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When the Back Door is Open
As value investors who never want to pay too high a price for the theme du jour, we often look for “back door” opportunities to gain exposure to growth or new technology without having to pay high prices that make good returns harder to achieve. An oft-used FRM portfolio example is Corning (NYSE: GLW). Though we aren’t buying this company in new portfolios today, we began buying this stock in 2013 in part as a way to gain exposure to rapidly changing mobile phone technologies without having to actually choose a winner among the various phone manufacturing companies. Corning develops and manufactures glass, ceramics and optical fiber, including glass for the cover of smartphones. When we initially purchased Corning in 2013, we paid 13.4 x free cash flow during a time when the four largest public smartphone manufacturers (Samsung, Apple, LG Electronics and Lenovo) were trading for an average of over 18x free cash flow. At the time, only one of those four smartphone manufacturers had a 5-year average return on equity (ROE) that was higher than Corning’s impressive 20.34%. Corning had a strong balance sheet with $1.79 per share in net cash (after subtracting debt). We paid $12.85 per share, which was 86% of book value, giving us an ROE on our purchase price of 23.7% (our return on investment is the company’s ROE on book value of 20.34% divided by 0.86x book value.) As the table shows the four largest smartphone manufacturers mentioned above traded for an average of 2.9x book value.
Our clients also benefited from a 2.5% dividend yield, which was more than triple the average dividend of the smartphone manufacturers at 0.69%. Corning had invested $10 per share in research and development over the prior 10 years and had just recently found success with the development of Gorilla Glass, a high-strength, scratch-resistant glass that was used in consumer electronics and numerous other products with electronic displays. At that time the smartphone market was growing ~38% per year according to Gartner, and ownership of Corning gave us diversified exposure without having to pick the winner or pay high valuations that would have made the investment potentially riskier. Corning already had a joint venture with Samsung in its Display Technologies segment to develop and manufacture liquid crystal displays (LCDs) used primarily in computers and televisions. Corning had also been reported to have worked directly with Steve Jobs to develop a new iteration of its Gorilla Glass for the screen of the original Apple iPhone launch in 2007. Of the four companies, only Apple has so far beaten Corning’s annualized total return of 15.83% from our original purchase through September 30, 2021. It would have been easy to observe the expensive valuations of the smartphone manufacturers and assume that there was no opportunity for a disciplined value investor. But Corning reminds us of the well-known, late value investor (and FRM friend) Irving Kahn who said, “There’s always something to do. You just need to look harder, be creative and a little flexible.”
We mentioned last quarter our investments that should benefit from the growth theme of decarbonization. Many of these investments can be described as “back door” exposure. There is an indisputable euphoria around anything “green” today that has driven valuations to absurd levels that leave very little room for error about future assumptions. Andy Kessler pointed out in his recent Wall Street Journal article “The Stock Market Fails a Breathalyzer” that Joby Aviation, a company aiming to launch their electric air taxi service in 2024, is trading for more than Lufthansa, EasyJet or JetBlue. We wrote previously about Tesla in our 4th Quarter 2020 Commentary, which was being added to the S&P 500 in November of 2020 at a larger valuation than the 12 largest automakers combined. (This was despite producing merely 1% of the number of vehicles.) At least now Tesla is merely trading for more than the largest eight automakers combined. (Though it still trades for more than 340x trailing earnings.) We recently analyzed Plug Power, a maker of hydrogen fuel cell systems used to power electric motors. Plug is down 65% from its peak $33 billion enterprise value this past January but still trades for a rich $10.7 billion enterprise value. A ten billion dollar valuation for a company that had negative revenues of -$93mm in 2020? Valuation levels this extreme do not include sufficient margin of safety to meet our requirements for investment.
Despite the hype and media attention around the growth of electric vehicles and their ability to contribute to a reduction in greenhouse gas emissions, passenger cars represent only 9.45% of global greenhouse gas emissions. The absolute emissions by this sector are also growing, driven primarily by an increased demand for travel with miles driven in the US up more than 50% since 1990. This was evidence to us that passenger vehicles might not prove to be the most impactful solution to worldwide carbon emission reduction goals. Globally, electricity and heat production remain the largest source of greenhouse gas emissions around the world, accounting for around 25% of total global emissions. Here in the US, the electric power sector has actually decreased greenhouse gas emissions by 11.5% since 1990. Though much of this reduction has been a consequence of fuel switching from coal to natural gas following the abundant discovery of shale natural gas, we do not see an economically viable path to a meaningfully lower carbon future without an increase in nuclear power generation. In advanced economies, nuclear power is the largest source of low-carbon electricity accounting for 18% of generation capacity. Nuclear is not only a carbon-free source of power but it is also reliable enough for utilities to use it as baseload power, unlike solar and wind.
We found an opportunity to own exposure to nuclear energy and the decarbonization of power production through our 2016 initial investment in uranium miner Cameco (NYSE: CCJ). Uranium is the fuel used in nuclear power production. At the time of our initial purchase, Cameco was facing a number of headwinds, both industry-wide and company-specific. The Fukushima nuclear power disaster in 2011 led to a protracted downturn in the nuclear power industry. Following the natural disaster, nuclear-heavy Japan shut down 54 nuclear reactors, removing 25 million pounds of annual uranium consumption (more than 10% of global demand) from the market. Uranium prices languished for the following six years. Additionally, Cameco had a $1.5 billion tax dispute with the Canadian tax authorities. We believed the uranium pricing situation was unsustainable as much of necessary existing production was unprofitable at the prevailing low prices of between $18 and $25 per lb. Though we were less certain about the tax dispute, early court inclinations were favorable and the margin of safety was sufficient for us to overcome fear of this risk. You can see below that we initially established our Cameco position at very attractive levels compared to a popular “clean energy” exchange traded fund.
Finally, the uranium industry dynamics are changing. New nuclear reactors are being built around the world as nuclear is increasingly seen as a credible component of emissions reduction goals and new generator designs are significantly safer. Another drawback of nuclear has been the large upfront capital investment required to build new reactors, but a new technology called small modular reactors (SMRs) is under development that aims to make nuclear more affordable to implement. Bill Gates has championed SMRs and formed a company, TerraPower, that is leading the development of them. We are happy to own Cameco, which has controlling ownership of 455 million pounds of some of the world’s largest high-grade uranium reserves. Cameco proactively shut down their low-cost mines during the pandemic when uranium prices continued to languish, but have begun restarting them just as uranium prices have begun a dramatic recovery. Today, Cameco has a strong balance sheet with net cash of $200mm and has decisively won several court rulings in their tax dispute with the Canadian tax authorities. They pay a modest dividend, currently yielding 0.28%, but yielded 3.41% when we first began adding it to portfolios in 2016. As the uranium market comes back into balance, we would expect management to consider reinstating a larger dividend.
Though we believe nuclear power will be able to play a larger role in decarbonization, we do also have “back door” exposure to motor vehicle electrification through our ownership in companies that mine copper. Copper is an essential input for electric vehicles. Overall global copper demand is forecast to grow 10x over the next 10 years, from 391kt to 4,080 kt globally in 2030. This is not only because the average vehicle has so much more copper than an internal combustion engine (4x as we mentioned last quarter), but also because copper is needed for ancillary aspects of vehicle electrification such as electricity generation, grid infrastructure, grid storage and charging infrastructure. We broadly own Teck Resources (NYSE: TECK), a diversified miner based in Canada that produces copper, zinc and steelmaking coal. We last wrote extensively about Teck in a section titled “Cheap, Cheap, Cheap” in our 4th Quarter 2019 Commentary. Though the stock is up 46% since then, we still see tremendous value in Teck’s business. Teck is nearing completion of a low-cost, long-life expansion project in northern Chile that will double their annual copper production by 2023. This will round out the diversification of Teck’s business, and copper will match metallurgical steelmaking coal as their two largest products. Teck still trades for 0.86x book value, pays a modest dividend and with steelmaking coal prices up 75% this quarter alone, should see a dramatic increase in earnings over the coming years.
In older portfolios we also have an investment in the world’s third-largest copper miner, Freeport-McMoran (NYSE: FCX). Freeport owns ~49% (~51% partner is a state-owned Indonesian company) of the Grasberg copper-gold deposit in Indonesia, which is the world’s largest gold mine and second largest copper mine, and also owns the Morenci mine in Arizona which is one of the largest copper deposits in North America. After exiting an ill-timed foray into oil and gas, Freeport is now focused on further balance sheet improvement and increasing production at Grasberg. These efforts, along with their modest dividend, should be easily funded by Freeport’s growing cash flows.
One final theme to which we currently have intentional “back door” portfolio exposure is the growing demand for data around the world. The theme was already in place prior to the pandemic but has been growing in prominence since lockdown measures rapidly sent 42% of the US labor force to perform their work at home. The world is also moving to 5G cellular networks, which require denser cell tower locations and more fiber to be laid between them. How many of you have a Nest thermostat, a Ring doorbell or a “smart” refrigerator? More and more consumer devices are now “connected” to the internet (often referred to as the “Internet of Things”), requiring an increasing amount of IT infrastructure to transmit and maintain these devices. Investor enthusiasm abounds in this growth segment and average multiples for any business with exposure to the growing demand for data have been high. In our portfolio, we see our investment in Lumen Technologies (NYSE: LUMN) as a much more attractive way to gain exposure to this growing segment. As a reminder, Lumen has a vast fiber optic cable network that it uses to supply communication services to businesses and consumers worldwide. When we first initiated our Lumen position in July 2020, we paid much lower multiples than other comparative companies as illustrated by the Indxx Global Internet of Things Thematic Index comparative multiples below. We continue to be very optimistic about Lumen, which today trades for only 7x earnings, 1.2x book value, merely 3.9x free cash flow and has a 7.8% dividend yield. (Our yield on average purchase is 9.4%!)
We are always on the lookout for ways to expose our portfolio to growing or changing aspects of the economy but remain committed to our belief that paying fair prices is the best way to increase the odds of a successful investment.
Winter is Coming
Some media coverage has been given to the goings-on in natural gas pricing, but we would argue not nearly enough. U.S. natural gas prices, near $6 per mcf, are up over 125% so far in 2021 at seven-year highs. Futures priced at $6 in January reflect the same tight markets. These natural gas prices reflect the increase in industrial and residential/commercial demand in a post-pandemic 2021 U.S. economy, large inventory drawdowns from last year’s extremely cold winter and also a shift away from coal. As the chart beside illustrates, coal has declined from a 45% share of electricity generation in 2011 to a 25% share, and renewables other than hydropower have increased from 5% to 15%. The other 10% of coal’s market share has gone to natural gas. Short time frames in which intermittent power (non-hydro renewable) sources are unavailable can result in natural gas use becoming an even larger share of electrical generation.
As recently as 2010, residential consumption accounted for over 20% of natural gas demand. In 2020, it was only 15%. Why does this matter? Most residential demand is for heating in the winter months, and so historically natural gas producers have produced the majority of the year to fill underground natural gas storage. As electricity generation has taken a higher percentage of consumption, demand at other times of the year can interrupt the storing away of natural gas for the cold months. We are seeing that this year with natural gas in underground storage 15% below last year’s level and 6% below the 5-year average level. This could set the stage for very high natural gas prices this winter, particularly in coastal population centers.
We should count ourselves fortunate that the U.S. produces most of the natural gas that it consumes. In countries where that is not the case, natural gas prices are already pushing all-time highs, and winter is still months away. Natural gas prices in Europe and Asia have more than tripled this year, causing manufacturers in Europe to curtail activity and a power crisis in China. On September 30, spot prices for Asian natural gas rose to $33.24 per mcf and in Europe prices are above $23 per mcf, around 5x and 4x the prices that the shale gas boom has allowed the U.S. to achieve since energy independence. These price spikes are causing significant issues in economic output and may encourage both regions to rethink the pace of remaking their electricity generating landscape.
Some of the tightness in the natural gas markets is due to the reduction in capital expenditures for new oil production. (Even the International Energy Agency (IEA), the agency formed following the 1973 oil crisis to prevent future disruptions in oil supplies, has been discouraging new capital expenditures for oil.) Often, oil wells will produce what is referred to as associated natural gas and natural gas liquids. This associated gas has been a very important part of the natural gas supply in recent years and until oil producers start producing more, it will remain constrained. This is not the only way that oil and natural gas markets are related: if natural gas prices get too high during the winter, electricity generators often switch to using diesel fuel. An increase in diesel fuel demand for electricity generation could drive oil prices even higher. Both of these could be a boon for companies that you own as our largest oil and gas producer holdings have 61% of their reserves in oil and 39% of their reserves in natural gas.
Free Lunch Revisited
One notable change in the stock market over the last two years has been the rise of commission-free trading at many of the major brokerages, including Charles Schwab and Fidelity. Charles Schwab slashed online trading commissions to zero for U.S. stocks on October 7, 2019, and Fidelity followed a month or so later on November 4, 2019. Schwab and others are able to accomplish commission-free trading by selling their clients order flow to unaffiliated broker-dealers and traders (Fidelity doesn’t accept payment for order flow). In this case, as with most developments on Wall Street, free isn’t exactly free. Most of the traders that pay for order flow are high frequency trading firms (HFTs) that use the information gained from the order flow to generate profits on small price moves in shares of stock. We wrote extensively about HFTs in our 2nd Quarter 2014 Commentary in response to the book, “Flash Boys” by Michael Lewis (we encourage you to read both, if you haven’t already). As a reminder, one of the main ways we limit HFTs’ effect on our portfolios is by having longer holding periods for investments and low turnover (i.e. we trade as little as possible.)
Recently, payment for order flow has come under public scrutiny because it is the brokerage firm Robinhood’s main source of revenue. (Robinhood is a do-it-yourself trading platform particularly popular with Gen Z investors.) If the scrutiny intensifies, it is possible we might see commission-free trading start to go away. We are happy to see this development and would support brokerages going back to competitive and transparent commissions, which might encourage them to keep their customers’ best-interest in mind.
Good News from Portfolio Companies
We don’t usually update you on every development within the businesses that we own, however, this quarter there were big developments at two of our portfolios’ larger positions, Fairfax Financial Holdings (TSX: FFH; OTC: FRFHF) and Lumen Technologies (NYSE: LUMN). In light of these positive developments, we decided to share them with you.
Many of you will be familiar with Fairfax Financial Holdings, one of our largest and longest-term holdings (over 20 years!). We last wrote about this property and casualty insurer based in Toronto, Ontario in our 2nd Quarter 2017 Commentary. There we stated: “We often describe Fairfax as a strong capital allocator because in addition to generating profits from well-run insurance operations, Fairfax has also produced stellar investment returns by investing their insurance “float” in a diversity of businesses around the globe. The “float” is the excess cash that insurance companies have on hand from receiving premiums that they have not yet had to pay out in claims.” Well, one of the investments they started making in 2017 has worked out extremely well. Digit, an Indian digital general insurance subsidiary of Fairfax, has received an investment that will substantially increase the value of Fairfax’s holdings. From the Fairfax news release on July 5: “Since Digit was founded in 2017, Fairfax has invested approximately $154 million in the company. That investment is currently carried on Fairfax’s balance sheet at $532 million and, when the new equity issuances by Digit Insurance close and the above-mentioned Indian government and regulatory approvals are given, will have an aggregate market value of approximately $2.3 billion. This will result in a gain of approximately $1.8 billion, resulting in an increase in the book value of Fairfax of approximately $61 per basic share.”
A 15x return for Digit thus far is a homerun by anyone’s accounting! As of June 30, Fairfax had a book value per basic share of $540.62. This one transaction will add over 11% to book value and take book value per basic share to $601.62. Shares are currently trading at around 65% of that level, which is very low compared to their 10-year average of trading at 113% of book value per share. We were very encouraged by Fairfax’s announcement of a substantial share repurchase plan on September 29. We agree with management, who is normally reluctant to buy back shares, that their shares are substantially undervalued and represent a very attractive opportunity.
Lumen Technologies is one of our largest and newest holdings. We first initiated a position in Lumen in July 2020 and have added to the position several times since. The company’s most attractive assets are 450,000 miles of fiber and its enterprise communication business in the United States and Europe. During the 3rd quarter, Lumen initiated two divestment transactions with private equity firms that will allow them to increase focus on their higher margin businesses. The first transaction that Lumen announced at the end of July was the sale of its Latin American business to Stonepeak for $2.7 billion. This transaction consisted of some fiber assets, but not their best fiber assets, and took place at ~9 times the Latin American business’ 2020 adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA). Early in August, the company announced the second transaction in which Lumen agreed to sell its ILEC (incumbent local exchange carrier) business, including its consumer, small business, wholesale and mostly copper-served enterprise customers and assets in 20 midwestern states to Apollo for $7.5 billion. These were likely Lumen’s worst copper assets and the company was not planning to invest more money into these businesses. This transaction took place at ~5.5 times the ILEC business’ 2020 adjusted EBITDA.
To recap, Lumen sold some of their non-core fiber at 9 times EBITDA and their worst copper assets at 5.5 times EBITDA to well respected institutional buyers. If you apply these valuation levels to the remaining businesses, you come up with a value of approximately $20 a share. We think this is a fairly conservative value given the remaining businesses are LUMN’s strongest operations. LUMN will be using the proceeds from the two transactions to pay down $8 billion in debt and also announced plans to buy back $1 billion worth of shares. We hope they have already started buying them given the attractive share price.
FRM Personnel Update
Well, the sun came up on the morning of September 1st, although we were not sure it would since August 31st was Gail O’Donnell’s last day of work before her retirement. Gail had a more than 4o year career in our industry, the last and best 19 years of which were working with FRM. In anticipation of this eventuality, we rehired Trina Boyd as we mentioned back in our first quarter 2021 commentary. Gail’s responsibilities have been distributed to more than Trina so we have had a great deal of cross-training in order to have a smooth transition. We are happy for Gail and especially thankful that she gave us enough lead time to transition well. We are ready for many more sunrises to come.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at firstname.lastname@example.org.