Last week, US interest rates completed a multi-year reversal pattern and broke out over a three-decade downtrend line. I believe that interest rates move in generational cycles and the chart pattern has now confirmed a long-term trend towards higher interest rates. This trend is across the entire US duration curve and appears to have been followed by similar moves in many other global benchmarks. While I do not expect rates to suddenly surge, the trend is clearly in the direction of higher rates and this has consequences.
In our over-leveraged world, the cost of capital is the life-blood of most businesses and a key factor underlying consumer spending. As credit gets more expensive, interest expense will eat into the earnings of most businesses. As funding costs increase, consumer discretionary income will also decline. Finally, as yields on government bonds increase, the relative attractiveness of equities will decrease—especially if they’re undergoing a secular trend towards declining profits. Interest rates truly are the one ring to rule them all, when it comes to financial markets.
Turning to property values, the move from a 2% cap rate to a 6% cap rate would entail a 2/3 decline in value and possibly worse if rental income also declines. If there was a mortgage, it is likely that the mortgage does not cover the equity value—even if it was conservatively mortgaged at the time. Now set the same paradigm to equity markets and add some financial leverage for good measure. Remember, equity multiples do not only reflect current funding costs—they also look forward many years into the future. If the expectation is that rates will continue rising, this must be now discounted into future valuation multiples. If history is any guide, this adjustment may be sudden due to all the margin debt outstanding. I believe we are about to enter one of the most dangerous moments for financial markets since 2008—especially as valuations are as stretched as at any time in history.
With this in mind; I went through a comprehensive review of my portfolio and decided that the time had come to harvest some gains and be prepared for the coming crisis with more cash. Remember, when they crash the market; even the cheap stocks decline.
I have sold all of my Aimia (AIM – Canada). I originally wrote about Aimia in June of 2017 when it was trading at $2.05. It subsequently declined into the mid-$1 range allowing me to add substantially to what was already an unusually large position. So why have I sold in the low to mid $4s if book value is somewhere between $7 and $8? Despite Mittleman Brothers having secured 2 of 8 seats, there are still 5 legacy board members with a long history of destroying shareholder value at every chance they can get (I assume CEO Jeremy Rabe is logical). Sum of the Parts investment thesis always take longer than expected to converge with fair value and without effective leadership, they may never converge with fair value. I also worry that, I may need to own the shares at least until the stand-still expires and the 5 legacy board members can be removed after a contentious proxy battle next fall.
Next fall is a long time from today. In the interim, this board is likely plotting to do something insane as a parting gesture to screw shareholders. Under the board’s incompetence, book value per share has already shrunk from something in the high teens to between $7 and 8. Aimia shares have doubled in value since I mentioned them 15 months ago and my margin of safety is much reduced. I feel like the supposedly “easy money” has been made—though it took a lot more blood, sweat and toil that I ever expected. I have confidence that Mittleman Brothers will eventually unlock the value at Aimia, but I would rather have cash to re-deploy into something with better upside as the immediate upside at Aimia is less than 100% today. I do not think there is any urgency to sell and my average sale price was in the low to mid 4s. At Monday’s closing price of $4.10, Aimia has increased by exactly 100% in the 15 months since I originally posted on it. They also owe me a $0.20 dividend that was declared yet not paid. In all my years of investing, this is the only unpaid dividend I have ever experienced, as all other boards are smart enough to ensure that they can first pay a dividend before they declare it.
I have sold all of my Viemed (VMD – Canada). I originally wrote about Viemed in February of 2018 when it was trading for $2.63. Viemed has executed well upon its plan to grow the COPD business. However, it has reached my price target of 15 times the 48 cents a share that I expect it to earn in 2019. I’m fully aware that Viemed has phenomenal returns on capital, a massive addressable market and a huge secular tailwind; yet trades at a below-market multiple, despite growing in excess of 20% a year. In fact, I wouldn’t be surprised if such a high-quality business traded up to an above-market multiple in the near-future. That is fine with me—the “easy money” has been made. As we enter a period of compressing market multiples, I’d rather sell too early and have capital to re-deploy. Besides, it’s hard to be unhappy with a 169% return (based on Wednesday’s closing price of $7.07) in under 8 months on a pretty large position.
Finally, I know I’ll regret this but I have booked all of my Tesla (TSLAQ – USA) Jan 2019 250/175 put spreads after owning them for almost a year, at a reference price of $255 compared to a reference price of $320 when I first wrote about them. While I am certain that Tesla collapses in the near future, all evidence seems to show that they’ve used every trick from every financial fraud over the past 100 years to put lipstick on the Q3 financial results. I don’t know if shareholders will look through to the Q4 demand collapse or if they will squeeze the shares one last time. In any case, with 3 months left on this put spread and a nice gain in front of me, I figured it was not worth the risk of seeing a Q3 non-GAAP, adjusted earnings before one-time expenses, adjusted for securities fraud penalties, adjusted for puking unicorns beat. Don’t worry, I haven’t given up on Tesla and I have plenty of 2020 put spreads in case it halts tomorrow and declares bankruptcy. I intend to use the proceeds to buy more put spreads after earnings. Q3 will be the high-water mark for TSLA from a deliveries and accounting perspective. At best, I expect them to show a reduced GAAP loss with epic cash flow bleed (before working capital adjustments as they stopped paying suppliers and sold the same car to multiple customers without delivering it). Starting Q4; le deluge.
I have used some of the proceeds from these sales to increase my positions in various energy related holdings such as Tidewater along with some natural gas producers. Paradoxically, an increase in interest rates will likely lead to an increase in oil and gas prices—this is because all investment decisions are based on expected returns on capital. Energy exploration and production is a multi-year process that often employs substantial financial leverage, therefore small changes in interest rates can produce very large changes in expected returns on equity. An increase in funding costs will reduce the number of marginal projects that get funded—naturally leading to less supply and higher prices. Additionally, higher energy prices are often a leading cause of headline inflation rates—which then leads to higher interest rates, marginalizing more production and leading to less future supply in an endless feedback loop. This is why; once inflation gets started, it tends to last for multi-year periods. I want to be long commodities and not exposed to interest rate sensitive assets here.
I suspect that we are coming off the final blow-off top in a decade-long bull market. I want a whole lot less exposure as we may experience a true bloodbath here. While interest rates are only marginally off their lows in terms of basis points, in percentage terms, they’ve already made dramatic moves. These moves have just started. With all the leverage in the system, I do not see how rates can continue to rise without leading to a crisis.
Disclosure: Funds that I manage are long Tesla 2020 put spreads, Tidewater, Tidewater warrants, various natural gas producers, calls on natural gas producers