, hungry investor who wants to beat the market. In this case, I want to use a 10% discount rate. However, I am competing with some institutional money manager that is ok buying stocks that return 7% a year. Many stocks seem reasonably priced at a 7% discount rate, but would have to fall a large amount to be cheap based on a 10% discount rate.

Conclusion

This wraps up part 1 of the introduction to discounted cash flow analysis. I described the four DCF inputs (cash flow, short term growth, terminal growth, and discount rate), and how to calculate them. Keep in mind that DCF inputs are all estimates. This can lead investors to creating overly optimistic valuations. However, I believe the main benefits to using DCFs is that they can help an investor really think about the business, since it considers the current earnings power, the growth of the business, and the time value of money. By introducing DCFs, I can help support one of the themes of this blog: don’t buy hyped up growth stocks.

For more value investing fundamentals check out:

What is Value Investing Anyway?

The Many Flavors of Value Investing

July 24, 2020September 8, 2020

The Many Flavors of Value Investing

One of my favorite things about value investing is that it is a broad church. A lot of people typically talk about value in generic terms, comparing value stocks to growth stocks. The reality is there are many strategies under the value investing umbrella.In this post, I’ll outline several of the main value investing strategies, give some examples, and discuss which ones I focus on.

Growth at a Reasonable Price (GARP)

GARP investors try to balance buying high growth companies while still maintaining an anchor to business fundamentals. Companies like Tesla, Beyond Meat, Uber, pot stocks, tech companies, are growing their sales at very high rates. Oftentimes, the narrative of their growth is driving the stock price to valuations that would imply unrealistic growth. Additionally many of these companies are not profitable. GARP investors would find high growth stocks that still had a profitable business trading at a reasonable price.

One of the main metrics used to find GARP stocks is the Price to Earnings Growth ratio (PEG). The PEG ratio was made popular by the famous fund manager Peter Lynch. Examples of GARP stocks are Apple (AAPL), Microsoft (MSFT), and Lowe’s (LOW). I don’t utilize this strategy in my investing since I typically focus on more modest growth, and more emphasis on being undervalued.

Quality

Warren Buffet says to “buy great companies at fair prices”, which is the definition of this value strategy. Quality stocks have strong brand names, competitive advantages, constantly growing profits, little debt, high returns on equity, low growth. These are companies like Coca-Cola (KO), Procter & Gamble (PG), and Johnson & Johnson (JNJ). It makes sense to want to invest in high quality stocks, however these companies are typically very expensive. With their predictable earnings, and often recession proof businesses, they are almost treated like bonds. ETFs such as QUAL contain these types of companies, but they appear overvalued for my liking. I would love to own a handful of quality companies at a good price. In reality, the only time you can find remotely cheap quality companies is during a market panic.

Compounders

Compounders are quality businesses with competitive advantages, good return on equity, and modest to high growth. The idea is that these companies will continue reinvesting earnings into their business in order to compound at attractive rates for 10 years or more. In many ways these are similar to GARP and quality stocks. Compounders will have high return on equity and consistently growing earnings. Finding an attractively priced compounder is an investors dream, but difficult to do so in a bull market.

This value investing strategy gets a bad rap from “Compounder Bro’s”. These investors buy companies like TransDigm (TDG), Roper Technologies (ROP), or software-as-a-service (SaaS) stocks, which are great businesses. Compounder Bro’s stereotypically over pay for these stocks, or may have over-optimistic projections of future growth. Additionally, Compounder Bro’s brag about how great their stock picks have done since these types of companies have greatly outperformed typical value stocks lately.

Traditional Value

What I consider traditional value stocks are good or decent companies that are temporarily undervalued. Reasons for their cheapness could be bad news, law suits, sector headwinds, being misunderstood, or the business is out of favor. Usually if the financial media is saying a sector or business is “dead”, then it’s time to sift through the depressed industry and find any hidden gems. These types of stocks are one of my main areas of focus. I typically look for solid businesses with low debt, then try to understand the narrative and decide if the consensus is overreacting.

In my current portfolio, Capital One, Emerson Electric, and Simon Property Group fall into this category. Emerson was simply sold off because of the dramatic March sell off. Capital One has to navigate this low rate environment, which means it’s cheap along with a bunch of other financial stocks. SPG has high quality malls in major metros which I think will do fine, while crappy malls in crappy cities will die.

Another example is in 2017, when all the headlines were saying Amazon is killing retail. Sure, Amazon will destroy companies like Sears and JC Penny who sell undifferentiated products. But retailers like Tractor Supply and Williams-Sonoma got caught up in the industry selloff. I thought these businesses were higher quality, niche retailers that would not immediately be impacted by Amazon. These companies had strong fundamentals but were selling at a discount. I bought both of these companies and sold them a year later for a 40-50% gain.

Quantitative Value

This strategy involves buying a basket of statistically cheap stocks. Out of this basket, some of the stocks will do poorly but hopefully a subset mean-revert to a typical valuation. The valuation metrics used to screen for these stocks could be price-to-book value (P/B), price-to-earnings (P/E), price-to- free cash flow (P/FCF), enterprise value over earnings before interest and tax (EV/EBIT) among others.

Buying low P/B stocks is a classic implementation, is often used in academic value investing papers, and often is used in value indices. Supposedly accounting standards don’t accurately account for book value with tech companies, or businesses with a great brand name. P/B seems to work better for financials or old economy businesses with little R&D or other intangible assets. Given these apparent limitations, I do not screen specifically for low P/B stocks.I like looking at P/FCF in general as a shortcut valuation, however I don’t screen strictly for low P/FCF stocks.

Deep Value

Deep value falls under the quantitative value strategy. The book “Deep Value” by Tobias Carlisle wonderfully discusses this strategy. I wanted to particularly highlight this strategy since I am interested in implementing it in my portfolio. This metric is also known as the acquirer’s multiple because instead of using the stocks market cap (the price), it uses enterprise value.

Enterprise value is the market cap of the equity, plus any outstanding debt, minus cash on the balance sheet. This reflects the price someone would have to pay to buy the entire business since they would have to retire the debt and could use the cash to offset the purchase price. EBIT is basically operating income, which is higher up the income statement than net income (earnings). Net income takes into account a companies interest payment on debt, but this metric factors in debt with the enterprise value.

Studies have shown that EV/EBIT is one of the most robust quantitative valuation metrics. This strategy has historically outperformed the S&P 500. Lately all quant value strategies have underperformed, with value investing in general having a hard time keeping up with the frothy market. I plan on incorporating the acquirers multiple strategy in my portfolio because of its long term track record of outperforming. Another reason I am drawn to this strategy is because it can be rare to find quality stocks at cheap valuations. Low EV/EBIT stocks can fill up my portfolio until opportunity arises.

Asset Plays

Asset plays are similar to buying low P/B stocks, but with a twist. The difference between asset plays, and simply buying cheap P/B stocks, is that the value of the company is based on a physical asset. Occasionally an investor can buy into these assets at attractive prices. If you really dig for treasure, you can find companies where the assets are under reported on the balance sheet, which creates value. An example would be a Maui Land and Pineapple (MLP), that has real estate recorded on its books at the price paid decades ago. Of course Maui real estate has greatly appreciated, but this value is not showing up in the accounting. Another example could be a timber company, or quarry, that owns natural resources. Additionally, these hard assets will probably do well during inflationary periods.

Net-Nets

This is the original value investing strategy devised by Benjamin Graham. While there are a couple of ways to implement this strategy, the most common is to buy companies that are trading below their net current asset value. Current assets are things such as cash, inventory, and accounts receivables. Current liabilities consists of short term debt coming due, and account payables. The net current asset value is arrived by subtracting the current liabilities from the current assets. When the market cap of a stock is below this figure, it is really freaking cheap. You are paying less than the cash on hand and the inventories of the business.

Warren Buffett cut his teeth on net-nets back in the 1950’s, helping him create a great early track record. The problem with net-nets is that everyone knows they are awesome, so it is very rare to find any. Right now there are only a few net-nets that may be worth buying. However, during big market selloffs, net-nets make a reappearance. Finding a handful of net-nets is something I am always on the lookout for.

Special Situations

Special situations, or “work outs” as Buffett called them back in the day, are corporate spinoffs, mergers, or emerging bankruptcies. I think this is one of the coolest value investing strategies. The unfortunately titled book “You Can Be a Stock Market Genius”, by Joel Greenblatt, explains special situations in great detail.

Occasionally companies spinoff operations into a new company in order to simplify the core business, among other reasons. Institutional investors are typically more interested in the parent company, so they indiscriminately sell off their shares of the spinoff. This selling can create tremendous value. Companies emerging from bankruptcy (not going into it like Hertz) can be dirt cheap, and ridden of their burdensome debt. These stocks, under the right circumstances, can provide great returns. I would love to invest more into special situations, however it is time consuming to research these opportunities.

Conclusion

There are probably a few variations of value investing that I missed, but the strategies outlined here are the most commonly discussed. I personally utilize a blend of value strategies. The most desired types of value stocks are probably cheap, quality stocks, and net-nets. In the meantime, I will continue searching for good companies that are misunderstood and share more reliable value investing strategies. Finally, I will use quantitative deep value to round out the portfolio.

Check out my other posts on the fundamentals of value investing:

What Is Value Investing Anyway?

Intro to Discounted Cash Flow Analysis, Part 1

July 18, 2020July 18, 2020

What is Value Investing Anyway?

So far on this blog, I’ve written about my current stock positions and have casually mentioned that I use the value investing strategy. In this post I want to define what value investing means to me. Value investing was pioneered by Benjamin Graham, who was Warren Buffett’s professor and for a short period, boss. Buffett took value investing to new levels. He built the juggernaut of Berkshire Hathaway and teaching his investing philosophy along the way. Other well known value investors include Charlie Munger, Walter Schloss, Lou Simpson, Bill Miller, Peter Lynch, Bill Nygren.

Value investing is the process of buying an undervalued asset and selling it if it becomes overvalued. This sounds like the age old “buy low sell high” mantra, which is what everyone is trying to do right?

The difference is that for a company to be undervalued, you must know what is a fair value…what the business is worth. There are many ways to value a business, which I’ll save for a different post. All valuation techniques involve some analysis of the earning power and growth of those earnings. Value investors believe each business has some intrinsic value, or a reasonable valuation, based on its earnings power. The price that a stock trades at reflects to some degree the performance and economic environment of the business. However, a large degree of a stock price is based on psychology and other market forces. This means that a stock can trade at a discount to its intrinsic value if the market is pessimistic on the company’s outlook. On the other hand, a stock can trade at a premium if the market is overly rosy on the business.

How Does Value Investing Make Money

Investing in a company at its fair value can be a reasonable proposition. The real money is made by buying below intrinsic value, and waiting for the company to appreciate back to its fair price. It may sound silly that businesses trade at a discount, then revert back to a reasonable price, but opportunities like these exist. The goal is to buy $0.50 dollars and wait for them to go back to being a dollar. This sounds simple…but it is not easy.

The Philosophy

Value investing to me is more than just another strategy like growth, momentum, trend following, technical analysis, risk parity, etc. It is a philosophy. Most people think stocks are a piece of paper that gets traded bank and forth, numbers on a screen that go up and down, a spin of the roulette wheel, some get rich quick scheme, or some amazing story of how this company is going to be the next Microsoft.

I saw the light when I read Warren Buffett’s shareholder letters. In these letters he described stocks as owning a fractional share of a business. Owning stocks means you are a business owner. Therefore you should only be buying good businesses that you understand. Businesses sell things, pay employees and incur other costs, produce a profit, reinvest those profits back into the business to grow, pay out some profits to the business owners (stockholders). Value investing is estimating what this business is worth, and opportunistically buying it when the market does not agree with you.

A write up of my Q2 2020 results can be found here

Check out my summary of my March Stock purchases

July 3, 2020July 3, 2020

Q2 2020 Portfolio Update

Performance Overview

For Q2 2020, the portfolio is up 6.65% and is up 4% year to date. The Q2 starting balance was $80,525.94, and finished the quarter at $89,241.80. Contributions to the portfolio during the quarter amount to $4,551.

No stocks were sold during this quarter, but four new positions were added. The four companies I have bought are Teekay Tankers (TNK), Frontline Ltd. (FRO), DHT Holdings (DHT), and Scorpio Tankers (STNG). These positions are oil tanker companies, and all were bought at the end of April and early May.

The current allocation of the portfolio is shown in the chart below. Currently, the portfolio consists of discretionary value stocks, oil tankers, 401k stocks, precious metals, and cash. It can be seen that 39.1% of the portfolio is in stocks, while 60.9% is in cash and safe haven assets. I would prefer to deploy more of the cash to undervalued stocks, but I am remaining cautious despite the market surging during the second quarter.

During the quarter I received $260.65 total in dividends, which is broken down in the table below.

Ticker	Quarterly Dividend
FRO	114.1
STNG	6.8
DHT	75.25
EMR	42.5
COF	22
Total	260.65

My Thoughts

Under normal circumstances, it should be a boring quarter where I don’t feel the need to ~~rant~~ comment on current events. However these last few months have been insane. Here are some of the notable crazy things, things that confuse me, things that worry me that have happened this quarter:

Unemployment around 20% and much higher for the service sector
The S&P 500 nearly breaking even for the year despite the quickest 30% selloff ever and then follows it with the best quarter since 1938
The Federal Reserve upping their game by buying bond ETFs
Consumer spending somehow rebounded quickly
Compelling arguments on either side saying that COVID is as bad as predicted, or not that bad at all
Whether you wear a mask is a strong indicator of your political affiliation
Rookie traders who stereotypically use the brokerage Robinhood gambling on airlines, cruise ship, vaccine biotech, work from home tech stocks among others
Barstool Sports founder Dave Portnoy becoming a stock market influencer…stocks only go up suckers
Hertz, Chesapeake Energy, probably others, massively rallying after announcing bankruptcy
Although they called it off, Hertz almost issued stock to gamblers after they declared bankruptcy…that means selling stock to suckers that will go to zero when the bond holders wipe them out
Protests…which I’m all for if done peacefully, but we are still in a pandemic which is scary
Riots (not cool) and autonomous zones
Nikola, a Tesla clone that makes trucks is now worth $20 Billion, an 8x increase in stock price, despite not having actually built a single truck
Negative $40 a barrel of oil…ie paying people to take the oil because it costs too much to store it

It’s like we’re living in the tech stock mania of the late 90’s, social unrest of 1968, and the economy of 1932 all at the same time. I’m just trying to think rationally, be empathetic of others, filter out the noise, do my best to keep my family healthy, and do my best to efficiently allocate my capital.

Or ya know, stocks only go up…

I’m sure Warren Buffett is a great guy but when it comes to stocks he’s washed up. I’m the captain now. #DDTG pic.twitter.com/WqMR89c7kt
— Dave Portnoy (@stoolpresidente) June 9, 2020

Discretionary Summary

Discretionary value is the label I’m giving to the positions that are fairly large (~5% of the portfolio) I believe are undervalued and may have the following characteristics: quality business, competitive advantage, misunderstood by the market, or a good company in a heavily sold off industry. The current discretionary value stocks I own consist of Capital One Financial (COF), Emerson Electric (EMR), and Simon Property Group (SPG). All three were bought during the March sell off. The table below shows the cost basis, current value, and gains/losses for these positions.

	Avg Price	Cost Basis	Current Value	Current Gain (Loss)
COF	63.25	3,478.75	3,442.45	-1.04%
EMR	41	3,485.00	5,272.55	51.29%
SPG	74.5	3,427.00	3,145.48	-8.21%

After the March lows, EMR quickly rebounded, which makes sense because it is probably the best quality company I own. Since March, COF and SPG were struggling, both down around 20-30% from purchase. Recently, the market has raised all ships, where all three of these companies were in the green for me…however the market has taken back some of those gains.

Notable News

There is not too much news to report for this set of stocks. Simon began reopening their malls in May, so hopefully Q2 results show some optimism. SPG also canceled their merger with Taubman Centers (TCO), which is another large mall REIT. These properties would be a nice addition to Simon since the ownership of quality malls is pretty concentrated to a few large players. However, given that 2020 is going to be very rough on SPG, it seems prudent to reserve capital.

EMR and Portfolio Management

At one point this quarter, Emerson was up 70% from my cost basis. While it was exciting to see the stock run up so much within three months of purchase, it creates quite the dilemma. A lot of people spend the majority of their time finding and researching stocks in order to make a buy decision. However that is only half the work. Now that you own the stock you have to decide when to sell, which could be:

The Stock runs up some random amount that makes you feel good, so you sell to take some money off the table
The stock reverts back to your estimate of the stocks true value, so you sell to find another undervalued stock
Lastly, you hold onto the stock indefinitely, allowing the businesses earnings to compound which will steadily increase the share price

Plus I’m not even getting into the thoughts that enter your head when a stock is down…The naive investor probably does the first scenario, buying a stock and selling it some arbitrary gain. There’s technically nothing wrong with the second scenario, but you’ll have to pay capital gains tax and it only makes sense if you have another good opportunity to roll your gains into, which is never guaranteed. The last scenario reflects investing in its truest form, and makes your life a little easier by reducing your tax burden, reducing the chance you’ll roll your gains into something dumb, and generally more hassel free. If you think about it in terms of internal rate of return (IRR), on paper the last option most likely will have lower (but still attractive returns). It’s possible to have higher returns value trading, but there is execution risk involved.

Long story short, it’s tempting to sell Emerson, but for now I don’t have a better company to reinvest in. I consider EMR fairly priced right now, my thought process might change if it becomes significantly overvalued. At this valuation, Emerson should have slightly above-inflation business growth, and throws off an attractive amount of free cash flow (I like cash flow over earnings but that’s a different tangent) from here.

Tanker Stocks

During the last quarter I jumped on the oil tanker trade (see my analysis) and entered positions in DHT, FRO, STNG, TNK. The table shows my cost basis, the current value, and the current percentage losses. I will probably do a write up revisiting the tanker thesis so I’ll keep this short. Oil tankers were very profitable during the first quarter. Oil tankers probably earned as much or more during the second quarter which will reflect the crazy high spot rates seen in April. In other words, the thesis played out just as the smart people predicted. The oil tankers have made record profits in the last 9 months, some even paying juicy dividends…yet I’m down 50%.

For now at least, the craziness in the oil market has subsided which has shortened the duration of the tanker thesis. However there are some other factors that are positive for tankers in the medium term. I was hoping this trade would have panned out by now, but I still think the value of these companies will eventually be realized.

DHT	8.17	1,755.90	1,102.95	-37.19%
FRO	10.66	1,738.29	1,137.74	-34.55%
STNG	26.63	1,742.67	871.08	-50.01%
TNK	23.86	1,765.88	948.68	-46.28%

401k and Precious Metals

My 401k is through my current employer and actively receives contributions. The 401k consists of a Blackrock Target Date Fund (which is no longer being funded), and the Oakmark Fund. The last asset class is the decent allocation to precious metals, which are used as a bond substitute, recession and inflation hedge. The table below shows the YTD performance for the precious metals and 401k, which includes the effects of contributions.

	12/31/19	6/30/20	YTD Gain (Loss)	YTD Contributions
Precious Metals	7,861.00	8,712.56	10.83%
401k	10,962.24	17,301.35	-9.37%	7,728.00

Value Papers

If you think this post is boring, or want to nerd out on value investing research papers, then check these papers I read this quarter.

Is Value a Value Trap?

Is Systematic Value Investing Dead?

A Quick Survey of “Broken” Asset Classes

Books I’m Reading

Usually I try to focus on one book at a time, but the past few months I’ve been multitasking. Eventually I may do full reviews of these books, but for now a little summary. I just finished The New Jim Crow: Mass Incarceration in the Age of Colorblindness. Given the current events, I thought I should go out of my comfort zone and read about race and the criminal justice system. It was a very powerful book that made me question some of my beliefs on why society is the way it is.

Next, I’ve been slowly making my way through Titan: The Life of John D Rockefeller, Sr. This book is huge, so it’ll take me awhile to plow through it. So far I’m at the stage of his career where things are really starting to pick up. It was fascinating to learn about the very strange childhood Rockefeller endured.

Finally, I’m almost done with The Rise and Fall of the Conglomerate Kings. This is a business history book of the founders and the companies that led the high flying conglomerate movement in the 1960’s. This includes Textron, Litton Industries, Gulf + Western, ITT, and LTV. These guys were pioneers at buying other companies and using financial engineering to drive up their stock prices. This book highlights these companies’ capital mis-allocation, which contrasts to everyone’s favorite conglomerate, Berkshire Hathaway.

Conclusion

This wraps up my Q2 2020 portfolio update. Hopefully Q3 is less eventful and my stocks go up…or better yet some new buying opportunities emerge.

A write up of my Q1 2020 results can be found here

Check out my summary of Berkshires Q1 portfolio changes

May 29, 2020June 6, 2020

Berkshire Hathaway Q1 2020 Portfolio Update

While I don’t own any shares of Berkshire Hathaway (although that could change), I still like to keep up with what moves Warren Buffett is making. This is especially true during the crazy first quarter of 2020. Buffett didn’t scoop up a bunch of good deals this quarter, in fact he did a lot of selling. In this post I summarize the changes in Buffett’s portfolio as described in Berkshire Hathaway’s 13F filing.

Bye Bye Airlines

The big news this quarter didn’t come from Berkshires 13F, but from the annual shareholders meeting: Buffett sold out all of his airline. Berkshire owned about 10% of each of the top 4 airlines. This includes Delta (DAL), Southwest (LUV), American (AAL), and United (UAL). During the shareholders meeting, Buffett mentioned he paid $7-8B on the investment, with the idea he would average about $1B of earnings a year.

Buffett was keen to mention that the airlines are managed well, and his decision to sell was no fault of the CEOs of the companies. The airline industry is very cyclical, which Warren understood, but he did not underwrite the economy being completely shut down. Going forward, these companies will probably take over $10B in debt, plus issue equity. Additionally, the airlines are going to have way more planes than demand for the foreseeable future. Despite the bailouts from the government, there is no indication the airlines are in the clear. Given these extraordinary circumstances, Buffett did not trim his position, but completely sold out.

A humorous point Buffett made during the shareholders meeting was that it took him months to build these large positions. However, when it came to selling, he found plenty of buyers. It is most likely folks from Robinhood.

Surprise Goldman Sachs Selling

The other major position reduction in Berkshire’s 13F is the reduction of the Goldman Sachs position by 84%. This investment was a remnant of the 2008 financial crisis, where Buffett bought preferred stock that was later converted into common shares. So far, there is no indication why Warren dramatically reduced his stake in GS. One theory is that they are venturing into online banking, so perhaps Buffett thinks they will be distracted and lose share of the investment banking business. Another potential reason is that Buffett sees Goldman as a risky operation during the COVID crisis. Or it could be as simple as this a legacy position, and Warren wants to shore up his already high cash reserves. Whatever the case, hopefully Buffett sheds some light on this sometime soon.

Small Trimmings

The rest of the Q1 Berkshire 13F shows minor position changes. Berkshire’s main purchase of the quarter was increasing its stake in PNC bank by 6%. PNC however, only makes up 0.5% of Berkshire’s portfolio so this purchase is peanuts.

Next, Berkshire exited its positions in Travelers (TRV) insurance and Phillips 66 (PSX) oil refiner. Both of these companies represented a small part of Berkshire’s portfolio at the start of the quarter, so the complete selling of shares is not very impactful. It appears Travelers shares started to be sold in Q4 2019. PSX was a much larger share of the portfolio, and has been consistently sold off since Q1 2018.

Finally, about a dozen positions were trimmed by a few percent, as seen in the table below. These companies make up a rather small part of the Berkshire portfolio. Most likely these stocks were bought, and trimmed by Todd Combs and Ted Weschler, rather than Buffett. These two manage small portfolios within Berkshire, and are more active than Buffett who typically only makes big acquisitions. I would be curious what is the rationale for selling small slivers of these companies, but there is probably not much to it.

Ticker	Name	Activity
GM	General Motors	Reduce 0.43%
SU	Suncor Energy	Reduce 0.47%
AMZN	Amazon	Reduce 0.74%
LSXMK	Liberty SiriusXM	Reduce 0.77%
AXTA	Axalta Coating Systems	Reduce 0.80%
BIIB	Biogen	Reduce 0.84%
VRSN	Verisign	Reduce 1.06%
TEVA	Teva Pharmaceutical	Reduce 1.06%
DVA	DaVita Healthcare	Reduce 1.22%
LBTYA	Liberty Global	Reduce 2.43%
SIRI	Sirius XM Holdings	Reduce 2.83%
JPM	JPMorgan Chase & Co	Reduce 3.03%
LILA	Liberty LILAC Group	Reduce 3.10%
SYF	Synchrony Financial	Reduce 3.24%

Conclusion

The first quarter of 2020 went by in a flurry, which makes looking at the Berkshire 13F so interesting. So far in Q2, the market has rallied on the belief the economy will quickly bounce back from the COVID crisis. It would seem that Berkshire’s Q2 13F will be pretty boring, just reporting the airline sales that were mentioned in the annual meeting. Perhaps the market will sell off again later this year, allowing us to pore over Buffett’s portfolio moves, and hoping he lands a big acquisition.

A good website to track super-investor portfolios is Dataroma.

To see my portfolio action in the first quarter of this year, check out:

My Investing Past, Present, Future

March Stock Purchases

May 23, 2020June 6, 2020

Lender of Last Resort

In the last financial crisis, Berkshire acted as a lender of support for eight different deals. Despite the injection of expensive capital through preferred stocks and securing warrants, these companies were in fact paying for the sign of confidence from Berkshire in the midst of a crisis and that was invaluable. Today we have QE, infinity, low interest rates, and hungry hedge funds, even though the economy has deteriorated rapidly over the last few months. Why have we not acted as a lender of support?

This is an interesting question because it brings up some history lessons from the last financial crisis. During 2008, Berkshire was primarily supplying capital by means of preferred stocks and warrants, versus buying common stock over the market. These capital injections were on terms that were pretty generous to Berkshire. These companies knew that Buffett’s reputation carried weight, and Berkshire has a fortress balance sheet that could provide funding. Berkshire was literally able to do deals that no one was able to do.

Interestingly, Buffett admits his timing of deploying capital in 2008 was a bit early, that he would have been better off waiting a few months. Even the greatest investors can’t time the market.

As for the market panic in March, Buffett says the phone wasn’t ringing. The Federal Reserve quickly swooped to provide loans to support the financial system. Even marginal companies are able to access funds, so there is no need (for now) to come crawling to Berkshire. While many people are critical of these actions for various reasons, mainly because it prevented stocks to get very cheap, Buffett admits it was the right thing to do even though he got undercut. It is interesting to see Buffett support Jerome Powel’s efforts even though most investors are whining (which some of that is deserved).

COVID Impact on the Insurance Industry

Would you please help us understand the effects of COVID-19 are on our insurance businesses? Other insurance companies have reported losses from boosting reserves for future insurance claims that they expect to be paying as a result of Coronavirus. Yet in Berkshire’s 10Q released this morning, we do not appear to have reported much of these future expected losses. Can you tell us why this is the case? What kind of risks Berkshire is underwriting that allows us not to be affected by the pandemic or conversely, what we are writing that might be?

When it comes to insurance exposure to COVID19, Buffett warns there could be a huge amount of litigation. Many businesses that were forced to shut down operations are looking at their insurance policies to see if they can make a case for a payout. The potential for insurers to be liable is if they wrote commercial multiple peril (ie business interruption) policy.

Arguably, a pandemic caused business interruption. However, typically the policy relates to physical damage to a building that prevents business operations. Buffett gives the example that a strike at an auto plant would not trigger a business interruption policy. An example Warren provided where it would qualify is when a fire at a neighboring building spread to a Berkshire subsidiary building.

Luckily, Berkshire is mostly exposed to auto insurance, which should not have this problem. Buffett did mention that one large insurer had ambiguous policy language that could in fact have to cover pandemic losses. He didn’t name names, so it will be interesting to see who wrote this policy.

Thoughts on Negative Interest Rates

Interest rates are negative in much of Europe, also in Japan. Warren has written many times that the value of Berkshire’s insurance companies derive from the fact that policy holders pay up front creating insurance float on which Berkshire gets to earn interest. If interest rates are negative, then collecting money up front will be costly rather than profitable. If interest rates are negative, then the insurance float is no longer a benefit but a liability. Can you please discuss how Berkshire’s insurance companies would respond if interest rates became negative in the United States?

It is reassuring that Buffett is confounded by negative interest rates just as much as I am. He mentions his disbelief in how long negative rates have lasted in Japan and Europe. Interestingly, Buffett is surprised that these negative rates have not caused significant inflation. A humorous quip Warren gave was that if you could have negative rates, high debt, and no inflation, then civilizations would have figured this out a couple thousand years ago.

It is fascinating to hear Buffett make these comments that are along the same line of thinking as all the Perma Bears have been screaming about for years, however he isn’t whining about how the system is rigged and ripe for collapse. The only advice he gives to navigate the negative rate world is to hold equities since negative yielding bonds only serve as speculation, not an investment.

Are Buybacks Evil?

Berkshire has invested in many companies with stock buy-back programs. Recently there’s been a backlash against buy-backs. What are your views on this subject?

During the response to this question, I felt like I was repeatedly yelling “boo ya!”. Buffett opens up his remarks by saying it is politically correct to be against buybacks. Stock buybacks have gained a bad stigma because some corporations take on debt for the buyback, or use their profits to purchase stock instead of spending it on R&D or increasing wages. While I don’t want to get into the nuances of the pros and cons of buybacks in this post, the key thing is that buybacks are another form of returning cash to shareholders.

Instead of paying a dividend, businesses can buy shares from those who wish to sell their shares, thereby increasing the continuing shareholders stake in the company. An example Buffett makes is the scenario when three partners run a business that reinvests all of its profits. One partner needs cash so he asks the other partners for a dividend. But the other partners don’t want the cash from a dividend, don’t want to pay taxes on it, and want to leave that cash in the business to grow. Instead, the two partners decide to buy some shares from the other partner. Now the partner gets their cash, and the other two grow their stake in the business.

This sounds all well and good, but most companies overpay on the shares they buy back. Buffett has long stated that he loves when companies (including Berkshire) buy back its own shares when it is trading below how much the business is actually worth. This is an especially efficient way to deploy capital if there are no other better investment prospects for the company to engage in. The problem is that buybacks have become a fad. Recently corporations are doing massive buybacks at the height of a bull market instead of when their stock is cheap.

Another point Buffett makes is that it is dumb to commit to buy $X amount of stock each year. He favors being opportunistic about it, not mechanical. An analogy Warren makes is that it is like saying you’re going to buy a $5B company without knowing what you are getting.

Bad buyback policies can make the company vulnerable during a crisis. This is the situation we are seeing with the airlines, they spend a ton on buybacks and now they need bailed out. This is an example of poor capital allocation, not proof that buybacks are evil.

While I do agree that many companies botch the execution of their buybacks, Buffett summarizes my thoughts on the matter by saying: “Some do it stupid but that doesn’t make it immoral”. Mic drop.

Q1 BRK Buyback

Can you ask Warren why he didn’t repurchase Berkshire shares in March when they dropped to a price that was 30% lower than the price that he had repurchased shares for in January and February?

One thing Berkshire followers have been wondering is whether or not Buffett bought any shares during the first quarter. The price of Berkshire B shares got down to around $165 during March, where it was trading between $200-220 last year. With Berkshires large cash holding, many have been hoping Buffett would reward shareholders with a large buyback.

When asked about the matter, Buffett confirmed he did not perform any buybacks during the quarter. Even though Berkshire appeared cheap, Warren said that it is not any more compelling than it was 6 months ago. Yes Berkshire has gotten cheaper, but the value of the business has decreased as well. For instance, Buffett’s airline investments suffered a loss that materially hurts Berkshire.

Additionally Buffett believes there will be better opportunities ahead than performing share buybacks. The large cash reserve that Berkshire sits on provides optionality, which is valuable during uncertain times like these. While I do not currently own Berkshire (which could change), I would much rather see Buffett have one last glorious buying opportunity instead of boringly buyback stock.

Conclusion

In my opinion, this was one of the best shareholder meetings. Buffett answered some hard hitting questions, and was more candid than usual. While he had to be careful not to sound too pessimistic, he definitely has concerns with the economy. These were just the highlights of the Berkshire shareholders meeting, but I highly recommend watching the meeting or reading the transcripts.

Here is the video of the full meeting.

A full transcript of the meeting can be found here.

My recent investing history can be found in this post.

May 16, 2020June 6, 2020

SPG Q1 2020 Earnings Update

Back in March, I purchased 46 shares of Simon Property Group. While I am optimistic about Simon, I feel like it needs close monitoring since it is a highly indebted company. I did a write up analyzing their debt and liquidity needs for the year, which provided some reassurance. Now that Q1 is over, I want to follow up on their debt situation, and see how the mall closures have impacted their operating income. Below are some of the highlights from the SPG Q1 2020 earnings call.

Q1 Income Statement

Now to dig into my favorite part, the financial statements! The table below shows the key income statement lines, comparing Q1 of this to last year. Revenue is down compared to 2019, however it is interesting that lease income is not contributing too much to the lower sales. The 10-K lists the various reasons that “other income” is lower in Q1 2020 compared to 2019, but I’m not going through that here.

Operating expenses were slightly lower, it would be interesting to see what Q2 expenses look like since it will capture more of SPG’s scaling back of operations. Interest expense is lower, due to lowering of variable rate debt rates and refinancing of other debts.

Finally we can see that the net income dropped, and that the business earned $0.35 less than this time last year. All in all, the Q1 income statement looks good given the circumstances, but Q2 results will sure to be uglier.

	Q1 2020	Q1 2019
Total Revenue	1,353,360	1,452,834
Lease Income	1,262,232	1,289,058
Operating Expense	698,491	707,813
Interest Expense	187,627	198,733
Net Income	437,605	548,475
EPS	1.43	1.78

Current Balance Sheet

The balance sheet of SPG is something I want to keep close tabs on. While I’m not too worried about Simon’s debt load, the possibility of large operating losses requiring them to access credit is a bigger concern. First, the cash flow statement shows that Simon gained $6.45B in proceeds from debt, while repaying $3B of debts. This must be refinancing a credit facility, or paying off a bond that came due. Elsewhere in the 10-K, Simon reports they drew $3.75B from their credit facility for operating liquidity. Given the proceeds of this credit line, SPG’s cash balance at the end of the quarter was $3.724B compared to $670M at the end of 2019. Next, the total debt increased from $24B to $27.5B this quarter. To satisfy the finance nerd in me, the breakdown of SPG’s debt is as follows:

$3.0 billion outstanding under the $4.0 billion unsecured revolving credit facility
$875.0 million outstanding under the $3.5 billion unsecured supplemental credit facility
$1.0 billion outstanding under the $2.0 billion global unsecured commercial paper note program
Unsecured debt consisted of $15.8 billion of senior unsecured notes (bonds)
Total mortgage indebtedness was $6.9 billion

Based on these figures, it appears Simon has plenty lines of credit to tap into if need be. Finally, the 10-K also reported that SPG is in compliance to all of their debt covenants.

COVID Response

As the COVID crisis unfolded, Simon claims to be one of the first companies to voluntarily close all of their properties. Recently SPG has been opening properties back up with added precautions. Currently, 77 of Simon’s U.S. malls have reopened. Within the latest 10-K, Simon outlined their business response to weather COVID19:

Significantly reduced all non-essential corporate spending
Significantly reduced property operating expenses, including discretionary marketing spend
Implemented a temporary furlough of certain corporate and field employees due to the closure of SPG’s properties
Suspended more than $1.0 billion of redevelopment and new development projects
David Simon, the CEO and President elected to reduce his base salary to zero and deferred his approved 2019 bonus until the market conditions improve
Implemented a temporary decrease to the base salary of certain of its salaried employees ranging from 10% to 30%
The Board of Directors agreed to temporarily suspend payment to the independent directors of their board service cash retainer fees

In my view, these measures seem rational, and it is good to see the CEO and board eliminate their compensation. That is to say, I will be curious to see how these spending cuts affect the operating results next quarter.

Dividend Payout

One topic of interest is what SPG will do with their dividend. Simon paid a quarterly dividend of $2.10 in Q1. Interestingly, SPG has declared they will pay a Q2 dividend, however they did not say how much it would be. As a capital allocator, I would hope they would only pay a dividend if they had the operating cash flows to support it. I do not mind if they need to temporarily reduce or suspend their dividend payments, however many people are very demanding of their dividends.

Looking Forward

During the SPG conference call, David Simon did say that he expects positive cash flow this year. This is reassuring, since most people are assuming they are going to run a deficit with retailers not paying rent. But of course, we don’t really know how things will pan out. Simon did mention that some retailers have negotiated delays in rent payments. The company did not specify how many retailers they have negotiated with, or how many retailers have failed to pay rent. Therefore number of rent collected in a key figure. It appears Simon does not want to speak too specifically about this so retailers don’t use it as an excuse to not pay rent because X% of retailers haven’t paid. SPG communicated its firm position that retailers signed a contract to pay rent and must uphold that.

Since SPG closed its properties only a week or so before the end of the quarter, Q2 should be more revealing of how this crisis has impacted the company. The occupancy at the end of Q1 was down 1.1%, amounting to a total occupancy of 94%. This occupancy level seems very strong, but it is definitely something to monitor in the coming quarters. If this crisis persists, it could take a while for retailer bankruptcies to shake out.

Conclusion

All in all, I think this quarter’s results were pretty positive given the situation, and given how beat up this stock is. In the coming quarters, it will be important to keep track of the occupancy, lease revenue, operating income, and how they are deploying their credit facilities. While it is very possible SPG suffers through more pain, I am still optimistic on its fundamentals looking a few years out.

May 6, 2020June 6, 2020

Investing in Oil Tanker Stocks

Weird things are happening in the economy now amidst this COVID19 crisis. Stocks sold off sharply, then largely recovered. Unemployment is rocketing higher and the oil market is in shambles. The chaos in the oil market appears to be offering an interesting opportunity. The oil tanker thesis has been floating around Financial Twitter, and appeared on Real Vision. This trade seemed interesting, but out of my comfort zone. I decided to investigate the opportunities from investing in oil tanker stocks, and share my findings in this post.

Current Oil Conditions

While I am by no means an expert in the oil market, there are a few interesting things going on that create this oil tanker trade. Right now there is an extreme imbalance between supply and demand in oil. Below is a chart from EIA showing global oil production and consumption. From the chart, it can be seen demand for crude has had a very sudden drop with the onset of the COVID19 crisis, where most economies around the world are shutting down or limiting travel. This type of sudden decrease in demand is unheard of.

With this drop in oil demand, you would think that producers would massively cut their production? Wrong, at the start of this pandemic, Saudia Arabia and Russia had a spat, and decided to go full steam ahead producing oil. To make matters worse, it is not trivial to reduce oil production, it is a slow process. The EIA data suggests there is an estimated 10 million barrel a day surplus of oil.

The oversupply in oil has created a bizarre reaction in the futures market. We recently saw the front month crude futures price go negative. The simple explanation of this is that there is so much oil that producers are paying people to take the crude from them because they are running out places to store it. Further out on the futures curve, the price slopes up, which is a scenario called contango. Contango means you can buy oil cheap now (or free?), store it, and sell it at a future date for a profit. Profiting from storing oil is where oil tanker stocks come in.

The Storage Problem

The massive oil glut creates a new problem: where does all this oil go? Data from the EIA states that there is about 650 million barrels of land storage in the US, with 1.2B barrels of storage globally. Below is a chart from EIA data showing the capacity utilization of US crude storage, where it can be seen storage 61% full at the latest data point.

With land storage rapidly filling up, and contango in the futures market, a scenario is created where oil tankers are being used for floating storage. As tankers are being utilized as storage, instead of transporting oil, the supply tankers available to transport crude decreases. This causes the price tanker companies charge to transport oil (called spot rate) rate to increase. Typical spot rates in 2019 were about $15,000 per day. Recently tanker companies have been charging over $200,000 a day to transport oil. Rates these high have been seen a few times in the past, but for very brief periods of time.

How Long Will the Rates Last?

It is difficult to predict how long these extremely elevated rates last. While $200k spot rates may not last for weeks or months, it seems very likely that rates will continue to surpass 2019 rates for some time. Even more difficult to predict is what magnitude these temporary increases in tanker rates factor into the full year earnings for these companies.

I believe the consensus among investors is that tanker rates settle back down to normal levels once oil production is cut, or demand rebounds. The counter to this argument is that oil producers can not flip a switch and cease production (why not). On the demand side, I’m not convinced global economies are going to immediately rebound from the COVID19 shutdowns. Basically everyone thinks oil production cuts will be swift, and we will have a V-shaped recovery in the economy. In my view, the mismatch of oil supply and demand will persist, although slowly improve throughout most of 2020.

Tankers: An Example of Operating Leverage

Now that I’ve covered the background information, let’s analyze the tanker business. Oil tanker companies are characteristically capital intensive because in order to expand, you must acquire more ships. The ships are purchased with debt, so tanker companies have high debt loads and interest expenses. Finally, tankers have high operating leverage, which can be beneficial but also pose a vulnerability.

A business with high operating leverage has a large amount of fixed costs, such as employee wages, fuel, ship maintenance, and insurance. These costs do not change much year to year. The leverage comes in when the business experiences higher revenues, while maintaining about the same operating expenses. This causes the operating income of the business to massively increase.

Oil Tanker Financial Analysis

Let’s dig deeper into the financial statements to better understand the operating leverage and estimate how much profit these tanker companies can generate. The table below shows rounded figures from Scorpio Tankers last annual report. While I’m using STNG as an example, the same analysis can be done to other tanker stocks. Between 2018 and 2019, Scorpio Tankers increased its revenue by 30%. Despite this increase in sales, the main expenses were pretty consistent year over year. This means the increase in revenue went straight to operating profits, which translated into a 12x increase from the previous year.

(Thousands of dollars)	12/31/2019	12/31/2018
Vessel Revenue	704,325	585,047
Vessel Operating Costs	(294,531)	(280,460)
Voyage Expenses	(6,160)	(5,146)
Depreciation	(180,052)	(176,723)
G&A	(62,295)	(52,272)
Total operating Expenses	(574,353)	(574,505)
Operating income	129,972	10,542

A Note on TCE

Additional concepts that need to be described are revenue days and Time Charter Equivalent (TCE). Revenue days is the total time the fleet has spent generating revenue throughout the year. Scorpio Tankers has about 115 ships in their fleet that spend most of their time generating revenue, but there are some periods where they are dry docked for maintenance. Time Charter Equivalent is a way to compare revenues from time chartering vs operating in the spot market, and is an industry standard way to measure operating results. Without going into the differences between time chartering and the spot market, the important piece is that TCE is vessel revenue minus voyage expenses. Another way to put this is that the tanker spot minus voyage expenses is the TCE rate. This is important since we want to see how the high spot rates affect the operating results of the business.

Income Statement Analysis

Using the simplified income statement in the table below, the operating income can be constructed from the revenue days and TCE. We can figure out the TCE revenue for the year by multiplying revenue days (42,000) by the TCE rate (17,000) to arrive at a TCE revenue of $714M. Voyage expenses amounting to $6M are added back to get the total revenue of $720M.

Revenue Days	42,000
TCE	$17,000
TCE Revenue	$714,000,000
Voyage Expense	$6,000,000
Total Revenue	$720,000,000
Operating Expenses	$575,000,000
Operating Income	$145,000,000

By working our way up to the total revenue, now we can go down the income statement to calculate the operating income. Operating expenses mainly consist of vessel operating costs, depreciation, and G&A. These add up to $575M, which means the operating income is $145M.

Estimated 2020 TCE Rates

The above calculations are based on 2019 figures where the spot rate/TCE are in the neighborhood of $20,000 per day. By adjusting the TCE to reflect the elevated 2020 spot rates, we can recalculate the operating income. For this analysis I’ll use an estimated yearly average TCE of $40,000 per day. This number seems modest given the spot rates of $200,000 per day, but it is hard to predict how spot rates will hold through the year. I would rather be conservative on my estimates even though there is a good chance of average TCE being significantly higher than $40,000 per day.

Income Statement Analysis Round 2

An updated income statement, with the new TCE rate, is shown in the table below. Even though we increased the TCE, the revenue days, voyage expenses, and operating expenses will stay the same since they do not vary much year to year. Multiplying the new TCE by revenue days arrives at a TCE revenue of $1.68B. Subtracting voyage and operating expenses shows an operating of 1.01B, which is almost seven times greater than the 2019 example. That’s the benefit of operating leverage when it works in your favor!

Revenue Days	42,000
TCE	$40,000
TCE Revenue	$1,680,000,000
Voyage expense	$6,000,000
Total Revenue	$1,674,000,000
Operating Expenses	$575,000,000
Operating Income	$1,099,000,000

Going further down the income statement, we can estimate the net income using the $40,000 per day TCE. The main expense after operating income is the interest expense on all the ships. This amounts to about $185M. Subtracting the interest expense from the operating income equates to a net income of $920M. The current shares outstanding for Scorpio is about 49.85M, so the earnings per share is $18.45. Compare this earnings per share to the current price of around $20, which creates a price to earnings ratio of 1.08. A price to earnings ratio this low is ridiculously cheap, therefore we should expect investors to buy up the stock to reach a more reasonable P/E ratio. Additionally, the management at the tanker companies could reward shareholders with a generous special dividend or share buyback.

Interest Expense	$185,000,000
Net Income	$920,000,000
Shares Outstanding	49.85M
EPS	$18.45
Current Price	~$20

The Trade

Since the high spot rates affect all oil tanker companies, I think the best method for investing in oil tanker stocks is to buy a handful of them. The four companies I have bought are Teekay Tankers (TNK), Frontline Ltd. (FRO), DHT Holdings (DHT), and Scorpio Tankers (STNG). These companies have a variety of fleets sizes, and composition of the fleet. Ships ranging from the largest VLCC to medium sized Suzemax tankers are represented. Since this is an industry play, where each stock should benefit equally from the higher rates, I am not looking to do in depth valuations on each business. Each one of these stocks I have allocated about $1750, which combined makes up about 8% of my portfolio.

Lack of Price Movement

While the spot rates have been elevated for over a month, and this trade has become somewhat popular on FinTwit, the stock prices for tankers have yet to respond. One reason for the lack of price movement is that oil tanker companies are mediocre, cyclical, capital intensive businesses, which means they have booms and busts. Furthermore, tanker companies are notorious for being poor stewards of shareholder capital. These factors have turned off many people from buying into these companies.

My other theory for the lack of price action is that a lot of people are watching from the sidelines, waiting for the latest quarterly earnings to come out in order to validate that these companies are raking in some cash. All four of the tanker companies I own announce Q1 earnings in May, so hopefully the catalyst will begin soon.

Plan Going Forward

My game plan is to see if these stocks readjust to a normal P/E ratio after the Q1 earnings are released. From there, I will assess the likelihood of the high earnings persisting through the year. I am not interested in holding these stocks for a long period of time, and I do not want to try to perfectly time the top of this trade. It is possible that I’ll hold these companies for a couple of quarters, but if they significantly run up during Q1 earnings then I may quit while I’m ahead.

Besides seeing what these companies are earning with these elevated spot rates, there are some other factors that I’m considering with regards to the timeline of this trade. The crude storage capacity is the key driver to this thesis, so I will be watching for drawdowns on capacity utilization. The cause of these drawdowns would stem from the supply and demand imbalance to normalize. Finally, as the country opens back up, it is possible the consumption of oil will return closer to normal.

Conclusion

Hopefully this post provides a sufficient overview of investing in oil tanker stocks, with simplified analysis of the current situation in the oil tanker industry. While trades like this are out of my comfort zone, I feel supported by the fact that the high spot rates are public knowledge, and the high profitability of these companies is not caught up in hope and dreams. However, this position could prove to be a lesson in sticking with my circle of competence, we shall see!

You can check out my latest stock buys here.

April 16, 2020June 6, 2020

Why Simon Property Group (Probably) Won’t Go Bankrupt

The March selloff provided some opportunities to buy undervalued stocks. One of the stocks I scooped up was Simon Property Group, which on the surface appears to be a risky business. However, the assumption I’m making is that the majority of tenants will continue to pay their rent through this COVID19 crisis. Since this is a big assumption, I decided to dig into Simon’s financials, model what would happen if a chunk of their tenants fail to pay rent, and try to prove why SPG won’t go bankrupt.

Estimating SPGs Finances During COVID19

Now let’s do some back of the envelope calculations to model what SPGs finances may be this year. Simon Property Group’s simplified income statement and balance sheet are shown below. In this exercise, we assume a scenario where a large portion of tenants don’t pay rent, however we have to balance being conservative with being realistic. First, let’s say that there is a 30% reduction in revenue from tenants not paying or going bankrupt. Factoring in the 30% haircut from last year’s revenue, this would mean an estimated 2020 revenue of $4B.

SPG 2019 Simplified Income Statement	(Dollars in Thousands)
Total Revenue	5,755,189
Expenses
Property Operating	453,145
Depreciation and Amortization	1,340,503
Real Estate Taxes	468,004
Repairs and Maintenance	100,495
Advertising and Promotion	150,344
Home and Regional Office Costs	190,109
General and Administrative	34,860
Other	109,898
Total Operating Expenses	2,847,358
Interest Expense	(789,353)

SPG 2019 Simplified Balance Sheet	(Dollars in Thousands)
Assets
Investment Properties Less Depreciation	23,898,719
Cash and Cash Equivalents	669,373
Liabilities
Mortgages and Unsecured Indebtedness	24,163,230

Breaking Down Expenses

Even though the revenues may be down because of the COVID19 crisis, expenses may be fairly fixed. The next line on the income statement shows SPG had operating expenses amounting to $2.9B in 2019. Operating expenses consist of property operating cost, real estate taxes, repairs, advertising, office costs, employee costs, and depreciation. Some of these expenses could be cut, but that would probably equate to a couple hundred million which won’t move the needle too much. Above all, the largest cost is depreciation, which is a non-cash expense. Depreciation spreads the cost of certain purchases over a period of several years, instead of charging the full cost upfront. Since we are primarily worried about cash flow coming in and out, we can add back depreciation, resulting in an adjusted operating expense of $1.5B.

Operating and Net Income

Now that we estimated expenses, we can find the operating income by subtracting the adjusted operating expenses ($1.5B) from the estimated revenue ($4B). This leads to an estimated operating income of $2.5B. Following the operating income are a series of line items that arrive at the net income. Examples of these items are income tax, income from unconsolidated entities, and unrealized losses on assets. For simplicity sake, let’s ignore these since they won’t change the outcome much. The last line item we care about is the interest expense, which amounts to about $800M this year.

Current Liabilities

A common metric used to judge a businesses credit worthiness is the interest coverage ratio. This is calculated by dividing the operating income by the interest expense. For instance, an interest coverage ratio below 1.5 indicates the company may have difficulties paying their interest if there is a bump in the road. Calculating the interest coverage ratio for SPG, with the estimated operating 2020 expense, yields 3.16. In short, Simon should be able to make its interest payments this year.

With the income and expenses tallied up, it is time to look at the liquid assets and liabilities on the balance sheet. So far we estimated the amount of cash coming into SPG this year, but we have to factor the cash already on hand. During the period ending in 2019, Simon has $670M in cash. There are some accounts receivables and payables, but let’s pretend they cancel each other out for simplicity.

Long Term Debt

The most important piece of info needed to judge SPGs financial strength is the amount of debt they owe. Currently, SPG has $24B in debt, with $6B of it in mortgages, and $18B in unsecured debt such as bonds, commercial. paper and credit facilities. As previously mentioned, interest on the debt is about $800M this year. Some of the bonds and the commercial paper come due this year, which means the principle needs to be repaid. Finally, the amount of debt coming due this year is $2.9B.

The big question is whether or not Simon can pay off the debt coming due this year, and make its interest payments with reduced revenue. The good news is that in March, SPG received an increase in their credit facility. They now have about $9B in credit they can tap into to pay their liabilities. Obviously it isn’t ideal to use debt to pay debt, but these are circumstances beyond their control.

Calculating SPG’s Deficit

Putting it all together, we can estimate how much of a cash surplus or shortfall SPG will have this year after paying its debts. The equation below shows that by adding the estimated operating income and the current cash balance, then subtract interest and debt coming due, Simon will approximately have a $500M deficit.

Estimated Operating Income + Cash – Interest – Debt Due = -500M

While it is not ideal that SPG will more than likely suffer a loss this year, they can easily cover this deficit with their credit facilities. Therefore, based on these rough calculations, I believe Simon Property Group will be able to weather this rough 2020.

Other things to consider are Simon’s debt covenants may be a limiting factor on how they can navigate this crisis. However, I couldn’t find much detail on their covenants. One can assume that if they had a large increase in their credit facility, then they must not be close to violating the covenants.

Simon’s Dividend

Another note is that this analysis did not take into account Simon’s dividend. REITS must payout a large portion of their profits, however I doubt Simon will be profitable in 2020. Although some investors would probably prefer SPG to maintain the dividend as much as possible, I believe the smart thing to do would be to cut the dividend if this year is indeed economically bad. In other words,I would be a bit disappointed if SPG tapped into their debt to maintain the dividend.

Conclusion

In summary, it appears that SPGs $9B credit facility can provide a life jacket during this pandemic. These calculations are based on a 30% reduction in rental income, which seems harsh but not out of the realm of possibility. If every retail company goes bankrupt or doesn’t pay rent, then I guess it’s force majeure and we must be in a depression. Therefore, in my view, there is a good amount of evidence to show why SPG won’t go bankrupt.

Let me know if I’m missing something crucial! I by no means claim to be a competent analyst.

April 5, 2020May 9, 2020

March Stock Purchases

It’s been a while since I’ve bought individual stocks, but the March sell off has me scrambling to scoop up some good deals. My aim for these discretionary stock picks is to find quality companies trading at attractive free cash flow yields. Each position I bought in March make up approximately 5% of my portfolio. So far, I’ve bought Capital One, Simon Property Group, and Emerson Electric. I believe all of these are quality businesses, however they are not without their short term troubles.

Capital One Financial

Capital One Financial Corp (COF) was the first purchase during the recent market selloff. Capital One is a diversified financial company providing consumer lending, commercial lending, and commercial banking. COF is one of the 10 largest banks based on deposits, and third largest credit card issuer. The business model is to lend money to consumers and businesses from capital received by bank deposits.

The founder of Capital One, Richard Fairbank, is still the CEO of the company. Managers that are founders is a trait I like in businesses because I believe their interests are better aligned with all the stakeholders, and are more likely to be above average capital allocators. Capital One used its strong balance sheet to make acquisitions during the 2008 financial crisis, so I have confidence they can navigate this current market turmoil.

The main risks to COF are low interest rates, which compresses the spread between the interest they receive from lending and the interest they must pay on deposits. The falling interest rate trend has impacted most bank stock valuations. During a recession, default rates and charge off rates could increase. While COF has reserves for increased defaults, it could temporarily affect earnings. Another reason for Capital One’s lower valuation is the recent data breach that occured in 2019.

The table below shows my purchase price, and some of the key metrics I use to evaluate a business. Typically I don’t use Price to Book value, but it can be useful to valuing financial companies. A stock trading below its book value, a P/B less than 1, is a sign of undervaluation.

Purchase Price	$63.25
FCF Yield	52%
P/B	0.5
D/E	0.95
RoE	9.5%

Simon Property Group

The second stock I bought in March was Simon Property Group (SPG), a mall REIT. Owning a bunch of shopping malls sounds like a terrible idea since the narrative is that brick and mortar retail is dead. While I think many malls will close, I believe this will be concentrated on the lower class malls in unattractive markets. SPG owns 204 properties, including 106 malls and 69 premium outlet malls. These properties are located in major metro areas such as Miami, Boston, San Jose, and Las Vegas. The quality properties in great markets should allow SPG to continue to provide steady cash flow to shareholders. Simon has the highest credit rating for a REIT, pays an average interest rate of 3.3% on its debt, and has a 5.3x interest coverage ratio.

SPG share price has been heavily beaten up from the Retail Apocalypse narrative, and now COVID19 fears. I believe these fears are overblown. Yes online shopping will continue to grow, but I believe brands will still want some physical locations as a showroom for their products. Since 2017, SPGs occupancy rate has only fallen 0.5%, to an occupancy rate of 95.3%. During this same period, base rents have increased. SPG is focusing on providing not only shopping, but dining and entertainment options to diversify the experience. As for the COVID19 concerns, it is possible some corporate tenants will not be able to pay their rent. However, I do not think it is likely that more than 50% of tenants are going to break their lease, or go bankrupt. It is my belief that Simon will be producing healthy cash flows two years from now despite a near term rough patch. If I’m wrong, then we are probably in the Great Depression 2.0 and have bigger things to worry about.

The table below shows my purchase price and key metrics used to judge the quality of the business. The debt to equity is high for this company because it owns real estate with mortgages. The return on equity is very high because the debt allows SPG to own a large amount of income producing assets. This debt means there is relatively low amount of equity, thereby creating a large RoE.

Purchase Price	$74.50
FCF Yield	13%
D/E	9.4
RoE	73%

Emerson Electric

Emerson Electric (EMR) is a diversified industrial company consisting of climate technologies, automation solutions, and tools & home product segments. Climate technologies include residential heating and cooling, commercial air conditioning, commercial and industrial refrigeration. The tools & home products segment makes professional tools, food disposal systems (such as its InSinkErator brand), electric water heaters, among others. Both the climate technologies, and tools & home products segments are low growth, almost commodity type products. What makes me interested in EMR is the automation segment, that provides measurement instruments, fluid control, process control, and Industrial Internet of Things solutions. This segment should provide Emerson with a runway of modest growth in the future. One application of EMRs automation products is in the oil industry, with computer controlled valves, pumps, flow rate sensors that accurately measure the transfer of oil in custodial transactions.

The main risks to EMR are a general economic slowdown, and slowdown in the oil industry specifically. While EMR is quite diversified, the shale oil recession in 2016 impacted Emersons automation segment. Going forward EMR could face near term headwinds with the economic slowdown from COVID19, as well as the collapse in oil prices. Despite this, I believe Emerson is a high quality company that is rarely undervalued.

It can be seen from the table that EMR appears to be a quality company that can produce healthy returns on equity, while having a strong balance sheet.

Purchase Price	$31
FCF Yield	13%
D/E	0.48
RoE	26%