Tuesday, April 28, 2020

Covid Destroys Crude!

The world was never meant to stop functioning for months on end. But this is the reality now with COVID-19 disrupting normal lives for most of humanity. For one, international air travel has grind to a halt. Singaporeans used to taking flights at least once every couple of months will find this new normal uneasy. Cinemas have stopped operating as we cannot practice social distancing sitting together in front of the big screen. Again, in entertainment deprived Singapore, we cannot wait for them to reopen. But who knows when that can happen.

Restaurants, bars, night clubs, live concerts and many other businesses which inherently cannot adhere to social distancing rules will find it difficult to operate as COVID-19 rages on. Many of these businesses may not survive. With businesses closing, we are talking about job losses. The US has seen over 20 million jobs lost. This is becoming a crisis that is be bigger than the GFC. In Singapore, we are lucky to still have our jobs.

Yet for most of us working from home, we have other worries. Family time is now on overdrive and we are restraining ourselves from committing domestic violence. Si Gin Na* Stop watching Youtube and do your homework! This is mental resilience training, so much so that we miss the office. There is no need for physical resilience, we practically just eat and sleep. So our bodies are transforming from the pic on the left below to the one on the right.

*Si Gin Na means obnoxious brats in Hokkien

Michelangelo's Covid

Actually, it's not a laughing matter. With economies collapsing, livelihoods are at stake. Nobody knows how long this will last. It could be many more months. We have to be mentally prepared. In a blue sky scenario, the number of infections continue to decline (as it has started to do so over the last two weeks), summer comes and we can reopen the economies. But this is now becoming less and less probable. Even if the virus goes away, we are faced with harsh realities with huge number of bankruptcies and millions of jobless people.

We may find ourselves in a very different world after COVID-19 subsides. 

A central scenario could be a slow, gradual semi-reopening of the economies in summer, hopefully the virus does not come back in fall and winter. The vaccines and cures are successful and we see a gradual normalization thereafter. International air travel may come back 2021 and summer Olympics in Tokyo next year could mark the turning point. We may have to accept the new reality - we live with WFH, HBL, social distancing and lockdowns for the rest of the year.

In a worst case scenario, COVID-19 hits us waves after waves. We see a Spanish flu situation. The number of infections goes beyond tens of millions and deaths spike. Efforts in finding vaccines and cures fail and we only defeat the virus after achieving herd immunity. This means months and months of lockdowns, failed reopenings and more lockdowns. Normalization might take years and we look back from the future recognizing today as one of the darkest period of modern society.

Last week, crude oil sort of gave a premonition of this armageddon. A barrel of crude which cost $20-160 over the last 80 years and average $40-60 over the last 10 years fell below zero. In fact, it went to -$40. This meant sellers paid buyers almost $40 to sell them a barrel of oil. Imagine, I make a bowl of bak chor mee and sells it to you for -$4. So you get $4 and get to eat the bak chor mee. Things went absolutely crazy. 

Long term oil price chart thanks to macrotrends

Why did this happen?

We do not have the full picture yet but as the days go by, more and more pieces of the puzzle are coming together. First, while the world stopped functioning, oil producers did not react fast enough to stop oil production. The drastic drop in air, land and sea travel caused demand for fuel to collapse. As such, the oil that is pumped out is not used and needed to be stored. But global storage facilities was never built to store months and months of oil. 

In the US, the main capacity to store crude oil in Cushing, Oklahoma was on the verge of running out. It was speculated that some novice market participants holding the expiring May contract of crude find themselves stuck because if they cannot find storage, they would need to take physical delivery and that was not an option. So in the last minutes of frenzy trading, crude fell below zero for the first time in history. 

This is a reminder that the finance world and markets are actually very complex. Don't anyhow play pay!

But things did not look good afterwards. Now the benchmark has rolled over to the June contract but prices did not recover. It traded at $1 the day after and both WTI and Brent are only at teens a week later. Still 40-50% below what was quoted just weeks ago. The same situation will come in a few weeks and traders might find themselves out of storage, this time not just in the US but globally! So we may see prices going negative again.

In a sense, we are witnessing a historic moment, how a virus - COVID-19 takes on the world's most traded commodity - crude oil and decimates its whole eco-system built over the last 80 years. We saw one US producer Whiting Petroleum going bankrupt and our own oil trader Hin Leong in huge trouble even before crude prices going negative. There will be more casualties along the way. Even Keppel Corp and Sembmarine could face their own issues. The saving grace for Keppel is that its property and telco / data businesses could help offset the weakness in its energy segment somewhat. But I would not be surprised if the stock retests its 2008 low of $3.41. 

Keppel Corp's share price

The other revelation last week's saga taught me was that commodities prices have no floor. I used to believe that a barrel of oil should have some kind of intrinsic value. People use it to power their cars, make plastic, produce electricity. So it should be worth something. When we look at the long term chart for oil, we could make an assumption that maybe a barrel of oil should be worth at least $20 and as oil get scarcer, perhaps it is worth more, maybe $40. Indeed, as mentioned, oil traded at $40-60 for the last 10 years. 

In the last few days, this thesis is turned on its head. If oil has some intrinsic value, how can price go negative? As such, I come to the realization that a commodity may not have intrinsic value. Crude oil is a commodity. A barrel of oil today is the same as that 30 years ago. It is also the same in US or in the Middle East. As such, there is no floor because when it is not needed, people will sell it at any price. Even negative prices. This is the same for copper, wheat and all other types of commodities. The exception might be gold. So between oil and gold, maybe gold might be the right commodity for the same thesis. 

In retrospect, perhaps crude price bouncing up and down all these years was all just speculation on supply and demand.

The same story actually played out in the different bits of the shipping industry. As astute investors would know, shipping is a commodity business. It does not make too much of a difference if you used NOL or Maersk or Evergreen to ship a container around world. So when there is a huge oversupply of ships, the shippers might pay customers and help ship stuff for them. The vivid example I saw in my investment experience was in the bulk shipping industry. 

When China was booming, there weren't enough large Capesize bulk ships and steel mills around the world paid exorbitant shipping costs to ship iron ore and coal to their mills in China and other parts of the world. Alas, good times came to an end and Capesize daily shipping rates fell below operating costs. So logically, the ships should just stop operating, since every single day in operation meant they bleed money, tens of thousands of dollars. But they have to do it for various reasons, the banks would cut the loans if they stop operations and docking these ships incurred cost as well. So it was a nightmare. They ship and bleed every single day. In fact, they are still in the nightmare today. 

So I guess the lesson learnt is to be very mindful when buying commodities and commodity businesses. In times like this we appreciate the boring businesses like Nestle and F&N that see relatively smaller impact and smaller volatility in share prices. While we are dealing with COVID and Si Gin Na in the house, at least we get to sleep better at night.

Stay safe and huat ah!

Saturday, April 18, 2020

MMM Analysis - Part 3

This is the last post in the three part analysis of 3M.

We have discussed 3M's investment thesis and its positives. Here's a summary:

3M is an innovative industrial conglomerate that has built its brand in safety healthcare and other niche segments in infrastructure and consumer businesses. It benefits from growth in Asia and US healthcare on the back of strong pricing power. The management understands capital and resource allocation well and has delivered a stellar track record of shareholder return. It is also one of S&P's Dividend Aristocrat.

3M has close to 40% of its businesses in growth segments namely Asia and healthcare and these businesses would be its growth engines in the next few years. Coupled with its strong management capabilities and focus on shareholder returns, 3M is poised to be deliver good performance. But we also need to understand its risks and look closely at valuations. If the stock price has already factored in all the goodness, then as investors, we cannot benefit. This is an important point that even seasoned market practitioners sometimes fail to understand.

Buy when price is way below value

This is also the reason why Benjamin Graham, the grandfather of value investing said that, "The three most important words in investing is - "margin of safety". Margin of safety refers to a buffer we need to incorporate into our calculation of the intrinsic value of the company. This means that we can only buy when the stock is way cheaper than its true worth. In short, valuations matter, if we overpay, we are not going to get returns because the high price we paid has factored in the growth many years ahead.

This is like paying up for an expensive meal or an expensive wine or whisky. If we spent $1,000 on a fancy dinner, it could be a very nice experience, the food could be exceptional and the service top quality, but we didn't profit from it. We paid up. Similarly, drinking expensive wine or whisky brings little "profit" except feeling shiok*. Unless it's a hot date and even though she's wearing a mask, your heart is beating so fast that margin of safety is the last three words that would come to your mind.

Margin of safety sir?

Haha, ok jokes aside, paying up usually have very little benefits. It's just emotional high and bragging rights. As such margin of safety, i.e. don't pay up goes against dating rules. But it is paramount in investing. By not paying up, we reduces the risk of losing money, even if we got the whole investment thesis wrong and overlooked all the damned risks. Alas, in our new era of negative interest rates, disruption and bitcoins, nobody talks about margin of safety today.

However, an investment always carries risks. The only protection that investors have is to know the risks and know the valuations well so that we know we are not overpaying. Back to 3M, we know there are a few big risks overhanging. We will discuss two today. The biggest of which is PFAS litigation. PFAS is an acronym for per- and polyfluoroalkyl substances. These were found to be harmful to humans, like asbestos in the past.

PFAS are a group of man-made chemicals that includes many other acronymic chemicals which most people (including this blogger) have no idea what the non-acronym names actually meant. But importantly, PFAS have been manufactured and used in a variety of industries around the globe since the 1940s and it was discovered that PFAS are super harmful to both humans and the environment. Sadly, 3M has manufactured and used many of these chemicals.

One of the many PFAS chemicals

As things turned out, 3M is on the hook to pay off huge litigation costs related to PFAS. The company took a USD 200m pretax provision charge but analysts are saying that the true cost could be in the tune of USD 5-10bn. Meanwhile the markets had factored in even more, with 3M's market cap dropping more than USD 20bn after this risk broke out. So in an interesting twist, the PFAS risk is already factored in by the drop in share price. Is actual impact then mitigated? Well, yes and no. Yes, because it dropped more than what the analysts calculated. But no, because the future is not predictable. Is it really only USD 20bn? What we have to really worry about is that more litigations will come and the true cost is not USD 20bn but more, say USD 40bn. Then we as shareholders are on the hook.

This is why Ben Graham said margin of safety was important.

3M has another risk which is related to the economic cycle. 30% of 3M's sales is described as short cycle and capex driven. This means that when the economic cycle is going into a downturn, 3M's customers are prone to cut back on buying these short cycle products. Needless to say, capital expenditure or capex, would also be cut back. This is the reason why 3M tend to fall before economic indicators actually turn bad. Conversely, during an upcycle, 3M's share price tend to rise before the rest of the market.

3M is not doing well despite it being a COVID-19 beneficiary with its N95 masks selling like hotcakes and its healthcare business seeing strong demand. This could be due to the PFAS litigation overhanging but we could also say the overall economic situation with COVID-19 will weigh on 3M. So, 3M could go down before it goes up. This is a timing issue. It's not easy to catch stocks right at the bottom and usually we will miss the whole rally by trying to be too smart. Hence, value investors like to look at valuations.

3M's share price since 1970

At today's price, 3M trades at 6% free cash flow yield which is considered cheap for such a high quality company. This is derived by dividing 3M's market cap of USD 90bn over its free cash flow at USD 5 to 6 bn per year. Looking at other valuation metrics, 3M trades at 15x PE and 12x EV/EBITDA. Since the global negative interest rate regime started in 2016, we can hardly find quality at low to mid teens multiples, especially PE. Lastly, just to complete the picture, 3M's Price-to-book is at 8x with ROE at 50%. Ben Graham would have scoffed at anything trading at 8x book. But we are living in a different world today. Remember? Interest rates are negative! Book value is no longer as meaningful.

So rounding everything up, I would say 3M is cheap. 3M's share price peaked at c.$240 when its PE was 24x and FCF closer to 4%. I think we would see the company going back there when the PFAS issue is resolved. This might take a few years and that's the kind of trade that I have been quite successful with over the last decade (see Bayer). I think it's a good risk reward and I should buy the stock even if I couldn't get its N95 masks.

* Shiok is a Singapore slang referring to something being enjoyable. 

Friday, April 10, 2020

Monetary Bazooka and Multi-Curves

This post was first published in 25 Mar 2020 but things moved rapidly and my views have changed. The updated parts are in red.

Since we last discussed COVID-19, the world has gone from bad to worse. We now have a global pandemic which is increasingly out of control. It is becoming a crisis in the same order of magnitude as the 2008-2009 Global Financial Crisis. I have been using the original thebaselab website of daily checks. It is depressing. We have exceeded 15,000 100,000 deaths with no end in sight.

Courtesy of thebaselab

To combat the virus, many affected countries have gone into lockdown mode following China's example. But they didn't do it fast enough. Some countries' healthcare systems could not handle the situation and many lives were lost. It is important not to stress the healthcare system because there are only so many ICU beds and only so many respirators. Unfortunately, we don't learn fast enough. The first lesson from Wuhan was not learnt quickly enough to prevent the tragedies in Italy, Span and Iran and New York. Hopefully other countries and cities can still save themselves by working hard now.

Meanwhile, global markets went berserk. It did not help that Opec and Russia decided to shoot themselves by not reaching an agreement on production thereby causing a huge collapse in oil prices. (They finally agreed but the damage was done) The direct link between COVID-19 and crude is not clear. There is reduced demand but it's not 40%. However oil prices fell from the 50s to the 20s. In stressful times, as we had seen during the Great Financial Crisis (GFC), market participants adopt the mentality of "sell first, talk later". Hence the correlation of different asset classes goes to 1. Everything gets sold. Even gold got sold.

So last week (19 Mar) gave us a glimpse of the confusion that took place. As markets collapsed, we saw indiscriminate selling across stocks, bonds and commodities. The USD spiked because investors sold assets in other currencies and revert their holdings to USD cash. But the US Treasuries also got sold off, because that's another way to raise cash for redemption as well. This selling will continue. In Singapore, we have seen many blue chips hitting multi-year lows. As long as the global situation remains dire and fluid, we should not expect any recovery. (Then the market saw one of its sharpest rebound in history)

Why is everything going to hell in the markets?

While some of us in Singapore probably don't feel this way, this crisis could actually be worse than the GFC. The 350,000 1.7m infections had affected hundreds of millions of families directly. They are seeing their loved ones succumbing to the virus. But as the lockdown continues, the livelihoods of billions are are now badly impacted. We are talking about millions of people being laid off. They could be in the service industries, their employers only have days of cash left before going bankrupt. They could be the small suppliers in the airline/aerospace industry and/or the oil and gas industry. The big boys in these sectors are having issues, so what are the chances that the little ones can make it? 

The situation is really, really bad. People cannot pay their bills, their electricity is being cut off. They cannot pay rent, and face eviction. They have no money to buy food. It is literally life and death, even when the virus is not nearby. Some experts have drawn parallels to war. We are at war with the virus. Hence we need the monetary bazooka to come and save the day.

Helicopter Money

Alas, politics get in the way. The politicians cannot agree how this could be done. Can we bailout the corporates with no strings attached? What if these big oils and big aerospace just use the money to prop up share price instead of saving their suppliers? What about helicopter money? This is an interesting notion Milton Friedman coined in 1969 but made really famous by the previous Fed Governor Ben Bernanke. He famously said he would get on the helicopter and throw money on Main Street in order to stop the rout during the GFC. We are now doing it because families really need that $1,000 to tide over this month. Not next month, this month. 

So the politicians need to sort this out. They probably have days. Lives are at stake. (30 Mar update: they got their act together) The saving grace is that they managed it during the GFC, so it can be done. Then we need the virus situation to subside. China managed to contain it. So did South Korea. We need the major affected economies now (US, UK, Italy and Spain) to follow the playbook. Lockdown for a few weeks, things should get better. The situation will be different for many developing countries. Hopefully their leaders are learning fast. If they don't, their healthcare systems will not be able to cope. We will see a lot more deaths. May the Force be with them.

Finally, we come back to the big question, what do we do now? Buy, sell, wait?

Like I have said many times before, it is not possible to predict what happens next. The politicians could get their act together tonight and we are done with the bloodshed. Then we curse and swear that we didn't buy enough. My base case is the selldown continues and things get really cheap. It could be close to or even below GFC levels for some stocks. Then it will be the best time to buy. But we cannot tell in advance. So we buy incrementally. I plan to buy 1/5 of what I intend to deploy fully every week or two, something like that. It is not hard math or science, so you need to figure out what works for you.

Markets have since rebounded sharply but it might be consensus that this is a bear market rally. It is quite unthinkable we will recover and exceed the previous 2019 high any time soon. The upside is capped and given the bounce, the time to buy is not now (10 Apr 2020). If there are things that could be sold to raise cash, maybe we should raise some cash to have some more dry powder. The next selldown will test the 2020 lows.

The worst case is that the COVID-19 pandemic drags on for months and we did not move fast enough. One, two or three large corporates fail and drag down some banks. 100 million or even more jobs are lost globally. Or, we see continuing rise in infections and many more outbreaks. We see waves and waves because different countries are on different curves. Some successfully flatten their curves but not others. 

In Singapore, we see a full blown community spread. The fourth wave gets us. Our healthcare system gets stressed. Then we will fall below GFC levels. It is a doomsday scenario. Maybe we won't be worrying about our portfolios at that point. We must not let this happen. Stay at home. Keep the social distance. Flatten the curve!

In short, there are many scenarios. No one knows which one will pan out. I would wait now but would look out for stocks that becomes too cheap to ignore. For example, DBS at 0.5x book with more than 10% dividend yield looks good (albeit banks may not be able to pay dividend in 2020 given the situation). Sadly, I have bought it way too early at $21. Now the stock is trading at $18. Dairy Farm breaking its all-time low at $3.30 or Ho Bee revisiting $0.90 will be interesting. Genting does look cheap at $0.50 (it has since rebounded to $0.70) but we have to assume its businesses will recover strongly once the virus is defeated. We have discussed these stocks before so click on the links for related posts if interested. 

Meanwhile, hang in there. This is a marathon. WFH is here to stay. Don't scold the kids. Avoid the spouse. Flatten the belly curve on top of the other curve. 

Huat Ah!