To Charlotte Lane partners:
February was a poor month for the strategy, with the Fund losing 2.27% in a choppy but net flat market. Since inception on January 4, 2016, the Fund has gained 2.35% vs. a 5.06% loss for the S&P 500. The numbers are presented in the tables below, followed by a discussion of portfolio performance, risk management, and the investment process.
Returns for Period February 1, 2016 – February 29, 2016 Source: Interactive Brokers (IB)1
Charlotte Lane S&P 500 Russell 1000 Total Return (2.27%) (0.08%) (0.04%) Sharpe Ratio (1.51) 0.03 0.07 Sortino Ratio (2.71) (0.46) (0.39) Carlmar Ratio (4.79) (0.26) (0.11) Standard Deviation 1.27% 1.13% 1.15% Max Drawdown (6.86%) (5.61%) (5.84%)
YTD Returns for Period January 4, 2016 – February 29, 2016
Charlotte Lane S&P 500 Russell 1000 Total Return 2.35% (5.06%) (5.42%) Sharpe Ratio 1.02 (1.74) (1.84) Sortino Ratio 1.06 (2.68) (2.80) Carlmar Ratio 3.34 (3.59) (3.58) Standard Deviation 1.18% 1.29% 1.31% Max Drawdown (6.86%) (10.31%) (10.91%)
1 All return information contained herein for information purposes only. All return data unaudited. Return data not presented as GIPS-compliant. Returns are net of management fees and expenses.
Charlotte Lane Capital 1 February 2016 Letter [email protected]
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Cumulative Return for Period January 4, 2016 – February 29, 2016 Source: IB, Charlotte Lane Capital (CLC)
15.00% Charlotte Lane SPX
10.00%
5.00%
0.00%
(5.00%)
(10.00%)
(15.00%)
Part 1: February Performance, Portfolio Management, and Risk Management February wasn’t a disaster, but the minute I come to you and blame underperformance on a “low- quality rally” or in any way avoid an honest discussion of why performance wasn’t up to our standards, I would advise you to terminate your account. Failures of one sort or another are inevitable in investing, and in all things, and February's drawdown offers an opportunity to discuss more fully my portfolio management and risk management processes.
Part 2: On Failure, Shorting, Rebirth, and Value Investing As promised in the January letter, I elaborate on why Buffalo, N.Y., is a perfect place for a short seller (and long investor!) to have spent the first 25 years of his life. In a phrase, nothing succeeds like failure. There was much to learn about shorting growing up amidst the failure of American integrated steel mills, the Love Canal environmental disaster, two of the top U.S. savings & loan (S&L) implosions, failed public policy decisions, and four Super Bowl losses by the Buffalo Bills. There is also much to learn about value investing in such an environment. The seeds of success are often sowed in and nourished by the ashes of decay.
Charlotte Lane Capital 2 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Companies Mentioned
Company Page Company Page
Synchrony Financial (SYF) 6 Cloud Peak (CLD) 16 Goldman Sachs (GS) 6 Vivendi (VIV FP) 16 PRA Group (PRAA) 6 Generac (GNRC) 17 General Electric (GE) 6 Seadrill (SDRL) 19 Deutsche Bank (DB) 7 Chesapeake Energy (CHK) 19 M&T Bank (MTB) 8 UnitedContinental (UAL) 20 Key Bank (KEY) 8 Union Pacific (UNP) 20 Australian, Canadian banks 8 Delta (DAL) 20 Transocean (RIG) 7% of 2028 11 Norfolk Southern (NSC) 21 Schlumberger (SLB) 11 Canadian Pacific (CP) 21 EOG (EOG) 11 Amazon (AMZN) 21 Chevron (CVX) 12 Boston Beer (SAM) 22 PACCAR (PCAR) 15 Bethlehem Steel 25 Brown Forman (BF/B) 16 Nucor (NUE) 26
February Performance, Portfolio Management, and Risk Management
February came in like a lion and went out like a lamb… on a spit. (I’m a month early with that metaphor, I know.) The second half of February was what is known as a “face ripper.” I have managed the Charlotte Lane strategy with a high gross, net short stance from the start of the incubation period in February 2014 and from inception as a standalone entity on January 4, 2016. This is the result of my read on bottom-up, company-by-company factors as well as top-down macro factors, which worsened in 2015 and have continued to worsen this year.
Given further macro deterioration, I started 2016 building short exposures and holding down long investments. Within the first week, Charlotte Lane was 96% invested on the short side and less than 50% in longs. Gross and net exposures to-date are as follows:
Charlotte Lane Capital 3 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Charlotte Lane Gross Exposures Source: IB, CLC
100%
50%
0%
(50%)
(100%)
(150%)
Long Short
240% Gross Invested Assets 220%
200%
180%
160%
140%
120%
100%
80%
Charlotte Lane Capital 4 February 2016 Letter [email protected]
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0%
(10%)
(20%)
(30%)
(40%)
(50%)
(60%)
On February 8, I concluded that bearish behavior in the market had reached a crescendo and cut short exposure that day by 22 points, to (101%). Had I done nothing else, that would have been the (more) correct move for the rally that followed. However, I replaced that exposure in short order, but I also built long exposure such that the quarter ended with a 91% long position and a 117% short position. Consequently, returns for the month suffered in part due to my stance on length of market, which averaged (38%) in February2.
From the end of January through the end of February, the net stance of the portfolio declined by nearly 20 percentage points:
2 Daily average
Charlotte Lane Capital 5 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Charlotte Lane Exposures at Month-End Source: IB, CLC
Gross Exposure Net Exposure 1/29/2016 2/29/2016 1/29/2016 2/29/2016 Consumer Discretionary 42.8% 53.5% Consumer Discretionary (15.9%) (13.9%) Consumer Staples 24.5% 25.6% Consumer Staples 3.3% 6.6% Energy 32.7% 25.3% Energy (8.5%) (5.0%) Financials 17.9% 34.3% Financials (6.2%) (3.3%) Health Care 8.5% 10.7% Health Care 8.5% 10.7% Industrials 55.0% 51.2% Industrials (21.4%) (15.2%) Information Technology 8.8% 6.0% Information Technology (2.4%) (6.0%) Materials 2.9% 0.0% Materials (2.9%) 0.0% Telecommunication Services 0.0% 0.0% Telecommunication Services 0.0% 0.0% Utilities 0.0% 0.0% Utilities 0.0% 0.0%
Total 193.1% 206.5% Total (45.6%) (26.1%)
Long Short Long Short 1/29/2016 1/29/2016 2/29/2016 2/29/2016 Consumer Discretionary 13.4% (29.3%) Consumer Discretionary 19.8% (33.7%) Consumer Staples 13.9% (10.6%) Consumer Staples 16.1% (9.5%) Energy 12.1% (20.6%) Energy 10.1% (15.1%) Financials 5.9% (12.1%) Financials 15.5% (18.8%) Health Care 8.5% 0.0% Health Care 10.7% 0.0% Industrials 16.8% (38.2%) Industrials 18.0% (33.2%) Information Technology 3.2% (5.6%) Information Technology 0.0% (6.0%) Materials 0.0% (2.9%) Materials 0.0% 0.0% Telecommunication Services 0.0% 0.0% Telecommunication Services 0.0% 0.0% Utilities 0.0% 0.0% Utilities 0.0% 0.0%
Total 73.7% (119.3%) Total 90.2% (116.3%)
In general, you will find my largest exposures in areas where I have the most experience3, and I will often stake out new or increased positions in sectors that have experienced a big move up or down. Take Financials, for instance. I have about 20 years of experience in the sector and nearly doubled overall exposure to it from the end of January through February after the S&P 500 Financials index turned in by far the worst YTD sector performance in the broad market.
This allowed me to nearly triple the Fund's long exposure to Financials by month-end, adding new longs in Synchrony Financial (SYF) and Goldman Sachs (GS) and increasing our small position in debt collection firm PRA Group (PRAA).
Synchrony Financial
I have long been involved in specialty financials, and Synchrony is a gem of a company spun off from General Electric (GE) late in 2015, straight into a Financials sector maelstrom. Synchrony is the largest provider of private label (PL) credit cards in the U.S. PL cards are growing on a secular basis because they provide a high return on investment to retailers, which use them to attract and retain customers. They allow a retailer deep insight into customer behavior, which provides the opportunity to target customer spending far more precisely than broadcast, direct mail, and even interactive marketing
3 Dollar-weighted and in years of experience
Charlotte Lane Capital 6 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 campaigns. For a sector under siege from online competitors, the value proposition for retailer customers is very clear.
Synchrony trades at 10x estimated 2016 EPS and has a well-capitalized balance sheet with 13%+ tangible common equity to assets. The PL card subsector has historically generated volatile credit results, which is a risk in this situation, but Charlotte Lane is amply hedged in general and with regard to the financial health of U.S. households.
Goldman Sachs
The Goldman investment arose from an idea that came from a key client who has extensive and very profitable experience in financial services. We were looking at the contingently convertible (CoCo) bonds of Deutsche Bank (DB), which were trading near 60¢ at the time. The credit of a number of European banks had imploded after Portugal’s largest bank changed the terms of its senior debt, switching the security attached to the debt from its consolidated balance sheet to the “bad bank” created to ring-fence bad debts from good ones.
When an investor lends money to a borrower or an investor assumes that debt, there is a contract, or an indenture, governing the terms of the relationship between the parties. The word “covenant” is found in the Bible, the Torah, and the Qur’an, as well as in most bond indentures because the concept lies at the very basis of all belief between the various parties in these documents. When those covenants are broken by the borrower with blithe indifference, creditors freak out, with good reason. Holders of DB’s CoCos feared this might happen, especially considering DB has 30 times the amount of assets on its balance sheet as it has tangible equity. In other words, a 3% drawdown in its asset values would render the bank insolvent, and it's no mystery DB carries some assets at eminently questionable marks (sovereign debt of shaky countries, for example).
I looked at this CoCo because I figured a conversion of the debt to equity would shore up the balance sheet and make the equity rise. Alternatively, if the situation passed, the bond would rise, perhaps to par in short order. However, this is a very complex security4 and Ich spreche kein Deutsch, so I considered U.S. securities. U.S. banks have been pummeled on fears of global interbank stress, which the above issues have signaled. If the large European banks indeed have a problem, globally interconnected interbank lending would face issues. However, the LIBOR-OIS spread hadn’t moved since the Fed tightened last year, and this market did not confirm worries about interbank stress.
That being the case and continuing with the idea that interbank security would be improved with the conversion of the CoCos, I bought Goldman around 86% of tangible book value per share. Goldman remains the best-operated large investment bank in the U.S. and is leaning in to take share in a number of markets where other banks are laying off people because those banks can’t take the pain. This is the sort of behavior we want to see.
Ultimately, too, Goldman’s capital strength is nearly three times that of Deutsche Bank. And here I’m not talking about tier 1 equity to risk-weighted assets. There is much phony baloney in the Bank for International Settlements (BIS) standards. In BIS standards, sovereign debt rated AAA to AA- carries zero risk weightings. ZERO. And sovereigns rated A carry a 20% risk weighting. So let’s say a bank with $3 in tangible equity held no assets other than, say, $100 of Latvian or Pakistani sovereigns. Its TCE ratio would be 3%, but its tier 1 ratio would be 15%. That is bonkers.
Risk Management
Wall Street often describes risk management in quantitative terms. If you conduct due diligence on a bank’s risk management approach, you’ll get loads of spreadsheets and wonderful value at risk (VAR) calculations5, a meeting with the chief risk officer and staff, and a 45-slide PowerPoint deck describing in
4 The devil lives in the details in credit indentures. 5 Including the occasional Excel coding errors! Charlotte Lane Capital 7 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 meticulous detail the firm’s risk management processes. That’s nice, but a CEO or Chief Investment Officer (CIO) will blow off all of it when they want, and god help anyone who takes the career risk of pointing it out.
Risk management lies between the ears and in the gut of anyone who handles capital and is the chief responsibility of a CEO, CIO, CFO, and all senior leaders in a fiduciary organization. In the case of the DB CoCos, I first decided that I didn’t understand these instruments well enough to make an investment. The fact that these CoCos are up 30% vs. 8% for GS in a few weeks doesn't bother me at all. In any probabilistic endeavor, one should focus on process and not outcome. The process of knowing one’s limitations is humbling but empowering.
In the case of BIS standards, who am I to say this cornerstone of international banking doesn’t know what it’s talking about? Not to front-run the Buffalo section later in this letter, but one of the top-10 S&L failures happened here when I was in my early 20s, and another would have qualified had it not been taken over by M&T Bank (MTB)6 and Key Bank (KEY). At that time, many S&Ls had consolidated over the prior couple of decades and were told by the Federal Home Loan Bank Board (their primary regulator) that they could count goodwill in their regulatory capital. This reminds me of a joke from President Abraham Lincoln:
“How many legs does a dog have if you call his tail a leg? Four. Saying that a tail is a leg doesn't make it a leg.”
Goodwill is no more capital than a tail is a leg. When federal regulators ceased allowing goodwill in the calculation of capital and then made financial institutions mark down illiquid assets to illiquid market prices, we got a very bad crisis.
I see the same problem today in banks around the world. Treating sovereign debt, corporates, mortgages, and other instruments as risk-free assets or very low-risk assets just based on credit ratings does not make those tails into legs. Charlotte Lane is currently short an Australian bank and a Canadian bank because their housing markets are highly inflated (beyond the U.S. peak in Canada and at multiple times the U.S. peak in Australia), their resource-based economies have slowed, and their housing markets are in part dependent on hot money flows out of China and other emerging markets. The Canadian bank has the added fun of having made a big push into Latin American lending and holding loads of exposure to energy credit.
As someone with “deep value” experience, I’ve been here many times, primarily in 2000-2003 and 2008- 2010, and with many vivid memories and study of the early 1980s, the S&L crisis, 1994, and 1997-1998. VAR doesn’t capture this, as it’s a calculation of past events that is crammed into a normalized distribution. Events that are supposed to happen every few thousand years occur with a regularity that makes VAR laughable as a useful tool. Yet the financial world relies on it and measures like “beta” as tools for risk management.
As you probably know, I teach the Security Analysis class at Columbia University on an adjunct basis with my friend Ryan Brown. One of my earliest lectures centered on the concepts of cost of capital, cost of equity, the calculation of equity risk premium (ERP), and the reasons why beta is a deeply flawed measure in calculating these data. In a nutshell, beta and ERP were invented as concepts in an era of expensive and hard-to-access computing power. Its progenitors wanted to link movements in equities with sovereign interest rates, so they came up with the mystical beta and ERP.
Something often lies, however, between sovereign rates and equity returns. It is often publicly traded, it has rights senior to equity but junior to the sovereign, and it has an explicit cost to the corporation that changes daily: “It” is corporate debt, and the classical capital asset pricing model is mute on that subject.
6 Still one of the finest large banks in the U.S. This is an amazingly opportunistic yet conservatively managed company in which I’ve been an investor for 20+ years.
Charlotte Lane Capital 8 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Let’s look at equity returns, ex post, vs. the Baa credit spread against the 10-year Treasury note yield:
S&P 500 YoY Performance vs. Baa Credit Spread Source: BBG, CLC
80.0% 0.00%
60.0% 1.00%
40.0% 2.00%
20.0% 3.00%
0.0% 4.00%
(20.0%) 5.00%
(40.0%) 6.00%
(60.0%) 7.00%
SPX, YoY Credit Spread (RHS, Inverted)
Mathematically, this is a very noisy series that I think is due to very high real rates from 1980 through the 2000s and the Greenspan-era Fed being supportive of the capital markets whenever they ran into problems. After many years, the market priced in the “Greenspan put” as a given, and this was arbitraged away as a consequence. To save the U.S. economy, the Fed had to engage in extraordinary measures in 2008 and has had to maintain them since. Despite the noise, the relationship is very clear.
Let’s look at another set of series:
Charlotte Lane Capital 9 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Credit Spreads vs. Equity Prices Source: Barclay’s
Looking at broad indexes vs. credit spreads, there is a clear relationship. And looking at individual equity prices vs. that corporation’s credit spreads, the correlations are very tight, especially for high-yield issuers.
When a corporation has 12-year debt yielding 18%, the Capital Asset Pricing Model (CAPM) will tell you using beta and the ERP that its cost of equity might be 10-12%. Again, bonkers.
A very large part of my risk management approach lies in seeking to understand the entire capital structure of the corporation and pricing expected returns using data the market gives us daily in corporate credits. Most equity investors can tell you equity is junior in claims to everything above it, but in my experience, maybe five out of 100 equity investors know how debt markets work and how to tie that information to equity prices. I’m not claiming wizardry for myself, but I can assure you if my understanding is incorrect, it’s the result of many years of intense study and testing of these concepts.
This comes in handy periodically for the same reason a pilot of a Boeing 767 makes a lot of money. The autopilot can handle 99.9% of situations, but you want a grey matter entity in control with lots of fuzzy data to handle the nonlinear emergencies. That pilot isn’t just a friendly, commanding voice – he or she is primarily the chief risk officer aboard that aircraft.
Not to belabor the analogy and needing to move on, it’s not spreadsheets and infrastructure that make for good risk management: it's self-control, humility, and recognizing when certain constructs are flawed or worse. The Australian housing market is one such situation. It’s been good for so long, the belief state is deeply entrenched across almost the entire population. The screeching rebuttals to my professional Charlotte Lane Capital 10 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 acquaintances who publicly criticized the situation and shorted these banks is absolutely amazing and a little sad. There is a huge misallocation of societal resources in that market, and I think it will end badly. With the slowing of the Chinese economy and the consequent implosion of commodity prices globally, I believe the catalyst is here, and our short in a very large bank offers 60-80% downside.
What Went Wrong in February
Now let's discuss what went wrong in February:
Charlotte Lane February 2016 Performance by Sector Source: IB, CLC
Industrials (1.65%) Energy (0.74%) Financials (0.67%) Health Care (0.27%) Consumer Discretionary (0.11%) Utilities 0.00% Telecommunication Services 0.00% Materials 0.11% Information Technology 0.34% Consumer Staples 0.91% Subtotal (2.07%)
Net interest (0.05%) Advisor Fees (0.12%) FX (0.01%) Reconcoliation (0.02%) Subtotal (0.20%)
Total (2.27%)
While Industrials were the biggest detractor for the month, the biggest unforced error was in Energy. Four positions cost us 49 bps, 32 bps, 24 bps, and 11 bps, respectively: long Transocean 7% of 2028 credit, short a U.S. natural gas liquefaction company, short Schlumberger (SLB), and long EOG (EOG).
The structure of the Energy exposure is meant to extract alpha from a position that is net neutral energy prices.7 I believe energy prices will be flat within a $10-15/barrel corridor for the next 3-5 years as the world remains oversupplied and as demand growth has been very poor. (However, I don’t cling to this belief, thus the net neutral structure.) Below we see proved global crude reserves in terms of years of demand:
7 On a delta-adjusted basis, with credit valued at par. At market, we were 5% net short at month-end.
Charlotte Lane Capital 11 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 World Proved Crude Oil Reserves, Years of Supply Source: BP Statistical Review, CLC
55
50
45
40
35
30
As I have previously discussed8, national oil companies’ return on invested capital (ROIC) and the low hurdle rate allowed by sovereign debt yields, geopolitical factors, macro factors, and ROIC for profit- seeking exploration and production (E&P) firms all play a role in how I forecast oil prices. Consequently, I know this is a highly imprecise exercise, and I don’t want to take directional price exposure, especially here.
Despite the net neutral to somewhat negative Energy structure, our February returns within the sector were particularly bad. The shorts went up and the longs, in the main, went down – not a recipe for success long-term. Throughout the month, I assessed whether the structure was poorly designed, as I had a long weighting in an energy E&P firm, credit of an oil & gas driller, and credit of a coal-mining firm against shorts in natural gas liquefaction and oil & gas services.
Basis risk is very important to my risk management approach. One of the easiest ways to blow up in long/short is to short small caps vs. long large caps, short growth (or high multiples) vs. long value (low multiples), short high beta vs. long low beta, or to have sizable currency and geographic mismatches. I do take sizable long and short positions in industries and have a few large exposures in single names. Without some concentration and high active share9, the chances for outperformance decline markedly. Deviations from market weightings and holdings are the only way to outperform. High active share is also, I hasten to mention, a ticket to underperformance by its nature.
Concerned with basis risk between being short producers of energy and long providers of energy services, I cut the 12.9% short position in SLB to 3.9% and replaced it with a 9.2% short position in Chevron (CVX). I believe this is a far better match against my long positions. Don’t get me wrong: I believe almost all energy equities are overvalued at current spot prices, but I think our shorts are more overvalued than our long equities while our long positions in high-yield (junk) credit are materially undervalued. These positions trade near 51¢ and 34¢ and hold the potential to rise by 100% and 200% to par if energy prices take off. I don’t believe our energy shorts have anywhere near that potential.
8 How Charlotte Lane Is Positioned, inaugural letter, Q3 2015. 9 "Active Share and Mutual Fund Performance," by Antti Petajisto.
Charlotte Lane Capital 12 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Below we see the relationship between Chevron and Brent, the global light crude oil benchmark. Since oil fell apart, the stock has come off some, but nowhere near as much as its longer-run relationship with oil would suggest:
Brent Crude vs. Chevron (Correlation Measured 2004-2013) Source: BBG, CLC
$100.00
Brent spot
CVX
$10.00
140
120
100
80
60
40
20 y = 0.7004x + 23.818 R² = 0.8072
0 0 20 40 60 80 100 120 140 160
I have seen the same relationship in a number of commodity-based sectors, and I believe quantitative easing makes it cheap to carry via equities the option on a rebound in oil prices. It will be far easier for investors to hold SLB as a speculative long, as its business model is far better than the reserve- replacement business model we find in Chevron. Charlotte Lane Capital 13 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Consider these data:
Chevron Metrics vs. Crude Source: BBG, CLC
12/31/2004 12/31/2013 Current Brent Crude $40.46 $110.80 $39.58 Market Cap $111B $239B $178B Stock Price $52.51 $124.91 $94.74 Enterprise Value $111B $244B $207B Net Debt $0.5B $4B $27B Year-Forward EPS $6.54 $9.94 $1.46 P/E 8.0x 12.5x 65x ROE 30% 15% 1.8%
Over the last 10 years, Chevron has converted 56% of its net income to free cash flow (FCF) while spending 170% of its depreciation, amortization, and depletion on capex. In the last three years, dividend payments exceeded FCF by a cumulative $15B, with FCF falling short of dividend payments last year alone by $6.6B. Based on consensus earnings estimates for this year, the company may generate anywhere from $2.1B to $3.2B in FCF and face dividend requirements of $8.1B unless it cuts the dividend.
Chevron has said its highest priority is to maintain and grow its dividend and provided an asset sale outlook of $5-10B for 2016 and 2017. That exactly matches the dividend shortfall I lay out above. If Chevron sells assets to cover this rather than cutting the dividend, it implicitly admits its assets are overvalued. Sure, in any portfolio there are discards, but I think this also demonstrates the institutional imperative to maintain a dividend once a certain level has been declared. This is a dangerous position for a company like this given this historical chart:
Real Crude Price, 1865-2015 Source: British Petroleum, CLC
$140
$120
$100
$80
$60
$40
$20
$-
Charlotte Lane Capital 14 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Nothing in financial theory I have seen indicates returns are enhanced by a fixed dividend. I would guess returns are hurt because corporations contort themselves to maintain a dividend they obviously cannot maintain through operations. I suspect Chevron’s board knows if it cuts the dividend by, say, 35%, the stock price will follow it down that much.
Compare this dividend policy with that of our #4 long position, PACCAR (PCAR). PACCAR produces Kenworth and Peterbilt trucks in the U.S. and elsewhere and the DAF brand in Europe and elsewhere. The same family has managed the company and maintained a major stake in it for 100 years:
PACCAR Dividend Payments, 2004-2015 Source: Company filings, CLC
$2.50
$2.00
$1.50
$1.00
$0.50
$-
Regular Special
PACCAR is a core long position at 6.5%, which comprises half our long position in Industrials vs. a 30% short position in the sector currently.
Back to Energy, I believe Charlotte Lane's structure that ended the month is much improved vs. the end of January. When shorting, one really doesn’t have the leisure of holding tight and claiming, "We're long- term investors.” That’s a good way to get killed. When you’re long and wrong, the problem becomes a smaller part of the portfolio. In shorting, you get the exact opposite, but this doesn't mean one must fold. I welcome some short positions becoming larger, as that's akin to averaging down on a losing long position. But averaging, in all its forms, both passive and active, is another cornerstone of my risk management approach.
When it comes to averaging, I fall somewhere between Paul Tudor Jones and Bill Miller, but much closer to Jones. Jones said, “losers average losers,” and Miller said, “lowest average cost wins.” I will decide ex ante whether a position should be averaged if the opportunity arises. The distribution of returns attaching to the stock’s subsector plays a large part in this decision. A former colleague, Arturo Rodriguez, formalized this theory about 6-7 years ago10. He analyzed 60 years of return data for individual stocks and sectors and found 18 larger return distributions.
10 Arturo Rodriguez is founder and PM at Simplexity Investment Management (http://www.simplexityim.com). Arturo was a PM and investment strategist at LMCM for many years while Charlotte Lane Capital 15 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 These patterns fall into three larger groups: those with a left skew, log-normal, and Pareto distributions. Banking, for instance, has a strong left skew to the distribution, meaning zeroes, giant drawdowns, and capital destruction events happen more often than we might expect if we fit history to a normal distribution:
Banking Equities Return Distribution Source: Simplexity
This isn’t academic. This pattern tells us the equity of a financial services company is not necessarily cheap at book value or even 60% of book value. I’ve literally held things at 1x forward EPS and 10% of book value. If you maintain this understanding going into a crisis like 2008-2009, your averaging behavior might not be as aggressive. Meanwhile, you might also understand the trailing return of something like Brown Forman (BF/B) was very unusual, given the log-normal return distribution of its reference class of equities. How one would average that company is far different, in my opinion, from how someone would average a bank.
As mentioned above, one of the two energy credits we’re long was a major detractor during the month, accounting for 49 bps of losses in February’s performance. In the Energy space, I believe high yield is far more attractive than equities. However, we must accept some degree of illiquidity to express that view. Whereas money flowed into large-cap energy equities in February at each whiff of a crude rally, many broken high-yield credits did not rally during the month.
Since the beginning of the year, I have averaged the Transocean 2028 position once and have left alone the Cloud Peak (CLD) 2024 position. While I believe the Cloud Peak position could be a 10-bagger, I did not feel the need to average it when it was a 2.1% long position during the month any more than I feel the need to do so now that it’s a 3.4% position. Contrast that with our 8% long position in Vivendi (VIV FP), which I believe could be an 8-bagger under the right conditions. I am not 2.4 times more confident in my
I was with the firm. His quantitative strategies (portfolio optimization and risk management solutions) were heavily influential in my evolution as an investor.
Charlotte Lane Capital 16 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 assessment of prospective return in Vivendi vs. Cloud Peak, so one of the most popular position sizing heuristics, the Kelly Criterion, would say I am mis-sizing one or both of these positions.
The Kelly Criterion is the most scarily misapplied portfolio construction concept I’ve ever encountered as a professional investor. This concept posits position size should be a function of expected return and the portfolio manager's confidence in the assessment of prospective return. First, this concept originated as an adaptation of a telecommunication engineer’s theorem as applied to gambling. While there are many parallels between gaming and investing, one of the biggest differences lies in the fact there is a defined set of odds in a deck of cards or a shoe with five decks. Once 20 aces or twos have been drawn from a five-deck shoe, the chances are nil another such card can be drawn. This is not the case in investing. You can draw 40 twos of clubs out of 50 attempts and that wouldn’t be all that odd in the securities market, which is subject to regimes that feed upon themselves. If you believe there is a fixed set of odds that will be depleted after 3-4 bad draws in capital markets, and you average each time a bad draw comes up, your “stack” will likely be severely reduced sooner or later.
So, the Kelly model applied rigidly to position sizing, on its face, is deeply flawed. Second, how does one quantify confidence? I can risk-adjust the net present value of cash flows all day long, calculate upside/downside until I’m blue in the face, and assess with risk management software portfolio clashes and aggregations until the cows come home and still miss completely the risk and reward in single positions and the portfolio overall.
Former Secretary of Defense Donald Rumsfeld11 (pictured right) captured this nicely when he said:
“Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don't know we don't know.”
It’s the unknown unknowns in markets that can destroy you, and the best software packages to deal with them are one’s grey matter and enteric nervous system12. This is one reason I believe investors, even those with very long analytical time frames and time-in-market on individual positions, should study great traders. This is why I include Jack Schwager’s Stock Market Wizards: Interviews with America's Top Stock Traders on the Charlotte Lane Reading List. Great traders are also great risk managers, and it’s not just IQ. It’s their limbic systems that make a difference. We’ve only traded securities in formal markets for a few thousand years, but as a species, our limbic system vouchsafed our evolution for at least 5-7 million years. We manage risk between our ears and in our guts – ego is the biggest risk I know of in markets.
On that topic, the second-largest detractor (60 bps) in the month was a short position in Generac (GNRC). We had a 4.4% short position going into the company’s Q4 earnings report, based on the hypothesis that the company’s wholesale channels are stuffed with inventory and it has been overproducing to keep its unit costs low and margins higher than they otherwise would be if it slowed production. Generac has compounded this with an M&A spree I find baffling, as it dilutes a great core business while the company strays further afield from its competitive advantages.
Unsurprisingly, the company’s inventory position and primary cash conversion cycle remained elevated at quarter-end, which I believe propped up earnings (along with M&A), so EPS only declined 12% YoY:
11 I feature many thoughts and personalities in my writing. I neither endorse nor condemn Secretary Rumsfeld’s policies in relaying this astute quote. For more on this idea, check out this Wikipedia entry on the Johari window. Photo source: Wikicommons 12 http://www.scientificamerican.com/article/gut-second-brain/
Charlotte Lane Capital 17 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Generac Working Capital Dynamics Source: Company filings, CLC
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Days supply, inventory Primary working capital CCC
I have written probably 100+ pages on Generac, spent 100+ hours researching it, and even done case studies extolling the strategic strengths of its core business. I believe I know the asset very well. The stock popped 15% the day of earnings because the bad downside case didn’t come to pass, and while inventories are still elevated, on the margin they trended in a bullish way. I closed that afternoon with the stock up 14%. No matter how much you know, what you don’t know can often kill you.
Drawdowns are no sin, but there is no virtue in wearing the hair shirt of clinging to a losing position when your hypothesis has been hurt or destroyed. While my fundamental view on the company remains largely the same, my enteric software told me to close the position, allocate the capital elsewhere, and avoid further drawdowns in the name. I can always come back to it. Since closing the position on February 16, Generac is up ~12%+ vs. 6.8% for the S&P 500.
Elsewhere, one bad apple spoiled the bunch in Financials. We were short a high-quality subprime auto lender13 for reasons discussed in past letters. The auto underwriting cycle has gone overboard14, and U.S. auto inventories are off-the-charts bad currently. This is a potentially toxic mix if collateral values go south. The main indicator of this, the Manheim index, indeed went negative for the first time in two years in January. Despite this, the stock staged a rally during the month, and we took a 10% adverse move in the stock before closing the position. I will give shorts some leash, but not the whole yard. Had this been a very low-quality small-cap lender, the move could have been worse, but a good deal of the short book is comprised of higher-quality companies precisely because a good deal of the long book is also comprised of high-quality companies.
13 Which I realize sounds oxymoronic, but this really is an incredibly well-run company. 14 Q4 “deep subprime” auto loans grew 15% YoY in Q4 2015.
Charlotte Lane Capital 18 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Basis matching on qualitative characteristics is an important part of Charlotte Lane’s risk management strategy. Had I been long large-cap energy and credit and short low-quality energy companies in the last few weeks, Charlotte Lane could have been hurt badly. Offshore driller Seadrill (SDRL), for instance, rose by 216% for the week ending March 4 while Chesapeake Energy (CHK) rose by 88%. Charlotte Lane is most often going to be barbelled with a few large long and short positions of 7-12%, but I don’t short small caps like these for precisely this reason.
Charlotte Lane Portfolio Structure, by Current Position Size Source: CLC
(15.00%) (10.00%) (5.00%) 0.00% 5.00% 10.00% 15.00%
As I have mentioned in past letters, I also don’t short moral turpitude/fraud stocks. They are often battlegrounds with high short interest. The skew on returns is huge, and they are research time sinks. There are very good investors who operate in this space, but most of my experience lies in the mid-cap to large-cap world, so Charlotte Lane will stick to its knitting as a liquid alternative strategy focused on mid- to large-cap equities with return distributions more normal than the binominal distributions of the high short interest situations.
The Industrials sector provided our biggest monthly performance detraction at 165 bps. With an average net short position of 18% through the quarter, the portfolio delivered more than twice the downside from the sector one would expect from a 4% move up in the S&P 500 Industrials index. The aforementioned Generac accounted for 40% of the adverse performance. That said, I am comfortable with our 15% net short position in Industrials (consisting mainly of large caps – our weighted average short market cap was $64B as of March 11), which remain extended and already discount a recovery while the manufacturing economy remains recessionary with the services economy now following it.
Charlotte Lane Capital 19 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 National Association of Purchasing Managers Index Source: BBG, CLC
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Manufacturing Nonmanufacturing
Airline UnitedContinental (UAL) provided 58 bps of negative contribution in February, and railroad Union Pacific (UNP) contributed a 49 bps loss. UAL is one of those “new era” stocks with a very stale bull case that largely revolves around industry consolidation. I maintain a variant perception here on a number of bases.
First, in its most profitable year since 2008, Delta (DAL) produced a 12.7% return on capital last year. It needed a 250% increase in EBIT to get there vs. the prior year. This was 3.4x the company’s average annual EBIT for the 2007-2015 period. This isn’t exactly the picture of placidity described by a bull case that has existed for nearly the entirety of this time.
So if that’s the best the class of the mainline/network carriers can do, how did the far more poorly regarded UAL do last year? Surprise: a nearly identical 12.8% ROIC. EBIT rose by 118% for UAL last year and was 3.2x the seven-year annual average. This looks cheap at 6.3x earnings, but the market generally doesn’t capitalize random number generators.
Second, bulls will say UAL owns the slots and gates at major airports such as Newark. Aside from the fact the Department of Justice has a problem with the way UAL has managed its dominant position at Newark, the airline no more owns those assets than first-time “homeowners” own the house they occupy when they have a zero-down mortgage and 359 more monthly payments to make or an automobile lessor owns the new Camaro he or she is driving.
Furthermore, the airport authorities own those slots and gates, and they love to flex their monopoly authority via landing fees and other taxes. Have you ever heard about airline ticket prices failing to rise over some period? Doesn’t feel like it, right? It doesn’t feel like it because it’s only partially true. The fare portion of air transport pricing may not have risen, but the landing fees component has (which plays into the final retail price). Have you noticed the beautiful new rental car facilities at the airports you frequent? All the recent repairs and additions at airports? All the security personnel and checkpoints? Fees and other surcharges pay for these.
Charlotte Lane Capital 20 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Between 2011 and 2015, UAL’s revenue per revenue passenger mile (RPM) grew at an annual 0.2% while landing fees and other rents per RPM grew at an annual 3.1%. I contend an oligopoly is an economically ineffective one if it lies downstream from a bunch of monopolies, which the airport authorities certainly are. I love shorting stuff that lies downstream from taxation authorities that get aggressive about flexing their mandates. When they do so, they break elasticity of demand and retard profit pool growth, crowding out private enterprise.
Put that together with the fact that airlines also lie downstream from the Air Line Pilots Association and other powerful trade unions that put forth big salary asks when airline profits balloon. These employees understand completely the volatility and fragility of airline profits and thus must get theirs while the getting is good.
In addition, low fuel prices are not all good for airlines. At first, it feels great. But it just incentivizes the reactivation of old aircraft stored in the desert, given some of those dinosaurs suddenly become economic with jet kerosene at 121¢ vs. 311¢ two years ago. That dings up the bulls’ capacity discipline story a bit. Toward the end of the cycle, capital also gets the brilliant idea to attack the long-haul airlines’ business class routes. This is the most profitable part of this multi-component profit model15 and fairly screams out for competition to come in at the wrong time.
UAL is a very touchy short that I will keep small and that will periodically extract a toll on the portfolio. You can also see that I have a very strong viewpoint on why the airline industry is awful for equity investors. However, I keep my head on a swivel in such positions, and if these conditions start to benefit the airlines away from my thinking, I will manage risk with an iron fist.
With Union Pacific, this is a return to a long-standing short. We kicked off the year short the stock16 and took it up to a 6.3% short position before closing on the day of its Q4 earnings release. The report was worse than even I expected and commentary on the call was bearish, but the move down was violent that day and Charlotte Lane closed its short just over $68 for a 10% gain. This was a nice contributor to January, but it detracted from February performance when I put the short position back on from late January though early February. This is the kind of position I will average because:
(1) It is cyclically extended and loved to an almost cultish level. (2) It is a megacap with almost no takeout risk from private equity or management. (3) It is a fairly predictable asset. (4) GAAP earnings do not convey the cash flow power of the asset, which is materially lower than the profit and loss (P&L) indicates. In addition, during a slowdown, deferred tax inflows can flip to outflows. This is always a nice bonus in capital-intensive shorts.
Finally, let’s quickly wrap up a couple of open issues from January:
1. Charlotte Lane in late January put on a 5% risk arbitrage position in the Norfolk Southern (NSC)/Canadian Pacific (CP) deal. This turned out very well, which I’ll detail next month, and we closed the position early this month.
2. The Amazon (AMZN) short was our biggest positive contributor to February returns. I closed the short on February 8 just under $482. We re-entered this trade on March 3 with a small position and have averaged it once.
3. I moved Vivendi up from our smallest position to our third-largest at 8.1%, as I have done additional research on it and as insiders continue to increase their positions. This is a story of extraordinarily remarkable17 corporate governance in a thoroughly under-optimized company.
15 In the terminology of one of my favorite strategy consultants, Adrian Slywotzky. 16 The short case can be found at: https://valuetrap13.wordpress.com/2015/10/31/rail-renaissance/ 17 I’m being delicate here.
Charlotte Lane Capital 21 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 4. Boston Beer (SAM) remains our largest long position. I was pleased with Q4 and 2015 results. For the latter period, revenue grew 6% while cost of goods sold (COGS) per barrel rose by only 0.9% for the year (and fell by 0.3% in Q4). Gross margin guidance on the Q4 call implied a decline in unit costs of up to 2% this year, which is the centerpiece of our variant perception in the stock, as I believe this benchmarks to a much higher gross margin globally. With a wide variety of stock keeping units (SKUs) and a long run of high growth that has now slowed, I believe there are abundant process control opportunities that will deliver a good deal of gross margin improvement in coming years. While management (whom I regard as very capable) had not communicated this prior to Q4, putting my variant perception in direct opposition to some of their earlier commentary on the subject, this was squarely ratified by Q4 management commentary.
On Failure, Shorting, Rebirth, and Value Investing
I relocated Charlotte Lane to Buffalo in late January. I could have located anywhere and considered Florida to be near my aging parents. But that’s what airplanes are for, and I am there every month. Buffalo puts me on New York City's doorstep, where I find myself once a week, as well as far nearer my daughter in Baltimore. I thought the big attraction here was the low-cost locale, but it quickly dawned on me that it has been very revitalizing to be in my hometown, surrounded by good friends and constantly running across the scenes of many great memories and hijinks.
I have long believed being a Buffalo Bills fan is great training for an investor. As the recent Buffalo Bills documentary Four Falls of Buffalo aptly demonstrates, what many football fans regard as a failure was truly an amazing triumph. Getting to four Super Bowls in a row may never be repeated, and going back three times with a loss in the rearview is stupendous when you think about it.
Who gets up like that time after time? Winners like James J. Braddock (the “Cinderella Man” 1935-1937 world heavyweight boxing champion), a little horse named Seabiscuit, golfer Ben Hogan, and numerous people whose names we don’t know but who live lives full of struggle every day and manage to support a family and be loving parents.
One of the most enduring memories of the Bills' grit came in Super Bowl XXVII, their third loss. The Bills were down 52-17 in the fourth quarter and possessed the ball near the Cowboys’ 35-yard line. Bills QB Frank Reich was stripped of the ball, and defensive tackle Leon Lett picked it up on the run and started to roll 65 yards unopposed toward the Bills’ end zone.
Starting from around the opposite 10-yard line, Bills wide receiver Don Beebe gave chase. Catching Lett would not have altered the game’s outcome, but there was no quit in the Bills or Beebe, who was one of the faster players in the NFL at the time (4.21-second 40-yard dash time). Lett would have scored had “The Big Cat” not let up to showboat 10 yards from the goal line. Holding out the ball at arms’ length allowed Beebe to swat it out of Lett’s hand, resulting in a touchback and re-possession for the Bills.
That moment endures as a top Super Bowl memory18 for many because it stands as a symbol of taking something positive out of a loss and never giving up. I find when I look down the list of recommendations and positions I have taken since joining the buy side in 1999, I focus very much on the underperformers or outright losers. Successful investments offer fewer lessons for me, as something happened that I foresaw or I got lucky somehow.
Unsuccessful investments usually arise from something bad I didn’t envisage because I didn’t ascribe enough probability to the bad outcome, I didn’t ascribe enough severity to that bad outcome, or something happened that was totally unexpected. Earlier in one’s career, bad outcomes can arise more
18 NFL video link.
Charlotte Lane Capital 22 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 often through poor ego management. (Biases such as anchoring, endowment bias, disposition bias, etc., are well documented in the sphere of behavioral economics). That’s one aspect of risk management that should improve as investors gain more experience, unless their experiences consist largely of bull markets or bear markets, which could make them a risk-seekers or risk averse unless they have studied a larger market data set and can abstract away from their own experiences.
This is part of the story of the Bills and Buffalo. The Bills were able to reset themselves year after year (and went to their first Super Bowl a year after a crushing playoff loss in the AFC divisional round on a grey January day in Cleveland)19. In the third year of the run, the Bills found themselves down 28-3 to the Houston Oilers at halftime in an ACF Wildcard game. Not many remember this, but Frank Reich threw a pick-6 interception on the Bills' first possession of the second half, putting the good guys down 35-3 in the third quarter.
The probability the Bills would win that game was tiny, but they didn’t let themselves be haunted by their mistakes or daunted by the number of points necessary to win the game. They just started to pick it apart, taking some bold chances to complement what was naturally a lightning attack, and went on to win the game 41-38.
There are many takeaways here for an investor. First, the set of potential outcomes is often wider than one might imagine. If we ask investors about their downside case on something, they'll say sales might be off a little bit, margins might come in a bit, and the multiple might drop a bit, giving us this:
0.97 (3% sales decline) * 0.9 (margin moving from 10% to 9%, for instance) * 0.9 (multiple moving from 14x to 12.5x earnings) = 21% downside
This model is too linear and rigid. Earnings declines often don’t look like this, and reactions in multiples in bad markets are often quite punitive. A more realistic and creative downside case might look like this:
0.8 * 0.5 * 0.6 = 76% downside
It takes creativity to think through how things will fail, just as it takes creativity to think through how things will succeed. As Bill Miller told us, “If you don’t go looking for 10-baggers, the chances you find them are greatly diminished.” Bill is without a doubt the most creative thinker I’ve worked with, and I’ve tried to adapt that idea to both long investing and shorting.
We as investors are surrounded by failure; failures in our own positions, failures of our colleagues’ positions, formerly great companies losing their competitive advantage, balance sheet blowups, bad M&A, cyclical implosions, ego-driven crackups, multiple contraction on high-flyers, huge earnings declines in value traps… the list is nearly endless. So it kind of blows my mind when veteran investors, even in long/short formats, say, “I don’t really have the temperament to short” or “I don’t know how to short.”
Why? We price securities all day long, we constantly analyze corporate strategy, and we are showered with data and experiences that should inform our view on shorting, so we should always be conversant in the antitheses of our investment hypotheses. Perhaps there is some deeper temperamental aspect to all
19 I watched this game on YouTube a couple weeks ago. Lo and behold, three days later, I saw #34 Thurman Thomas on a JetBlue flight to New York. Thomas had 177 total yards and two TDs that day, most of which he gained in the second half. I said hi and told him what a great game that was.
Charlotte Lane Capital 23 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 of this; maybe formative experiences imbued with the stench of failure are necessary to be a short seller. Buffalo is a good example.
Buffalo’s formation really took root in the disruptive innovation of the Erie Canal period (Buffalo As It Looked in 182520, at right). Turnpikes and wagons were at that time the low-cost transport medium, but incremental returns diminished quickly and made this a still capital-intensive transport modality. Canals, on the other hand, had far more attractive cost curves. When the Erie Canal opened in 1825, the rate per ton-mile for shipping goods immediately dropped by about 65% vs. turnpikes because incremental costs of water transport are very low given friction and hydrodynamics.
As operators of the locks, canal administrators, and boat captains climbed the learning curve and as an inland empire grew up around the Great Lakes to leverage fixed costs and further innovation, unit costs plummeted. By 1845, rates had dropped by ~85% vs. 1825’s rate and were ~95% below turnpike freight rates 20 years earlier. Buffalo lay at the mouth of the funnel for much of the goods shipped from the interior of the country to the large cities on the East Coast and beyond. Buffalo’s situation as a burgeoning entrepot allowed it to amass real, financial, and human capital at the head of the canal and led to a number of innovations such as the steam-powered grain elevator (right)21.
This allowed for a material decline in the cost of processing commodities, permitted commodities to be stored for trading purposes (such that producers and dealers could achieve price improvement over a cycle), improved human nutrition, reduced insurance costs, and improved capacity utilization on the canal, among other benefits.
Innovation fed upon innovation, contributing to a massive rate of capital formation in Buffalo such that the city was a top-10 metro area at the turn of the 20th century and claimed the highest number of millionaires per capita in the U.S. The incredible examples of Louis Sullivan, H.H. Richardson, and Frank Lloyd Wright architecture serve as a testament to Buffalo’s status as a Gilded Age powerhouse.
20 Image source: Wikicommons 21 Image source: Wikicommons
Charlotte Lane Capital 24 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 Buffalonians have long had much to be proud of, but almost like a value stock an analyst struggles to convince her portfolio manager to buy, it was hard to convince the outside world in 1980-2005 that this was a great place. Granted, the State of New York made some boneheaded errors. Robert Moses, for example, never met a greenspace he didn’t want to pave over with a highway.22 His urban plan ruined and set to blight Buffalo’s fantastic Olmstead Park System23 and L’Enfant-inspired radial grid.
Yes, we had one of the first Superfund sites in the horrific and shameful Love Canal disaster. And yes, our waterfront looked like Stalingrad c. 1942 with the twisted remains of what was once a huge cog in a mighty arsenal of war and industrial growth.
Bethlehem Steel in Better Times Source: Wikicommons
Urban planners and the state also had the brilliant idea in the late 1970s to install a light rail system down Main Street, cutting off vehicular and pedestrian traffic to an already struggling corridor. That killed the downtown core and made it appear to Central Business District visitors that Buffalo was a dead town24, which it kind of was in 1980.
Capping off a decade in which it was Morning Again in America for much of the rest of the country, part of Buffalo’s prosperity was built on bad balance sheets and tax-code-driven overinvestment in real estate. For a metro area that was falling through the 30s towards the 50s in rankings of America’s largest metro areas, it boggles the mind we had essentially two of the top-10 U.S. S&L failures.
There are plenty of reasons these failures happened: incentives lie at the root of many things. The integrated steel mills missed the mini-mill boom because this innovation initially served low-value
22 As laid out in The Power Broker. Moses accomplished many spectacular feats. 23 The same thing happened in Baltimore, my home for 11 years, with the Jones Falls Expressway. 24 The same happened in Baltimore. “Strategery.”
Charlotte Lane Capital 25 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 segments of the steel industry from which it was easy for the majors to retreat. Bethlehem Steel was probably trying to maximize FCF and margins, so it elected not to invest in mini-mills to preserve capital. Leverage and massive pension obligations also probably held it back.
Good old bureaucratic ossification was part of it too. When I was around 25 years old, I read a PaineWebber report about an iron feedstock initiative conducted by Nucor (NUE). I was interested in this and remembered having read in American Steel, a great case study about Nucor, that CEO Ken Iverson supposedly answered his own phone. So I called Nucor HQ in Charlotte, and darned if Iverson didn’t pick up the main number on the third ring and then talk to me about his company for 30 minutes. I seriously doubt I would get the same treatment had I called Bethlehem Steel HQ, with its many palatial offices and management golf courses.25
Bad investment in capital projects can permanently slow and deform the core, as we saw with expressways that cut up the Olmstead Park Systems and the light rail systems that destroyed parts of the Central Business Districts in Buffalo and Baltimore. I see this all the time when corporations take their lovely cash flow and reinvest it in bad M&A and overpriced buybacks that kill value. Riding around in a bus from one manufacturing facility to the next last summer, I asked the CFO of one such company why they felt the need to diversify, pointing out we as investors can take care of that at the portfolio level. He gave me precisely the reasons boards of directors in the conglomerate boom of the 1960s engaged in this activity.26
Incentives drive people. In the case of this company, I think management are good manufacturing people, but I also suspect they want to be a bigger company, make more money personally, and be the heroes in their hometown. Which is fine – for other people’s money. Think of a company generating a 15% ROIC in its core business that doesn’t pay out any dividends or buy back stock. Within less than five years, the current board and management will have allocated half the capital ever laid out in the life of that corporation. If they’re investing it at negative rates of return,27 they gravely endanger the value of that equity.
A company whose core business does not grow, regardless of its return on capital, that reinvests at rates of return falling below its cost of capital is worth a multiple less than the inverse of its cost of capital28. So if its cost of capital is 9% and it’s all equity financed, it should be valued at 11x earnings or less when these conditions hold.
Assuming 90% of the S&P 500’s 2016E consensus EPS translates to FCF, the market is currently trading at 19x that number. And that’s a pro-forma EPS number. On a more conservative basis (not the pro-forma EPS number), the FCF yield of the market may be below 5%. That is an expensive number; I believe the total profit pool being chased by the S&P 500 is not growing fast enough to satisfy the expectations embedded in the market at that multiple.
In 2000, Peter Bernstein and Rob Arnott quantified the real growth rate of EPS for the broad equity indexes from 1871 through 2000. You may be surprised by this number. The retained earnings yield on the market over that time and real GDP growth suggest the rate of growth should have been nearly 3%. It turned out to be 1.5%. Where did half the earnings go? According to Arnott and Bernstein, two well-
25 For a good illustration of the imperial CEO and diminishing competitive advantages, Bloomberg BusinessWeek’s October 15, 2015 article, "How Bad Will It Get for American Express? As Costco Cuts Ties, Amex Struggles to Hang On," is one of the most illuminating looks into corporate cultures I read last year. 26 This idea has long since been discredited, yet here I was hearing it from the CFO with unabashed enthusiasm. Here’s but one example of where the generalist has an edge. We get to hear many good and bad ideas. 27 Which happens all the time – just look at write-offs in the difference between S&P 500 GAAP EPS of $91.46 and pro-forma EPS of $117.92. 28 Michael Mauboussin derives the formula in this note from 2006.
Charlotte Lane Capital 26 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 respected theoreticians and practitioners, it went to dilution, M&A, and the fact that owners of the index only get the economic returns of the index, not the growth produced by innovative, young companies not included in the index.29
I’ve dealt with this many times. One company in particular was growing EPS at a 5-6% rate before stock option dilution and was issuing options equal to 2% to 2.5% of the company annually. I asked management what special thing they were doing each year that entitled the recipients of the options to 20-25% of the growth of the company (after taking into account treasury share accounting). They didn’t like that question much, but that’s precisely among our chief questions as fiduciaries – how do people who control the company act on behalf of passive shareholders?
Being surrounded by bad outcomes and poor incentives growing up in Buffalo, I can’t help but be healthily skeptical of how agent-principal behaviors go awry. To me, the problem at many large companies is the same problem that exists in legislatures at the state and federal levels. The agents have little skin in the game, their compensation is based in the here-and-now and is quantified by activity that is not necessarily economic, and the good and bad outcomes that flow from their actions can sometimes take years or decades to manifest themselves. Election cycles or board evaluation cycles are far shorter, however, which creates a serious temporal disconnect between risk, reward, and compensation.
So over the last 190 years, Buffalo went from a hot micro-cap stock, to a full-on growth darling, to a growth at a reasonable price (GARP) stock, to a mature blue chip, to a value trap, to a beaten-down and nasty value stock. From that last phase forward, beautiful things can happen.30 When a city gets pushed down this far (and you’ll see the same in Detroit), real costs can decline and make it more competitive. Assets become cheap enough that it makes more sense to locate there vs. cities with more advantages. The overall quality of life for proprietors is more attractive when a beautiful Georgian house with 4,000 square feet on a lush parkway costs less to inhabit than a 1-2 bedroom apartment in Manhattan. So, heck, throw a beach house on the tab in Buffalo.
You see the same thing in stocks. Well-planned M&A strategies go off-track or returns stagnate for so long the board sees the light and management teams are shown the door. A terrible company going to average can produce great returns, and a company with real growth going from thoroughly mismanaged and maligned to universally loved can deliver 10-baggers and 50-baggers. This is why I don’t manage a pure growth or value strategy. “Value” multiples can be funhouse mirrors, and the existence of growth and a higher multiple doesn't mean there isn’t value.
This is also why I short things. Nothing succeeds like failure. Competition, entropy, bad management, overvaluation, and bad outcomes emerging from the interplay of many complicated factors in a complex adaptive system all can drag down the most wonderfully regarded companies. And the best thing is wonderfully regarded companies are generally very well-behaved shorts when their cults die hard and hang on too long. The final capitulation phase, when the scales lift from their eyes, often provides the fun internal rate of return (IRR) capstone in closing a short in a failed former darling.
We don’t even need to see the failure. When the market projects 10-25 years into the future fantastic rates of growth and increasing returns for very large companies and discounts all the positive optionality that could lie in the future for that company (the “quality” premium or “platform value”), I know looking at a robust set of baseline data that this is a very low-probability outcome. The bulls will cling viciously to the scenario and claim it’s assured, asking me what my problem is that I can’t see it. I think I can see it, and I acknowledge it, but if I price it out and there’s enough negative excess return at my assessed value (a margin of safety), I’ll short it.
Narratives can also rule perception. The perception that railroads were secular winners was invalidated a couple of years ago when their growth rate in freight tonnage went negative over a 10-year time horizon.
29 "What Risk Premium Is 'Normal'?” by Arnott and Bernstein. 30 TV anchor Katie Couric recently visited Buffalo and hosted this video on the city’s comeback.
Charlotte Lane Capital 27 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021 “It’s consolidation,” I was told over and over, even though nothing happened post-consolidation until commodities took off with the Fed’s help. Now there is a report out that rails and commodities aren’t connected. I’m no math genius, so I asked a MIT grad with a degree in computer science to vet my numbers. He agreed with them (always good to know some math geniuses). So I continue to believe railroads were commodity supercycle beneficiaries that were able to raise prices because their customers were doing well. That is done for the time being, as is freight growth. Unless we get a new round of inflation and a new commodity cycle, which would confound all long-run histories of commodities cycles, these are still good shorts with excess return. A glowing, widely held narrative is always a good thing to have to prop up a short when vitiating data and a supportable counter-narrative are also available.
And Finally…
The future doesn’t unfold in linear fashion and often looks very little like the past, at least in critical ways. In making forecasts, we have to remain humble and willing to sacrifice beliefs we hold strongly. This is a difficult thing to do and explains why belief states at the tops and bottoms of the lifecycles of a stock, a city, a football team, an industry, or a species can be extreme.
Cycles larger than our limited frame of perception can be hard to see, and regime changes are often hard to perceive even if they happen slowly (probably precisely because they do happen slowly). Being open to regime change is a state of mind and a key tool at Charlotte Lane for managing risk and pursuing opportunity. You have to be different from the market to outperform, and Charlotte Lane certainly is. High active share is also a ticket to underperformance, so I remain as flexible, humble, and open-minded as I possibly can be. I thank you for your support and your belief in me and treat with care every dollar under my management, from the first one in the door to the last.
On a final note, March is off to a good start even in a goofy market. I hope to provide a similar report at the end of the month. I leave you with this picture of Charlotte Lane’s namesake and me. This bear caught my eye at Costco ($35! How could I turn that down?). Charlotte named him Barney. Feel free to call me Barney the Bear as well until we open up our exposure.
Dale Wettlaufer Charlotte Lane Capital March 15, 2016
Charlotte Lane Capital 28 February 2016 Letter [email protected]
Downloaded from www.hvst.com by IP address 192.168.160.10 on 09/26/2021