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obliquity portfolios

Perhaps more surprising than the results itself was the market’s reaction to Britain’s exit from the European Union: for such a momentous event, it was very mild, not getting materially out of recent trading ranges, and with the FTSE100 (though a poor proxy for the British economy) back where it was before the vote at the time of writing, with only the rather modest GBP re-rating remaining material.

Portfolios almost unchanged

I couldn’t find any noticeable distressed prices in my watchlist(s) and only sold Panmure Gordon, in the Stamp collection, on the grounds that being a small broker focussed on the London small cap market may not be very promising, as business is delayed or shifts to other places. Companies I hold are are biased towards exporters and  otherwise not UK-centric stocks, which has worked reasonably well despite the London listing bias.

Is the market right?

Is the market dominated by trading noise, or is it successfully predicting that Brexit will have little negative impact? Uncertainty will certainly be there but the outcome is hard to predict. Negative scenarios are all other the press, but one can imagine a few positive ones as well:

  • On consumer confidence, ex-UK consumers will probably ignore it, or plan holidays to the UK. UK consumers might prove stoic, optimists perhaps balancing pessimists. It’s hard to imagine that it wouldn’t at least slow down the housing market (in transaction volumes if perhaps not prices).
  • Business investment should be down, from some plans being frozen or moving elsewhere, though the outlook seemed pretty positive before the vote, down a bit from there may remain positive.
  • Sterling devaluation, if it persists, which is not a given, may help a bit. It could also remain at a sweet spot: big enough to help but small enough not to trigger enough inflation for the Bank of England to have to tighten monetary policy. Indeed, business investment slowing down may be all the tightening that’s needed.
  • Last but not least, there may be positive impact from EU re-focussing (see below).
Doc Marteens with Union Jack toe

Britain kicks arse? (credit: I Ransley via Flickr)

The European Union becomes the Eurozone

A potential positive side-effect of Brexit is that it might help refocus the European Union on improving its institutions, in particular finishing off building the Eurozone.

The United Kingdom was perpetually only half-way in, making the whole system an unwieldy variable geometry construction, both adding complexity and slowing down integration as exceptions piled up, and other member states had a strong incentive to get their own special case deals. When membership was irreversible this made sense, but if it turns out leaving has a precedent, that is not an unmitigated disaster, then there’s a way out. Then, variable geometry need not be inside the EU but between EU membership and the various forms of association around it (e.g. Norway or Switzerland style deals).

This enables the EU to become the Eurozone: the Eastern European states are committed to join; Denmark is de-facto in economically as they operate a fixed exchange rate system with the Euro; Sweden entry seems permanently suspended due to a failed referendum, but then they, or other reluctant members, could choose to either come in or leave and get a UK style deal.

So we have both a simpler and clearer framework institutionally, and an incentive to escape the current deadlock on Eurozone construction, as the choice between further integration or dismantlement becomes clearer and clearer. If this works out, it could be of great benefit to everybody, including the UK, which would be (much) better off with prosperous partners.

As a short term little bonus, if some business, financial or otherwise, moves from London to the continental financial centres, it’s a mini-Keyneysian stimulus programme for the Eurozone, which may help accelerate the recovery process.

Maybe the whole world will in the end need to thank UK voters for their selfless, if unwitting, sacrifice.

A few portfolio updates:

Volex reweighting

Doubling down (once again) on Volex, the troubled cable manufacturer. As this was under half weight, this is under the scope of the “sell or top up” for stocks below half of the reference allocation. This is in Obliquity London.

This is a classic obliquity-style stock, and priced on a distressed basis. The recovery process has produced serial disappointments, rotating top management at a frantic pace. Major shareholder Nat Rothschild is now full time in charge, as executive chairman, and I think he seems to have the right long term vision so I’ll give him another chance. Short-term funding issues seem resolved as well.

Plastic is fantastic

fox-prilep-sivec-blocks

Anybody buying? (credit: Fox Marble)

In the stamp collection, speculative marble digger Fox is out. It was a fun punt from a couple of years back. On reflection it fails most of my current small cap tests: I wouldn’t trust the somewhat slimeballey CEO with my wallet, it’s not obvious whether it’s a long term operation or a stock promotion, takeover potential is probably limited as there isn’t an obvious buyer for whom it would be a good fit (it’s not really mining, and other marble market operators may not want Kosovo exposure), and banks would probably not loan due to the country risk (expropriation, corruption, etc), and it’s far from being profitable, let alone make a million a year. So actually it’s almost a complete mismatch!

The cherry on the cake was the company PR emphasizing a deal with a distributor, which on cursory research with Companies House and web searches, seems to be a one-man shop created last year…

Of course it’s gone up 15% the day after I sold, but that’s par for the course.

Ascent and descent

Lest we have no fun at all, I’ve topped up again with speculative punt Ascent Resources (see previous episodes). At 0.6p, this is well below exercise price of the recent batch of executive options (around 1.5p) and below the credit notes’ option value (1p). A few days later main creditor and fund manager Henderson topped up at the exact same price, which I find reassuring. They had a setback on getting permission for an on-site processing plan, but they have a plan B (now plan A) of sending it off to a neighbouring country with a partner with a use for it there, that might still work out.

So, I’ve totally failed to follow my “blog before trading” rule these last couple of months. Maybe at a cost. Let’s catch up.

Obliquity London

Regular maintenance here, exiting Rexam which is (very slowly) being taken over by American competitors. Big mergers tend to be overpriced, though the long regulatory process has forced them to sell some assets which may mitigate that. But I’m not keen on having US mid-cap positions in this portfolio where they’re expensive to trade — although I have kept Steris when it reverse merged into UK-based Synergy Health last year.

A mid-cap position in Sthree, a plain regular classic quality-style recruiter was added to the portfolio. Exposure to the recruitment sector, along with Manpower, is probably complete now.

Stamp collecting

The position in Ascent Resources was halved during a speculative spike on news they might be taken over. This is a single project natural gas rights in Slovenia, from a notoriously accident prone company with a long history of failed projects — hence a discount to fair value, I’m betting.

The one remaining project has been stuck in a regulatory and funding conundrum for year and they’re making noise it might unlock this year. The takeover attempt produced a spike in the price, with hindsight it may have been better to sell the entire stake but now it’s gone back to earth I’ll sit and wait in case it either works out (the project start producing gas and the shareholders are not completely diluted) or perhaps more likely there’s another speculative spike.

The corporate structure is interestingly convoluted: Henderson Investors (and a few minority partners) own about £10 million of convertible loan notes (used to keep the company on life support while waiting for permitting to progress all these years) that they can convert to shares (at 100 shares per pound of loan value) thus diluting current shareholders to about 20% of the company. But if they did exercise in full, they’d own the company outright, which is unlikely to be either legally possible or simply desirable for fund managers. So in an exit they may have to negotiate their stake at above the loan value but possibly below the theoretical full dilution value.

Penguins on a beach

Investors in Falkland Islands Holdings waiting for returns.

On a more rule-based adjustement, I doubled the position in Falkland Islands, a most eccentric mini-conglomerate which has been perennially cheap. They’ve sold their oil shares and are reducing Falklands exposure, which is just retail and services by now, probably changing name, so might decouple from being seen as an oil-linked stock which might help towards a re-rating, perhaps. The rule triggered here was to either sell or re-weight positions falling below 50% of target.

I couldn’t resist adding to my collection of falling knives with Snoozebox, who also incidentally have some of their container rooms stuck in the Falklands. The already depressed price sank after the CEO departure and a profit warning with the dreaded “going concern” notice.

I think they had a good concept with very poor execution: the original container rooms were not adapted to short term events, their core proposition, as the cost of moving them and setting them up will be too high. Current management understands that they need to redeploy this stock of container rooms on semi permanent assignments, and do the event accommodation business with more appropriate products, which they have just finished developing (foldable trailers, inflatable rooms). They’ll need funding to scale the latter, and or support the legacy business if it doesn’t get enough tenants to break even. Failure and/or dilution is a clear possibility, but success is also possible and it’s now priced as an option with odds towards failure. The price sank further the day after my first buy, possibly on a sell recommendation from Investor Chronicle, so I added up some more.

On the art of knife juggling

It may be too early: falling knives are probably better caught when they start getting better, after a few years, as it not only avoids those who sink straight down, but the market seems to have memory of the failure and to take time to accept good news after a few years of poor results. This would combine well with my new “net income > £1m” rule (here catching things emerging from losses). I will still keep this position as the trading spread is huge and I’d be upset if it does recover quickly, but I should perhaps avoid that in the future. Having blogged it first might have helped moderate speculative urges, as would perhaps being fully invested (so that buying something requires selling something with worse prospects). Thankfully my position sizing for small caps is very modest.

I’ve been an oil bear since last year, which has worked out quite well so far. It may be a good time to summarise my case. I should have written about it earlier, as it’s starting to become mainstream!

Demand and supply

On the demand and supply front, the big shock is increased from US shale. This is well known, but it seems to have taken some time to make an impact. Besides, many US exploration ventures are funded by a lot of debt, so not flexible as they could be — they’ll keep pumping as long as operational cost are break even. Exploration and setup costs are sunk costs, and leveraged structure prevent waiting for better times. Rapid technological improvements in extraction add to the price pressure.

Shale also applies to natural gas, which has seen it’s own supply boom, likely taking market share for some oil applications (NG vehicles?). For electricity, renewables have been getting from insignificant to a minor player, which is also more competition.

On the demand side, it seems merely steady, or facing downward pressures (“China”, austerity). With all that no surprise the price has to come down.

Besides known reserves are vast on a human lifetime scale. If we keep facing static or slowly increasing demand, speculative exploration could be totally suspended for thirty years or more, and the world would be unlikely to run out. This is a challenge to new exploration, which is merely adding to the glut.

Politics

On the politics side cartel agreement seems harder to obtain than in past cycle bottoms. US producers and OPEC agreeing seems very improbable. Even the recent partial deal between Russia and Saudi Arabia — keeping production at the current relatively high level — might be difficult to maintain as producing more to compensate for lower revenue per barrel will be a temptation difficult to resist.

Climate change policies may work out in reducing demand (at least some).

Cycle timing

Commodity cycles — over-investing when prices are high and under investing when they are low — tend to be quite long (5-10 years) as it requires project planning to flow through to reality on the ground and there’s lot of inertia around.

There are several signs of not being at the bottom, like high volatility, media interest, bullishness of traditional oil sector investors although this may be turning.

A strong contango (higher prices on contracts for future deliveries) is a sign of probably excessive hope, and keeps supporting production at above-spot prices — until it doesn’t.

The money shot

Not making any precise forecast, but let’s say that WTI is probably going to stay in a range $20-$35 until at least the end of 2017, with perhaps short lived escapades on both sides of the range.

Back to the trading floor

This post is really just an excuse to make a portfolio update less boring: in addition to selling BP and Total, as previously discussed, I’ve sold Petrofac. Although they seem well equipped to survive a downturn, the market will probably ignore that for a long while (the name of the company may be a curse). I’ve added more Amec Foster Wheeler, which is a more diversified (and further diversifiable) engineer at a distressed price (hence being underweight in the portfolio).

This is despite not being supposed to do significant sector bets in the Obliquity portfolios, but I make an exception in order to minimising regret: I’d be pissed if I’m right on oil while owning sector losers. It’ll be easier to accept missing a sector rebound (if possibly costly).

On the trading front, I’m short contango and long crude carriers (the speculators will need storage, while the carriers’ share prices have been moving down with oil) via options.

Finest English toiletries

Today adding Creightons to London Stamps. I was mostly sold from this video presentation. It seems a neat little business for an outright silly price. In addition to passing my check list, it’s very illiquid which I like — I’m happy to wait for normalisation and can survive getting stuck if not. There’s some insider control, which I don’t usually like, but it seems spread between several people who seem benign. I don’t quite understand the market but it does not seem rocket science either, happy to bet on the management here.

There’s very little else to say about it, possibly a good thing.

Diesel fumes

I didn’t buy it at the best time — it was quite fashionable at the time — but I like cyclical generator and chillers rental business Aggreko in Obliquity London, so I’ve put it back up to full mid-cap weight. The portfolio is possibly diversified enough, so consolidating or selling positions that have become underweight seems appropriate at the moment.

Despite having a notional check list for small caps, I’ve not been very careful with checking it formally. It’s also a good time for a review as my small cap investment style is maturing.

Picture of earthquake survival checklist

Earthquake survival checklist (credit: David Pursehouse on Flickr)

Owner business

As a replacement for the vague “useful business”, I’ll now try to answer the question: “would I like to own, and possibly run, this business as a private company?” However preposterous for a pint-size armchair investor, the idea is that it’s a business I must be interested in and understand enough, and would be happy to be stuck in (swapping CEO roles or even a majority stake in a private business is considerably illiquid compared to flipping listed stocks). This should eliminate a whole class of scams, and encompass classic criteria like “do not invest in things you don’t understand” or “invest like a businessman”. Besides, if one likes a business it’s much easier to weather price weakness, as one can emotionally compensate for (potential) financial failure with satisfaction from higher purpose (within reason).

Takeover potential

I’ve realised that since starting the portfolio many of my small cap exits are companies being taken over by larger groups. This is a pretty nice way to manage small cap exits: no transaction costs, usually a price premium, and no decision to take. And it makes a good sanity check new investment, as a company must be in some shape to be worth taking over.

The wallet test

As a simplified version of the executive character test, I have to ask myself “would I lend my wallet to the CEO for safekeeping?”, trying to guess that from hints in CEO interviews, reading reporting narratives between the lines, or interviews by trusted third-parties. (Idea first seen on the Value and Opportunity blog.)

Access to bank lending

This is about finding out whether a conservative banker would lend to the candidate business. This implies a solid balance sheet and somewhat predictable cash flow. It can be inferred from regulatory reporting on credit lines or covenant updates, or guessed from the balance sheet and business model.

Minimum (expected) profitability

Is this business making at least £1 million (or equivalent) profits annually, or, for recovery situations, can it be expected to reach that within the next 3 years? This takes out things that are too small to be listed, or too far away from break-even. Most story stocks (notoriously disastrous as a class) should drop out here.

The pass rate should be at least 4 out of 5.

In the spirit of the obliquity principle there’s no price or valuation test (other than that implied in the takeover test). Looking at the price too closely is probably counter-productive — I’d expect buying blind based on the above checklist should already give appreciable outperformance compared to small caps as a whole. And in any case I can’t help doing it, which is not incompatible with passing the check list, which is just a minimum standard.

A review of the existing Obliquity London Stamps portfolio holdings is now due.

Hubris

Here is a belated report on (breaking my rule on writing before trading here) for the sale of Tungsten in London Stamps.

Tungsten is an invoicing network that processes supplier invoices for blue chip companies. The processing network is barely break-even and the business model was to make money on value added services, notably invoice discounting (factoring). It’s a fair idea, and goes well with the theme of banking disintermediation which I think will be relevant for some years to come. The problem here was that the approach was full of hubris, which fell flat so far.

The company has now re-framed its ambitions and management: same business model, less hubris. Perhaps not the time to sell, but it’s still materially loss making, and the market hostile. Break even is probably at least two years away, with probably a fundraising or two in the pipeline, so more one for the watchlist, to revisit in 2017, maybe. The market will forget having been burnt, but in the next few years the memory will probably cap the upside. Basically I think it’s highly likely to get cheaper before it gets better, and that some years away.

I probably shouldn’t have invested in hubris, though my rationale was that they only needed to achieve 20% of what they promised to justify their valuation.

But hubris is costly. For instance, reading between the lines of the latest update one guesses they structured the deal with their financing partner so that it paid off above high volume thresholds, so modest but real factoring volume produces zero income…

Gadgets

The proceeds were reinvested in Toumaz, doubling down an existing position back to median weight. I’m still confident the new health products have a chance of success. Liking the product range, I’m happy to give it a chance longer term.

Losing the bulk

Interbulk, the dry bulk business will soon leave the portfolio as the company is being taken over. This was a bet on their market turning from cyclical lows. The company was heavily indebted but with cash flow just enough to fund the cost, and backed by large logistics company who are the controlling shareholders who could support it through bad times, it did not seem too likely to go bankrupt.

Obviously someone else will get the full upside (if any), but as a 30% profit above cost, and a large premium on the recent share price, I can’t complain. The risk the controlling shareholders would not be nice to the minority was also a potential issue.