New Site

I moved my site here:

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The Choreographed Trade War

The list is out.  So China will put tariffs on American fruit, wine, and pork.

Clearly, China is showing some real restraint here. If they really wanted to go after agriculture (a major American export), they would have went after corn and soybeans. Instead we have:

• Fruit and wine. These are major California produces. California is clearly on Trump’s shit list, so China is almost doing Trump a favor.
• As for pork, a Chinese company WH Group owns America’s largest exporter in Smithfield. So this is China offering to tax themselves.

It's starting to look like Trump and Xi had some sort of handshake deal, because this is looking very much choreographed. Talk tough, slap some non-punitive tariff on each other, then take some victory laps with political constituents.

Ironically, Emporer Xi’s total grip on power allows him more flexibility to extend concessions in the face of US demands. “Xi for life” is bad for democracy, but so far good for U.S. commercial interest.

If Trump is smart, he will take this olive branch from China, claim victory and call it a day.

The best case for markets is if Trump keeps his strategy of speaking loudly and carrying a small stick. The economy would hum along with little damage.  Meanwhile, the Fed can use this trade war thing as an excuse to get dovish and delay rate hikes.

Notes from 1Q18

I was 100% allocated to stocks coming into 2018, had an ecstatic January, then a crappy February that led me to cut exposure. I continued to cut exposure in March and now sitting on more than 30% cash.

The low volatility regime has decisively ended, which means all sorts of previously overvalued stocks can come down on the slightest negative news. Fundamental based investors need to watch out for value traps! 

Often these negative news are laughable and are just an excuses to sell stocks. The problem is “value investors” have a tendency to confusing these negative news as the actual cause of stock drop, find reasons to say it doesn’t matter (which it doesn’t), then proceed to buy. But often the negative news is just a catalyst for a hibernating bear case to resurface, and NOT the real reason, so these investors are led completely off track.

The Facebook/Cambridge Analytica scandal is one such example. Bulls are attacking a non-existent bear case that people will somehow stop using Facebook. This line of reasoning dominates the market today, and will likely prop up the stock for now. But I do not think that is the reason for the price drop! There are other legit, but dormant bear cases that runs much deeper.  But I will save this for another time..

Some notes on a few stocks I’ve been involved in recently:

Digital Realty Trust (DLR) – bought at around $105/share
Very simple thesis: 1) Positive industry trends, 2) valuation/dividend coverage/leverage all check out fine, and 3) timely technicals

• Positive industry trends. 1) Datacenters have plenty of runway from ever-expanding cloud adoption. 2) The race toward over-the-top video means companies will want their content physically closer to consumer locations, so the Google, Facebook, and Netflix of the world will need the physical proximities that DLR can offer. 3) Edge computing is the future (required by internet of things, autonomous cars, 5G…etc), and again that raises the value of physical proximity to end consumers

• Numbers check out fine. About $18.5bn of market cap versus ~$1bn of cash flows from operations. That CFFO is growing rapidly. $1bn of CFFO easily covers ~700mm of dividends. Debt to EBITDA is high at > 6x , but comparing debt to value of investment properties shows a manageable ~50% loan to value ratio.

• Timely technicals. 10 year U.S. treasury yields got close to 3% resistance and backing off. DLR stock seem to bounce of $100 support level.

Arena Pharmaceuticals (ARNA) – bought around $41.5/share
I bought ARNA right after their March 21st secondary offering. ARNA has market cap of about $2bn, but it has two phase 3 assets that are potentially best in class, targeting multi-billion dollar markets. You really don’t need to be that smart to see this is good risk and reward here.

The 2 drugs are different mechanism targeting different indications. So success probabilities are uncorrelated. Etrasimod is an S1P modulator that is targeting ulcerative colitis, a $4-5bn market. Ralinepag is an IP receptor agonist going for the pulmonary arterial hypertension (PAH) indication, a $10bn market.

Phase 3 trials have about 50% chance of success, so that means only about 25% chance of failing both. I think the distribution of outcomes are follows:

• 50% chance they have 1 indication with peak sales 1-1.5bn; at 3x revenue, this thing is worth 3-4.5bn enterprise value; stock doubles 

• 25% chance that both Etrasimod & Ralinepag scores, then peak sales would be like $2-3bn. Again at 3x EV/revenue this thing is worth 6-9bn. Stock triples or more.

• 25% chance that both fail, so stock trades down to cash value, or down something like 80-90%.. But realistically they still have other early stage pipelines and that’s worth something. 

There’s actually more upside than this. First, another asset, APD-371, has its phase 2 readout coming in 2Q18. If successful we have not two, but THREE phase 3 assets. 

Second, Etrasimod’s real value is that it’s an S1P modulator, which has applications beyond ulcerative colitis. Novartis’ Gilenya and Celgene’s ozanimod are both S1Ps and can be used to treat rheumatoid arthritis, a much bigger market. 

The risk is time to market (will take at least a couple years) and cash burn before we get there. But ARNA just raised a ton of cash so we're somewhat de-risked.


A big loss in Melinta (MLNT), and lessons

I’m taking a big loss here. It was never a big position, but a 55% loss on a ~2% position still hurts.

I bought at about $17.2/share. Originally, my thesis was that at that price, MLNT has ~$500-550mm market cap. They have 4 FDA approved drugs hitting the market, and I estimated $250mm peak sales. So this is a great bargain given established pharma regularly trade at 4-5x EV/revenue.

So what went wrong? 1) too slow to adjust fundamental outlook, 2) failure to see that future fund raises are a form of leverage.

First, I was too slow to adjust my fundamental outlook. I watched happily as MLNT stock collapsed. Small cap biotech/pharma is notoriously volatile, so there’s nothing out of the ordinary. The company has a big pile of cash, so net debt is low, and I’m not worried. “This is the sort of stuff I can double down on!” Management talked about $1bn peak sales, so my $250mm peak sales is quite conservative. I cheered as the stock went down so I can buy more at lower prices.

It’s pure negligence. If I never believed management’s $1bn peak sales numbers, why should I think my much lower estimate is conservative? That's straight up anchoring bias. Only after the latest earning call did I revise my estimates. I dug deeper into competitor revenues and downgraded my estimate of peak sales to $200mm, then $150mm. Now I’m not even so sure about that.

Second, I failed to realize that future fund raises are a form of leverage. I falsely thought of MLNT as a low net debt kind of company, the sort I can double down on. The truth is that MLNT is burning cash, meaning at some point they will need to raise equity or debt. This means MLNT is way more leveraged, and stock valuation is way more sensitive to peak sales than I realized. I underestimated modeling error, and that led to overconfidence and negligence.

High Upside Ideas that Will Take Time to Play Out: Natera and Quotient

It's been a while since I last wrote. Things have been good. I got out of market in September in anticipation of a downturn, only to scramble and buy back stock in October. Following the crowd has not been good for my ego, but it sure is great for my money! I also felt like there's not much to write about. 2017 is one of those years where you can randomly buy anything, as long as you cut your losses and let your winners ride, you'll be ok. It's a bull market after all!

I tried to do a couple write-ups the past few months, but didn't bother posting them because the stocks ran up while I was editing them (FSLR is one example). Here are a couple thesis that won't have that problem - they should take years to play out.

Natera (NTRA)

It’s a land grab right now in molecular diagnostics (the analysis of genome and DNA). Natera is a known player in non-invasive prenatal testing (NIPT) and carrier screening with their Panorama and Horizon tests, respectively.

When I read transcripts I like to scribble down sources of upsides at the edge. In the case of NTRA’s 2Q17 transcripts, I nearly ran out of room. I list them out below.

• Operating leverage from improving reimbursement - only 10% of microdeletion panel reimbursed so far. Management estimated that they can make $30mm more a quarter if all jobs are reimbursed jobs – keep in mind 2Q17 revenue was only $54mm! Since NTRA already incurs the costs for these tests, any reimbursement goes straight to the bottom line.

• Increasing uptake in carrier screening, and shift to multi-gene screening. The number of Horizon tests ordered went up 63% yoy in 2Q17. Some of that was from increased sales focus and crossed selling, but there’s also a secular trend in carrier screening. This year the American Congress of Obstetricians and Gynecologist (“ACOG”) issue updated guidelines recommending carrier screening more than cystic fibrosis.

• New/recent product launches
• Vistara (NIPT for additional conditions)
• Signatera (cancer diagnostics, for research use only for now, but will have clinical use product as early as next year)
• Evercord, this is a cord blood banking service (they offer to store baby’s cord blood after birth, which can be later used for genetic analysis and potential transplants). 

NTRA is an expensive looking, highly volatile stock that demands a long term investing mentality. At least its strategy makes sense to me. They have a strong position in the prenatal niche and they’re using that strong base to expand into neighboring areas.

In the coming years, I expect revenue to accelerate as mix shifts toward higher growth products. There’s potential for great operating leverage from additional reimbursement (remember this goes straight to the bottom line), and from improved sales productivity as they add new product to the same sales touch points (fertility doctors, OBGYN).

SG&A is currently a huge drag on profitability and cash flows. I suspect this is all easy synergy for potential acquirers.



Quotient (QTNT)

Quotient is making a new machine, MosaiQ for the blood transfusion process. MosaiQ promises to making donor blood typing (determine if your blood type is A, B, O, or AB), as well as testing (checking for diseases) more efficient and more affordable. The plan is to launch 2018 in E.U., then 2019 in U.S. They have a $3bn addressable market, with $1bn in just its top 10 prospective customers.

The new product has been in the work for years and there were plenty of setbacks on the way. But the finish line is near. I particularly like the support from Ortho Clinical Diagnostics, one of the largest players in blood testing. Ortho will distribute MosaiQ for the patient testing market (with donor testing market retained by Quotient), and will make milestone payments to QTNT.

The combination of a fairly concentrated customer base, support from one of its biggest industry players, and ability to lower customer costs makes me think the product should sell well.

Management expects 60% operating margin. Conservatively, I assume they take just 20% of top 10 customers. That’s $200mm sales x 60% margin = $120mm EBIT.

Quotient has financing lined up to get them through the finish line. This includes raising $36mm from issuance of senior secured notes, as well as $49mm in FY2019 from warrant exercise. At $5.2 a share, QTNT current has enterprise value of less than $300mm, but given these capital structure change, EV by 2020 (again using $5.2 a share) would be in the $400-450mm range. That is still very cheap in my opinion.

Following Buffett into STOR Capital

In the past few years I watched with confusion as Buffett bought up IBM, Apple, airlines stocks, and just last month a shady Canadian lender called Home Capital Group. There are definitely times I wonder if he's gone senile. But Berkshire's investment in STOR Capital makes a lot of sense and I'm following.

Trading at $22-23 range, STOR Capital (STOR) can offers 20% IRR over the next few years. This comes from mid-teens adjusted funds from operation (AFFO) growth plus dividend yield of ~5%. I assume Price/AFFO multiple stays constant since it’s already a reasonable ~14x.

Thesis Sketch

• STOR’s sales-leaseback model has a long runway for growth, and the weak retail environment may actually help in that respect. 
• Berkshire’s involvement strengthens the already solid balance sheet. There’s a possibility that STOR can turn into a platform to consolidate the industry. 
• Just a well-run company. Prudent leverage levels means this is something I can double down on if stock goes south.

What They Do
STOR Capital buys retail locations from companies and leases back to them at negotiated rates. Unlike typical landlords who start by targeting desired locations then try to minimize vacancy, STOR starts with specific business customers and then figure out the lease terms they need.

In this way STOR is more like a financial service company than purely an asset owner. Another way to view the company is that STOR takes on credit risks of their clients, but that risk is collateralized by revenue generating real-estate.

There are inherent advantages with this business model. First, since these properties come with tenants, occupancy rates are high (~99.5%) and STOR don’t incur much costs to lease out the properties. Second, the leases are “triple-net”, meaning tenants are responsible for not only insurance and taxes, but also property maintenance costs. This means STOR has very little capex needs, so their AFFO is a good proxy for free cash flow. Finally, the customer service component allows STOR to stay away from auction situations, and historically they have been able to buy real estate at below replacement cost.



Growth Prospects

STOR has a track record of dividend growth, backed by mid-teens growth in cash flows. The growth is mostly through acquisition of real estates, which STOR has been investing about $1-1.2bn per year. Keeping up this pace would imply rental revenue growth of ~15% CAGR the next 3 years or so.

I think STOR can continue, if not accelerate, this pace of expansion. In the latest 10K they estimated an acquisition pipeline of $8.6bn at December 2016, compared to $5.2bn worth of properties on balance sheet. Furthermore, the U.S. is in a weak retail environment, and more companies will likely try to offload their real estate and optimize their capital structure. This would create opportunities for STOR to buy at attractive prices.

STOR is also now a strong hand in a weak industry. On 6/26/2017, Berkshire invested some $375mm into the company. These are newly issued shares so STOR further strengthened their capital base. STOR is now in a position to consolidate weaker players in the distressed retail REIT space.



There are other considerations. Let's quickly go through them in bullet points.

Just a really well run company

• The basics all check out fine – geographic diversification, tenant diversification, inflation escalators…etc. 
• Property investments require unit level profitability, not just corporate credit or property value
• Great disclosure. Management collects abnormal amount of data.
• Prudent debt levels with property asset covering debt by 2x. They use non-recourse asset backed funding.
• No staggered board.
• Unlike some of the REITs out there, STOR actually has good GAAP net margin.
• 5% dividend yield is very sustainable and is well covered by AFFO (which closely tracks cash flow from operations before working capital)

Is The Market Wrong?

• Retail REITs have been killed due to threats from Amazon. But STOR has differentiated exposure like health clubs, movie theatres, day care center...etc. They even have industrial/manufacturing exposure.
• I’m not sure physical retail is dead just because of Amazon. Maybe physical retail still works but the business model needs to be tweaked. Amazon is actually moving to physical stores. If anything, Amazon’s recent purchase of Wholefood validates value of physical stores.
• One of STOR’s clients, Gander Mountain, just entered bankruptcy, but that is only 2% of their rental income and another client is negotiating to buy them out. Gander Mountain’s troubles have been known for a while and I would be surprised if it’s not already priced in

Everything checks out great. Global bond yields have been going up the past week so dividend stocks have not done well. Once those bonds stabilize though, this should be a good one. 

Musings: Cash on the Sidelines and the Illusion of Market Cap Calculations

Cash on the Sidelines

I read Zero Hedge regularly. It is not the most reputable publication, but once in a while it bring up interesting topics. Like this article: Destroying The Myth Of 'Cash On The Sidelines'.

Permabulls love to argue there are all these “cash on the sidelines” ready to buy stocks and jack up prices. The article disagrees with the very idea of it. It quotes Cliff Asness:

“There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.”

Asness is saying there are no sidelines because buy/sell transactions do not increase overall cash in the system, since for every buyer there’s a seller.

I used to think that, and it’s something clever to say. But it’s wrong.

We all know friends, relatives, or neighbors who, at one point or another, try to put their growing cash piles to work. These people clearly have cash and its growing. Where does that come from?

First, it’s called money creation. As people earn wages and deposit that in their bank account, their “cash on the sideline” grows. So you say, “but the employer who paid them now has less cash, so total cash level don’t change right??” Well, at least some of the employers borrowed money, the act of which is how our financial system expands money supply.

Second, there’s asset class rotation. Asness would be right in a world where it’s just cash and equities, (and no liquidity creation). But you know, there’s such a thing as fixed income and bonds and they get used as cash alternatives. You see all these balance sheets where companies list “cash and marketable securities”? That’s your T-bill/CP’s/notes/bonds…etc.

So to the extent bond prices start going down and people rotate into equities, that’s “cash (and marketable securities) on the sidelines” which can boost equity prices.

The Illusion of Market Caps

The big news last week was Amazon buying Wholefood. As CNBC reported here, Amazon is paying $13.7bn for Wholefood, yet AMZN’s market appreciated by $15.6bn when the news hit.

CNBC wrote: “So, you could argue, they are getting Whole Foods for free, and pocketing $1.9 billion as well.”

How could this be? Are investors stupid? One explanation (which is the CNBC editor’s view) is that the market thinks Amazon will get so much synergy that it exceeds the entire cost of acquisition.

Maybe. But there’s another explanation - that the way we calculate market cap renders it a flawed concept.

The CNBC article wrote: “Amazon's stock was up $32 and change mid-morning. There are 478 million shares outstanding, so Amazon's market cap has appreciated by about $15.6 billion today.”

The flaw is one of extrapolation. The deal was announced on June 16th, 2017. That day 11.47mm shares of AMZN traded.

That tells us the market was willing to pay $32 more for 11.47mm shares. That’s it. It does not mean the market was willing to pay $32 more for all 478mm shares outstanding. In fact, if all 478mm shares were for sale, I’m sure AMZN stock price would crash!

But that’s what our market cap calculation does. We take the increased price for 11.47mm shares, and then extrapolate that to say every single share, to the tune of 478mm shares, gets the increased valuation. We take one single point in the stock’s demand curve, which tells us there’s demand for x # of shares at y price, and extrapolate that to total shares outstanding.

And we do this all the time. We do this whenever we calculate market cap, which goes into enterprise value, EV/EBIT, EV/sales, and so on. 

It get's dangerous when we apply this false logic to value investing. How many times have you heard this type of argument: "This company had one little bad news, and its market capitalization declined by $7bn! How can the worth of the company change that much!?  It's irrational! Misunderstood! Buy buy buy!"

Again, it's extrapolation. We take one single point on the demand curve and assume all shares will clear at that price. Then we make claims about what the whole company is worth.  

This should make you think twice about using these metrics to make buy/sell decisions! Our “fundamental” valuation isn’t just subjective based on our view of the future - it is fundamentally and precisely wrong!

Notes on Wachenheim’s “Common Stocks and Common Sense”

Ed Wachenheim runs Greenhaven Associates, a $6 billion value fund. He piled up an enviable track record over the past 20+ years, regularly making 20%+ a year. And he does this by investing in large caps like IBM and Lowe’s. I’ve been resorting to nanocaps to in my quest for returns, so I wanted to read his book and see how he did it.

The book, "Common Stocks & Common Sense" has an excellent format. It is a series of case studies, each about a particular company Wachenheim invested in.

He would typically start with some historical backgrounds for the industry and the company in question. Then he shows how he develops a thesis, problems the company was having (to the extent there were any), and how the idea played out the next couple years. Throughout these passages Wachenheim would sprinkle in bite sized philosophy about how to use sell-side research, his view toward interviewing management…etc.

We need more books like this. This is a little like “Alchemy of Finance” where Soros documented his real time decision making. If anything, this book provides interesting snapshots of some industries from 1990's to now.

This book was helpful in confirming some of the ideas I have on how to approach research, on top of some great insights. I will first share my observations about Wachenheim’s style, then list out some general takeaways.

Observations of Wachenheim’s style

• Buy large cap liquid securities. 15-25 stocks in the portfolio, try to be fully invested all the time. 
• Targets 20% return. This means individual ideas need much higher upside (say 60%+), because there will be losers also.
• Ignore broad market moves, focus on fundamentals.
• Not a buy and hold forever type of guy. Willing to hold for 2-3 years and sell when the thesis is played out.
• In general stay away from growth stocks with high multiples. But also try to stay away from severely distressed companies. 
• Typical type of plays:
• Turnarounds/ leadership changes: e.g. IBM, Interstate Bakeries
• Cyclicals: e.g. U.S. Home Corp, Centex, Southwest, Lowes, Whirlpool
• Good companies with temporary issues: Union Pacific, Lowes, Boeing, Goldman Sachs 

Miscellaneous Notes and Takeaways

1) Focus on the upside first. Creativity is key in target identification.

Before doing a big deep dive, do a simple model and project 2-5 years out to see if there's enough upside to justify further work. Try to be creative in generating thesis - what can make revenue and margins go up? Can management cut cost here and there? What happens if input cost goes down…etc.

A lot of people say “focus on the downside and the upside will take care of itself”. But at least in the idea generation/filtering stage, you have to demand the upside - else you’re just wasting your time. The focus on downside can come after an idea passes the initial filtering and you’re doing deep dives and running scenarios.


2) Know the long term history of the business and industry. This helps you appreciate the structural difficulties and what it takes to fix them. 

IBM was an example in the book. In the 1990’s the company’s business model of selling, leasing, and servicing mainframes became outdated due to emergence of the PC. That left IBM with a bloated cost structure which old management was not willing to address. The buying opportunity came when Lou Gerstner became the new CEO and showed “the courage to take tough steps”.

Knowing the long term history also helped Wachenheim invest in cyclical companies. He bought Southwest Airlines in 2012, understanding that the decade of 2000's were miserable for airlines and forced them to cut capacity.


3) True insight comes from understand the unit economics of the business well.

Knowing the economics of Union Pacific helped Wachenheim differentiate between a temporary problem and a structural one. In UNP's case, congestions led to train delays, which hurt margins because revenue is a function of volume, while much of the expenses like labor are a function of time. When congestions were fixed, UNP’s margins improved and stock went along with it.

Another example is when he talked about Southwest Airline's capacity utilization. 83.1% utilization might seem like there's some excess capacity. But that is the average. Since unpopular flights (bad hours, remote locations...etc) are going to have many empty seats, the more popular flights are probably operating at full capacity and having wait lists.


4) Historical average P/E of the market is a little less than 16x. When valuing companies Wachenheim would use the 16x as a benchmark and adjust up and down based on business quality.

This is a better approach than using comparable multiples, which may be the most over-rated valuation methodology of all. “Peer comps” is an easy way for unscrupulous bankers and analysts to justify over-valuation in bubbly markets (“hey Alibaba trades at 56x PE so let me value this other shitty e-commerce stock with 45x PE! Look I’m really conservative here!”)


5) Use sell side analysts mostly as a gauge of market consensus, and think “do I see an upside here that consensus is not pricing in?” 

That makes sense because sell side guys get their feedback from buy side community, so these analyst reports in some way reflects prevailing opinions.


6) In my humble opinion, Wachenheim can screen stocks more effectively. He seems to run a lot of screens based on low valuation ratios, which he himself admitted is rarely productive, since these “cheap” stocks are usually cheap for a reason. 

I think you’re better off screening with charts and basic technical analysis. For example if you're looking for out of favor stocks, don't screen for low P/Es, low EV/EBIT...etc. Rather, find some price charts that dropped like a rock more than a year ago, underwent heavy capitulation selling, and have since showed price stabilization along with low volume (a sign of investor disinterest). What I typically do is screen for some minimum quality (low debt, high ROIC...etc) then run them through charts.