A Tale of Two Companies

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Benjamin Graham

You may think that you are immune to the story that management tell you about their companies. However as charities & marketing professionals know, the reality is we are hard-wired to respond to stories far more than facts & figures. The market votes for the stories it likes with capital flows and it can take a long time for those stories to be weighed by actual future results.

Take for example the tale of two companies that I know well. Both are in the business of designing & manufacturing technology products (although in different fields.) Both have recently gone through a difficult period due to increasing commoditisation of their markets. Consequently both companies have undergone restructuring including outsourcing of manufacturing to China to reduce their production costs. However they have taken very different approaches to their accounting treatment of this period. Company A has presented all of their restructuring costs as exceptional costs to be removed from reporting. Company B has presented only a small bad debt as exceptional. Company A has also been regularly capitalising development costs whereas Company A has expensed theirs’. If you took the adjusted figures at face value you would likely conclude that Company A has been the most successful in their turnaround:

And looking at both the company fundamentals & chart the market appears to have voted this way:

(Blue is company A, Grey is company B, compared from the start of 2014)

However let's do a bit of weighing.

When we adjust for the capitalised development & exceptionals we get a different story:

Although the net margins for both companies clearly indicate companies undergoing challenges it is Company B that appears to have better navigated those challenges.

Net margins are of course not the only factor to consider. The story that the management of company A are telling is one of strong operational gearing. However when we compare gross margins we see that although company A has done well to increase theirs’ over the last few years they are still 10% below those of company B:

It would seem that company B is likely to have better operational gearing and a greater competitive advantage.

Free Cash Flow margins also seem to be the same or better for Company B:

What company A has been successful in doing is driving higher revenue higher, particularly in 2016H2:

(For ease of comparison revenue of company B has been normalised to company A 2014 H1.)

Although looking at the previous charts we see it has been at the expense of Net Margins & Free Cash Flow.

In these times of low economic growth in developed markets & record low interest rates the market has been paying a high price for revenue growth. Could this be the source of the difference in rating? I don’t think so since it is company B that has double the broker forecast revenue growth of company A:

All in all it would appear that company A is overvalued or company B is undervalued. Maybe both. It really does matter what story you tell investors and certainly at the moment investors are willing to ignore the adjustments made to tell the story. I think it is telling that company B is run by highly paid turnaround specialists with large stock option grants whereas company B is run by a long term managers. I look forward to the market weighing. 

Know Your Competitive Advantage

It’s a feature of a competitive market that over the long term a company without competitive advantage will not earn a return above its economic cost of capital. Even if a company has a competitive advantage those supra-normal profit margins will attract competitors who will try to erode that competitive advantage over time.

It is for this reason that so much of successful investing is about identifying companies that possess a sustainable competitive advantage. That is a competitive advantage that cannot be attacked by competitors or it’s difficult to do so due to network effects or legal monopolies like patent protection. A lot of literature is written on the subject. Warren Buffet has become a multi-billionaire mainly due to his ability to identify companies with a wide competitive moat. Even more quantative investors like Joel Greenblatt try to use metrics like ROCE to identify those companies that possess a sustainable competitive advantage, with varying degrees of success.

While understanding the competitive advantage of companies can be a vital part of success as a stock-picker many people forget to apply the same principle to their own investment practice. Simply put if you are a good analyst but don’t have any competitive advantage in investing then you will earn the market return minus costs. If you are an active investor these costs are likely to be large enough for you to underperform the market. If you are a bad analyst you will significantly underperform the market.

As an individual investor (and for most professionals too) the following are NOT sustainable competitive advantages:

I am more intelligent

You may be clever. Most investors I know are. However you are unlikely to be the cleverest person to trade stocks. If your strategy requires you to know a large cap company (even the one you work for) better than a full time analyst with a PhD and access to the management you will lose.

I am quicker

However quick a decision-maker you are, you will never compete with a high-frequency trader. In this realm microseconds are becoming the norm for news reaction and machine readable news aggregation is becoming the way that economic news like interest rates or non-farm payrolls are integrated into pricing. Very few hedge funds even can afford to compete in this space and the incremental returns to speed have probably already reached a plateau. If you are not already one of these few you are unlikely to become one of them. They possess the moat not you.

I work harder

If investment returns were proportional to the man-hours put into it then you are always onto a loser. No matter how many hours a week you personally put in another investment firm can simply hire more analysts to out-work you.

I have a good gut feel

The problem with basing an investment strategy on your feel for the markets is that it is very hard to get effective feedback on how good you actually are. We all suffer form a form of attribution bias where we remember the successful investments we make and forget the losing ones. Even if you keep detailed performance records of your investments it takes a lot of data to be able to show that your gut feel adds any value. And since the market is a complex adaptive system your gut feel may stop working. You can lose a lot of money until you realise that things have changed.

Although it is unlikely that you will be a successful investor unless you are clever, work hard and are able to make quick decisions based on your accumulated experience, these are only necessary conditions not sufficient.

In his latest book ‘David & Goliath’ [1] Malcom Gladwell points out the underdog doesn’t always lose. When the David’s of this world choose to fight unconventionally rather than face a much stronger opponent head on they win a surprising number of battles.

So what are the unconventional sustainable competitive advantages that an individual investor can possess?

I am able to invest with a longer term horizon

This is an area where a private investor can have a real advantage. Most professional investors bear significant ‘career-risk’. That is they are likely to be fired or lose mandates if they have a period of long underperformance. Outperforming the market by definition requires doing something different to everyone else and hoping that you are both right and that the market comes round to your viewpoint. This takes time and the more different you look to everyone else e.g. by refusing to buy tech stocks in 1998/9 the more likely you are to be fired for a period of underperformance. As Lord Keynes said ‘worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.' For this reason most professionals prefer to chase small relative short term outperformance than true long term outperformance. When you manage your own money you don’t report to anyone but yourself. You can focus on mis-pricings that may take years to correct without the fear that short term under-performance will hamper your ability to retain capital or your job.

Find areas where the market is excessively myopic. For example a company may warn on profits dues to delayed contracts and be marked down significantly. However the reporting period of a company is essentially arbitrary. If you can be confident that the contracts are delayed not cancelled and the delay won’t cause financial issues for the company you may be able to buy at an undervalued price from investors who are overly focused on the next set of financial results only.

I am willing to bear risk that others aren’t

Bearing risk alone doesn’t guarantee return since if it did then everyone would bear more risk to get that return and the excess return would be arbitraged away. What we are looking for is situations where other investors won’t take a given risk at any price. One example is that historically if you bought non-Investment grade bonds after they have been downgraded from an investment grade they outperform. The reason is that a lot of bond funds have rules that say they can only own investment grade bonds so after the downgrade you have forced sellers. An individual bond is still risky (hence the downgrade) but on average across all recently downgraded bonds the forced selling has taken the price below the level that balances risk & reward.

It is price insensitive sellers in spin-offs that Joel Greenblatt describes taking advantage of in ‘You can be a stock market genius.’ You have shareholders who end up with a small spun-off holding that is insignificant compared to their other holdings and in an industry they maybe didn’t want to own. The spin off company will also have limited financial history so few new investors want to bear the risk of buying the spin-off immediately creating a price anomaly.

Find areas where price insensitive sellers and a lack of buyers willing to bear risk creates opportunities.

I can invest in smaller and less liquid stocks.

This is an area where hard work can pay off. When you get to the small and micro cap part of the market then professional investors would struggle to get enough stock to make any meaningful impact to their performance no matter how compelling the investment case. Hence it is simply not worth them researching these smaller stocks and equally it is not worth brokers producing research since no one will pay for it. Although the previously held belief that smaller stocks outperform simply due to being small is probably weak [2] it is that lack of competition that means being willing to work hard in this area can pay off.

Academic studies suggest that the average individual investor makes very bad investment decisions [3] . So if these are your only competitors you stand a good chance of success. Assuming of course that you don’t fall for the same poor behaviours and biases that lead this set of investors to underperform on average. e.g. [4]

Find good companies that are not well understood by the average small cap investor and are priced cheaply. Work hard to understand those companies better than the market.

So you see that the individual investor ‘David’ can win against the professional ‘Goliath’, but if you want to be successful you have to learn to fight unconventionally - where you have the competitive advantage.

[1] http://gladwell.com/david-and-goliath/

[2] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2553889

[3] http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20of%20individual%20investors.pdf

[4] http://www.dangercapital.co.uk/2015/08/RuleYourPortfolio.html

My Investment Mistakes 2016

I’m a bit late to the party but have finally had the time to do a review of 2016. Although 2016 was a better year than 2015 in absolute returns (+18% vs +10%,) the relative out-performance vs FTSE all share has been much lower. So again rather than celebrating too much on the high performers I focus on my mistakes with the aim of continuously improving my investment process. These mistakes broadly fall into 3 categories, buys or sells that shouldn’t have occurred, missed opportunities and incorrect position sizing.

Wrong Buys or Sells

Selling Lavendon for £1.33. I sold because I was worried about the increasing debtors from its Saudi Arabian business. Although the company appeared to be cheap even if they did have to write off significant portions of the Saudi debtor book I feared the negative market reaction if this happened. Letting the fear of price action rather than valuation lead my decision making process turned out to be a mistake as Lavendon received competing takeover offers from a number of larger hire groups. Currently it looks like they will be sold for about £2.70.

Another sale mistake was selling Somero (SOM.L) after the surprising Brexit vote. Being in the construction industry Somero’s markets are highly cyclical so I thought that any economic weakness would disproportionately affect them. In reality there has been little sign of any significant economic weakness and Somero’s dollar earnings combined with continuous shift into eCommerce (whose warehouses require the flat concrete floors that Somero’s equipment provides) means that their business continues to thrive and it was a mistake to sell.

In terms of purchase mistakes almost all of these took the form of companies that I didn’t research fully enough. For example low end clothes retailer Bonmarche (BON.L) looks very cheap on historic earnings and cash flow metrics. What became clear though is that the free cash flow generated was through cutting all capex to the bone. When it became apparent that the company was going to have to spend significantly on IT systems simply to have a viable business going forward I sold at a loss. Another example of where previous private equity owners managed to generate good earnings and cash  flow for a stock market flotation at the expense of the long term success of the business. I am now very wary of all Private Equity floats.

Missed Opportunities

A couple of times I missed good opportunities because I didn’t react quickly enough. In one example Sirius Minerals announced a placing at the bottom end of their proposed 20-30p range. Good news for me since I had initiated a short position at an average of 35p. The price reacted negatively at first as one would expect – an underwritten placing at the bottom end of the range almost always means that the underwriters have taken some and will sell as soon as they get the shares down the placing level. So when the shares briefly rallied to 31p to sell this essentially was free money – I just wasn’t quick enough to grab it.

One of my core positions is in the airline Flybe (see here for investment thesis: http://www.dangercapital.co.uk/2016/09/flybe-dog-is-value-investors-best-friend.html) I believe that in the long term their strategy of flying short routes with turboprop planes that jet operators can’t compete economically on is a good one. (For example a friend of mine regretted spending 11 hours on the train to get home to Inverness for Christmas when he could have caught a 1hr Flybe flight. If he had booked a month or so in advance the Flybe flight would also have been cheaper.) In the short term though they face some significant headwinds. Therefore I was pleasantly surprised when their interim results in November were not as bad as I thought they would be. I read the results, thought no drama there and got on with my day. Being the day that Donald Trump was elected I was also distracted by other news. It is only later that I saw that the initial price had dropped as low as 30p (maybe due to the Trump factor) before rallying to close at around 40p. Again there was a brief market inefficiency that I should have taken advantage of and didn’t.

Probably the biggest missed opportunity that I didn’t purchase was Boo Hoo (BOO.L). Paul Scott made a convincing investment case for this up and coming internet fashion retailer when it traded as low as 20p in 2015 after it missed broker forecasts following flotation. I was late to see the attraction and the price had rallied 20% to 24p before I became convinced of the investment thesis. However I became anchored on the 20p low and never bought. The price today is £1.44 having rallied 363% in 2016. Given the current rating I’m sure I would have sold too early but even so price anchoring has cost me significant gains.

Position Sizing

Towards the end of last year I had to reduce some losing short positions because my exposure became too large. Essentially I underestimated the extent that the current market would ignore bad news and in the light of this my initial position size had clearly been too large. There are pockets of the market that currently seem crazy to me. Here are a few examples:

• A company with a history of aggressive accounting treatment that hasn’t generated any real cash return for shareholders in the last 4 years doubles when based on the company’s own highly adjusted earnings figures it is no longer losing money. The market gives it a rating of 37x forward adjusted earnings.

• A bank doubles to trade on 3x Book Value when it is revealed that the regulators are unlikely to clamp down anytime soon on its lending practices to criminals, foreign nationals & high risk short term borrowers (payday loans) and that a Trump presidency is likely to be even laxer on regulating banks. The market completely misses the point that the risk here isn’t more regulation but that those type of borrowers are at a much higher risk of not paying the bank back. If that happens in any significant numbers the equity is toast.

• A company whose product generates almost no consumer benefit reacts positively when it is announced that they are to do a corporate transaction with no economic merit whose sole purpose seems to be to reward Chinese officials for allowing them to keep selling their product in China via a Multi-Level-Marketing scheme.

• The market thinks that 4.5x Sales & 6x Book Value is the right price for a highly indebted company that aims for 8% revenue growth and consistently misses that aim.

To me it seems that particularly the US market is bid up on expectations of rapid earnings growth across the board and if this fails to materialise there could be a big correction. I expect most of the examples above to trade significantly lower in the next few years but that doesn’t remove the fact that I made a mistake in position-sizing them and had to reduce my position to prevent over-exposure.

None of these mistakes proved to be catastrophic but they did take the shine off an otherwise good year. On a positive note there were also a few key learning points for me during 2016 that didn’t necessarily come from investment mistakes but will help prevent them:

When to average down

This is one of the most difficult decisions for a value investor. I touched on this topic briefly in the past here:

 http://www.dangercapital.co.uk/2015/11/should-you-average-down-or-up.html

However John Hempton covers this topic better than I ever could in a simple but profound blog post with one of the best explanations of how to do it while effectively managing the risk of doing so:

http://brontecapital.blogspot.co.uk/2017/01/when-do-you-average-down.html.

Also in this space the book The Art of Execution by Lee Freeman-Shor which I read in 2016 gets a very honourable mention.

How to react to a profit warning

Recently published research from Stockopedia suggests that on average you are better off selling as rapidly as possible on a profit warning:

http://www.stockopedia.com/content/the-anatomy-of-a-profit-warning-159139/

Of course market being complex adaptive systems if it gets to the stage where everyone follows this advice and sells at any price following a profit warning then it will become better advice to buy. It feels like we may be a long way from this at the moment though – particularly in the more inefficient small-cap space. Michael Mauboussin also covered this topic from a slightly different angle here:

https://doc.research-and-analytics.csfb.com/docView?language=ENG&source=ulg&format=PDF&document_id=1043195371&serialid=EG%2B%2B1j2BkWEvUN9KViYq5aPtZr%2BXVuTuiyw8mq3JLts%3D

I'm sure 2017 will have plenty more learning opportunities to come!

Flybe – A dog is a value investor’s best friend?

I think there is one thing we can all agree on – no one has much love for Flybe (FLYB.L). Even after a recent small bounce it has lost almost 50% of its value over the last year and is now trading at a PTBV of just 0.8 and an EV/EBITDA of 1.4.

And many would say that’s fully justified. For example a few comments from here:

http://www.stockopedia.com/content/is-now-a-good-time-to-buy-flybe-130478/

‘The real killer for me is these persistently low level load rates despite the generally favourable conditions for air travel.’

‘They must surely be near rock bottom on load factors. Generally when LF's get to 65% is frequently game over for an airline.’

‘Also, if they barely make money with low oil prices & the economy moving along nicely, what happens when we have a recession linked to high oil prices?’

‘Anyone short or considering shorting here?’

UK Small Cap Analyst & Blogger Paul Scott also turned negative on the stock following poor Q1 trading:

http://www.stockopedia.com/content/small-cap-value-report-27-jul-2016-vcp-staf-nxr-flyb-144477/#comments

‘However, for me this is one disappointment too many, and I'm currently in the process of ditching my position in the company today. The load factor dropping to 70% is worrying me, and I think it's possible that this company may never move back into proper profitability.’

Here’s the main reason for being bearish in 1 graph:

Load factor is passenger numbers divided by seat capacity. This doesn’t look like the turnaround story investors were promised. It can be hard to make money when your average plane is less than 70% full.

Things are unlikely to change soon either early indications for Q2 in the Q1 trading statement indicate that there is a risk that H1 won’t be significantly above break even.

http://www.investegate.co.uk/flybe-group-plc--flyb-/rns/q1-2016-17-trading-statement/201607270700123242F/

And after all this is to be expected, Warren Buffett has given us repeated warnings against owning an airline:

"I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."

So that’s that then. £FLYB is a dog and best avoided…Or is it?

The opposing view

Flybe popped up on my radar again when it appeared as the highest risk-reward & ROOIC pick for a value investing Hedge Fund:

http://www.gwinvestors.com/wp-content/uploads/2016.07.19-Q2-2016-Letter-to-Investors.pdf

When smart value investors suggest a 10x upside then I certainly start to take notice.

Essentially their argument is:

• CEO is a smart guy with extensive industry (EasyJet) and restructuring (Gores Group) experience who is committed to only flying profitable routes and will quickly take action to eliminate routes that are facing too much or loss-making competition.
• Clean under-leveraged balance sheet following 2014 rights issue means that there is very little chance of bankruptcy and the company can easily whether periods of poorer trading due to external circumstances like terror attacks.
• Have now dealt with and ring-fenced legacy issues surrounding leases on unprofitable E195 regional jets.
• 2.5 years into a 3 year turnaround plan with key issues like plane utilisation and staffing levels now at industry norms.
• Plane choice of Q400 Turboprop allows profitable routes from smaller airports at lower passenger numbers.
• Main competition is often rail travel which is more expensive and slower in most cases.
• Flybe has a long runway (pun intended) of short profitable routes in Europe that it can add to drive growth over the medium term.
• Their valuation metrics on an EBITDAR, EBITDA & EBIT basis are so undemanding that a move to trade at an average for the sector would see the share price multiples of today’s price.

The Alternative Load Factor Story

Now a lot of that makes sense but on the surface doesn’t seem to line up with the story that the load factor graph is telling us. However when you graph the components of the load factor separately and apply a trend line to help remove seasonality you get a different story:

So the load factor decline is due to passenger numbers increasing at a slower rate than the seat capacity increase. According to the CEO this is as expected since a new route takes 2 years to develop the volume to become profitable and the company has added seat capacity recently.

We can actually model the lag in passenger numbers following an increase in seat capacity. Taking the Q1 figures to avoid seasonality I am going to assume a route starts at 55% load factor when opened and then hits 65% after 1 year and 75% after 2 years. I assume mature existing routes stay at 75% load factor. This is what you get when I model this against past Q1 numbers (to avoid seasonality effects I compare just Q1 to Q1):

Notice how closely the model matches the actual Q1 passenger numbers. When the seat capacity growth moderates the maths means the load factor tends to return to the 75% that I’ve assumed for a mature profitable route. This year Flybe have moderated their seat capacity growth in response to a weaker market and will only add 6% this year (calculated from the plane deliveries this year.) If I assume zero seat capacity growth after this year the load factor trajectory will probably be something like this:

i.e. a return to a 75% load factor 2 years after seat capacity growth stops.

Of course this model doesn’t prove that growth in seat capacity is the sole reason for the drop in load factor but does give some confidence that it is at least part of the explanation.

The reality is also more complex since there is a strong relationship between load factor & yield (revenue per passenger.) There is high price elasticity meaning that small changes in pricing have big impacts on passenger numbers. The company will adjust pricing to maximise revenue per flight just this revenue will be bigger for more mature routes that need less marketing for public awareness and get scale from airports.

Valuation

Flybe is very low on multiples of EBIT, EBITDA & EBITDAR compared to its peers and with those metrics likely to increase in the future they will look even better comparative value unless the share price responds. However in general I’m not a big fan of sector multiple comparisons when valuing a business since the whole market or sector could be under/over-valued or there may be differences in tax rate etc. that are not properly accounted for. For this reason I prefer to value businesses on a Discounted Cash Flow basis. It is clear that a DCF is at best an attempt to understand the factors influencing intrinsic value not a way of determining an absolute value. They are equally as dependent on assumptions as sector multiple comparisons but at least the assumptions are explicit and can be tested or varied as required. Here I am going to make some pretty conservative assumptions.

Assumptions:

• Load factor as per above profile with 75% maximum.
• Zero growth in seat capacity beyond this year.
• Contract revenue flat.
• Other operating revenue flat.
• Fuel pricing drops 32% in line with oil price hedges next year +6% seat capacity increase.
• Staff costs +2% for 3 years as per recently announced pay deal.
• Airport & route charges, ground operations & maintenance track seat capacity.
• Aircraft rental charges flat as capacity expansion is through ownership.
• Marketing & distribution, Finance costs flat.
• Other Operating Expenses includes things like Insurance, Travel Costs, Property Rent, etc. so it is conservative to assume this is proportional to seat capacity.
• Cash Flow = profits over the long term. i.e. depreciation = maintenance capex and working capital flows are neutral.
• Grounded lease cost £20m this year, £10m next year.
• 20% UK Tax Rate
• 15% discount factor.
• 6.67x terminal multiple (equivalent to 15% discount factor applied to no growth scenario) from FY19/20.
• £49.4m net cash = £62.2m net assets - £7.8m restricted cash - c.£5m share purchase (see next point)
• Fully diluted shares in issue of 218.7m (note employee 5% share aware will be met with on-market purchases.)

This gives a fair value estimate of £1.23 or 2.3x current share price even after the recent rise from sub 40p to the current 53p.

A less conservative discount rate of 10% and hence 10x final multiple would see a fair value estimate of £1.88 or 3.6x current share price.

This is based on a management team doing the basics of running an airline right: scheduling, pricing utilisation but not much else. If we assumed that the CEO can actually do what he says and add further profitable routes to the network, oil price stays low & revenue/passenger increases slightly then 10x share price is not unreasonable.

Obviously reality will not match my model of smooth growth. Each quarter, half or year will be noisy as external factors like fuel pricing or consumer confidence provide head-winds or tail-winds. With net cash on the balance sheet though Flybe has the ability to weather these periods of poor trading and capitalise on the periods of good trading.

I see three major risks to the type of upside I am modelling here. The first is a long severe recession in the UK that would seriously impact passenger numbers across the industry for an extended period. This was certainly a risk with the Brexit vote however PMI indicators seem to have bounced back recently. I am actually surprised at the apparent strength of the UK economy in the wake of the Brexit decision. Flybe has significant economic exposure but given its higher proportion of business travel than most other low cost carriers it is much less impacted to weak sterling reducing leisure travel that could be a challenge for other low cost carriers. And of course if you were concerned about the severe recession scenario you would own no UK stocks. The second risk is another cash-rich airline competing aggressively on the shorter regional routes that Flybe fly. Unless this competitor is willing to fly Q400 or similar aircraft Flybe will have the cost advantage but as Warren Buffet alludes to we shouldn’t underestimate the willingness of airlines to burn shareholders capital on unprofitable route expansion. I think the risk of an airline competing across a large proportion of Flybe’s routes is limited by the fact that it would be cheaper to simply buy Flybe. Which is my third risk. That someone else runs these numbers and Flybe gets taken over for less than a conservative estimate of its intrinsic value.

All things considered I’m struggling to find a better risk/reward situation in the UK market at the moment. At least for investors willing to live with the volatility of short-term results.

Disclosure: Since my analysis indicates a very significant potential upside to Flybe shares I am long the equity. I may be wrong. I reserve the right to change my mind at any time if I perceive the facts have changed.

The Big Short

I recently caught the film in the cinema. I’d read the book a few years ago but none the less the film was both entertaining and thought provoking. As one would expect from a film about financial markets it had a lot of relevance to investing.

Firstly what a great trade it was. The main characters in the film spotted an asset that was priced as if its components were uncorrelated (as they always had been in the past) and realised that they were in fact highly correlated. The best thing was that the trade had a very high pay out. By buying Credit Default Swaps on Mortgage Backed Securities Derivatives they were paying an insurance premium and getting the principle in return if they were correct. These sort of opportunities don’t come around very often but when they do they are highly lucrative.

The film showed really well why value investing is hard. Buying or selling something because its market price varies significantly from a conservative estimate of true value sounds great but the only reason that you get mis-pricing is because very few people agree with this assessment. It can be psychologically hard to go against the consensus opinion with your own money. The film showed that when you do it with other peoples’ money there’s always a chance they will call you up, shout at you and then threaten to sue you.

Short selling is hard. When you take a short position you are essentially betting that something will fail. This often has real world consequences like people losing their house or jobs. I think this is one of the reasons that a lot of short selling focuses on frauds. Yes a fraud is usually a zero which is the best return you can hope for as a short seller. But I think there may be something deeper too. By exposing fraud it is quite clear that justice is being done whereas it is less clear cut with a business that is merely overvalued or fails due to management incompetence. That said I do believe that for good businesses to succeed, some bad business need to be starved of capital and fail. I personally have never had a moral issue shorting a company. But as the character Ben Rickert points out in the film, when they do fail sober reflection is probably a more fitting reaction than triumphalism.

Despite being a great trade I do think the film showed all the participants making mistakes.  Mike Burry in particular was too early putting his trade on in 2005. This is always a difficult part of investing, particularly for those of us of a ‘Value’ bent so I’m not sure really what he could have done to prevent being early. Where I think he did go wrong was with position sizing. He thought that his history of past returns was enough for his investors to stick with him through all short or medium term under-performance as long as he was right in the end. He suffered from the illusion of permanent capital and in the end had to gate his fund to get the permanent capital he needed to see the trade through. I reckon a lot of value investors who took large positions in specific stocks and underperformed in 2015/2016 may find that they were suffering from the illusion of permanent capital. We all sometimes underestimate how long it will take for a particular investment thesis to play out and we would be wise to treat each investment like a DIY project. Think how long it should take, then double it…and double it again.

I think the final mistake that most of them made was underestimating the counterparty risk in the trade. The character Mark Baum’s hedge fund was part of Morgan Stanley so had exposure to the financial crisis despite his short position. All the others had bought their CDS from investment banks so would have been potentially valueless had the investment banks failed while they still held them. If they truly saw the scale of the coming financial crisis they should have had CDS on each counterparty and maybe even a long government bond position to protect themselves further.

And as always in investing luck played a part. Several of the characters found the trade because someone else introduced them to it. And the founders of Cornwall capital were able to access CDS because of a former neighbour.

The secret of finding the next Big Short? Be open to new ideas, bet on value, look for asymmetric returns, focus on position size, consider counterparty risk up front and practice humility when it pays off.

My Investment Mistakes of 2015

One of the reasons I love investing is that it is not just a battle against other intelligent, knowledgeable and committed people but a battle against yourself. Each of us have biases that prevent us from acting optimally and it is by knowing ourselves better and designing strategies to overcome these biases that we become better investors. It is in this spirit I offer, not a celebration of the 2015 successes or tips for 2016, but some of the mistakes I made this year:

Not being bold enough when the downside was negligible

On 12^th August a company called Pure Wafer announced that they would return 140-145p to shareholders from an insurance payout related to a fire in the UK part of their business. The shares opened that day at 145p to buy, presumably due to generally poor market sentiment in August 2015. Given that the company still retained a profitable US trading business then it was highly unlikely the shares would be worth less than 145p. I used all of the spare cash in my dealing account to purchase shares and then turned to my spread betting account. However at this point I was not bold enough. Given that the downside was negligible I should have used all available margin to open a position however I was too cautious and only added a small amount. The shares rapidly rose to 165p that day as others realised the opportunity and following the sale of the trading business should return 188p in total to investors. The market rarely offers a free lunch but when it does you need to absolutely stuff yourself.

Thinking that buying the best companies in an industry with bad economics would protect the downside

One of the biggest investment themes of 2015 has been the rout of commodity prices and the impact on commodity producers. Although I’ve never liked commodity exposure as investment theme in itself there are certain attractions to owing oil companies. Their assets are easily analysed and assets that will be drilled or developed far in the future are often neglected in valuations giving opportunity to those with longer term investment horizons. As a contrarian investor I wanted exposure to the sector but to limit the downside should there be no medium term oil price recovery. Therefore I added shares like Ophir & Bowleven that had strategic assets and large cash holdings. Despite paying historically low prices and below cash in the case of Bowleven that didn’t stop prices falling as the oil price fell further. When a sector is seriously out of favour then everything gets sold. This maybe illogical and may be a good contrarian buy going forwards but the strategy of buying the cash rich oil companies didn’t in reality protect the downside in 2015.

Being too worried about the spread

The commodities rout has had a knock on impact into the oil services sector leaving a number of companies looking very cheap, at least on historic metrics. I’m always interested in extremely sold off shares and unlike oil exploration and production companies the service companies often have other subsidiaries unaffected by the oil price collapse. Two such companies that are on my watch list are Northbridge Industrial and Pressure Technologies. In both cases I was very close to buying, Northbridge quoted at 66p and Pressure Technologies quoted at 147p. In both cases I rejected the quote because I didn’t want to pay the full ask. Prices now are 89p for Northbridge and 192p for Pressure following trading statements or results that were not great but simply not as bad as the market feared. Sometimes it pays to pay up, especially when prices are already significantly depressed.

Failing to exit an investment going wrong quickly

On 17^th March defence training specialist Pennant International reported their FY results. Although on the surface they seemed to be fairly positive a detailed reading of the figures suggested that they were struggling in a number of areas and were overly reliant on a few contracts. Since I was slow to do the full analysis the price had dropped from 98p to c.80p by the time that I had realised that things were not as rosy as they initially appeared and due (presumably to loss aversion) I didn’t sell. Today Pennant trades at 40p.

Exiting promotional shorts too soon

Nothing goes up 4-5x in a couple of months without significant amounts of ‘hot money’ being involved. Therefore when you see these sort of rises in story stocks they can make very good shorts. Particularly where there is some kind of share overhang on its way (e.g. a lockup period for a major holder ending) which will apply pressure to reverse the flow of hot money. The area that I have found most lucrative is companies that have entered into an equity swap financing deal like Amur Minerals or AFC Energy. These deals see the company raising funds by issuing shares to a company like Lanstead Capital but using that cash to enter into a swap agreement with Lanstead whereby the cash payment they receive each month depends on the share price. This leads to a strange mix of incentives. The management want the share price as high as possible but once it has risen the swap provider wants to sell as many shares as possible to fund their payments to the company and reduce the amount that they pay. Hence the spike up and the slow decline:

Amur Minerals

 AFC Energy

So what’s the mistake? In both cases having got good entry points (40p for Amur Minerals & 54p for AFC Energy) I closed the shorts far too soon (27p for Amur & 33p for AFC.) What went wrong was I started to fear the promote would push the shares higher and failed to believe my own analysis that said that the share overhang of the equity swap provider exiting would push the shares much lower and reverse the flow of hot money. Amur currently trades at 8p and AFC at 24p. It’s annoying to get the analysis right but not fully capture the resulting move.

Underestimating how foolish takeover buyers can be

In March 2015 the Australian law firm Slater & Gordon paid £640m for the legal services part of Quindell a company of which I was short. My analysis had shown that there were significant issues with the quality of Quindell's business and that without Slater & Gordon's intervention the group was likely to run out of cash. It seemed completely illogical that S&G would pay a significant premium of £640m for a business that was close to bankruptcy particularly since it would require significant debt and equity raise by S&G to fund it. As it turns out that my analysis was probably correct and Slater & Gordon have subsequent lost almost 90% of their value since the deal. What I got wrong was probably not the analysis but dismissing quite well sourced rumours that a deal had been done and then closing the short when the deal was announced. The rest of the Quindell business was of such poor quality that if I'd simply rode out the intitial deal spike I still would have made money on the short.

I’m sure I’ll make many more mistakes next year and despite these this year I made enough good decisions to generate an ok return. My aim however is not to repeat these particular ones.

Wishing you all a Happy Christmas! And may you only make new mistakes in 2016 too.

Is Avanti Communications' equity worthless?

I originally wrote a version of this post on stockopedia.co.uk but thought worth re-jigging it on here to incorporate some further research and thoughts into one place.

Avanti (AVN.L) is a communications company operating satellites providing internet capacity to users who don’t have access to regular high speed internet capacity via broadband. Currently they have 4 operational satellites (ARTEMIS, HYLAS 1, HYLAS 2, HYLAS 2-B) with plans to launch 2 more in 2017 (HYLAS 3 & HYLAS 4).

http://www.avantiplc.com/

Launching satellites is a capital intensive business. You spend hundreds of millions of dollars getting them into space with the expectation that they pay for themselves many times over in their c.15 year useful lifetime. The capital intensity combined with the long payback period makes Avanti a high risk investment. If the geographic areas they covered were to receive broadband access of high speed mobile internet then the demand for their services would decline rapidly or face severe pricing pressures. The investment case for Avanti very much depends on how rapidly they can sell their satellite capacity while retaining premium pricing. Any analysis of the company should focus on these factors.

They have been heavily loss making so far but promise rapid growth that will deliver profitability to the company in the future:

‘…management expects cash generation to grow swiftly as revenues exceed Avanti's largely fixed cost base.’ Q1 2016 Trading Statement

http://www.investegate.co.uk/avanti-comms-group--avn-/rns/1st-quarter-trading-update/201511120700084267F/

In order to judge their success we need to look at what are their sources of revenue. These are my understanding of the main categories of Avanti’s sales in order of declining quality:

1. Data sales – these are really what Avanti is about selling internet data - they should be high margin and cash received under normal payment terms.
2. Equipment sales – Avanti also provide the equipment for users to access their data services. Usually these will be paid in cash, again good quality but variable in nature.
3. Project sales - where they are paid to do work for a client, good quality but usually non-recurring.
4. Equipment sales where they are paid over a number of years - presumably they are intended to allow cash strapped customers to generate data sales they couldn't otherwise however these are particularly poor quality earnings since the revenue is booked in year 1 with the cash coming in much later and the risk of bad debt (of which they have had some.) Also since they are lending the money to the customers at about half of their cost of debt capital the longer the terms the worse the deal as Matthew Earl points out here: http://lordshipstrading.blogspot.co.uk/2014/11/avanti-avn-questionable-quality-of-sales.html
5. Spectrum sales - as far as I can tell these seem to be completely non-cash since there is no up-front payment to them and no accrual in the balance sheet. As Tom Winnifrith points out rather than generating cash for Avanti this ‘sale’ is costing them $13m cash over the next few years: http://www.shareprophets.com/views/16999/avanti-communications-a-letter-to-the-financial-reporting-council-re-2015-accounts . These sales are of such poor quality that it seems Winnifrith has written to the FRC to question it.

It would be great to be able to separate out the revenue and costs associated with data sales and equipment sales and analyse these separately but as far as I can tell Avanti have not provided these consistently. In the 2014 Annual Report they do break revenue out into $16.6m of equipment sales out of $65.6m total. They did the same in 2013 but in the 2015 Annual Report they only break out the $25.1m Spectrum ‘sales’. Also you have to read the notes to the Annual Reports to see these. They don’t seem to be broken out in the half year results or in the results RNS’s. Hence the analysis that follows excludes the non-cash sales of Spectrum Rights but assumes all other revenue is recurring.

Things were going well for Avanti until H1 2015 when revenue started to drop. (H1 2016 is estimated by doubling Q1 2016 revenue.)

This sort of drop off in revenue can mean one of two things. Either customers are using less of £AVN ’s services, or they are paying less for them. 

Not that you’d be able to see this revenue drop if you read Avanti’s management commentary. By careful choice of comparatives, last quarter vs same quarter in the previous year, and including exceptionals in the reporting period and excluding them in the comparative period they have managed to give the appearance of rapid revenue growth in a period when revenue has been dropping half on half:

Let’s look at some of the comments relating to utilization and pricing:

‘Average Fleet Utilisation was at the upper end of the 20% to 25% range during the period’ Q1 2016 Trading Statement

‘Avanti's average pricing remained stable.’ Q1 2016 Trading Statement

‘This was lower than Avanti's prevailing run rate of growth, due to a larger amount of equipment and government revenue in the previous year, which, although recurring, tends to be recognised on a non-linear basis.’ Q1 2016 Trading Statement

‘Avanti's Fleet Utilisation was within the 20% to 25% band at the end of 2015, having increased from the 10% to 15% range in the prior year.’ 2015 FY Results

http://www.investegate.co.uk/avanti-comms-group--avn-/rns/avanti-communications-full-year-results/201509160700221954Z/

Based on these comments I’ve added estimate of the utilisation to the revenue graph:

So it seems that data rates are stable but customers are paying less for £AVN’s equipment or value added services meaning that rapidly increasing utilisation is not turning into increasing revenue.

So if we are conservative and assume that Q1 2016 had very little equipment sales and was mostly data revenue what is interesting is to scale up the Q1 2016 revenue to get the maximum theoretical revenue at full utilisation as Avanti suggest we do in their 2015 annual report:

If we take 23% as ‘the upper end of the 20% to 25% range’ then based on the Q1 2016 revenue of $13.6m at the current pricing the maximum theoretical revenue of the existing satellites is $238m a year.

So how fixed are those costs? The accounts split costs into 3 categories:

1.   ‘Satellite Depreciation’ we will ignore for now as a non-cash cost.

2.   Operating Expenses do appear to be largely fixed costs running at $35m pa for the last couple of years. If anything these will increase slightly as Avanti state ‘There will be a modest increase in costs in 2016 as further investments are made in sales and marketing and ground operations ahead of the launches of HYLAS 3 and HYLAS 4.’ Annual Report 2015

3.     Cost of Sales however do not appear to be fixed as an absolute value but as a percentage of revenue of c.60%. I had expected the gross margin to increase as data sales made up a greater proportion of revenue however there is little sign of this in the numbers. Given that COS as a % of revenue are around 60% when revenue is $7m or $40m then it would seem a reasonable figure to take for COS as a percentage of $238m revenue = $143m.

So at full utilisation the current satellites will generate OCF of $238m – $143m – $35m = $60m.

However Avanti has c.$640m of debt accruing interest at 10%pa = $64m/year interest which means even at full utilisation the current satellites would generate a cash loss of $4m/year. Given these sums it is somewhat surprising that the Avanti share price reacted positively to the Q1 2016 results, although it has since fallen back to below previous levels.

Avanti have $219m of cash on hand so can manage an extended period of high negative cash flow however the majority of that cash is committed to the development and launch costs of HYLAS 3 & 4. This means that although I don’t think the committed cash should be included in a valuation it is also wrong to exclude the future potential revenue from HYLAS 3 & 4 when they are launched in 2017.

In order to work out what the impact of the valuation implied by the $13.7m Q1 revenue and 'upper end of the 20% to 25% range’ for utilisation we need an NPV. To do this we always need to make some assumptions, here are mine:

1.      As previously stated Avanti don’t consistently break out data revenue and equipment revenue so I have to assume that these move roughly in step.

2.     Maximum Revenue is assumed to be proportional to capacity in GHz with ARTEMIS, HYLAS 1 & HYLAS 2 adding up to the $238m current max revenue at full utilisation. The revenue capacity of HYLAS 2-B, HYLAS 3 & HYLAS 4 are proportional to their capacity.

3.     Avanti depreciate satellites over 15 years which is meant to be there useful life. Therefore I assume they generate no revenue 16 years after launch. This looks like:

4.       Cost of Sales remain at 60% of revenue. Admin Expenses at $35m pa and debt interest at $64m pa.

5.       Utilisation increases 10% each year to reach full utilisation at 100%.

An NPV is only as good as its assumptions of course but with these (that could be considered aggressive in some areas e.g. 10% discount factor when the debt is yielding 10%, they are funding with debt & equity and equity holders are taking more risk) yields an NPV10 of only $480m – considerably less than the outstanding debt:

With the current 182p share price you have a market cap of c.$400m and an EV post capex of c$1.0b vs a $480m valuation.

Of course this analysis ignores revenue from any future satellites Avanti may develop & launch. The reason is that these would have to be funded via further debt and/or equity. In lieu of this I have excluded satellite depreciation. With these assumptions Avanti would be FCF positive in 2019 however not earnings positive until 2021 or later with depreciation charged to the income statement. Note that the senior secured notes are due in 2019. Since Avanti will not be able to repay these from cash flow they will be reliant on credit markets at the time to refinance this debt.

Assuming they can increase the utilisation more rapidly at 20% pa to reach full capacity then the NPV10 increases to c$840m. More than the debt but still makes the equity significantly overvalued. Add in an extended life of each the satellites for 5 years at full capacity in addition to the rapid utilisation and you still get an NPV10 at a discount to current EV.

In conclusion, unless Avanti can rapidly increase capacity utilisation much faster than they have done in the past or if they can generate significantly higher pricing & margins then the equity could well be worthless. That Avanti’s management seems to prefer finding creative ways of giving the appearance of growth in their commentary rather than actually driving the business to create this growth, gives me little confidence that they will deliver improved growth or margins in the future.

Disclosure: Since the current equity valuation seems to be pricing highly optimistic scenarios for both pricing and utilisation that I believe to be unrealistic based on the performance of the company over the past 2 years I am currently short the equity.