Randall Abramson of Trapeze Asset Management Q2 Letter – The Only Game In Town
Our recent quarterly letters cautioned that, as the market was fully valued, a modest correction was likely, and that investors needed to proceed carefully, seeking out undervalued stocks. Yet, the market continued to make record highs. That, despite stretched valuations, public participation at the highest level since ’07, margin debt higher than the ’07 highs, high insider selling, short selling at the lowest level since the Lehman collapse, and the S&P 500 up for six consecutive quarters and over 1,000 days without a 10% correction—the longest since 1987. Stocks, bonds and commodities all rose in the first half of 2014, even though they are typically not positively correlated. And, volatility in stocks and in bonds was very low, an indication of investor complacency. The Fed itself noted it believed investors were too complacent and was concerned about excessive risk taking.
Correction Potential
The markets recently began correcting, but have now mostly recovered. Though U.S. small caps are still down 4% from their peak after suffering 9% and 8% corrections ending in May and early August, respectively. The corrective action came despite 75% of U.S. companies beating earnings expectations for Q2. Also, despite satisfactory U.S. economic news, including a better than expected GDP of 4% for Q2, July employment up by 209,000 mostly from private sector hiring— the sixth straight monthly employment up over 200,000—with unemployment up only marginally at 6.2%, and July manufacturing activity at its highest level in over 3 years.
Well, we still maintain the market is fully valued, and vulnerable to the potential correction we have been warning about. And, that recent investor concerns could be realistic. Earnings have been driven, somewhat unusually, by profit margins at all-time highs, likely unsustainable, assisted in part by the low cost of labour, low interest rates, low commodity prices and cost cutting generally. Less so from rising revenues. Corporate earnings now represent more than 10% of GDP. Remember reversion to the mean. U.S. corporations are holding a record amount of cash to fund buybacks and increase dividends. And, of course, share buybacks have helped per share earnings, and M&A activity and a dramatic drop in the number of publicly traded companies have created a lower supply of investment opportunities.
Stock market corrections should become more frequent but leave the bull market nevertheless intact. Under current conditions, compared to other asset classes equities are the best, if not the only game in town. When stocks enter a slump, like that other game, we want to wait for the right pitch. Hopefully when the bases are loaded.
We have our own variation of the equities game. We are value investors. While growth investors tend to look up, as value investors we tend to look down, to assess value and risk. Growth investors tend to gravitate to what’s popular and sexy. Value investors are into personality and character. And winning. We want to buy bargains—at least $0.80 dollars and much lower for small caps. We look for undervalued stocks, strong balance sheets, and prospects for growth not reflected in prices. Our game is to seek out mispriced assets, often from being temporarily unpopular, or ignored or misunderstood. Our game is not to speculate, but to analyze, understand and invest. Our game often requires patience but tends to be worth the wait.
The Big Picture
In terms of the big picture, the signs for the economic outlook are somewhat mixed, especially abroad. While the U.S. seems to be resuming growth after a weather-driven negative first quarter, it is still relatively slow in Q2 from fewer shoppers even as weather improved and even as unemployment has declined. Consumer sentiment declined in August and retailers have seen a sharp drop in sales. Poor wage growth has restrained consumer spending. And the labour participation rate—Americans looking for work—is at a very low level. Mortgage applications fell 2.2%. New home sales also fell in the first half and should negatively impact home construction and hiring in that sector. July home sales, housing starts and building permits were up, although June pending home sales were down. A mixed bag. Consumer spending could be further impacted, and consumer spending accounts for two thirds of U.S. output. The Chicago PMI for July was down to 52.6, a 13-month low. One would have thought that with all the monetary stimulus the economy would be booming. It’s not. The U.S. trade deficit declined 7% in June from declining imports caused by slower demand for consumer goods. But the trade deficit, impacted by a rising dollar, may not continue to decline and likely won’t help GDP going forward. Indeed, the International Monetary Fund recently cut its U.S. growth expectations for 2014 to 1.7%, warning of losses to investors from a potential stock market correction.
The I.M.F. also lowered its forecast Canadian growth for 2014 to 2.2%. And the Bank of Canada lowered its own forecast based on the failure of exports to recover, impacted also by a stronger Loonie, though Canada just reported an unexpected rise in exports (and a decline in imports) in June, providing the largest trade surplus since December 2011. Canadian consumer sentiment in August just rose and the revised jobs data for July exceeded expectations. The Bank must be a little relieved.
The Global Picture
Around the world, the outlook is for tepid growth too. And most countries would like to help lower their currencies.
China has suffered from a housing slump, and it has been trying to help exports by keeping its currency down, recently by buying record amounts of U.S. treasuries for its foreign exchange reserves. August manufacturing data showed a sharp drop in growth which should encourage continuing stimulus to help it meet its 7.5% GDP growth target. July exports soared 14.5% which will help too.
The Eurozone’s economy is not growing and European markets have corrected, with indexes in Europe having fallen around 10%. While Germany’s manufacturing continues to grow, business confidence in June fell to the lowest level since October. The sanctions on Russia will impact German growth. Indeed, Germany just had its second consecutive quarterly decline in its GDP growth. Russia, the world’s eighth largest economy, from all the sanctions and capital flight, hiked rates to 8% to support the Ruble and will probably have no economic growth. Italy has fallen back into a recession. France’s economy is struggling. The U.K. is doing somewhat better, although wage growth recently declined and retail sales are slow there too. The Bank of England, accordingly, is in no rush to raise rates. Unemployment in many European countries, such as Spain and Italy, is still unconscionable. The European Central Bank intends to keep rates low to help, to weaken the Euro further, and to boost inflation which, at 0.4%, is well below its 2% target, and it sees risks in the economy to the downside.
The Japanese trade deficit worsened from weaker exports and its inflation, which it has been struggling to move up, slowed in June. Its economy declined in Q2 from declining consumer spending. Japan has been doing its own quantitative monetary easing to help. And, of course, Argentina defaulting on its debt hasn’t helped the global mood. All in all, global economic growth is disappointing. In fact, new Fed Vice Chair Fischer recently said the U.S. and global economic recoveries have both been disappointing. And the game of the drivers at the Fed and Central banks everywhere will be pedal to the metal, to try to increase the speed of economic recoveries.
Our Strategy
We rely on our four pillars, including two top-down macro pillars. One of those is TEC™, our economic composite, and it currently does not indicate any forthcoming recession. Nor does our TRIM™ work indicate any new bear market, just a normal constructive correction.
As consummate value investors we will continue to carefully select undervalued companies worldwide, and where authorized, to hedge a potential decline by selling short overvalued stocks and buying puts on an overall market susceptible to decline. And typically to hold a modicum of cash when we are concerned.
We are gratified with our recent performance, and we believe our proprietary tools, both macro and micro, to select undervalued opportunities and to optimize the trading of our buys and sells, should help us outperform the benchmarks.
Our All Cap Portfolios – Key Holdings
Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and, generally, lower volatility. Importantly, they tend to recover back to their fair values much faster. We continue to increase our large cap weighting. However, our small cap positions are cheaper as they trade far below our fair value estimates and therefore our All Cap portfolios still hold a significant position in small caps
Specialty Foods Group, a shareholding in a private company held in our taxable accounts, ispreparing to liquidate its assets. Its value is mostly from the company’s substantial cash balance (over $50 million). The company will likely be in a position to return capital to its stakeholders beginning later this year. Remaining distributions will likely take place in the middle of 2015 or when the last of its brands/operations are sold.
Manitok Energy is our largest equity holding in most All Cap accounts. Our estimated fair marketvalue (FMV) remains above $4.50 per share, more than 60% higher than the current share price. The company is on track to produce over 7,000 boe/d by the end of 2014, an $80 million ($1.15 per share) cash flow run-rate. And, the next few months should help bridge the gap between the stock price and the underlying value. The market has been waiting for Entice drilling results. Initial results showed several oil pools but specific flow rates are still forthcoming.
Continued drilling at Manitok’s Stolberg core area and the new Entice area has the potential to increase value to over the $6 per share level over the next year, versus its $2.70 share price. A material decline in the price of oil, which we do not anticipate, remains the main risk for the company. Assuming $85 oil (our conservative figure), in just 3 years Manitok should have annual cash flow of more than $1.80 per share, and a reasonable valuation of 5x cash flow would justify a share price more than 3 times today’s level.
Corridor Resources’ core McCully field, its infrastructure and the company’s net cash (over$35 million) are worth more than the current share price. The significant potential from Corridor’s 3 megaprojects remains essentially free.
Corridor’s results over the next few months could help the market’s perception of the company’s underlying value with drilling taking place at the McCully field, on the Frederick Brook shales, and on cores at Anticosti Island. Corridor now has partners—the Quebec government and Maurel & Prom, a mid-tier international oil company—spending up to $100 million drilling on Anticosti Island. It’s still seeking a partner for its Frederick Brook project which, at over 1,000 metres of depth, is one of the thickest gas shales in North America. Corridor continues to seek a partner for its Gulf of St. Lawrence Old Harry project. Though Old Harry and Anticosti have significant promise, much more work needs to be done to ascertain their viability.
Current production is sent to the New England market which was extremely undersupplied last winter. The company typically receives a premium of about $2.80 per mcf over prevailing gas prices that should be sustainable for several years. With higher natural gas prices expected ahead, Corridor’s cash balance and cash flow, sufficient to grow the company, and the megaproject prospects, the share price appears too low.
Orca Exploration is probably our position with the largest disconnect between price andunderlying value. And underlying value keeps accumulating. The disconnect, caused mainly by issues in Tanzania, should dissipate as the issues are resolved. The inability of Tanzania to satisfy its financial obligations has been the most significant issue. The World Bank has been providing aid to the government of Tanzania. TANESCO, the national power utility, has had better income and with some direct funding is now in a much better position to repay its substantial obligations to Orca and other suppliers. The new pipeline in the country, allowing expansion of Orca’s production, is mostly built with its commissioning expected in less than a year. The key risk for Orca continues to be a prolonged period of uncertainty. However, in order to fill the pipeline and
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limit the brownouts in the country (which would certainly help in the fall 2015 elections too), the government needs to move fast to provide clarity for Orca so it can continue its spending. The fact that Orca’s gas production generates over 50% of the power in Tanzania should expedite the government to resolve a poor situation.
Orca’s cash (it has no debt) represents half its share price and including receivables—from TANESCO—the resultant cash is equivalent to the current share price. With an estimated reserve value of $12 per share, the combined value is about 4 times the share price. Meanwhile Orca is producing at record levels, has long-life natural gas reserves, and operates at low costs with high netbacks.
St Andrew Goldfields just boosted its production guidance for 2014. The Holloway and lower costHolt mine (where all -in costs, including royalties and sustaining capital expenditures, are below $1,000 per oz.) have been performing better than expected. Drill results from the Taylor mine have been impressive too and we expect next year’s
