Monday, February 15, 2016

Investing in Bull and Bear markets

In 2010, I posted a brilliant essay on the future of natural gas backed up by research from Chesapeake Energy.  Chesapeake’s stock has fallen from a $60 plus in early 2008 to $3.50 lately. These guys were considered geniuses – what do people call those same guys today I wonder? 
Investors gather assets that throw off cash flow that allows them to pursuit the lifestyle they want and make their dreams reality. But life is so uncertain and we always seem to believe fairytales or research that just a few years later appear to have missed the boat completely. In fact, the only forecast that seems to be accurate are the most recent forecasts – until next week! Does that mean we’re all should become traders?  NO! Heaven forbid!
This blog has always believed in buying assets for a good price; in having cash for ‘bad times’ so that we are not forced to sell at depressed prices. Some leverage may be good – but define your safety margins.  We should be happy that we’re not like those poor sods that manage public corporations! Those guys are not there to run businesses but to drive stock prices higher and higher while trying to cash in their stock options.  If their companies don’t earn enough during booms using maximum leverage and when their companies have too much cash, the next group of vulture investors in waiting will jump on their backs and kick them out of their jobs. During the following downturn those same vultures will accuse the companies that they have too much debt… yeah duuh… and kick the old managers out anyway together with all the near bankrupted shareholders.  We call this laughable game ‘optimizing shareholder value’ rather than running a good business.
We hear all those pundits talking about diversifying amongst asset classes but rarely do they mean diversifying into real estate or gold or collectibles. No all they do is selling you stocks, preferably those IPO’d by their own brokerage firms. Please, do not fall for this noise!  Today China is bad; tomorrow it is the country that owns the 21st century! Invest in Emerging markets you stupid… oops, get out of emerging markets. Invest in BRICS… no in FANG… No run! The world is coming to an end.
Let’s look at investing and diversification in a more down to earth way. Don’t look at countries – today’s hero is tomorrow’s credit crisis!  Look at ASSETS that throw off cash… preferably in the form of rent, dividend, interest or if all else fails, capital gains. Really, where does this cash ultimately come from?  EARNINGS or better FREE CASH FLOW!  In the end, rental income is the profit from your rental property. Dividends are from earnings; ultimately even capital gains stem from earnings growth - either real or engineered from stock buybacks. There are also capital gains from speculation – those are the earnings that smelt like snow in the sun – the casino earnings you may say.
So if we talk diversifying is that stocks versus bonds?  Diversification amongst countries?  I have come to the conclusion that all that is poppycock. We should not see us as investors in countries but rather investors in cash flow producing assets all over the world. Now, accounting standards vary all over our globe; thus stick to investing in assets with reliable accounting. Yes, it is not always that advisable to invest in China or in India – too much sh..t is hidden from the investor’s view. If you think property rights are scary in North America or Western Europe, what about a nice dacha in Siberia?  Technology maybe where the future of endless growth is, but what about today’s earnings?
Basically, when we talk about assets that throw of cash flow, we do not care about 60/40 stocks versus fixed income. We only care about income producing assets such as:
1.       Real Estate
2.       Bonds
3.       Oil and gas stocks
4.       U.S. blue chips (Microsoft; GE; Hersey)
5.       REITS
6.       Banks
7.       Gold miners
8.       Pharmaceuticals
9.       Etc.
Gold is kind of unique in that it does not throws off cash. Instead, it is the ultimate currency hedge.  It also seems to go up with market volatility (safe haven); deflation (holding gold is better than negative interest rates) and significant inflation. See gold as your preserver of purchasing power.  Use it as an alternative to cash.  There is a big difference between cash and companies that print money or between gold and companies that produce money. So don’t mix up owning gold with owning gold miners nor for that matter with companies that finance gold and other resource production.
We diversify our assets classes and realize that real estate in Vancouver is different than real estate in Calgary. There is a difference in active and passive investing. So you can own passive real estate in REITS or rental pools (unless you sit on their board), Self-managed real estate such as a small apartment that you rent out. We diversify by investing in Canadian Banks; or U.S. Banks; or European Banks. Another asset class may Canadian Oil and Gas or International Oil & Gas. Pharmacy; Consumer Staples. Don’t worry about whether you’re dealing with stocks vs bonds – look at your overall portfolio and see in what industries you’re active and yes distinguish between active and passive management. 
With active management you are in control. You do the work! You determine the degree of leverage you may want to use it in the form of a student loan when investing in a career or line of credit when investing in a rental apartment unit. Because you are in control of the asset you can afford to own it at a larger proportion of your net worth than when dealing with passive investments.  And then there is the grey area, your stock savings plan or options in the company that you may be employed. All asset classes have different characteristics.
Suppose you invest in a bank – it’s performance often reflects the economy – the Canadian economy or in case of TD, the North American economy. In case of the Bank of Nova Scotia it may be better aligned with the Canadian economy AND with that of South America.  Wells Fargo is more aligned with the U.S. economy while others such as City Bank or Goldman Sachs are reflective of the U.S. economy with a heavy weighting on the rest of the world. But all are stable companies, heavily regulated and when in trouble they’re often bailed out by their respective governments.  Their leverage is typically quite high considering that they use money that is lend to them by depositors or by preferred shareholders or by investors in corporate debt etc. They live of the margin between their cost of capital and the yield of their investments: corporate loans; mortgages, or the government debt they often invest in. They also make money of the accounting and insurance services they provide their clients.  When investing in banks you often do so on a buy and hold basis and with a large proportion of the profits coming from dividends and dividend growth.  Bank dividends often reflect the highest quality of dividends available amongst publicly traded companies.
On the other side of the spectrum are oil and gas companies and other resource producers.  Quite different! These companies make money by producing fossil fuels (resources) from their assets at a price higher than their operating costs and finding costs. Today, many of them cannot expand their production, although they can still extract money from their existing wells at a price that is higher than their operating costs. But those existing wells decline in production rate over time; between 20 to 80% percent per year. So really, virtual no oil company can make money these days. For oil companies to prosper they need cash flow from their operations (oil price minus cost of operations) from which they pay their staff and offices (G&A with should be between 17-25% of EBITDA) and their interest (typically 2-10% of EBITDA for the best companies).  So if 35% of EBITDA goes to interest and G&A, the remainder can be used for capital expenditures (land; drilling acquisitions) and income taxes as well dividends and stock buy backs. Right now, many oil companies have G&A plus interest nearly exceeding their EBITDA and that is why they cannot drill without incurring even more debt and who is crazy enough to lent them money right now? 
A lot depends on the price of oil. The intrinsic value of that oil is probably around $50 U.S. This represents the price at which companies can cover their all-in-costs plus profit margins which typically averages 8-15% (not a fat pot when compared to high tech industry margins - sometimes 40% and higher). You may say that countries such as Saudi Arabia can beat that intrinsic value hands-down but that is not true.  You see, comparing a publicly traded company with a state owned (or better dictator owned) company is kind of tricky. Because many of those’ countries need their companies’ profits to control their populations. So if a country like Saudi Arabia is seeing its treasury decline and even considers selling part of Aramco of in an IPO they produce below the intrinsic value of oil as well.
So, really the current market value of oil is strictly based on the price war tactics of over production and it does not reflect the worldwide intrinsic value of oil. If the price war mongers Russia and the other OPEC countries would reduce their output by 1-2 million barrels per day (which would be by less than the famously quoted 5%) oil prices would shoot up to $80 per barrel or higher in no time. This is not a price war between Saudi Arabia and North American producers!  We’re just collateral damage!  Because the moment oil prices recover our production would go up and much of the treasure money lost by the price war mongers would never be recovered. No this price war is about market share in the rest of the world (Asia, Europe and part of South America). And the price war mongers are not only in a price war they are at physical war amongst themselves as well in Syria, Yemen and where ever else they can fight. The question is when do they give up their price war before going bankrupt?  The markets suspect they are close to maximum pain and that is why every time there is a rumor about production cuts the oil price shoots up by up to 10% in a single day.   We’re near a bottom in the North American market. It is time to accumulate some oil and gas upon oil price weakness over the coming months. Yes, everyone does know about buy low and sell high; but do we have the guts to apply that?  I don’t know but if you have the nerve to buy now and oil returns to its ‘intrinsic value’ you will do well over the coming years.
There is a lot of worry about oil and gas being on the way out.  Yes, this is the green dream (for now) but the key word is ‘dream’; we’re years away from low fossil fuel consumption but the masses believe Obama. In the meantime, people buy bigger cars again and as Jeff Rubin once aptly noticed when car efficiency and prices are down, oil and gas consumption increases. So don’t hold your breath about the disappearing oil and gas industry.  Look at coal! It is still with us despite all the consumer disdain and so called decades of decline!
World economy growth is very dependent on demographics! China’s population is greying rapidly thanks to the past ‘One-Child’ policy. North America’s population is young and the Millennium generation, comparable in size to the Baby boomers, is about to start families. Yes, it may have been delayed by the financial crisis which kind of resulted from the start of Baby boom retirement. The fallacy of demographics is the assumption that each generation follows the same habits as their parents. But Baby boomers behave different than Millenniums, which marry later (in their late twenties or early thirties) and which stayed home with Mon and Dad much longer than previous generations.  But just like Baby boomers they will retire later in life if ever.  And it is not only about generations; it is also about emigration and fugitives from war. In the short term these people may be a drag on the Western societies but over the longer term they will rejuvenate the population. So, where do these people go? To China or India? Hell no! They’re on their way to Europe and North America.  That is where the future lies and that is where innovation blossoms. I foresee that these years of muted economic growth will disappear soon and that investing will become very profitable of the next decade.  I don’t think emerging markets will disappear from investment portfolio’s but just like the Japan of the 1970, their days of explosive growth are over.  So buy today to reap the profits tomorrow! 

We had low growth years from 2008 until today – nearly a decade – growth will be back and probably soon. Nobody can time market turn arounds; first we need our portfolios to survive and for that we need cash flow – just like the oil companies and when too heavily indebted we won’t be able to invest and prosper of the coming decade (or two?). So aim for cash flow by reducing interest payments and increase dividend and rental income. Stabilize and protect your cash by keeping it in gold (or in the Canadian dollar because the U.S. dollar is not far from peaking barring stupidities by the current Liberal government).  That is my road map for investing in the current Bear market and the Bull to come: conserve or improve cash flow and buy on market weakness solid cash flow producing assets at dirt cheap prices.

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