Ships, hogs, dirts and the shipbuilder called Conrad

Ships, hogs, dirts and shipbuilders. What do they have in common?

Their economics.

Ships

A while back, the dry bulk shipping industry caught my attention. You can see why from the 3-year BDI index chart below. The BDI index is the barometer of the charter rates for dry bulks. The industry has been in recession since GFC.  It is severe. Besides, I remembered one of my role models, Mohnish Pabrai, described in his book how he scored a multi-bagger win in his bet on the oil shipping company Frontline when the industry was in recession in 2001.

Source: Bloomberg

Were there values among the dry bulk shippers? 

The initial look looked promising. Listed dry bulk operators like DSX and GNK spotted attractive ROAs, profit margins and P/B ratios. However, the more time I spent to understand the industry and its economics, the less sure this was a game I was capable to play.

Take a look at the supply/demand curve I reproduce from Martin Stopford's book Maritime Economics :

Source: Maritime Economics, by Martin Stopford

Let me point out the important bits:

• Shipping is essentially a commodity business. (You generally don't care too much who is shipping you stuff as long as your goods arrives in one piece.)
   
• In short term, demand is inelastic. (If you need to buy steel beams to build your Olympics stadiums, high shipping cost won't easily deter you.)
   
• At the same time, worldwide shipping capacity is finite, because it takes years to build a new ship. Thus, supply becomes inelastic once you reach a certain point. Hence, the "hockey stick" shape supply curve. Freight rates can go from $6,000 to $44,000 in the space of a few months.
   
• When freight rates skyrocket, shippers will decide to invest to expand their capacity. It takes 1-3 years to build a new ship. By the time the shipbuilders expand their shipyards and new ships are built, the demand is no longer there. We now have an oversupply of ships and freight rates tumble.

So, here we go. Boom and bust cycles. Because of the above structural reasons, the magnitude of boom and bust cycles is extreme. Consider this: BDI was at its highest 11,000 in mid-2008 before the GFC, tumbled to 700 in Dec 2008, recovered to 4,600 in Nov 2009 and is now hovering around 1,000. To get a sense of what this means in real life, just imagine bus fare tumbles from $110 to $7 and then climbed back to $40 in the space of months.

This means the usual metrics like ROA, P/E and P/B are all meaningless. Earnings and asset values are quick sand. They are extremely unstable. You can't rely on them to value dry bulk shippers.

I ended up not investing in any of them because I just had no particular insight into individual shippers. Nor had I any insight into the cycles and the macro environment surrounding them.

Hogs and Dirts

I've omitted a lot of details about maritime economics which contribute to the "hockey stick" supply curve. (e.g. Ship owners can slow down their voyage or lengthen their maintenance time in response to low demand.) But the above supply/demand captures the essence. Furthermore, there are 2 key factors underscoring this extreme economics: (1) The decisions to expand the supply (i.e. the fleet) take years to materalise. (2) Each player in the industry is making rational decisions, but only considers themselves in isolation. Some kind of prisoner's dilemma is at work here.

This pattern shows up in another industry that I'm been worried about for some time: the mining sector in Australia.

Professor Steve Keen at University of Western Sydney explained it the best in this Business Sepctator piece. He pointed out this is nothing new. This was long recognised in hog cycle, the volatile 4-year cyclical pattern of prices for pigs in the US. And there is a neat economic theory, the cobweb model, explaining it.

(This is a good example that knowledge is accumulative. You builds up your circle of competence organically over time. From time to time, Things I learned from one place would show up in another place in a slightly disguised form. Things learned from one domain are never wasted if they didn't lead to any investment idea.)

Conrad Industries

This brings us to CNRD, the shipbuilder that I'm investing in.

My original conservative estimation of CNRD's intrinsic value was $18-20 per share. The current share price has now fallen into this range. Isn't it time to take the money off the table? This is the question I've constantly had in my mind in the recent weeks.

The original investment thesis was essentially based on a single event, the oil spill, or the recovery from it. But I have since realised there is more with CNRD. CNRD's management is more competent than I initially thought. CNRD has also become less sensitive to the exploration activities in the Gulf region than it used to be as the management has diversified its client base. CNRD may not have any structural advantage, but it is a very efficient business. It has the appearance of a "hidden champion". It's more like Buffett's Nebraska Furniture Mart than his Coca-Cola.

The difficult question is: how to value it now?

CNRD isn't exactly Nebraska Furniture Mart. Even though CNRD's client base is more diversified now, the products it makes are still commodities. It is still at the mercy of boom and bust cycles. "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." More importantly, the longer I hold CNRD, the more important the cycles will become.

For a cyclical business, the concept of intrinsic value as in Ben Graham's way of thinking may not even be applicable. Even if it exists, it's close to unknowable. There is no stable earning. It will be dangerous to normalise CNRD's earning over many years to arrive at an artificial figure. If we do so, we will be like having one foot in a bucket of ice water and another foot in a bucket of boiling water and claim we feel good on average.

And it is equally dangerous to time the cycles. Stopford says in his book the average length of boom and bust cycles in the shipping industries is about 7-8 years. This is, again, just an average. These cycles don't come in as clock work. The constant changing macro environment has significant influences on the supply-and-demand.

Where does this leave us? Without an estimation of the intrinsic value, I don't have a rational basis to judge when to sell. And forcing an estimation may easily give me a precisely wrong figure.

I'll follow Keynes' doctrine: "it's better to be vaguely right than precisely wrong". Here is how I will approach it:

• I mentioned in a previous post there are a few catalysts surrounding CNRD: the BP settlement, full recovery of its repairing/maintenance segment and a small possibility of some kind of corporate action. So, instead of getting obsessed with figuring out a valuation, I will wait for one or more of events to play out.
   
• I will add one more event to my list above. There is an important observation from the discussion of the boom and bust cycles of the shipping industries: The length of the cycles is a directly consequence of the duration it takes to materialise the investment/expansion decisions made by the players. It is not precise and will never be precise because unpredictable macro events will push things around. But the general cause and effect is there. If it takes only one week to add capacities in an industry, you will  expect to see the length of cycles in the order of weeks, not years. And here, we see CNRD is also buying land and getting government grants to expand its capacities. We can reasonably expect other players in the industry are doing the same within a similar time frame. (This will be a good place to do more scuttlebutt.) When all of these new capacities come online, we have to be worried. So, if we work backwards from here, the completion of CNRD's expansion program will be a signal the industry has passed its peak.
   
• I will err on the side of being over-cautious. I will rather leaving too much money on the table than being caught in the downturn of the industry.

I mentioned in my previous post the Credit Bubble Stocks blog is an excellent source of intelligence on CNRD's industry. Credit Bubble has linked to an informative research piece Good Year for the Barges. Being a contrarian, I'm becoming more cautious, treading with my eyes wide eye...

(Disclosure: Long CNRD)

Internet heartbeat, the industrial giant approach

A week ago, I wrote Internet heartbeat, the Canadian way.

Someone at General Electric must have read my blogspot, decided to take a time-machine to travel a few months back and told their colleagues to re-align their corporate strategies.

GE released a white paper this week on its industrial internet vision. The news was subsequently picked up and reported by New York Times and InfoWeek, among others. The piece by C|Net provides the best "at a glance" summary.

Again, we really have to give Sun Microsystems the credits. The current cloud computing movement is essentially Sun's "The network is the computer" vision, just re-branded with a silly name. And this "industrial internet" vision is essentially Sun's "internet heartbeat" vision.

Hemptonology: The art of spotting frauds

If watching your downside is the defining characteristics of value investing; if it's more important to avoid costly mistakes than spotting multi-baggers; then spotting frauds is simply the flip-side of value investing.

If there is anything to learn from last week's HP-Autonomy saga, it is that, regardless whether it is a microcap or a large-cap, anyone investing doesn't do his own due diligence is a fool. (In case you missed the story, here is the abridged version: HP now thinks it was conned in its US$11B acquisition of Autonomy  and has written this investment down by a whoppy $8.8B.)

John Hempton, the hedge fund manager based in Sydney who is short HP, shows how you can spot Autonomy's fraudulent accounts in 5 minutes. As a hedge fund manager, Hempton mainly goes long. He says shorting frauds is only his sideline. But throughout the years, he has dissected many frauds on his blog. If Buffett makes value investing look easy, Hempton makes uncovering frauds look like a child's play. But make no mistake. The look is deceiving. As with any intelligent approaches in investing, "it is simple, but not easy". Behind the scene, a lot of brain power and fact finding are involved. If it were that easy, John Paulson who made his name in betting against subprime mortgages wouldn't have been deceived in the Sino Forest fraud.

Every business is unique. Every fraud situation is also unique in its own way. If you look at how Hempton skillfully deconstructs the meaning of low capex here or high receivables there, you see that almost any single number worth scrutinising. There are infinite variations. So, I don't think it's useful to have just a catalog of fraud detection techniques. Instead, it's more important to internalise the underlying principles, the first principles.

Here are principles I distilled from Hempton's blog:

• Visualise how the business operates from the numbers - Don't fall into the trap treating the numbers as abstracts. When seeing the gross margins going up every year, it's far too easy to tick the "this business has pricing power" box on your checklist and then move on. What is more important is to visualise how the physical goods flow from here to there and how the money flows in the opposite direction. The more vivid it is, the more powerful it is.
   
• Cast a skeptical eye on any outliner - Continue from the previous point, always ask the question: "what does that very favourable metric mean in the context of the company's competitors and its industry? Is that economically or physical possible?"
   
• The personalities behind a business are as important as the numbers, if not more important - If you catch 100 burglars in a year, how many of them have only done this once? None? Then, track down the histories of the CEOs, the bankers, the lawyers and the accountants!
   
• Data point, data point and more data point - Ben Graham says "you are right only if your facts and reasoning are correct". Without the facts, you only have a hypothesis. Look at what Hempton did. He paid "spies" to visit local factories. He took note how often a founder-CEO flew 12 hours to see his mistress living on a different continent.
   
• It's all about Bayesian reasoning - How to put the collected anecdotal evidence together? You have the evidence (E). You have the competing hypotheses (H), "this business is a fraud" vs "this business is brilliant". You apply Bayesian reasoning, reasoning things in Occam's Razor style, to find the hypothesis (or the theory) that fits the evidence the best, going from Pr(E|H) to Pr(H|E).

Yes, all these look so common sense and self-evident on paper. But no, it's not easy, it's not easy to have the mentality and emotional strength to apply these consistently in practice.

I'm writing this post not because I'm an expert in fraud detection or in shorting. Exactly the opposite. I'm a novice. I'm writing this as a reminder to myself.

Internet heartbeat, the Canadian way

More than a decade ago, Sun Microsystems' CEO Scott McNealy had the vision that every household or commercial electronic device would have an "internet heartbeat". Things ranging from light bulbs to refrigerators would be networked and speak the same language. Of course, in McNealy's vision, the enabling technology was Sun's Java platform.

McNealy was ahead of his time. Sun has since been swallowed by Oracle.

But the vision lives on, And its form has morphed.

The internet heartbeat beacon is now carried by Android. At the moment, Android is still just the software which powers mobile phones. But it's slowly changing. Android is turning up in unexpected places. If you don't believe me, take a look at this array of (weird) espresso machine and washing machine , this platform for medical devices, this latest and greatest camera made by Samsung, or this Android-powered satellite built by NASA.

Okay, I've stretched my argument a bit too far. There is no cellular network in the space. NASA doesn't put Android into the satellite in order to connect it to the cloud. But my point is, Android is becoming the common denominator for everything electronics. Every electronic device requires a real-time operating system (RTOS), be it a dumb firmware burnt into the circuit or a smart one. If you are a manufacturer and someone is giving away a free RTOS which has baked in wireless cloud-connectivity, is proven to run well on embedded architectures like ARM and offers a whole array of other bells and whistles, it's an offer too good to refuse.

To give McNealy more credit, Android is actually a descendent of Java. (That's why Oracle sued Google for intellectual property infringements.)

However, I've been blind to one thing until I spotted a writeup on SeekingAlpha today. There is another contender to proliferate the internet pulse: Blackberry 10. Or more precisely, QNX.

When I decided to invest in RIMM, my focus was the downside protection. The beauty of this approach is there are more than one way the upside can unfold. High uncertainty, yes. But you don't need to predict precisely which way it goes. And out of all the possible paths, apparently, a sustainable BB10 ecosystem will deliver the true multi-bagger result. To achieve this, RIMM doesn't need to unseat Android or iPhone from the market. It just needs to have enough critical mass. This in turn requires a solid BB10 OS. So, as long as I knew QNX is a solid RTOS with good reputation, I stopped investigate further. (If you don't know what QNX is, it's enough to say that it's been powering cars, medical devices and even nuclear power plants.)

What has escaped my mind is the possibility RIMM has more far-fetched strategic plans for QNX. What will the possibility be if QNX is married to RIMM's secure network on which BBM and BES currently run? You get an end-to-end "smart grid" solution with some interesting mission-critical applications in vertical industries.

Will it be successful? I don't. In a world where everything is converging towards TCP/SSL, do we need a solution based on proprietary network? Again, I don't know. But I won't sweat it. I'm more than happy to have an additional way for the investment thesis to work out.

(Disclosure: Long RIMM, ORCL)