It is my pleasure to report the results for the 6 months ended December 31, 2015.
2015 turned out to be quite a year. It appears that we can find water on Mars, take selfies with Pluto and land a rocket upright after going to space, but struggle to maintain any semblance of sanity in the global commodities market. Oil has crashed from US$100 a barrel in mid last year to US$37, with the U.S. ending its 40-year ban on exports. Not to be outdone, natural gas dropped from a high of US$5 to less than $2. Iron ore fell from US$100 to US$50 a ton, continuing the trend from a high of US$180 in 2011. Since our inception on July 13, 2015, the S&P 500 fell by 0.9%, and the TSX Composite fell by 10.6%. Athena Capital Partner’s global equities portfolio fell by 3.9%. The fund remains over 50% in cash, and with the recent market correction, we find our days much brighter and much more interesting.
I have to admit that I am almost embarrassed to finish the first full quarter on such a down note, so I will focus this report mainly on the mistakes that I have made and the lessons I have learned.
The negative results for the quarter is mostly attributable to two investments in the mining and oil sector, namely Labrador Iron Ore Royalty Trust (TSX:LIF) and Transocean Partners (NYSE:RIGP). Truth be told, while I still believe the overall thesis, I did not expect the commodity rout to be as severe as it turned out to be. As a result, when I thought I was picking up some nice Wusthof knives on Black Friday sale, it was more like trying to catch all them falling. Barehanded. To quickly recap, LIF’s source of cash flow is an overriding royalty on one of the lowest cost and highest quality iron ore producer in the world, which means the cash flow is secure so long as the price for iron ore is above the mine’s marginal cost and the mine stays in operation. Further adding to the security, the mine’s expenses denominated in CAD but revenue in USD, creating a natural hedge against deteriorating commodity prices. Similarly, most of RIGP’s cash flow is generated from its two fixed price contracts with Chevron and BP, which expire between 2016 and 2020. While the terminal value of the rigs after that is certainly subject to the then prevailing oil price and producers’ capital budget, the shares were already trading at a level that ascribed minimal terminal value. In actuality, the multi-billion dollar rigs, which typically have 30-year useful lives, will have been less than ten years old, and is certainly worth something more than scrap.
The key problem, which I was aware of but clearly did not appreciate enough, is that a few factors worked in concert to create the opposite of Charlie Munger’s lollapalooza effect. The first factor is operating leverage. With technological advancement and the insatiable demand from China over the past decade and a half, mines have been getting much bigger and much more automated. While these mines are much more expensive and takes much longer to build, the marginal cost of production has come way down. In fact, most of the cost of production is fixed, regardless of whether it runs or not. The second factor is that to build these expensive mines, most producers have taken on a tremendous amount of debt, financed by the easy money since 08 and aided by the commodity supercycle. The debt load not only increases the fixed cost for the miners in the form of interest expense, but also exacerbates the pressure to produce in order to avoid a default. The third factor is the declining power of the likes of OPEC, as they control less and less of the global market. When OPEC controlled the majority of the global oil market, they had every incentive to keep prices high, as the marginal benefit would mostly accrue to its member states. However, as Russian and US shale production increased dramatically over the past decade, any supply constraint created by a production curtailment from OPEC member states would be more than offset by these new kids on the block, who are not bound by the old rulebook. As a result, OPEC is now more incentivized to keep production high and prices low, so as to discourage new capacity growth from non-OPEC states and especially the new higher cost producers. The combined result is that when commodity price craters, most producers have no choice but to increase output, as their cost base is increasingly fixed, and the lack of a swing producer only compounds the problem. Hence, the positive feedback loop became a self-fulfilling prophesy like the bankruns at the turn of the 20th century, leading to an unprecedented collapse of almost all commodities.
Despite the general malaise, there remains a bright spot in the market – the FANG. Over the past 6 months, Facebook was up 22%, Amazon 57%, Netflix 24%, and Google 45%, while the NASDAQ index as a whole was up a mere 1%.
While I am a devout customer of all four companies, and I firmly believe that they each enjoy a unique competitive advantage that will allow them to do fantastically well in their respective fields, their valuations are beyond my humble comprehension. For instance, after Amazon announced that it would breakout AWS results in its next quarterly report, AMZN shares rose 25%, before the actual report was issued. Similarly, when Google announced that it would reorganize itself into Alphabet, and report its core operations separately from the other alpha bets, GOOG shares rose almost 30% overnight, also before anyone actually had an inkling of idea how the core operations were actually performing. While increased transparency should certainly be celebrated, and the additional information could theoretically enable better analysis and thereby reduce perceived investment risk, I find it difficult to understand the value assigned to the announcements, especially before the additional information became available.
More importantly, these firms were not trading at a discount for nondisclosure before the changes in reporting. They were already priced for almost perfection, with significant growth and market dominance implied by the lofty multiples. While, individually and independently, one might argue that Amazon and Google have incredible cloud computing offerings, or Netflix and Youtube have unparalleled distribution for video content, etc., not all of them can be winners at the same time. The situation reminds me of the epic battle for market share between Uber vs. Lyft. Both have been darlings of the VC industry, and both have engaged in a cutthroat price war to win customers. I personally received more than $300 in credits from each of them over the course of two years, and still checks both apps for prices/availability before I book a ride. Most of the drivers I spoke with are registered with both companies and take customers on whichever one that happens to have higher fares/more customers at the moment. No one can predict the future winner of the war, or whether there can be only one winner, but I would go out on a limb right now and boldly predict that they cannot both end up with a majority of the market at the same time. When the probability of success assigned by their respective investors (or the same ones – aye, here is the rub, there are investors that invested in both companies) do not add up to 100%, something is amiss somewhere.
2016 is poised to be quite an interesting year. The hulking driver of global growth is sputtering, all but the largest commodity producers are in distress, the Fed’s promise to raise interest rates is putting itself in a bind, and the market continues to swoon. But it is in these uncertain and terrifying conditions that great opportunities present themselves. Over half of the partnership’s capital remains in cash, and after spending six months agonizing over the sky high valuations, things are finally getting interesting.
Athena Capital Partners