December 2016 update – Single Names

It’s been a while since I last wrote. Here I will just give a quick update then sketch out a couple stock ideas I’m still in. I will leave the forward looking macro view for the next post.

It’s been a good month for all investors and I’m no exception. Post the Trump win I loaded up on financials (SLM and WFC), and tripled my holdings in Sterling Constructions (STRL). These are concentrated 7%-12% positions. I also went long the US dollar against yen and euro, riding USD/JPY from 105 to 115. A week ago I cut back on STRL, exited WFC completely, then went long Russian rubles.

This series of frantic trading and macro maneuvers paid off. In the last month I did better than the S&P index even with all my large cash holdings/shorts/hedges. I started taking chips off the table as the market looks extended again.

Single Names I'm still Bullish On

I’m still very bullish on Salle Mae and Sterling Constructions over the next 3 years. FNF is another that can double. Below are a just some bullet points.

Sallie Mae (SLM)

So the stock trades at $10.8 at the time of writing. Downside is $10-$10.5. Upside could be $15+ and a highly probable one.

This is a company that was doing well even before the election – strong growth, strong ROE, and solid capital levels. Management is also trying to improving cost efficiency. The only thing that held back the stock was Democrats’ various attempts to undermine the private student loan market (free college, student loan forgiveness, and general hostility toward lenders…etc).

After November, all the sudden we have 1) decline in regulatory risk, 2) potential market size expansion as Republicans might scale back government funded student loans, 3) higher rates and steeper yield curve driving higher net interest margins, 4) a big tax cut (SLM pays a high 35-40% and their preferred dividend further leverages EPS to tax cuts). The last point alone could juice their earnings by 30%+.

Here’s how I roughly think about floor value and upside. The stock was trading in the $7-$7.5 range before election. Republican president and congress removes an existential threat to the business and should make this worth $8-$8.5. Tax cut improves earnings by 30%+, so add another $2/share and we’re already at $10-$10.5 as floor value – not far from where the stock trades now.

And that’s before factoring in better net interest margin and market size expansion! All together, there’s a high probability that SLM earns $1.5/share within 3 years. At a fair 10x multiple SLM could easily be worth $15/share.

We have a nice bet here. SLM represents 7-8% of my portfolio and I will look to add on weakness.

Sterling Construction (STRL)

Although a construction/infrastructure stock, this is not really a “Trump Trade”, as I wrote about Sterling Construction back in July here. The thesis has not changed much, but the emphasis has shifted from company specific factors to the industry and macro pictures, which has gotten much better.

The company is highly leveraged to gross margins, which was already improving back in July, but now will likely go higher due to 3 factors. First, management has stated their intention to go after higher margin, non-highway projects (commercial, airports…etc), and have in fact started to win them. Second, the local projects passed during November 9th will be supportive for industry competitive landscape and margins.

Finally, Trump’s $1 trillion infrastructure plan threatens to take margins, and by extension STRL’s stock, to a whole new level.

So both the probability and magnitude of a win are much higher now. Right before the November election, I would say STRL’s floor value is about $6.5 and ceiling about $8.5. Now I would say the floor is ~$7.5 and the upside is uncapped until the teens’ or even $20’s.

The key is to not get ahead of ourselves too much though. I’m looking for improved quarterly results, new contract wins, or legislative progress on Trump’s plan to add to my positions.

Fidelity National Financial (FNF)

This is the largest title company and the most profitable one. The company operates in an oligopoly with captive customers - title insurance is mandatory purchase. At $34 per share, the stock is acting incredibly bearish right now. But a catalyst has surfaced.

Currently there are 2 negatives holding back the stock in my opinion. First is structural complexity. FNF consist of the core FNF title insurance company, a publicly traded subsidiary Black Knight Financial (BKFS) and the FNFV tracking stock (which represent a portfolio of side bets like restaurants). The second problem is commercial title revenues are slowing down.

There's a catalyst coming next Fall. Management announced they will address the structural complexity issue by cleanly splitting out core FNF title division, BKFS, and FNFV. This would allow the core FNF business be included in indices.

The core FNF title business then has a path to double once commercial revenue stabilizes. Here's what could happen with some back of the envelope math:

• Home sales picks up. Perhaps because millenials are reaching the 30-40 age zone for peak home buying, or because Trumponomics puts more money in peoples pocket. Say home sales up 5% and housing price up 5%, that's a 10% revenue gain. With operating leverage you get to 15% gain pretax.
• 3 years from now pretax grew by 1.15^3-1 or 50%.

• Tax rate cut from 35% to 20-25%. That means EPS could be 70%+ higher in 3 years
• Just making up some numbers - right now $1 pretax get you 0.65. In 3 years you have $1.5 pretax at 25% tax rates. That results in an 70% higher EPS.

• P/E multiple of core title business re-rates from 12-15x because revenue outlook reverted to growth. Removal of structural complexity in the FNF complex also helps. That's another 25% gain.

Compounding these effects get you a double. I already have a solid position on this. But I could really go big (thinking like 20% position) if I see commercial title revenue to stabilize.

Revisiting the Big Picture

I try to hold in my mind several macroeconomic scenarios that are likely to play out, as facts come in and probabilities shift, I rethink my investments themes accordingly. The most bullish scenario (for equities and commodities) is as follows. The time frame I’m considering is next 2-5 years.

The outline of a macroeconomic progression:

1. Higher inflation expectations…

Crude oil has bottomed in the $40-50 range. As energy is a key ingredient in all other commodities, this is likely the end of the commodity deflation cycle. Indeed, other commodities sectors (particularly agriculture), looks to have trough too. If the world then starts eating into the currently very high inventory levels, that would leading to inflationary pressures.


2. …leading to higher yield in long bonds…

As inflation targets are hit, the central bankers will face pressure to hike rates. But hiking short rates would lead to a flat or inverted yield curve, damaging the banking system, so the central bankers have hinted they’ll let inflationary pressure push up longer term bond yields.

In recent weeks we have seen 5yr/5yr forward inflation breaking above 1.8%, and 10 year treasury yield going above 1.8%.

At this point the impact on US equity markets is unclear. Do we have real growth? Or do we just have stagflation? If the former, then inflation expectations lead to more investment and real growth, then equity markets could look up again. If the latter, then stock prices would take a hit because the market assigns higher discount rates with little growth to offset it.


3. …But underlying GDP growth is still weak, prompting fiscal stimulus.    

With rates around the world still near 0, central banker will have a harder time inventing new monetary tricks. But that’s missing the point. Pushing people to borrow don’t work because we have industrial overcapacity everywhere so businesses don’t want to invest. Thus government has to take the lead.

Fiscal stimulus can drive inflation up further. But this time both real and nominal GDP rises. 

 

4. We end up with (still) easy monetary policy and fiscal stimulus. 

In this world, the US dollar would be stable, commodities prices goes much higher than today, long bonds gets crushed, and US equities go through the roof into an unprecedented bubble, setting up for the next crash.

Where Are We

We seem to be at step 2 right now. But note that step 1 & 2 does not necessarily lead to 3 & 4. Alternatively, we could have just easily skipped 1-2 and go straight to fiscal stimulus in an effort to drive inflation.

My view is that inflation cannot sustain itself given the current macroeconomic regime. This is because higher inflation drives Fed rate hike expectations, which (in today's upside down world with quantitative easing) drives the US dollar up and defeats the commodity price rally.

Regardless of how the sequence plays out though, there are certain themes here for investments purposes: fiscal stimulus, commodity price recovery, steeper yield curve, companies with structural growth prospects. 

In the past month, my research have focused on the commodity front, taking a particular interest in the agriculture space. Here the key questions are 1) can price increases sustain itself or is it self-defeating? 2) what has to happen to drive a sustained increase? These will be for another post.

Keeping Track of Ideas from This Year

After analyzing my results year to date, I see the need to be more concentrated and find more “investments” as opposed to “trades”.

Here is a table of my write-ups on this blog year to date, and how they’re doing

There’s also stuff that I did not write about that detracted from my returns. Macro trades/hedges killed me this year. Those deserve a separate post-mortem but I think the writing process forced me to think through everything more completely, yielding better results.



What’s interesting in the table above is how active management detracted from my returns. One clear pattern above is “actual return since write up” is much lower than “hypothetical return from buy & hold”. This is because I sold early: either I cut positions early, or traded in and out of the stock.

Why is that? Sometimes a sell is justified – as in when stocks simply reached my estimate of fair value, or when my thesis proved false.

But other sells are more questionable. Sometimes I would sell a position just because new facts came out and I have not had time to assess the situation. So I would sell first, sit on the sidelines until I get around to updating my assessments. This has saved me from losses in the past but can also be costly as stocks fly upward. I think it’s a sign that I have too many positions and not enough focus (I have 30-40 positions going most of the time).

Some Ideas Look Better in Models Than in Real Life

Sometimes it’s the nature of the idea itself that limited the upside. I can explain this better by grouping ideas into categories:

Pure mis-valuations

Examples: FNFV

Problem is that the initial asymmetric risk/reward goes away as soon as price moves up, so you get limited upside. Let’s say I think company A should be worth between $90 to 130. Stock is at $100 so you say “downside is 10% and upside is 30%, and the probabilities are about 50/50, this is nice risk-reward”. So you buy.

Next month the stock moves 10% to $110. But the fundamentals have not changed so your valuation range stays at $90-$130. With stock now at $110 the upside/downside is now at 18% each, and the probabilities are still 50/50. This bet is no longer tilted in your favor, so you exit the trade.

Despite the perceived 30% upside at trade inception, you exit the trade at a mere 10% gain.

Lousy businesses at attractive prices

Example: Omega Protein

These are naturally not going to be long term holds. You’re just looking for fundamentals to shift in a better direction and thus stock price along with it. But ultimately the fundamentals is capped (still a lousy business), so the upside is limited like the above “pure mis-valuation” category.


Cyclicals

Examples: Select Harvest, Sterling Construction

The problem with these is you’re looking to catch a cyclical bottom in the industry. In practice there’s also an element of price speculation. That tends to keeps my confidence low and my positions small.

In the case of Select Harvest that I missed the move completely (waiting for a pull back that never happened). In the case of Sterling Construction, I cut stakes early because I didn’t have enough conviction, only to buy back later at higher prices. Perhaps I will learn to get more conviction and bet bigger one day.




Going forward, I want to have a lower number of positions be more focused on each. And also less of these “this is a crappy to ok business but it’s cheap” ideas, and find more companies with structural growth prospects. 

"Investing" is preferable to "Trading". “Value investing” does not have to be “cigarette butt investing”. These are, of course, easier said then done and will depend on what the market gives you. For now I have been forced to look into smaller companies and foreign stocks.

Best Deal I'm Seeing Now Is a Macro Trade: SPY Put Combos

Update 8/4/2016

Looking at this post from a couple weeks ago, I seemed to be making the assumption that low VIX = low option prices. That is a naive view. I have learned a little more since this post and I will try to share here.

1) VIX only covers front month contracts, so options 6 months out are not necessarily cheap just because VIX is low. To get a sense of how expensive options are further out, you can look at VIX futures curve. In this case the VIX futures curve is actually quite steep, showing that options 6 month - 1yr out is reasonable but not super cheap.

2) Ok, so volatility is cheap, but is it calls or puts?  For that you can look at "skew". Barrons is a good source here. For a longer term view, you can look at the CBOE SKEW index. This shows that while demand for puts have came down from earlier in the year, it is about normal relative to recent history.

3) low VIX also benefits from low implied correlation. If the individual stocks in S&P500 are going to go opposite directions in prices, that would balance out index prices and dampen the overall index volatility. We're in the middle of the earning season so the low expected correlation makes sense.

So my post below is incomplete. However, the risk/rewards of the below trades are still what they are. Numbers don't change just because my understanding is flawed. They may not be as cheap as the low VIX would suggest, but I still find them attractive.  

Original Post:

Once in a while a good deal comes your way. That can happen in the single stock universe or in the macro world. At the moment I see one in the latter.

Right now, SP500 put combos offer a high probability trade with 4.5-to-1 upside/downside ratio.

Option prices are based on volatility and that is clearly at the lower end of historical range. Below is the historical chart of the VIX index from 1990. The red line is the latest VIX reading of 12.8 and green line is the 10th percentile level of 12.2.

While the VIX can go lower, any drops below 12-13 level tend to be followed by sharp bounces upwards within a few months. A 6 month option should be long enough.

With the VIX below 13 and SP500 at all time high, this is a good time to buy some SPY puts. Here’s a combo I was able to buy last week (all puts expire Jan 20, 2017).

The payoff diagram at expiration is as follows:

This combo goes in-the-money with SPY at $214 - the chances of SPY falling more than 1% from its current $216 level seems pretty high to me! It's not like the world has no problems! Peaks profitability comes if SPY falls to $203 by Jan 2017. Maximum upside is 4.5x the downside.

More importantly, you spend $2.54 to control a $216 position. That leverage allows you to hedge your entire portfolio with an 1.2% option position.

I started accumulating this last week. If the stock market continues to go up, I plan to take profit and plow it back into more of these trades as they become available. The plan is to be very aggressive if VIX falls to low 12’s or even lower.

Good News for Omega Protein

A quick update to my Omega Protein ("OME") write up from a few months ago.

1. On 6/28/2016, shareholders elected Wynnefield Capital's nominees for the board. The activist investor now has 2 out of 8 board seats.

2. The latest NOAA Menhaden fishing season status came out 7/5/2016 and it looks like OME is off to a strong fishing season.

These good news should lead to an upbeat 2Q'16 earning call and drive stock price upward.

Sterling Construction Will Enjoy Higher Margins For Years to Come

Sterling Construction Company (STRL) works on transportation and water infrastructure projects (more of the former, particularly highways). It’s a microcap that few analysts cover. The stock trades at $5/share and I think it could be worth $8.

The company has all sorts of not-so-obvious positives: turnaround play with operating momentum, low margin legacy contracts fading away, big net operating losses (NOLs) to monetize, understated book value due to off-balance sheet asset. On top of all that, management incentives are aligned with shareholders.

The political/economic climate also favors Sterling. Monetary policy is running out of bullets and politicians have to start pulling fiscal levers. Highway construction is one area that enjoys bipartisan support – even Republican candidate Trump talks about using constructions to provide jobs.

The next few paragraphs will give a brief industry background before getting into company specifics.

Cyclical business, But Right Part of the Cycle

Coming out of the Great Recession, federal and state governments tightened their construction budgets. For the past few years, companies competed intensely for limited work and margins fell as a result.

That picture is reversing. At the federal level, Obama signed a $300+bn Fixing America’s Surface Transportation Act (“FAST Act”) in December 2015, which provides certainty over the next 5 years. At the state and local government level, politicians have also been working to boost construction budgets.

Texas and California are Sterling’s two biggest markets. Texas is already seeing a spike in highway construction budget. Not only that, the recently passed Proposition 7 will provide billions more in funding starting late 2017. California is also in the works - although transportation needs were not addressed in the June budget, it remains high on the agenda. Multiple stakeholders are united in their push for increased funding. Here’s a taste of what's happening from Granite Construction’s latest transcript.

"We are helping lead the charge in California where construction industry and labor leaders are working shoulder to shoulder to build legislative support for a long-term incremental commitment for transportation investment of at least an additional $40 billion over the next 10 years."

In the coming years, I expect even better legislative support for infrastructure projects as politicians turn to fiscal stimulus. With a bigger and more visible budget, competition will be more rational and that should lead to better margins.

Gross Margin Turnaround and Other Good Stuff

In fact, Sterling Construction is already seeing improving margins. Gross margin is by far the largest driver of net income and cash flows, and here’s how that’s looking:

The momentum is clear. Gross margin troughed during 2013-2014 and has been going up since. Also note that margins have plenty of upside before returning to historical norm of 10%+.

Backlog margins are improving as well. Gross margins in the backlog for the past 4 quarters (starting 1Q’15) are 6.0%, 6.5%, 7.0%, 7.7%. Management expects 8.5%-9% by year end.

Part of the margin improvement will come from better mix. Sterling has been held back by legacy low margin projects from 2013, but it is quickly working them down. Here’s what CEO Paul Varello have to say:

“…we have to complete approximately $70 million worth of legacy jobs that will finish over the next couple of quarters and will generate small to zero margins. We believe that we will start to see the higher margin projects generate stronger earnings in Q3 and beyond…In addition, by year-end we anticipate that our overall backlog margin will be in the range of 8.5% to 9%.”

Those higher margins come at a great time as Sterling had accumulated a big NOL. With the cycle turning, it will basically pay no taxes the next few years.

There are more goodies and I will quickly outline them here:

• Sterling bought $40mm of life insurance policies. The policies are to cover Sterling’s commitment to buy out minority interests upon death of key executives. That commitment is booked as a liability on balance sheet, but the insurance policies are off balance sheet. So book value is understated by a material amount. 
• The company just did an equity raise to deleverage the balance sheet. 
• CEO Varello took an $1 salary and restricted stock when he took over last year. 

Put it all together

Backlogs have been increasing and will likely increase over the next five years. Margins have gone up with lots of room to go. But at $5/share the stock is trading like a normal cyclical. It certainly does not reflect the extended growth runway I described above.

2017 P/E is a modest ~9x. The real question is how does 2018+ look? I think the answer is higher revenue, higher margin, and no taxes will translate to explosive free cash flows growth and multiples expansion.



Note: Competitor Primoris was also bullish about Texas in its 1Q’16 call.

“We continue to expect substantial growth in the Texas heavy civil market, especially once Prop 7 money starts to flow. Which should be sometime late next year.”

Teekay Tankers Will Be Owned By Creditors for a While

• TNK stock has been down more ~50% year to date. It trades at less than 3x earnings and this has shareholders calling for buybacks.
• However, management is paying down debt instead. They have to do because of lower cash flows in 2016 and 2017, as well as demanding debt maturity schedule.

Back in December 2015, Teekay Tankers (TNK) announced a $900 million refinancing, including a term loan and a revolver that are both due in 2021. I thought the deal was bullish for the stock, since it cleared out near term maturities and allows TNK to buy back stocks.

This is not the case. That deal did push out a lot of near term maturities, but a substantial amount remains. In addition, the new term loan actually has an onerous principal payment schedule.

The $525 million term loan matures in 2021 but demands principal amortization of $31.94 million per quarter for the first few quarter and $24.845 million per quarter thereafter. This amounts to $99-106 million of principal payment per year.

What’s more, a sizeable chunk from old loans remains. The annual report has a maturity schedule pro forma for the refinance. Backing out the January 2016 loans, and assuming the debt payment made during 1Q16 was toward near term maturities, the current debt schedule would look like the below.

The big question is the $215 million due 2017. To put that in context, TNK only generated $167 million of cash flows from operations for the entire 2015, and that’s with peak tanker rates! So far in 2016 we are already seeing lower tanker rates and lower cash flows.

More headwinds are coming in 2017. Tanker supplies will come on line second half of 2016 and through 2017. So rates in 2017 will likely be lower. In-charters will expire so TNK will be operating with a lower number of vessels.

So forget about TNK paying off the entire $215 million out of cash flow from operations. It will struggle to even pay the ~$106 million term loan scheduled principal in a weaker market. It will certainly have to refinance the rest of 2017 maturities; failure to do so means another round of equity raise, or even bankruptcy.

To entice lenders for the 2017 refinancing, TNK will need to demonstrate credit worthiness and deleverage in the near term. This explains management’s focus on deleveraging, why the company has not repurchased any shares despite the ostensibly low P/E ratio, and why an equity offering is still on the table.

So creditors will get most of the cash flows for now. This is not to say avoid the stock, but investors should recognize the credit situation, and be willing to hang on for a couple years for their big pay day.

Advice for Investors

In this situation, demanding share buybacks is to demand a short term boost in the stock price while risking equity dilution or even bankruptcy down the line.

Instead of pushing for buybacks, big boy activist investors can provide the refinancing themselves. Just to toss some ideas around, with $250 million of 10% senior notes, weighted average cost of debt would still be under 5%.

Even after the 2017 maturity is addressed, TNK will still face a demanding term loan amortization. But by late 2017, it should have shown progress in deleveraging and tanker rates should have stabilized. Management can then refinance the January 2016 loan into another with easier principal payment schedule, and finally release free cash flows to shareholders.

There is also a lesson here. P/E ratios and free cash flow yield (free cash flow divided by market capitalization) are meaningless measures for companies loaded with debt. “Free cash flow” is not really “free” in terms of using it to reward shareholder, especially if there are near term maturities/obligations that can’t be funded from operation.