Elm Ridge letter for the fourth quarter ended December 31, 2016; titled, “We Like The Odds.” The energy focused hedge fund successfully went long near the bottom in early 2016 and have some interesting commentary and positions. See the letter below.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain
“Value investors must be strong and resilient, as well as independent-minded and sometimes contrary. You don’t become a value investor for the group hugs.” – Seth Klarman
“Whoa, is this the first time these are all positive numbers?” - My Daughter
We posted a decent end to a solid year, but we think we’re just beginning to turn the corner as value begins a long overdue resurgence. Although it may seem out of character for us to embrace the current thinking on Wall Street, we can see how rising interest rates and revised interpretation of already improving economic statistics will help a host of (not all) banks, insurance companies and some downtrodden cyclicals as they end their lengthy exile from the Good Hedge Fund Seal of Approval list.1
We think we are finally emerging from a dark time. Ever since 2010, when Washington infighting and the sovereign debt crisis first took center stage, the investing world has been running scared, with the 10-year yield tumbling from almost 4% to about 1.5% this past summer. In this “Safety Bubble,” there have generally been just three types of winners: apparent bullet-proof growth stories; stable bond proxies; and financial engineers benefitting from the extension of low cost credit. Value, driven mainly by financials and other economically sensitive areas, took it on the chin.
While it appears that the safety bubble was already leaking air this past summer, it might have taken a surprising election result for the market to really question the apparent consensus view that a host of traditional industries were perennially threatened with slow growth, deflation, a China slowdown and info tech-based disruptions. The fact that GDP, unemployment, wage and inflation statistics (that might have spurred rates upward and got the value ball rolling at the end of September) were already improving well before that event seemed of little import. And while we have our doubts about some of the less thoughtful claims about who is going to benefit from a Trump administration, we do agree that it is highly unlikely that the Republican Congress holds him to the same spending rules they imposed six years ago. Starting with a current federal budget shortfall now below that of the average since Reagan took office,2 a unified government should have little trouble dialing up deficit spending once again. While we often take issue with such consensus thinking, higher long-term rates do make a lot of sense. It’s not a sure thing; but we like the odds.
Just as the election woke them up to the realization that there are a lot more angry people in this country who do not think that a free economy with subsidized credit works for them, cliquish investors seemed to recognize that there are at least a few more companies that can thrive in our new world than were formerly thought to be the case. And when growth folk are confronted with an expanding list of “approved” holdings (diluting the impact of their herding), value benefits. Indeed, value (as measured by the difference between the Russell 1000 Value and Growth Indexes) just posted its best quarter since 3Q08.
It's Where You Are, Not How Fast You're Going
“People will agree with you only if they already agree with you. You do not change people's minds.” - Frank Zappa
“It all has to do with the differences between rates and levels.” - Nobody
But as we look to the rear view mirror, aren’t we just doing what everyone else does, extrapolating the recent past into the future? This is going to force us back into a discussion of levels versus rates-of-change, a topic that I couldn’t even find a quote for. Most of what you will read in the popular press is a recitation of growth rates, which are often confused with the thing being measured. But above average growth doesn’t tell you a thing about whether some long-running measure of activity is above trend. Where you are is often way more informative than how fast you’re going.
We forecast normalized earnings and use them to calculate fair value because stocks do, over time, cycle through these levels. While we might not be able to tell (or more accurately can’t) when the market will appreciate a company’s sustainable earnings power, it will at some point. And when we get our estimates correct and that appreciation does occur, the moves toward our targets can be both swift and – if the gap is sufficiently wide – enduring. We’re feeling better because this nascent value cycle is starting from a rather extreme point as you can see on the next page: both with the readily available price/book data and that for the Elm Ridge P/NEPS, short-tolong ratio,3 our primary internal measurement of the overall potential return.
Starting points like these help – with those on the other side so convinced of their positioning – to make the combination of value and momentum so powerful, as cheap stocks start their move, but have a long way to go, toward (and often past) fair value. And that seems to be where we’re starting, as Empirical Research Partners noted this past summer:
The magnitude of the financials’ [relative share in our best quintile of valuation] is comparable to that of the technology stocks back at the peak of the New Economy era, albeit in the opposite direction. Historically when value has become this concentrated and this antithetical to the market the future returns to value investing have been better-thanaverage [see exhibit lower left]. That’s true even if we exclude the bursting of the New Economy bubble, although in our view that’s not necessarily the right thing to do; the whole point of the exercise is to capture periods of extreme dislocation where a segment of the market is trading at unprecedented, and potentially unsustainable, multiples. Back then it was the tech stocks and today it’s the financials, in opposite directions.4
Our work, based on price-to-book statistics (below right), illustrates just how large that tail wind at a turn can be.
For instance, while we’ve already seen a big move in oil, we think that the commodity, and our stocks in particular, have a long way to go – and thus it still remains our largest sector overweight at just over 45% of our long portfolio. We’re sure you’ve all heard the pundits declaring that oil prices will be capped at $50-55 for the foreseeable future, since the industry just “works” at these prices, and the futures curve flattens at $55. (In fact, our energy deck illustrates why the futures curve can be very misleading.) Yet we see a very different story, leading us to expect much higher prices this year.
Let’s start with the E&P spending necessary to offset natural field declines. Next year will mark the third consecutive year in which global spending outside of the U.S. will drop, an unprecedented occurrence over the last 30 years.5 Non-OPEC supplies are now falling at their fastest pace in almost 25 years.6 Before we violate our levels and rates dictum, we will also note that even taking into account the sharp rise in U.S. drilling activity and the accompanying service cost inflation, real global capex will be at a level last seen in 2006. As we highlighted in our last letter, there is little evidence of a return to growth any time soon, as global new project sanctions since 2015 have approximated 1% of supply in total versus the 5-7% needed each year to offset the combination of depleting fields and normal demand growth.
Oh, but can’t the U.S. grow rapidly above $50 and fill any supply gaps? Not likely. We admit that the Permian (and the Permian alone7) seems to “work” at these prices, albeit mostly in core regions with service costs down over 50% (many service companies are generating negative EBITDA). But, even if we assume that the Permian rig count jumps from its current 264 to 450 by the end of 2018, we calculate that its production can only grow 1.7 mmbd in total (averaging 0.4%/year of global consumption) over the next four years.
What gives us greater confidence that prices will trend higher in 2017 are the monthly draws in our global inventory tracker, which have shown substantial declines in each of the last three months, with early indications for draws in November as well (see table below).
Tracking inventory changes is the best indicator of global supply/demand balances (initial supply and demand estimates are heavily revised) and recent data tells us that we are currently undersupplied (pre-OPEC “cuts” and in spite of OPEC / Russia “ramping” into November’s meetings) and working down excess barrels accumulated over the last two years. All of this leads us to believe oil prices will be significantly higher in 2017. And we think our holdings are particularly misunderstood, with our oil E&P stocks trading at only 27% of our 1,200 company universe’s median price/normalized earnings multiple. It’s not a sure thing; but we like the odds.
The Law Of Cantavity
“It’s the law of Cantavity. Whatever can’t go around the corner, can go around the corner” – Huey from Englewood, circa 1974
While Huey was talking to a couple of kids trying to have a Frisbee catch from two different sides of the gym as he left basketball practice, he could have been describing market positioning as well. As trends endure, investors become so attached to the strategies that best capitalize on them that they begin to dismiss any regime changes lurking around the corner. Not so here. As I noted a couple of years ago, it has been our ability, and burden, to see around the corner (but not the corner itself) that has driven Elm Ridge and my career. We think about and attempt to calculate normalized earnings over cycles, not just under present conditions, having made rather successful bets that: the “old economy” was not dead (2000-01); suspicious accounting masking deteriorating business conditions was rather widespread (2001-02); paper, steel and iron ore supplies were coming up well short of demand (2003-05); the housing market was in danger of a serious crash that would in turn inflict some serious harm on our financial system (2006-07); and inventory liquidation in a number of cyclical industries would soon run its course leading to some rather extreme production gains (2009-10).
But, as we noted at the beginning of this letter, the sheer length of the macro and investing regime prevailing since 2010 has left us high and dry (and my daughter accustomed to only one type of report). Well, it now looks as though what can’t go around the corner might already be coming around the corner. And this is where we thrive, as our focus on normalized earnings has its best payoff when the is’s and should’s start out in different continents on their way through the same zip code.
Now Evan McCordick, who runs our investor relations effort, probably heard just enough of our “should’s” to check if we really did do a decent job forecasting normalized earnings per share (NEPS) over five years, upon which our process depends. Indeed, he found that we have remained remarkably accurate in this effort.8 On the long side, you need to remember that our portfolio companies sell at very low entry multiples,9 as controversies brew over their future earnings prospects. There is almost always a visible condition or threat to future profitability and growth that scares away investors. We take the other and clearly more provocative view, with our median forecast of earnings (the green dotted line) doubling over the ensuing five years.
The earnings posted by our longs (green solid line) do eventually come up somewhat short of the median of these 5-year forecasts. But, on average, from a starting point less than half our NEPS, they reach 86% of that target without too much dispersion across the different vintages.10 Compare this to the S&P bottoms up estimates that, on average, have come up 7% short for just the following year.11 Moreover, given their low multiples, we would guess that most investors think that these companies can grow at 75% of the Street’s always optimistic (13% on average) bottoms-up company growth estimates12 at best, and thus think that the red dotted line is the best straw man we can find (since we don’t really have a real one) for our competition. Indeed our longs’ 90% five-year cumulative earnings growth (13.7% CAGR) has both dwarfed the 29% figure (5.3% CAGR) posted by the S&P (blue line) and what we think are our competitors’ expectations. Note that our sample includes many companies that beat our numbers by a considerable degree. It is these stocks that generate the high payoffs that define our process.
On the short side, our positions are, on the whole, loved by their acolytes who extrapolate and amplify recent earnings growth without much rigor.13 Here, the dotted green line shows that we have expected earnings growth of about 19% cumulative (3.5% CAGR) over five years. Since we tend to give an 8% after-tax return to redeployed free cash (e.g. acquisitions, share buybacks), and assume ongoing inflation at the 2% level, this trajectory implies that we are assuming that real operating earnings actually decline slightly over the forecast period.14 Once again, we are a little too provocative. But our shorts’ earnings still settle in at just 8% above our forecasts, having generated an S&P-trailing, median annual EPS growth of 4.9% over five years and well, well below our 125% x 13% straw man red dotted line.
As an illustration, let’s take the admittedly extreme case of California Resources, (CRC). CRC focuses on using enhanced recovery techniques to revitalize abandoned conventional oil fields. Given the volatility of oil prices, most investors we talk to are looking to avoid price risk, and in doing so, are steering clear of CRC. At its fully loaded operating cost structure of just under $30/boe, $55 Brent ($40 net revenue) doesn’t support reinvestment, and we will be the first to admit that CRC’s assets and balance sheet require higher prices to make this a worthwhile investment. However, our work has shown that equilibrium in the global oil market requires oil prices at least $20 higher than today, and when it does we think CRC can generate more than $2b of EBITDA versus $640m in 2016. While the company is indeed quite levered with a $5.2b debt load, it has the runway to allow it to wait for the global re-balancing to occur, with no maturities due until a $450m term loan in September 2019 and covenants that can withstand oil into the low $40s.15 If CRC reasonably traded at a multiple of 6x EBITDA, the implied equity value would be $180/share or 8x today’s price, all before taking into account the $15/share of free cash flow (CFFO less capex required to sustain EBITDA) they could annually generate to de-lever. It’s not a sure thing; but we like the odds.
In fact, CRC reminds me of the Mad Dog, McDonnell Douglas, which in the early 1990s sold for about what I calculated as 1x free cash flow. While the company was financially levered, I was able to derive some sort of comfort in that I could observe inventory (I only needed to use my fingers and toes to count the MD11s and C17s sitting out on the tarmac,16 while taking a flyer that they flew and met government specs), that should have been worth what I remember to be MD’s total debt load. Its stock rose some 15-fold over the next five or so years and was eventually acquired by Boeing.17
Our 30+% deployed in financials again led our performance, adding almost nine points of alpha for the quarter (and ten for the year, after overcoming our first half losses), led by the two monoline insurers (MBI and AGO) and moneycenter banks (BAC and C) that entered October still selling at a fraction of book value and whose stock prices rose by about 40% on average. We noted three months ago that even though low interest rate levels remain a general overhang (although we thought it would be rather difficult for them to decline too much further), we expected our large basic financials (including BPOP and AIG), still selling at less than tangible book value to retire 7% of their shares over the next year, in addition to their 2% dividend yield, without levering up. While their rising share prices will make the buybacks less accretive, rising interest rates are about to provide a rather nice earnings tailwind.
On the other hand, our profits in energy merely offset the large losses posted by RR Donnelley (RRD) and its spin-offs (LKSD in long-run print and DFIN in financial data management) and Hertz (HTZ). In the first case, we recognized that the poorly communicated spins would probably cause some shareholder dislocation and we trimmed a little more than a third of the position during the third quarter. To make matters worse, what should be a still-growing new RRD20 first released results in a manner – without any quarterlies and negatively impacted by non-recurring carveout accounting21 – implying earnings had turned down. It was only as we headed into Christmas Break that the company filed financials showing that core profitability had indeed recovered from the 2015 local sales force reorganization and turned upward again this past summer. A 7x EBITDA multiple would get us nearly a double, and more direct competitors could make accretive acquisitions of the other two companies at 50-100% premiums and still keep all the synergies to themselves.
But the booby prize went to Hertz, falling more than 40% in the quarter and approximately 60% for the year. Hertz has been struggling with antiquated systems and managerial missteps, the existence of which was known. What we failed to appreciate was the extent of the issues. We believe Hertz’s problems are fixable. Indeed, as they integrate Dollar Thrifty, they are in the process of addressing most of them, but these solutions often cause disruption before operations improve. In 2016, with only three players left (Hertz, Enterprise and Avis/Budget), it is likely to show around 1% pre-tax margins, just one-quarter of what they posted just a few years ago under a less favorable industry structure. Meanwhile, both the competitors are reporting results that are flat to improving (and Avis’ pre-tax margins are still in the 4% range), so the industry is healthy. Getting back to normal profitability would leave our out year earnings about 2 1/2 times next year’s consensus forecasts, generating a target 3x the current stock price.
Turning back to the short side, where we were somewhat busier during the quarter (adding nine positions during the quarter while covering a similar amount), let us repeat that research here tends to focus on those situations where supply responses (excesses) overwhelm the more accessible demand stories one often sees trumpeted in research and the media. These tend to fall into four general buckets: 1) cyclically-induced capacity; 2) competition from new entrants into a formerly attractive, secularly-growing business; 3) additional supply of an asset class; and 4) herding into a heretofore successful investment strategy. As we noted in September, we think that in the present environment, you could think of 3) as the efforts to create new “safety” stocks and those with high-dividend yields (a number of which are unsupported by cash flow and are financed with asset sales and equity issues instead), and 4) producing all of the roll-ups, platform companies and excess leverage designed to reward activist financial engineers. Our performance here was basically a wash, as the post-Trump rally gave some renewed hope to our cyclical shorts (costing us about 1.5 points of alpha for the quarter and about two for the year), offset by gains in our “safety” stocks (1 and 2) and platform/leverage companies (0.5 and 3.5).
Turning to the statistics that we typically report, low near-term energy expectations are still producing the rare condition where the Street P/E’s of our longs exceed those of our shorts. But we can again repeat that our estimates paint a remarkably different picture. Meanwhile, as noted earlier, the short-to-long ratio for the Elm Ridge P/NEPS (our primary internal measurement of the overall potential return in the portfolio) has continued to remain at elevated levels relative to our history.
On The Corner
“Building a better mousetrap merely results in smarter mice” - Charles Darwin
We’ve been looking toward the corner for a long time – about as many years as I spent on one every night waiting to turn 17.22 Arising out of the abyss in 2008-09, trends endured for so long that new money flowed to those absolute return strategies that promised to capitalize on them with lower volatility at the same time. Many value investors were forced to either change their stripes or shut down, leaving a situation where we look very different from even those who carry the value moniker (see charts below). But the old game looks played out. And as we may be at the corner of a new regime, and a new game, those who chased hedge funds as some magical provider of low-vol and market-beating returns are now off chasing new fads. It now looks like they’ve set their sights on private equity,23 where past results look great as cash deployed at the much lower multiples of 2009-11 gets turned at today’s higher valuations.24 We’ve seen this before and know how it ends.
But on the other hand, we understand that there are at least some, more thoughtful, long-time and long-term investors who want to zig when the crowd zags, and are redeploying assets toward equity absolute return as the past regime has left us with such large valuation gaps that “need” closing. These are the people we want to speak to, and would appreciate any help in that effort.
It looks like it’s our turn now. It’s not a sure thing; but we like the odds.