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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