I started the year on skis and ended it hobbling around after an ACL reconstruction, but it wasn’t all downhill in 2015. In fact, it was a good year for both Forager funds and the business.
This calendar year was also a treacherous one, though, with a number of high profile disasters catching investors unware and a global commodity bear market turning into an out and out rout. Combined with the ups and downs of our own small investing world, this provided the backdrop for plenty more deposits in the Forager knowledge bank. I asked the team to share a few of their own lessons from the past year and have summarised it all into the following six lessons.
1. The volatile nature of commodities businesses
The mistake that cost you money this year – particularly if you are invested in the Forager International Shares Fund – was our assumption that oil prices would remain above $100, or potentially rise from there. Our investments in oil services stocks were belted in late 2014 and belted again in 2015, partially offsetting some excellent results elsewhere in the portfolio.
There are a few lessons here. The first, as our Americas analyst Kevin Rose points out, is that the market is highly sensitive to what we would previously have considered relatively small changes in supply and demand. “We didn’t appreciate that oversupply of 2 to 3% could send the oil price plummeting 70%”. We discussed the impact of US shale supply in depth before investing in the oil-exposed stocks but didn’t anticipate how significant its impact would be on the price. When you look at the past 50 years of historical oil prices, we probably should have.
Second, a few years back the price incentive needed to add additional oil resources was north of $100. We underestimated how malleable this number was. Kevin’s big lesson for the year is that, when the price falls, industry participants miraculously find a way to pump oil at half the boom-time cost.
“Once demand starts to dry up, contractor capacity that had been added is suddenly superfluous, and prices begin to contract. This means that the marginal cash cost of production does not remain where it was, but falls, leading to greater production and longer down cycles than one might originally estimate.“
This dynamic is playing out across the whole commodities sector and means that much needed supply curtailment is taking longer than expected and happening at much lower prices than previously envisaged. Those cost curves aren’t worth the paper they are drawn on.
The final lesson from the oil patch relates to the specific risks of investing in businesses where the main determinant of value is something as volatile as the oil price.
There’s a healthy debate going on at the moment about the value of one of Australia’s great businesses, ASX-listed Woolworths (ASX:WOW). The bulls think its dominant market position means 7% EBIT margins in Woolworths’ groceries division are sustainable. The bears think low cost competition will have the same impact it has had in the UK and drive margins down to 3-4%. That wouldn’t be a good outcome for shareholders, but it would still be a very profitable business.
Contrast that range of potential outcomes with our oil services investments. They were nicely profitable a few years ago and are bleeding losses now, almost exclusively because of something completely outside of management’s control – the oil price. The degree of variability in these businesses is dramatic and the value of them is dependent on something which is largely unknowable. We should only be investing in them at times of peak pessimism and, even then, in very small portions.
2. Too much talking to management is dangerous
“Not much” is my answer when asked how much time we spend talking to management. Most people seem to think we should be doing a lot of it, but 2015 reiterated the dangers of getting too close to CEOs.
Concerned about the company’s viability, we had a call with the management of Dolphin Geophysical in March 2015. The share price had already fallen roughly two thirds from its peak but we were worried about it going to zero given the state of the oil market at the time.
Armed with the knowledge that the company has now filed for bankruptcy (fortunately we sold it a few months ago, but not before losing the vast majority of our investment), the notes from that call are laughable. Of course everything was going to be fine. Of course they had plenty of potential to cut costs. Of course their “asset light” business model would enable them to skilfully navigate the current market conditions.
What did we expect? Were they ever going to tell us they were going bust? It is often more nuanced than this, and getting the most out of management meetings is all about reading between the lines. But they are always going to tell you what you want to hear, and more often than not you only want to hear what reinforces your pre-existing ideas.
Management meetings can be a useful part of an investment process – particularly when you have already done a significant amount of research and are tying up loose ends – but they are a relatively small part of ours, and I expect it will stay that way.
3. Our edge is small companies
We’ve had some big wins this year. Betfair (LSE:BET) and Kapsch TrafficCom (WBAG:KTCG) almost doubled in the International Shares Fund and Service Stream (ASX:SSM) and Coffey International (ASX:COF) did the same for the Australian Shares Fund. It’s not going to surprise you that they are all relatively small companies. As European analyst Gareth Brown points out “There’s danger in extrapolating” but the year provided “further evidence that we can develop an edge most convincingly in smaller stocks and this is where we should focus our resources.”
Forager is a small team of analysts competing with giants of the funds management world. Apart from loyal and long-term clients allowing us to make genuinely long-term investments, our most significant advantage is being able to invest in parts of the market where the competition can’t. This year has reiterated how successful that can be and you should expect an increasing percentage of the International Shares Fund to be invested in stocks like those mentioned above over the coming years.
4. Don’t let rising prices kill good ideas
Both Gareth and junior analyst Alvise Peggion listed some of their biggest mistakes of 2015 as “errors of omission”. Gareth’s most significant was German car-wash manufacturer Washtec: “I came across it around the same time I was studying Kapsch, so it took a temporary back seat. By the time I returned, it had risen 25% which, irrationally, put me off. It has subsequently doubled.”
Junior Analyst Alvise Peggion went one better than that with ASX-listed honey company Capilano Honey (ASX:CZZ):
“When we started analysing the stock in 2014 the company was trading on a pre-tax earnings multiple of about 8 times (adjusted for insurance reimbursements). That looked low for a company with a strong competitive position and one set to benefit significantly from strong Asian demand and a lower Australian dollar.”
However, the stock was illiquid and the price had jumped 40% by January this year to about $7. Despite the signs that the investment thesis looking better than originally envisaged, we decided to wait for the price to fall.
“Well it didn’t – today the share price is $22”.
We tend to be pretty good at ignoring the pessimism when a stock is trading at or near its lows, but this same bent for a bargain sometimes stops us buying a stock simply because its price has risen. As Alvise puts it, “the lesson here is that the market can underreact to new positive information, just like it overreacts to new negative information”. We tend to be pretty good at factoring the new information in when we already own a stock. Over the past year we have added to our largest holdings in both portfolios as good news didn’t move the share price as much as it should have. We need to get better at doing the same for stocks we don’t yet own.
5. Good ideas are simple
The best investment ideas are very rarely immediately obvious. Except in times of extreme distress, we shouldn’t expect fellow investors to leave $100 notes lying around on the pavement. Looking back at our best investments from the past year, none of them would have looked cheap on the basis of superficial ratios (each of the stocks mentioned above would have been trading at large multiples of both earnings and assets at the start of the year).
We generally need an insight into the business or the opportunity that other investors haven’t had. Regarding Betfair, that was the competitive advantage and scalability of its business model. For Coffey, it was that one division was worth more than the entire value implied by the share price. These key insights might require a lot of work and a lot of thinking but, once you have the insight, the idea itself should be very easy to explain.
Simplicity is often a key indicator of a bargain. Take Kapsch TrafficCom for example. This Austrian tolling technology company has its complications. The company has two main divisions, one of which is loss making, and dozens of new business opportunities that haven’t yet been executed on. The idea was simple, though, because the share price was low enough to ignore the complexity.
As Gareth puts it, “at a price of €20 per share, you were buying the whole business for less than the value of Kapsch’s reliable, predictable truck tolling division of the business”. If the rest turned out to be worth anything positive, “the stock would turn out to be a bargain”. At a higher price, you need to start putting a value on all of those options and that’s where the idea gets complicated.
And generally, the more complicated an idea, the more things that can go wrong. Our investment in oil-services company Subsea 7 (OB:SUBC) was dependent on the oil price, the relative competitiveness of offshore oil versus other sources like shale, management execution and the political environment in Brazil. The more factors an idea is dependent on, the more there is that can go wrong.
6. There’s nothing lost about the past decade
The media (and apparently some fund managers) is calling the 10 years to the end of 2015 the “lost decade” for Australian shares. It is presumably going to look better after the last week of market gains, but the decade’s return at the time the article was written was a “miserly 5.4%”.
First, that doesn’t include dividends. In a country where the tax system encourages particularly high payout ratios, dividends should and do represent the bulk of investor returns. Incorporating dividends, the total return over the 10 years has been a much more acceptable 68%.
More importantly, though, it has been a great decade for stock pickers. We’ve had numerous market panics provide opportunities to invest widely, and almost every year has provided enough volatility to find individual opportunities. The past year has been no exception.
Kevin, talking about his biggest successes for the year, notes the Google (NASDAQ:GOOG) share price volatility as providing a great opportunity: “Continuing to follow Google after we had sold the stock enabled me to spot a change in its attitude towards capital allocation and costs”. But it was August’s mini meltdown that allowed us to execute on this rediscovered optimism. “Across two trading days in August, the share price of one of the world’s largest businesses traded between $565 and $640, allowing us to pick up shares for $585 each”. Now called Alphabet, it trades at $776 per share.
There have been hundreds of episodes of market madness that have made the past decade a great one in which to be an active investor. As long as we keep building on our list of investable opportunities, I have no doubt that the coming decade will offer up the same.
8 thoughts on “Lessons Learned in 2015: Oil, Anchoring and Simple Ideas”
Thanks for that Steve. Good reading. Happy New Year.
Please send a copy of this to Forager Investors in the next report you guys send out.
This is worth keeping and reading over and over again.
Number 4 is the killer. Sanjay Bakshi described this as the problem Value Investors have in “averaging up”. When I first read this statement he made in an interview, it really hit home for me.
Resonates the most with me and one I’m constantly guilty of
Since day 1 at Forager I’ve been running 52-week low filters seeking bargains, and we’ve had some good ideas come from it. Over the past year I’ve also been running 52-week high filters – there are plenty of non-rational or non-price sensitive reasons for someone to sell a stock that’s gone up a lot that should have gone up more than a lot. It’s a tough bias to overcome but we’re working on it. ‘Averaging up’ is a nice way to put it, I’ll keep that in my mind thanks Eswaran.
Thanks Steve, some great points. I never buy commodities businesses and never will. Regarding rising prices, I like the expression I’ve heard from Geoff Wilson, “Buy on upgrades, sell on downgrades”, VTG is one recent example for me. I never talk to management, to me the numbers are the numbers. I like the approach from one of Buffett’s investment managers, “Ted does not meet or talk to management. He reads annual reports, transcripts, 10K’s and 10Q’s. When he identifies a good investment, he waits for the right price.” http://blogs.rhsmith.umd.edu/davidkass/uncategorized/highlights-of-warren-buffett-todd-combs-ted-weschler-and-tracy-britt-cool-on-cnbc-march-3-2014/
Demand for oil is inelastic.
If Iran adds to supply, we could be looking at US $20/barrel.
Too right Kenneth. I think I’ll get that plastered on my forehead as a lesson.
I think for point #1 rather than the lessons you have taken, Ben Graham would give us his often repeated warnings to have complete skepticism in analyst forecasts.
You guys did all the right things but to the extent the future was known it was factored into the price of oil already, maybe you could have been the smartest one to pick the bust but easier just to call it unknowable for lazy people like me. You lost money because you paid a price too high based on an uncertain prediction of the future.
What is knowable is classical economics which tells us that in the long run the price of oil must rise to cover the marginal cost of new production when supply outstrips demand. It doesn’t matter if this takes 6 months or 3 years to the long term value investor, the longer the slump the stronger the price recovery when it comes.
As the typical analyst is a desk jockey steeped in a deeply flawed ideology who has never worked on site they don’t realize that the declining cost of production is not a miracle of modern capitalism, instead most of the reductions are from companies laying a lot of the most useful people off.
This will exacerbate the skill shortage, there will be few skilled contractors left standing when prices recover so expenses will boom again and any warm body with a hammer will be sold as an expert. That could cost a lot.
I think oil and gas is substantially different from coal and iron ore because of the short term nature of the US tight oil reserves and because there was not such a boom in supply or collapse in demand.
Now that analysts have written the price of oil down to next to nothing in perpetuity and are standing with egg on their face wearing their darkest sunglasses there is the opportunity to pick up a bargain or two among the companies they have just transferred to sell.
This would be what I would refer to as value investing and I think rightly so.