Shutter Island: Financial Edition

12-5-2019

None of the below is investment advice. [Cue the lights and dramatic music] In a world… where you are stuck in a mental prison cell but free to leave whenever you desire… This is Shutter Island. Happy holidays to you all. What a strange financial environment we find ourselves in. Unfortunately, I believe much of the madness out there is self-perpetuating. Below, I discuss some general investing concepts that are becoming more critical to Advisory firms, a brief overview on macro/top-down concepts, and some specific bottom-up concepts, including a shift of my strategy overall. Jim Grant has written about economies since 1975, authoring 9 books and a news service that publishes daily and monthly articles. I\’ll admit, Jim is entertaining to listen to (not unlike Leo DiCaprio) and he is obsessed with divulging the economy for what it really is [cue another dark orchestral score] but he seems to miss the forest through the trees these days. The markets lately aren\’t acting rationally, and Jim gets more and more exasperated with every rate drop. His refrain? Low interest rates create an environment where bad corporations find cheap money to continue on as \’zombies\’. Is he really trying to find truth or is he obsessed with chasing the lie? This is Shutter Island. A Google search for Pacific Gas since its bankruptcy in January of this year has resulted in defaming articles virtually every time. I would imagine this is the case because the negative story sells better than the reverse. How would newspapers, and moreso Google, come to such conclusions? A better question is – when will be the day that Google search results be taylormade to each searcher? Big data is a technology that is affecting all facets of life, and while media has always had a disproportionate influence on financial markets, it will get worse. For this reason, I believe that most financial advisors will need to get smarter about what the search for and how they parse news articles. Biases drive the media, and a biased financial advisor is ultimately worthless. So, if a firm was betting against Pacific Gas (PG&E) last Friday, it would have followed articles about PG&E\’s potential incrimination in past wildfires. This is important, as Citi Group\’s Praful Mehta (among many others) argues for a 75% chance of a $0 price target for PG&E. However, the rational firm would have also noted on the same day that PG&E was found to have no responsibility of damage in 2019 fires. This is more important, since official financing agreements with both J.P Morgan and prominent \’backstop shareholders\’ were contingent on no further damage liabilities. Let\’s shift to a darker theme – 2U (TWOU) TWOU fraud – November 4th, 2U rose 14% on a Bloomberg news that Sachem Head Capital was preparing a buyout offer. The sources were \”asking not to be identified because the matter is private\”. This company is run by Chip Paucek and two lead boardmembers are Sallie Krawcheck and ARK Investments funds. This is your textbook example of a board selling a business model rather than executing a business model, which they aren\’t capable of. Thus, every article that comes out on TWOU is designed to oversell and underdeliver and TWOU will do the same in the very near future. A few thoughts:

Business Model doesn\’t work due to increasing competition and costs
Current SG&A alone is more than 100% of revenues. Really, need I say more?
Loss will be around $430 Million on $560 Million of revenue.
- 2018 loss was $38 Million on $410 Million of revenue
- 2018 SG&A was about 85% of revenues
Last quarter, an impairment charge of $70 Million was recorded. More to come.
Spent $610 Million acquiring Trilogy, which will have revenue of $120 Million this year…
- Without the acquisition, TWOU is growing revenue by only 7% YOY.
Market cap is now $1.5 Billion, a 2.9x revenue multiple.
$140 Million of Working capital, which gives the company a couple more quarters at this burn rate.
Free Cash flow.. a bloodbath. Remarkably, TWOU will need to continue buying businesses to grow that revenue number.

TWOU reported a loss of 0.41 to investors in Q3 2019… but GAAP results showed a loss of $2.23, which shows up in -0- press releases. Non-GAAP measures should be outlawed in 99% of cases, and even in the 1% segment, Non-GAAP is a very fine line. In most cases, Non-GAAP allows businesses to virtually admit failure, and say, \”If we didn\’t have to pay bills, we would have higher earnings.\” At the end of the day, those figures can probably be extrapolated anyway by the discerning advisory firm, but unsophisticated firms will lose; so the only reason to put the non-GAAP figures in is to sugar coat bad results. I can guarantee you there are no businesses reporting great figures that also report non-GAAP figures. GAAP is a standard because it forces companies to put forth proper financials. TWOU is obviously cognizant of its own failure, but has somehow gained 6% since that Q3 earnings press release. As an aside, how is non-GAAP reporting different in principle to Enron and other schemes at predatory sales practices? It\’s as though businesses went from saying \’We\’ll hide problems where you can\’t find them and you will buy our stock\’ to saying nowadays \’We\’ll disclose problems in statements, but tell you a different story and you will buy our stock.\’ Investors should be aware that Non-GAAP reporting arguably came onto the scene only in 2003, in the Sarbanes Oxley Enron aftermath. Perhaps not a coincidence. Back to the central theme – going after bad actors like TWOU might not be the best idea, because as I discussed above, nobody is concerned about the numbers and are buying a story from the board of directors\’ press releases. Perhaps these people want to be sold a bad business; after all, until the company is bankrupt, it can theoretically sell a dream forever. And the press releases paint a very rosy picture. So do you keep chasing them down the road knowing that they are bad actors, or do you wake up to reality telling you that the research you have isn\’t important to anyone else? This again, is Shutter Island. Brief overview on Macro, which, as Jim Grant is discovering with every passing day, is virtually unknowable. Three items: 1) Lower yields are here to stay and no US growth is the future. Get used to it. Real estate and bonds will probably be safe investments with steady returns for 2-3 years at least. 2) Financial engineering is destroying inflation. Why is that a problem? Short answer – it isn\’t. 3) Is it safe to invest in emerging markets like China yet? Short answer – no. Shifting strategy A move away from preferring balance sheet analysis toward preferring Free Cash Flow seems logical at this stage in the cycle. Also, toward a preference for small caps. This area of corporations under $2 Billion still has good opportunities for various reasons. I believe shorting fads is the only consistent opportunity above that market cap figure. Getting bullied. When dealing with small caps, you must have full confidence in the stocks you take positions on. For instance, this excerpt from The House of Rothschild (Niall Ferguson) – \”When contemporaries called Nathan Rothschild \”The Master of the Exchange,\” they were not wholly exaggerating: by the late 1820\’s the positions he took were watched closely by traders who credited him with superior information and intuition. This meant that overt sales triggered a general flight from or into a particular stock, a ripple effect the brothers generally did not like to encourage. \’If Nathan possessed news calculated to make the funds rise, he would commission the broker who acted on his behalf {initially} to sell half a million.\’ \’It was a common practice with this mighty speculator to have one set of agents selling, and another buying the same stock so that there was no ascertaining what in reality was the object of his maneuvers.\” So if a stock moves against you, is it the fault of a business occurrence or is it simply the strategy of a Nathan Rothschild? How can you determine strategies of other traders in the face of 30% price swings, or is it better just to stay away from such positions? This too, is Shutter Island. Let\’s wrap this up… Sectors that are strongFintechInternet/mobile device businessesUtilities (Electricity)Telecom Infrastructure, very selectivelyB2C E-CommerceB2B E-Commerce Sectors that are notAuto (GTX trades at 5 times Free Cash Flow, and I\’m still not buying)CannabisBitcoinAgricultureManufacturingOil/Gas

I recently found that Energy Transfer (ET) is trading around 4 times Free Cash Flow, and the 11% current dividend yield therefore is easily covered. If you buy ET, you are virtually guaranteed a $1.40 per share return of capital in dividends. The issue is that the high correlation to oil could drop it to $6 for no financial reason and if you are forced to sell ET, well, you have a $4 loss per share from an $11.40 price.

Note our firm has positions in PG&E and TWOU.
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