SUI Generis Investment Partners January 2016 letter titled, “Absolutes, Nationality & The Definition Of Insanity.”
Friends & Investors,
Like December before it, January was a particularly tumultuous month in North American stock markets with equities declining across the board, save perhaps gold miners. And like December before it, January was a strongly positive month for the Sui Generis Investment Partners Master LP and our investors, a record positive month in fact. Our healthy dose of realism (not to be confused with pessimism) has kept our investors in good stead and we continue to maintain a net short position in equities as we still see a dangerous combination of negative macro indicators and expensive stocks. We’ll actually limit the housekeeping section of Multiple Thoughts right there as we feel there are particularly interesting topics to touch on this month, and since you already know what happened in January there is nothing to gain by rubbing salt in the wound, it’s time to move on to navigating the stormy waters in this sea of red.
We believe that rational people do indeed act on the margin and we think this is a very logical way to think about investing. And yet when it comes to investing we find that more often than not the exact opposite is true when describing investor behavior. Our constant discussions with both investors in our fund and those seeking to learn more about Sui Generis have given us the distinct impression that many investors tend to think in absolutes rather than increments; that one must be either bullish or bearish and act accordingly. Part of our obsession with managing the risk in our portfolio means that every change we make is an incremental or marginal shift rather than a wholesale one because we don’t deal in certainties, we deal in probabilities. To this point, we’ll discuss how a fairly dramatic shift in thinking by our team over the past month resulted in what may seem like only incremental changes, but yielded a substantially lower risk profile as it relates to our energy investments. These moves in combination with a few things we think (but do not know) are going to make the balance of 2016 a difficult year for stocks, keep us believing the best is yet to come for our fund.
SUI Generis - Short position in Suncor Energy
Wednesday January 20th was an important day in our brief history as a fund because it marked the bottom in the oil market (so far) and entirely coincidentally, the day we shifted away from our net short position in oil exploration and production companies (important distinction). We weren’t declaring a bottom, we simply felt that remaining short E&P’s represented more risk than we felt comfortable with and we wanted to remove some of the torque our portfolio had to the oil price (regardless of its direction). We didn’t exactly turn bullish on oil, just less bearish on oil equities. So we covered shorts in a trio of oil & gas producers and added to our short position in Suncor Energy on the basis of their very high cost of production and that refining margins, the profitable savior for integrated oil companies in 2015, had begun to compress and would continue to do so in the first half of 2016. Think about the optionality this trade gives our investors; 1) if crude stays flat or trades in a range at these low levels refining margins should continue to compress, and Suncor’s upstream (production) division would continue to burn cash given their high cost of production. 2) If oil rises to any price between here and $50 a barrel refining margins will compress much more quickly (as they do in a rising oil price environment) and Suncor’s oil sands production still won’t generate free cash.
The idea of energy optionality is a concept that is actually more prevalent throughout Sui Generis long book than our short book. And while Suncor was a great example of a position that gives us the most options under our most probable scenarios for crude oil, SNC Lavalin gives us similar optionality on crude from the long side of our portfolio and we added to our position during the week of our shift in thinking regarding oil. SNC is the largest engineering firm in Canada and has a very large energy franchise, for context roughly 30% of their EBIT came from their energy division in Q3 of 2015 ($62mm of $205mm). What we find appealing about SNC is that the energy division provides great exposure to any future increase in oil & gas capex, but we’re not paying for that optionality. Trading at an EV/EBIT multiple of just 4x, SNC doesn’t need a dramatic rebound in oil prices to justify its share price the way Suncor does, but we get that upside if such a rebound does materialize. A large cash balance, their 16.77% ownership in the 407 ETR toll highway north of Toronto and their market leading position in infrastructure in Canada give them steady state earnings that on their own justify a share price much higher than where it trades today. Though we didn’t exactly place a lot of emphasis on it above, the idea of SNC’s exposure to infrastructure spending is actually the most compelling reason to own the shares today, which brings us to the last topic we think bears discussion this month.
SUI Generis - Japan shifting from ZIRP to NIRP
We recognize that our fund occupies a rare intersection where short selling, global macro and value investing all intersect and though you’ve likely noticed, the only one of those three we’re yet to touch on is the macro picture. Global growth indicators (ISM manufacturing survey, trade/export data) continue to tell us there is a growing probability of a recession and oddly, the central bankers of the world have decided that this is something that needs to be avoided at all costs. We’re not sure when cycles became blasphemous but with Japan having recently joined Europe in shifting from ZIRP (zero interest rate policy) to NIRP (negative…) we believe central bank thinking regarding monetary policy is approaching Einstein’s definition of insanity. This idea was actually put in our heads during an exceptional interview with former Dallas Federal Reserve advisor Danielle DiMartino Booth on RealVision, and we can’t help but agree with her entirely. Cutting interest rates to zero or making them negative has clearly failed to stimulate real growth in the economy but instead has fostered asset bubbles that, like all other bubbles, pop. And yet quantitative easing is a policy that continues to be pursued ad infinitum. Borrowed free money has continued to flow into technology stocks, share buybacks, shale oil production, subprime car lending and all forms of real estate rather than towards research & development and capital expenditures.
Beyond the obvious negative long term implications of creating asset bubbles, we spend a lot of time thinking about the negative consequences on currencies from ZIRP and how that affects our investment outlook and framework. Specifically, a concept we call the “FX Lid” should play out where as central banks lower interest rates to devalue their currencies there is a lag between policy implementation and economic benefit (investment into the country) yet in between the policy implementation and the benefit, the cost of the policy acts as a tax on the shoulders of the consumer via higher import prices, this is particularly acute in countries like Canada where we import many consumer staples. With the “fixed” cost portion of the consumer budget increasing the discretionary dollar pool shrinks until wages increase to fill the gap, the problem here in Canada of course is that the unemployment rate is increasing as well.
SUI Generis - The affects of a strong US Dollar
The opposite effect is true for the American consumer and though we note that household income in the US is lower today than it was in 2007, the price of energy has come down substantially and with import costs coming down (thanks to a universally strong USD) the American consumer is actually richer these days relative to consumers elsewhere in the world. To us this is the economic equivalent of a head fake. If the Fed reads it as anything other than that and continues to hike interest rates the game could really be over. It would become more expensive for Americans to service their debt and the last bastion of strength in the world economy will be gone. Too, continued strength in the USD will likely yield adjustments by corporate America including the forced offshoring of manufacturing capacity to cheaper jurisdictions and increased competition over sales in USD (now the highest margin dollar of revenue for American corporations), neither is a positive for corporate America.
We don’t want to drive you insane by dwelling on this point, so we’ll simply leave you with the idea that the result of all this is likely to be coordinated stimulus spending on make-work infrastructure projects across the developed world as both governments and central bankers will realize that they’ve reached the limits of any benefits that can be extracted from driving interest rates to zero. If we’re right about this, few will have the scale or expertise of SNC Lavalin to accommodate the government’s newfound interest in spending.
The Sui Generis Team