Why I Continue To Invest In Oil / Recent Reads / Recent Listens / Happy Thanksgiving!

Why I Continue To Invest In Oil

I’m not actually a masochist, even though it may seem like it with respect to this investment theme.  In Kaoboy Musings 10 & 13, I talked about a deeply contrarian investment thesis I’ve had for the last several years – oil and oil equities.

This has been an extremely challenging space to be invested in during the last several years, but I want to share some thoughts about my thesis and refer to some slides from a deck put out by energy consultant Art Berman (see attached):

LSU-NOV-22-2019_REDUCED-1

This has been an extremely challenging space to be invested in during the last several years, but I want to share some thoughts about my thesis and refer to some slides from a deck put out by energy consultant Art Berman (see attached):

  • Despite the growing share of renewables, oil/gas’s share of world energy consumption will continue to dominate for decades to come (slide 1, 31).
  • The hydrocarbon is, quite literally, the most efficient “battery storage” for solar energy that nature has devised and will be difficult if not impossible to fully displace given the sheer energy density, lack of intermittency, and economic efficiency with which it can be produced, stored and transported.
  • Although the U.S. does not have a monopoly on shale deposits, the U.S. does wield a confluence of factors that have enabled a “shale miracle” in our country that is not easily replicable in other countries These factors include:
    • Plentiful shale deposits spanning contiguous acreage (required for horizontal drilling) – see slide 8.
    • A political system that allows private land ownership to retain mineral rights (provides the right economic incentives to develop this resource)
    • An advanced economy with unparalleled access to innovation and technology
    • An abundance of water (required for hydraulic fracturing)
    • Cheap cost of capital
    • An extensive transportation network that does not require international cooperation to build out/maintain
  • Yet despite these advantages, I believe U.S. shale oil alone will not be enough to cover the world’s growing appetite for oil – even without a frac ban, which would be economic catastrophe for the U.S. and the world in my opinion, given shale’s nearly 60% share of total U.S. production (see slide 4).
  • Key statement from slide 13: “U.S. and the world have been borrowing forward on their surplus energy.”  I agree with this statement and find it ironic that the debt-fueled boom that enabled rampant land-grabs and undisciplined production have led to cheap oil for the world but resulted in massive value-destruction for investors.
  • As Slide 20 shows, this is changing.  With energy now comprising an all-time low of 4% of the S&P, investors are demanding capital discipline and free cash flow.
  • As mentioned in Kaoboy Musings 13, I believe the process of consolidation is occurring in the U.S., and the day will be won by the players in the best basins, with the strongest balance sheets, who can execute the most efficiently and be the lowest-cost producers.  These will be the “last guys standing.”
  • I believe the supermajors will continue to shift their resources from higher-cost projects to lower-cost projects, and this augurs well for the “last guys standing.”  See this article: http://www.ejinsight.com/20191122-exxon-aims-to-sell-us25-billion-of-assets-report/.
  • In the U.S. I believe the “last guys standing” will be the best players in the Permian Basin in West Texas, which is blessed with geology that features multiple zones of hydrocarbon deposits “stacked” on top of one another.  This feature allows the Permian producers to have much lower well-costs as well as greater inventory depth than anywhere else; already, every other basin in the U.S. has peaked in production.
  • The Permian alone cannot carry the day, and I believe the EIA production projections (which have historically been terrible) are going to disappoint.  See Slide 17.  Art Berman has been saying this for years.  I will caveat this point by saying that U.S. technology ingenuity has surprised us in the past, but I wonder if the best days of those surprises are behind us at least with respect to U.S. shale.  For other higher-cost sources of oil like deep-water or Canadian tar sands, much higher oil prices will be required to enable economic viability.
  • So the bottom-line of all this is to say that I believe, barring global recession, oil prices will continue to grind higher and possibly spike if shale production overall disappoints, and that the best way to play this theme will be through the best-capitalized “last guys standing” in the Permian Basin.  Full disclosure: I am long both public and private equities of various Permian oil/gas producers.

Recent Reads

Andrew Carnegie by David Nasaw

I already gave a synopsis in Kaoboy Musings 12, so I will keep this short.  My biggest takeaway from this book was how “history may not always repeat itself, but it often rhymes,” to paraphrase Mark Twain.  The exorable march of technological progress has consistently exerted deflationary pressure on wages and forced labor to become more educated/skilled in order to adapt.  Another recurring theme that is topical to today’s world is how the capitalistic engine of the Industrial Era in the U.S. both laid the groundwork for tremendous economic growth as well as some of the social issues that go with that growth (wealth inequality, labor rights, etc).  Finally, germane my own investments in commodity industries, it outlined the importance of being the lowest-cost producer when one has no control over commodity prices as was the case with Carnegie and the steel industry. 

The Politically Incorrect Guide to Climate Change by Marc Morano

My intent was to get educated on this subject, because it has become such a political hot potato when it seems to me that it should be a discussion that is fact-based.  This book, although partisan at times, was very revelatory on several fronts and at least gave me an overview of the main points of controversy in this debate.  I believe it is an important topic that affects everyone on Planet Earth and that there are extremists on both sides of the argument that obfuscate the issues in the name of politics and policy objectives.  At the minimum, it has led me to purchase several more books on the topic and led me to create a chat group on WhatsApp to discuss this topic intelligently.  Please feel free to join if you are interested: https://chat.whatsapp.com/DT2bQrLyb5AJxhZuN2I8EI

The Man Who Solved The Market: How Jim Simons Launched the Quant Revolution by Greg Zuckerman

This was a quick, fun read but as an investor I was selfishly hoping for something a little more market-insightful, but I guess it’s not surprising to me given the iron-clad NDA’s required of all of Simons’ employees.  After reading this, I don’t know whether to be inspired or depressed as a fundamental investor, because it seems like the Renaissance team has truly carved out an almost unassailable edge through the successful harnessing of complex mathematical algorithms and machine learning.  I used to require my hedge fund employees to read Reminiscences of a Stock Operator by Edwin Lefèvre, which was about a legendary speculator named Jesse Livermore (1877-1940) and his incredible ups and downs in the markets during the end of the 19th century/beginning of the 20th century, because I always said that, “Markets and technologies may change, but the two market constants are investor greed and investor fear.”  While I still largely hold this thesis, this book was sobering to me in that it shows that technology can even disrupt a highly uncertain and dynamic field like investing, so as in Carnegie’s/Livermore’s era, we need to keep learning new things to adapt. 

Recent Listens

I recently discovered a great, free app called Hoopla that allows you to “borrow” audiobooks from your local library electronically for free!  Hence, I’ve supplemented my reading with a healthy dose of audiobooks as well.  Here are some:

The Power of Vulnerability by Brene Brown

This was more like a 6-7 hour podcast interview than a traditional audiobook, but it was a very effective format for the content.  I’ve always liked to read self-help books, but now that I’m discovering this medium, I find that listening to the actual author convey his/her message may even be more effective – at least for this genre.  There are a lot of great nuggets of wisdom in this book about how to be present, but I had one powerful takeaway from this book: when confronted with demands that may not work for your present circumstances, it’s more important to be authentic and uncomfortable in saying “no” than it is to say “yes” inauthentically and harbor resentment.  Lots of wisdom in that, in my opinion.

Stillness Speaks by Eckhart Tolle

I’ve read several of Tolle’s books, including The Power of Now and A New Earth.  Stillness Speaks covers roughly the same topics about how to find presence in stillness as well as learning to recognize one’s attachment to ego.  Honestly, none of this material would have resonated with me even 5 years ago, but in 2016 I attended a life-changing retreat in Napa Valley called “The Hoffman Process” which introduced to me the practice of being present as well as recognizing that we are not our patterns.  Since then, I’ve come to realize that almost all of these books and seminars basically share the same essence – just with different vocabulary and perspectives.  Eckhart Tolle to me is one of the best authors on the subject, and I highly recommend his podcast with Oprah Winfrey:

https://podcasts.google.com/?feed=aHR0cHM6Ly9yc3MuYXJ0MTkuY29tL2EtbmV3LWVhcnRo&episode=Z2lkOi8vYXJ0MTktZXBpc29kZS1sb2NhdG9yL1YwL2ZadkJOQjI3enZVRkM1aUUtUU5kVDZsc0NMblFJZHRLZFlDbDgzNjZXU3c&hl=en&ved=2ahUKEwixp4rzg__lAhUmc98KHfn3CyEQjrkEegQIChAE&ep=6&at=1574467346121

With that, I wish you all a wonderful and Happy Thanksgiving -- we can all be grateful that we are not turkeys!

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Climate Change Chat Group

Climate Change Chat Group

Hi friends,

We all know that climate change is a politically charged topic these days when really it should be about the legitimate science behind it, imho.  I have been reading a lot on this topic lately and think it is an extremely important topic for discussion, but given the strong polarization of views on this topic, I have decided to create an opt-in chat group to discuss this topic in-depth.

The goal is to have a fact-based discussion on the science and NOT to have a partisan flame war.  I am hoping to add some leading authorities on the topic as well.  If you would like to join, here is the link:

https://chat.whatsapp.com/DT2bQrLyb5AJxhZuN2I8EI

 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

GSE Update — COFC Hearing

GSE Update -- COFC Hearing

I guess I should have waited one day before hitting “send” on yesterday’s missive, but since this is timely, I wanted to share this ASAP. 

Of the myriad lawsuits against the Treasury/FHFA by different classes of GSE investors, one very important hearing regarding the government’s motion to dismiss in the Court of Federal Claims (COFC) was held yesterday.  

While I don’t have the full transcript yet, I’ve heard several key soundbites from the presiding Judge, Margaret Sweeney, that appear quite positive for plaintiffs (shareholders):

  • She was concerned that the current terms of the Net Worth Sweep would never allow the GSEs to become solvent and exit conservatorship, and she questioned how the government could justify never allowing repayment of the liquidation preference so that the companies can get back on their feet
  • She opined that Treasury/FHFA placed the GSE’s in a “death grip” and used them as a “piggybank,” comparing government’s actions to “the mob”
  • She opined that a “reasonable investor” would not have expected all profits to be swept to Treasury forever

 While these soundbites appear way more constructive than I expected, I caution that the wheels of justice have moved very slowly in these GSE cases.  Nevertheless, if the COFC strikes down the government’s motion to dismiss, it will add to the political cover that Mnuchin/Calabria need to do the right thing for shareholders.  Stay tuned…

 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Q3 Report Card / GSE Update

Q3 Report Card

Since Q3 earnings are now mostly out of the way, I thought it would be a good time for a recap as well as a candid self-assessment on my own prognostications.

What I Got Right So Far

Since Kaoboy Musings 3 (9/27/19), I have been sharing my then-contrarian viewpoint that the U.S. economy was not about to go into recession -- notwithstanding a spate of weak economic data, an inverted yield curve, heightened trade tensions, etc.  There is nothing magical about using 9/27/19 as a basis for comparison, but since that is the date I began pontificating about the economy, I will use that date in my forthcoming comparisons.

So far, this sanguine view of the economy has borne out.  In Kaoboy Musings 5 (10/3/19), I predicted that the Administration would use the trade tensions as a lever to induce the Fed to shift into a dovish stance and then get a trade deal done before 2020 elections.  This, too, appears to be happening.  Jerome Powell has definitively shown the markets that the Fed is more likely to let the economy run hot than allow the specter of deflation to take hold.  Jobs numbers have subsequently surprised to the upside, and whereas in the past “good” economic numbers may be negatively received by the markets in anticipation of hawkish Fed policy, Fed effectively negated this upside headwind. 

The yield curve has steepened materially (see chart below), and not surprisingly, the XLF (ETF that tracks financials) has ripped 6.2% since then (although it surprised me that this was not much better than the S&P 500’s overall 5.4% ascent over the same period).  Financial institutions, which are generally in the business of borrowing short-term and lending long-term, benefit from a steep yield curve.

On the “micro” side, the resilience of the economy is borne out by the Q3 earnings scorecard as well.  As of this writing, 93% of the S&P 500 companies have reported Q3 earnings.  The trend I outlined in my Mid-Earnings Season Gut-Check in Kaoboy Musings 10 (10/29/19) has largely continued.  Overall, the earnings beat was a whopping 4.74% with a sales beat of 0.44%.  10 out of 10 industry groups reported earnings beats, and 6 out of 10 groups reported sales beats.  The 4 groups that had negative sales surprises were: energy (-0.43%), materials (-1.48%), industrials (-1.99%), and utilities (-5.5%); it amazes me that despite these headwinds in these 4 groups, all of them still reported earnings beats, demonstrating that they’ve been able to reduce costs faster than revenue declines.

Part of my optimism about the markets and economy ironically comes from the fact that there have been almost as many “rolling recessions” within certain pockets of the economy as there have been mini-bubbles and that the overall market, while not cheap, is also not “irrationally exuberant” as it was back in 1999-2000.  The weakness in the 4 industry groups above illustrate this in real-time.  As long as this weakness does not metastacize into other industry groups, I would argue that this weakness actually provides our inflation-targeting Fed an even longer runway to be accommodative since at least 3 of the 4 industry groups that missed on revenues (energy, materials, industrials) seem to be directly exerting deflationary forces.

Although I think there is risk of a “melt-up” into year-end, it’s worth noting that the stock averages are all plumbing all-time highs already: the S&P 500 is up 24.6% ytd, the NASDAQ is up 29%, and even the Russell 2000 is up 18% ytd.  The markets are not cheap and have now discounted a lot of good news already.  I tend to get more cautious as contrarian views become more mainstream, and I believe that is happening now.  I am not chasing beta here and prefer to stick to less frothy, “value” names in this tape. 

Heady markets notwithstanding, I still do not believe we are on the precipice of recession simply because we are in the “longest expansion ever.”  As I have opined in the past, I believe the intensity of the expansion matters more than the duration; given the somewhat flaccid recovery of most of the last decade, I believe that the duration of the expansion will exceed most people’s expectations. 

What I Got Wrong So Far

In Kaoboy Musings 10 (10/29/19), I gave several reasons for why oil and oil stocks may be poised to outperform.  So far, not so good.  Oil is down 1.3% since then, and the XOP (an ETF for oil and gas exploration and production) is down ~8% since.  Believe it or not, this 8% decline belies much more severe carnage in the sector as worries over free cash flow and scale have hammered smaller-cap players – the small-cap (TEV of $4 bn and below) basket of Permian shale developers I follow is down 10% to 72% ytd!  Worse, the basket of 20 post-reorg (names that have emerged out of bankruptcy over the last several years) names that I follow in this space is down an average of 51%, with several of them down 80+% and likely to go “Chapter 22” (industry slang for Chapter 11 a second time around).  Even some names that I consider to be “best in class,” like Diamondback (“FANG”) (which I own, in the name of full disclosure), have stumbled badly in this environment – down ~16% just from 10/29/19.  This sector is not for the faint of heart!

Truth be told, this sector has been my personal albatross over the last several years, as the “shale miracle” that has enabled the U.S. to export more crude than Saudi Arabia has largely resulted in massive value destruction amidst lack of capital discipline and way too many players.  Consolidation is happening now through mergers as well as bankruptcies, but the process of rationalization has occurred far more slowly than I thought. 

In the end, the situation in U.S. shale reminds me of the cutthroat steel industry of Carnegie’s heyday, plagued by long periods of brutal commodity prices.  The winners in these industries will be those with strong balance sheets who can execute with capital discipline and be the low-cost producer. 

Although it’s always challenging to be a deep contrarian and look for “treasure” amidst what is being tossed out as “garbage,” other investors that are more well-known and well-capitalized than me appear to be doing the same thing:

https://www.bloomberg.com/amp/news/articles/2019-11-14/sam-zell-says-he-s-buying-distressed-oil-assets-amid-slowdown

 

GSE Update

Another name that I’ve been wrong on so far is the GSE preferred securities, which I recommended all the way back in my Kaoboy Musings debut on 9/18/19.  The on-the-run benchmark that I view as the proxy for all 40 flavors of these securities is FNMAS, and this name is down 28% from 9/18/19, with 10% of it coming today.  What’s even more surprising is that most of the news that has come out has been generally supportive of the thesis even if the timing is not 100% known.  Therein lies the trickiness of timing markets and the importance of being patient – in the short-term, it is often impossible to ascertain what kind of expectations might be embedded in the market.  In the longer-term, I might be 100% right on my thesis and potential upside target in this name, but in the short-term, I could be very wrong in knowing what market participants have embedded into the stock price.  In my experience, volatility and timing uncertainty almost always accompany situations with outsized return potential.  For this trade in particular, it has been an 11-year roller coaster; the difference this time, however, is not if GSE reform is happening, it’s when; given that, I’m surprised at the depth of the selloff even if timing is pushed out by a year or so (and I’m not convinced that it is).  As I have previously indicated, I have owned these securities from much lower levels for 11 years now.  The reasons why I continue to think these preferred securities are interesting (far more so now given the near 30% decline) can be summarized in Kaoboy Musings 1-4, 9, 12.  I added to my position today for the first time in several years.

The Billion Dollar Question, however, is timing – I believe recent comments from FHFA Director Calabria have introduced some uncertainties regarding timing of the outcome, and I think this is the primary catalyst for the selloff as opposed to anything material to the thesis.  On November 15th, Calabria suggested that Fannie/Freddie may not exit conservatorship until 2022-2023 but in the same breath mentioned that they would likely need to raise new capital by 2021-2022 – this suggests to me that they still have a lot of heavy lifting to do (negotiating with Treasury, settling the lawsuits, etc.) in a hurry despite Calabria’s comments about the process not being calendar dependent.  On November 19th, Calabria and the FHFA announced that it will re-propose capital requirements for the GSE’s in early 2020, and since a capital raise is unlikely to happen before such capital requirements are finalized, the bearish argument I’ve heard is that this pushes out the capital raise/conservatorship exit to a date beyond the 2020 elections, which then presents political risk in that a Warren Presidency could conceivably fire Calabria and name its new FHFA Director with a different agenda entirely. 

I have several problems with this bearish thesis: 1) it should not be a surprise to anyone that it will take time for the GSE’s to rebuild capital even under the partial uncapping of the Net Worth Sweep enacted on 9/30/19, 2) given the hostility Calabria/Mnuchin encountered at the 10/23/19 testimony in front of the House Financial Services Committee, I don’t think it’s a bad idea to avoid making GSE reform a political football until after the 2020 elections, 3) as I’ve opined many times, I don’t think even a Democratic Administration will ultimately risk destabilizing the mortgage markets by severely altering the trajectory of the GSE’s; if the end goal is to get them well-capitalized enough to stand on their own in the future and still preserve the 30-year mortgage, I don’t see many alternatives to the current plan, 4) I still believe that between now and the 2020 elections, the FHFA/Treasury are likely to take several steps (in addition to some of the ones already taken) that will make it difficult if not impossible for a new Administration to “unscramble the egg” without risking disruption to the housing market; as mentioned earlier, if they plan to raise capital in 2021-2022, this only gives them a year or two to accomplish a lot of milestones – almost all of which should be positive for the thesis, 5) finally, if the depth of the selloff can be truly attributed to a real chance that Warren may win the Presidency, one would think the overall markets would be correcting severely instead of plumbing new highs. 

There is one more credible explanation for the severity of selloff, since I don’t believe it has to do with the fundamentals of the thesis.  Two other widely-held “hedge fund” names, Pacific Gas & Electric (“PCG”) and Intelsat (“I”) have collapsed due to idiosyncratic issues (see below).  My sell-side trading contacts tell me that there is significant cross-ownership of these names along with the GSE preferred securities and that heavy losses in these unrelated securities may have led to forced selling of other holdings like the GSE’s.  Taken in isolation, I would be a bit skeptical of this as the proximate reason for the GSE selloff; however, taken with the concurrent Calabria comments that may have disappointed some weak-handed holders with perhaps unrealistic expectations on timing, I think it is very credible.

Interestingly, I came across a blog post from Todd Sullivan who is a fellow value investor that has been invested in these GSE preferreds for years.  The following are paraphrased notes he took from a talk Craig Phillips (a Treasury official who worked extensively on GSE reform with Mnuchin before he resigned on 6/17/19) gave on 11/15/19:

  • He thinks the GSE’s will be privatized Administratively with “zero chance” of Congressional involvement
  • Treasury thinks that its warrants are potentially worth $60-$80 bn and that it wants to IPO
  • He thinks that Treasury must deal with junior preferred holders in order to IPO
  • He thinks that preferreds get equitized to common (see my “home run” scenario below)
  • After this equitization, he thinks the capital raise occurs
  • The “receivership option” mentioned in the 10/23/19 hearing was just “posturing” and “not even being considered”

The most interesting thing that Todd speculated on is that Warren Buffett was being considering to write the sizeable check required for the capital raise.  I quote Todd: “Why Buffett? I’ve heard now from 3 different people that execs from Freddie were in Omaha last week. I doubt it was for steak dinner.”  Indeed, as an avid Berkshire/Buffett watcher myself, I’ll note that Berkshire now has $128 bn of cash burning a hole in its pocket. 

The bottom-line is that outside of timing uncertainty, I don’t think anything about my thesis has changed, except that the original upside / downside risk of 100% up / 50% down has now improved to  ~180% up / 30% down based upon my original price targets for FNMAS.  For certain less liquid, off-the-run issues like the ones I own, I believe the upside / downside is more like ~235% up / 15% down.  I am basically modeling slightly above par (~107%) for the upside target and around ~27% of par as the downside.  I believe there is very low likelihood of a zero outcome in the GSE’s, and I think that there are “home run” scenarios where the preferred gets equitized to new common, and the upside becomes uncapped and can ultimately be 300-500% in this case. 

Given how long this thesis has taken to play out, I think the market is perhaps exhibiting some PTSD whenever there is any uncertainty, but I think to dismiss the very real momentum behind the push to exit conservatorship when the only real issue is timing is to miss the forest from the trees – especially when the timing of events required to occur before a 2021-2022 capital raise still suggests the likelihood of many positive catalysts within the next 12-18 months, which was the original timeframe I mentioned in Kaoboy Musings 1.  

At the end of the day, anything with this kind of potential return often carries with it an enormous amount of volatility, so caveat emptor -- if it is not within your constitution to withstand this kind of volatility, I would not get involved in this name. 

Copyright

© 2019-2020 Akanthos Capital Management, LLC. All rights reserved. Protected by copyright laws of the United States and international treaties. This website may only be used pursuant to the subscription agreement and any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), in whole or in part, is strictly prohibited without the express written permission of Akanthos Capital Management, LLC.

About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.

Moving The Goalposts / What Inflation? / Andrew Carnegie / UFC 245: Cooperman vs. Warren? / GSE Update: Calabria at American Action Forum

Moving The Goalposts

In Kaoboy Musings 5 (10/3/19), I posed the question: “Is ‘bad’ once again ‘good’?”  I was referring to the notion that “bad” economic data might be interpreted positively by the market on the notion that a once hawkish Fed might be convinced to become accommodative in the face of economic weakness.  After last week’s FOMC meeting on 10/30/19, I opined in Kaoboy Musings 11 that the Fed overtly tied its future policy stance to a 2% inflation bogey, which I thought was significant.  On the one hand, Powell showed his cards already with respect to his “downside playbook,” after 3 cuts to the Fed Funds rate year-to-date; ergo, “bad” is “good.” 

But what was most significant about last week was that Powell also revealed his “upside playbook” by dispelling the converse theory that “good” is “bad,” that strong economic data would lead to a hawkish response and a swift return to tightening.  In fact, by this line of reasoning, when the jobs number came out last Friday (11/1) and showed a whopping 128k addition to payrolls versus the 85k consensus (lowered due to the GM strike), not to mention strong upward revisions of previous months, one might have expected a negative market reaction over fear of a Fed policy whipsaw.  Instead, the market ripped to new highs.  By moving the upside goalposts to an inflation target rather than, say, strong employment numbers or GDP growth, Powell all but admitted to a patiently accommodative Fed policy stance and summarily exorcised the “good”-is-“bad” bogeyman.  So now, at least from a Fed policy perspective, “bad” is “good” but “good” is also “good.”

 

What Inflation?

The two charts below show the current state of inflation in the U.S., or lack thereof.  The left shows the CPI (Consumer Price Index), and the right shows the PPI (Producer Price Index); both are popular barometers for inflation rates.  Both indicators display strong downtrends in the short-term – despite strong concerns that the tariffs would result in higher consumer prices.  While tariffs have impacted certain industries, they are just not causing inflation in the aggregate.  My hunch is that this is the strong USD at work, “importing” weakness from abroad, which is why I am supportive of the Fed easing – if only to arrest the relentless surge of the USD. 

Over the long-term (see chart below), we have not had significant, sustained CPI increases (>5% per annum) since Blondie had the top song (“Call Me”) on the billboards in 1980 (technically, the CPI didn’t break down below 5% until almost 1983, but 1980 marked the peak)!

Clearly, something else has kept inflation subdued for decades.  Most would point to technological innovation as the secular culprit, and I would agree – we have seen this before.  Paraphrasing Mark Twain, “history may not repeat itself, but it often rhymes.”

 

 Andrew Carnegie

One of the books I am currently reading is the fascinating biography of Andrew Carnegie by David Nasaw (hat tip to Bob Lesko for the great recommendation).  On the one hand, this “rags-to-riches” tale extols the virtues of the “American Dream” made possible by capitalism: how a poor immigrant boy from Scotland began his career as a “bobbin boy” in a cotton factory and stair-stepped his way  from industry to industry, eventually becoming one of the most prominent industrialists and philanthropists of America.  On the other hand, it also paints a dark side to the fully unregulated capitalism of the day, showing how a complete lack of government protections against trusts/price-fixing led to rampant crony capitalism and a very uneven playing field, often causing violent clashes between corporations and unions. 

Most interesting, however, was the fact that throughout Carnegie’s lifetime, technological innovation was the one constant that kept exerting a deflationary force on the economy.  The widespread adoption of the power loom cost Carnegie’s father (a handloom weaver) his job and forced the family to emigrate to America.  Throughout Carnegie’s steel career, inexorable advances in steel-making technology like the Bessemer process constantly created efficiencies that increased productivity but exerted downward pressure on wages.  If this happened over 100 years ago, imagine what is happening today in a global, cloud-connected society with AI/machine learning advances every other day. 

Ergo, “good” is now “good” from a Fed policy perspective now that the goalposts have been moved to “sustained inflation above 2%.”  Good luck with that, Jerome.  I’m guessing other economic measures will run hot before this measure -- I believe that this will be a concern at some point, but I think we have a ways to go due to all of the aforementioned reasons in past Kaoboy Musings for why this economy still has slack in it, despite an ebullient and arguably overbought stock market in the shortr-term. 

 

 

UFC 245: Cooperman vs. Warren?

Talking about Andrew Carnegie and the “American Dream” is a perfect segue to the current war of words between Democratic hopeful Elizabeth Warren and retired hedge fund manager Leon (“Lee”) Cooperman on the topic of wealth inequality – an issue as germane today as it was back in Carnegie’s day. 

While I’m generally going to steer clear of politics in this newsletter, I am a truth-seeker at heart and have enclosed a copy of his recent open letter to Warren, because I think Lee does a phenomenal job of cutting through the political snarks and offers a well-reasoned defense of our successful, capitalism-based economy.  I have known Lee a long time and have always respected his thoughtful, balanced views. 

  

 In particular, Lee’s distinction between “income opportunity” vs. “income inequality” on page 4 of his letter resonated with me.   His list of countries with the lowest Gini coefficients (measures of income equality – the lower, the more “equal”) included Afghanistan, Albania, Algeria, Kyrgyzstan, Moldova, Romania, Slovakia, Slovenia, and Ukraine.  To quote Lee:

 ”Yet despite the relatively high degree of financial equality implied by their numbers, none of these countries can boast booming economies or generalized income and wealth-creation opportunities.  It would therefore appear that their citizens may be more aligned than those of most other countries in the fair distribution of wealth, but that does not translate in any meaningful sense into widespread prosperity.”

 In my opinion, this letter is worth a read no matter what your political persuasion is, because it not only invites thoughtful two-way, bipartisan discussion (is this even possible anymore?) on the hot topic of wealth inequality, it also offers pragmatic, viable solutions versus some of the blatantly confiscatory ideas floated by politicos that are more pandering than practical.  

Our society has come a long way from the “Wild, Wild West” of Carnegie’s day – we have antitrust laws, we have securities laws against trading on inside information, we have regulations in all kinds of industries that protect both the consumer as well as the employee.  Yet our economic system stands almost uniquely in the world in terms of the widespread creation of opportunity and wealth because we’ve managed to preserve the “secret sauce,” which in my opinion, is the capitalistic impulse that says if you create a product or service that is deemed valuable by society, there is (almost) no theoretical limit to where you can go with it.  I believe we must never lose sight of that – no matter who is in the Oval Office.

 

 

GSE Update: Calabria at American Action Forum

 

GSE Preferreds (see Kaoboy Musings 1) have been drifting lower in recent weeks, likely due to lack of near-term catalysts.  There is some truth to this, although I’m somewhat inured to this given my 11-year hold so far.

FHFA Director Mark Calabria spoke today at the American Action Forum.  Here are some quick soundbites which I found interesting.

  1. Calabria emphasized that staying in conservatorship is NOT an option and that exit from conservatorship does NOT depend on Congress.  On this last point, he called this dependency on Congress a “myth” and said he “won’t wait for Congress to authorize him to do something he’s already been authorized by Congress to do.”
  2. Rather, it is FHFA’s statutory mandate to EITHER 1) get the GSE’s out of conservatorship, OR 2) put them into receivership.  Significantly, he followed up with this comment: “I want to emphasize that the conditions for receivership are not here today.”  This is exactly what I conjectured in Kaoboy Musings 9 after so many news outlets latched onto Calabria’s comment that “receivership was still an option.”  Sure, it’s an option, but it’s no longer a relevant option.
  3. He worries that a certain “complacency” has developed around conservatorship and hopes to keep the momentum going on “administrative and regulatory reform,” saying that “hopefully this time around we can do this before a crisis.”  Channeling JFK, he quipped, “The time to repair a roof is when the sun is shining.
  4. I thought it was interesting that he said that getting the GSE’s out of conservatorship and back into private hands would “depoliticize mortgage finance reform.” 
  5. He summarized the recently released Strategic Plan from FHFA as having 3 main objectives:
    • Have the GSE’s foster a liquid, competitive mortgage finance market
    • Remind the GSE’s to operate in a “safe and sound condition,” making sure no “conservatorship complacency” sets in
    • Prepare the GSE’s for exit from conservatorship
  6. With the breathing room of the recently relaxed Net Worth Sweep requirements to allow for $45 bn of capital buildup (vs $6 bn previously), they now have 4-5 quarters of time to restructure the agreement with Treasury
    • This gives them time to get the GSE’s ready for exit
    • This gives them time to get the FHFA ready to be the post-conservatorship regulator
    • Mentioned that the exit is process-driven rather than calendar-driven (this may be why the market may seem disappointed at a lack of near-term catalysts)
  7. Perhaps most significantly, at the end of the speech, he said that if he were a future creditor to the GSE’s, he’d want to see “a whole lot of equity beneath him” and said that that is exactly what their goal is.  

And herein lies the crux of my thesis: if the goal is to have a “whole lot of equity” in the capital structure, can you accomplish this by eviscerating the old equity and then tell would-be investors to trust them?  I say no.

  

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About

Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets.  I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.

Disclaimer

Akanthos Capital Management, LLC (“Akanthos”) is an exempt reporting investment adviser with the state of California.  This message is for informational and professional purposes only, cannot be distributed without express written consent, and does not constitute advice, an offer to sell, or a solicitation of an offer to buy any securities and may not be relied upon in connection with any offer or sale of securities.  The contents of this message should not be relied upon in making investment decisions.  The information and statistical data contained herein have been obtained from sources that we believe to be reliable but in no way are warranted by us as to accuracy or completeness.  The accompanying performance statistics are based upon historical performance and are not indicative of future performance.  The types of investments discussed do not represent all the securities purchased, sold, or recommended for clients.  You should not assume that investments in the securities or strategies identified and discussed were or will be profitable.  While many of the thoughts expressed in this message are stated in a factual manner, the discussion reflects only Akanthos’ beliefs about the financial markets in which it invests portfolio assets.  The descriptions herein are in summary form, are incomplete and do not include all the information necessary to evaluate an investment in any investment or strategy.