Valuentum Exclusive Yearly Round Up
publication date: Jul 11, 2019
author/source: Valuentum Analysts
Select the following link to access the Annual Exclusive Call.
Transcript Provided Below.
President of Investment Research Brian Nelson:
Ladies and Gentlemen,
Thank you for your attendance. Today marks three years since we first launched the Exclusive publication.
The Exclusive is our premiere offering for sophisticated investors and builds upon our successes of the past, not only in establishing one of the first methodologies that successfully blends enterprise valuation with behavioral valuation and technical and momentum indicators, but also in making such a process available to individuals, financial advisors and institutional investors in full transparency.
The Exclusive publication is in many ways an extension of the strong performance of both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio as well as arguably one of the greatest high-profile stock market calls in history, Valuentum’s bearish case on Kinder Morgan (KMI) and the MLPs (AMLP) in mid-2015. We have not rested on these laurels. While many may have thought this enough, we said no, and we put our reputation on the line again to roll out this publication we are talking about today.
During the past three years, we have now highlighted 108 ideas in the Exclusive, fully presented in thesis form. We are not throwing darts at the dartboard in selecting these ideas. We are not picking tickers based on a gut feeling, but our work is backed by the experience and analytical know-how of a team that lives and breathes success. We are not interested in just highlighting ideas for members, as in the case of most blogs or content farms. We’re interested in highlighting winners and backing our views with in-depth analysis.
That has been our focus from the very beginning, and I’m very pleased to say that we have delivered on our promises. When we first launched the Exclusive, I believed that average performance would mean a success rate of 50%, great performance would mean a success rate of 55%, and fantastic performance would mean a success rate of 60%. I’ve always focused on setting the right expectations for our members, but I could not have imagined the success rates we have achieved.
For capital appreciation ideas, we have posted a success rate of 83.3% (30 for 36), and this success rate includes some huge winners. Swedish Match (SWMA.ST) up nearly 40%, Wingstop (WING) up nearly 120%, Qualys (QLYS) up nearly 50%, Square (SQ) up roughly 90%, Planet Fitness (PLNT) up nearly 40%, Invitae (NVTA) up nearly 50%. These are some real home runs (closed for huge "gains"), and we keep coming to the plate and belting them, too. After watching the Home Run Derby Monday, I feel as though we’re hosting our own little home run derby in the Exclusive.
But we cannot forget that the markets have been resilient during the past several years, but this only makes the following stat even more impressive. 75% of the short ideas highlighted in the Exclusive publication have worked out, and there have been many sizable winners in this category, too. Lloyds Banking (LYG) down 16%, GoPro (GPRO) down 33%, Snap (SNAP) down 26%, Del Frisco’s (DFRG) down 17%, and Installed Building Products (IBP) down 29%. Again, this success rate for short idea considerations comes amid a strong bull market.
We are pleased with the performance of income ideas. Our members in the first year of this publication demanded that we focus more on the long term with the income ideas, so we migrated the format to assessing how they have performed with respect to income expansion until close. Adjusting for currency, not one idea has cut its payout. We cannot go back to evaluating income ideas for capital appreciation, nor can we evaluate capital appreciation ideas for income. These are two different categories with two different approaches. For those investors focusing on total return, the capital appreciation category may be most appropriate.
I must mention Value Trap, Valuentum’s first book. In it, we explain a great many things, but most importantly that the dividend is but capital appreciation that would have occurred had the dividend not been paid. Certainly, this is just one instance of how we try to deliver investors the truth and cut through the sales process, and while we are big fans of income and dividend growth, we want the Valuentum name to be synonymous with the idea of presenting our views with candor.
I strongly encourage each and every one of you, if you have not already, to study the material in the book. It gets to the core of what we live and breathe at Valuentum, but so much more. Value Trap truly aims to redefine the field of finance in a forward-looking manner. Without you, our dear members, Value Trap would not have received acclaim from the prestigious Next Generation Indie Book Awards, nor would it have been among the best-selling books on Amazon for the category of Valuation to begin this year. Thank you.
Today, finance is faced with a great challenge. Nearly 80% of the stock market is on auto pilot, either investing in passive instruments or engaging in quantitative algorithmic trading, both of which pay little attention to the concept of intrinsic value based on future expectations of free cash flow. Some estimate that only about 10% of trading today is discretionary stock selection. For systems such as indexing and quant, which rely on the active investor to set the right price, the markets are in great danger of breaking down. Perhaps not today, not next year, but in the decades ahead.
Where regulations no longer require due diligence on individual holdings to meet fiduciary standards, incentives are in place for passive and quantitative trading to continue to proliferate, and for prudence and care to fall by the wayside much like the scenario that set the stage for the collapse leading up to the Financial Crisis. In this case, selling index funds for high margins have now replaced repackaging and selling mortgages in CDOs. There are significant problems with the system, not only in rent-seeking fees charged to hold index funds, but also in that index funds and quantitative trading contribute to systematic risk to the market structure, itself.
The outcome of a damaged market structure is not necessarily one of collapse, but rather one of significant volatility. In December 2018, just after Christmas, we moved the newsletter portfolios to all-in on account of our views that the markets would experience a substantial melt-up. Almost impeccably, this has happened, and today the S&P 500 has just crossed the 3,000 mark. Though the markets have always experienced booms and bursts, I believe that in the decades ahead we will see only increased levels of volatility, to the point where the most opportunistic investment opportunities may rest within private equity as market prices become substantially irrational.
Stock selection is simply getting a bad rap. Many may believe that the 90% underperformance of active funds over the prior 15-year period is due to traditional equity processes, but this performance is a function of passive and quant, not the prudent, intelligent investor, or those practicing variations of the Graham and Buffett discipline. It is clear based on the success of ideas that we put up in this Exclusive publication that stock selection, if done prudently and within the context of a diversified portfolio, is very much relevant to achieving goals at a low cost.
The false dichotomy of presenting either active or passive funds or ETFs must not stand in such an abysmal marketplace for active funds. Investors need more choice, and that means an advisory community that is equipped to build customized stock-based portfolios that meet client needs, portfolios that are grounded in due diligence and prudent risk-taking. Just because active funds are underperforming does not mean that index or passive is the answer. It is a logical fallacy, a false dichotomy, and the industry must adapt.
However, the industry is doing more of the same. More quant, more machine learning, more artificial intelligence. Finance needs a new plane of thinking, not the same old way of doing things. We have already witnessed what can happen with quantitative models that embrace backward-looking analysis and spurious correlations. The Gaussian copula function almost killed Wall Street during the credit crunch of late last decade, a quantitative formula that could turn just about anything into a triple-A bond, or CDO. You know the rest of this story. The quants brought the financial system to its knees years ago, and the seeds are being planted again.
Congress didn’t just bail out the banks and the mortgage markets during the Financial Crisis, but it bailed out the thinking that led to the demise. Today, the catch phrases evidence-based and empirical are nothing more than sales pitches to attract a public that demands some certainty, and certainty with realized data can be provided, even though it may have little to do with actually explaining stock returns.
That we have nearly 80% of the market not even considering future forecasts, with many just looking in the rear-view mirror, should be concerning. We cannot blame stock picking for the vast underperformance we see in active funds today, but rather the proliferation of a mindset that doesn’t stand a chance of winning. The value of any asset will always be a function of future expectations. That investors are still trading on spurious correlations based on ambiguous historical data is simply tragedy.
Just like good manners, individual stock selection will never go out of style, and that’s our focus with the Exclusive. It would be inaccurate to tell you that you should expect a success rate in the 75%-80% range to continue, as we have achieved with capital appreciation and short idea candidates. In fact, I think it would be very foolish for me to say that we can sustain at such high levels of outperformance, but then again, I have severely underestimated what we have already achieved, so I remain optimistic, and I am a firm believer in our team’s abilities to keep the Exclusive one of the best publications out there.
In addition to what I believe are real risks of a market structure breakdown, we continue to monitor global developments. Deutsche Bank’s (DB) recent troubles may be the start of something more serious on the European continent. Across the pond, the ECB is hinting that it may restart its quantitative easing, and now some $12.5 trillion dollars of bonds are negative yielding. More than a dozen junk issuers have euro-denominated bonds that have negative yields, too, and according to the Financial Times the average yield of the global bond market is just 1.8%.
The US economy is the strongest it has ever been. Inflation is tame. Unemployment is near the lowest levels it has been in decades. The S&P 500 is near all-time highs, and so far, the markets have even shrugged off the behavioral implications of an inverted yield curve. Right now, things are going great, and S&P 500 (SPY) stocks themselves aren’t terribly overvalued trading at a 12-month forward P/E ratio of 16.9, according to FactSet. But the conditions that have driven the markets to such levels may not be sustainable, and forward earnings are incredibly dependent on a healthy China (FXI, MCHI) and Europe (VGK), which simply cannot be guaranteed.
At this point, I’d like to turn the call over to Callum to discuss our outlook on the oil and gas markets and insights therein.
Associate Investment Analyst Callum Turcan:
Thank you Brian.
The world’s two main benchmarks for crude oil, West Texas Intermediate and Brent (OIL, USO), are likely to remain rangebound. While the combination of the OPEC+ cartel extending their production cut deal into 2020 and expected global demand growth will provide a floor to oil prices in the short-term, surging non-OPEC supply will keep prices contained for some time.
OPEC+ agreed to remove 1.2 million barrels of daily crude supplies off the market through March 2020 during the group’s latest meeting in Vienna. The goal is to bring down global inventories to historical levels, particularly those seen during the 2010-2014 period before the oil bust that started in late-2014, during which global inventories started moving significantly higher. An agreement was reached after Saudi Arabia and Russia (RSX) had come to an understanding on the sidelines of the June G-20 summit in Japan (EWJ), showcasing the growing clout Russia has within the OPEC+ cartel. Russia is not a member of OPEC, at least not yet.
Compliance with the deal has been good so far this year, and we expect that will likely continue being the case going forward as Saudi Arabia remains committed to maintaining deeper production cuts than its quota. We caution that when oil prices start to run higher, certain nations have a tendency to begin producing more than their quota would allow with an eye on Iraq, Nigeria, Kazakhstan and Russia. Iraq and Nigeria are OPEC members, the other two aren’t.
Non-OPEC supply growth, particularly in America and Brazil (EWZ), will keep a lid on prices for a much longer duration. No matter how hard the OPEC+ cartel tries to manipulate prices via production cuts, onshore shale and offshore pre-salt plays will keep prices in check.
The US Energy Information Administration reports that non-OPEC supplies of petroleum and other liquids products surged by 2.6 million barrels per day from 2017 to 2018. Furthermore, the EIA forecasts non-OPEC supply will rise by over 2 million barrels per day in both 2019 and 2020, which is largely why OPEC+ was forced to keep the production curbs in play for nine months instead of six. Please note that the EIA is using a broader definition of oil supplies here than just crude, including liquids like condensate in the mix as well.
Against this backdrop, global demand for petroleum products has grown significantly in the recent past. Relatively tame oil prices in the face of rising global demand highlights the very powerful effect non-OPEC supply growth has on controlling prices.
Demand growth isn’t just coming from the transportation sector, demand from the petrochemical industry has been steadily becoming more relevant due in part to the emergence of the global middle class. Specifically, demand for naphtha, which is used as a feedstock by petrochemical plants. Naphtha is derived from the refining of crude oil.
The global middle class is expanding and that’s leading to greater consumption of packaged goods, plastic products, detergents, clothing, makeup and countless other items as those consumers purchased goods we would normally take for granted. Petrochemical demand has legs and is a growth story we like, keeping in mind the space is very exposed to the state of the global economy. We see this is a major long-term growth driver for oil demand.
How that trajectory plays out will be key in determining the longevity of the oil industry as the world slowly begins to lay the foundation for a world without internal combustion engines, inevitably leading to a decline in crude demand from the transportation sector in the distant future.
From 2017 to 2018, the EIA notes that global consumption of petroleum and other liquids rose by over 1.4 million barrels per day. The EIA expects that world demand will continue climbing this year, rising by just over 1 million barrels per day. Please note that the International Energy Agency sees global oil demand rising by 1.2 million barrels per day in 2019, down from its previous forecast but roughly in-line with the EIA’s estimates. There is a slight difference between what the two entities are measuring, but the story is effectively the same.
Demand growth alone hasn’t been enough to absorb surging non-OPEC supplies, with global inventories rising throughout 2018 and during the first half of 2019. While demand is expected to pick up materially in the second half of 2019, the EIA sees global inventories staying broadly flat through the rest of this year.
Both the IEA and the EIA expect global oil demand to grow by 1.4 million barrels per day next year, and therein lies the problem. Everyone expects global demand will keep growing by a healthy clip, something that’s far from certain as forward-looking macroeconomic indicators are flashing signs of trouble. The slowdown in China and Europe, if sustained, could see demand come in below expectations in the face of a tsunami of non-OPEC supply. That combination would surely depress crude oil and other raw energy resource prices.
The real wildcards relate to supplies out of Iran, Libya and Venezuela, all of which are OPEC members. Under President Trump’s administration, America has withdrawn from the 2015 Paris nuclear treaty and instead applied a maximum pressure policy by imposing onerous sanctions on Iran, backed by displays of American hard power in the Gulf region.
Some tanker tracker services report major declines in Iranian oil exports and production, but others aren’t so sure as Iran has been known to turn off their tankers’ AIS transponders in order to use ship-to-ship transfers and other clandestine means to evade sanctions. TankerTrackers’ Samir Madani sees Iranian oil and petroleum exports holding up better than what larger tracking services are reporting. Iran was exporting around 2 million barrels of crude per day in 2018, but whether that’s still the case depends on which tanker tracking service you believe.
In Libya, the NATO-led toppling of longtime strongman Qaddafi in 2011 has created a power vacuum that still exists to this day. Competing governments in the east and west vie for control over the nation’s oil & gas infrastructure. As we speak, the UN-backed government in Tripoli is actively beating back eastern forces that had laid siege to Tripoli in an all-out offence launched by General Haftar in the Spring of 2019. General Haftar is the leader of the Eastern government based in Benghazi. Libya produces roughly a million barrels of crude per day, most of which is at risk of going offline due to the ongoing multi-faceted civil war that has no end in sight.
Pivoting now to Venezuela, not only is the country facing American sanctions, but its foreign currency reserves have almost completely dried up while the nation’s inflation rate is reportedly north of one million percent. Civil tensions keep rising, with widespread shortages of food, medicine, and other necessities prompting millions to flee the country. The nation has been relying heavily on several joint ventures between state-run PDVSA and foreign operators to maintain some level of crude production, which has collapsed since 2015. Venezuela at one point produced around three million barrels per day, but now the country would be lucky to maintain its current oil output of around 750,000 barrels per day.
The joint ventures include partnerships with Chevron (CVX), along with Russian and Chinese entities. If America doesn’t extend sanctions waivers covering Chevron’s ability to operate in Venezuela, which expire late-July, production in the South American nation may move lower still as Chevron would be forced to leave. While Russia or China could step in to fill the gap, output would likely move lower in the short-term as Chevron has been covering the cost of new supplies and equipment, something cash-strapped PDVSA would be unable to do in the interim.
While there is a modest chance crude oil prices could spike higher in the short-term due to a Black Swan event occurring, such as a confrontation between America and Iran that spirals out of control, in the medium-term our outlook is for West Texas Intermediate and Brent to remain rangebound in the $50-$70 per barrel area. Due to pipeline and export constraints, Brent will likely maintain its premium over West Texas Intermediate in the $5-$10 per barrel range, at least until several new proposed Cushing-to-coast pipelines are brought online, allowing for additional exports of American oil.
Thanks for being with us here today, that concludes our assessment of the global oil industry.
Thanks for the great insights Callum.
I’m optimistic about what the future might bring, but we are facing some real risks. The structure of the marketplace is simply under attack by passive and quantitative investing that is being driven by misaligned incentives fueling this fire. US sovereign debt stands at $22 trillion, and across the globe sovereign debt is roughly $66 trillion, or about 80% of global GDP, according to Fitch. This debt-issuance spree has expanded to corporates, too, with some estimating that total corporate debt is now at ~$9 trillion.
Wall Street has a short memory. We just experienced a massive credit crunch just about 10 years ago now, and instead of sovereigns and corporates prudently managing their balance sheets, keeping a tight lid on leverage, it’s as if the Financial Crisis did not happen. Companies now are buying back stock hand over fist, as though easy money will be available forever. Moral hazard has proliferated. Buybacks during 2018 totaled roughly $1 trillion, money that could have been used to shield businesses from potentially having to raise capital at depressed prices when economic conditions slow.
I want finance to learn from the past, the quantitative mistakes of yesteryear that brought the world economy to its knees. The misaligned incentives that created a massive bubble and subsequent housing market crash. The problems of leverage in yet another quant hedge fund Long Term Capital Management that caused panic in the late 1990s. Wall Street is not learning from history, and many are going wildly down the path of destruction. Don’t confuse indexing with a bull market. Pay attention to what you own. Stay diversified, and most of all, do your own due diligence.
This concludes the call today. Thank you for your attendance.
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Callum Turcan and Brian Nelson do not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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