I’ve been adding a decent amount of long risk the last couple of weeks. Now, if you believe Covid-19 is ‘the big one’ – that is, some kind of quasi-Armageddon event that will permanently scar humanity and change how we live forever and always – then you should not be buying anything beyond canned soup, guns, and (maybe) gold. If, on the other hand, you believe in human perseverance, ingenuity, and the unerring human ability to get on with it, even if it takes a year – then it’s a great time to go shopping (just don’t do it on margin, and scale in when you buy as you most likely aren’t picking the bottom in anything). Yes, stocks can always get cheaper; in fact, the market as a whole probably will. But now more so than basically any other time I can remember, I believe we are presented with ‘a market of stocks’ rather than ‘a stockmarket.’ That is to say – the amount of value dispersion present not just within the market, but within seemingly adjacent sectors/businesses, is incredibly high. There have been plenty of proverbial babies thrown out with (lots of) bathwater – this is what happens in liquidity crises/moments of extreme panic – to the point where I believe anyone investing on a multi-year (rather than multi-day) view is drinking from a firehouse. The question, of course, is what do you buy?
I bucket the opportunities into three broad categories:
- No direct impact; or, beneficiaries of the crisis: companies that are either unaffected, or direct beneficiaries of the effects of the virus (Amazon, Zoom, Teladoc, Campbell’s Soup, Costco, semiconductor names, etc etc). The problem with this strategy is a) most of these names haven’t traded off very much; or b) they are actually up a whole lot; or c) they were already expensive in the first place (many utilities and staples); and d) if or when behavior normalization occurs they may well see their fundamentals deteriorate (this is certainly true of the supermarkets/food staples/etc). Ideally you want to find names in this bucket but have nevertheless been punished by the market, for NON-FUNDAMENTAL reasons (eg small-cap, no liquidity, etc). We will look at some of these, but in general I find this less appealing than category 2…
- Massive virus impact, but normalized business ‘raison d’etre’ is clear: this is where it gets interesting. It includes a whole host of sectors – airlines, hotels, hospitality, entertainment/leisure, REITs, a fair few industrial segments, etc etc – and there will be plenty of restructurings. Notice that I said ‘raison d’être’ – the premise of these kinds of trades is to buy something cheap enough that it simply has to exist in a year (it doesn’t have to thrive). Yes there will be a large number of doughnuts, but if you can find the ones that will survive the next, say, 1+ year of dislocation WITHOUT having the equity impaired, then there are multi-baggers for the taking. This is a very broad category, with the potential for lots of misses, but provides the most attractive multi-year return profiles at the moment, in my view, since a number of stocks are being priced for imminent restructuring and simply the avoidance of that would result in supernormal returns.
- Special situations/cross-capital structure opportunities: this includes a hodgepodge of strategies/ideas that do not fall into the normal ‘long equity’ bucket. Some of this is by far the most compelling on a risk-adjusted basis, but may be more difficult to execute for liquidity or specialist reasons (eg its not easy for all retail investors to trade corporate bonds). However corporate debt is showing value for the first time in a very long time, so it is worth at least considering.
So – there’s a lot out there to look at. This list will be by no means exhaustive, and these abbreviated notes are far less rigorous than I usually try to be in my writeups. Still, I think a lot of these are fairly compelling around current levels and some may turn into longer posts in the future.
A few good ideas (in no particular order)…
Universal Entertainment 8.5% Dec’21 bonds – 83c offered, 18% yield
Universal Entertainment (6425 JT) is a Tokyo-listed pachinko OEM; it also owns Okada Manila, a large integrated resort in Manila, Philippines. The company has a ‘colorful’ history – it is 65% owned by Kazuo Okada, a fairly controversial figure who helped put Steve Wynn, the US casino mogul, in business, before being booted from the Wynn share registry with much acrimony a few years ago. I wrote up the equity on SeekingAlpha a number of years ago, here. The stock since tripled but has given all the gains back.
Let’s get down to business: this bond, a $600mm issue, is backed by a direct guarantee on the Filipino casino assets, where ~$3bn has been invested to date and non-depreciated book value of PP&E is $2.5bn today. Moreover you also have an unsecured claim against the rest of the company (the Japanese OEM pachinko business) that is highly profitable and cash generative (the second-largest such business in Japan, after Sega Sammy) . There is very little other debt ($150mm out to Filipino banks, secured on the same casino assets) – but these are more than covered by cash deposits held in escrow to guarantee the operation of the casino ($250mm in long-term assets). Oh, the company also has ~$350mm in cash on hand and another $130mm in liquid investments. Basically, I think the bonds are at least 3x, if not 4x, covered through the assets, irrespective of thinking about claims on the operating business in Japan. In total the company has $3.5bn of book equity on balance sheet to cushion these bonds (even though the market cap today is only $1.5bn)…
The bear case would be that the Filipino casino – currently closed of course – will incur large cash operating losses whilst it is shut and also needed capex spend to finish the second phase of expansion. I would counter that cash operating losses, even if the casino remains closed the rest of the year, shouldn’t exceed $300m – a number clearly covered by the assets and (partially) by the Japanese OEM cashflows – and most of the capex for phase two is either complete or could easily be deferred another year if necessary.
Furthermore if these bonds were to be equitized it would imply that kingpin Okada would have walk away from his entire equity stake (basically his life’s work and the entirety of his fortune). I simply don’t see that coming close to happening – he would hock the Japanese assets for cash before allowing that to happen (or ask for a mercy bid from one of the other Filipino gaming tycoons, again, something that would involve repaying these bonds at par).
In sum – I get paid a near 20% return on short-dated paper where I feel the likelihood of capital impairment, whichever way it goes, is basically nil. That is an equity-like return with a strong carry in a dicey market with almost zero permanent downside. Seems juicy.
Japanese hotel REITs – 8985 JT and 8963 JT
Both of these names trade around 0.45x P/NAV; both are levered 45-50% LTV. I much prefer Japanese hotel REITs to the US varieties (which are of course also really cheap) because the debt structure is so much more favorable: both these names borrow at 0.5-1% (it’s Japan, remember) with pretty relaxed covenants (which I feel will be waived for 2020 even if they come close) and very manageable maturity schedules. Frankly, whilst NAV may well be remarked lower, given where interest rates are and the ‘one-time’ nature of the obliteration to demand we will see near-term, I am not sure it will be cut too much (especially with the Olympics boost coming back in 2021). Most importantly, since China/Japan/Korea/Taiwan have already gone through the virus and come out (or are coming out the other side), it stands to reason that regional Japanese travel – upon which both of these names depend – will rebound faster than it does in the West. You can see here that the majority of visitors to Japan come from other Asian countries – all of which have handled the virus far, far better than we did in the West:
Of course, with the Olympics postponed to 2021, we now have that catalyst on the horizon too – yes, 2020 will be horrible (though potentially not as horrible as other hotels globally given this customer mix), but the shining light of the ‘recovery Games’ will likely focus investor minds in the back half of 2020. The valuations today are such that they both offer double-digit dividend yields on normalized earnings – whereas pre-Covid these names traded closer to 3-3.5% yield, suggesting 3x upside and more if they can get back to those levels. That would imply a return to a solid premium to NAV, which I don’t underwrite – but as long as the banks don’t call time on these names, I can’t see how these aren’t multi-baggers on say an 18-month view. It’s also worth noting that these names are both predominantly budget/affordable properties (ADRs are in the $80-$130/night range) so they are less sensitive to a deep global recession than say upper upscale brands reliant on chunky ADRs and big-ticket business travel.
Offshore Gold stocks – DRD US and PLZL LN
I’m quite bullish on gold. Every government this side of Pluto is falling over themselves to debase their own currencies so I believe its a matter of time until either a) we see some kind of inflation (either stagflation or otherwise); or b) there is some kind of seismic shift in the way the world views fiat currency such that permanent stores of value – like gold, and, to a lesser extent, hard commodities – come back into vogue. Still, if I like gold, then I LOVE expressing the view through offshore – that is, non-USD cost-based – miners. This is because many non-USD currencies have been destroyed, so these miners’ cost bases are now much lower (80% of costs are in local currency for most miners), whilst at the same time their topline (selling gold) is in USD so margins should be going through the roof. The other kicker is oil: since it constitutes up to 40% of the direct/indirect costs of operating a mine (through electricity, consumables, etc), as oil has been obliterated, you get an added benefit on the cost side as well.
There are two names I like more than most: DRD Gold in South Africa; and Polyus Gold in Russia. DRD Gold is a tailings miner, massively net cash, owned 50% by Sibanye (who may simply acquire the minorities at any time), and I think trades around 2-2.5x run-rate earnings with Gold at $1550 and spot FX and oil. That is simply stupid given that these mine tailings have at least 25yrs of life left and there is organic growth possible through treatment of other tailings mines elsewhere in the Sibanye asset mix. Also, did I mention it is massively net cash and has no debt? Essentially then if things stay as they are today you pay off your entry price in two years and change and get the rest of the 23 years remaining in the tailings (and whatever new business they can generate in the meantime) for free. I like the sound of that.
Polyus is not as cheap – around 6x normalized earnings on spot FX, oil, and $1550 gold on my numbers – and it has rallied more recently. But it is the largest low-cost gold miner in the world (cash cost BEFORE the move in the RUB and oil was <$425/oz); it has a well defined dividend policy that protects you from below-the-line funnies (since its based on EBITDA, not net earnings); it is well managed (for a Russian company); and the oligarch who created it still owns ~75% so is incentivized to pay out cash. Yes, it carries a bit of debt (2x LTM) but since all revenues are USD-linked and some debt is RUB-linked it is well covered in any case. Furthermore there is exciting mid-term growth potential through some Siberian deposits that could add 50% to annual production in the coming years. So I really like both names here, as well as the precious metal more generally. I discussed this theme in some detail here.
OK, that’s enough for today. I may well do a follow-up with a few more names/ideas…as I said, there are increasingly more opportunities across the capital markets these days. Happy hunting!
Disclosure: Long UE bonds; 8985 JT; 8963 JT; DRD US; PLZL LN