Thursday, 15 August 2019

Investing in low conviction stocks; jumping the gun on EVs; and Tenneco

It is fashionable amongst the value investing community these days to hold a concentrated portfolio of high conviction ideas. Indeed, any other approach is usually greeted with suspicion, if not outright disdain. And yet, in my experience, often some of the very best investment opportunities exist in areas of the market where one is intrinsically capable of only low levels of conviction, extending to situations where a zero is a reasonable possibility. Obviously, smaller position sizes and a more diversified approach is warranted with such situations, but on a portfolio basis, they can yield a portfolio with very agreeable risk/reward characteristics - indeed uniquely so I would argue, given how few value investors are adopting such an approach in today's world.

An example at the moment is automotive component supplier Tenneco (TEN US), whose stock has been decimated and fallen to just 2x earnings (closer to 1.5x recently). Why is it so cheap? Three reasons: (1) they have a lot of debt, partly due to the ill-timed acquisition of Federal-Mogul last year, which despite being partly equity funded, has significantly increased the company's leverage; (2) global auto sales have declined this year, pressuring earnings and leverage ratios, and investors are also fearful about an impending recession in the US/globally exacerbating the company's plight; and most importantly (3) a significant portion of the company's business is making engine components for internal combustion engine (ICE) vehicles, including powertrain components.

It is now a widely-subscribed belief that electric vehicles (EV) are set to imminently displace ICEs, which means that Tenneco will likely be disrupted before it is able to successfully deleverage and return capital to shareholders - particularly if a recession happens in the interim. Should an EV transition occur, ICE suppliers such as Tenneco will also be the first affected, and the impact will be exacerbated by the company's high operating leverage. Once EV production ramps up, it will still take 10-20 years to gradually replace the existing installed base of vehicles, which will defer the impact on after-market players for an extended duration (including gasoline refueling stations, and also the impact on oil demand), but TEN's powertrain business is leveraged to the pace of new ICE construction (not the parc). While surviving for now, in the eyes of many, TEN appears to be on death row.

One of the keys to identifying investment opportunities is to always be prepared to challenge widely accepted notions by considering the other side of the argument, and being willing to ask, what happens if people are wrong? People forget that the really big moves in markets are driven by changes in opinion. What is currently widely known and assumed to be true about the future is invariably already embedded in current valuations. (This is one reason why broker recommendations are so frequently wrong and are best used as contrary indicators - they succeed in writing lengthy and eloquent reports that are best viewed as explanations for why a stock is already cheap/expensive, rather than guides to how one should position themselves today).

I was previously also of the view that EVs were inevitably set to dominate the future, but I actively sought out contrary arguments, and having done so, I am now convinced that many investors may have jumped the gun, and are too confident that a transition from ICEs to EVs is inevitable. I emphasise the word may here, because I don't hold this view with conviction - I just believe there is a larger probability than is generally accepted. And when stocks get cheap enough to be priced like options, a reasonable probability - even if significantly less than 50% - can still be sufficient to justify an investment case.

Elon Musk has been absolutely central to popularising the notion that a full conversion to EVs lies in our near future. Tesla's early premium models - the Roadster, Model S, and Model X - showed the world that EVs could not only be environmentally friendly, but also high performance and downright cool as well. His PR offensive has been extremely successful (too successful for Tesla's own good - it is now facing a wave of EV competition). It has lead to the hasty preparation of regulations in many markets mandating steadily increasing EV penetration; a surge of investment by traditional automakers into the electrification of many of their models; and has convinced the majority of the investment community that a full transition to EVs is only a matter of time.

The problem is that despite all the hype, it is still yet to be proven that EVs can be produced profitably, at scale, for the mass market. Tesla has proven, I believe, that they can be viably produced for the luxury market, because the premium prices of these vehicles provides much more margin to work with (and because Tesla has shown that EVs are capable of extraordinary performance). But the mass market is an altogether different question.

Tesla's ambition was always for its Model 3 to be the model that ushered in mass market adoption, but on an unsubsidised basis, along with practically necessary add-ons, on-the-road prices are still in the vicinity of US$50k - about double the cost of a new ICE vehicle of comparable size/specs. And despite this rich price tag (and the contribution from Tesla's more profitable luxury models; recent cost-cutting measures bordering on desperation (closing dealerships); and in the opinion of some - aggressive accounting), Tesla is still unprofitable, and in the opinion of many credible observers, destined for eventual bankruptcy. The inconsistency of widespread EV adoption now being considered inevitable by the investment community, and the leading player in the segment fighting for its survival, has apparently been lost on many (and it is also interesting to consider whether any eventual demise of Tesla will cause widespread assumptions around mass-market EV adoption to be revisited).

Furthermore, this lack of cost competitiveness also exists before considering the reality that if EVs were to go mainstream (nearly 100m vehicles are produced globally each year, compared to about 300k by Tesla at present), the world is going to need a lot of automotive-grade batteries, and a lot of batteries will require a lot of lithium, cobalt, and nickel. The sort of scale required could well result in the cost of these raw materials increasing many multiples from current levels. A significant fraction of the world's known cobalt reserves are located in the DRC (Democratic Republic of Congo) - a destination not renowned for its political stability or predictable mining industry regulations. The battery is already by far the most expensive component of EVs - costing at least US$10-15k, and cost reductions here are not subject to Moore's Law type declines (microprocessor performance and cost improved because transistors were made exponentially smaller, allowing more of them to be packed onto a given surface area, but there are physical limit to how much energy can be stored in the chemical atoms of batteries; you can't make electrons smaller). Produced at scale, there is a good chance the cost of batteries would rise rather than fall, as raw materials costs spiraled.

Musk makes the (fair) point that one ought to not just consider the price tag of EVs, but the 'total cost of ownership', and it is true that electric vehicles cost less to power than ICEs. The cost of electricity is higher than gasoline on a cost-per-raw-unit-of-energy basis (as electricity has already absorbed conversion losses at the point of generation), but EVs are much more efficient at converting electric energy to kinetic energy than ICEs are at converting the chemical energy in gasoline into kinetic energy (heat losses are significant), more than offsetting this disadvantage.

However, balanced against this point is the important issue of battery longevity. As anyone who has used a laptop or smartphone for an extended period of time can attest, battery performance degrades over time. The Nissan Leaf's battery performance reportedly degraded by as much as 60-70% five years after purchase. While efforts are underway to improve battery longevity, it is not yet clear if they will be able to extend the practical life of the vehicles beyond 10 years, without a battery overhaul being necessary. This is an important issue, because most mass-market second-hand ICE cars are worth less than US$10k after 10 years, whereas that is the likely minimum cost of a new battery pack. In practice, this would mean that it would not be economically viable to undertake such an overhaul, and EVs would have a practical useful life of perhaps half that of an ICE. This would represent a meaningful (if not total) offset to the 'lower cost of ownership' Musk speaks of.

What about regulations? Both EU and Chinese regulators have pushed hard to accelerate the adoption of EVs, imposing mandatory EV sales targets (as a percentage of total sales) in the case of the latter, and aggressive average fleet emissions reduction targets in the former, which will likely require rising EV penetration to meet. China's policies likely also partly reflect geopolitical motivations as well (to reduce its reliance on imported oil).* While these regulations might seem destined to hasten adoption, as we have seen with solar subsidies, it is one thing to force-feed a small minority of the system average onto a structurally more expensive platform, but it is quite another to roll it out to the entire system, which is orders of magnitude more expensive.

As we have seen with the recent Yellow Vest protests in France (as well as the general tide of rising populism), there is a political limit to how much of a decline in living standards you can force onto the electorate in the name of environmental protection - at some point the cost becomes too burdensome and people revolt at the ballot box. How will the broader population feel about being forced to spend a minimum of US$50k on a new car? And will Germany really want to bankrupt its economically important auto industry by forcing them to sell cars people don't want and can't afford?

It is also worth remembering that in the entire history of advanced civilization, there has never once been a transition to a technology platform that is less economically and energetically efficient than the prior model. In this respect, EVs are attempting a transition that is unprecedented - at least with respect to the current state of technology and relative cost structures.** Now, the world has also never been (or needed to be) more concerned about the impact of human activities on the environment either, so things could change. It is also possible that the heavy investment now going into EVs and batteries will yield significant innovations which change the current comparative cost calculus. However, it is far from guaranteed that these efforts will be successful.

In short, the investment community appears to have jumped the gun on EVs in my opinion. Widespread adoption may well happen, but we do not yet have sufficient evidence to declare it a fiat accompli, as most in the investment community now have.

What is most intriguing about this is that if markets are wrong about the coming EV transition, a company like Tenneco is likely to not only survive, but thrive. The company is a world leader in clean-emissions technology, for instance (what passes as 'high tech' these days is somewhat bewildering - writing some simple software that allows someone to manually go to a restaurant, pick up food for you, and take it to your door, is considered high tech, when coming up with the most sophisticated emissions-reduction technology in the world - a feat of advanced engineering - is considered old hat). If the EV transition fails because it is discovered to be uneconomic, by far the most likely Plan B around the world will be to force tighter ICE vehicle-emissions standards onto car producers. Tenneco will be exceptionally well positioned to meet this demand, particularly because auto companies are all preoccupied with rapidly building out their electrification capabilities at present, and are neglecting investment into ICE engine components (and are increasing outsourcing). There also aren't too many Silicon Valley start-ups racing to raise capital to invest in more efficient ICE engine technology either.

Future outcomes are also not binary, and it is also quite possible - if not likely - that hybrids emerge as the preferred platform, as a compromise solution which are cheaper than full EVs (but more expensive than pure ICEs), but are more environmentally friendly than pure ICEs, and still allow for significant reductions in average emissions. Hybrids will also ease some of the challenges of full EV adoption (range anxiety; a lack of recharging infrastructure; and the customer inconvenience associated 20-40 minute charging times compared to a few minutes to refuel). This future will also be a good one for Tenneco as well, as core ICE engine components will retain their relevance. And all of this is before mentioning the fact that Tenneco also has a DRiV division that focuses on ride-control/suspension and after-market products that are immune from EV disruption risk (although they are not large enough to support TEN's group debt burden in isolation).

All told, Tenneco looks to have a good risk/reward to me, because there is a decent chance the consensus view is wrong. But do I have conviction? No I do not. I don't hold the above views with any certainty - I merely think it is a possible scenario, whose probability is being underestimated. And it would be silly to have conviction in the outlook for company with high leverage, and where technological disruption could well lie in the company's future. Tenneco could well ultimately go to zero (or be required to issue so much new equity that it dilutes existing shareholders to something approximating that). But this lack of conviction and high risk profile does not make TEN a poor investment on a risk/reward basis - merely one that needs to be appropriately position sized on account of its large idiosyncratic risks.

Opportunities like TEN are rife at present, because they fall between the cracks of the investment approaches/styles/philosophies that are currently widely practiced. Obviously, the growth and high-quality crowd are going to be uninterested in a stock like TEN, as will the momentum and macro crowd, given the current state of markets and prevalent macro anxieties. But intriguingly, the vast bulk of value investors are also uninterested, as the majority of them insist on high-conviction and concentration, often quoting Munger in defense of such an approach (the tremendous irony here is that Munger reportedly purchased TEN around the turn of the century when it was very cheap, and made a tonne of money). Consequently, companies like TEN face an almost complete absence of willing buyers at times like these, and can therefore fall to extraordinarily low prices.

This highlights yet again the importance of adaptability in markets. Where the best opportunities happen to reside is always changing, and a flexible approach is essential. There are times when a concentrated approach focused on high quality stocks makes sense, and there are times - like the present - where it makes much less sense. This is something I wrote about in more detail in my article on fishing where the cod is. Fixed rules about the appropriate level of concentration therefore don't make a lot of sense to me - the appropriate level of concentration reflects the nature of the present opportunity set - and dogmatic adherence to certain rules like 'we don't invest in cyclicals'; 'we don't invest in companies with high leverage'; or 'we don't invest in capital intensive industries such as auto suppliers', doesn't make a lot of sense to me either. As always, flexibility and the capacity for independent and original thinking are essential to success in markets.


*Incidentally, those bullish on the LNG market, and particularly US exports of LNG, based on an expectation China will significantly increase LNG imports in coming years (as they substitute domestic coal for clearer natural gas), may be overlooking geopolitical risks to this view. If you were China, given the current state of geopolitical relations between China and the US, would you really want to rely on US LNG imports for your energy security? This is one reason I own China Shenhua Energy - China's largest and lowest-cost coal producer (the main reason is because it is very cheap).

**When energetically more efficient, transitions also often happen relatively fast - after the invention of the automobile, the horse was almost completely displaced within 20 years. Tesla has now been in business for about 16 years, and EVs still represent only about 1% of global automotive sales.