Friday, April 25, 2014

Mining stocks

A big contributor to the housing bubble was housing developers borrowing a lot of money to buy land. After the bubble burst, they had to monetize the land in order to pay back the debt. Since all the big developers were in the same situation of needing to sell land, there wasn't anyone in a position to buy. That left them with only one way to monetize it: building more houses into a housing market that was already glutted. It was a vicious cycle.

Right now mining companies are in the same position. Most of the big miners, especially iron ore miners, have borrowed money to develop new mines. The market is on the verge of being oversupplied, but nearly all iron ore miners plan to increase production, and their significant debt levels make it tough for them to reduce production in a down market. If Chinese growth falls and demand falls significantly, the more indebted producers will go bankrupt. Even with a (relatively) soft landing, I expect them ultimately to go down 80%+.

That doesn't necessarily make them good shorts at this moment, however. Mining stocks have steadily marched lower during a bull market, and the bear case for these stocks and related securities like the Australian Dollar is well known among hedge funds. It's almost a consensus short, and I wouldn't be surprised to see some kind of relief rally. Just looking at the charts, many of these stocks like TCK and VALE look tightly wound and could easily bounce 20% in a few weeks.

An under-appreciated part of investing is recognizing one's psychological limitations and trying to minimize their fallout. I would be beside myself if I shorted these stocks, knowing that there was a high risk of a bounce, and quickly lost 20%. So I'm in the position of being very bearish but staying on the sidelines for now. If there's a bounce, I think that would be a good shorting opportunity.

Thursday, April 17, 2014

Value Investors Club

Value Investors Club (VIC) is a semi-private website where people share investment ideas. Becoming a member of the club requires submitting an application and then, if the application is accepted, writing up two or more ideas per year. People whose applications are rejected, or who don't apply, can view the site with a 45-day lag.

VIC began in 2000. I learned about it in 2002, when Whitney Tilson mentioned it in one of his Motley Fool columns, and since then I've been a regular reader of the site. At this point VIC has a database of thousands of investment write-ups, which is great for 1) testing which investments and investing strategies have and haven't done well over time and 2) seeing what people thought about a particular investment at the time of the write-up, which helps against hindsight bias.

VIC's demographics have changed a lot over the past 14 years. When the site started, it was mostly individual investors. Now it's mostly hedge-fund analysts and portfolio managers. As the membership has become more professional, the write-ups have grown longer and more detailed, although that's not necessarily an improvement: In my experience, the greater detail often gives a false sense of precision. Also, while the pros may be more sophisticated, their thinking seems narrow in a lot of ways. Some of them seem to live in a bubble in metropolitan NYC.

When the stock market becomes overvalued, many VIC members respond by lowering their standards. Sometimes they buy junkier stocks than they normally would: instead of buying stocks that trade at 6x earnings, they'll buy stocks that trade at 6x earnings pro forma for a turnaround that probably won't happen. Sometimes they talk themselves into paying higher multiples than they normally would. One write-up from last year begins: "While SODA is not the type of traditional low multiple value idea I would normally post on VIC, I am finding a dearth of traditional deep value type ideas with the market at all time highs."

Members rate the write-ups that are posted on VIC, and certain types of write-ups consistently get higher ratings than others. Contrary to Buffett's famous quote that "I'd rather jump over a one-foot hurdle than a six-foot hurdle," VICers tend to rate ideas better if they're more complex or novel. Write-ups that have colorful anecdotes about the CEO or the company's history also get better ratings, even though those things don't really matter.

Write-ups recommending a short sale tend to get higher ratings, especially recommendations to short overvalued growth stocks. I'm primarily a short-seller, and in my experience these are the absolute worst stocks to short.

Ultimately, VIC is kind of paradoxical: it's a great research tool, and there's a lot of intelligent commentary on specific write-ups, but the site's overall sentiment is often a contrary indicator.

Sunday, April 6, 2014

Declining businesses

Declining businesses are companies whose revenues are shrinking on a permanent basis, usually because their products have become obsolete. In my experience, these are almost always bad investments.

Most declining businesses were once growing and highly profitable-- e.g., newspapers or yellow pages-- and as a legacy of that, they carry large debt loads. For a stable or growing business, debt is a non-issue because the market is happy to refinance it absent a crisis and carrying the debt doesn't preclude paying dividends or buying back stock.

The situation is very different for declining businesses, for which debt becomes a kind of supra-equity: not only does the company have to use declining profits to make fixed interest payments, it has to repay the debt's principal before shareholders can receive any money.

Even without the problem of debt, investing in a declining business is an uphill battle: long-term investment returns depend on the power of compound growth, and declining businesses have the opposite of that.

Another issue is that it's hard to know how quickly a declining business will fade away since there are no precedents for its decline, at least not in the same industry. That uncertainty makes it tough to value these companies with much confidence.

A good case study is US Mobility (USMO), which provides paging services. At the beginning of 2005, USMO traded at $35/share. Today, after paying $16 of dividends, the stock trades at $19/share. USMO had a lot of advantages that other declining businesses don't: it had large tax-loss carryforwards, it was debt-free, its management was committed to distributing profits to shareholders, and its business wasn't going away completely: pagers have no alternatives in certain places, like hospitals, and paging networks are much more robust than cellular networks, so pagers will always have a use as a backup after natural disasters. Despite all those strengths, USMO has produced a return of exactly zero over the past nine years.

A common argument for investing in declining businesses is that they tend to be undervalued because they have no natural constituency: institutional investors don't want them, growth investors don't want them, et cetera. That might have been the case historically, but I don't think it's true today. Many hedge funds look specifically for out-of-the-way stocks like micro-caps, spin-offs, and declining businesses. Many investments that were traditionally overlooked are now picked over.

Saturday, April 5, 2014

Gold miners

Gold-mining stocks have dropped a lot over the past two years but they're still bad investments. These stocks have numerous problems, including but not limited to awful management, awful cashflow, and uncontrolled cost inflation.

Bulls often say that mining stocks are much cheaper, relative to the price of gold, than they've been in the past. John Hussman has frequently made this argument. The flaw with that reasoning is that for most of the past 25 years, the price of gold was much lower than it is today. Since the price was so low, people could value the miners off hopes and dreams about how much money they would make when the price of gold went parabolic. It's since gone parabolic, but the miners still aren't making much money, so people can't value them off hope anymore and have to face the poor fundamentals.

Another big issue is that gold is clearly a bubble–the price of gold has risen much faster than the prices of industrial metals, which are themselves very bubbly. (I'll have a separate post about that soon.) Gold went up for ten straight years, and that attracted a lot of momentum investors, but because gold is considered a safe haven, these people didn't think of themselves as momentum players. In reality, if one wants a safe haven, one can't hoard the things that everyone else is hoarding. A speculative investor base is inherently dangerous and unstable, and the fact that most of these people don't realize they're speculators makes it even more unstable.