- For most of the last 8 years there has been a large liquid bid for most small-cap stocks from private equity. Private equity has several advantages over us – in particular they can borrow money non-recourse at 6 percent and they can do extensive due diligence. The latter amounts to legalized insider trading. This may explain why in developed markets, penny stocks are more traded by retail investors than these midcaps
- we expect almost every stock we are short to go to zero or thereabouts –that is the end-game for scams and stock promotes. However we are completely unaware of and unable to predict the path to zero. Some of our shorts will go up 400 percent on their way to zero – and we will necessarily lose money on them even if we are eventually right. We will lose money because we are forced to buy them to avoid potentially threatening losses if they go up further. Essentially, markets can remain irrational longer than you can remin solvent, hence the need to be able to hold your bets yet cut your losses.
- There is a reason we keep possible fraud shorts small. Fraudulent companies are not reporting results that are linked to reality. They are making them up. If a fraudulent oil company tells you they have 10 million barrels (when they have nothing much) there is nothing that stops them telling you they have 1 billion barrels. The stock could go up massively. When companies take the path of offence, then it is quite difficult to prove otherwise except in case of ghost assets etc.
- The fraud-shorting business is complicated. We think that (by far) the hardest part of it is risk management. It is easy to identify frauds but it is very hard to work out what breaks them. We have often been short a fraud and had it double, even triple on its way to zero.We have lots of tricks to limiting losses (put options, shorting the debt rather than the equity , small position size) but these tricks often limit our gains too and we need to get better at working out when to press on a fraud (increasing our position as the stock goes down) and when to keep out of the way. Market Timing is always an issue, more so here if you have put options that expire within time limit
- Alas we think the amount of fraud out there is so high, and the standards required of regulators so demanding, that the job of head of a regulatory agency is nigh impossible. And that suits us – and so we celebrate our relatively good returns as we celebrate (unavoidable) regulatory failure. It is not always a regulatory breakdown, as standard of proof may differ
- Some people might wonder why they are paying us hedge-fund fees (as opposed to index fund fees) to invest in large cap stocks on which we can add little value. We offer a modest defense:
(a) We do have some selective small-cap stocks which are likely to give us enough returns to pay the
fees and then some. For a variety of reasons these are not attractive to PE funds. (b) We still short small caps. The extraordinary crowding into some of these names gives us good opportunities to short. (c) You will be here for the swing. When we no longer find nonsense frauds and promotes amongst $300-500 million companies with ease, we will turn around and go long small caps. At the moment it is so easy to sell nonsense that you know the small caps are nuts. One day we will be a small cap –fund. That day however is not today. This should console the fund managers of PIPE(Private Investment in Public Equities) who get a good sum!
- We are not averse to takeover arbitrage - but it has to be in an industry and with businesses we understand. Both are utilities and are within our field of expertise. We are also -and very unusually - doing two reverse arbitrages. (The jargon is that we are going “Chinese the spread”). What this is, is betting that the a takeover deal does not close - an unusual position. If we are wrong on these we will lose say 1.8 percent. If we are right we might make 4-8 percent. In India, since the hostile takeover/debt financing/bidding battles are less common, this strategy would be difficult here.
- We will have to be doubly-clever to detect fraud on which we can earn “lottery-ticket” type returns.
As explained last month we are very fond of positions where our losses are capped at (say) 2 percent
of the portfolio but which have the possibility of delivering 10-20 percent months. Winning lottery
tickets however are very hard to find but have been responsible for a fair part of our returns.This is similar to purchasing out of the money calls/puts in anticipation of a regulatory/legal event.
- With small and medium capitalisation stocks we see nonsense everywhere. We see companies with venal management and limited prospects but enormous amounts of stock promotion. We see bulge bracket Wall Street brokers getting involved in the IPO of companies we consider to be criminal enterprises. By contrast, with large caps we see real businesses with considerable cash flow (free cash flow measured in the billions and sometimes tens of billions) but with some business challenges. And they are invariably being priced on a “glass half empty” basis. This is true even of many Indian companies which attract less retail investor interest under the faulty assumption that they are anyways fair valued/over valued. But in reality, they may be cheaper than their smaller peers, where an excessive premium for growth is paid.
- Our clients know things we do not. If you are an insurance broker and you see a company reluctant
to pay claims then please tell us. If you see a supplier discounting insanely or alternatively raising prices please tell us. We are in the new ideas game – and one of the advantages in being a long way
from Wall Street is that we have quite different ideas from the New York/Connecticut consensus.
Crowded trades are dangerous trades and very few of our positions are crowded. One of the disadvantages is we get less idea flow across our desk A pretty interesting processs on how they get short selling ideas-from seeing a business model that is broken rather than looking at pure financial metrics.
- The midsized banks however are a mess. They have neither the personal skills of the better microbanks or the management depth of the larger banks. Fundamentally they have no competitive
advantage and hence have no long-term reason to exist. This does not mean that equity holders are
doomed – but even if the banks survive, the best exit will be to sell to a large bank that will use the
cheap deposits to make better-selected loans.This is an interesting take on why size or personal connect matters in banking. When yyou have neither of these, you are in trouble
- To make money in technology you need to do two things. Firstly you need to change the world
(which First Solar clearly did) and secondly you need to keep the competition out. Alas very few
businesses manage the second trick. http://www.brontecapital.com/peformance/2010/Client%20Letter%20201003.pdf Excellent explanation of why they shorted FirstSolar, along with the underlying philosophy. Interestingly, the jury is still out on this one, as the furious debates on Seeking Alpha would show. Is it fair that Palm is facing bankruptcy? Or that Garmin is being displaced? We don't think so –but then capitalism is not necessarily moral or fair – but it does produce goods and services quite well. We don't invest on the basis of fair – we invest to make you good returns.
Wednesday, January 23, 2013
Bronte Capital first came to my attention through an RSS feed, when it was reported that they had correctly drawn attention to accounting redflags in Autonomy Plc financials, much before its acquirer HP wrote off nearly 2/3rd of the acquisition price as impairment charges. Intrigued, I thought it worth a deeper look. And then I stumbled upon this goldmine of interesting comments/info(http://brontecapital.com/Letters.html). I urge you to read them in their entirety-monthly letters going back nearly 3years-but for those starved of time-not of interest else you won't be reading this(!), I post verbatim the bits I found interesting with my comments in italics
Monday, January 21, 2013
Last week, RioTinto(the global miner) announceda $2.8bn writeoff of its Mozambique coal mines. Since companies like Jindal Steel, Tata Steel and Mercator Lines have coal mining operations in Mozambique, I thought of analyzing this situation if it holds any insight for investors. For some background, note that by acquiring Riversdale’s operations in Mozambique, Anglo-Australian RioTinto took control of 22 exploration licenses in Tete, including 65% of the Benga mining project (Tata Steel from India holds the other 35%) and the 100% of Zambezia project. Benga mine was under prelimnary production while Zambezia was under exploration. Under RioTinto's original plan Coal would have to be moved from its mines then loaded on to a train so it could travel 600km to the Zambezi River where it would be taken to the coastline
But Rio could not win the approvals to ship the coal down the Zambezi. To compound its challenges, coal prices have stayed weak and Rio appeared to overestimate the amount of coal it could access in Mozambique. As per the Reuters article below, 65% of the Mozambique coal holding company is now valued by RioTinto at $600MM, thereby giving a total enterprise value of $1bn. Even giving a 50%(very conservative considering it was the higher potential mine) valuation to Benga, that gives it an EV of $500MM.
Given that Tata Steel paid a bargain basement price of $88MM for its 35% stake, it need not fear any impairment even using the same assumptions
Even for Mercator Lines which I wrote about earlier below, the Kotak Report in below PDF of 23Aug2012, assigns a value of around Rs 12 to the coal mining operations+coal trading operations. By coincidence, the market values the company at the estimated NAV of the ships only, without giving value to the volatile coal business, or the troubled mining business.
Lesson:- Companies like RioTinto have global experience of navigating these issues. The fact that they failed to do so in Mozambique, should be a cautionary note to the other Indian companies who rushed to do business in Africa-for example Karuturi which faced flash floods wiping out its first year crop in Oct-12 http://financeandcapitalmarkets.blogspot.in/2011/12/karuturi-global-africa-agriculture.html And before according premiums to the relaxed regulatory regime in those countries(like for African farmland/mining concessions), do accord the regulatory risk and enhanced NGO scrutiny.