ValueWalk’s Raul Panganiban interviews Crescat Capital’s Kevin Smith And Tavi Costa, discussing their trade of the century idea. In this part, Tavi and Kevin discuss the macro trade of the century, how they evaluate opportunities in mining stocks and precious metals, Chinese banks and stocks, and shorting banks based in Canada and Australia.
Q4 2019 hedge fund letters, conferences and more
Raul Panganiban: Can you guys go over the macro trade of the century and then lay out the foundations for that trade?
Tavi Costa: Happy to, I can probably do that one. So, you know, the macro trade of the century really started by looking at, again, what is at the centre of most of the imbalances that we see in the world today. And what we found is that China really was a problem. It was if you step back, you know, we had a, China was responsible for 60% of the global growth in GDP terms since ’08, and China has really built the 300% of their banking assets relative to GDP. It’s a 400%, normalised growth in banking assets. You know, we’ve had a real estate bubble in China and infrastructure, almost a bubble in China in general.
And from there, we started looking at other places like Canada and Australia and finding issues in their banking systems because of the outflows that capital outflows from Chinese debt from the Chinese economy, they’re really exacerbating the real estate market in those places, and also Hong Kong. So that’s really the start. That was really the credit imbalance that we’ve that we’ve found overall.
And when you look back in history of how to really protect yourself from a credit bust, from emerging markets, in general, especially emerging markets, is that what you find is that sometimes the equity markets can actually rise as long as you have the crisis, especially local currency turns in and that’s mostly because of an inflationary bust sort of scenario.
Sometimes you have the currency crashing completely. Now, the one consistent trade that we found, that actually works, most times I would say almost every time is gold in local currency terms. And that really gives us the idea of of looking at gold and Renminbi the terms and at the time, there was this sort of nonsense. It was very uncrowded view back in the beginning of 2019, a lot of people were saying that China was pegging its currency versus gold.
And we were, you know very much on the other side of that saying that was a completely nonsense. That peg was was just going to break at some point. And it really did was what we call the macro trade of the year was buying gold in Renminbi the terms. But now when you look at that relative to record over value stocks, especially in the US, and one way we find it just to represent in a chart, and this comes more from me of looking for a way of simplifying the idea and putting on a chart, and that’s really where the macro trade centric kind of came about. And looking at the you know, just gold in Renminbi terms relative to MSCI world, which is not even the most expensive index in the world today in terms of equities.
And when you look at that, you can see that there’s, you know, that ratio tends to rise. Not when he will not what not just when you see turmoils globally, but when you also see turmoils in China, like you had in the early 90s. And especially in 93-94, when when China devalue its currency by one third. But in one day, not necessarily what we think it’s going to happen in one day.
But as we think that China it will be the consequences of all this of all this debt build up that China has really has over the years. So I think that’s really how the macro trade of the century came about. And the idea is not just laying that out, but in our view is to search for most of symmetric bets that we can find in terms of that. Is silver in Renminbi terms, is it just maybe perhaps, buying gold in Hong Kong dollar?
Which is a currency that is also linked to China. Or instead of just shorting MSCI world? What are the most expensive stocks in the world today? Can we use our models to find those those stocks? Can we use our model Find the most expensive industries in the world today? What about those Canadian and Australia based banks and Hong Kong banks or Chinese ADRs? Anyways, that goes on that list goes on. So that’s really, that kind of laid out the foundation of the idea itself. But the way we positioned that is a little bit more complex than that, I would say.
Kevin Smith: Yeah, indeed, because we we have over 100 stocks in our hedge fund portfolios, long and short that to express these kind of core macro themes. So we are definitely, one thing that differentiates us as a macro oriented firm is that we’re also value oriented stock pickers and I think that’s a really adds a really unique flavour to how to get alpha relative to the kind of core macro ideas that we have in the portfolio.
You look at the precious metals theme for instance, and you know, mining stocks are just an incredible study and in all the basic, you know, value oriented financial statement analysis, and business analysis that one can do. And we have over 40 different mining equity positions long in the portfolio right now. And while we, while we say that US equities are the most historically expensive they’ve ever been across the board, actually precious metals, mining stocks are the cheapest they’ve ever been. When you look at things like free cash flow among the producing miners, and for instance, there’s some incredible, incredibly low valuations and high free cash flow yields out there today in that space, and we think it’s only going to get better because of the macro environment.
And the fact that that this industry went through about a six year bear market from from 2010 through 2016. And really for the past 8 years or more, there’s been a lack of capital investment in the space. So you have, you have this under investment that is also making a lot of the more junior mining stocks that have the golden ground just the exploration place extremely cheap as well in terms of the resources in the ground relative to the current of the price of gold, to the enterprise value of these companies, and the future likely price of gold.
These companies are going to make some excellent takeout candidates as well just have some of their own internal great future free cash flow as they go into production themselves if they do it on their own. So we are, so we look in and these more in depth ways and in the past few quarters We’ve met with some over 50 different management teams of mining companies to do our due diligence and really flash out what we think are some of the best opportunities there.
Raul Panganiban: Yeah, when you when you’re looking at those precious metals, or mining stocks, do you use like a factor based approach? Or how do you evaluate those opportunities? And then how did you come up with 40 names to pick?
Kevin Smith: Well, it actually started from the macro standpoint of really trying to understand where we are in the cycle for gold itself and given the bear market that it went through, you know, we don’t just, you know, we think there’s a big opportunity in the junior space and in the Explorer space, as I was alluding to, and, and so you know, there’s a little bit there’s different types of factors you want to look at when you’re looking at the companies that just have gold in the ground like EV reserves and resources, for instance, that the the viability of those resources, the cost the jurisdiction, you know, the experience of management, you know, etc.
The more established producers, you know, we’re we’re looking at more traditional metrics, like, you know, like free cash flow yield and growth metrics on production and again, you know, jurisdiction and it’s, you know, we’re so excited about the space in general from a macro standpoint that we want to own across the entire space. And so it’s really that that mix of focusing on value and growth out of the producers as well as some of the best management teams and the best deposits out there that have not been developed yet.
Raul Panganiban: Yeah. And so is this a good time for stock pickers to look over that space and try to pick out a few names and write those out?
Kevin Smith: Absolutely. I don’t think you could get down to give me a better time.
Raul Panganiban: All right, um, yeah, then wanting to get back on China, and Canada banks as well. So with those macro overlays, is it can you or is it the time to like short, certain like bank stocks and Canada and Australia and then shorting certain Chinese stocks as well.
Tavi Costa: So we think so actually matter of fact that Chinese stocks just started to break down now recently, it’s insane that even with the virus outbreak, we’ve had Chinese stocks actually still at the highs of the last month or so and just now begin to really start to break down. Obviously today, it’s going to be a different day, because a lot of everything is up, but we’ll see if that’s going to be sustainable.
But uh, but I think that that’s sort of posing an opportunity to a fund that is looking for short opportunities in general. And in terms of Canada and Australia while they’re commodity economies with strong ties to China and one thing you can you can find in terms of especially Canada is look at the Canadian dollar. How it’s been reacting recently. It just broke down from from a bearish flag in a massive bearish flag going back to the, you know, two three decades and it’s, I think that that’s very telling for for what’s going on in their economy with oil prices collapsing the global economy grinding to a halt.
And also having this sort of slow down in general, especially coming from China that we think it’s even in a more of a contraction mode right now, but when you look at valuations in multiples of those banks, they look a lot like the banks in ’06 and ’07 here in the US, especially in the price to book basis and the valuation of the housing market in those markets is incredible. It’s, this is even worse than some metrics, you know, versus the housing bubble here in the US. So I think that those are the most important parts and also the how leveraged, you can see the households are in those two countries relative to their income ratios and so forth.
And so there’s something there’s something that is not adding up, especially at a time when you have unemployment rate just begin to rise, especially in Canada after being a you know, all time lows. And that’s always an alarming situation. Unemployment rate tends to be at its best at the peak of the cycle when that starts to rise in a year over year basis.
You know, look how below that’s essentially, the signal that that we are, it’s starting a downturn. Here in the US. That’s actually surprisingly, one of the one of the few things that we haven’t really cracked yet fully is the labour market and consumer confidence. But, you know, in our view, that’s going to be on in the next six months. I think unemployment rate is poised to rise here. But going back to your question, I think, yeah, those those are the places where the debt imbalances are, are more prominent. And I think that it’s, it’s what we want to focus on. And in terms of the parts of the short in terms of thinking in general.
Banks in Canada and Australia
Kevin Smith: Yeah, we had a lot of success. I did early on in my global macro fund and long short fund in 06-07 with the housing bubble thesis that we had at that time here in the US. And, you know, we were short homebuilders and banks and brokerage firms, and we’ve been short Lehman Brothers and Bear Stearns, for instance, in both of our hedge funds back then and did extremely well. And key was being being early and all those those themes. Housing stocks peaked out in late ’05 and with the current situation the current housing bubbles in Australia, Canada, Hong Kong, China.
So these are two acts what the housing bubble was here in the US on measures like household debt to income on prices to rents, you know, etc and I know a lot of people have been, you know, talking about housing bubbles and these countries and, and and most people you know have been downplaying. And they know, it’s different or you know, it’s just the way it is. It’s just taken so long, but you will get Australian banks they have finally conclusively broken down and you Those have been some of our shorts for a while. But they are, you know, take a look at those stock prices, they’ve already conclusively broke down.
The Canadian banks, on the other hand, have only more recently broken down from higher from higher levels. But all these, you know, all these stocks not too long ago, the bank stocks were trading at two times book value two times tangible book value. And, and that’s, you know, that’s about the same, the same levels that they were trading out here in the US in 2006, before things started to turn down for them. But but like I was saying that the other imbalances are more than twice, twice as much, whether it’s household debt to income price to rents.
Why Australia and Canada might not be great shorts anymore
And in China and Hong Kong in particular is insane. You know, obviously those, those debates in Hong Kong are broken down, also more conclusively. And those have been some of our shorts, as well and in China. I don’t understand how the banking system in China has been allowed to get the way it is. 40 trillion of assets and people think oh assets that’s good, right? No, the assets are loans and the loans are mostly non performing loans and when your bank you can and when you’re a communist, you know, own bank you cannot, you can just print it and just make more loans. You control the entire money supply, you control the you control the banking system, but if you continuously make loans, more loans to companies that cannot pay them back in the first place.
What you have is an enormous non performing loan problem. It’s not an outright Ponzi scheme and who are the ones holding the bag with this scheme, it’s the depositors in the banks themselves first and foremost. And I think that is the thing that people don’t understand about China. I know, you know, guys like Charlie Munger can say that China has really strong companies and I don’t know how he can say that. Because when we, when we look at the the underlying dynamics of the of the free cash flow and the banking system, and, you know, this government owned communist control, planned economy. That’s not what we see at all. We see a lot of bad lending. And we see a lot of companies that that, you know, that would not survive in a real free market.
Hong Kong better alternative to Australia and Canada
Tavi Costa: I just wanted to add to Kevin’s point especially going back to Australia and Canada and why they do look attractive today is it’s incredible houses industry that Agilent industry in general is shying away from shorting in general markets and, and China away from taking risk or calculated risk for, for for significant upside returns, which, you know, in our view, the the short side really was screaming as a huge opportunity has been screaming for some time now, and especially when you can find smart hedges like we found.
Last year for instance when the precious metal side being incredibly attractive as a long part of the portfolio as you would think that this reliance on central banks would just make them intervene even more and make you know, precious metals prices overall rise in general but I think that that’s that’s that that sort of phenomenon has really made investors to shy away from those ideas and they in our view looked incredibly attractive and is still are there’s a lot of room For, for it to play out in our view.
Raul Panganiban: You know, it’s gonna be my next question if there’s still room with the Australia and Canada trades to short their banks as well?
Kevin Smith: Yeah, we think so certainly on Canada and Australia it’s later in the game just because of how much they’ve come down already. But look at what happened to the banking system here in the US during the global financial crisis and in Europe. And I think you can see there’s a lot more downside when the when the bad loans in Australia and Canada really starts to surface and the write offs. You know, come into play and the recapitalisation and the dilution I mean, there’s still a lot of downside in the banks, we think in Canada and Australia. Hong Kong, on the other hand, is, you know, that’s when it’s the most extreme. That is that is the absolute most extreme housing bubble on the planet. There is a lot more downside there as well.
Tavi Costa: It’s incredible it related to that is also you have all this false thesis that, you know, especially like Australia now Australia never had a recession in the last since the 90s or so. And it is, you know, it is that’s not technically so important for an investor. I mean, Australia had plenty 50% draw downs and stocks during during those times if your investor who cares if he didn’t have recession, he did have a draw to suffer a drawdown 60 plus percent, that that will hurt you regardless.
Japan
So I think that that’s a very important point, not the one that that is also another sort of false narrative is we hear about, you know, this, this environment of low interest rates and you can’t have a recession when interest rates are so low and because, you know, central banks are holding their hands of ambassadors in general, we’ll look at Japan. Japan is one example of that we’ve had in the last 20 years or so, if you look at 10 year, yields in Japan was averaged below two percent I think even below 1%, I guess, or I should say one or 2% for the last 20 years or so.
And and and what’s interesting about it is that they had at least six recessions, technical recessions, and to 60% draw downs and stocks and the valuations of those Japanese companies are not even close to the valuations of the us today. So I think that those false narrative narratives, in our view, at least, will be proven wrong, again, will be proven to be false. And I think that that’s, again, it poses an opportunity for the for the people that are willing to take the short side here.
