Cash & Oil

In recent weeks I’ve opted for the contrarian position that is cash in significant size. Not calling a top or anything like that, just not smart enough for that, but I do think there is a lot of craziness going on in the markets that calls for at least some degree of caution.

Short interest is low:

Margin buying is high:

Insider selling is high:

On top of that you have rampant speculation in SPACs and stocks like Tesla that has 20x’ed in 18 months to a valuation exceeding $800 billion. If that story unravels how would it impact the general market? Is it possible to imagine there not being some sort of ripple effect?

It is said that valuation doesn’t matter anymore, to which the proper response throughout market history has always been: “Until it does”.

To me it seems like investors are loaded on one side of the boat and that the market is priced close to perfection. Ergo the market could be in a more fragile state than is generally perceived.

Since a dollar saved is more valuable to me than a dollar won I want outrageous value propositions, ie. absurdly low valuations. And I’m just not finding as many of those in the corners of the market that I spend my time. In many of those sectors the stocks have risen sharply while the fundamental picture is less clear. Which makes me err on the side of caution and trim positions where I think the risk/reward is still attractive but less so than a few months ago while exiting others.

Oil

In oil I am seeing a different picture. Fundamentals have recovered but the stocks much less so.

This is a supply story more so than a demand one – despite the media focus on the latter (“peak oil”, “electrification will eat the world tomorrow”, etc.).

The oil majors have been cutting their capital expenditure budgets since 2014 which has led to underinvestment and a drawdown of reserves and the virus has accelerated that trend. This could lead to a squeeze in a few years time.

A number of the oil majors are cleaning up their image by moving towards renewable energy. Strangely many investors see this as a sign to exit oil stocks. What I suspect some are failing to see is that when supply takes a hit you want to be a buyer of that commodity, not a seller.

You would think investment activity would pick up to make up for those lost years, especially as oil prices are increasing. However, so far that is not happening. On Q4 conference calls with US shale producers the mantra is “debt reduction and returning capital to shareholders”. What you don’t hear is the word “growth”. And even if US producers wanted to expand it is doubtful that they are even able to make such a decision after 10 years straight of negative free cash flow.

Both lenders and investors want to see cash returned rather than entering into new adventures. On top of that ESG comes more and more into the thinking of banks, putting yet more pressure on the idea of growth.

And I think one of the big changes that may have been missed by some parts of the market is the ramped up frequency of OPEC meetings that are now on a monthly basis. This can be seen as a veiled threat to US shale producers: “We are keeping a very close eye on what you are doing and if we see any sign of significant increase in your drilling activities we may respond by dropping more oil on the market leading to lower prices making your capital investments very risky. So don’t do it! Keep doing what you are doing now (ie. hold back on your investments) so that we may all prosper.”

Naturally there are many ways to play the thesis depending on one’s tolerance for risk. Personally my largest exposure in the sector is with International Petroleum.

International Petroleum

Lundin Energy is a famous 200-bagger if you bought the stock in 2001 and include dividends. In fact, today’s quarterly dividend alone is higher than what you paid for the stock back then! A lot of luck involved in being on the right side of the commodity cycle of course but I imagine skill is part of the story as well.

In 2017 Lundin Energy spun-off their non-Norwegian assets into a new company called International Petroleum, ticker symbol IPCO. And with it some key management people. Among others the CFO, Mike Nicholson, who became IPCO’s CEO. And the former CEO for more than 13 years, Ashley Heppenstall, became Chairman of the board of the new company. Both have decent amounts of shares in IPCO and both have bought more at various points in time.

The intention was for the company to take Lundin Energy’s mature and declining assets in Malaysia and France and use the cash flow from those to expand opportunistically into new non-Norwegian areas and leave those for Lundin Energy. Since then the company has made three acquisitions of oil and gas assets in the Canadian oil sands. 75% of their assets are in Canada. And of those Canadian assets 25% is gas and the rest oil. This means that roughly 60% of their revenue depends on the price of Western Canadian Select, WCS, while Brent oil makes up 15%-20% of the revenue. Gas is doing very well currently and IPCO has hedged most of 2021 at decent prices compared to historical averages.

Because of sub-optimal pipeline infrastructure in Canada transporting oil from there to the US has historically been an issue, which is the main reason why WCS always trades at discounts compared to Brent and WTI oil. The discount has narrowed recently and pipeline expansions are expected to come online within a couple of years. (Note, the WTI/WCS differential is currently significantly lower than what IPCO has assumed in their price decks, leading to conservative estimates)

Oil prices are back but share prices are not

The virus led to a hard drop in oil prices, especially for WCS. But that has come back hard and is now above $50 per barrel, a level not seen since April 2019.

Back then the IPCO share price was above 50 SEK and now it lingers around 27 SEK. USD/SEK has declined by 10% over that period making up for a small portion of that = 30 SEK by comparison.

So oil truly is in the dumps, sentiment wise. However, free cash flow generation is not:

IPCO Valuation

At 27 SEK IPCO market cap is: $510M (USD)

Net debt after Q4: $320M. (EV: $830M)

Based on their 2021 production guidance (42,000 barrels per day) and capex guidance ($37M) (https://www.international-petroleum.com/investors/presentations/) I calculate free cash flow of $185M for 2021 given WCS $50 and Brent $65.

Normalized capex in the coming five years looks to be around $80Mish and production $46,000ish barrels of oil per day = FCF of about $180M given today’s oil prices. That equates to an EV/FCF below 5. So less than five years of free cash flow to pay down all debt and buy back all shares.

Very handsome FCF yields that are difficult to find elsewhere in the market. And if my oil thesis turns out to be correct those free cash flows will be improving over the coming years.

So what will IPCO do will all this cash?

Ressource companies have a tendency towards growth for the sake of growth, often at the expense of value per share. However, the Lundin companies have demonstrated again and again over the years that per share thinking permeates their culture.

IPCO has demonstrated a willingness to shrink the company via accretive buybacks when debt was manageable and the discount to net asset value was large. My sense from the recent Capital Markets Day from last week (https://edge.media-server.com/mmc/p/x8ykwcpj) is that this could be in the works again in about a year’s time when debt has come down to a more suitable level.

Caution now is the main focus after a tough 2020. As it is for pretty much everyone in the industry. Which is why supply is so constrained. And which again is why oil prices could meet little resistance on the way up even though Saudi and Russian oil will fill some of the gaps in the months to come. The larger question is whether they are able to further out in time, even 1-2 years from now.

IPCO has proven and probable reserves (2P) lasting 18 years. They also own a project, Blackrod, with potential for adding 3x of those reserves a few years down the road if oil prices stay elevated. That could potentially add 150% of production although it is doubtful IPCO can lift this project without a partner given the size of it. The valuation of this project is close to 0 currently among analysts. However, that could change in a big way in a higher price environment. Worth noting that the previous owners have already invested $180M into this project.

How about further acquisitions? Lots of struggling companies and majors that want to divest at cheap prices. Why not pick up the spoils on the side of the road? Frankly, I hope they don’t go down that route, even though it could potentially add more longer term value. I prefer to think that now is the time to harvest at as low risk as possible. Seems to me they have plenty of run way, especially with Blackrod in the pipeline, and a size that is adequate.

Conclusion

If my view that oil is heading towards Brent $70-$80 in the coming 2-3 years plays out and if we return to normalized valuation multiples the stock could easily 5x over that time frame.

At current oil prices I would expect at least a 2x over the coming year or two.

I would expect the truly long-term investors who are able to sit on their butt for 10-20 years to be collecting some fat dividends over that time period.

Supposing oil prices fall from here I think there is a lot of cushion built into the current share price. Also, the Saudis have demonstrated a willingness towards quick cuts (unilaterally even) in case demand wanes. That ought to keep a floor under the price. Given their own precarious economic situation I doubt they will be tempted to start yet another price war.

Disclaimer: I own shares in International Petroleum. If you become interested in the company based on this article please do your own due diligence before buying or selling shares in the company.

2021 Portfolio Positioning

A volatile year has come to an end. The gain to the portfolio has been surprisingly good, especially when considering the slaughter early in the year. In the red for tankers but everything else, uranium, oil, gold, containers, liquified petroleum gas, was in the green and the year ended with a 31% portfolio gain. The portfolio churn has been much higher than in previous years due to the many trading opportunities that presented themselves.

CAGR for the 7-year period since going full-time is at 24%. My approach has been highly concentrated towards few names so the element of chance is likely quite high, even over a 7-year period. On the other hand there has been no tail winds from high flyer tech companies in my portfolio and it has been almost exclusively restricted to deep value. The latter has had a tough decade, so significant outperformance versus the major indexes despite this headwind gives me some confidence that stock picking may have added value outweighing at least some of the potential luck factor.

2021 portfolio

After quite a bit of reshuffling late in the year my portfolio as of January 1st looks like this (biggest positions in each sector in paratheses):

Shipping, energy, commodities. Definitely not for the faint of heart. However, valuations are low for these sectors and if one can stand share price volatility I would argue that risk/reward is more a function of price versus value than anything else.

Diamond S Shipping – Revisiting a Disastrous Pick

$15.28 at the time of my article in mid November 2019 where I suggested this tanker stock stood a good chance of outperforming. Now, almost one year later, the price is $6.38 – a 58% decline.

So what the hell happened?

Three record quarters of fantastic earnings in a row for the tanker industry has rewarded shareholders with share prices that are more or less cut in half. Whether it is the ESG focus leading to investor flight or whether the market is accurately evaluating a high likelyhood of a multi-year prolonged downturn currently no one can say for sure. But the fact remains that almost all tanker companies have much stronger balance sheets compared to a couple of years ago so most ought to come out of the current low rate environment intact. How long it takes depends mainly on when oil inventories have been drawn down to more balanced levels.

According to Vessels Value, the valuation firm which is regarded as the go to shop in the industry, tanker vessel values have fallen 15-20% since the peak at the end of April and are still declining as of last week. At some point, and I suspect that moment can’t be too far off, values will stop falling and then the market might look at valuations and say, hey wait a minute, we threw the baby out with the bath water, this is nuts. But that is a subject for another article. Here I will look at the relative performance vs other tanker companies, which is usually my main focus, rather than the macro, which has many more factors of uncertainty. Getting the macro wrong is much more acceptable in my world than getting the micro wrong.

DSSI underperformance vs peers

And the fact remains that Diamond S has underperformed most peers, except Scorpio Tankers and Ardmore Shipping.

So what did I get wrong and what can be learned?

My current view is that I had a far too optimistic view of management based on history and significant share ownership.

Navigate around NAV

For one, the shares have traded at much larger discounts to net asset value than all other comparable peers and management could easily have taken steps to take advantage of that gap via share repurchases, which, when you trade a big discounts, increase the value per share. The steeper the discount, the more accretive it is to repurchase. This could in turn have led to a narrowing of the gap and the shares trading more reasonably over time.

A lot of talk and no action

Mangement talked about this constantly in conference calls and on panel discussion, even after the great contango trade had evaporated in May, but never did anything and now it is too late because they don’t have the earnings that will allow them to do so. Covenants state that only 50% of earnings from the prior quarter can be allocated towards repurchases/dividends and now that window has been closed for many quarters to come.

With vessel values falling hard that can now appear as a prudent action on their part conserving cash for this difficult period BUT they have always had the opportunity to sell a few of their vessels to secure a stronger balance sheet for tougher times ahead. They did not do that when times were great and they still haven’t done so. In my opinion this comes close to being abuse of us, the owners. It was such an easy course of action to take not requiring any brains at all. Currently the shares are trading at 65% discount to net asset value = P/NAV 0.35.

Bad luck on the operational front?

But that is not all. On the operational front they have drawn the shorter end of the stick quarter after quarter. My view of commodity driven businesses is that operational performance is not what you should be focusing on. This tends to converge over time. All ship owners pride themselves as being better than the next guy on that front but the reality is often there is very little difference. Bad luck in one quarter is usually evened out by good luck in another, or close to it.

But having followed them closely for four quarters now the extent of their bad luck is astounding. And this to an extent that I am no longer willing to ascribe only to bad luck. And perhaps I should have been a lot quicker coming to that assessment.

A few examples:

In Q4 two of their Suezmaxes were to have scrubbers installed (this is air pollution control devices) and they were supposed to arrive at the yard 30 days apart for maximum efficiency. Instead they arrived almost on the same day which meant unnecessary waaiting time. Could that happen easily or was it due to incompetence? I don’t know the answer to that but it is not something that I have heard in earnings calls from other companies so that was a clear warning sign.

In the first half of the year they missed out on super earnings for a few of their Suezmaxes due to being taken advantage of by charterers who had negotiated low demurage rates which meant that these vessels were sitting ducks with a lot of oil and nowhere to go when rates were great. Was this again simply bad luck? It might have been by why were other ship owners again more lucky on this front?

And in general they seemed to have missed out on more super trips in the March/April period than other tanker owners as well as having secured fewer now valuable longer time charters.

Their MR product tankers have been underperforming all along. Their ice class vessels consume more fuel but this is taken into consideration in the vessel valuations so putting them in the penalty box for that would be akin to double counting so no critique from me on that. However, given the Suezmax mishaps I am pleased they have decided to leave this side of the business to Danish ship management company Norden who have a strong and long lasting reputation. I hope they will do the same with the Suezmaxes.

Too cheap despite poor execution?

Having said all of the above I still regard the stock as too attractive to dump as I think there are still too many good outcomes relative to the share price but on the other hand until something changes such as vessel values rising again, or if they start selling some of their vessels, or if something good happens on the vaccine front, I’m not eager to have a big position either because the balance sheet is more strained than I would prefer in this uncertain environment with financial leverage around 45% currently. This is lower than most peers but I would still perfer a bit more safety.

For that reason I prefer a stock like International Seaways with a safer balance sheet (32% leverage), fine management excecution these past twelve months and at $14.15 an attractively priced share (50% discount to NAV) for bigger allocations even though it isn’t as dirt cheap as Diamond S. I might elaborate a bit more on this stock in a future article.

It is noteworthy that there are tanker stocks that are much more highly leveraged and dangerous in a prolonged downturn. Scorpio Tankers is close to 70% and Ardmore Shipping 60%. If values don’t improve soon those may have to dilute shareholders via equity raises and I find that scenario much less likely with Diamond S (and practically impossible for INSW and EURN).

For those following the space: Am I being overly harsh here and were the odds truly less favorable than what I thought back on November 20th? Did I miss something obvious? Also, have they truly been unlucky and was their decision to not go for share repurchases a wise decision?

Yellow Cake Takes Advantage of Historically High Discount

I’ve been writing on the uranium theme for a couple of years now and even though the price of uranium (U₃O₈) is up from $22/lb when I started writing to now $33/lb the share prices have not performed in that period.

In my mind it makes some sense that the junior miners have come down as the price of uranium is still lower than their cost of production so obviously they cannot sell their goods at these levels (they need $50/lb+) and are instead forced to dilute shareholders to keep the lights on while they wait for higher prices.

So fair value for the miners can be debated but what makes less sense to me is that those companies whose business it is to simply buy and store uranium rather than mine it are also not performing.

In fact both Yellow Cake and Uranium Participation are trading at historically high discounts to their net asset value at a time when uranium fundamentals are clearly improving with uranium inventories being drawn down at a rapid pace not seen for years, in part, but not solely, due to Covid 19 (which I will get back to) and also because psychology is shifting in favor of nuclear energy due to climate change.

For Yellow Cake especially the discount is kind of astounding: 30% here and now (upside to NAV = 43%). And for Uranium Participation it is at 21% currently (upside to NAV = 27%).

A Brief History of YCA/UPC Trading Patterns

Here is a graph of how the latter has traded in relation to NAV since 2007. The orange line represents the price of uranium and the green one the NAV the company trades at. Whenever the green line is above the orange line it means the shares trade at a premium (and vice versa).

And here is the same graph zoomed in on the last three years:

As can be seen it is not the natural state of affairs that these companies trade at a deep discount. In fact for long stretches of time they have traded at a premium.

And as can be seen in the graphs Uranium Participation currently trades as if the price of uranium was below $26/lb. For Yellow Cake that figure is $22.50/lb currently(!). Since my view is that the longer term trajectory of the price of uranium is quite clearly pointing upwards from the current $33/lb I view the current situation as one where my margin of safety is so large that I can comfortably make a big bet and sleep well knowing that if I’m wrong I likely won’t take much of a hit. A protected downside along with a leveraged upside is my idea of fun in the markets and for that reason Yellow Cake is my biggest uranium position currently.

Since Yellow Cake’s inception in July of 2018 it usually traded around NAV (except for a brief tantrum in December 2018 along with the rest of the market). In that same period Uranium Participation has usually been priced 2-3% higher (perhaps due to a combo of a longer history in the markets along with more liquidity since it is listed in Canada along with most other uranium equities while Yellow Cake is listed in ”uranium poor” London). Now the gap between the two is 9%. A few weeks ago it was even higher. (Edit after posting: The derivative liability does not explain the discount gap because the maximum cost of this vs what is in the books is slightly more than 1% of market cap ($6.5M vs $2.6M in the books, see disussion in the comment section below).

Covid19 – A Temporary Situation?

”But wait”, you might say, ”the boost in the uranium price is all about Covid19 shutting down a large percentage of mines temporarily and thus the boost in the uranium price is articifial. This is a situation that goes away!”

And this is indeed what I suspect the wild discount is all about: The market seeing this as a short term thing that will ”revert to normal” (ie. a uranium market that is soundly asleep!) once the Covid restrictions are lifted.

You might also say: ”Look at the predictive powers of the high discount in the 2015 period. At that time the spot price went down when the discount was high. That will likely happen again!”

While that viewpoint may prove to be correct in the very short term here is why I personally believe this time is different:

• A large amount of pounds of U3O8, at least 20 million, have in fact been taken out of the market bringing inventory levels down further. Kazatomprom have announced that these pounds are not coming back by increased production at the other side of this. That means that the bull will arrive sooner than if Covid hadn’t happened.
• Spikes in commodity prices, such as what we saw in uranium in March and April, are almost always signals of underlying tightness between supply and demand even if the immediate trigger that sets it off is a supply shock caused by outside events that are temporary in nature (such as Covid now, and such as the Cigar Lake flooding in 2006). If there was a lot of available supply ready to be sold the price would likely not have responded as it has. Sellers would have been more willing to offload uranium into the market to take advantage of the situation.
• But perhaps the most significant part of the equation is the longer term significance: When the cost of shutting down a nuclear power plant is much greater than the cost of the fuel (ie. uranium) security of supply becomes an issue that increases in importance for uranium buyers and the focus on price becomes less important. Covid19 has exposed the “just in time” supply chain thinking to be a dangerous one. For that reason I would think the utilities will likely want higher levels of inventories than they wanted pre Covid19 and that they will start to come into the market in the not too distant future.
• Last, but not least. Say the doubters are proven correct: The cushion is very soft when buying a commodity as if the price is $22.50/lb when it is currently selling at $32.60/lb.

Yellow Cake Changes Course – Selling Uranium No Longer Off Limits!

Apparently Yellow Cake also thinks the current discount is unsustainable because today came the announcement I have been waiting for for some time: https://otp.tools.investis.com/clients/uk/yellow_cake/rns/regulatory-story.aspx?cid=2392&newsid=1399401. Yellow Cake announced that they have sold 300,000 lb of uranium, correesponding to 3% of their holding, at $33.20/lb (which is slightly above the current spot price) and that they will be using the proceeds, $10 million, to repurchase their own shares thereby increasing the value of that $10 million by 43% (upside to NAV at current share price) to $14.3 million. The current market capitalization of the company is roughly $220 million so 2% of value was created out of thin air with a shrewd shareholder friendly decision. Capital allocation at its finest because value was increased without taking ANY risk! Like picking up free cash from the street…

And importantly, it carries with it the possibility that if the discount persists Yellow Cake could, now that the door has been opened, decide to sell all of their uranium and distribute the resulting cash to shareholders. That would mean a 43% increase in the share price overnight and if the market starts pricing in such a scenario as a possibility we will obviously see the discount gap narrow leading to a higher share price all other things being equal.

Go For the Easy Stuff!

As an investor this is why you chase value even when it has been sleeping for a long time rather than chase the next hot thing for fear of missing out (which was the subject of my most viewed post to date: God Damnit, I Missed the Boat!).

Value has periods where it underperforms – but it is there! It is no illusion. And it isn’t dependant on being smarter than or outmanuvering other market participants. And the great thing for someone with an IQ below average, such as myself, is that no brilliancy or deep insights into the market is needed.

We all know we overestimate our own abillities. It is in our nature. And it is what pushes us to perform in all other areas of life. But in investing it usually is a liability because you want accuracy of judgement above all else. Inflated egos crash and burn all the time due to perceived prowess because 90% of investors aren’t better than the average investor and so ought to opt for prudence over excessive risk-taking. Just like 90% of drivers aren’t better than the average driver. But we all think we are the exception to the rule. This benefits society but necks are being broken in the process. So take advantage of this human glitch. Go for the easy stuff and outperformance over time becomes almost a given even though there will be prolonged stretches of underperformance along the way.

For inspiration of such an investment philosophy here is a clip from the humble and dignified human being who first inspired me to look towards the deep value approach, John Templeton:

John Templeton on deep value investing

By the way, somewhere in this post I have dared to contradict this greatest of deep value legends. Can you spot where?

 

Disclaimer: I own shares in Yellow Cake  at the time of this blog post’s publication. Nothing herein should be considered investment advice. The post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.

ADS Crude Carrier – the low risk play in a sea of uncertainty?

At a time where the coronavirus has wreaked havoc around the world and where oil demand has crashed it might seem strange that those who transport oil around the world are seeing record high rates. But that is indeed the case. And the primary beneficiaries are the owners of the bigger vessels, the Very Large Crude Carriers. Those are currently Very Large Cash Cows printing money at a pace that rival that of the central banks…

In this post I will provide an investment idea that I think is uniquely positioned for the current situation, ADS Crude Carrier. The key is this:

Large vessels with short lives and a business model that is all about distributing cash in massive amounts to shareholders in the near term.

(For a quick summary scroll down to the end of this article)

Why are current rates so high?

Before I get to the company specifics here is a bit of background on why the current collapse of oil demand has ended up benefitting tankers immensely here and now.

What we have now in the oil market is the rare situation where short-term contracts are priced much lower than those further out into the future. This situation is known in the commodity markets as contango. The bigger the gap, the steeper the contango: https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html

This has come about because short-term demand for oil has collapsed by unprecedented 30+% due to the coronavirus situation we have all been subjected to. And because production is much higher than the demand the market is way out of balance even when factoring in a huge production cut by OPEC. So this excess oil must go somewhere: Hello tankers!

Oil traders can benefit from this by buying short-term contracts and simultanously sell contracts further out and lock in the difference. Except, they don’t get to keep all the spoils. Actually by the far the majority of it goes to those who can store the oil that is being bought. And since the world is soon running out of storage on land rates for storage on tankers have increased tremendously.

In fact, to rent a VLCC for storage at this moment for six months the contango supports rates above $110,000/day and for one year $70,000/day. Contrast that with a cash break-even for an 18-year old VLCC at around $15,000/day. And tankers tied up for storage decreases the overall supply which pushes up rates for the vessels that get booked for what they were actually built for: sailing, transporting oil. Just yesterday a VLCC was fixed at $187,000/day for an 80 day trip.

There will come a time, however, when rates will plummet from these high levels and that could happen once oil demand start to outstrip production again. This sounds like a great thing for tanker demand but the problem is that initially there will be a drawdown from all the inventories that have been stored. So the whole storage story is double-edged. But the good thing for tankers is that earnings are many multiples above break-even now so it isn’t as easy as to say that a bad month cancels out a good month. Each month that this goes on is tremendously valuable for tanker owners. Those negative on the sector point to the inevitable hangover that will follow. And they are right. But it doesn’t matter all that much to the bull thesis since some tanker owners are likely to earn their entire market cap in 2020 alone.

ADS Crude Carrier – well positioned for this particular market

And this gets to the heart of why I have picked ADS Crude Carrier ahead of other tanker companies for this particular environment.

ADS is listed on the Merkur Exchange in Oslo. The share price currently is 25 NOK and the market cap 585 MNOK ($57 million).

The company owns three 17 ½ year old VLCCs with an average life of 30 months left in them before they are likely headed for recycling.

Of those 30 months 5.5 months have been locked in at rates that cover more than half of the current market cap in operating earnings(!). On a per share basis this is equal to roughly 13 NOK/share – all of which I expect to go towards dividends and debt reduction (less future vessel opex) as per company policy.

Since rates are ”unnaturally” elevated now it isn’t as simple as saying 30/5.5 x 13 NOK to get at the expected return to shareholders over those 30 months but it does go to show that there is a huge margin of safety already built into the numbers, even in the unlikely event that rates crash through the floor in the very near term. I will get to my baseline assumptions for rates for the rest of the period a little further down in this article.

Based on conversations with management I expect capital expenditures and fleet renewal to be zero in 2020 and 2021. And in H2 2022 the base case as I understand it is that the three vessels will likely be recycled and earn their steel value and the remaining debt will be paid off.

The math of it based on current steel prices looks like this:

So approximately 4 NOK/share of additional value when adding back working capital and subtracting the debt. Note that the number supposes current steel prices 2 ½ years down the road which of course is a very big if. For the number to be negative steel values will have to decline by more than 30% from already depressed levels. I don’t deem that a likely scenario but of course not an impossible one either. If steel prices revert to where they were in the fall of 2019 ($16 million per vessel rather than $13 million) the total value would be 8 NOK. In other words, I suspect 4 NOK is on the conservative side.

Optionality kicker

There are other possible scenarios in H2 2022. One is if rates are still expectionally strong the company could decide to take the vessels through a survey that would potentially give them an additional life of 2.5 years. From my understanding this is unlikely to happen.

Another scenario in a strong but not crazy strong market is that the vessels can be sold as storage vehicles. This supposes ADS will be able to get a higher value than they would by recycling the vessels. Also not a likely scenario from my understanding.

So while both of the above two scenarios are unlikely they do provide free optionality for the company. So what is the value of that?

My estimate is 5 NOK and that is the number I will use going forward but it is very hard to assess, admittedly.

The theoretically correct way to find this number would be to multiply the value of all the possible scenarios by the probability of each and then add them all together. Too many unknowns to arrive at an accurate number of course but it certainly is above 0 even though 0 is the outcome in most scenarios. The reason is that some scenarios are worth a lot.

For instance: Supposing ADS were able to sell the vessels for $26 million per vessel in H2 2022 for storage or trading instead of recycling them at $13 million that would equate to 13*3=$39 million of additional value, which is 17.60 NOK per share.

That is obviosuly a blue sky scenario but to put things into perspective: Earlier this week a 2001-built Suezmax vessel (which is half the size of a VLCC) was sold for $21 million which is a figure that is more than double its scrapping value even though it only had one more year left of trading. But of course the main reason for this price is the current contango making it an earning machine in the short term. I wanted to mention it because even though the contango likely will be long gone by 2022 other factors could come into play that would make the vessels sell above scrap value.

Valuation

So what we know for sure is 13 NOK is in the bank for 5.5 months out of 30. This number is the most important of all because of the certainty of it and it is the basis of the whole safety thesis.

4 NOK for scrap value+working capital-debt. And 5 NOK for optionality. Those are both my fair value estimates and neither are close to being bankable.

In total: 22 NOK.

What then is the value of the remaining 24.5 months of vessel days? Again, remember this is a period with a lot of uncertainty in a space that is already known for high volatility so whatever estimates one arrives at will be extremely uncertain. At some point the current steep contango will no longer be in play and rates will go lower. Judging from analyst reports and adding a layer of conservatism I arrive at the following estimates for TCE rates going forward.

$60,000/day average for the remaining 6.5 months of 2020. OCF 12.60 NOK/share.

$40,000/day average for the 12 months of 2021. OCF 13.20 NOK/share.

$30,000/day average for the 6 months of 2022. (They reach their 20th birthday on different months: March 2022, August 2022 and October 2022 so 6 months is an average.) OCF 4.20 NOK/share.

Adding all of it together I arrive at 52 NOK per share. (Fair value is slightly lower because of the time value of money but I expect most of this value to be earned and distributed in 2020 already so not a huge effect.)

To give an idea of how quickly estimates might change let’s say in an upside scenario that the company manages to fix their two vessels ADS Serenade and ADS Stratus that will both be open for new fixtures in a couple of weeks time at the current rates of $110,000/day for 6 months then that would add another 8 NOK of value to the 2020 scenario. And in that case operating cash flow will exceed 30 NOK/share for the year with still approximately 150 of a total of 1095 vessel days left in the year. And again remember there is no capex for 2020 and 2021 so all earnings are headed for shareholder pockets.

In a downside scenario where rates fall to below break-even levels on a cash basis there is some protection in the possibility that the vessels can be recycled ahead of time.

Quarterly dividends

One reason I like the thesis is that most of the cash that is currently being generated will be returned to investors in the very near term due to the company’s philosophy of returning excess cash on a quarterly basis.

An agreement with debtholders stipulate that once debt has been reduced from currently $36.6 million to $27 million all excess earnings (minus liquidity needs) can be distributed to shareholders:

Since earnings are so massive right now this debt reduction can be accomplished using cash flow from Q1 alone. According to my estimates ADS will earn approximately $15 million in operating cash flow in Q1. After debt reduction $6 million of that can be distributed to shareholders, equal to 2.70 NOK/share.

For Q2 I estimate operating cash flow to be $17 million and that all of it will be distributed to shareholders, equal to 7.70 NOK/share. So by August/September of 2020 my base case is roughly 10 NOK/share will have been distributed to shareholders.

So what can go wrong?

There are a few yellow/red flags that needs to be monitored by investors, such as party-related transactions. Because the two major shareholders John Fredriksen owned SFL (17% owner) and ADS Shipping (10% owner) provide both loans and technical management services to ADS Crude Carrier there is a question of whether interests with other shareholders are 100% aligned.

And there is also the question of whether they are incentivised to close up shop in H2 2022 or whether they will prefer to buy vessels when that time comes in order to continue earning management fees. This is not clear currently.

So besides declining rates this is my primary concern. On the flip side I expect investors to have received dividends covering more than the entire market cap by the time these decisions will be made.

Summary of the thesis – fair value: 52 NOK/share

I believe ADS Crude Carrier provides excellent downside protection and very decent upside potential despite an uncertain environment because of the following:

• They own three 2002 built VLCC vessels that are likely headed for recycling by H2 of 2022. This leaves 30 months of trading from January 1st 2020 till then.
• 5 1/2 months already booked at an average rate of 72,000/day in 2020 providing 13 NOK per share of free cash flow to shareholders. The stock currently trades at 25 NOK.
• The most likely scenario in my view is that the company will earn its entire market cap in 2020 alone.
• Company policy is to return excess cash as quarterly dividends to shareholders.
• The contango is exceptionally steep currently and this supports storage rates of $110,000/day for 6 months. Two of their vessels are up for booking within the next two weeks.
• Current scrap value plus working capital minus debt: 4 NOK.
• Additional optionality value in H2 2022: approximately 5 NOK.
• Tanker companies that own younger fleets always have to worry about others spoiling the party by ordering large numbers of new vessels thereby putting pressure on the value of their fleet. Not a problem when your vessels are soon heading for recycling. It takes two years for a VLCC order to be built.
• Red flags: Unclear whether there are conflicts of interest between the top two shareholders and the rest of shareholders longer term. Empire building has not been ruled out.

 

Disclaimer: I own shares in ADS Crude Carrier at the time of this blog post’s publication. Nothing herein should be considered investment advice. The post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.

Diamond S Shipping – Taking Advantage of Shareholder Overhang in this New Oil Tanker Play

Investors have been burned badly in the shipping sector for the last 10 years or so. As has lenders. Now a perfect storm appears to be brewing, especially in the oil tanker segment, where new supply is at an all time low due to longer-term regulation uncertainty which has led to lower levels of new ship ordering as well as an unwillingness from lenders to commit more capital to the industry after all the painful years.

On the demand side the ton/miles ratio is set to increase as the US is loosening up on prior restrictions on export of their shale oil. Since Asia is the big oil consumer this leads to much longer transportation routes than the traditional Middle East to Asia ones.

On top of this there is new regulation called IMO2020 which is likely going to disrupt the broader shipping industry. From January 1st all vessels are required to run on bunker fuel that has lower sulfur content than in the past for environmental reasons. This means a lot of refined oil (clean product) is going to be moved around. This is already starting to cause some chaos which is good for tanker rates. Shipowners can bypass this regulation by installing an exhaust system called scrubbers. Those installations will lead to less supply on the water which is another tailwind for rates for the coming 12 months or so.

Diamond S Shipping

Diamond S Shipping is an oil tanker company that has exposure to both the clean refined products (60%) and the dirty crude (40%) segment. The market cap is currently just below $600 million and the share price hovers around $15. Two private equity shareholders holding 44% of total shares outstanding want to exit and this, perhaps counterintuitive to a lot of people, is why I see a great risk/reward opportunity here. But more on that later.

Diamond S is valued lower than comparable peers by an eye opening margin but before I get to that I want to highlight management’s track record. The company is run by Craig Stevenson who was the CEO of OMI Corporation where he timed a terrific exit within months of the absolute top of the latest true tanker bull market in 2007. In the process they launched a massive share repurchase program when their stock traded below net asset value (NAV) and bought back 36% of the shares outstanding in a three year period. And shortly thereafter sold the company at a 30% premium to net asset value. Shareholder friendly capital allocation of this sort is relatively rare in shipping, to put it mildly.

Craig Stevenson is now back in the public markets for a second run with Diamond S Shipping which he founded in 2007 and where he holds a $6 million stake. About a fifth of that was bought in May earlier this year. Two members of management also hold stock valued slightly below $1 million. Significant insider ownership like this is relatively rare in shipping where empire building for the sake of generating higher management fees is the general rule.

At the age of 65 my guess is Stevenson is more likely to continue focusing on building shareholder value rather than on building a career, ie. he is more likely in my view to focus on the bottomline rather than the topline.

Note however that he has commented on the need for industry consolidation and multi-billion dollar companies to attract institutional investors so mergers involving Diamond S are likely happen. But given all I have written above I think such transactions are more likely to be accretive to shareholders rather than dilutive. But again this is a faith based assumption and I may be proven wrong down the line. If you want more info on his views on consolidation you may want to watch this (Stevenson is the second guy to the left on the panel). I will also link to an informative interview with him and his CFO by shipping analyst J Mintzmyer (whose service I subscribe to) once it becomes public, probably in a few weeks time.

Valuation

If you look at net asset valuations for Diamond S Shipping (ticker DSSI) and compare to competitors then you begin to scratch your head because it turns out Diamond S trades at a significant discount to peers with a price/NAV in the 0.65 range when factoring in earnings from Q4 thus far. Comparable competitors (Scorpio Tankers, Ardmore Shipping, Torm, International Seaways, Teekay Tankers, DHT) trade in the P/NAV range between 0.90-1.20 with Frontline an outlier at 1.70. The latter probably due to the Frederiksen premium based on his history of large dividends. Investors love such unsustainable dividends but ignore what often happens when the market turns south: here and here (click on max number of years for both of those links to see the full picture).

Asset values have started rising slightly and I think we are approaching mid cycle territory. Historically P/NAV approaches 1.00 around here and in the later stages go beyond that. My base case is 15% vessel appreciation and P/NAV of 1.10 one year from now which would equal  $30/share, equal to a double from here.

Since normalized earnings are extremely hard to estimate in such a volatile business such as shipping where companies will often go 20 quarters or more in a row with negative earnings and then have 10 quarters with explosive earnings I find net asset value (NAV) to be the best metric to use in shipping. It is based on a mix of actual vessel sales which uncover the price market participants are willing to pay here and now combined with 1-year charter rates. It is a lagging indicator but it is the best one available. Some find cash flow more useful but this is also hard to predict. Earnings per share is the worst of the three by far as depreciation and book value comes into play. Because asset values fluctuate so much historic book value figures are completely useless. They are rarely adjusted up or down to reflect real value. Since vessels are currently valued lower than their historical costs depreciation will be too high so EPS will be understated in relation to the true value of current earnings. Therefore cash flow is the far superior metric of the two.

So if we look at cash flows and we take current 1-year charter rates of $35,000/day for the suezmax fleet (the crude part of their fleet) and $16,000/day for the MR fleet (the product fleet) then we arrive at cash flow from operations of approximately $5/share, corresponding to a 33% cash flow yield. Capex for 2020 will eat about 10% of that, so no biggie (see page 12 in the latest Q3 presentation). The above mentioned doubling of the share price would not be far-fetched given the above assumptions on rates.

Note that in the rear-view mirror spot rates usually turn out to be higher than 1-year charter rates and since 80% of the DSSI fleet is in the spot market I would expect their 2020 cash flow from operations to be substantially higher than $5/share.

Most analysts expect the period from now until at least the end of 2021 to be a bull market due the conditions I described in the beginning. There is relatively good visibility on the ordering of new vessels in the big segment (no new VLCCs and Suezmaxes that are ordered now can be built within the next two years) and somewhat lower in the MR segment where ships can be built in 15 months. But for all segments the age profile looks favorable as many are close to the end of their useful lives and owners don’t know what to build until there is more certainty around regulation and so the bull market could very well drag on into the mid 2020s. After all, it would suck to build something that is built for a 20 year life and then new regulation comes in to chop off a ton of the value before the vessel even hits the water.

The advantage of age?

Diamond S Shipping’s fleet is around 10 years old which is older than the industry average. I view this has an advantage because the bull is here now and if it lasts for 2-3 years then that is a more significant part of the life of a vessel that only has 5-10 years of life left in it than a newer vessel that has say 15-20 years left to breathe. The latter is likely to see a greater proportion of bear years I would think. And if that is so older vessels would have more price appreciation potential than newer ones. This is illustrated by management in this slide on page 8.

The flip side to that argument is that newer vessels, especially those with scrubbers, may get a premium on their voyages depending on how things turn out with the new focus on ESG (Environmental, Social and Governance). But again what about new regulation? You would hate to have a two year old vessel be on the wrong side of that. Better to have one that is 15 that is closer to scrap value as you risk less.

Downside protection

On the cost side Diamond S has among the lowest break even Time Charter Equivalent numbers in the industry (the day rates at which their vessels break even), primarily due to cheap ship financing. The financial leverage ratio is at 48% which is reasonably safe if the bull thesis doesn’t play out. Most other names have higher leverage, for better or worse. Of course some of the ultra leveraged plays will take off faster than Diamond S but when combining the upside and downside scenarios I see only extreme bull runs as an area where Diamond S is likely to underperform some peers, and even then I think only a few of them will (Scorpio Tankers, Teekay Tankers, Frontline and some of the Greek names come to mind). The more certain you are of an extreme bull market the more you should be inclined to add to those names. But the flipside in those names is that they are much more vulnerable on the downside.

On the other side of the equation a few good downside protection names besides Diamond S in my opinon would be International Seaways and Euronav. Obviously those will rip in a bull market as well but likely not as hard. In my estimate the overall risk/reward ratio favors Diamond S over other names at current valuation.

Why is it cheap?

So why is a company of relatively high quality trading way below peers? That is the key question.

Those below $1 billion market cap will always trade a bit lower than the three names that are in the $2 billion market cap range (Euronav, Scorpio Tankers and Frontline) but the majority of tanker names have a market cap below $1 billion so that cannot be the explanation. (Btw. I think a price differential for those three and the rest will likely average P/NAV of between 0.10-0.20 going forward because those three are easier to enter and exit for institutional money.)

One reason could be that Diamond S is the newest kid on the block so perhaps part of the market hasn’t noticed they are around yet. Many analysts don’t cover them yet so they have gotten less expsoure. DSSI became public in March of this year. Capital Product Partners spun out the tanker part of its fleet to merge it with Diamond S and with it came investors that were used to big quarterly dividends from the more stable container business. So that means no IPO, no road shows and a ton of investors with shares from an income play now stuck in a volatile tanker play.

I think a more significant reason, and this I think is the reason for the attractive price, is that the two largest shareholders, WL Ross & Co (shareholder since 2010) and First Reserve (founding shareholder since 2007), both want to exit. This wish has been communicated by management since becoming public but it is only now that the offering saw the light of day. So 44% of shares are looking for a new home and the market often hates situations like that although it doesn’t interfere in any way with the company’s operations. The reason is of course that the supply of shares is now much greater than the demand for them. But the thing is:

THIS IS TEMPORARY

My time horizon is longer than next weekend so I say thank you for the cheapness this situation provides. Some participants may be able to game the market by waiting for the overhang to clear out and I wish them luck but I suspect it will be hard to enter at today’s prices once the two major shareholders are out. I also suspect that this is another one of those many instances where you get paid for the impatience of other investors. Waiting when others are unwilling is in my opinion the easiest edge attainable in the markets today, one that requires very little brain power and the one we have to fight the least for (except against our own impulses, which can be hard enough).

There comes a lock up period with the two major shareholders’ shares. The first half of that expired in September and it didn’t lead to any selling. The other half comes in March of 2020. So there may be buyer hesitation till then. We will see.

An added benefit of being a shareholder in DSSI that I see is that if shares still trade at a heavy discount 6-12 months from now the company will probably have generated enough cash flow to repurchase significant amounts of shares from the market cheaply. And history has shown they are likely to do so.

I’m betting on a repeat of history on this one.

(NOTE: A few hours after this blog post was publised an offering from the two major shareholders was announced for 4.7 million shares at a selling price of $13.75/share. The share price dipped when the market opened the following day but gained half of the loss at the close of the day. More than 1/4 of the stock overhang is now gone and that liquidity is now added to the market. There is a loc-up period until March 21st before the two shareholders are able to sell the remaining shares should they choose to do so.)

Disclaimer: I own shares in DSSI at the time of this blog post’s publication. None of this is to be considered advice to buy or sell any of the stocks mentioned herein. Instead this post is to be considered a starting point for further investigation. Please perform your own due diligence before making any investment decision.

 

5-Year Anniversary Today – Pros & Cons of Blogging

The blog turns 5 today and I thought I’d use the opportunity to reflect over the pros and cons of blogging as an investor.

Pros:

• You learn a bunch. And by writing you crystalize your thoughts.
• By being public about your stock picks you put maximum pressure on your process to be rigorous. Looking like a fool too often is no good.
• You get feedback that allows you to rethink your ideas and possibly drop them completely. Immensely valuable when it happens however irritating it may be in the moment when you realize you need to drop an idea you have spent a lot of time on (the sunk cost fallacy, a common bias).
• Investment research is a solitary undertaking. Talking with managements and other investors take very little time in relation to all the hours of reading and thinking on your own so other outlets for social interaction about a subject you care about deeply takes on an increased importance.
• I’ve increased my investing network many fold both on and offline as a result of blogging and the benefits of that cannot be understated.

Cons:

• Make sure you stay agile and nimble! Don’t get tied to your picks as a result of going public with them. If a thesis changes on a fundamental level and the price doesn’t reflect it? Cut ties with it. Before blogging I was sure I wouldn’t run into this issue but it really is a lot harder than it sounds once you go public on a pick, as many other bloggers will attest to.
• Realize that your blog is about idea generation and only that. A starting point for others to dig further if they think there might be something there. I have personally felt an obligation to update people on a quarterly basis in the past but have dropped the idea as it is just too time consuming when writing a blog in your free time. That time is better spent on researching new ideas.
• Don’t write for the sake of adding content after a hiatus. Don’t be one of those. Wait until your heart is full. Wait until you are certain what you have to say adds value.
• Realize not all picks will work out. I had a pick that went terribly wrong a few months after starting writing my blog (Polarcus, a seismic name) and it weighed heavily on me that others might have been affected to an extent that I considered quitting writing. But it is the nature of investing that sometimes you are the hammer and sometimes you are the nail. Some of our picks WILL fail.

Performance

On the performance side I’ve had a nice run these five years: 23.9% CAGR from Oct 9th 2014 when I started the blog till now. This is a somewhat deceiving number though because it is measured in SEK, a currency that has been on a downward spiral in recent years. Also, individual periods have been lumpy with massive drawdowns exceeding -30% twice. And if I exclude my two best years, 2016 & 2018, I land on 4.5% CAGR after significant underperformance in both 2014 and 2015, as well as slight underperformance in 2017. So it is a testament to the fact that the concentrated deep value approach exposes one to some wild storms along the way and it isn’t always easy to hold on when a protracted downswing is taking hold.

Five years is close to meaningless in the investing universe so it could very easily be the result of a large part of positive variance (luck). But still I’m glad that the results stack up well vs momentum/FANG strategies that have really had the wind at the back in this period. I suspect that in the coming years the tide will turn and the wind will be at the back of deep value. Personally I’ll be satisfied with returns in the 10%-15%-range in real terms and an outperformance of the general market of 5%+ (to justify making investing my job, otherwise indexing would be an alternative).

Before starting my blog I believed that market beating returns are very possible for investors who invest relatively small sums of money and who restrict themselves to looking at areas where smart money generally can’t go due to illiquidity concerns – and I obviously still believe that. From watching many in my network produce solid numbers when averaged out over a number of years I am absolutely certain that the efficient market hypothesis is BS and that you can as an individual investor beat the market over time if you are disciplined about it and stay away from what everyone else is looking at.

From Fuzzy Idea to Yes – Or How U3O8 Twisted my Arm into Submission

A couple of weeks ago I had the honor of being a guest on my current favorite investment podcast, The Mike Alkin Show. On it we discuss why the contrarian approach can be a profitable one and why so few investors are comfortable with it, how my 12-year poker career has affected my view on investing and we also touch on mistakes I have made in my investing career so far. I will dig deeper into this last part in a future post because I think there are some lessons to be learned – especially on what not to do!

Mike has done a ton of deep work on the uranium sector and is probably the person with the most knowledge on the current supply/demand & inventory situation in the space. And I am quite vocal on my findings on individual uranium companies on Twitter, on YouTube and on my blog. So that is how we connected on Twitter.

An example of how I generate investment ideas

As Mike has played a role in my uranium education and since many people have asked me how I generate investment ideas I thought this would be a great segue into how uranium initially caught my interest and perhaps an example of how one can go about turning a fuzzy idea into a possible investment. (Note that this post is only meant to be an example of the initial stages. It won’t cover the work on individual companies as that would be outside the scope of one article)

How Xi Jinping showed me the light in a roundabout way

In early January I was looking around for new investment ideas and thought Xi Jinping’s speech to the 19th Party Congress could be a starting point. Those are held every five years and they have all been fabulous at predicting what was to come. When Chinese leaders decide on a long-term idea they are able to follow through, unlike in a typical western democracy.

So who are these speeches aimed at? Probably first and foremost the leaders out in the municipalities throughout China. If they don’t listen to what the President wants and then implement his wishes they will be out of a job. So it gets done.

From GDP growth to blue skies again

What was interesting about this particular speech is that whereas previous five-year plans have focused on GDP growth at all costs this speech had a different focus in that the environment is mentioned again and again and a recurring theme is how China needs to ”make our skies blue again”. The Health Effects Institute estimates that more than 1.5 million die from air pollution in China.

Deciding on an investment theme

So I started thinking about how an investor can approach this shift. How can China make the transition from dirty coal to cleaner energy sources? Initially I thought liquefied natural gas, LNG, was the play. Recent activity certainly suggested this was a good idea as China had increased their imports from 2016 to 2017 by a whopping 50%!

On top of that, Japan, the largest importer of LNG in the world, had held the course while most analysts had expected Japan to decrease their imports.

But as I started looking deeper into it both of those factors turned out to be warning signs, at least that is how I viewed it. It turned out that China was experiencing bottle necks due to the sudden increase. Their infrastructure couldn’t keep up which might lead to a slowdown, I thought. So that was one risk.

From liquefied natural gas to nuclear power

Another issue came up when I started looking into why analysts expected Japan to decrease their imports and that was related to the Fukushima accident which brought down all of Japan’s 54 nuclear reactors. Most of those were expected to come on soon after but it wasn’t happening at the pace everyone thought it would due to constant court delays. But since it seemed to be a question of time the whole LNG idea started to seem more risky to me and it warmed me up to the idea of nuclear power. And one thing I didn’t initially understand was that LNG wasn’t THAT much cleaner than coal. On an index where coal is at 100, natural gas is at 45. On that same scale nuclear energy is somewhere between 0 and 1! Time for the left to wake up to this fact…

Introduction to uranium in late 2016

A fellow Swedish value investor, Kenny Granath, had alerted me and my investing network to the idea of uranium/nuclear power as an investment theme back in late 2016.

Kenny worked in the nuclear industry so his words obviously carried extra weight due to that fact alone. But not only that, he had shown an ability countless times via his blog to do deep sector analyses in a way I hadn’t seen before from individual investors and those posts were the initial inspiration behind my investment blog in 2014.

But he also said it was probably too early to enter the uranium space as production cuts and consolidation had been minimal at that time and for that reason I simply made a mental note of it but never took a closer look.

CO₂ emission quotas explode

I started doing just that in January after having discarded LNG. The climate was increasingly on the agenda and the price chart for CO₂ European emission allowances were making some big moves, which had increased the price of electricity in Sweden, and which in turn had renewed my interest for Swedish wind energy companies.

Swedish nuclear power had been on the retreat since 2014 when the owners decided to close down four of their ten remaining nuclear power plants due to the low price of electricity. I had been following the electricity space and the political discussions quite closely since then and my impression was that the owners unsuccessfully had tried asserting pressure on the Swedish politicians to give compensation for delivering baseload energy.

But things have been changing lately and the idea of building new power plants further out in the future has started entering the discussions, so while I knew nuclear was struggling I also knew that it was far from dead in the west. And so after LNG was dropped as an investment idea I started looking closer at uranium.

The uranium price chart from hell

Being a deep value guy a price chart like the above is interesting. The first thing I usually do when a sector peeks my interest is to read the annual reports of the biggest companies in the industry, initially at least those parts give a sector overview. That meant I started with Cameco and what struck me immediately was their mentioning of the fact that the price of uranium was way below the marginal cost of production, as could perhaps be expected by looking at the graph.

Obviously that cannot continue indefinitely so the next step is to look into what has been the cause of it and what may trigger a change to a normal pricing environment where the price returns to equilibrium, ie slightly above the cost of production.

The cause of the bear leading up to 2004

Historically uranium has had these extremely long bear markets that makes your stomach churn. The bear market that proceeded the current one was mainly due to downblending of atom bombs from the former USSR and the US creating the equivalence of a gigantic mine that simply destroyed the market.

The cause of the upwards explosion

Then in about 2004 China started getting interested in nuclear power and due to flooding in some large mines that were supposed to come online this created a squeeze on both the supply and the demand side. The long bear market had made exploration unattractive so when demand started showing up suddenly there was fear there wouldn’t be enough uranium available which along with financial players rushing in created the panic that can be seen in the chart in 2007 and so the price overshot by a large margin.

When financial players started liquidating their holdings, partly due to needing funds in the wake of the financial crisis, the price came back down do equilibrium like levels, which is to say slightly above the cost of production.

The cause of the bear from 2011: Fukushima, Kazakhstan &…???

Then in 2011 the Fukushima accident happened which made Japan decide to close down their reactors for review. At the same time the production from Kazakhstan had increased at a pace no one saw coming from 10% to 30% of global production in only 4 years.

In more normal liquid markets the price would be hurt by such a squeeze but it would also quickly correct after the marginal players had been knocked out. This wasn’t happening and in the first weeks of research I didn’t really get a firm grip as to why even though I had read the reason in Camecos annual report and had seen the graph that explained it. For some reason the significance just didn’t register.

It’s the long-term contracts, stupid!

So I started looking for other views on the sector and for that Real Vision is often top notch. This is a subscription-based financial media service where people who have dedicated large parts of their lives to understanding a particular field are being interviewed in long-form. I have spent countless hours as a fly on the wall during my daily long walks with my dog listening to world-class experts in different areas. And here I found two excellent presentations from Mike Alkin of Sachem Cove and from Adam Rodman of Segra Capital that really hit home the point that was right in front of my nose:

Long-term contracts fixed at high prices during the good years were the reason the miners weren’t dying and killing off supply!

The above graph is the primary reason why uranium is in the state that it is in. And it is also the reason why I pulled the trigger and started investing in uranium now rather than wait.

Once one knows that annual demand is in the 170-180 Mlb range then it becomes only too clear what is going on. And as can be seen below where demand is included in the picture, it is a very constant thing in that business. It doesn’t jump up and down along with the general market cycle.

I would spend a few minutes studying the graph below, which is essentially the same as above but with demand added in. Note that the numbers on the right side, the price, is only applicable for the red line. For all other information, the volume in millions of pounds (Mlbs) is the reference. What the graph tells you is that from 2005-2012 the contracted volume was way above annual demand so the decline in price from 2012 should come as no surprise, especially when factoring in Kazakhstan and Fukushima as well. Those contracts are now rolling off and new ones will have to be signed in the coming years and it will be done at prices that are above the cost of production, which is at least north of $50/lb.

A new Fukushima = a new bear?

And by the way, that graph is also the main reason why I, unlike most people who follow the space, am less concerned with a new Fukushima type-accident knocking down the price of uranium.

People have a tendency to equate Fukushima with the bear market and forget the Kazakhstan and the contracting situation. But we are in a completely different place now with regards to those last two factors so I don’t think you can simply point to the accident and say that the last time it happened can be a road map for how the price of uranium will develop. Unless the world decides to dismantle nuclear power once and for all following such an accident. But then what happens with the climate change push that is really taking a hold on the world now?

So in the unlikely event an accident happened tomorrow my money is on a scenario that says the price is higher two years from now, after an initial dip.

A shout-out to true environmentalists

As an aside, now that I am on the topic of safety: There are some so-called environmentalists out there that need to examine their real motives when speaking out against nuclear energy…

The question is: Are you concerned with saving lives in the real word, or are you more concerned with the idea of pressing on a topic that gets you a knee-jerk hug from do gooders who do no good? Because an anti-nucIear stance will certainly give you that quick gratification of the warmth of the crowd.

Let’s say you agree coal has to go but that nuclear is no option. Electricity from wind and solar tends to hit the grid all at once, or not at all. So what to do at those times when the weather doesn’t behave? Pray?

Arise Valuation – 50% Target Reached, Now What?

In March I set a 50% year-end price target for the Swedish windpower company Arise and this has now been reached. So is now the time to sell?

In my opinion no. I estimate the risk/reward to be roughly the same as back in March when the price was 12.50 SEK/share (now 19 SEK). Granted, the risk has increased but the upside is also significantly higher now as my calculations further down will show.

And by the way these calculations are based on current market conditions and are not dependent on blue sky scenarios, which would only provide further upside not accounted for here.

The reason for the greater downside is that the price has further to fall in case the electricity market reverts back to the unprecedented slump that plagued it in the period from 2015-2017.

So how have market conditions changed? The basic drivers are:

• The project sales market is stronger than ever. For the last three years projects were generating 1.0 MSEK/MW of profits or less while recent sales ranged from 1.5 MSEK/MW for a project of average quality to 1.1 MSEK/MW for a project of below average quality. And I expect the hunger from institutional investors to result in increased sales of at least 100 MW per year – and more likely closer to 150 MW per year.
• Electricity prices are much higher. Short-term in part because of weather conditions (this effect is excluded from my calculations further down) but more importantly due to what I believe is a sustained trend in CO₂ emission quotas. The two electricity analysts I have spoken to believe this trend is set to continue because of rising environmental concerns.
• E-certificate prices have gone up dramatically. This impacts years 2018 and until 2020. Post 2021 is more of a question mark but in prior periods politicians have stepped up to secure a system that favors a continuation of the renewable build out.

As a result of the above I estimate EBITDA to more than double within the next couple of years from currently 135 MSEK to 275 MSEK. A word of caution though: Other analysts have much lower estimates in the 160-180 MSEK range. Not exactly sure why but I assume this is due to lack of updating to reflect the new reality.

Let me split up how I arrive at that much higher number:

1. 40 MSEK additional EBITDA from e-certificates. Here are my calculations for the years 2018-2020 (results in grey cells). Hedges are accounted for. Post 2021 the numbers are currently uncertain.
2. 40 MSEK additional EBITDA from electricty prices. This is based on current CO₂ quotas alone resulting in 140 MSEK/MWh higher prices (15 Euro higher * 0,9 Euro = price). Per 100 MSEK/MWh in price EBITDA increases/decreases by 34 MSEK. Lots of other factors influence electricity prices but most of those are weather dependent, and others are impossible to predict and model out due to their complexity so this and forward curves are all we can rely on in my opinion.
3. 60 MSEK additional EBITDA from project sales. (100 MW * 1.2 MSEK/MW vs. previously 60 MW * 1.0 MSEK/MW)

The above number is a conservative estimate in my view. I actually think they will sell closer to 150 MW on average per year but I have discounted the number to account for possible permitting/construction problems that may come about. Note though that in its short 10-year history Arise has not encountered construction problems before and only once, with Kölvallen in 2017, have run into permitting problems.

When will the effects kick in?

#1 and #2 have started to kick in but the full effect ought to be evident from the full year 2019. #3 will take effect from late 2019 and onwards and I expect EBITDA to gradually arrive at 275 MSEK for the full year 2020 and be in the range in the yeaers following.

Despite the above mentioned effects starting to kick in from now on my base case for 2018 is only 160 MSEK in EBITDA due to low winds in H1 – and as a kite surfer I know this spring to be an unusually disappointing season! In addition to this project sales that are being delivered this year were sold in 2016/2017 when they had a lower value than those that can be expected going forward.

Valuation and some key metrics

EBITDA 2017: 135 MSEK

Estimated EBITDA going forward: 275 MSEK

Current enterprise value: 1628 MSEK

Estimated EV/EBITDA: 5.92

Price-to-book: 0.82 (Asset-light competitor Eolus Wind: 1.58)

Since 2011 Arise has traded at an EV/EBITDA multiple in the 11-15 range. Companies trading near 5 are often takeover candidates.

As a result of the above estimates I believe the current fair value of Arise to be in the 30 SEK range +/- 5 SEK.

Note that the above is my base case scenario and all of the above numbers are based on current market conditions and prices. Be aware that the volatility has been quite extreme for all three factors historically and that the risk is significant. For that reason I have erred on the side of caution in my estimates, especially when it comes to project sales.

Post Mortem

Let’s say two years from now the above thesis has been proven wrong and the numbers above did not materialize. What killed the case?

• Project sales volume was lower than expected due to institutional investors finding other ways of deploying their capital at a higher rate of return, perhaps helped by higher interest rates. The realized prices were lower than expected because the energy market went into a slump, perhaps as the result of an abundance of natural gas hitting the market from Russia and the US. Also, the politicians failed to move ahead to squeeze out coal via increased CO₂ emission quotas.
• The E-certificate system that was widely expected to get fixed was not fixed and as a result e-certificate prices post 2021 were too low to attract enough institutional investor resulting in lower sales.
• Permits for projects were delayed and/or not granted at all which created holes in the pipeline as happened with the Kölvallen-project in 2017.
• EBITDA Bear Case Scenario: 120 MSEK. If this happens two years out I think the effect on share price will be limited to a downside of approximately 15 SEK per share as debt repayment until then will have decreased the overall risk.

3+ years out:

• Grid connections are being planned to continential Europe and the UK. This will likely lead to Sweden being able to export electricity generated from wind and solar at higher prices.
• Arise may divest some or all of their own windfarms down the road. This would bring down debt dramatically and likely result in a repricing as I believe the debt level is the primary drag on the share price. While this is likely to boost the share price short term I am unsure whether it is the optimal move long term as these assets, especially those in the southern part of Sweden, are becoming increasingly valuable in the current pricing environment. Arise CEO have recently stated they believe their wind farms are likely to have a longer lifespan than the 25 years that are reported in the books.

Never time frame forecasts again!

And by the way let me end this post by apologizing for that 50% year-end target I made in March even though it panned out.

I believe all we can comment on is our estimate of fair value and not what the markets will do, especially short term like within nine months, and for that reason I will refrain from commenting on that going forward. I never do this in written form but on video it slipped out in a moment of uncertainty and regretably I didn’t bother with the editing.

Disclaimer: I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision. I own shares in Arise.

Let the Uranium Bull Market Begin

“The most exciting returns are to be had from an asset class where those who know it best, love it least, because they have been hurt the most.” – Done Cox

Major supply destruction

Sector analysts in the uranium space have been saying that the world’s largest uranium mine, McArthur River, would likely reopen after a 10-month temporary shutdown that started in February and their overly conservative supply/demand forecast models have reflected this. Meanwhile, the owner, Cameco, had repeatedly said they would not bring it back unless uranium prices were meaningfully higher as it would make no sense economically.

Last night a decision was made to put the mine on hold indefinitely until nuclear utilities are willing to sign long-term contracts at a price that reflect their true costs plus a reasonable return – probably north of 45 USD/lb – the spot price is now at 24 USD/lb and the latest long-term contract price was around 29 USD/lb. This shutdown equates to supply destruction of 12% of the global production that nuclear power plant utilities thought would come back online as they have relied on paid analysts and consultants filling their ears with the sweet words that it would.

A domino effect is likely

I believe this marks the beginning of a new bull market for a few reasons.

1. The nuclear power plant utilities will have to wake up from their dream state to a new reality in which cheap uranium below the cost of production is no longer available in quantities they had been hoping for.
2. Cameco will have to buy significant amounts of uranium in the spot market to fulfill their contracts to customers. This will inevitably push prices higher.
3. Kazatomprom plans to IPO in a few months time. It would make sense for them to delay any action that will result in higher uranium prices (such as further production curtailments) until after Cameco has made the decision to put McArthur River on hold indefinitely. This game of chicken has now been won and they can now pull whatever levers they please without shooting themselves in the foot.

There are many other reasons that I have already covered in previous posts but the above three are linked directly to the news release from last night.

The final de-risking of the case for uranium

I cannot imagine the risk/reward will get any better than it is at this moment. My opinion is that the McArthur River decision is the straw that will break the camel’s back and if one prefers to wait for further de-risking it will almost certainly come at the cost of more expensive stock prices, thus reducing the risk/reward. In my opinion the way to handle risk is in how one sizes a position, not wait for all the stars to align because all opportunities will be gone when the skies are completely clear and everybody can see it. One wants to be positioned before the price of uranium moves because now it is pretty much inevitable that it will.

My current uranium positions

For the record and for transparancy, my bets are primarily with US producer Energy Fuels and London-listed Yellow Cake. The latter being the safer “in case I am wrong on the time horizon”-type of bet – like Uranium Participation, that I have highlighted previously in a video, but YCA trades at a larger discount. I also have smaller positions in Paladin Energy and GoviEx as well as a tiny position in the optionality play Virginia Resources.

Disclaimer: Note that this may change at any time and while I intend for all of these positions to be longer term I may enter and exit positions without notification of this on my blog. I do not accept responsibility for any loss that may occur as a result of any recommendation I make and urge readers to perform their own research and due diligence. My posts are intended to be treated as a starting point only.

Arise Q2 – Higher Electricity Prices Appear Sustainable

Although the reported numbers were in the red (due to factors that were known and expected) the quarter was an exceptional one nonetheless as reflected by a 40% increase in the share price.

Electricity prices are booming both on the short and on the long end of the curve. On the short end due to water reservoir levels being low, and on the longer end, which is perhaps more significant, due to rising demand and carbon emission quotas increasing steeply because of an increasing focus on the environment from governments.

The impact of carbon emission quotas on electricity prices

To give an idea of the impact carbon emission quotas have had: Quotas have risen from 7 to 16 EUR since January 1st. For every 1 EUR in quotas the impact on the price of electricity is 90 cent. On a SEK/MWh basis this translates to about 85 SEK of sustained improvement. Given that the forward curve for 2020 indicated a price of 280 SEK/MWh one year ago (when large impairments were taken by Arise!), this now sits at 360 SEK/MWh – a significant boost upwards that is mostly the result of the carbon emission quotas move. The two electricity analysts I’ve been speaking to recently both expect the quotas to go higher still.

The impact on rising e-certificate prices on cash flow

On top of that we have had a boom in the forward prices of e-certificates for 2018-2020 since the start of the year.  I’ve created a spread sheet to calculate how much this means in terms of the net present value of the increased cash flows to equity holders when comparing to the outlook at the beginning of the year.

Given that my assumptions on their current hedging percentages are correct (and their slides today indicate it is in the right neighborhood) I estimate the value to be 80 MSEK. To put this in relation to equity and market cap those are 800 MSEK and 580 MSEK.

See the spread sheet here. Admittedly it is a bit messy (did it for myself initially) and so you may need to have looked at the case in some detail for this to make any sense at all.

Why is this important?

Because their debt level at 1,000 MSEK is relatively high in relation to their past cash flows and now that both e-certificate prices AND recently also electricity prices look to contribute much more cash the debt can be reduced at a much faster pace than previously believed which means the stock has started to reprice. This effect is what makes highly levered stocks go bananas, as has been the case for Arise these last few months. Note that the 80 MSEK number is for e-certificates only. Add to that the impact of the rising electricity prices as well as the increased capacity (and increased willingness of potential buyers) for project sales.

The pipeline is more robust than ever

On top of that the pipeline is looking more robust than ever. With projects of 180 MW, 150 MW, 45 MW and 35 MW ready or close to ready to be sold from now and until the end 2019 (potentially providing 1 MSEK/MW on the bottom line). The Kölvallen project, which initially failed to get environmental permissions, is another 150 MW that could potentially be brought online by 2020/2021.

One of few downsides that I see is that the market could get ahead of itself believing that current electricity prices are likely to stay as high as they are now. While I do think we will see much higher prices than we’ve seen in the last 3-4 years the current 550 SEK/MWh (excl e-cert) in the warmest months of the year is perhaps at an extreme – and if not shareholders will have very nice ride going forward!

Another downside is that the forward prices for e-certificate prices are very low from 2021 and onwards due to the construction of the current system. There is some expectation from industry players that this will be fixed to ensure that the long term build out goals will be reached but this is in no way a certain outcome. There is also some chance that institutional players will invest even without the subsidy from e-certificates if the current electricity pricing environment trends continue via support from carbon emission quotas.

Take profits or  hold for the longer term?

I am personally retaining a core position for the longer term but I have been reducing my holding by about half this past week. I still see the stock as under valued but not by the same extreme amount as when I last wrote about it in my post of April 30th when the price was 12,30 SEK.  I tend to be quite aggressive in my sizing when opportunities like that come along and the risk appear low but the flip side is I am forced to reduce earlier than I would have had my position size been a more standard one.

So I think much of the upside has been realized but that there is still some way to go when having a two year+ time horizon. Given current fundamentals my estimate of fair value two years out is 22-24 SEK per share, equal to 0,9-1,0 of book value (the price is now 17,30 SEK). I arrive at that number partly because I see potential for a reversal of past impairments now that fundamentals have improved and partly because I think the chance of project sale success in the coming two years is high.

I’d appreciate any feedback on what your current view of the stock is and if I have overlooked anything!

Disclaimer
I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision.

My #1 Uranium Bet – 5 Catalysts

5 catalysts for company X – in short form:

1. US Section 232. First steel and aluminum – uranium next?
2. Modest valuation compared to US peers while having superior near-term production capacity.
3. Potential other sources of revenue from vanadium and clean up work for the government of old US uranium mines that were never restored.
4. There has been forced selling of shares from the uranium ETF Ura Global X for the past three months. This will slow down and stop completely by July 31st.
5. Inclusion in the Russel 3000 index on June 25th = forced buying from institutions and small cap ETFs. News from yesterday.

So company X = Energy Fuels. This is a company which I’ve been accumulating from the end of March till now to a degree where it has now become my largest position in the uranium space so I thought I’d write a few words about why this is my #1 pick currently.

Note that this post will be a company specific post and not about the uranium sector. I made two videos on my view on uranium here: The Case for Uranium Part 1 and The Case for Uranium Part 2 in case you are interested in a deeper dive into that. Both were made before I started accumulating Energy Fuels (EF). My general view on uranium is unchanged since then if not slightly more bullish as hedge funds have started to enter the space buying physical uranium realizing that the industry is now on its knees so severely that supply destruction has become an economic necessity = uranium prices must rise. As always in cyclical industries where demand is certain: After rain comes sun.

A word of warning

Before I elaborate more on the 5 catalysts let me stress that EF (ticker symbol: UUUU) is an aggressive pick that comes with a certain amount of risk. I have personally chosen to size more heavily than I am normally comfortable with in relation to the amount of risk the stock carries with it because I see huge potential within a 1-year time frame. But realize that my uranium outlook is a lot more bullish than that of the general market, and even among uranium bulls. If I am proven wrong on the timeframe there are better uranium stocks available, specifically Uranium Participation where I’d postulate that the risk is almost insignificant and a 2x on one’s money in a three year time span extremely likely.

Note that if U3O8 prices stay below 45 USD/lb for the coming 12-months it is likely EF will need more capital as they have no long-term contracts and would sell at a loss at current prices. This could potentially lead to bankruptcy, but much more likely a dilutive capital raise. Neither option is ideal for investors but that is the price one pays for the significant upside potential.

Now for an elaboration of the above mentioned catalysts.

The 5 catalysts – in elaborated form: 

1. US Section 232. EF has tremendous upside if the Trump administration decides to help out US producers by forcing US uranium buyers to buy a 25% quota domestically (12 million pounds out of 180 Mlb of global demand = limited impact on the overall market).This could result in a two tier pricing system where US producers receive up to 30 USD per pound of U3O8 more than non-US producers = 55-60 USD/lb. Were that to happen EF would go up at least 3x and probably more.According to my calculations Energy Fuels EBIT at a U3O8 price of 60 USD/lb will be about 90-110 MUSD when ramped up fully (assuming 5 Mlb of production). Current share price of 2,06 USD = market cap of 150 MUSD.This may appear to be a long shot on the surface as it seems to go against the very soul of America. However, it has been in place before and many in the industry believe this to be a very real possibility and judging from that I’d say the chance is at least 30%.

   The reason for all this speculation is that Energy Fuels and Ur-Energy sent a so-called 232 petition to the US Department of Commerce on January 15th claiming unfair competition from state-owned players in Kazakhstan much like the petition that the steel and aluminum industry submitted in the summer of 2017 and which the administration have now acted on in 2018. The argument is that subsidized players can afford to dump prices whereas others cannot and this leads to elimination of competition on unfair grounds.

   Section 232 of the Trade Expansion Act in 1962 focuses on national security and for that reason the administration can act without support from congress. And since uranium is much more of a national security concern than steel and aluminum (20% of US electricity comes from nuclear energy) one might conclude that the administration is likely to act on it.

   However, if national security isn’t the real motivation behind the steel and aluminum tariffs but instead it is jobs for American workers then uranium may not get the same backing as the new jobs it would provide are in states where the republicans are already dominating (Wyoming, Texas) and where they don’t really need the extra votes.

   Note that there is a risk the stock will fall if the administration decides not to act. EF has outperformed the general uranium market the last three months and much of that could be due to investors beginning to price in the possibility of 232. The flip side to that argument is that the petition was submitted on Jan 15th and as can be gleaned from the graph below the response initially was not only muted but even negative.

   And while we’re at it let’s include a graph for the last 5 years to illustrate the suffering that has been going on for shareholders (the general direction is similar for all other uranium producers):

   

2. Modest valuation. EF can bring on more U3O8 in production in a shorter amount of time than the two other main US players, UEC and Ur-Energy, despite being valued significantly lower (close to 0,5x!) on an Enterprise Value to pounds in the ground basis. Because of those factors EF has significantly more upside.Why do I single out UEC and Ur-Energy specifically? Because they will also be affected by petition 232 (if you are in uranium for that specifically and want a US producer) and because all three have similar mining methods and mining costs (which are in the lower 2nd quadrant globally). This means all three can bring on production faster than most global competitors, which is why I believe that in the current environment this is where to look primarily. EF can potentially bring those costs even lower than the others, see catalyst 3.On the flip side, EF has higher overhead costs due to a bigger operation and a dilutive capital raise is likely to hit EF shareholders harder than those of UEC and Ur-Energy. UEC has a nice titanium deposit that potentially is worth a lot of money and Ur-Energy has some long-term contracts that go into 2021 whereas the two others have no existing contracts beyond 2018. In terms of current shareholder base rating EF would come in last of the three. That could change as a new management have been in place since January. My impression is that it is a more alert one.

   Summary: If you believe that crunch time is very close EF is the play of the three imo. If you believe it happens in 1-3 years, Ur-Energy and UEC may be better options. If you don’t believe any of that stay out for now!
    

3. Unlike most uranium companies, EF has other potential sources of income from vanadium and clean up work of old US uranium mines from the 1950s era when environmental considerations weren’t the same as they are now. Both are new opportunities that did not exist one year ago.The US government has set aside significant amounts of cash in the recent budget for clean up work of these old non-restored mines and it is my understanding that Energy Fuels is in a prime position to receive much of this work because of their White Mesa mill which sits close by.They also have vanadium in the ponds at White Mesa which they are now looking to extract as vanadium has shot up in price this past year. See graph:
   
   On top of that EF can knock off about 10 USD/lb of U3O8 costs per pound from bi-product vanadium on some of their conventional mine production (which is set to come on at U3O8 prices of 60 USD/lb) if vanadium prices stay where they are. That means it could potentially come on sooner, perhaps at 50 USD/lb. UEC also has conventional mines with vanadium but it is my understanding that permits are years away for those.

   Both of these potential revenue streams can turn out to be of extreme importance to shareholders should uranium prices remain subdued for longer as new capital may not be needed. Note that both are in the ”if” category still though. We don’t know for sure if they will make a dime on either.

   And two short term tactical triggers:

4. The Uranium ETF Ura Global X is transitioning to go from 100% uranium producers to 70% uranium producers and 30% ”nuclear components”. This change started in March and the transition will be complete on July 31st. This means the ETF has had to sell 30% of it’s holdings in many producers.I started tracking their EF holdings from April 6th and the share count was then at 9,3 million. As of today this number is now 6,5 million = 30%. So that means the selling ought to stop if not shortly then at least by the end of July.Interesting to note that the EF share price has held up well in that period rising 35% despite the heavy selling. Ura Global X has been selling about 60,000 shares daily in the last two-three months. Considering the average daily volume in EF is around 500,000 this is a significant amount of downside pressure that is soon to be removed. Will the effect be like that of a bathing ball under water?
5. Russel 3000 index inclusion. Yesterday EF announced it will be included in the Russel 3000 index from June 25th. This may lead to institutional buying propping up the price. However, there is some chance speculators have already anticipated this and bought ahead of time making the effect of the inclusion less significant. We’ll see.

I’d be interested in your view. All feedback is welcome. (And please excuse the formatting. For some reason spaces and paragraphs are getting messed up in this article even after being corrected).

 

On valuation – some numbers

 

Energy Fuels

Stock ticker: UUUU

Stock Price: 2,06 USD

Enterprise Value: 180 MUSD

U3O8 resources: 130 Mlb (EV/Res = 1,38)

Near-term annual production potential: 5 Mlb annually. (2,5 Mlb at 45 USD/lb + 2,5 Mlb at 60 USD/lb)

Annual Burn Rate: 30 MUSD.

Net Working Capital: 43 MUSD.

Interestingly: According to my calculations U3O8 prices at 45 USD/lb means Energy Fuels EBIT is at 10 MUSD, ie. barely above break even. However, at 60 USD/lb EBIT is around 90 MUSD (110 MUSD if vanadium prices stay where they are at now). This goes to shows the leverage that is at play here.

 

UEC

Stock Ticker: UEC

Stock Price: 1,56 USD

Enterprise Value: 255 MUSD

U3O8 Resources: 112 Mlb (EV/Res = 2,28)

Near-term annual production potential: 4 Mlb annually. (2 Mlb at 45 USD/lb + 2 Mlb at 50 USD/lb but the later cannot be brought into production till at least 2 years out)

Annual Burn Rate: 20 MUSD

 

Ur-Energy

Stock Ticker: URG

Stock Price: 0,70 USD

Enterprise Value: 95 MUSD

U3O8 Resources: 42 Mlb (EV/Resource = 2,26)

Near-term annual production potential: 2 Mlb annually. (1 Mlb at 45 USD/lb + 1 Mlb at 60 USD/lb)

Annual Burn Rate: Doesn’t apply due to long-term contracts.

 

Disclaimer
I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision.

Wilhelm Wilhelmsen Holding Q1 Update

WWL & Maritime Services

The daughter company, Wallenius Wilhelmsen Logistics, or WWL, were hurt by lowering rates, higher bunker costs and currency headwinds. Surprisingly for me the improvements in the mining segment wasn’t significant enough to offset the negatives and the share price was hammered down 20%. The stock had climbed 200% in less than two years so even slightly deteriorating fundamentals got punished harshly.

For the maritime segment the EBIT-margin improved slightly from 4% to now 6%. Not enough improvement to warrant a rerating of this segment in my Excel valuation.

Discount to NAV has narrowed

The updated excel sheet for Wilhelm Wilhelmsen Holding, WWI, shows the discount to NAV at 35%, which is the lowest it has been for the past 24 months. As a result of that I have scaled down my position somewhat.

Get Paid for Being a Masochist: Oil Tankers

The product tankers are bleeding and have been since the end of 2015 due to oversupply from the good years when too much capacity was ordered. Some are even reporting negative cash flows. So what is changing now?

• The supply/demand balance is improving, especially when accounting for increased scrapping of older vessels ahead of 2020 regulations and demand growth of 4%. (2017 was a big scrapping year and 2018 will top that as 66% of 2017 numbers was reached already in April). 
• Global Clean Petroleum Products inventories are coming down to below average levels. This may the most important chart short term indicating the wait for the turnaround could be a short one:
• As are crude oil inventories (the green line has fallen below the 5-year average in 2018)
• Prices have been significantly below 5-year averages for almost three years
• The price of vessels are stabilizing (new builds increasing slightly) 
• Shipyard capacity is stretched. Scorpio Tankers 10K: “Shipyard capacity has rapidly and dramatically declined”. I have not been able to find numbers on that though.
• New financing methods in the shipping sector will lead to increased discipline.

We all know what tends to happen in cyclical industries when these dynamics are at play, right?

Concordia Maritime, Torm, Ardmore Shipping and Scorpio Tankers, to name a few in the product tanker space, are all struggling, naturally. Torm and Scorpio both took in new capital in recent months. But despite being the cheapest of the bunch, Concordia Maritime is in a very comfortable position when it comes to the cash position, meaning they can weather the storm for longer than their competitors before needing additional capital. On top of that they are achieving market beating pricing rates quarter after quarter.

On a peer-to-peer basis the stock has underperformed peers in the last three months despite a similar environment, and despite the Swedish currency performing terribly. (STNG = Scorpio Tankers. ASC = Ardmore Shipping. TRMD = Torm)

The price is currently 10,40 SEK and the market cap 450 MSEK. It currently trades at 0,4 to NAV, which is lower than peers… A major impairment was taken six months ago when the pricing environment was at the bottom. I believe there is potential for a multiplying effect here: 1) The discount to NAV narrows, and 2) Vessel pricing rise = higher book value = potentially creating a nice multiplying effect on the share price.

Added to this the Swedish currency has been absolutely demolished the last three months. It is down 8-12% against the USD, EUR, NOK and DKK, to name a few related currencies. This means an added cheapness (the price of the stock + some of their costs are in SEK).

Patience and the importance of cultivating a tolerance for pain

The question, as is often the case with these deep value cyclical situations where future demand is certain is not if the market comes back, but when…

This is why patience is the mother of all edges in cyclical industries. A curious Chinese proverb states that patience is only possible from a place of strength, which from an investor’s point of view can be interpreted as not depending on near-term gains and refraining from using leverage in cyclical stocks. There is a tremendous advantage to be had in never being forced to sell.

The second magic ingredient is cultivating a tolerance for pain. This is essential because the troughs are often outdrawn and longer than expected and the upturn often short and violent, so while the net result may be overperformance in the end deep value investors experience more defeats on a daily basis than momentum investors, which is why it is harder. This is also why the opportunity exists: One gets paid for being a masochist 😉

And just to be clear: In my opinion this is not a “buy and hold forever” type of stock. Instead it is a “get in when the market is depressed and get out when normalization has occured”. If you are a splendid market timer you may even want to wait till euphoria has been reached. Personally, I am usually off to other hunting grounds before that happens.

Concordia Maritime is controlled by a major shareholder, Stena Sphere, which holds 52%. Some have pointed to corporate governance issues with a majority shareholder being in control while at the same time providing customers to Concordia Maritime for a fee. I personally am undecided whether this is a good or a bad thing for Concordia Maritime’s shareholders. Better debt terms are possible when you have a financially strong player backing you. On the other hand there is the possibility of overcharging for their services. But if that were the case, EBITDA-margins would be worse than competitors and that isn’t the case. Either way, this is more of an issue if you hold for the long haul, rather than taking an opportunistic approach to cyclicality, which is the game that I would recommend playing in this particular case.

Disclaimer: I do not accept responsibility for losses that are a result of buy/sell recommendations I make. I encourage you to do your own reserarch before making an investment decision.

Arise: Price Heads South, Fundamentals Head North – A Few Charts

The share price of the Swedish windpower company Arise indicates a struggling company.

However, the balance sheet is solid after the recent refinancing and the pricing fundamentals have improved significantly this last year, especially since the start of the year. The combination of electricity prices (first graph below) + e-certificate prices (next two graphs) are now consistently above the 500 SEK/MWh range. A level we haven’t seen for the last three years. Finally “in the money”-territory on an allin basis, not just on a cash flow basis as has been the case in recent years. I believe break-even (e-spot + e-certificates) is now around 400 SEK/MWh if we include the recent impairments.

March was particularly cold and was probably an outlier. The price has come down and settled at 400 SEK/MWh for April (still way above previous years: April 2017: 280 SEK/MWh, April 2016: 200 SEK/MWh, April 2015: 240 SEK/MWh).

E-certificate prices have risen sharply in the last few weeks:

Much of this has to do with rising coal prices (and CO2 emission pricing has an impact on this which is why I include a graph of that as well).

The story has changed but the price hasn’t reflected this change, yet!

The Case for Uranium, Part 2 – 4 stocks

Slides from the presentation: The Case for Uranium – Part 2

The Case for Uranium

Presentation slides: The Case for Uranium.pdf

Cliff notes:

• Unsustainble gap between production costs and prices
• The number of miners are down 90% since 2011
• Both sides of the supply/demand balance is shifting in a favorable direction and the longer term outlook is fantastic
• Adding new supply is a lengthier process than in other sectors
• Game changing events are taking place in Kazakhstan – OPEC-like structure in the near future?
• Investors hate uranium after a 7-year long bear market
• Upside potential is explosive while downside is well-protected

 

Wind Power: The Fundamentals in Arise Have Improved

Cliff notes:

• Arise has refinanced their bond = less risk.
• Demand for wind power projects among institutional investors has risen.
• Valuation gap. Trades at half book value while competitor Eolus trades at book value. The size of their pipelines is the same.
• The forward price curve for electricity has improved. Probably a function of the price of coal and carbon emission quotas rising throughout 2017 and continuing in 2018 laying a floor under the price of electricity.

Summary: The fundamentals have improved while the price of the stock has fallen to 12,50 SEK. I expect a rerating to occur and see fair value in the 18-19 SEK range.

Wilhelm Wilhelmsen Holding Q4 Update

Sorry for the delay in updating the excel sheet following Q4, which was released on the 15th, but here it is: wwhq4-2017.

I have the discount to NAV at 38,3% currently and the total NAV at 396 NOK. Nordea has the same NAV at 522 NOK… Not sure why we get such different numbers, as they don’t specify how they arrived at them but I suspect they value WMS more ”aggressively” than I do. I’d like to see a few more quarters of stable results before I revisit that valuation.

Either way, there seems to be plenty of room for the share price of Wilhelm Wilhelmsen Holding to grow just on the basis of the discount gap shrinking. On the business side there are promising signs as well. I expect mining related commodities to do well in the coming years and the group is well positioned to take advantage of that.

Q4 – Holding

As for the report, it was pretty much in line with expectations at the holding level. Wilhelmsen Maritime Services, WMS, improved both the topline and the EBIT-margin (after M&A costs) which is now at 10%, which is about where it should be longer term. Apart from that there was no big news.

Q4 – WWL

The daugther company WWL was hit by a 140 MUSD provision on top of the 300 MUSD that had already been set aside. This was a surprise to the downside that I had not seen coming and the market cap effect is -4%, which equates to 2% for Holding.

The operating results of the daugther company continued the postitive trend from Q3 and High & Heavy volumes have started to kick in, which is evident in the cargo mix when adjusting for seasonal effects. Volumes grew both quarter-on-quarter and year-on-year. The company has raised the expected synergies from the merger another 20 MUSD annually and they also benefit by 6 MUSD per year from the US tax cuts (which are absolutely madness if I am allowed to have an opinion on the subject!).

Coming up

I am currently digging into the energy space and I expect some of that research will find its way into this blog. So if this is an area that interests you please stay tuned for an update within the coming weeks 🙂

God Damnit, I Missed the Boat!

Every investor knows the feeling of having followed a stock for a while and having considered buying it when all of a sudden the thing takes off and you are left on the dock viewing the boat and its cheerful passengers from afar as it disappears into the sunny horizon while you are beating yourself over the head for missing out on yet another opportunity!

You know that feeling, right?

If so here is why you MUST silence that voice in your head and overcome what could otherwise end up eating away at your life savings:

1.  That voice is a liar. You would have bought the stock if you had thought it sufficiently attractive. There always is a reason why you didn’t act – most often a very good one. Perhaps you hadn’t put in enough work to understand the company sufficiently, which again is a reason why you could not and should not buy it.
2. Remember all the bombs and mines you avoided over time due to craving large enough margins of safety. Don’t give in – stay on the path!
3. If the stock went up based on positive unexpected news flow then it isn’t the same stock any more and therefore it is irrational to have any attachment to what once was. It’s simply a different situation from the one you considered before the news broke. Analyze anew, carefully and deliberately and without haste. Mistrust any bodily reaction compelling you to jump onboard. Detach!
4. Recognize the danger of hunting the next hot thing that has left people disconnected from their rational selves in a blind hunt for quick profits. One word: Refrain. Fundamentals are what drives prices over the long haul – and they usually come down after the time of exuberance is over. Remember Warren Buffett’s quote: “The market is a device for transferring money from the impatient to the patient.”
5. You want to always be in a calm state of mind when considering financial actions. Fear of missing out (FOMO) takes you out of that state and into caveman territory where the amygdala and fear and greed rules. When fear or greed has become rampant in the market you want to be an observer as opposed to a participant – and generally opt for the opposite side.
6. In the history of the markets FOMO is the single biggest contributing factor to bubbles. If you can manage to stay away from those you probably won’t get rich quick but you will live to fight another day when drowning is taking place all around you. In the markets not losing is more important than winning – unlike in life! You won’t die if your neighbour gets the prize and you don’t. Deal with it!
7. Recognize FOMO as the biggest monster in the market and as a crusher of souls. It may not have devoured your savings yet – your gambles may even have paid off handsomely a few times and lured you into thinking it is a viable strategy – but if you don’t actively keep FOMO a bay, one day the odds are it will devour you cold-bloodedly. Therefore: A day without FOMO in our lives is a day worth celebrating!
8. Finally, and most importantly: There are tons of boats in the ocean arriving at our shores every year (and by the way, having enough dry powder is also such a boat: the optionality of cash). The best counter to FOMO is to put in the work and dig up enough cases with enough margin of safety so that you can wave goodbye to all of those boats that you will miss with no feelings of regret – and to do so with a smile knowing that yet again you conquered the mighty enemy that is FOMO!

Much of this is easier said than done. And no, I don’t have it down completely myself. But in the words of JFK:

We choose to go to the moon. Not because it is easy but because it is hard!

 

Are You a Cowboy or Are You a Chicken?

Do you swing for the fences or is your main focus on not getting killed? And is your assessment of that question even accurate?

Say Hello to a Chicken (I Think)

Personally, I like to think I’m a chicken as my focus is almost always downside oriented first and foremost. However, when discussing position sizing with friends more often than not I get labeled a cowboy as few and large positions is usually my game.

Charlie and I disagree with that! (Hm, for some reason that line felt good. I wonder if Warren gets the same pleasure from it when he says it – which is often…).

A few bets are all you need, but when you find the few, act aggressively. Diversification is for people who don’t know anything. – Charlie Munger

The point of the above quote is that with knowledge comes risk protection. And in my world big bets are reserved for especially safe situations where as many angles as possible are covered through relentless investigation. For me that tends to be investment companies and conglomerates as these are already quite diversified through their holdings in multiple companies and where there is an added layer of safety through an unusually large discount. I rarely take super large positions outside of those types of companies. So in spite of having massive positions percentagewise I would argue that this is in fact a chicken approach to investing, one in which it is hard to get hurt in a big way.

A hypothetical example

Take an example. Which is more diversified: five promising growth stocks or one investment company with an unusually large discount to NAV? More often than not I’d bet on the latter, but a more accurate answer is, of course, that it depends. If you have deep expert knowledge and an intimate feel for the industries in which the five growth stocks operate, preferably through working or having worked in the field, then you may have yourself a near perfect match between diversification and a high expected value situation, supposing the fields are non-correlated. But few of us have this much expert knowledge and on top of that it would require a lot of work.

 Laziness can be riskier than big bets

So risk comes more from laziness than the sizing and the amount of companies in one’s portfolio. And risk can be materially decreased from understanding and being able to identify the type of situations where one can size up with a large degree of safety. More on that in a recent post: https://hammerinvesting.wordpress.com/2016/12/18/the-sizing-of-a-bet-the-art-of-not-blowing-up-while-getting-the-best-of-it/

Bonus: The title of this post was inspired by a recent Howard Marks interview on Bloomberg Radio : https://www.bloomberg.com/news/audio/2017-02-17/interview-with-howard-marks-masters-in-business-audio To Marks devotees, such as myself, it may not contain anything new in terms of substance but ohhh the pleasure of this man’s eloquence! Poetry blended with the sharpness of a Japanese knife…

Macro Risks & Arise Sold

Macro view

A disclaimer is in order:

1. A broad macro view of the world in all of its beautiful complexity is a really, really dangerous and risky thing to have. Most people are best off simply buying whenever they have spare cash – as long as it doesn’t threaten their personal situation. Never taking chips off the table at anytime in one’s life except when needing it to buy something is almost always the most prudent thing to do in order to secure buying power as we get older and to fight the fact that inflation eats into the real value of our savings.
2. Whenever you or someone you listen to is having a negative and bearish macro view you should be particularly sceptical of that view. Being bearish is more interesting and intellectually stimulating so in that respect it can be rather seducing. The question is whether it is beneficial to the wallet because over the long haul being positive has won in the market by a huge margin historically. It does seem that humanity has a tendency to always overcome hardships. Many would argue though that recent decades have been aided artificially by mountains of debt, and that this is now a major source of our current problems.

The optionality of cash and equivalents in a high-risk setting

The markets seem very sure that 1) giant stimulus packages will be approved by the US congress, and 2) that they will work where everything else has failed. That may happen but it is very far from a sure thing and it won’t happen tomorrow, more like 2+ years down the road. In the meantime we are entering into dangerous territory and the risks are mounting on multiple fronts in the coming years. I realize it is unfashionable to make macro calls – and perhaps rightly so – but I do think prudence is called for considering the following factors, many of which have reached proportions unseen for decades:

List of macro risks:

1. The geopolitical power balance is out of whack which has led to instability not seen since the late 70’s/early 80’s. Could turn out explosive.
2. Rapidly growing tensions within all developed societies. Is this strictly limited to the immigrant situation or is it also rooted in the enormous inequality divide which is stifling consumption and thereby economic growth?
3. Poor underlying demographics in the developed world, which may be a deeper and more fundamental cause for the slow growth of the last 10 years.
4. A possible bubble in the bond market. This is way more dangerous to the world economy than a stock market crash due to the sheer size of the debt market (this could actually be bullish for stocks if money from bonds retreat into stocks). Will haircuts be needed for bondholders? And if so, what happens to the balance sheets that are heavily exposed to that debt?
5. 0% interest rate for 10 years ought to lead to poor capital allocation, which in turn usually leads to recessions or outright depressions.
6. How will the steep mountains of sovereign debt all over the world be paid back? Will central banks continue to stimulate and thereby increase risks of a giant blow-off and/or runaway inflation somewhere down the line?
7. A global trade war seems increasingly likely (given administration picks). This could lead to a global recession.
8. Low capex globally and high share buyback (which is typically a late-cycle phenomenon) means there isn’t much belief in the future. If companies aren’t investing where will future growth come from?
9. Historically high margins. Is mean reversion inevitable or is it a sign of the IT economy being less capital intensive? If the former turns out to be true we are in for a multiple contraction.
10. US jobless claims has fallen to a 43-year low. This is often an early indicator of a downturn and a late-cycle phenomenon since it suggests the potential for further growth is low as there isn’t much slack left. On top of that, even now when unemployment is this low the economy is struggling, which is not exactly a sign of underlying strength.
11. AI could be here much sooner than expected. Some experts talk about a couple of years rather than 10 years. While this will provide opportunities in the long run – is our system adequately prepared for it in the short term?
12. How will the stimulus package get financed? More debt or will Trump find a way to let Chinese money invest in roads, airports, etc.? Perhaps in exchange for not imposing trade tariffs on Chinese goods? Win-win if possible but is strong-arm tactics viable in the longer run…?
13. High valuations among so-called ”safe” dividend stocks due to “reach for yield” desperation. Shiller PE of 28 and the non-manipulative Price/Sales ratio is through the roof at 2,6 (1,6 being the average). Warren Buffett’s favorite indicator Total market cap/GDP is also blinking red. This is currently at 127%. Based on historical averages a fair valued market would be at around 85-90%.
14. Trump being Trump.

The bullish arguments that I see:

1. A giant stimulus plan corresponding to 2,5% of GDP over a 10-year period in the US ought to move the needle IF it indeed is approved. And if Germany picks up the mantle and does the same if could have a big effect. It is also a huge gamble because if it doesn’t do much the debt situation will be even more dire as a result.
2. Deregulation and tax cuts may also add some umpph. However, the latter could have a negative effect on long-term growth if much of it is given to the top, which would not do much for consumption.
3. Bond weakness could transform into stock strength as the money leaving the bond market has to go somewhere. If I had to choose, I’d feel safer in the stock market than in the debt (bond) market right now.
4. The possibility of a Trump impeachment would reduce many of the outlier risks. I suspect there will be a huge number of Republicans that will leap at the opportunity to get rid of him if it arises now that they have secured power. And I suspect there will be ample opportunities as the guy is likely to confuse his own financial interests with those of the state at some point.
5. In general I think it is more prudent to move to the emerging world where there is growth potential due to low debt levels as well as lower valuations.

Conclusion

One can argue whether the risk/reward points to a bullish or a bearish view, but one cannot argue against the fact that the risks are high. As a consequence of my own cautious view I have set out to increase the cash position to at least 30% and I am currently looking into gold miners as a potential currency and market hedge. I will probably post something about my findings further down the line.

For Those About to Trump etc.

In my last post I had said I’d write in depth about the US election situation but decided I cannot do it without it quickly becoming a private issue, which isn’t of interest to anyone. So I’ll just quickly say it makes me boil with anger that people chose untruth and unchecked aggression and that they were willing to put on a big gamble that will undoubtedly cause a great deal of harm to living beings all over the globe. But one either gets this or one doesn’t and my words won’t make dent of difference.

I hate what happened with uncontrollable anger. So this is my mistake for the year: In order to preserve mental health I will resort to shielding myself from the words of Trump and his lunatics to prevent that anger from taking over, preferring instead to read commentator’s analyses of the situation. As an investor you always want the naked source not other’s interpretations of it so this is a step backwards for me. Hopefully something will come in the way of this presidency so we can move on.

For the record: I was for Bush being elected in 2000 (and against in 2004) so this is not automated knee-jerk lefty speak. I have listened to tons of past interviews with Trump and figure I have a grasp of what the man is made of and it isn’t the material of a man with a grand and carefully thought out vision. His path is fraught with bankruptcies and court battles and there isn’t much else there except the ego’s will to express itself.

Portfolio update – Arise sold

I decided to sell my remaining stake in Arise. I took some chips off following the September spike and now I let go of the rest. The reason being the combination of 1) a collapse in e-certificate prices lately (143 SEK/MWh in October to 69 now) as well as what I regard as a surprising weakness in the electricity spot price (below 300 SEK/MWh for a full week). A combined price below 370 SEK/MWh in wintertime despite extremely low water reservoir levels (low capacity in the system ought to lead to higher electricity prices) while the share price is approaching a three-year high has made me decide to move to the sidelines.

In addition to this there is a bit of uncertainty about the fact that the Kölvallen-project (150-200 MW) has still not received the final permit. It was scheduled to happen in the fall of 2016 and now the decision is expected in Q1.

To be clear it was a close decision to sell and my cautious macro view and my wish to increase the cash position played a part. I still think the share price is a bit lower than fair value even given current circumstances but on the other hand it isn’t as much of a no-brainer proposition for me currently so I elected to monitor the situation from the sidelines and perhaps re-enter at a later time should the outlook as well as the margin of safety become more attractive again.

When I started writing about the stock in October 2014 the stock price was 17,10 (https://hammerinvesting.wordpress.com/2014/10/09/arise-windpower-traded-at-a-historically-large-discount-part-1/). Now it sits at 21,50 for a gain of 26%, which isn’t great for a two and a half year time frame but market beating nonetheless.

The #1 Error I Committed in 2016

An interesting, a tumultuous and an utterly horrifying year for the developed world has come to an end and even though I am thankful the year was extremely kind to me personally I find it difficult to shake off the nasty feeling that something terrible could be about to unfold in the world. More on that in my follow-up post. In it I will outline an investment mistake that I will make in 2017 and there is nothing I can do to prevent it due to a flaw in my mental constitution…

For now though I’d like to focus on the one giant mistake that I know for sure that I committed in 2016 because I think it is one many of us make and I think it is very much avoidable. At the end of my post I will also get into my current top positions.

Preparation, damn it!

Trump wins and I sit and sweat like an idiot researching military defense companies and pharmaceuticals after the fact instead of putting in the work ahead of time. This isn’t merely one of those excusable mistakes we all make during a year. Instead this is one that cannot be brushed off lightly because it is one of few areas where there is a significant edge to be had by individual investors who are free to ignore the day-to-day noise as opposed to many money managers who get measured on quarterly performance.

Frantic research leads to fuzzy thinking, which again tends to lead to rushed, subpar decisions. (I bought one company, Invisio Communications, after only a few hours of research only to sell it the next day after further research. Great company, stretched valuation in the near term.)

So the lesson is: Plan ahead or prepare for getting pushed around by the market and expect mediocre results.

Definitely easier said than done as many events will be of the ”thief in the dark”-variety, i.e. completely unknowable ahead of time. But there are others that are dimly available to our eyes out there in the distance.

Think ahead – examples

Suppose, for example, that China is forced to devalue their currency by a massive amount, say 25%. This would send violent shock waves through the global markets but it would probably also cause many Chinese stocks to become extremely attractive right after the devaluation (as opposed to before!). And I imagine in the first few hours of the panic one may be able to pick up some nice bargains while the markets are searching for their footings. This presupposes that one has done the work on the potential individual companies and that money can be moved to those markets quickly.

For individual companies there will often be ”trigger events” where one can calculate the value of each outcome ahead of time. This road is perhaps a better one to take, especially with regards to smaller companies, than trying to get ahead on the macro front.

Time is of the essence

You will notice that I am preoccupied by time and tactics here. The reason being that I have a lot of respect for the market’s ability to correct mispricings quite quickly and so often they will only appear for short periods of time before the gap is closed.

Many value investors will not bother with such tactical maneuverings preferring instead to search for compounders and worry less about hitting them at the point of maximum pessimism. This strategy relies on superior analytical ability and patience (the mother of all edges) and it is a fine one.

It isn’t one that is ideally suited to my personality though as I tend to look more in the deep value and ”special situations” space where mispricings are more temporary in nature and where my superior tolerance for pain (if I may say so myself!) can create potential edges in the market. A more opportunistic mindset.

For those wondering about my tolerance for pain… Yes, your suspicions are correct: This skill was carefully crafted over years as a slave in a sadomasochistic relationship giving in to the needs of the wife! That plus a side career playing cards characterized by violent volatility on a daily basis helped as well.

Strategic focus

If I had to put percentages on my general strategic focus I’d say somewhere in the range of 60% deep value, 25% tactical/special situations, 15% buy-and-hold compounding and 0% momentum. So compared to many buy-and-hold value investors I usually turn over my portfolio more than most, often in the 100-200% range.

Unusually low portfolio turnover for me in 2016

In 2016 my big positions in Wilhelmsen Holding and Arise Windpower (which at one point constituted 80% of my overall portfolio, unfortunately I sold off 1/3 in WWIB following Trump) called for lots of waiting, so I did almost no buying and selling until mid-September – 11% of my portfolio was turned over altogether, unusually low for me. By the end of the year that had climbed to 40% due to rearrangements in the portfolio following the US election, which I believe to be a game changer event.

My top 6 positions going into 2017

As of this moment my top 6 positions and their weightings are:

Wilhelm Wilhelmsen Holding (WWIB, NO) – 32% weighting

Cash and equivalents – 18% (including time arbitrage positions)

Mylan (MYL, US) – 13%

Arise Windpower (ARISE, SE) – 11%

Protector Forsikring (PROTCT, NO) – 8%

AO Johansen (AOJ, DK) – 7%

(Smaller positions – 11%)

Cash = optionality

The plan is to increase cash to about 30% in the following month or two as I am becoming more and more fearful of the mounting risks on multiple fronts and want the optionality that cash provides.

It won’t be fun to watch the market likely go higher while sitting on cash but there are meditative ego lessons to be learned in the process of sitting on one’s hands…

My next post

In my next post I will get into the risks that I see as well as go into the mistake I am inevitably going to make in 2017.If you are in the mood for some gloom and some doom stay tuned for For Those About to Trump – I Salute You!

The Sizing of a Bet – or the Art of Not Blowing Up While Getting the Best of It

In many areas of life size is overrated in my opinion. The wife thinks otherwise – which is always a cause for concern as evening approaches… Now, when it comes to investing you cannot afford to close your eyes to uncomfortable facts. And one such fact is that if your strategy to outperform the market relies on high concentration on a relatively small number of high conviction ideas you will blow up at some point in time if your understanding of the mechanics of bet sizing is flawed.

The better the odds, the bigger the sizing – then readjust for risk

The main idea is very intuitive to most. We size each bet according to the expected value of it. EV being the difference between the stock price and what we perceive to be fair value after careful calculation, which is the difficult part. Only then do we readjust for risk by scaling down when the risk is high and conversely scale up when it is not.

(Two notes: 1) EV in this context should not be confused with Enterprise Value, and 2) The time horizon is unimportant. A ”bet” could easily be a 20 year long position. I use the term ”bet” in the title for two reasons. The more important one is the wife thinks ”position” is better used in other contexts. And so being sensitive to risk I opted for ”bet”. The secondary and less important reason is that on a musical level ”bet” is more pleasing to the ear!)

Why the highest EV idea should not always be our biggest position

Assume that we are magically confronted with two bets that both have a 3x expectation and the outcome of both will be decided tomorrow. Bet both our own house and that of our grandma, right? You know the answer: Not so fast – it depends on the risk involved. So let’s quantify:

In example A there is a 30% chance the company gets bought tomorrow at 10x our investment and a 70% chance the deal fails and as a result that the company goes belly up and our investment is worth 0.

In example B the numbers are 4x 75% of the time, and the remaining 25% of the time it goes bust and we get 0.

The Expected Value of each is the same:

EV in example A: (10 x 0,3) + (0 x 0,7) = 3x

EV in example B: (4 x 0,75) + (0 x 0,25) = 3x

Let’s ignore the fact that both of these very hypothetical bets rank in the ”72 virgins in the sky”-sphere, ie. not gonna happen, but really, really nice to think about nonetheless and let’s instead agree that bet A is way riskier than bet B though the average expectation for each is the same. Neither proposition are in the ”bet grandma’s house”-range, but for some very risk tolerant dudes or gals bet B may actually be within the ”bet our own house”-range.

Size really is everything!

The EV is massive for both bets and therefore no-brainers that are criminal not to make. But since we ruled out betting grandmas house on the grounds it was too risky (though plenty of people had no problem taking risks at the expense of others in the years leading up to 2008!) the question then becomes one of sizing.

The Kelly criterion not suitable for everyone

How much then? Some use the so-called Kelly criterion, which is a mathmatical formula that provides the theoretically optimal way to size one’s bets to maximize long-term growth of capital. I would caution against it, however, since it does not take your own personal situation into account, such as cash flows from your job, risk preference, age, mental constitution and last but not least errors in judgement. To add a margin of safety some will use fractional Kelly (mentioned in the link above).

What I do

I don’t use Kelly myself but I do factor in both my personal cash flow situation, the number of opportunities I currently am aware of, my conviction level in each as well as the risk inherent in each – all to best of my ability.

The gold standard: many non-correlated high EV bets

The gold standard is to have a ton of non-correlated high conviction bets. For that to be the case one of two things need to happen.

One is you need to first narrow the field of ideas intelligently and then do a huge amount of work on all of the most promising ones. Only a rare few possess both the intelligence and the inclination for constant hard work such as a Warren Buffett, a Peter Lynch or a Mike Burry (think The Big Short), so many high EV ideas will be hard to come by for most.

Investment ideas from people you know to have the right process in place can be a source but remember you will need to have a thorough understanding of the drivers and the details of the business in order to know when to sell so work is always necessary unless you take to index investing, which is probably preferable for most people – though I will provide another solution that almost certainly will beat the market over time at the end of this post without too much work. It probably won’t be by a huge amount but it will beat indexing.

Absent that you may need to wait for the market to take a big dive and suddenly the waters may be ripe with opportunity.

A history of three 50%+ positions – and a gut wrenching loser

In the past five years I have had three 50%+ positions. Most people I know would never even consider this a possibility and it certainly isn’t the gold standard you want to aim for most of the time. However, I would argue there are times and situations when huge bets are very rational and not especially risky.

The first of those three times was in early 2012 in a Danish company called United International Enterprises, or UIE. This is a holding company where the discount to net asset value (NAV) had risen irrationally to 46% while the historical average was in the 20-30% range. The assets were stable in nature and on top of that the brothers who held the reins had recently bought shares for 1.5 million USD in the company. To me this seemed like a situation with both significant upside and a lot of safety on the downside attached to it, which is what you want out of a big bet. It worked out well and after 7-8 months the discount had narrowed to more normal levels and so I sold.

The second situation was a Swedish company called East Capital Explorer in late september 2013. The situation is similar in many respects, except the assets were more diversified and it required some work to ascertain the NAV as the holdings consisted of 40+ companies in 10 different countries listed on obscure exchanges. The company would issue a quarterly update of the NAV in 8 days time and due to heavy insider buying (8 million USD) I thought there was a good chance the NAV would increase significantly and that I could front run the update by doing the work myself and know the result ahead of time. I concluded it was at 42% while the historical average was at around 25% so I took a large position and sold it 2 months later when the discount went below 25% and received a 30% gain in exchange for a little effort.

The third case is Wilhelmsen Holding. I’ve written extensively about that so no need to go into detail here except to say that since it is also a conglomerate with a huge discount to NAV as the other two cases the risk is greatly reduced when comparing to a one trick pony type of company that sells products within one sector only. Leverage at the holding level is also very limited in this case.

Huge insider buying adds to safety as well. Also fraud becomes less of a concern in conglomerates and investment companies with many holdings, especially when insider buying has been prevalent.

Greed gave rise to this post 

Back in October 2014 I got greedy and loosened up on my bet sizing requirements (read: I screwed up on them). A Norwegian company in the oil service sector, Polarcus, had essentially been reduced to an option because of declining revenue coming from the big oil companies. The upside was huge but so was the downside risk due to high leverage. Still I thought the EV was attractive enough that it warranted a bet, especially since pension funds were selling out desperately in what seemed to me to be a forced fashion.

My thinking was that these are not the sharpest knives in the industry and that the reason for their selling might be due to institutional market cap constraints following the decline in price or managers simply trying to protect their job by not having a loser in their books. Seeing this I got greedy and violated my own rules and put 20% in it.

The oil price declined further in the weeks that followed after an OPEC meeting in which the Saudis decided they would go for market share rather than cut production. The oil companies cut their capital expenditures more and more as time passed and it started to seem likely that Polarcus would need a cash injection to stay afloat which would probably wipe out the existing shareholders given the size of the loan in comparison to the market cap.

I got out ahead of that, luckily, and took a tough 35% loss on the position. It turned out to be the right decision but still I was taught a painful lesson about sizing.

I don’t regret the bet which I still think was good in terms of risk/reward but hopefully I can control my greed the next time a similar one presents itself and size these option-like situations more appropriately.

Summary

The big bets should be reserved for cases where the downside is extremely well protected along with significant upside to protect the opportunity cost. The gold standard is to have many non-correlated high EV bets because then downside risk suddenly becomes much less relevant. This is difficult to obtain at any specific point in time due to both time restraints and due to the market seldom cooperating in providing you with tons of non-correlated high EV bets. And non-correlation is genereally hard to come by in the interconnected world we live in.

So how can someone who isn’t well versed in the markets use the above info and expect to outperform the market? By zooming in on investment companies in particular (and perhaps also conglomerates) and buy when the discount to NAV is above the historical average, preferably by a significant amount, and sell when it goes below. This is an easy way to buy a significant portion of the market while doing it at a discount, which ought to lead to outperformance. Seems almost too easy but it really does work.

Here is a list of Swedish investment companies you might want to look into so you can strike when the discount is out of whack.

Next post

Stay tuned for my next post around New Year. It will be about the mistakes I committed in 2016 as well as the composition of my portfolio going into 2017. Having made almost no changes all year I made some significant ones following the insane Trump victory.

Takeaways from the Wilhelmsen Capital Markets Day

I attended the Wilhelmsen Capital Markets Day in Oslo last week and it turned out to be fruitful in many respects. More than 100 people showed up and it was great to have the chance to exchange ideas with other investors and to meet management for the first time in a format that allowed plenty of time.

While there weren’t any ”breaking news” (plenty of those leading up to the event) Wilhelmsen’s investor day turned out to be a smörgåsbord of relevant information, and not exactly of the blue sky scenario garbage variety that is often dumped on investors at similar events. Those following the Wilhelmsen companies may have already seen the slide presentations but I will just add my 2 cents in a note-to-self format as things were said that weren’t in the slides.

Notes from Wilhelmsen CMD

The holding company, WWH (stock ticker WWIB):

• The merger will add ”at least” 50-100 MUSD to the bottom line of WWL, primarily due to the utilization rate of the vessels improving. “At least” was new information to me.
• Major reasons for the merger: Quicker decisions, less stalling = more manuverability in a market where margins are under pressure.
• Share buybacks is not on the table currently. The overarching goal is ensuring long term value creation and survival by keeping the holding company net debt free as it is now (no bond debt to use for share buybacks in other words). Subsiduairies can potentially assume more risk in the form of debt – all at an arm’s length away from the mother.
• Aquisitions targets need to be close to debt free (I like the sound of that!), dominant in their field and have an underlying positive cash flow. No experimentation that will endanger equity in WWH.

WMS:

• Margin pressure. Outlook in the near term is cloudy.
• Low customer credit default risk despite shipping customers hurting perhaps more than ever. Partly due to WMS being able to withhold vessels until payment has been obtained, meaning bills from WMS are not the ones you want to stall.
• Interesting Survitec deal. 20% in a company that is a dominant market leader in all segments they enter into. High margins and nice pricing power. IPO potential in 2-3 years.

WWASA:

• Margin pressure going forward. Merger to offset some of that.
• Supply/demand under pressure as there is very little scrapping potential for the next 10 years world wide and the world fleet is younger than ever (Chinese boom 5-10 years ago to blame for that). Scrapping/new building-ratio does not look favorable many years out unless new building cancellations start to take place.
• WWASA best in class? Utilization rate of 85-90% is above industry average of 80% and EBIT-margins seem to be better than their biggest competitors, though it is difficult to measure as the competitors are not pure RoRo players only and do not specify their margins by segments in their financial reports.
• Mining is finally showing signs of improvement (Rio Tinto capex expanding again) and big opportunity for growth particularly in Australia where WWL has a strong inland logistics network.
• WWL’s land based logistics business is asset light and has grown rapidly. Revenue now about the same as ocean transportation (although most of it comes from the low-margin distribution business). Margins from Terminals and Tech Services, which currently accounts for 40% of inland logistics revenue) are handsome in the 10-15% range. Long term contracts and cash flow is stable. In my opinion this change in revenue stream will lead to a repricing of WWASA further down the road.
• The inland and ocean based businesses are separate financially, meaning should one experience difficulties it will not drag down the other.

Conclusion – what has changed?

Wilhelmsen Holding’s prudent capital allocation strategy means one can view an investment in the company as a storage of value with almost bond like safety while also getting the benefit of a lot of upside potential due to the generous discount-on-discount effect, which I find to be counterintuitive. A simple sum of the parts-valuation (based on mark-to-market pricing of WWASA, Treasure and Qube, book value of NorSea and EBITDA*6 for WMS) gives an upside of about 100% from the current market price. Added to that both the holdings in WWASA and Treasure appear undervalued (hence the discount-on-discount). Both of those companies probably have sharper upside potential in the near term but at greater risk, in my opinion, particularly WWASA.

Adding monetary experimentation and mindboggling politics into the equation

The current non-tested central bank experimentation, the weird political scenes around the world and high valuations in general leads me to believe that one ought to focus on safety rather than going for that extra percentage point here and there while exposing oneself to the enormous risks lurking out there. So in general I think defense is the play right now. In life the mindset of not losing is often equal to losing. But in investing there are times when not losing is a way to set the stage for winning…

Wilhelmsen: On Today’s Merger

A quick update on my opinion on today’s proposed merger. You can read the press release from the company here: http://www.newsweb.no/newsweb/search.do?messageId=408785

Expected gain for the holding company (WWIB): 30 MUSD per year (250 MNOK)

First the hard numbers. The synergies – a larger and more robust company will be able to achieve better financing terms, will need to employ fewer people as well as being able to direct their combined vessels more efficiently – are expected to result in a gain on the bottom line of between 50-100 MUSD for the new merged company, Wallenius Wilhelmsen Logistics.

Wilhelm Wilhelmsen Holding (WWIB) will own 40% of this company, which means the bottom line will improve by 75 MUSD (average estimate) * 40% = 30 MUSD per year = 250 MNOK per year. There are 46,5 million outstanding shares which means earnings will improve by 5 NOK per share. If we assign a conservative PE of 5-6 that would mean 25-30 NOK/per share. The market’s verdict today: 7 NOK.

Now that I got my scorn for the market’s ability to do simple math out of the way let’s focus on the broader picture because there is more to this merger than the gain from synergies.

The name itself indicates a gradual move which has been underway for the last couple of years away from shipping and towards inland logistics, where margins are better – and where stock valuations are much higher. WWASA is valued at a gigantic discount to book value, while inland players such as Hyundai Glovis (p/b 2) and Qube Holding (p/b 1,5) – both of which Wilhelmsen Holding hold a minority share in – are valued much higher.

There is also the fact that the Wilhelmsen’s have once again demonstrated a willingness to let go of majority control and instead focus more on releasing shareholder value. I think this trend is very clearly going to continue. Once a tightly controlled company starts to open up like this the odds of it reversing course are low. The selling off of the Hyundai Glovis shares may now have come closer and perhaps there is more streamlining to come from the Wilhelmsen Maritime Systems division in the near future as well.

Just my two cents on the meaning of today’s development. I’m curious about your view…

Video Post: Wilhelm Wilhelmsen Holding Analysis (Part 2)

Slides that were used in this video: Slides WWH 2

Link til Excel sheet used in Part 1: WWIB Presentation Excel

Video Post: Wilhelm Wilhelmsen Holding valuation + Peer Analysis (Part 1)

WWIB Presentation Excel

Wilhelm Wilhelmsen – Glovis Shares to be Spun Off

Just a very brief update on Wilhelm Wilhelmsen ASA & Holding after restructuring announcement and Q4 results yesterday. I will go into more detail on my estimates of normalized earnings when I come back from a two month vacation to the beautiful country of New Zealand.

The market price of Wilhelm Wilhelmsen Holding’s main asset, WWASA, has been very suppressed in relation to current earnings for quite some time – and even more so in relation to my estimate of normalized earnings. When I checked last week it has gone from very underpriced to comically underpriced considering the following simple math:

Market value of WWASA: 6900 MNOK.

Market value of share in Hyundai Glovis: 6600 MNOK

Market value of WWASA excluding Glovis: 6900-6600 = 300 MNOK

WWASA profits after tax for the last two challenging years: around 1000 MNOK per year excluding contributions from Glovis and after one-off provision for the antitrust case.

A first step toward a more market friendly direction?

Yesterday management took a step that surprised both the market and myself – namely to prioritize transparency in relation to the company structure by spinning off the shares in Hyundai Glovis in a different listing. The company has for many years been more focused on creating long term real shareholder value (as can be seen by the constant increase in shareholder equity over the years) than caressing the market with cosmetics moves such as simplifying the company structure but apparently the mispricing became too much even for them (being a publicly traded company and all) and the market has reacted with long overdue hoorays, especially for WWASA. I personally think this move is mainly a cosmetic one as no real value was added equity wise by today’s announcement but still important in that it could signal a first step in a more market friendly direction which could lead to repricing faster than otherwise might have been the case.

2016 will most likely be another challenging year for High & Heavy

Q4 saw an expected decline on the top line while profit margins improved. Considering that major customers such as Caterpillar and John Deere are having the fourth straight down year for the first time in their history I believe better times are to come in the years ahead for the High & Heavy (mining & agriculture) segment, which is the most profitable segment and one that WWASA is particularly exposed to. Business has always proven cyclical in nature while many analysts tend to extrapolate recent trends into the future leading to faulty expectations. It may still take some time for the segment to turn around – most industry players (WWASA, Caterpillar & John Deere among others) expect 2016 to be another tough year – but profitability is still good for WWASA currently and investments into new vessels by competitors have been at stable levels so no reason to suspect a substantially tougher playing field in the years to come, in my view.

Disclaimer: I am heavily exposed to WWIB and may unconciously be biased in my views. Always advisable to do one’s own research…

It’s That Time of year – Window Dressing and Tax Selling

A Danish poet wrote a poem many years ago saying that the year contains sixteen months and five of those are November! A not so subtle hint that darkness and cloudy weather is becoming the norm at this time of year and that time tends to become more of a drag.

My mother and I are less pessimistic. In fact it is a month where we indulge in our disorders and celebrate them. For her Christmas comes early. And those 107 Santa Claus characters populating every shelf in the house? Well, they are just not enough. And so as soon as the stores make new ones available she acts swiftly and decisively. With skills carefully crafted and perfected over many years she picks out the most spectacular ones before anyone else can get to them – and thus fulfills her cravings.

I’m also like that at this time of year except my disorder is more related to stock purchases. I load up on stocks I have had my eyes set on and I even buy on margin (4% currently and I will most likely boost it to 10% as I have done in previous years). Doing so makes me tense but I simply refuse to let those crumbs lie on the floor without picking them up when they are thrown around so carelessly by money managers clinging on to their jobs. You might say I have a mean streak in me because I don’t believe in leaving money on the table for my fellow man but when I see mispricings before my eyes without acting on them, I become physically ill. The stomach ache from buying on margin I can handle but not that other pain. Also, stomach ache is the constant companion of the bargain hunter so I get a bit of extra practise at the same time!

So what makes some money managers become so generous all of a sudden? Why do they act like amateurs and let small investors eat their lunch?

Window dressing

Some investment funds mislead their clients by selling badly performing securities before the end of a reporting period – month, quarter or year – and use the money to buy a rising security instead or to hold cash to buy back the securities they sold when the new period begins. By listing the stocks they hold at the end of the period the fund wants to appear to have performed better than it actually has. It is a despicable practise but it is a well-known fact within the industry that it occurs and it is most prevalent during the months of November and December.

Here is another window dressing technique that I witnessed in real time as I had an interest in buying a related stock at the time: Check out Wilhelmsen Holding’s A stock movement, ticker WWI, on October 30th, the last day of the month. In the last half hour of trading that day the price jumped 10% from 154 to 170,5 on low volume ochestrated by one buyer, CSB, who had been buying heavily in the previous weeks. The related B share hardly moved and in the following days the price came down by the same amount. This maneuvre is not legal but nonetheless it can often be witnessed in several illiquid stocks, especially on Dec 31st. The purpose is to inflate performance numbers at a relatively small price. It seems silly and if you or I did that it would be akin to pissing in our pants to keep warm for a few seconds. But perhaps you would also be tempted by sub par investment decisions if you had clients or bosses to report to?

Tax selling

In an overall rising year selling losing stocks to cancel out part of the wins can lessen the tax burden. For this reason you will often see stocks that have underperformed reach their lows in November/early December.

Be on the other side of the trade

You could call both of the above light forms of ”forced selling”. Any time you can be on the other side of a trade that isn’t driven by company fundamentals you want to be in that position – supposing of course that you want to own the particular stock in the first place. Note that what I am talking about here is the general odds of the above happening – you never know with absolute certainty who you buy from or what their motives are.

The January effect and small cap losers

Part of the reason January is often particularly good to small cap stocks that performed badly the year before can be attributed to the above practises. The market tends to correct itself and smooth out ineffeciencies but strangely this one has persisted and I will continue the uncomfortable practise of buying on margin for three months of the year and then gradually become non-leveraged come February/March until evidence says the market has erradicated it.

This bet doesn’t always turn out favorably, of course. In fact as late as 2014 I was not treated with any respect whatsoever by Mr. Market when I went for a leveraged oil play that turned sour as the oil price decline worsened. I won’t know for sure whether my bet was sound but I believe it was and therefore I would do it again. Investing is at heart a mathmatical undertaking where you attempt to estimate the likelihood of different scenarios happening:

Expected value = (Intrinsic value of the company in Scenario A * likelihood percentage) + (Scenario B * likelihood) + (Scenario C * likelihood) etc…

Dance like a butterfly sting like a bee

The above is a quote by Muhammad Ali to describe his boxing style: Non-dogmatic and opportunistic. When you see an opening: Pounce. I think this flexible attitude can also be applied by the enterprising investor even though check lists and hard rules are also a fine way to guard oneself against permanent loss. But to completely shut oneself off from action when circumstances are especially favorable is also a mistake in my book – mistakes can also be ones of omission as Charlie Munger puts it.

There is only principle I will not bend ever and that is the idea of a large Margin of Safety. The gap between what I perceive the value to be and the market price needs to be large for me to consider an investment no matter the circumstances.