Author Archives: memyselfandi007

Some links

Thanks to a stock forum I discovered that John Hempton from Bronte is issuing a monthly letter for his Australian fund (H/T qed1984). The last one about China is brilliant.

An interesting article about a Whistleblower at Halliburton with some insight into the arcane world of “revenue recognition”.

Charlie Rose 30 minute interview with Ginni Rometty, CEO of IBM

Q1 report of Centaur, the US value fund run by Zeke Ashton

Must read: Roddy Boyd exposes US pharmceutical company and stock market darling Insys Therapeutics which seems to be literally “killing it”

A couple of presentations from the Ben Graham Centre 2015 Conference

Finally interesting research from German StarCapital on country by country valuations adjusted for differences in the underlying industry sectors

AerCap Holdings NV (ISIN NL0000687663) – How good is Einhorn’s new favourite ?

A friend forwarded me the latest presentation from “guru” David Einhorn where his main long pick was AerCap, an Airplane leasing company.

To shortly summarize the “Long case”:

– AerCap is cheap (P/E 9)
– they made a great deal taking over IFLC, the airplane leasing division of AIG which is several times AerCap’s original size
– they have great management which is incentivized along shareholders
– The business is a simple and secure “spread business”
– major risks are according to Einhorn mostly the credit risk of the airlines and residual value risk of the planes

There are also quite obvious reasons why Aercap is cheap and trades at lower multiples than its peers:

– share overhang: AIG accepted new AerCap shares as part of the purchase price and owns 45,6%. They want to sell and the lock up is expiring
– following the IFLC/AIG transaction, the company was downgraded to “Non-investment grade” or “junk” and has therefore relatively high funding costs compared for instance to GE as main competitor

What kind of business are we talking about?

Well, Airplane leasing is essentially a “special purpose lending business” without an official bank license, one could also say it is a “shadow bank”. What Aercap essentially does is to loan an airplane to an airline.

In order to make any money at all, they have to be cheaper than the simple alternative which would be the airline gets a loan from a bank and buys the airplane directly. As Airlines are notoriously unprofitable and often thinly capitalized, they often need to pay pretty high spreads even if they borrow money on a collateralized basis.

As any lessor funds the plane mostly with debt, the cost of debt is one important factor to make money compared to competitors. It is therefore no big surprise that GE with its AA+ Rating is the biggest Airplane leasing company in the world and that ILFC thrived while AIG was still AAA and had comparably low funding cost.

Airplane buying is tricky business

A second aspect is also clearly buying power. Planes have to be ordered many years in advance and the two big manufacturers want to be sure that they are getting paid. I assume a reliable bulk buyer gets better access to the most sought after planes and maybe even better prices. Prices for planes at least in my experience are notoriously intransparent. Nobody pays the official list prices anyway. I found this interesting article in the WSJ from 2012.

When Airbus and Boeing Co. announce orders at the Farnborough International Airshow this week, they will value the deals based on the planes’ catalog prices—which no one pays. Airline executives, when pressed for details, will probably say they got “a great deal.” But actual terms will remain guarded like nuclear launch codes.
The aviation industry’s code of silence on pricing is notable in this era of information overload. Thousands of people world-wide are involved in airplane purchases, yet few numbers spill out. That yields much mystery and speculation.

Discounts are large:

But there are ways to estimate the range of discounts. An analysis of public data by The Wall Street Journal and interviews with numerous industry officials yielded this: Discounts seem to vary between roughly 20% and 60%, with an average around 45%. Savvy buyers don’t pay more than half the sticker price, industry veterans say. But deal specifics differ greatly.

But no one wants to talk about it:

One reason for the secrecy surrounding all this, say industry officials, is psychology: Less-experienced plane buyers like to think they got a bargain and don’t want to be embarrassed if they overpaid. The safest approach then is silence. More-seasoned plane buyers also know that bragging about discount specifics would anger Airbus, Boeing or other producers and hurt the chances of striking a sweetheart deal again.

Clearly, as a large “quasi broker”, Airline leasing companies seem wo have a chance to make some money in such a intransparent market. But it is really hard to pin down real numbers. It reminds me a little bit about how you buy kitchens in Germany where the system is pretty much the same. Everyone gets a discount, but no one knows what the “true” price looks like.

But this also leads to a problem:

With the current funding costs, AerCap would not be competitive in the long run. Let’s take as a proxy the 10 year CDS spread as a proxy for funding costs and compare them across airlines and competitors (more than 50% of AerCaps outstanding debt is unsecured):

10 year senior CDS Rating
     
AerCap 215 BB+
     
     
Clients    
Air France 96  
Singapore Airlines 105 A+
Southwest 109  
Lufthansa 195 BBB-
Thai Airways 240  
Delta 256 BB
Emirates 257  
Jet Blue 362 B
     
Competitors    
GE Capital 72 AA+
Air Lease 175 BBB-
ICBC 194 A
CIT 229 BB-

So purely from the funding cost perspective, AerCap at the moment has a problem. Someone like Air France could easily fund a loan for an airplane cheaper than AerCap, so cutting out the middle man is basically a no brainer and even the smaller competitors could easily under price AerCap when they bid for leasing deals. On top of that, a lot of non-traditional players like pension funds and insurance companies want some piece of the action, as the return on investments on those leases are significantly higher than anything comparable. Even Asset managers have entered this market and have created specific funds for instance Investec.

AerCap does have a positive rating outlook, so there is a perspective for lower funding costs. Just to give an indication of how important this rating upgrade is: On average, 10 year BB financial isuers pay 2,4% p.a. more than BBB financial issuers at the moment. The jump from BB+ to BBB- will not be that big but it would increase the investor universe a lot for AerCaps bonds.

The biggest risk for AerCap

So although I am clearly no match for David Einhorn (*), I would argue that the biggest risk for AerCap is not the residual value of the planes or the credit quality of the Airlines but quite simply the refinancing risk. AerCap has to fund a significant amount going forward and if for some reasons, spreads move against them, they will be screwed. Just a quick reminder what happened to ILFC in 2011:

Credit-default swaps on the company climbed this month as global stocks tumbled and speculative-grade debt issuance all but evaporated. The cost reached as high as 663 basis points on Aug. 11, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. The contracts have held at prices that imply ILFC’s debt should be rated B2, according to Moody’s Corp.’s capital markets group.

However if they manage to to get an investment grade rating and lower their funding cost, then it could be an interesting investment as funding is cheap and they do have access to a lot of new and sought after aircraft. Again, borrowing from Warren Buffett, with any leveraged company, management is extremely important.

And one should clearly compare AerCaps valuation and risk/return to banks and not to the currently much higher valued corporates. AerCap is much more similar to a bank than anything else. This general valuation disconnect seems to be also one of major reason why GE announced the massive reorganization just 2 weeks ago. However, as far as I understood tehy will keep the leasing business as this is unregulated.

Summary:

Although I slightly disagree with the risk assessment of Einhorn’s case, I still think AerCap could be an interesting case and is worth to dig deeper. I don not have a problem investing into financial companies and I do like those “share overhang” situations. However, I will need to dig deeper and especially try to figure out how good AerCap’s management really is.

(*) I did disagree with David Einhorn already once with Dutch Insurer Delta LLyod which was Einhorn’s long pick of the year 2011. Overall in this case I would put the score of MMI vs. Einhorn at 1:0 as Delta LLoyd did not outperform.

Update: TGS Nopec Annual Report 2014 and Q1 2015

TGS Nopec is one of my larger position which I bought back in November 2013 when oil (WTI) was still trading at ~100 US and the world looked great for oil and oil service companies.

In the meantime, as we all now, the oil price fell substantially since 2014 and especially oil service companies were hit hard. In contrast to other oil service companies however, TGS share price has decoupled from oil to a large extent as we can see in the chart:

This is especially interesting as 2008/2009 for instance, TGS lost almost -70% when oil crashed back then. Almost always when I discussed TGS with other investors, the argument was like this: TGS is a great company but the price has to fall at least -50% or more as it did in the past. Well, for now they are holding up pretty well.

2014 annual report

Anyway, the 2014 annual report can be found here

I would recommend anyone to read the annual report, at least the one page letter of the CEO, which in very clear words describes how TGS operates.

The highlights from my side:

– EPS dropped significantly from 2,59 USD to 2,09 USD per share
– however there were several negative one time effects included (around 65 mn USD or 60-65 cents per share).
– interestingly they make no effort to adjust those one time effects. You won’t find adjusted numbers anywhere in the report. I like this VERY MUCH.
– Operating cashflow actually increased by 10%
– Operationally, the Americas were doing very well in 2014. Asia was growing strongly but deeply negative
– payroll costs increased by ~10% in 2014
– they are still committed to invest counter-cyclical into new data by taking advantage of low charter rates for ships

Overall, they way TGS operates, 2015 will not look good from a P&L perspective, as they expense a lot of their investments and sales might take a little bit longer than usual. However if the past is any guidance for the future, in 2-3 years time the investments will then turn into nice profits down the road.

Q1 2015 update

A few days ago, even before the official Q1 report, TGS issued a Q1 update press release. They reduced significantly the expected net revenues for 2015 as E&P companeis are delaying their projects. Additionally, they announced a significant cost cutting program:

The Cost Reduction Program will position the company for the more challenging seismic market caused by the significant drop in oil price. A key element of this program is a reduction of more than 10% of TGS’ global workforce effective from April. Restructuring charges of approximately USD 4 million will be booked in Q2 as a result of this Program. The company expects annual cost savings of approximately USD 10 million as a result of the Cost Reduction Program.

Interestingly, this 10% reduction seems to off set the salary increase in 2014. At first, the market seemed to be shocked and the stock lost around -20% intraday but since then things have recovered. Maybe the recommendation change from Goldman has lifted the stock. This is what Goldman wrote last week (via Bloomberg):

(Bloomberg) — Offshore seismic market set for structural changes as oil producers rationalize costs, optimize upstream portfolios and concentrate on efficiency, Goldman says in note dated yday.
Goldman: multi-client segment has strongest outlook; data acquisition will continue to face challenges with at least six vessels needed to leave market to achieve balance
TGS raised to buy vs sell, is best-positioned in new oil order; co.’s library has highest N. America exposure which should remain most attractive onshore area
Strong financial position can sustain div.; selloff post 1Q creates buying opportunity

So it seems that this time, TGS does get better credit for their countercyclical business model than in 2008/2009. Maybe investors have learned actually a little bit since then ?.

In any case, from my side, TGS is a clear long-term core investment. Although the industry is very difficult, TGS is very good company with strong competitive advantages. Oil companies must replace their reserves,the demand for seismic data is not going away. Maybe it gets postponed a little bit ut they don’t have a choice. Without replacing reserves, atraditional E&P will not valued as going concern but as a run-off which much lower multiples.

Even with the reduced forecasts, TGS is still very profitable and who know what opportunities show up if some of the competitors get deeper into problems.

Some links

The Brooklyn investor looks at the JPM annual report and Loews

David Einhorn’s presentation from the Grant’s Investment Conference 2015

A new White Paper from AQR called “Fact, Fiction and Value Investing” (h/t Valuewalk)

Frenzel & Herzing look at Greek company Metka

Is Google the next Microsoft ?

Some interesting thought about the issues in Turkey

And finally, Hedge Fund billionaire Paul Tudor Jones wants to change capitalism

Lloyds Banking Group Special Situation investment – Management & Valuation

This is the follow up post to the first post on Lloyds Banking group 2 weeks ago.

By chance, I just saw this research note from Investec which perfectly sums up all the reasons why Lloyds is not a favourite of investors at the moment:

Bloomberg) — Lloyds cut from buy on concern about outcome of U.K. election, probability of a “raft of negative one-offs in 2015” and on U.K. govt plans to exit its 22% stake, Investec says in note.
Says Lloyds has “sensibly’’ signalled it will call all remaining Enhanced Capital Notes
That should speed-up negative fair value unwind of GBP0.7b
There could also be extra charge if Lloyds pays any premium
January PPI redress costs for bank industry rose to 14-month high of GBP424.5m
Planned sale of TSB to Sabadell means deconsolidation in 1Q, that could mean charge of GBP0.6b
Sees U.K. govt stake reduced to ~20% by end June, with sale of govt shares accelerated after that, acting as drag on stock
U.K. May 7 election poses risks to banks with uncertainties over macro economy, another bank levy increase, restrictions on use of residual tax losses
Lloyds less vulnerable than peers over regulatory/conduct issues and less exposed to bank levy than other FTSE 100 banks

For me, this is actually a good sign that a lot of the short-term bad news is on the table. But let#s look at the company now.

Just as a refresher, the quote from Warren Buffett which I used already when I looked at Handelsbanken:

The banking business is no favorite of ours. When assets are twenty times equity – a common ratio in this industry – mistakes that involve only a small portion of assets can destroy a major portion of equity. And mistakes have been the rule rather than the exception at many major banks. Most have resulted from a managerial failing that we described last year when discussing the “institutional imperative:” the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so. In their lending, many bankers played follow-the-leader with lemming-like zeal; now they are experiencing a lemming-like fate.

Because leverage of 20:1 magnifies the effects of managerial strengths and weaknesses, we have no interest in purchasing shares of a poorly managed bank at a “cheap” price. Instead, our only interest is in buying into well-managed banks at fair prices.

Lloyd’s Management

So let’s look at Lloyds Management. The CEO, Portuguese António Horta Osório is considered to be one of the “best bankers” in the business. He was appointed in 2010 and lured away from Santander, where he build up Santander’s quite succesful UK subsidiary.

He became CEO in March 2011 but then something strange happened: He “disappeared” for around 6 weeks due to a “burn-out”. He cam eback however and actually did not take his bonus for that year.

But how can one determine if he is really a good manager? Well, a first step would be to look at videos and interviews. As an INSEAD alumni for instance a quite interesting inerview with him can be found when he still was in charge of Santander UK. There are a lot of speeches and interviews found on Youtube from him, for instance here or here. Despite his “slick” look, he comes across as a rather thoughtful person trying to restore some kind of trust into the banking industry.

But public appearance only is a part of management assessment. The more important aspect in my opinion is a very simple question: What does a CEO actually do and achieve compared to what he is promising. In Lloyd’s case, a few months after he started, the CEO presented a strategic plan which covered the years 2012-2014. The main features were:

– reducing cost by 1.5bn GBP with a target cost income ratio of 42-44%
– Statutory ROE of 12.5%-14,5%
– Core tier 1 equity ratio > 10%

If we look at the latest presentation from March, we can see the following “score card”:

– cost was reduced by 1.4bn, but cost income ratio was 50%.
– Tier 1 ratio 12,8% —> fully met
– Statutory ROE: not met, it wasn’t even mentioned

Overall, Orosio delivered on the cost side but failed to increase the “other income”. Additionally, he clearly underestimated all the PPI, Libor scandal fines etc. but this is outside of his control. One thing which annoys me a little bit that they basically dropped the ROE measure from their reporting. The are now reporting non-sensical numbers like “return on risk weighted assets” which IMO is a “BS number”. For a financial company, ROE in my opinion is “THE” measure of success in the long run and nothing else.

So overall, I would give “good” marks to Horosia. I do think he is a great “operator” and maybe one of the bank “cost cutters” in the industry, but maybe not the one to create a lot of new business opportunities.

If we compare Lloyds for with RBS which was more or less in the same situation, financial markets seem to think that Lloyds has done better:

Valuation

As always, one has to make assumptions for any kind of valuation exercises. For banks, I like to keep it simple:

I Estimate a target P/B multiple, target ROE and target retention ratio to come up with a potential return calculation. In Lloyds case, I assume that 12% ROE is a reasonable target to be achieved within the next 4 years. Other than for Handelsbanken, I think that Lloyds can only reinvest 25% at those rates and will pay out 75% of earnings.

  1 2 3 4 5 6 7 8 9 10
Book Value 65 66,3 6791% 6961% 71,5 73,7 75,9 78,2 80,5 82,9 85,4
ROE 8,0% 9% 10% 11% 12% 12% 12% 12% 12% 12% 12%
EPS 5,2 6,46 6,79 7,66 8,58 8,84 9,11 9,38 9,66 9,95 10,25
Implicit P/E 80,76923077 13,0 11,7 10,6 12,5 12,5 12,5 12,5 12,5 12,5 12,5
Retention ratio 25% 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25 0,25
Dividend   4,8 5,1 5,7 6,4 6,6 6,8 7,0 7,2 7,5 7,7
Target Price   84,0 79,5 81,4 107,3 110,5 113,8 117,2 120,8 124,4 128,1
                       
NPV CFs 10 Y -79 4,8 5,1 5,7 6,4 6,6 6,8 7,0 7,2 7,5 135,8
NPV -79 4,8 5,1 5,7 113,7            
                       
IRR 10 year 11,5%                    
IRR 4 year 14,1%                    
                       
                       
Div. Yield   5,77% 6,41% 7,05% 6,00% 6,00% 6,00% 6,00% 6,00% 6,00% 6,00%

If my assumptions would turn out to be correct, over a 10 year period, Lloyds would return around 11% p.a. Not bad but worse than Handelsbanken. Selling after 4 years however would lead to a return of 14% which I find quite Ok. The difference comes from teh fact that I assume relatively low “compounding” which I think is realistic.

Other considerations

What I do like about the risk/return profile is the fact that there is a kind of “soft put” at 0,736 GBP. This seems to be the break-even of the UK Government. I assume that if the price would move below that, they will lower their sales volume or stop sales altogether as they want to show a “profit”, which should support the stock price at that level.

I think there could also be an interesting effect with regard to index weights. I am not sure how often index providers refresh their weights for instance for the Footsie, but there is most likely a time lag between the UK government selling and the index providers adjusting the weight. I know that for instance the DAX is only reweighted once a year which would then, in the caso of LLoyds would suddenly increase the amount to be bought by the index funds.

Summary:

Summing up the two posts, I would look at Lloyds the following way:

+ Lloyds look like solid UK bank which has cleaned up its portfolio and will return respectable returns going forward
+ The bank is run by a good operator which will decrease costs further
+ The UK Governemnet selling down and overall negative sentiment towards UK banking could explain an undervalutation of the stock
+ fundamentally I find UK banking attractive as there is significant concentration and interest rates are still high enough to make money
+ profits and dividends will improve significantly over the next 2-3 years
+ Threat of new entrants lower than for the other large peers due to low costs
– there is not a lot of growth potential in the stock as the market share is so high already
– short term nagative surprises/charges possible

In its current form, Lloyds is clearly not a growth/compounding story but rather a 3-4 year “special situation”. It similar to my 2 other “forced IPO” or “forced sales” investments Citizen’s and NN Group.

So overall, I find it a quite attractive special situation. Banks in general are one of the last truly “cheap” sectors and I do think that Lloyds has most of its problems behind it, especially compared to its large UK peers. So despite the relatively high valuation, I do think Lloyds is one of the most interesting situations with large UK and European banks at the moment.

Due to my position limitation however, this will get on the “queue” for the time being and decide by the end of the month if to buy, unless the price woul ddrop significantly. My buying limit would be around 79-80 pence/share.

Some links

Looks like that the 3rd Romanian stock gets finally listed in London: Fondul Proprietatae (h/t valuewalk)

Good (partial) interview with the guys of Boyles Asset management

Wertart has a post on French Microcap Microwave Vision

The UK Value investor with a great analysis on what went wrong with his Balfour Beatty investment

FT Alphaville has some issues with Greak stock Follie Follie

And finally the MUST READ: Credit Suisse Global Investment Return Yearbook 2015 (h/t Meg Faber) with, among other, some very interesting 115 years (!!!) historical data on industries

Time to admit a mistake – but still slow investing …

Time to admit a mistake: Thanks to reader Roger, I found out that my table showing the tax benefit in the “discovery of slowness” post has some major errors. This was the table from the post:

turnover/year Total gain AT p.a. AT in% of max
1 1024% 8,4% 35%
2 1735% 10,2% 60%
3 2061% 10,8% 71%
4 2284% 11,1% 79%
5 2363% 11,3% 82%
6 2444% 11,4% 84%
7 2529% 11,5% 87%
8 2616% 11,6% 90%
never 2896% 12,0% 100%

Well, as always, what looks too good to be true isn’t true and now, you will not reap such large enefits by extending the holding period only a few years.

The mistake was that I actually did not calculate a full sale at each intervall but only a partial one. If I calculate the effect of a full sale, the table looks like this (with hopefully fewer mistakes):

Avg. holding period Total P.a. In % of total
1 1024,3% 8,4% 35%
2 1068,5% 8,5% 37%
3 1112,8% 8,7% 38%
4 1232,0% 9,0% 43%
5 1201,2% 8,9% 41%
6 1245,0% 9,0% 43%
7 1361,3% 9,4% 47%
8 1558,9% 9,8% 54%
never 2896,0% 12,0%

It’s very easy to see that only the 1 year and 30 year number were correct, but in between the benefit of a longer holding period accrues much slower than in the initial version. The strange behaviour in the 4-6 year range is due to my arbitrary cut off at 30 years.

Holding your stock on average 8 years vs. 1 year still gives you 50% advantage after 30 years but it doesn’t look that spectacular. And to be honest: What fun it is to have for portfolio fixed for 30 years to gain the full “magic of compounding” before tax?

That led me to another thought: What is the impact if you manage to hold at least a certain percentage of your assets for along time ?

Again a very simple table to illustrate the effect and again hopefully with only a few mistakes:

% 30 year vs. 1 year Total p.a. In % of total
0% 1024,3% 8,4% 35%
10% 1211,5% 9,0% 42%
20% 1398,6% 9,4% 48%
30% 1585,8% 9,9% 55%
40% 1773,0% 10,3% 61%
50% 1960,1% 10,6% 68%

This table shows under the initial assumptions (12% p.a., 30% tax on realized gains), how a portfolio develops consisting of one sub portfolio with 30 year holding period and the other with annual turnover.

The results are interesting if compared to the first table: Even if you manage to hold only 10% of your assets for a really long time, this is equal to increasing the total holding period of the portfolio to 4-6 years.

So a small percentage of very long holdings really can create quite a nice benefit after tax, even before transaction cost etc. Intuitively I was trying to achieve something like this by defining a “core value” sub portfolio but I didn’t focus that much on long holding periods yet.

So what now ?

This is what Roger commented:

If they are relevant for you and your investment strategy (as your article suggests) I would suggest to revisit your calculation.
At least for me it would be quite annoying to change my investment habits due to an important insight from a calculation and later having to recognise that calculation was obviously wrong.

Well the good news is: Holding stocks longer is still positive even with the corrected numbers. But more important was this part of the original post:

Secondly, and even more important, being slow in my opinion is the best defense against any kind of behavioural biases.

I think this holds true in any case and the tax effect is just a niece side effect. I hope that the major “behavioural” benefit from this rule will be better investment decisions and the ablitity to hold winners for a longer time. If I look into my personal portfolio, a disproportionate amount of “alpha” comes from my long term winners, not from my rather short term special situations kind of investments. And rather nothing on average from short term “spontanious” trades.

I don’t think that I have to sacrifice anything by limiting myself to one position change per month.

Even more, since I decided for myself to slow down which I did already a few months ago, oddly enough I feel more relaxed overall with regard to the markets and my cash position. I have to admit that I used to pressure myself to come up with many new ideas before actually drilling deeper into existing ones. Especially right now, with a lot of annual reports coming out, I used to feel some stress in the past. This year I am actually quite relaxed. As I already know what I do in April (buy a fund), I now have a lot of time and leisure to prepare a potential transaction in May.

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