Sui Generis Investment Partners February 2016 letter on Boralex Inc, titled, “Blowing In The Wind.”
February 29th marked the culmination of the first year for the Sui Generis Investment Partners Master LP and at the onset we would like to extend our sincere gratitude to all of our friends and investors for your support. For our investors, we hope you feel rewarded for your loyalty as the fund returned 9.53% from March 2nd 2015 through to February 29th 2016 against a -16.56% return for the S&P/TSX Composite. As the managers of the Fund we are very pleased to have done exactly what we set out to do, protect our investors in an environment that required protection. The Fund posted another positive return for the month of February against what continues to be a remarkably volatile environment for equities. And while we intend to recap some of our favorite themes from the past twelve months, we are excited about how this market is setting up for us so we want to jump right into the next few months, and at the moment the past and the present are looking strikingly similar.
When studying the performance attribution that allowed the fund to markedly outperform our benchmark over the past twelve months, we can’t help but be drawn to our “short oil” trade that was the single largest contributor to our positive performance. Feeling nostalgic, we pulled out our old issues of Multiple Thoughts and were struck by how relevant our May 2015 issue was today. To wit, “US department of energy (DOE) crude oil stocks are now north of 490 million barrels, a record and yet the market continues to rally. While we know markets are forward looking…the fundamentals of the oil market still appear unwaveringly bearish to us…This particular rally has limited upside because we believe the rally itself is the worst thing that could happen to crude as more producers will be enticed to bring production back on line after a 45% rally from the bottom. As the pendulum swung in the direction of capex cuts and a decline in rig counts on the way down, it swings the other way on the way back up for oil prices. One needs only to look at the heavy activity in the oil futures curve to see that producers are locking in prices at relatively benign levels through 2016, or put another way, oil producers are shorting oil in 2016.”
Sui Generis – The Oil Market Rally
Sui Generis apologizes for the long winded pat on the back, but one can’t help but notice the parallels with the oil market today. Oil has rallied 45% and on the back of that rally we have had a rash of equity financings that will enable these companies to continue to produce into the oversupply situation they find themselves in. The same arguments we heard a year ago are still echoing around the street over the last couple weeks. “Saudi Arabia can’t keep this up for long”, “the drop in the rig count will yield a big production drop in the lower 48 US States”, “the best cure for low prices is low prices” etc. Of course we’ve learned a few things about these arguments over the last year. Regarding Saudi Arabia’s wherewithal, it’s now safe to say that they’re in this for the long haul and as far as investing timelines go, they can keep this up forever. Per the rig count, it’s now become very obvious that the relationship between the number of rigs and oil production is not linear. Necessity being the mother of invention, oil companies have taken a quantum leap forward in efficiency because frankly, they’ve had no other choice; these advances should be applauded. The final point relates to low oil prices being the cure for low oil prices and this axiom has taken a curious turn away from relevance over the last 18 months. It really doesn’t seem applicable in a battle for market share because it makes one very large assumption, that the motivation to produce a barrel of oil is to earn a profit. The production that one would expect is most price sensitive, that which is profit motivated, continues to be thrown lifelines via billions of dollars of equity financings by investors in the capital markets who are terrified of missing the bottom. We believe this mindset in and of itself tells us we’re not at a bottom.
Moving on to what Sui Generis sees influencing returns in the coming months and again echoing a thesis that drove returns for our fund for long stretches of time in 2015, we can’t help but believe that the US dollar bull market should regain strength. As central bank policy continues to diverge we should see the creation of market distortions around the world that we will hopefully be fortunate enough to exploit. We believe that the eventual end game is that the Fed will be forced to stop raising rates because the contrast becomes too stark and US-based manufacturers and exports would become too disadvantaged. So what sort of investment idea makes sense in an environment with so much uncertainty? Given our modus operandi, we can’t blame you for assuming that we’re about to tell you to short something, but instead we’ve decided to share with you a long idea that operates within one of the few secular bull markets we can see in the world and thus, shuts out all the noise we just referred to, and that is renewable energy.
Having a background in oil & gas research, we are well aware of the fact that suggesting renewable energy is in a great bull market for the foreseeable future is nothing short of blasphemy. To that we would say two things, 1) our investors don’t pay us to be dogmatic about the supremacy of fossil fuels, and 2) we know a trend when we see it, which is something our investors do pay us for. Pragmatism is the defining characteristic of our investment mindset and it is this open mindedness that has allowed us to deep dive into the polar opposite of what has traditionally been our favorite business, oil & gas (ex. price wars). Our research into renewables has introduced us to a concept that we are now infatuated with, perpetual cash flow.
Sui Generis – Boralex Inc
Enter Boralex Inc. (BLX-T), a Canadian hydroelectric and wind independent power producer (IPP) that we believe is both well run and uniquely positioned to capitalize on the direction the worlds politicians have decided we’re going (tip of the cap to Leo as well, he may as well have said “buy Boralex” in his Oscar speech). It’s fair to say that the economics of renewables, when forced to stand on their own, don’t hold up (yet). It’s also entirely fair to say that doesn’t matter even the slightest bit. Inflated rates of return per kilowatt of power produced will be paid to the Boralex’s of the world for decades to come because their kilowatts are perceived to be cleaner than those created by fossil fuels, which is by and large true. This brings us to the real joy of the idea and the great contrast against resource extraction companies, perpetual cash flow. The terminal value of every oil well is effectively zero and yes of course money can and often is made during the best producing years of that well, but it eventually runs dry and you’re left with an abandonment liability and some roughnecks looking for more work. Tell me when the wind will stop blowing and when the rivers will stop flowing and I will tell you when the cash flow stops for Boralex. So, months ago when we first glanced at the name we thought Boralex looked rather expensive, until we realized we had never tried to put a multiple on cash flow that would never stop and continues to grow at 10% per year. Further, because the contracts for the inflated rate of return being given to renewable IPP’s comes from a government, banks are often keen to lend very long paper at very low rates, thus locking in a fantastic financing base for, again as far as we’re concerned, forever.
So perhaps the point of all this is to keep a very sharp eye on the noise that comes from the macro world, as Sui Generis do, because it’s particularly important in today’s investing environment…and then tune it out from time to time. There are always bull and bear cases playing out around the world that, in spite of short term share price movements, aren’t at all related to the latest blast of economic data. Renewable Energy is a perfect example of a secular bull market that, sure as the wind blows, we’re quite confident will last for many years to come.