The charm of old economy investing: simplicity and cyclicality
Supply-side, NAV, and volatility
Investing is an exercise in looking into the future. We make assumptions based on our interpretation of available information. Assumptions have a habit of being wrong. Not only that, but errors don't simply add up. Instead, they compound.
For this reason, assumptions in the investment process should be kept to a minimum, yet no more than necessary. That's why I invest in markets and businesses with fewer moving parts and catalysts on the horizon. The best-case scenario is when I have both.
Examples of “simple” industries are the platinum and uranium markets. Both are dominated by a few companies operating several mines in less than five countries. An option for a complex market, but with a strong catalyst, is shipping companies and, in particular, tankers. Oil rigs also fall into this category, especially in South America and West Africa.
What do these businesses have in common besides the features listed? They belong to the old economy based on intensive capital investment. They share three characteristics that make them attractive:
· Supply side changes take time, unlike the erratic demand, so evaluating the future supply is relatively easy.
· Pronounced cyclicality following the slow supply changes, the tortoise, rapid demand shifts, and the hare.
· Simplistic valuation approach based on net assets, prone to fewer errors.
I include traditional banks and banks financing capital-intensive businesses in the old economy. I will mention some of their features at several points in the article, but the focus today is on companies creating value from tangible assets such as mines, oil rigs, and ships.
In separate paragraphs, I discuss each of the benefits mentioned and conclude with some investment ideas for the year ahead.
Supply and demand
Which side should I start with - supply or demand?
The answer to this question is the first advantage of businesses like mines and oil rigs. Demand is highly volatile and dependent on multiple factors, while supply changes slowly and depends on three variables - capital investment, sufficient staff, and geopolitics. Fewer variables mean fewer assumptions, and fewer assumptions mean less chance of error.
Building a supertanker or oil rig takes at least two years. It often takes at least ten to fifteen years from discovering the ground's first resources to the mine outlet's first ore.
At the same time, demand for this period may go through highs and lows several times.
Lack of capital investment undermines future deficits. The same applies to the lack of qualified staff. Following the theory of constraints, the latter represents a limit for any business. If we put all the capital necessary to develop sufficient copper deposits, the productivity of the mines will be limited by the number and quality of personnel.
Geopolitics is the spark in our investment hypothesis. It affects supply more than demand. Extended supply lines due to the Red Sea crisis, the Panama Canal draught, and the diplomatic crisis between Ethiopia and Somalia are examples of such influences on shipping.
The crisis in the Middle East also impacts the market for oil rigs and offshore support vessels. Increasingly, the focus is shifting to the (ultra) deepwater fields around West Africa and South America. Argentina and Namibia are the rising stars, while Brazil and Angola are consolidating their position as leading players in the industry.
The sanctioning of Russian uranium imports to the US is an example of the influence of geopolitics on the supply of raw materials. The U.S. is pushed to import uranium from producers that cannot keep up with current demand. At the same time, uranium producers such as Kazakhstan and Namibia have closer ties with China. The supply distribution will suddenly be distorted while demand remains unchanged. The US will be looking for uranium from a handful of producers who are already struggling.
Relatively easy supply-side analysis does not mean ignoring demand. Instead, it tells us to focus first on the part with fewer assumptions and only then on the part with many assumptions.
Cyclicality
Oil rigs, ships, and mines are highly cyclical. Banks also follow cycles, but they are different and are not the subject of today's article. It focuses on businesses owning tangible assets—mines, oil rigs, and shipping companies. Depending on their size, companies in their respective industries have different Beta manifesting themselves at different cycle stages.
When the cycle is up, all companies win. However, those that fail do so individually. This is why diligent company selection is essential. The primary goal is to limit the downside risk. And the secondary goal is to boost the upside potential.
The rules are simple:
· Managers and founders with industry (and company) experience and skin in the game
· Solvency and liquidity above the industry average
· I seek bottom fishes based on Price to Net Asset Value
The presence of all three features significantly reduces the risk of irreversible loss. Managers who are also shareholders have a clear vision of what they do NOT want—to lose money. The point is to ensure the company's survival capabilities. Then comes profitability.
When a company is liquid and solvent, it ensures its survival in difficult times, which always come. Problems in the business, the industry, or the global economy may cause these crises. However, if the company has resources set aside for rainy days, the causes of the crisis don't matter as much.
The low market price relative to valuation fulfills two roles. First, even if the timing is wrong, the price is already at the bottom, and we are unlikely to lose much. If we're in the wrong company or industry, then we haven't done our job of weeding out the crappy companies (see the first two points, they weed out over 90% of ideas). The second advantage is the pronounced asymmetry of the bet if we pay cents for every dollar in net assets.
At the bottom of the commodities cycle, companies are often sold at a market price 70%-90% below net asset value. The shipping industry also has similar examples. When TCE rates are so low that they are below daily operating costs, the ships are annihilating cash, and it is more profitable to tie them up or scrap them. Then, the prices for old vessels fell significantly, dragging down the shares of shipping companies. However, the latter often falls much faster than the former.
So, the company's market capitalization may end up being lower even than the scrap value of its ships. At times like this, we pay cents on the dollar NAV. The exact logic applies to oil rigs. And if we're generally right about the new cycle, the bet is highly asymmetrical in our favor.
How much is the business worth?
What mines, oil rigs, and banks have in common is that they are relatively easy-to-value assets (financial in the case of banks and tangible in the case of mines and oil rigs). They are much easier to value than the assets of a software company. The latter will have many more intangible assets that are almost impossible to value for 99% of investors.
The reason is simple: Intangibles are often patents and other sensitive information deliberately not published because they are the company's advantage. If they are disclosed, competitors will immediately take over.
Intangible assets include goodwill. It is calculated based on future cash flows and net assets of the company. The first variable is based on assumptions about the future, i.e., we have more chances of being wrong than right.
Companies with significant goodwill on the balance sheet often justify this fact with abstract arguments such as brand recognition, patents, or specific know-how. All three are essential to any business but are difficult to measure, making accurate goodwill valuation a futile endeavor for most investors.
Often, intangible assets account for over 90% of all assets, meaning we are ignorant of a company's net asset value. In addition, clever and not-so-clever accounting frauds are often hidden under intangible assets. In other words, valuing a company with primarily intangible assets is risky.
Methods based on discounted cash flows are at least inappropriate for valuing such companies—great formula but with many assumptions. Our assumptions love being wrong.
Even better. When there are more than two wrong assumptions, they don't add up; they compound. In other words, there are more ways to be wrong than to be (mostly) right when valuing a company using discounted cash flows.
Old economy companies, on the other hand, have relatively simple balance sheets. The emphasis is on tangible assets for mines and ships and financial assets for banks. In both cases, formulas can be used with limited assumptions, such as net asset value (mines, ships, and oil rigs) and tangible book value (banks). In the case of banks, I also use an excess return model, which is not perfect but is more appropriate than discounted cash flows.
According to the industry in which the company operates, there are at least inappropriate and extremely inappropriate valuation methods. NAV is among the valuation methods with the fewest input assumptions. Fewer assumptions mean a lower chance of error.
Multiple assumptions are like the moving parts of a mechanism. Their sufficient number, not absolute, determines their usefulness for the mechanism.
Net Asset Value equals the sum of tangible assets (calculated according to their type) plus current assets minus enterprise total liabilities. The catch is in determining the value of tangible assets. The figures given in the financial statement do not work for us. They only reflect the book value.
As investors, we look from a different perspective –a company's owners. We need to know the specifics of the business to value its tangible assets. Whether we are evaluating an oil rig, a tanker, or a mine, we must know the specifics of the asset.
For ships and oil rigs, these features are:
· Age of ship/platform
· Annual depreciation rate
· Annual inflation
· Price per tonne for scrap
· Price of a new ship/platform with the same characteristics
In the case of mines, the features are:
· Reserves
· Resources
· Plausible reserves
· Spot price
· AISC
The valuation will not be perfect, but it will be good enough to estimate if we buy at a discount.
When we meet a person, we can quickly determine the age category—child, youth, adult, elderly. In 99% of cases, this is enough. It is the same in the markets—we need to know if the company is exceptionally cheap, cheap, expensive, or too expensive. Focusing on details like whether we have a 45% or 52% margin of safety is unnecessary. Seeking precision in our value estimations, we fall into a certainty trap. Let’s not forget the only certain thing on the markets is the uncertainty.
Our advantage as market participants lies elsewhere. An information edge in the markets is almost non-existent; instead, analytical and behavioral edges are becoming increasingly important. In an era where everyone has access to (almost) the same information, the "secret" lies in its interpretation and the application of the conclusions.
One of the nuances of the analytical edge is knowing the businesses we analyze in detail. The majority look at price to book and price to earnings, regardless of the industry in which the company operates. However, a tiny group of investors look at Enterprise Value/Plausible Reserves or Operating costs/Time charter revenue. Of course, being familiar with those metrics does not guarantee success; however, ignoring them guarantees us a lack of analytical advantage. Without an analytical edge, our chances of long-term market success tend to be zero.
How to play the game?
The two cycles do not precisely resemble each other but rhyme. There are common principles to guide us as we ride the wave. Their goal is to get the most Alpha out of the cycle.
Just as the cycles are not the same but rhyme, their stages have peculiarities. We can get the most out of each stage if we know them. Here are the stages of a bull cycle:
· Skimming the bottom - specialist funds only invest in the best (in their view), not the most liquid companies.
· Emerging bull trend and media attention - institutional investors are entering the most liquid companies.
· The parabolic trend (media attention to Mania) - smaller institutional investors are getting into mid-cap companies and even small-cap stocks.
· Mania to euphoria - any company within the current hype is bought, no matter its merits. The retail investors are joining the party. They buy from specialist funds and institutional investors who are already coming out.
Let's examine each stage of the cycle in detail. Cyclical businesses like ships, oil rigs, and mines are often unpopular among institutional investors. However, that constantly changes in a strong bull market.
These markets are small even compared to individual companies of MAG7. That's why the major funds usually don't look at them. However, on the few occasions they do, it causes parabolic bull trends.
The big players are involved in stage two, i.e., after the specialized funds. Institutional investors pour in liquidity, a small percentage of their portfolios, but too large for small niche markets. The latter would mean that with a miniscule fraction of its funds(for the large institutional investors), maximum results are achieved, i.e., the price makes a sharp move of considerable magnitude.
At some point, a self-fulfilling prophecy occurs. The large funds pour capital into industries where they expect the price to rise. Their actions push the price north, attracting more market participants until the last market participant has caught on.
The uranium market is a great example. We are between phases two and three, where the big investors are starting to come in.
Institutional investors first turn to the only adequate option for them, Cameco, because it is the most liquid. Next, interest will turn to major developers such as Denison, Nexgen, and Uranium Energy. At some point, the stock prices of uranium miners will rise enough to attract the general public's attention. Then, retail investors will talk about Cameco instead of MAG7.
This is when smart investors start to exit the big companies and invest in smaller ones. Small companies lag behind big ones due to insufficient liquidity for institutional investors. At some point, however, the big companies have gotten too far ahead of the small ones. In other words, there is more alpha to extract in the small caps.
At that point, uranium will become a top story in the financial media. The general public's interest will turn to all things "uranium." Junior miners will be the center of attention. This is the euphoria stage. Then, any company with uranium in its name will be bought, no matter its merits (or lack thereof). At this point, the smart money starts coming out.
The icing on the cake will be a cover of The Economist extolling the investment potential of uranium. We are still far from such headlines in the mainstream. Uranium is currently a topic fit for economic magazines' last to middle pages. If the growth rate in its price continues through 2024, we will likely see magazine covers pointing to uranium as an investment.
I gave the example of uranium, but the same principles apply to all cyclical markets. Platinum is still at the beginning of the cycle, where only specialty funds are entering, while oil rigs and tankers are in the middle of their expansion cycle.
Ideas for 2024
This section will provide investment ideas on my watch list over the next 12-14 months. I start with commodities.
When I invest in commodities, I look for them to have at least one of the following characteristics: OPEX commodities and the supply to be dominated by a few players.
Only one commodity has both qualities—uranium. It is the fuel for nuclear power stations, and they have no choice but to buy the uranium they need to fuel the reactors. Otherwise, the capital investment to build them goes to waste. At the same time, over 90% of the uranium comes from ten mines operated by five companies located in eight countries.
Platinum Group Metals (PGMs) are not OPEX commodities but CAPEX. At the same time, one country dominates the industry - South Africa. Over 80% of the world's platinum and rhodium deposits are in the Transvaal region on the border with Zimbabwe. South Africa is not only leading to palladium annual production. Russia produces about 45%, South Africa 40%, and the rest is split between Zimbabwe and Canada. As much as the end of ICE vehicles is predicted, it won't come so soon. In other words, exhaust catalysts will be needed for a long time; hence, the demand for platinum will grow.
Tin is one of the most esoteric CAPEX commodities. The market for physical tin is estimated at around $9 billion. Even the platinum and uranium markets look like mastodonts compared to the tin market. Again, a handful of countries dominate supply - Myanmar, China, Indonesia, and the Democratic Republic of Congo. Over 50% of tin is siphoned off for the electronics industry as solder for microchip fabrication. The other leading consumers are the chemical and tinplate industries. Potential catalysts for tin demand are photovoltaic panels and electric vehicles.
OPEX's raw materials are coal and oil. Unlike uranium, PGMs, and tin, their industries are complex, with multiple moving parts. However, as OPEX feedstocks, their use is not desirable; it is mandatory.
Coal is one of the most undervalued industries, as reported by any measure - EV/Sales, EV/EBITDA, Price/Book, Price/Free Cash Flow. Some companies distribute dividends with double-digit yields and buy back their shares. Over the past two years, metallurgical coal companies have significantly surged, though they remain undervalued.
The crisis in the Middle East is shifting interest to other fossil-rich regions. South America and West Africa are the big winners. Apart from Vaca Muerta, Argentina has significant undeveloped fields on the continental shelf. Colombia is also attractive to oil companies as it has several large fields in its waters. Guyana is one of the smallest countries in South America, but it has the most oil reserves per capita. Time will tell how the diplomatic conflict with Venezuela over the Essequibo region will develop. Brazil is set to enter the world's top five oil exporters. I assume companies operating oil rigs in South America will be among the big winners during the current bull cycle. The exact correlation applies to Angola and Namibia.
Conclusion
The old economy has its charm, which lies in its cyclicality, emphasis on tangible assets, and analytical advantage of supply. Companies in this category have another advantage worth mentioning—they are inherently volatile.
I love the volatility. If I'm chasing 100% ROI on an investment, high volatility is the fee I pay to get the opportunity to earn that 100%.
Volatility is the price of admission. The prize inside are superior long-term returns. You have to pay the price to get the returns."
-Morgan Housel
There are many roads to Rome, that is, to make money in the markets. Denying and, therefore, exalting a particular strategy, instrument, or asset does more harm than good. While I invest primarily in old economy companies, that doesn't mean I don't also take positions in technology companies or indices. Put another way; I don't ignore the opportunity to generate Alpha from all other sectors and industries of the economy.
Whether we generate Alpha depends on how well we can use the tool's utility. The latter is a function of three variables:
· Who uses the instrument - how well does the market participant know the features of instrument X
· What are its objectives - what does the market participant aim to achieve by using instrument X
· The exact point of use - at which part of the cycle is the market for which the market participant intends to use instrument X
The three variables must be in sync to get the most out of any instrument. Otherwise, we doom ourselves to failure.
As always, I will end this article with the usual reminder—all of the above is the product of my limited, incomplete, and biased reasoning. Use that information not as a final stop but as the beginning of a journey. Journey through unpopular sectors and industries that hide asymmetric investment opportunities.