Trading diary 13 December 2017
Today marks the first day of a trading experiment. The date is 13 December 2017 and I plan to continue writing a diary until exactly one year from today. A US brokerage account with what I would consider “play money” currently has exactly $90,000 in US Dollars. I plan to invest this capital for maximum returns without much regard for volatility.
In terms of portfolio construction, I am mostly concerned about market liquidity and to a lesser extent, the risk of a recession.
Liquidity has been strong and is likely to deteriorate. I base this forecast on a number of factors:
- Total central bank asset purchases are set to go negative by mid-2018
- A clamp-down on the shadow banking sector in China
- A rate-hike cycle in the United States (and other countries following suit to avoid capital outflows – primarily China)
On the other hand credit spreads are tight. Stocks are rising despite some lingering skepticism.
PMIs are still strong, strongest they have been in many years. Conference Board LEI for the United States is accelerating on the upside.
I will continue playing for now and get ready to hedge whenever liquidity deteriorates – possibly by February or March.
I intend to position myself 100% long and 30% short with a few number of idiosyncratic longs and a larger number of small shorts.
A few broad conceptions that I will be using as inspiration to find individual long/short ideas:
Oil services stocks
Energy has been the worst performing sector in the S&P 500 over the past year. Much of this is warranted. Shale E&Ps have been overvalued and over-indebted due to massive decline rates in production causing volatility in EBITDA and high capex just to maintain production. They are also commodity businesses with no barriers to entry.
US oil production is now rolling over as E&Ps are exhibiting discipline with regards to capital allocation. OPEC production is also being contained. The oil reserve replacement ratio has reached 20% from 64% just two years ago. We are now seeing the fewest oil discoveries since the 1940s. Demand is continuing to grow at a rate of 1.5mbpd / year with only a modest slowdown expected. We are seeing inventory drawdowns vs 5-year average production in the United States. The impact on demand from sales of electric vehicles will not reach 1.5mbpd until the mid-2020s on any reasonable estimate. The biggest risk to oil in the short- to medium term in my view is a devaluation of the Chinese yuan. My working hypothesis is that a Chinese tightening will be followed by easing – including a weaker currency – sometime prior to the 2021 CCP 100-year anniversary. In the short-term, extreme positioning will probably be unwound – pushing the oil price lower. But the underlying dynamics speaks in favour of $70+ oil by the end of 2018.
I have tried to identify longs within the sector with minimal downside. Both Tidewater Inc (TDW US) and Standard Drilling (SDSD NO) own oil services vessels valued at mere fractions of what these vessels were worth prior to the 2014 oil slump. Net cash positions also limited the potential downside. Vessel prices are at 30-year lows. I am partial to the latter as Øystein Stray Spetalen has been shareholder-friendly in the past and is known to be a savvy speculator.
Bitcoin and other crypto currencies are showing every sign of a speculative bubble.
Factors that suggest we are in an early stage: CME Bitcoin futures and (inevitably) ETFs on Bitcoin futures. The number of hedge funds investing in cryptocurrencies is also going up rapidly. Another thing missing from a late-stage bubble is short capitulation.
Factors that suggest we are in a late stage: Sornette’s LPPL model suggesting a critical time in mid-December. A high level of public attention, as evidenced by this thread on Twitter.
My working assumption is that we hit a local peak in attention on 7 December, that retail money will get flushed out in short order and then perhaps a last bull run as institutional money and ETFs get in on the action.
Given this short-term view, I could short Bitcoin futures, which are currently trading in contango. But even putting 5% of the portfolio at risk could lead to a blow-up given the potential for a 20x run. There is no saying how much the price could go up.
Much better risk-rewards can be found in Bitcoin proxies – stocks that speculators are buying for their “exposure to Bitcoin”. Out of the ones with significant borrow available, I am the most negative on MGTI US, XNET US and SRAX US. If crypto enthusiasm dies down, they will all fall at least 50% in my view. The upside is substantial given speculative sentiment. Short levels are also very high as % of free float. So sizing is important, as well as keeping the exposure at reasonable levels. I expect the current frenzy to cool down in the next three months. The fad might then die down, or possibly run for a final blow-off. I would be very surprised if public attention to crypto currencies will stay this strong through next summer.
Another long-term theme that I think is in the very early innings. On the demand side, the story is simple: China will have a greater number of reactors than Japan in 2025. Over 70 reactors are currently under construction. Nuclear is perhaps the only non-pollutive option that can satisfy baseload demand. Further delays are possible and perhaps even likely. Japan will perhaps never restart its reactors, but the impact on the uranium market has already been felt.
Supply is looking incrementally tight after Cameco’s decision to shut down MacArthur River, wiping off roughly 10% of production. On top of this, Kazatomrprom cut another 10% of global production earlier this year. There has been almost zero capex in new mine construction since Fukushima. Given a 8-10 year lead time to build a mine, we are likely to see the impact on supply from 2019 onwards.
My experience of investing in metals & mining is limited. As I believe stock prices have run up a bit too fast too quickly, I am happy to stay on the sidelines until I find a particular company that is either cheap or misunderstood.
I am not satisfied with the portfolio. While I believe some of the holdings will work out reasonably well over the long-run, most lack catalysts that could shift expectations in the next 3-6 months.
My goal over the next year is to follow my own advice set out in my book, to go against the grain and find instances where expectations are misguided and due for a correction in short order. I want to be in sub-$500 million market cap small- and micro caps, not the Facebooks and Tencents of this world.
In the variant view with a catalyst part of the portfolio, I own the following stocks:
- Standard Drilling (long 20%)
- Hibbett Sports (long 10%)
- Great Wall Motor (long 10%)
- Zhengtong Auto (short 10%)
The case for Standard Drilling is simple: ownership of oil services vessels at 50-70% discounts to newbuild parities, 30-year low vessel values, early signs of a turnaround for the offshore drilling sector, zero new construction from 2016 onwards and a very strong management team.
Hibbett Sports is sports retailer with significant exposure to footwear, a segment that is experiencing the late stage of a sneaker fad. Hibbett launched a website in 3Q17 and will most likely double its visitors again in 4Q17 as per similarweb and alexa data.
Consensus numbers are still too low. Much of the weak SSS in mid-year was simply due to discounting for inventory clearance. Inventory is now clearing at a very rapid rate. I’ll keep the stock until a February earnings beat and then sell.
Chinese auto is likely to experience a year-end growth spurt and then very weak sales in 1Q18. The reasons are three-fold: monetary tightening, which is impacting financing conditions as well as unemployment, weaker housing transactions and lastly a hike in the 1.6L purchase tax from 7.5% to 10% by year-end. I’m therefore short Zhengtong Auto, a dealership network with particular exposure to the luxury market. It should not trade at 20x PE given the oversupplied dealership market, especially not when the auto market is decelerating as we’ve seen in the CPCA data for November. Great Wall Motor released an updated version of its 1.5T engine H6 SUV in early November. Given that the 1.5T version represents 93% of all H6 sales and the H6 represents ~50% of all volumes, I’m expecting a significant impact on Great Wall’s net profit. Even without the 1.5T H6, sales has been improving regardless as their mid-year-launched Wey vehicles are rolled out to dealerships. I am seeing 2018 EPS revisions and the stock trading at less than PE 6x vs next year earnings, despite a weaker auto market.
I own two growth stocks where there is a significant amount of skepticism about their long-term growth potential.
- JD.com (long 30%)
- Criteo (long 30%)
The market view on JD is that the company is losing market share to Alibaba. In my view, much of Alibaba’s growth is illusory, due to misleading GMV measures and monetisation that could effectively just be a recycling of cash via subsidiary acquisitions – i.e. fake revenue. In most other markets, C2C have lost out to B2C and the trends clearly indicate the same thing will happen in China. JD has a comparative advantage at this point over Tmall thanks to its logistics network and the partnership with Tencent. At 1.1x sales the stock is a steal, especially given improving earnings. The overall e-commerce market is still growing quickly and will continue to grow for another decade or two. The bears are asking themselves if JD will ever be able to turn a profit. I believe the answer is obvious: customers are voting with their wallets. Surveys are now ranking JD as the most popular e-commerce website in China.
Criteo is an ad-tech company that buys ad inventory from Google and Facebook and offers customers performance-based, targeted ads. The moat is possesses comes from network effects: it sits on a treasure trove of data, which helps explain why its click-through rates are 4x the industry average. Customer retention rates are 90% and ROI for customers is very high. The reason the stock is down is because of third-party cookie restriction in iOS 11 (potential impact of 7-10% of revenues). I consider this to be a one-off – with still-positive growth to be expected in 2018. I am comfortable with the risk of ad blockers, for the following reasons: 1) tough privacy restrictions in Safari is nothing new, in fact Criteo’s competitor AdRoll expects almost zero impact on its business thanks to work-arounds 2) publishers already adjust their impressions based on the percentage of users using ad blockers anyway 3) advertisers usually find ways around ad blockers and 4) ad blockers don’t work in apps, which is where time is increasingly being spent. Ad fraud may be common across the industry, but customer retention rates are high and ad performance is easily measurable through ComScore data. Much of the negative news should be priced in at this point with the stock down 42% from the peak and short-sellers doing victory laps. The stock is relatively inexpensive given the underlying overall 20-25% growth momentum in the digital advertising market in my view, and will continue to grow on a secular basis.
In the boom & bust category, I am short three crypto related stocks, which I think have downsides of 50-90% with relatively high conviction:
- Social Reality (short 6%)
- MGT Capital Investment (short 6%)
- Xunlei (short 6%)
All three stocks are directly related to the health of cryptocurrency markets. If crypto prices crash, then the stocks will crash as well. I manage the extreme volatility by constantly reducing exposure if and when prices go up, and vice versa. I am making the assumption here that their prices will trend (rather than fluctuate at a certain level) and then ultimately crash.
Social Reality wants to issue a utility token called BIGtoken that rewards users for imparting their data to advertisers. I doubt users would input data in exchange for a small fee. Everyone is in crypto currencies for speculation, and nothing but speculation. They are short-term fads. There is no white paper, no time schedule and no experience in pulling off similar types of manoeuvres. The underlying business is deteriorating quickly, loses about $1-2 million in cash per year and is trading at 10x book. Management doesn’t seem fit to run a publicly listed company.
MGT Capital Investment is a stock promote by John McAfee. They have gained access to 5,000 Antminer S9’s, which are currently in short supply. All segments except Bitcoin mining are losing cash. Unit economics of crypto currency mining make sense in the very short-term, especially if prices continue to rise. However 1) crypto currencies could potentially have zero intrinsic value if users lose trust in them 2) they are inferior payment mechanisms given the power consumption needed for a transaction 3) it is a commodity business, and the ASICs needed to mine crypto currencies will at some point be in ample supply, taking away MGTI’s first-mover advantage 4) mining difficulty levels are rising extremely quickly, reducing profitability. The company is almost sure to experience losses one or two years out under any reasonable assumptions.
Xunlei’s legacy business running a BitTorrent client is dying, with the business already losing $50 million a year with trends deteriorating. P2P software violate copyright laws in China, so it is doubtful whether the business is legal in the first place. As a last saviour of the company, Xunlei has issued a cryptocurrency called OneCoin, which can be exchanged for RMB and rewards users for borrowing computer capacity. OneCoin has already been banned but is still trading. They now want to release “WankeCoin”, yet ICOs are illegal in China and the coin can only be used to buy Xunlei services. On top of it, Xunlei’s own subsidiary is accusing the company of fraud.
Overall 100% long and 28% short.
Over time I will try to reduce exposure to mega-caps such as JD.com. While I love the company, I doubt that I have an edge in determining its competitive advantage or long-term growth prospects. If Interactive Brokers is able to find borrow, I would like to switch Zhengtong into Zhongsheng, as the latter has a higher exposure to Japanese vehicles whose sales will be hurt by the resolution of the China-Korea THAAD conflict. I am also considering reducing the size of the crypto bet to avoid a Volkswagen-type situation which could potentially blow up the portfolio.