Hazelton Capital Partners commentary for the third quarter ended September 2021, discussing their top holdings; Renewable Energy Group Inc (NASDAQ:REGI) and Micron Technology, Inc. (NASDAQ:MU).
Q3 2021 hedge fund letters, conferences and more
Dear Partner,
Hazelton Capital Partners, LLC (the “Fund”) declined by 7.8% from May 1, 2021 through September 30, 2021 and has returned 7.0% year-to-date. By comparison, the S&P 500 returned 0.6% during the same quarter and 15.9% year-to-date.
The Quarter in Review
Hazelton Capital Partners ended the 3rd quarter with a portfolio of 16 equity positions and a cash level of less than 10% of assets under management. The top five portfolio holdings, which are equal to roughly 57% of the Fund’s net assets, are: Renewable Energy Group Inc (NASDAQ:REGI), Micron Technology, Inc. (NASDAQ:MU), Caesars Entertainment Inc (NASDAQ:CZR), Apple Inc (NASDAQ:AAPL), and DXC Technology Co (NYSE:DXC). Renewable Energy Group and Micron Technology were responsible for the majority of the portfolio’s quarterly decline, falling 18% and 14% respectively in the quarter. Both companies had earnings that beat expectations and in REGI’s case, guided for earnings slightly better for the upcoming quarter.
In September, the S&P 500 declined nearly 5% as slowing supply chains, disappointing employment numbers, and the delta variant began to weigh on consumer spending. By October 19, the market had not only quickly recovered from the selloff but continued its upward climb. Market sentiment has become very reactionary as investors, fearful of a market reversal, are quick to sell stocks on any negative outlook. At the same time, not wanting to miss out on the upside, investors are crowding into technology names that have little exposure to supply chains or staffing issues (technology jobs pay well and are coveted), especially with the flexibility to work remotely. This bifurcated market will continue until market sentiment becomes less reactionary.
Renewable Energy Group (REGI) - Current Holding
Since the beginning of the year, Renewable Energy Group’s share price has declined over 35% and nearly 60% since February when Hazelton Capital Partners cut its position in half. During the 3rd quarter, Hazelton Capital Partners repurchased another tranche, returning REGI to the Fund’s largest portfolio holding with a share count greater than where the position started the year. Renewable Energy Group continues to execute well in a market where supply and demand pressures remain both dynamic and uncertain. Beneath the veneer of a company that has a track record of meeting/beating its revenue and profit guidance, lies a management team whose main focus is on its supply chain and logistic operations. REGI leverages its competitive edge at both procuring cheap feedstocks and delivering its refined biodiesel & renewable diesel to the highest value markets while growing downstream opportunities. The company recently announced partnerships with both GoodFuels, which supplies biofuels to the marine industry and Canadian National Railway. Both companies are looking to expand biodiesel into their fuel mix to reduce their greenhouse gas emissions.
In October of 2021, Renewable Energy Group broke ground on its 250 million gallon/year (mmgy) renewable diesel refinery expansion at its Geismar, Louisiana refinery. The $950 million project is expected to come online by 2023, achieving a full run rate by 2024. With debt of $550 million and a net cash position of roughly $500 million, REGI’s balance sheet is prepared for the upcoming expansion. About 80% of the long lead items have been procured, and their prices locked in. The construction costs will be spread out over the upcoming years, with 15% of the total construction costs hitting in 2021, 45% in 2022, and the remainder in 2023. The nameplate capacity of the new refinery is 250mmgy but given that all of REGI’s refineries have an effective capacity that exceeds their nameplate, one can expect that Geismar will be producing over 400mmgy (Geismar 1st refinery effective capacity should benefit from site improvements as well). That will greatly change Renewable Energy Group’s renewable diesel mix from 17% to 46% of total production and have a meaningful impact on the company’s future margins and cash flows.
Micron Technology (MU) - Current Holding
It’s hard to explain how shares of Micron Technology, manufacture of DRAM and NAND semiconductor chips, can fall during a global chip shortage. In most industries, focusing on demand can give you a clear insight into what lays ahead for a company. Today, the memory and storage chip industry is no different. However, in the past, companies focused on market share led to the reckless build out of chip fabrication plants (FABs), oversupply, falling average selling prices (ASPs) of memory and storage chips, lower margins, and declining cash flows. As the industry consolidated – there are now just 3 major producers of DRAM and 5 on the NAND side – rational behavior among the key players began to take hold as competitors began focusing more on R&D. Currently, chip pricing remains cyclical although less so than in the past and that cyclicality has a long-term upward bias. The ongoing transition to newer and more robust platforms (3D 176-layer NAND & 1-Alpha node DRAM) has provided the memory and storage chip industry with improved supply capacity under its current manufacturing footprint, ultimately pressuring ASPs. Over the past three years, as most of the large platform conversions have already taken place, being able to add more bits per wafer has reached a saturation point. With no major FAB build outs planned in the near-term by competitors Samsung or SK Hynix, constrained supply and flattening cost curves should lead to durable and upward sloping ASPs once the recent volatility from the chip shortage subsides.
Currently Micron Technology trades at just 8x 2022 estimate earnings. MU is expecting growth in both DRAM and NAND not just from the supply of more chips to data centers, artificial intelligence, the auto sector, and mobile devices, but also from greater demand for gigabyte capacity per unit within those segments. With a healthy balance sheet, improving return on invested capital, and expanding cash flows, not only should Micron benefit from improving future earnings but its multiple should also reflect the transition to a flattening cost curve.
Interest Rates are Still Driving the Boat
In late August, the Federal Reserve Chairman, Jerome Powell, tried to calm inflation fears by reiterating that “longer-term inflation expectations have moved much less than actual inflation … suggesting that households, businesses, and market participants also believe that current high inflation readings are likely to prove transitory." Powell went on to frame “transitory” to mean that the recent rapid increase in both wages and cost of goods will continue in the near term but will “likely moderate.” For those of us not used to the often-obscure language of the Federal Reserve, let me try to translate: Expect prices of goods and services to be more expensive now and in the future. There are two key factors impacting inflation: the source and the speed of the price increase.
The source of inflation, like all economic conditions, is generated by supply and demand imbalances. This was demonstrated during Covid, when people from the cities began to move to the suburbs and the demand for homes inflated suburban housing prices. Currently, the costs of goods have been rising due to inflated shipping and delivery costs. Reopening of the global economy has led to greater consumer demand, especially from the US, and US ports are currently seeing a 15-20% increase in shipments compared to 2019. In 2019, it took less than 40 days to get products from China to US store shelves vs. nearly 80 days today. The extended shipping times comes, in part, from overwhelmed US ports that are unable to unload ships at their prior cadence due to increased shipments and the lack of “free” workable space at the shipyards. A shipyard is a complex ecosystem that unloads, stores, delivers, and reloads shipping containers daily. The speed at which a yard can accomplish this choreographed dance is dependent on space. Because of the significant shipping imbalance that started during Covid (more products being shipped to the US vs. from the US) a glut of empty shipping containers has been building up at the shipyards, making it difficult to find working space to unload cargo ships and drastically slowing the unloading process. This, in turn, is causing a logjam of anchored ships just outside the port waiting for weeks to get a berth to unload.
Once unloaded, getting shipping containers to the warehouse and distribution centers has also been a challenge due to a shortage of truck drivers. It is estimated that there are currently 22,000 fewer truck drivers in the US than in 2019 and to attract drivers, trucking companies have had to increase their wages and benefits. In addition, as shipyards are limiting the amount of empty shipping containers they are willing to stockpile, truck drivers/trucking companies are scrambling to find places to store the empty containers in order to return to the shipyard, slowing down the delivery process even further. All of these headwinds are causing delays in addition to the higher shipping and transportation costs that most retailers and businesses are forced to pass along to their customers.
The rate at which these costs are rising is also impacting consumers and the economy. Most consumers are used to the idea of “creeping” inflation, where goods and services have an upward bias over time. Business can often adjust their expenses or structure deals with their suppliers to offset the impact. However, when costs continue to spike higher most businesses have no alternative other than to pass those higher costs of goods onto their customers. In the short-run, consumers may be accepting of the higher costs but, over time, even consumers flush with cash will begin to reduce their spending habits, decrease restaurants visits, pause monthly subscriptions, and cut back on holiday travel. Although it appears that we are not at that stage just yet, continued higher expenses and uncertainty could cause the US consumer to recoil.
In addition to inflation, the US economy is also facing headwinds in the form of an exploding national debt (~$29 trillion), ongoing domestic and geopolitical conflicts, and the continued overhang from the Covid-19 pandemic. In the past, any one of these headwinds would have easily disrupted the stock market’s upward glide path. So how is it that the stock market continues to appreciate unabated? The one economic variable yet to be mentioned is interest rates. What the last twelve years have taught investors is that cheap and accessible money can overpower most economic and geopolitical headwinds. Providing cheap and accessible money is like pouring lighter fluid on a barbecue, it will create an intense fire, but the only way to keep that towering fire going is to continue dousing the flames with lighter fluid. That is exactly what the Federal Reserve’s “zero” interest rate policy and monthly bond purchases (~120 billion/month) were designed to do.
“Winter is Coming”
The Federal Reserve is expected to begin tapering its monthly bond purchases by year’s end in advance of raising interest rates. Consider the Fed’s tapering to be a clear indication that the carefree days of summer are coming to an end and it’s time to start preparing for the change in seasons. In the HBO series, “Game of Thrones,” the phrase “winter is coming” is used throughout the series as a reminder that challenging times lie ahead.
The ongoing uncertainty surrounding geopolitics, interest rates, and inflation will have an impact on the markets, but will this affect the way Hazelton Capital Partners manages its portfolio? The short answer is no. The more involved answer is that market headwinds will not change the Fund’s investing criteria, but they may influence the margin of safety required before investing.
It is a lot easier to ride a bike when the wind is at your back. Riding into the wind requires more energy, focus, and time to get to your destination. A strong investing headwind, all things being equal, will require a greater margin of safety as more uncertainty is created as to when the company’s share price will reflect its future intrinsic value. In the short run, headwinds can disrupt a company’s business model, negatively impact its profit margins, and, if left unchecked, reduce its competitive edge. It is important to remember that a company’s value today is a discount of its future value based on its expected revenues, margins, earnings, and cash flows. Since those future metrics are uncertain, the company’s stock price today is more a reflection of changes in market sentiment. However, over a longer period of time a company’s share price will reflect management’s ability to improve revenues, margins, and profitability.
Embedded in Hazelton’s core strategy is a 5–7 year investing horizon, reflecting the historic business cycle which is roughly 5-1/2 years long (trough to peak). Given that Hazelton Capital Partners tends to be early in its investments, the Fund rarely initiates a full position from the start, choosing instead to invest gradually in tranches that reflect a growing margin of safety. Having a long-term outlook helps the Fund weather the periodic financial storm, flood, and hurricane. However, these supposedly infrequent events have been occurring with chronic regularity and disruption making it difficult for investors to remain calm and anchored to a longterm plan.
Winter is always coming. It has been a long time since the US economy has had to deal with inflationary pressures, let alone the possibility of rising interest rates. Investors have naturally forgotten that companies can continue to prosper even during economic headwinds, it will just take more focus and time. Having cheap and easy access to capital has been a huge tailwind for the equity markets and the main reason why the stock market has appreciated to its current level. Unfortunately, a company’s ability to borrow cannot offset the current supply chain bottlenecks and labor shortages that inflate prices and impact corporate margins. Hazelton Capital Partners fully expects there to be continued disruption and downward pressure on the market and its portfolio as assets move from the weak hands of reactionary investors to the strong hands of long-term investors. As long as there is a meaningful margin of safety between the current price of a stock and its future intrinsic value, Hazelton Capital Partners will continue to invest for the long-term and not try and time the market.
Investing in Hazelton Capital Partners
Hazelton Capital Partners was created as an investment vehicle, allowing those interested in long-term exposure to the equity market to invest alongside me. With a substantial portion of my own capital in the fund, I manage Hazelton Capital Partners’ assets in the same way I manage my own capital. The best source of introduction to potential investors in the Fund has come from those that have invested or followed Hazelton Capital Partners progress over the years. Introductions are both welcome and appreciated. If you are interested in making or increasing your contribution to Hazelton Capital Partners or just learning more about The Fund, please feel free to contact me.
Please do not hesitate to call me at (312) 970-9202 or email me [email protected] with any questions or concerns.
Warm Regards,
Barry Pasikov
Managing Member
Hazelton Capital Partners
