Tuesday 14 February 2017

Crisis investing, prejudice, 'blink' investing, and Ferrexpo as a compelling long

I like to go hunting for bargains in off-the-beaten-path places, and particularly in areas of distress. When a figurative financial bomb goes off, I like to run towards it.

This is not an exercise in financial masochism. There is a logic to this eccentric proclivity. If you take a look at a long term chart of the S&P 500, it is fairly obvious when the best times to buy were – they were during recessions and/or financial crises (e.g. 2000-03; 2008-09). That was when the best bargains were to be found. One option is to sit around and wait for a once-in-a-decade market downturn. Another is to actively seek out parts of the world where downturns are already in motion.

This inclination lead me to poke around and look for opportunities in the Ukraine. After Russia’s Chimera invasion/annexation, the economy has been a mess, with the currency declining by two thirds; the economy contracting by 20%; and inflation reaching well into the high double digits. There were bound to be amazing opportunities amidst the figurative (if not literal) rubble.

Unfortunately, Ukraine it is a small and relatively closed economy that is difficult for non-Ukranians to invest in. My next step was therefore to screen for stocks domiciled in the Ukraine that were listed on overseas exchanges, including London. That search process threw up a company called Ferrexpo (FXPO LN). Alas, it was an iron ore company. 

Like most investors, I had/have an aversion to iron ore companies. I struggle to see how China can continue to import 1bn metric tonnes of iron ore a year – a staggering number (about 32 tonnes a second), and I share Jim Chanos' skepticism about the sustainability of China's current real estate boom, which will almost certainly end in tears (and that is where a lot of iron ore is going). I almost gave it a quick pass. But then it occurred to me – this stock has not one but two stigmas attached to it – it is in the Ukraine, and it is in the iron ore business. How many investors are going to bother to look at it? Not many. I forced myself to take a closer look.

Stigma and prejudice in financial markets work in much the same way as they work in the real world. They are the antithesis of meritocracy, and they result in judgments being cast before all the facts are in and are considered in an unbiased manner. If you want to find bargains in the market, it pays to keep an eye out for widely held stigmas and prejudices – even ones you hold yourself – because that is where other investors’ prejudgments are likely to have resulted in neglect and the associated mispricings that can sometimes result.

What I found

I’m glad I did take a look, because what I found at the time (August 2016) was very interesting:

*As a commodity exporter, FXPO earned foreign exchange, whereas a lot of its costs were denominated in Ukrainian Hyvnia. Consequently, its USD-denominated production costs had fallen sharply alongside Ukraine's currency devaluation, and its margins were benefitting. In addition, its operations were located in regions unaffected by the Chimera conflict. Ironically, FXPO was actually doing better because it was based in the Ukraine, not worse. Indeed, the costs savings were so significant that FXPO had become the lowest cost pellet producer in the world.

*Secondly, the company was primarily a producer of iron ore pellets – a relatively small part of the global iron ore market – not iron ore fines, for which the Pilbara is famous. Pellet production requires both higher quality ore as well as significant and expensive processing installations, and not much of the latter was being built given the state of iron ore prices (US$50/MT at the time) and general pessimism towards the industry's outlook. Also interesting was that the total global supply of pellets had only risen by about 50% during the past decade, compared to many multiples for fines, and comprised only about 10-15% of the overall iron ore market by volume. The potential 'decoupling' of demand and supply dynamics in this niche segment was intriguing.

*Thirdly, one of the largest and lowest-cost pellet suppliers in the world was the Vale-BHP Samarco JV in Brazil (20% of global supply), and as many have no doubt read about in the financial press, this operation suffered a major tailings dam failure in late 2015 that resulted not only in a major ecological disaster, but also a mine shuttering that had removed 20% of the global pellet supply from the market. A quick google search revealed that the earliest production was expected to resume was mid 2017, and extensive further delays were quite possible, if not probable. A sudden and unexpected 20% reduction in supply is usually a good thing for prices. Pellet premiums (above base 62pc Fe fines prices) were starting to rise, and there was a strong argument to be made that that would continue, as this sub-segment of the iron ore market tightened.

*Forthly, based on the company’s recently released 1H16A result, the stock was trading at a PE multiple of about 3-4x the company's recent earnings run-rate, even with average 62pc Fe fines prices averaging only US$50/MT (well off their highs), and with TTM pellet premiums having averaged levels significantly below spot premiums (as at August 2016).

A 15 minute research process

The story seemed compelling and I immediately bought some shares. Indeed, I bought my first block of shares within 15 minutes of first looking at the company, as the above factors quickly became evident. This is my fastest turnaround between discovery and purchase to date. The original purchase was small – about 20bp of the fund – and I subsequently did a lot more work to confirm my initial judgment before increasing the position size meaningfully (subsequently to about 3-4% of the fund, acquired between 62-75p). However, this experience drives home yet again something I have come to strongly believe with investing - that more information or a more extensive research process does not necessarily lead to better investment decisions or outcomes, and is simply not necessarily to make a lot of money in markets. All you need to know is what is truly important, and you also need an ability to ignore everything else, which is usually irrelevant noise (and there is a lot of irrelevant noise in markets)

I want a stock to be so obviously cheap that I can determinate almost instantaneously that it is a buy, in Malcolm-Gladwell-style ‘blink’ fashion. Many of the world’s greatest investors, such as Buffett and Greenblatt, are similarly minded in this regard. Buffett is famous for making decisions within 10 minutes. He bought a US$500m position in PetroChina in 2002-03 after doing little more than reading company’s the annual report. He sold his position in 2007-08 for US$4bn (the hour or so it took him to read the annual report was a fairly productive hour). 

People familiar with my prior work as a securities analyst will find this quite ironic – I was famous for writing extremely long and detailed notes (I wrote a 70pg quarterly result note once). However, with my investments, I usually know almost immediately whether something is a buy or not.

What I also found that was less relevant

The other immediately observable but less relevant fact was that the stock had already rallied from a low of 12.5p in Jan-Feb 2016 to about 70p at the time I first looked at it in August. I.e. the stock had nearly 6-bagged in the prior six months. As a value investor that likes to buy bargain issues, it is easy to be psychologically deterred by this. After all, you've already missed a 500% return.

What I have discovered through long and painful experience is that there are two easy mistakes to make in markets – the first is to buy a stock (or be influenced to buy a stock) just because it has fallen significantly from its recent highs; and the second mistake is to not buy a stock (or be influenced to not buy a stock) just because it’s gone up a lot from its recent lows.

The former mistake – aka ‘bottom fishing’ – is particularly dangerous because here you are not just looking at the prospect of a missed opportunity, but also the prospect of losing real money. Seth Klarman put it best – you should buy a stock not because it’s down, but because it’s cheap. Stocks can significantly overshoot on the upside, so one should not assume a stock is cheap merely because it has fallen 30-40% from its highs. Indeed, former market darlings that have already de-rated 30-40% from their highs are often the most hazardous stocks to buy, because these issues have usually already been picked over by many investors and sell-side analysts and were formerly well owned. If a stock such as this is going down, there is probably a good reason for it, and those reasons may not yet be fully visible to outsiders. Caution is well advised. One good antidote is to compare a stock not to its recent highs, but to its prior cycle lows.

The latter mistake is not buying something just because it has gone up a lot from its recent lows. This is the mirror image of the above mistake. This mistake lies in the ‘errors of omission’ camp – i.e. no money is wagered and therefore no money is lost, but significant potential gains can be foregone. But stocks can also overshoot significantly on the downside, and still be cheap despite significant recent gains. A useful antidote is to compare a stock not to its recent lows, but to its former cycle highs. That helped. FXPO was still more than 75% off its prior highs. This process is still irrational, but it's slightly less irrational, and so it helps.

Fortunately, I’ve made a lot of mistakes as an investor over the years, which has battle-hardened me into a better investor (there are no short cuts in this business, and most lessons need to be learned - or relearnt - the hard way). Fortunately, I didn’t have to to relearn the mistake again with FXPO, and plowed in with alacrity despite the significant YTD gains. 

Recent updates

Since my original purchase in August 2016, FXPO has moved up to 166p – a 137% gain. Luck has played a role – iron ore fines prices have risen unexpectedly (to me) from US$50/MT to US$85/MT. That was not part of the thesis, and it certainly didn't do any harm. However, pellet premiums have also risen from US$20-30/MT to US$45/MT - something that was much more predictable. And more generally, a truism is that good things can happen to cheap stocks.

FXPO recently announced its Dec-16 half operating results, and it can be easily inferred from the movement in the company's net debt position during the half that the company generated US$196m in equity FCF in the second half alone. That is a not inconsiderable amount for a company with a US$1.2bn market capitilisation (and US$1.8bn EV) at present (at 166p). Furthermore, that was in a half where base 62pc Fe fines prices averaged only US$65/MT – significantly below spot levels of US$85/MT. I immediately bought more at 132p. The market took a few days to do the math and cotton on, but the stock then started to move higher. 

In my view, it still hasn't moved enough. The market's math is improving, but it is still a bit slow. FXPO’s all in cost of production (including D&A, SG&A, royalties, etc) is about US$50-60/MT at present. Pellet premiums have reportedly reached as high as US$45m/MT of late, and the spot iron ore fines price is currently US$85/MT. FXPO’s ASPs are therefore likely approaching US$130/MT at present (85 + 45). I will use US$120/MT ASPs and US$60/MT in costs to be conservative. This suggests they should be making about US$60/MT in operating profit at present. 

Meanwhile, FXPO produces approximately 11.5m MT a year. Last I checked, 11.5m x US$60m = US$690m. At this earnings run-rate, the company is trading at just 2.5x EV/EBIT, and will be able to pay down its US$600m of remaining net debt within 12-18 months (after factoring in interest costs and tax) if current prices hold. This is likely to de-risk the equity and result in a re-rating.

I also estimate FXPO's total deployed capital - once forex translation marks are excluded (which are an accounting fiction) - to be US$2.5-3.0bn (including debt). For the lowest-cost producer in the world of pellets at present, with an extremely long reserve life, replacement cost should represent an absolute floor on valuation. If iron ore prices can stay high for a while and they can pay down the last of their debt, this suggest there is still 100-150% upside from current prices. A US$2.5-3.0bn EV would also still only represent about 4x the company's current EBIT. Per-tonne margins will likely fall over time, but the company would also like to expand production to 20m MT, which will likely act as a partial offset.

What’s the downside? I think iron ore fines prices are quite likely to fall back towards US$50/MT over time, and could do so at any moment. I could be wrong, however (I hope I am). Pellet premiums will likely also eventually normalise – to perhaps US$25/MT. If both of these things occur, FXPO will make a more normalised US$150-200m in NPAT excluding interest costs (i.e. after debt is paid down). This is still quite satisfactory relative to the company's US$1.2bn market cap, and implies a reasonable amount of downside protection is in place.

Of course, the stock will likely trade down if spot iron ore prices roll over. That is the biggest short to medium term share price risk. However, in the short term, the risk is mitigated by the company’s upcoming FY16E result, which is likely to highlight to investors more clearly just how much money this company is making at present. I still like the risk/reward. 

Portfolios I manage continue to maintain a 4-5% portfolio position in the name.

Comments welcome.