Volatility and Melting Markets in February

Over the last two weeks investors have been bombarded with a range of financial commentary, some of which comes with the conclusion that investors should sell everything as we are facing price falls in 2018 similar to what happened during the GFC a decade ago. This intensified after the S&P 500 fell -3% on Monday, its biggest one-day fall since 2012.

In this week’s piece we are going to look at some of the factors behind February’s fall and subsequent market volatility, and how we approach investing during times when the Chicken Littles are suggesting that “The sky is falling in!”.

Setting the Scene: A shaky background in January
Prior to the market volatility in February, the stage appeared to be set for a correction. The US market had enjoyed a two year run without a major correction,  as the S&P 500 smoothly gained 54% from the 12th February 2016. In late January US stocks were trading at lofty valuations: the S&P 500 was trading on a price to earnings ratio of 21 times, fuelled by improving corporate profits and impending tax cuts.

However, the market was also concerned that if the US economy gets much stronger, we could see inflation, something that many younger analysts only dimly remembered from dusty economics textbooks. Finally, with the changeover in the leadership of the US Federal reserve occurring on the 3rd February, there was concern that the US Fed would drive up interest rates in 2018 and that this would be done too aggressively, triggering a fall in equities.

Low Volatility
Against this background, market volatility had declined to extremely low levels, as the share market enjoyed a prolonged period of smooth rally without a correction. Moreover, this low volatility extended to a range of assets including shares, currencies and bonds. The decline in volatility is something that we had observed over the past year, and which influenced income in the Atlas High Income Property Fund.

Whilst Atlas have been unhappy about the prices we have been receiving due to the low volatility, a range of hedge funds have been profiting from this phenomenon. Essentially this involves betting that stock markets would continue to remain benign. This is done by shorting the volatility of the market 1. Short volatility has been a very consistently profitable trade over the past year, collecting consistent premiums every few months from derivative positions that return a profit if the stock market does not swing wildly in either a positive or negative direction.

A Crowded Trade and the Stampede out the Door
At the end of January there was US$3 billion in exchange traded funds (  ETFs) in the US using this strategy. Amazingly two ETFs alone – VelocityShares Daily Inverse VIX Short-Term ETN, and ProShares Short VIX Short-Term Futures ETF – increased assets by US$1.7B between them in January 2018. After the first of these funds fell more than 90% in a week, Credit Suisse are in the process of shutting it down.

However, it would be incorrect to think that a few small funds alone contributed to the market falls we have seen in February. According to Bloomberg in the wider funds management universe more than $2 trillion of investments are linked to this short volatility strategy. These hedge funds are connected via systematic strategies such as short volatility, risk parity, and volatility targeting. This very profitable trade betting on low volatility soon became a crowded short, vulnerable to a short squeeze when a large number of traders are forced to try and make the same trade at the same time. A situation similar ten people trying to quickly leave a room through a doorway when a giant rat falls from the ceiling.

What we have seen over the past fortnight was the unwinding of a crowded trade, and the resulting squeeze. The market movement – as these funds unravel and hedge funds using these strategies see outflows – has fed into weakness in the underlying shares due to forced sales of equities.

 1. The short volatility trade involves two constituent parts; 

a) Initially selling longer-dated futures on the Volatility Index (VIX) which were priced based on the expected volatility of the S&P 500 a few months in the future. The VIX is itself derived from the volatility of options on the S&P 500 which are primarily derived from the recent volatility in the price action of the market itself.  Atlas have observed the declining volatility of markets over the past year, because as a seller of covered call options, the premiums we have been receiving for the call options sold have been declining.

b) As for the past two years up until February these futures in volatility traded above the current level of volatility or VIX, provided the market remains placid,  the short seller covers their short sales as the price of the future falls towards the spot price as the future expire.

Our take

Atlas considers that what we are seeing at the moment is the disconnect between the “financial economy” and the “physical economy” and an element of reality returning to stock market valuations.  At the halfway mark of the February profit-reporting season, the overwhelming theme is that both Australian and US companies are making healthy profits.

When a major market dislocation occurs, the best thing for investors to do is step back and think what this particular dislocation will do to the earnings and dividends from the companies held in their portfolio. If the answer is not much and the dividend stream will be largely unaffected, then the falling market has given you the opportunity to add to positions at a discounted price. This is markedly different to the conditions that investors faced ten years ago. At that time the seizing up of the credit markets both disrupted the ability of most global companies to refinance their debt, and also saw profits fall heavily as global trade declined sharply.

Monthly Newsletter October 2017

  • The Fund posted a small gain of +0.8% over the month of October, trailing the S&P/ASX 200 A-REIT Accumulation index that was dragged upwards by the strong performance of the trusts with property development earnings. Following the McGrath profit warning in the first week of November (attributed to slowing off the plan apartment sales), we are happy with the Fund’s focus on rent collectors rather than property developers.
  • In the first week of October the Fund paid out a distribution to investors of 4.85 cents per unit.
  • In October the Fund bought put protection out till March 2018 that will offset some of the impact of a significant fall over the next five months. In our opinion the market appears to be mispricing downside risk and we will look at add to this protection.

Go to  Monthly Newsletters for a more detailed discussion of the listed property market in October and the fund’s strategy

The biggest IPO of all Time

Since mid-June the oil price is up 15%, which has breathed fresh hope into beleaguered energy companies globally.  The catalyst for the recovery in the oil price was the announcement that Saudi Arabia, OPEC’s largest producer, will limit exports to 6.6 million barrels a day in August, 1 million lower than production this time last year.  This has been interpreted as rational profit maximising behaviour by the world’s largest producer, which has traditionally sought to defend market share and maximise oil revenues to prop up the Kingdom’s budget.

We see this as behaviour designed to boost the profit margins temporarily, similar to what is done by many vendors prior to any IPO.  In early 2018 the Saudi’s are looking to conduct an initial public offering (IPO) of around 5% of energy giant Saudi Aramco for a predicted price of US$100 billion. In this week’s piece, we are going to look at how to analyse IPOs and specifically this one, which is likely to be the biggest IPO of all time.

When analysing IPOs, few have been more eloquent on this subject than Benjamin Graham, the Father of Value Investing;

“Our recommendation is that all investors should be wary of new issues – which usually mean, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under ‘favorable market conditions’ – which means favorable for the sellers and consequently less favorable for the buyer.” (The Intelligent Investor 1949 edition, p.80)

The biggest IPO in history

Last January the Saudi Arabian Crown Prince Mohammad bin Salman Al Saud announced that the Saudi government intends to offer shares representing about 5% of Saudi Aramco, its national oil company. Aramco has been under government control since the Saudi Arabian Oil Company was nationalised nationalized in the 1974 following US support for Israel in the Yom Kippur War.

Aramco is the largest global oil producer and therefore this IPO marks a shift in thinking in the Kingdom as the proceeds are being used to help diversify the economy away from oil. The IPO is planned to be listed on exchanges in Riyadh, with a secondary listing in London, New York, Hong Kong or Singapore. The expected value of 5% being floated in 2018 is touted as around US$100 billion which would value the entire company around US$2 trillion. This is significantly larger than Apple (US$742 billion), Google (US$653 billion) or Exxon Mobil ($342 billion). Under these circumstances the Saudi’s have a very strong incentive to move the oil price higher over the next 9 months!

Factors to look at in an IPO

Why is the vendor selling?

The motivation behind the IPO is one of the first things we consider. Historically investors tend to do well where the IPO is a spin-off from a large company exiting a line of business. An example of this is Orica and their paints division Dulux. New investors also tend to do well when the vendors are using the proceeds to expand their business. The probability of new investors doing well from an IPO is far lower when the seller is just looking to maximise their exit price. A classic example of this is the Myer IPO. In the case of Aramco, the IPO is designed to help makes changes to the Saudi economy and increase investments in non-oil assets. Cynically it could be viewed that the vendor is concerned about the longer-term demand for oil with increasing amounts of Teslas roaming the streets, though only 5% is being floated off at this stage.

Is the business easily understood?

Given the reduced level of historical financial data it is important that an investor can easily understand how the company makes money and maintains competitive advantage. When Shopping Centres Australasia was listed in November 2012, it was clear how the company made money from collecting rents on Woolworths’ shopping centres. Similarly, in the case of the best float of 2015 (+127% since listing) it was easy to understand the Costa Group’s business model of growing mushrooms, berries, citrus and tomatoes with the logistics operations to deliver these to consumers.

Whilst the Aramco business of extracting oil easy to understand, like most IPOs the financial data may be limited. The secretive company has never needed to disclose any kind of financial statements and details about the company’s most important asset, its oil reserves are state secrets.

Is the company profitable?

Any IPO is presented to the market in the most favourable light (albeit with a large number of disclaimers), and at a time of the seller’s choosing. Over the last six months we have seen a number of businesses being listed that have been unprofitable for a number of years, yet are expected to switch into profitability in the years immediately after the IPO. We put little store in the notion that companies are being listed for the altruistic benefit of new investors. Thus, investors should be sceptical of predictions of dramatic improvements after listing, especially when the IPO vendors have significant incentives to show profits before listing!

Saudi Aramco is likely to be very profitable with international energy consultant estimating costs of production around US$9 per barrel. The cost of production is so cheap as the oil in Saudi is primarily located near the surface of the desert and pooled in vast fields, so unlike Australia it doesn’t need to invest very expensive offshore oil platforms taping into reserves often 100kms off the coast.

The question for minority investors is the extent to which this enormous company will be run in the interests of the minority investors committing $100 billion or whether profits may be diverted to the state.  Two months ago, the Crown Prince said that decisions about oil and gas production and investment will remain in the hands of the Saudi government after the IPO.  In March 2017 in what looks like a move to improve the books prior to the IPO, the Saudi government reduced the tax rate levied on Aramco from 85% to 50%. Investors in this IPO would probably be concerned that this tax rate could change post-IPO to fund government budget deficits given that Aramco currently accounts for 80% of the Kingdom’s budget revenue.

Is the price attractive?

The sole reason behind any new investment is the view that it will generate a higher rate of return than alternative options in an investor’s portfolio.  It is too early to make any pronouncements as the financials have not been released, but any investment would want to take a conservative long-term oil price into account and discount stronger oil prices that we may see over the next nine months.

Despite what is contained in the marketing documents for every IPO, in determining a valuation potential investor should apply a discount to currently listed companies. Due to an IPO lacking a listed track record and investors having less financial data; a discount to currently-listed comparable companies should be applied when valuing an IPO. In the case of Aramco, in our opinion the price investors should pay would be a 20% discount or greater to valuations at which companies such as Exxon Mobil, Chevron or Shell are trading at.

Our Take

Whilst new IPOs are presented as fresh, exciting ways for investors to make money and access different high growth companies or assets, we see that the best approach to evaluating IPOs is to start from the default position that the vendors are trying to cheat you and then work backwards from there.  The best IPOs I have seen over the past 20 years have been one’s where the vendor is under-pricing the asset being sold, leaving some upside or “margin of safety” for the new investors.

Understandably this is a very rare occurrence for profit-maximising private equity owners and possibly Middle Eastern Kingdoms.  The Saudi government (just like private equity vendors) may face some domestic backlash for pricing the IPO too low if Aramco performs strongly post listing!


Not all Great Ideas turn into Great Companies

In my experience, most professional fund managers and equity analysts are frequently given unsolicited stock ideas from clients and friends. Generally, these are small companies, with a great idea that is either going to turn them into the next Amazon or revolutionise a particular industry.  Frequently these companies are difficult for investment professionals to value as they are often at a very early stage. They tend to be long on promise, but short on profits and assets that provide the basis of most valuation methodologies. Inevitably the person presenting the idea knows much more about the exciting technology behind the company and is very enthusiastic about its prospects.

In this week’s piece, we are going to look at the processes and questions that investors should ask when looking at early-stage listed companies.  Atlas is not endorsing any of the companies mentioned in this piece, they are only mentioned in the context of the process that we use in evaluating early-stage companies.

1. How much runway do management have?

The first thing that I look at when reviewing one of these speculative companies is how much time or financial runway management has in which to commercialise their idea before running out of cash. Whilst companies can look to raise additional equity to extend this runway, this is almost always done at a discount to the prevailing share price and relies on supportive investors. Few early-stage companies are financed by debt, as the interest rates charged are likely to be high to compensate for the risk of lending to an unprofitable company.

Investors should look at the company’s cash flow statement to gauge how much cash the company has been burning for the past six months. Compare this against how much cash is on hand on the balance sheet. The reason for using the cash flow statement is that this represents actual cash flows and is harder to manipulate than the profit and loss statement. For example, when I looked at cloud call recording software company Dubber in February, the company reported a cash burn of $4M in the previous six months, yet had $5.2M cash on hand. Here unless there is a dramatic change in the company’s fortunes, one could expect another equity raising within the next 9 months.

Conversely, technology company Fastbrick Robotics had no debt and $10M of cash on hand. This is sufficient to fund the company’s development of a bricklaying robot beyond 2019. Without making any judgement as to the relative investment merits of the two companies, the second company has more flexibility to weather delays, without coming to the market to raise more equity to keep afloat. Obviously, the spectre of near-term equity raisings provides a cap on a company’s share price, as outside investors know there will be discounted share issues in the future.

In more extreme circumstances, the lack of a financial runway has seen companies with solid ideas or assets going into administration, with these assets later picked up by competitors.

2. Management’s record and shareholding

The next step is to look at the experience of management and board of the company in question.  Here what I am looking for is not so much experience at large and well-known corporations such as General Electric or Westpac, but rather experiences in guiding small and more financially unstable companies through to an IPO or trade sale. Large companies have little difficulty in getting attention from potential investors or banks and managing cash flows. Additionally, executives from large organisations are unlikely to have had experience of running a number of business areas while also having a laser-like control of costs.  Looking at job management software GeoOp, it was apparent that the chairman and CEO have solid experience in the digital space and in running start-up ventures.

Additionally, investors should look at the percentage of the company owned by management, as a management team with a significant portion of their personal wealth invested in the company are more likely to act as good agents on behalf of the other shareholders. Here investors should look at existing holdings, as well as the share options granted when management hit certain targets such as profitability and specific share prices.

3. Who else is on the share register?

The presence of larger corporations or well-regarded fund managers on a fledgling company’s share register should be viewed as a good sign. This can indicate that others have done the due diligence on the company, and it is often helpful that they have the voting firepower to stand up to management and scrutinise decisions. The presence of competitors or corporations in similar industries could indicate the possibility of a takeover at a later stage. In the Dubber example mentioned above, the presence of small capitalisation manager Thorney on the share register at 6.4% is a positive sign.

However, the presence of well-known fund managers on the register should not by itself be viewed as sufficient grounds for investment.  Most if not all small capitalisation fund managers have positions in their fund that they now regret and may be quite illiquid at the size of their investment. What may seem to be a significant investment for an individual investor may only represent 0.25% of a large fund.

4. Who are the Company’s competition and what is the size of its addressable market?

All successful small companies face the spectre of competition from large industry players. In some cases, large competitors may be watching the target company closely, learning from their mistakes, before launching a competing product or technology drawing on the larger company’s scale and market access.  Whilst “disruptive” financial technology companies or fintechs are very much flavour of the month at the moment, I find it hard to believe that the big banks and insurance companies are not keeping a close watch their activities. A great example of this is mobile payments company Mint Payments which in 2013 went from 2c to 40c per share on expectations that the company’s wireless point of sale would enjoy spectacular growth. The share price has slid back to 6c as the banks and technology companies such Apple launched competing payment products.

When looking at the prospects for a company and its potential growth, it is important to look at the size of the market to which its products can be sold. A small niche market might not attract competition from larger players, but significant share price growth is unlikely to come from dominating a very small market. Additionally, investors should be wary when a company suggests that it has no competitors, often this is a case of no competitors yet.

5. What barriers to entry are there?

A small company’s prospects of enjoying significant share price gains are significantly decreased if there is little in the way of barriers to stop other firms from entering into their industry. The technology sector in particular has been an elephant’s graveyard of large companies laid low by smaller, more nimble competitors that jumped over the low barriers to entry.  Examples of once exciting companies that only had low barriers to entry include AltaVista, Netscape and Myspace.

Recently we looked at social media marketing company VAMP that was planning on listing on the ASX and was backed by high profile Nova Scotian Qantas and Fairfax Media director Todd Sampson. The social media marketing firm had an exciting buzz as it was designed to capitalise on growing demand from advertising agencies and high-profile consumer brands to connect with Instagram ‘influencers’. However, on reflection, this particular antediluvian fund manager thought that the barriers to entry into social media marketing are quite low.

Our Take

Whilst most small companies have an exciting good, technology or concept that is inevitably presented in a form that will result in large gains in the share price, we see that it is helpful for investors to have a five-point checklist to look at when evaluating a small, exciting, yet unprofitable company. Atlas would like to thank our supporters whose ideas helped in writing this article.