I know, I know, you’re sick of hearing about my vacation. Don’t worry, I’m not sharing vacation pics again. Rather, I want to talk about what I “discovered” in my weeks away from the screens. I believe that most serious investors are smart enough to buy cheap stocks—it’s the harder “other stuff” that separates those who excel in this industry from everyone else. I went to the beach to dwell on that “other stuff.”
Q3 2019 hedge fund letters, conferences and more
Unlike a lot of guys who write a public blog boasting about big returns, I’m not in any way embarrassed to admit that 2019 hasn’t been my year. Sure, I have absolutely murdered shipping, but in turn, energy, small-cap value and shorting have not been kind to me. In aggregate, those positions all balance out to a small loss on the year. Even worse, I can’t think of a year since 2008 where 3 of my top 5 core positions (AR, SD, TSLA) went dramatically against me (I’m leaving ASPS in the undecided category). That’s not supposed to happen when you’re running a highly concentrated portfolio.
Oddly, despite the price action, I still feel that my fundamental analysis was spot-on. I bought two energy stocks with clean balance sheets, at massive discounts to PDP—even before counting all the other assets on balance sheet. Meanwhile, Tesla (TSLA – USA) remains a fraud. The stock prices tell me I’m wrong, but I am convinced that my fundamental analysis remains correct. I’m a concentrated deep-value-meets-catalyst investor. I have had a repeatable process that has worked for two decades. Usually I capture the turn. Ever since the fourth quarter of 2018, I haven’t been catching enough turns and I wanted to dwell on why that was.
The great thing about a vacation is that you can get away and think deeply. 2019 hasn’t been kind to many of my friends either. They also tend to buy bargains and short frauds. I cannot think of any year where the two style groups have diverged this badly, even 1999 and 2007 seem tame in comparison. My friends consistently tend to be in the top decile of all hedge fund performers. Trust me, these guys didn’t suddenly get stupid. Rather, something structural has changed. It’s been going on for a few years now, but lately, the market simply seems broken when it comes to the pricing of public securities. That’s why I went to the Caribbean. I knew I wouldn’t clear my head if my phone was still ringing. I couldn’t think with brokers trying to place blocks or IR guys trying to tell me why I should look at some wonky fraud. I’m always there for my friends, but I can’t help them if they keep reminding me that it’s even cheaper today and they don’t get it. I needed a chance to step back and analyze the market for what has changed.
There’s a famous saying that you trade the market you have, not the one you want. During my entire career, I have constantly been reminded that there are thousands of smart, hard-working guys all trying to find opportunities. My job had always been to work harder and figure out tricky situations faster. I had to predict cyclical inflections sooner than the other guys, as stocks reacted to forward looking information two to six quarters before the event. For many reasons, the market seems changed over the past few years.
For starters, there are fewer guys like me and the guys left are fighting redemptions and dumping cheap stocks—making them cheaper. They’re no longer trying to beat me to a bargain, they’re the ones causing the bargains. You have quant programs that are designed to extrapolate trends into the future. They’re great at modeling that Costco (COST – USA) will keep growing at a set rate and then dynamically discounting that back to a present value based on hundreds of factors to arrive at the right price each day. They’re terrible at any business with quarterly or cyclical volatility as the computers think linearly. Even after the turn, they’re still shorting more using backward looking data. The shift from active to passive, the rise of ETFs that blindly buy some basket of stocks, the elimination of trade desks to absorb fund flows and make orderly markets, the advent of QE that puts a perpetual bid under anything in an index. All of these things have changed the market in a way that is unfamiliar to me.
I have friends who like to bitch that the market has changed—they believe they’re right and the market is stupid. That may be true, but you can’t spend your time complaining about a server farm in New Jersey. If you have permanent capital like Buffett, today is the greatest time in history to be an allocator in the under $500 million market cap space. There’s an extinction event going on amongst funds and the shares they’re coughing up have rarely been cheaper. If you’re running a fund like I am, either you perform or you don’t have a fund. I don’t have the luxury to buy cheap stocks and hope they eventually re-value over the next few decades. I need to accept that the world has changed and evolve with it.
So, where are the opportunities in this quant, AI, passive world where performance is judged hourly? How do you exploit the inefficiencies in the brave new market we’ve all inherited? That’s what I tried to piece my way through while sitting at a beach bar, drinking my English Harbour Rum.
Gradually, it came together for me. What is the fatal flaw in an AI model? If it hasn’t happened in the data-set the computer cannot predict it. Why could I buy Scorpio (STNG – USA) during the first quarter of 2019, during a time when charter rates were lapping the prior year at huge premiums, while Scorpio still traded less than half of NAV, despite it being three quarters from IMO2020? The computers weren’t programmed to look at shipping broker reports and see rates increasing. The computers are oblivious to IMO2020. Instead, computers were shorting more Scorpio each time it rallied to the down-trending moving average because that had been the winning trade for the past decade. I could sit there, see the trend inflection in the daily data, see charter rates screaming and know I was right, while the IMO2020 catalyst was sitting there on the immediate horizon. It was literally a risk-free investment to buy a position-limit as the company was also there buying back every share they could and propping the stock up. Management saw it, the computers didn’t. Look at the short interest data—the computers kept shorting stock to me at half of NAV. It was like stealing from a blind man, because the computers are programmed to be blind.
Why is Altisource (ASPS – USA) so cheap at a similar inflection? Because management didn’t XBRL their one-time expenses so that the computers could see how cheap it is. Those numbers are hidden in a conference call transcript. Besides, the computers are focused on the trend in financial data comping negatively—just like with Scorpio, they’re backwards looking. AI can’t see the coming inflection in housing defaults. Only my friends in the property industry can see that.
I started to think back to my other big winners lately. My edge wasn’t valuation based. I found strong trends in motion and I strapped myself onto them. Valuation was only there to protect my downside so I didn’t overpay in case the trend failed. The only outlier I could think of in years was Aimia (AIM – Canada). It was my biggest win last year, but it only worked out because a bunch of value guys unseated an incompetent board. Call it value investing’s last stand. Still, the computers couldn’t see ahead that a coalition of the willing would remove bad people. The computers rightly assumed that the board would destroy every last dollar they could. The computers were extrapolating past trends.
Previously, in my career, I had to guess when a trend would inflect. I’d rely on all sorts of metrics and a good bit of luck to catch the turn as the share price would inflect long before the fundamentals. Today’s market is different. You have a lot more time to learn the industry and choose the right stocks. You can literally wait to buy until AFTER the trend has changed and we’ve inflected into a bull market in the industry. Even then, you may have a few months before the machines realize it and the share price responds. It’s actually a lot easier and less risky now. The key is making absolutely sure that you’re in a trend that is robust—one that will carry for a few years. Then let the computers do their thing. When I look at the winners I’ve sold over the past few years, I’m stunned at how much further they’ve trended. Overvalued stocks doubled and tripled again. The computers don’t care about value. They just want to make sure the trend stays in motion—in a ZIRP world, valuation is passé. That’s another, harder lesson for this value investor—there aren’t that many great trends. When you have a good one, keep riding.
After I digested that information, I started to look at my mistakes this year. There’s nothing wrong with my energy plays. They’re cheap by historical standards and cheap compared with competitors. Antero is fully hedged—they literally don’t even care what happens to natural gas prices. The computers don’t care either—Antero is lumped in with a massive basket of energy names that are traded as a group. In today’s market, share price appreciation is only based on the strength of the trend. Oil has been chopping around in a $50 by $65 range. Natural gas is $2 by $3. There is no trend. Due to shale, these commodity prices are somewhat capped as supply ramps each time we get near the top of the price range.
The energy stocks I chose are insanely cheap, they’re creating value, but the computers don’t care. Small-cap energy names are in energy ETFs with outflows, they’re owned by funds getting redeemed. I should have waited to buy these until I saw a trend higher in energy prices. That’s coming, but we need another few years to chew through Tier 1 shale inventory first. My mistake was assuming today’s market is like historic markets that looked ahead a year or two and used fundamental analysis to separate the winners and losers early in the process. Instead, I need to be buying energy names AFTER the inflection is obvious. Sure, I won’t get the absolute low tick, but even buying 20% off the lows won’t matter once the trend is in motion. Most of these names are ten and twenty baggers from today’s prices—there will still be plenty of meat on the bone, even if I pay up—especially if energy prices are actually increasing.
Meanwhile, Tesla (TSLAQ – USA) is using fake numbers to mimic a trend. Computers can’t see fraud. They just see up and to the right. They are factor based. Revenue, earnings, margins, analyst upgrades and price action drive the models. Tesla found a way to cheat in school. Meanwhile, the humans have been programmed in a Pavlovian sense to buy what the computers will buy. Without regulators doing their jobs and short-circuiting this process, it can go on almost forever. In the past, the catalyst on the short side was the business collapsing or the complete exposure of rather blatant fraud. Both of these happened. Nothing matters, Lol.
Over the summer, I spoke at the Real Vision Black List event in Cayman. After I gave my presentation, one of the members came up to me and said “Raoul does Global Macro, you do Global Micro because you look at all the funny little trends that no one else follows.” I took that as a compliment on many levels. I hadn’t thought of it in such terms, but I focus on the Global Micro market. I want to find those trends that no one else is in. Ignored trends are the ones with the most opportunity. I want to watch dozens of them like a hawk. I want to learn all there is to know, but most importantly, I want to wait until the last possible moment to pounce. I want to wait until things are inflecting and then I want to max out my position. I know that the computers are looking at the numbers with a lag. One quarter is statistical noise, two is a pattern and three is a data series. By the time we’re comping positive yearly, the computers are buying every share in sight. Cheap valuations stopped mattering. There are lots of cheap companies slowly plodding forward. Today’s market wants to see revenue growth as that’s the style factor that matters most to all these computer models. Find the growth and you’ll find the share-price appreciation. Find the trend in motion and you make money.
From now on, I need to watch the Global Micro for the trend change. My insistence on owning cheap businesses may narrow my universe as I refuse to own overvalued assets, but I haven’t in any way given up on being a value investor. However in today’s market, valuation cannot be the primary factor in a decision—no one cares if it’s cheap, as cheap stocks keep declining. You need to find the trend inflection first, then determine if your entry price makes sense. This isn’t a new epiphany; equity markets have gravitated towards trends since the invention of equity markets. However, they haven’t done it with this much conviction at any other point in my career. More importantly, I now know the fatal flaw. The machines cannot look behind corners or down rabbit holes. If you are armed with facts that don’t show up in past data series, you’re going to make a fortune as the computer models overshoot chasing the growth.
Every trend is a bit different. I’m a historian at heart. I intuitively know that no two cycles will be the same. You can program a computer with all the data in the world, it’s the subjective ability of a human that can see things for what they are that gives me my edge. I know that in global micro investing, I can run laps around the computers, they’re still dumb at trend inflections. Going forward, I intend to focus a lot more of my energy on these trends. There is real edge here as less humans are in the markets and the computers remain blind. I now know the critical flaw in the computers—I can see the inflection changes before they can.
You can either complain about how unfair the new market is or you can capitalize on it. I intend to capitalize like I always do. I had the wrong mental construct at the start of this year as buying cheap stocks had worked for the past two decades. Now I have my marching orders. Find the most robust global micro trends that the computers cannot yet see and time my entry to be a few weeks before the first positive quarterly comps. Then, sit back and avoid doing something stupid like selling before the trend changes.
One last pic from St. Lucia. Can’t believe I’m only three hours away…
Disclosure: Funds that I control are long ASPS, SD, STNG
Article by Adventures In Capitalism
