Sunday, 30 April 2017

Some further thoughts on automakers and auto credit - the UK market

As a footnote to my analysis of the US automakers and the credit cycle it is worth mentioning the way that credit in car sales is actually magnifying a trend which is likely to accentuate a cyclical downturn in demand from a drop in lending. 

In the UK back forty years ago most people bought cars with cash - or had company cars back when taxes were higher and perks were less punitive. Either way car sales relied on hard earned cash and people kept and cherished those cars often for many many years with good cars passing down through the family.

Today instead we have PCP - this is not the illicit hallucinogen although it may have similar effects on the auto market in particular used car values. Personal Contract Purchase deals allow people to finance a new car with a modest deposit and series of monthly payments typically over say a 3 year period. 

Now at the end of the PCP period you can either purchase the car outright for a given figure, walk away and not have a car or take the dealers favourite sales option; take the difference between the guaranteed value and their determined market value (assuming it is positive due to good residuals) and carry this over as 'equity' in another car purchase under PCP reducing your next deposit.

To my mind there are two significant issues with this (i) Usually PCP deals have limited mileages say 8,000-10,000 miles per year in order to guarantee the minimum value. So essentially you the consumer pays off the depreciation on a new car (which is eye watering and usually around 50% of the value) while it sits on your drive and you can't take it on holiday because you fear breaking your mileage clause. What a great deal, for the dealer. They get a nice, low mileage used car to sell 'preowned' and 'approved' to the next consumer off the lot (since 4 in 5 PCP people do not purchase the car at the end). And you just had the privilege of paying off the massive initial depreciation on a new car.

I think PCP is a bad deal for the consumer as you are usually still paying finance costs on a car but once the term completes you do not even own it. There is a sort of 'faustian bargain' here where consumers get their shiny new car and the manufacturer boosts its sales volumes. I am always suspicious of such 'innovations' in finance. But there is one way that the PCP is bad for manufacturers (other than giving them enough rope to hang themselves) and that is these are non recourse loans - more on that in a moment.

SMMT UK Car registrations graphic

So why would anyone take this PCP deal? I suspect the origins lie in the last crisis (as they so often do). Try and find a used car from the 2008 - 2011 period. They are rare because consumer spending collapsed, not just that rental fleet managers also cut back on purchases. This meant used car prices firmed up a lot in the period following the crash against what had been the underlying trend. Which meant your 'equity' went further when making that next purchase reinforcing the cycle.

This leads to my second issue (ii) - with the huge rise in car sales driven principally by PCP deals used car prices must soften as the cars sold in the 2012-2017 period are recycled onto the market in far greater volumes. This already seems to be happening and hence the poor performance of car rental shares in Hertz and Avis as residual values soften. 

Now what happens when residuals soften and consumers are feeling the pinch on incomes as we are seeing in the UK with terrible real wage growth since the crisis? Well they now find they have no equity when their PCP deal ends - not only that they won't have the cash savings to buy the car outright at the end of the term either. Sales collapse. 

They hand back the keys and try and find something to drive either downsizing to a cheaper model with smaller deposit or buying a 'clunker' for the medium term and there are lots of those from bumper sales in the 2012-2017 period. Either way; sales collapse.

The secondary effect for manufacturers is that this hit to volumes then also happens at the same time as the automakers financing arms are taking the hit on cars which have a residual value below the guaranteed future value given to the consumer. Therefore unlike a UK mortgage these financing deals have no recourse except in the case of damage and mileage.

Therefore all car makers selling in the UK have a vested interest in high residual values of used cars even as they fall over each other every year trying to sell as many cars as they can into the market.

Now consider what happens if sales demand declines due to a lack of consumer appetite and finance:

Automakers have huge factories and tonnes of capital tied up in them. They have to keep making cars and ultimately they have limited pricing power (unless we are talking Ferrari). So I suspect they will have to slash prices further and offer all kinds of deposit free, interest free financing to keep selling cars. The juicy profits of the credit divisions will have to take a hit. 

Google Finance: European automakers since the crisis

Essentially my theory is the UK at least (and likely the developed world) is awash with cars. 

Now all those cars still exist in the world, albeit with higher levels of built in obsolescence than the great cars of the 90s. I am talking about UK specific issues but auto finance is something which effects most international markets. So my medium term forecast for automakers is cyclically negative. I foresee falling sales, falling residual values and losses on finance.

Disclaimer: I have no interest at present in any of the stocks mentioned in this article. This article contains opinions not investment advice. If in doubt read my disclaimer.

Saturday, 29 April 2017

US automakers - Good value or value traps?

I was attracted by the valuation of Fiat Chrysler, Ford and GM recently noting the low multiples these stocks trade at. Compare them to the likes of Tesla and they look like a screaming buy. These are companies with extensive histories of mass producing reliable vehicles.

I think the US automakers have really upped their game since the crisis. Debt has generally been restructured, obligations to the unions adjusted etc. I had a good read of Fiat Chrysler's last 20F and was impressed by the turnaround demonstrated there.

However it was noteworthy one of the key risks for FCAU, as they disclose, is the sales of SUVs in the states. In general total sales in North America are the most profitable area of the business with 80% of EBIT and the largest area with 64% of revenues. 

FCAU 20F 2016

FCAU have some great SUVs - generally I consider American cars to be cheap and awful, I am a BMW man to the end. I remember the woeful Chrysler my parents had back in the 90s. Terrible car. But visiting Canada last year I was blown away by my rental Dodge Durango. A brilliant, nimble, massive, quality feeling SUV. Chrysler are actually making good cars! Now SUVs are by far the biggest cash cow of the company. Despite the discipline that seems to have been brought in the Fiat side this is still an automaker whose primary market is the US. They have really improved their offering. So what worries me?

US subprime auto loans are turning over. Defaults are rising - this is likely to damage sales for all automakers in the US. Also in the last 10 years the auto industry has changed significantly with more people than ever leasing vehicles and taking up finance. Cars rely on credit - and the credit cycle is turning and with it the economic cycle. It will likely happen first in the US this year and then later in Europe.

Now add to this cyclically depressed oil prices. Low oil prices mean US consumers feel more comfortable with driving 2 tonne plus heavy vehicles with at least 6 cylinders. These also happen to be the most numerous and profitable vehicles sold by the US automakers:

FCAU 20F 2016

Therefore I consider the big three automakers may be trading at low multiples of peak earnings for this cycle. [A bit like my view on UK Homebuilders Land Bankers]

Do I think these companies are structurally more sound than 2007? Yes I do. And they have better products, better workforce incentives, better debt profiles.

But faced with such a highly capitally intensive, low margin, debt financed industry that seems to be finally gaining decent profitability I fear we are rolling over. 

If I were Tesla I would be really scared. These companies can actually produce cars -  on time and on budget - and they even make a profit on each sale.

The EV landscape is evolving rapidly and I don't expect the majors to lie down and have Tesla steal the show. Established automakers have had the origins of self driving technology since the early Mercesdes S Class models 20 years ago. I would rather own any of these three established US automakers than Tesla. 

But who can stand in the way of one man (Mr Musk) and his multifarious dreams? i.e who is brave enough to short it given the rampant price momentum...

My conclusion on US automakers is that short term they are value traps - when the cycle turns I think they have great potential for a risky leveraged bet on consumption. They are not yet discounting a slowdown in sales and credit so I think this is not the time.

Disclaimer: I have no interest at present in any of the stocks mentioned in this article. This article contains opinions not investment advice. If in doubt read my disclaimer.

Monday, 24 April 2017

Is Nigeria a value destination or a value trap? Part I - Macro & Market

Nigeria has one of the cheapest stock markets in the world right now. Trading at around 6x-9x PE it is even cheaper than Russia. This is principally due to the fact that the economy and currency is driven by oil and rife with corruption – not unlike Russia. However Nigeria has a few key benefits that I believe make it a more attractive investment proposition and an attractive market in its own right.


The economy is primarily agricultural and underdeveloped. Nigeria has the highest agricultural output in Africa. Most agricultural produce is consumed internally by the populace.

Nigeria is seen internationally as an oil producer because oil is >90% of exports. Oil is therefore the source of foreign exchange for the country and the pole which the economy tends to swing about.


This is a really young country which already has a massive population. The most populous nation in Africa has 187m people. In 20 years time it is projected to have 293m people. The sheer mass of humans means demand for domestic services must rise. That isn’t to say the people cant remain in abject poverty. But the huge numbers involved here and the youthfulness of the country are a profound driver for the kind of services the stock market offers – staples and banks. - Nigeria

Just to make the Russian comparison again -  Russia has a declining population, a resource oriented stock market (53% energy) and terrible ageing demographics where most of the men die younger: - Russia


The currency should trade inline with oil prices. This is because oil exports are the principal source of foreign exchange. Dollar reserves have been falling due to the declining oil price.

Trading Economics: Nigeria Foreign Reserves

Now the currency was pegged to the dollar for a long time and recently was allowed to depreciate substantially – hence a lot of the underperformance of the market which is all Naira linked in terms of earnings (quite different from the way the FTSE 100 has rallied against the drop in GBP since Brexit). Naira Depreciation

Therefore the currency can’t appreciate without better terms of trade from the oil market. So again I see Nigeria as an option on higher energy prices. In the meantime the companies are doing just fine in Naira terms earning decent profits and with good cashflow. So I don’t think Nigeria is going to go bust as a nation. Note also debt to GDP is just 11%.

It is however noteworthy that there is a parallel black market rate and that the parallel rate is around the 500 Naira level suggesting a further devaluation remains a risk - but I would say a floating rate might sit between the two as often black market rates take an enlarged spread on a more realistic rate. Still a further 20-30% devaluation is quite possible in the medium term if terms of trade do not improve just given the inflation picture let alone the reserves. But this seems less of a farce at present than the Venezuelan situation.


Now they do have an inflation problem. Some of this is just par for the course in Nigeria. Inflation has been running over 8% a year since 2010. However given the recent devaluation in the Naira the rate has peaked at 19% recently. So not a great situation. But I have seen this before with Argentina – loose fiscal policy, a terms of trade shock, dwindling FX reserves, devaluation – eventually the terms of trade improve and the economy booms. For a while. 

Now I am running a long-term pension portfolio here. So, I can wait. I struggle to see the market getting a lot cheaper from here but again the FX situation will likely worsen before it gets better due to the depressed oil price at present – so it could do. However note reserves have recovered slightly since the devaluation - so maybe there is light at the end of the tunnel.

Nigeria is currently experiencing a recession. The first in nearly a generation. Or at least a Nigerian generation given the rapid pace of demographic growth. But again recessions mean opportunity.

What about corruption?

Yes corruption is high, very high. But this is widely known and I think baked into the lowly valuation. I don’t imagine Russia or Argentina are any less corrupt. Now my view would change if Nigeria went fully Venezuelan but for now things look ok – they don’t have the crushing debt load nor the pure populist politics of Venezuela at this stage. But that is a highly relevant long term risk. This risk of economic meltdown would probably be most material in changing my long term investment case.

Economic 'unorthodoxy' is not per se a bad thing but when a country starts to take dictatorial decisions which act as plasters for plasters for the plasters then the downward spiral digs a very deep hole to climb out of. It is very hard to argue with the numbers and accept your fate - particularly when you are an oil nation enjoying the high life during the up cycle. Oil economies without any real industrial base really do have a poisoned chalice in this respect.

What about conflict?
This too is an issue. The Boko Haram group remain an issue for security but in general their activities have been more subdued since 2015. To be honest given how strong the market and currency were in prior years when violence has been worse I think the conflict has no real impact on the long term stock market valuation for Nigeria. 

Sadly the violence continues today and it is part born of the great divisions of wealth between the rich delta Christian elites who control the oil and other groups within the populous and disparate nation.

Market Composition

Unlike the economy the Nigerian stock market is almost entirely domestic focused. As at March end 2017 39% of the MSCI index is consumer staples and 44% is banks. The residual 16% is principally cement stocks and the index has only 5% energy exposure. Now generally banks trade at lower PE ratios so this can explain some of the cheap valuation of the market. But with a Brewery and the local Nestle subsidiary making up 33% of the index the consumer staple element should be highly valued in a country with such appealing demographics. 

An ETF or Individual stocks?

Global X offer an ETF which tracks the MSCI Nigeria index. The only singular stock I can buy as a GDR is Guaranty Trust Bank. This stock is 16% of the index and the biggest bank in the MSCI index. Now I would rather own the consumer staples from a pure long run demographics perspective. So the opportunity to own some GRTB via an ETF rather than just GRTB is appealing. However within my SIPP wrapper the ETF is ineligible for some reason - i think as it trades on the NYSEARCA exchange - so GRTB it is.

I do note that the banking sector accounts for the majority of the apparent cheapness of the market. Frankly the consumer stocks still trade at lofty valuations. However the banks will be the play on the upside story in the economy - so if one wants to buy an eventual recovery in the Nigerian market banks offer the most leverage to the upside.

To my mind the principal risk with the ETF is that Global X close the fund. This fund has $25m in AUM – hardly a profitable level of scale despite the relatively high fees  (>1% p.a.). It would be typical for a provider to close the fund right at the bottom of the market due to the lack of popularity and scale. No other providers offer an ETF. 

In summary I think Nigeria is undervalued as a stock market. I think it offers deep value investors a long term option on a country with exciting demographics and cyclical upside improvements to its terms of trade. 

Having studied Argentina in depth in my time and seen the massive rally in Argentine banks and utilities generally following the fall of the Kirschners I can see the potential huge upside of nations which appear at present to be ‘garbage’ for sensible investors.

Things I think make Nigeria a Value play:

A very cheap stock market by global standards trading on 6x-9x PE
Domestically focused stocks
Currently the country is in the midst of a cyclical downturn in terms of trade and currency
Highly favourable demographic trends for consumer focused growth
It is off the radar and generally disliked - $25m in ETF assets globally!

Things I think make Nigeria a Value trap:

Corruption is rife and conflict risk is high
Cyclical improvements are out of the control of the nation and make take years
The country may become increasingly populist and dysfunctional (the Venezuela model)

In Part II I will have a look at GRTB for bottom up red flags to the apparent cheap valuation.

Disclaimer: I have an interest in GRTB as mentioned in this article at present. These are opinions only, not investment advice. If in doubt read my disclaimer.

Thursday, 20 April 2017

Can we find a truly Defensive utility? ENEL Generacion Chile (NYSE:EOCC): Part II

So in part II of my analysis of EOCC I wanted to look at the specifics of the company. The most important issues are:

  • Company structure and history
  • Corporate governance
  • Alternatives
  • Debt and pensions
  • Assets and Moats
  • Earnings Outlook
  • Uses of cash
  • Valuation

Company structure and history

ENEL Generacion Chile (EOCC) used to be called Endesa Chile and it used to trade with the ADR (EOC). It is the former national electricity company of Chile which was privatized in 1989. The company contains a mix of hydro and thermal power generation facilities across Chile.

The ultimate parent in ENEL the Italian utility giant which in turn owns Endesa Chile and Enersis Chile as they then traded. Enersis Chile contains the distribution company Chilectra. In 2016 ENEL changed the company structure and Endesa Chile and Enersis Chile were split out with a number of assets moving within the convoluted organisation. 

The impact essentially is that prior to this point Endesa Chile contained the majority of generation assets of ENEL within Latam - so the stock was pan regional with generation assets in Peru, Colombia, Brazil and Argentina. Following the reorganization Endesa was rebranded ENEL Generacion Chile now contains only the Chilean assets with the other regional generation assets being consolidated within what is now called ENEL Americas (NYSE:ENIA). 

To further complicate things the immediate parent of Endesa Generacion Chile is ENEL Chile (NYSE: ENIC) which is an electricity distribution company which was formerly Enersis Chile (and which similarly has had the ex Chile distribution assets stripped out into ENEL Americas.) 

ENIA Company Presentation

So for comparative purposes the stocks have a limited earnings history as solely Chilean enterprises. Also this restructure was controversial which leads us onto:

Corporate Governance

ENEL do not have the best reputation for corporate governance. As part of the reorganization they overvalued assets that were transferred into the new ENEL Americas group and only changed the valuation after AFPs got involved and put pressure on ENEL with their own valuations. 

ENEL is ultimately controlled by the Italian government. Which is not great news. It is also indebted so again has an incentive to take cash out of these EM businesses. Although EM also offers it growth so the incentive to invest gives some balance.

Fortunately EOCC is as far down the chain as it is possible to be from ENEL. In my experience the local management are decent operators.

Share based payments are not an issue.

Debt and Pensions

Employee benefit liabilities of CLP 15,820m or $24m dollars this is only 3% of profits for 2016 and therefore not a material concern. The reason this is so low is the success of the 1980 pension reform undertaken by the military government which saw the formation of state mandated defined contribution schemes for all workers in the 'formal' economy - except funnily enough the military. This means that defined benefit pension schemes are generally non existent in Chilean companies. So we do not have to worry about a BT or Centrica sized pension black hole when looking at company fundamentals.

The debt level in EOCC is also low by industry standards at around 2x prior year profit gross (1.7x net debt). Debt in FY2016 was around 30% of capital , interest is 8x covered and net debt is 1.3x EBITDA. Debt is around 20% of the enterprise value. This is modest gearing and generally we expect a decent level of gearing in a utility to drive up returns on equity from a regulated assets base. I consider these debt levels vastly superior to the those offered in the UK.

These strong metrics mean EOCC has an international debt rating of BBB+ investment grade and AA within Chile (note Chilean government debt rating is high grade AA-).


It is all very well comparing EOCC to UK utilties but what about regional alternatives? Well I profess I am but one analyst so I start with my circle of competence. That excludes Brazil as I have less experience in that market so will put it aside for now. Still there is ENEL Americas (ENIA) and ENEL Chile (ENIC)?

I had a look at ENEL Americas but ultimately I feel it has a less appealing asset base, a slightly higher valuation and greater regulatory risk. The generation assets are less appealing as they are principally thermal and therefore replaceable (although the Colombian El Quimbo dam is a great asset). 

The distribution business is more highly regulated and therefore has more limited upside. The regulatory risk is greater especially in Brazil and Argentina where government are more interventionist. 

Note until recently the Argentine utility sector was totally depressed due to price freezes - it has had a substantial run in the past year or two though - have a look at Pampa Energia (NYSE:PAM) a stock I used to recommend in Latam as a free option on energy liberation.

ENIC on the other hand is basically EOCC + the Chilectra distribution utility. I prefer the pure play of generation in Chile rather than owning Chilectra too as Chile has a lower growth profile than the other countries in the region for electricity demand and hence the distribution assets are less appealing in the long run. 

Assets and Moats

EOCC has some excellent irreplaceable assets that give it something of a moat. Thermal power plants are generally not great assets as they have limited lifespans and are quite readily replaceable with newer, more efficient thermal plants. Therefore the capital intensity of thermal energy companies is high, not quite as expensive as Nuclear (have a look at KEPCO in Korea) but still high. These assets of EOCC are therefore not that exciting.

The hydro assets though are excellent. Hydro assets are irreplaceable in that their unique geographical advantages cannot be readily replicated with an alternative. Chile has already exhausted most of the best locations for these assets and EOCC own several of them. Furthermore international water rights are not an issue as Chile captures all the water flows which drain west of the Andes within its borders. These assets give EOCC a small but significant moat. Barriers to entry in the hydro sector are huge due to the scale required for projects and the scarcity of new potential development sites. 

Earnings Outlook

I am assuming a moderate normalization in rainfall with some increased hydro resource available. If we consider relatively low revenue growth of 3% a year but operating margin improvements from 26% in 2016 to 30% in 2017 and 33% by 2021 then I foresee decent earnings growth for the future of 7% a year (with a dip in 2017 comparison from 2016 due to a one time comparative gain from 2016 in non operating income). 

Amiable Minotaur Model: Margins Forecast

Margins should improve slightly from a structural perspective aside from hydrology because the Los Condores plant will be completed in the next 2 years offering additional low cost hydro to the mix.

Uses of Cash

With no further significant projects currently in the pipeline and good cash generation EOCC are guiding for an incremental increase in the dividend payout ratio from 50% in 2016 to 70% by 2020. That would see the yield increase from 3% this year to 7.5% by 2020 which would be a robust return for those seeking income.

Amiable Minotaur Model: EPS and DPS forecast

Even with this raised payout in my model and assuming decent profitability as disclosed above the company will be running net cash by 2020 on my numbers. It is likely of course that within the next three years a new major project will be initiated but it is noteworthy that they would not necessarily need to cut that dividend to fund it.

Taxation is an issue. Chile has a withholding tax of 35% but there are credits to this for corporation tax paid and DTT treatises which Chile has with the US and the UK. I believe the effective rate of WHT is between 8% and 15%.

Therefore the yield I have demonstrated gross will be slightly reduced by the WHT. But this is not a substantial reduction. Still another reason why investors often prefer onshore dividend income, depending on your own tax code. 


The company trades on 10x FY16 earnings and whilst there is no long term average for EOCC the former Endesa Chile long term average was 11.6x. So valuation on that metric at least seems fair.

On the DCF I get a valuation of $35 per ADR. This assumes a 2% end period growth rate and a WACC of 8% (Ke 10%, post tax Kd 4.2% and 35% debt ratio). This DCF value is quite high and in part driven by low capex in the medium term due to no foreseeable projects. 

On the DDM model I get a value around $21 due to the still low payout ratio expected in 2017 and using a 5% dividend growth rate long term (below the growth from payout increases but more inline with long run earnings growth potential). If I assume a 70% payout next year the DDM rises to $26. Still a bit low but the Ke is quite high for this company due to the foreign risk vs say a US or UK Risk free rate.

Using a forward multiple I might pay 14x earnings for the stock. That is a bit arbitrary but not out of line with the forward multiples of the UK sector. Here again I see a value of $28 per ADR. 

So taking a stock that has a floor value in the dividend of $21 and is potentially worth as much as $35 and trades today at $23-24 seems like a fair risk reward given the potential for a decent dividend in the meantime. This means a 30-50% upside to my fair value range. The currency will also of course play a part so softness in copper could cause weakness in the meantime.

I think EOCC shares are worth around $30-35. 
(assumptions are USD = 650CLP - April 2017)

The utilities in the UK all seem to offer a decent return today in yield but I worry even on a 5 year view about the pension and/or debt levels. I think that EOCC offers something better and currently this is a good entry point to purchase EOCC as it trades relatively cheaply and offers decent long term prospects with low specific risk due to a strong balance sheet: Exactly what I want in my long term value portfolio. I would happily buy this stock for the long haul and - subject to no significant changes in its structure or governance - keep it.

Reasons I like EOCC:

  • It trades at a fair price with a good and likely improving yield
  • It has some high quality irreplaceable hydro assets
  • It has a strong balance sheet
  • It has upside risk to earnings from better hydrology and the aforementioned ENSO
  • It diversifies my portfolio risk profile away from developed stocks
Reasons I worry about EOCC:
  • The ultimate owners are unsavory
  • The currency situation / Chilean macro could deteriorate due to copper/global trade
  • The growth profile from new projects is limited at this point
  • A La Nina cycle would likely squeeze margins again
Disclaimer: I have no interest in stocks mentioned in this article at present although I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Tuesday, 18 April 2017

Can we find a truly Defensive utility? ENEL Generacion Chile (NYSE:EOCC): Part I

My fruitless search for a truly defensive utility in the UK took to me to foreign shores and back into the arms of an old acquaintance. 

ENEL Generacion Chile (NYSE:EOCC) is a Chilean electricity generation company. I used to cover this company and was very familiar with it having visited management many times. In the last couple of years they have had something of a reorganisation but the fundamentals remain the same.

Let us do a quick surface appraisal. EOCC pays a 3% dividend yield rising to 5%+ in the medium term (as the pay-out is scheduled to increase), it trades on 10x 2016 PE, it has gross debt of only 2x the last net profit and it has negligible pension liabilities. This makes it immediately more appealing than the likes of Centrica and SSE. EOCC is a former state company too but unlike the UK entities the pension liabilities of EOCC are tiny because Chile established a private national defined contribution pension system decades ago.

Let us look at the macro in this part I and valuation in a separate part II. 

Chile is the Norway of Latin America. The comparison is pertinent as both nations have huge coastlines, small populations, strong governments and a cash cow export – (they also both do a lot of salmon farming). Chile has the best institutional integrity in the region, the kind of strong institutions that Argentina used to have and were totally eroded under the Kirchner government. That means regulators, the central banks, companies and investors in the country are among the least corrupt in the region. 

The Chilean economy is driven by copper. Chile is the world’s largest producer of copper and it has both private and public (Codelco) investment in the copper industry. This means Chile is an export oriented mining economy. Chile also has a very open import system with low barriers to trade. 

Generally Latam is split between larger nations which have attempted to build their own industrial base (Brazil and Argentina) and smaller nations that have accepted their export oriented position and have more open economies (Colombia, Chile and Peru). 

In between are nations like Venezuela which have neither an industrial base (just oil) nor an open economy – and countries like Bolivia and Paraguay which are generally populist and underdeveloped. Uruguay is an oddity – being a bit like Switzerland – Uruguay has agriculture and banks where Argentines hide their dollars.

So Chile’s economy is generally vulnerable to global shocks and follows the global industrial cycle as copper (and other minerals) follow closely the industrial cycle. Investment has been strong in recent decades due to Chinese industrial growth and global demand for copper. Interestingly the stock market does not reflect the mining base of the economy being principally banks, retailers, pulp, utilities and an airline.

Now because the Chilean government are sensible people they recognise they are vulnerable to copper. Therefore the government budget is cyclically adjusted to reflect the variance of revenues from the mining sector to produce neither a net deficit nor a net surplus over the cycle. 

Government Budget (Trading Economics)

Not only that, the government also has very low debt levels. 

Debt to GDP (Trading Economics)

Debt to GDP is just 17%. A few years ago it was approximately zero. The government issues bonds primarily to create a market of liquidity for local and international banks. Furthermore the pensions of this relatively young nation are invested in defined contribution funds called AFPs. By law all workers contribute ~10% of their salary to these funds. These funds are heavily invested historically in the local equity market. This tends to keep valuations elevated and means Chile is off the radar for a lot of stock screeners.

So here we have a highly cyclical and open trading nation with a prudent policy of economic management and decent quality institutions. Chile is really quite close to being a developed nation. If you go to Santiago it feels like any modern city in the west. But outside of Santiago the nation is still relatively poor by western standards. However these growth trends toward development and relatively young demographics mean Chile has greater potential for growth.

Chile has a younger population than say the United Kingdom. However the pyramid is less impressive for demand growth than another regional economy like Peru:

This brings me onto EOCC. EOCC is the largest generator of electricity in Chile. It has a 35% market share with 6,350MW of installed capacity being principally Hydro (55%), Gas (34%) and Coal (10%) with some limited wind assets (1%). The primary competitors are Colbun, AES Gener and E.CL none of which you can buy as an investor without local market access. So I will focus on EOCC as it has an ADR.

The Chilean system works with a mixture of contracted energy and uncontracted supply. The generators will contract a large proportion of their production ahead in contracts with suppliers. The price of electricity is controlled via the regulator through the distribution system. The distribution system is separate from the generation side and is also private. This pricing takes into account some pass through for generation fuel costs and hydrology. The generators then bid to contract energy to the distributors at competitive prices. That contracted base will be an estimate made by EOCC of how much energy it can produce via Hydro in combination with Coal thermal base load and some gas base load and peaking. ~80% of sales are via the regulated system with the residual being unregulated (which means commercial sales to industry usually mining) and spot sales (meaning energy sold into the system at marginal cost during times of supply shortage.)

Now this is all a bit complicated but essentially what it means is if hydrology is better than expected EOCC can produce more energy via hydro and therefore reduce its cost of generation even whilst its contracted sales price remains relatively firm. Essentially EOCC are long rainfall - or rather snowfall -as most of the water in the reservoirs is derived from snowmelt in the Andes – hence hydro production peaks in the spring and summer. 

Now this is a crucial point – EOCC has a driver for better margins and earnings that is totally uncorrelated with global capital markets which are in a time of massive risk on/risk off trading.

The Fed can make it rain dollars, but they can’t make it rain.

In recent years it hasn’t been raining. Rainfall in Chile is driven by the ENSO cycle:

ENSO Cycle - note the last very strong El Nino 1998 and  moderate one in 2009 (Met Office)

During El Nino years Chile experiences bumper precipitation – during La Nina Chile experiences drought. A La Nina cycle followed by several neutral years has depleted reservoir levels driving down margins and driving up power costs in Chile. A new El Nino cycle would drive up rainfall – given the havoc El Nino causes in crops etc this makes EOCC quite an interesting hedge. We are currently overdue an El Nino cycle but present conditions are uncertain.

Note some modest correlation between EOCC results over the last 10 years and the El Nino pickup in the 2009/10 period:
Endesa Chile 10 year earnings - Note the 2009 brief El Nino impact vs La Nina from 2010/11

Interestingly during periods of extremely good hydrology the whole system can take advantage as thermal based companies like AES Gener can simply buy hydro on the spot market and sell it under their contracts at prices well below the marginal cost of thermal production so they just shut down plants.

Now Chile has another interesting quirk. It has four electricity grids. The country is several thousand kilometres long which makes transmission of electricity challenging. The main grids are the SIC (central) and SING (northern). The SIC grid serves principally residential and industrial customers around the populous Santiago area. This grid draws a lot of energy from Hydro sources south of Santiago. The other grid of note the SING is almost entirely thermal being situation in the arid Atacama desert and primarily provides energy to the mining industry. EOCC operate in both but the primary exposure for the company is the central grid.

EOCC is indirectly and directly exposed to the copper price and copper mining industry. 

It is indirectly exposed via the currency. As EOCC is a domestic producer it generates sales in CLP but purchases a lot of fuels in USD. Therefore higher copper prices mean the CLP appreciates and thus reduces fuel costs increasing margins. It also drives up the value of the CLP cashflows and dividends that EOCC generates. (Much of this is however hedged)

The company is also directly exposed via demand – increased mining activity means increased sales and generation both from miners and from general business activity. Copper ore grades have been falling for years as the best assets are mined first meaning the industry is becoming more energy intensive which should drive future growth in the SING grid at least.

So EOCC is, like most EM stocks, a play on a weaker dollar or at least a higher copper price. 

Now EM stocks are about growth. Chile has some growth. The demand CAGR over 10 years for electricity is 3.4% - if we add to this some price inflation a revenue growth rate of 5-6% seems reasonable. This is decent but unexceptional. However Chile is much closer to being a developed market. Energy consumption is around 3,000 kwh/per capita compared to ~5,000 in the UK or ~7,000 in Germany. Now Chile has far greater consumption than Peru or Colombia (~1,000) – so there is less potential for growth as the country is higher up the development curve. The underlying economic growth rate is decent but slowing compared to history:

Annual GDP Growth Rate (Trading Economics)

The real barrier to growth in Chile is environmental opposition. There is opposition to new hydro projects due to the flooding of land and environmental concerns. This saw the HydroAysen mega project shelved by the government. Aysen was a proposed project with 2,750MW of capacity jointly owned by EOCC and Colbun. This would have given a huge boost to Chilean hydro resources but it was technically difficult being in the deep south of the country the transmission line was a major environmental sticking point. Aysen may come back in a revised form – which would boost the stock. 

Now the issue is there is also environmental opposition to thermal energy, especially coal, due to pollution. Chile however imports all its natural gas and much of it via LNG due to disputes historically with Argentina so gas production is expensive. And there is opposition to expensive energy!

This leaves renewables. In Chile they call them ‘non conventional renewables’ (NCRE) due to the fact that they already have renewables in the form of hydro. EOCC do therefore have a small amount of wind based renewables and the energy companies have a legal commitment to increase their NCRE production in the coming years. 

Most likely solar power will pick up the slack as Chile has a lot of sunshine. But the difficulty is the best sun is in the northern area and solar only runs during the day so is unsuitable for mining projects with crushers running 24 hours. There is currently no interconnection between the two grids so harnessing the power is a bit more difficult. ENEL Chile has no solar power because ENEL Green Power consolidates the solar assets of ENEL in Chile (more on the group structure later.) Solar development has been rapid in Chile but this causes problems for pricing depressing prices periodically and within the daily cycle discouraging new alternative base load projects.

What about nuclear? Nuclear energy in Chile theoretically would be a good idea. The country has a huge coastline and lots of depopulated areas especially in the north of the country. Much like Japan they import all their fuels so it could also improve the trade balance. However much like Japan Chile has massive earthquakes and tsunamis. After Fukushima we can assume nuclear will never happen in Chile.

So the Chilean generation capacity is not really growing as new projects can’t get approval and this is reducing the potential growth of the sector. EOCC has one project currently underway which is a 150MW hydro project called ‘Los Condores.’ This is a run of river plant rather than reservoir based so should have an estimated 46% load factor or 600Gwh which is around 2.5% of current generation sales. The capex for that is $660m and to date it is 45% finished. After 2018 capex should drop substantially upon completion. 

What this means is EOCC has limited growth beyond 2018 with earnings growth driven by (a) higher sales prices (b) lower cost production. What is likely to happen is revenues growth is limited whilst margins expand due to improving hydrology. Without a substantial growth in the asset base EOCC cannot grow their market share and therefore cannot grow top line much beyond the market level. 

The good thing for shareholders is a lack of available projects means the dividend should rise. The company is guiding for an increase in the pay-out ratio from 50% today to 70% by 2020 raising my estimated yield from 3% trailing to 7% by 2020. (Note by law Chilean companies must pay out a minimum of 30% of earnings as dividends.)

Therefore somewhat unusually you have an EM stock where really the value proposition is greater than the growth proposition – or at least the defensive quality of low debt and low variability in earnings is stronger than the potential for greater capital reinvestment and appreciation. 

Things that are good about Chile:

  • A sensible and macro prudent government with low debt
  • Good hydrology conditions and conditions for renewable energy
  • Decent economic growth and population growth rates
  • Reasonably low corruption

Things that not great about Chile:

  • The country and currency are heavily exposed to copper and the global industrial cycle
  • Limited capacity growth opportunities and significant environmental opposition
  • The demographics/growth profile are not as favourable as other regional economies

In Part II we will look at the company specifics and valuation case.

Disclaimer: I have no interest in stocks mentioned in this article at present although I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.

Friday, 14 April 2017

Portfolio Strategy: Why holding gold and associated equities may be a prudent action at this point.

Considering the present state of valuations in the US equity market with the S&P pushing 28x the shiller PE now is a time for caution in managing the portfolio. Only stocks with exceptional risk reward characteristics should be considered. I will continue to research these opportunities but I wanted to digress a little onto the topic of macro and gold.

"Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head." 
- Warren Buffet

Now in all honesty I agree with Mr Buffet. Except for the fact that others do consider gold a store of value and gold is a real asset by this measure. Not a productive one like farmland. Not a useful one like real estate. But it does have the characteristic of being liquid, tradeable on an exchange via physical ETFs and therefore it does qualify to go into my SIPP which needs to either be invested in securities or held in cash.

Therefore from a portfolio perspective I have to ask the broad question - is a stock market valued at 28x PE likely to give a significant return in the next year.  Valuations at this level are synchronous with poor or usually negative returns. Therefore I should hold more cash. Which I do.

[For the sake of simplicity I will stick to US valuations and the economy as due to the 'dollar standard' this really drives global markets]

Now the issue is in my opinion that the stock market is a bubble - and it will burst - followed by a huge negative wealth effect on the US consumer and things start to look highly deflationary. The US is already slowing and credit growth today is falling and this drives US economic growth. The Fed is tightening but they are way behind the curve. They are tightening into a slowdown. 

Trading Economics: US Loans to private sector

So currently the markets seem to have a collective delusion that the US is going to happily re shore jobs, raise interest rates and become the global powerhouse it once was. This is reflected in the very lofty value of the S&P because earnings growth has been very meager in the last 5 years. The S&P is rising due to expansion of the PE multiple. If earnings don't catch up, or fall, as happens in  recession, then the market is prone to a significant correction.

Now I may be wrong. But it would be prudent to position the portfolio defensively to prevent further capital loss when such an asymmetrical risk reward exists. And to take hedges.

Several weeks ago I bought a series of put options on the S&P because they seemed cheap. I have Puts at 1,975 expiring in June and in September. I took that level as it seems attractively priced. I consider these speculative insurance against a fall in the S&P. At current levels the S&P is at 2,328. This is less than 20% above the level of my options. Given the valuation levels today a very simple market shock could easily take the index down to a merely overvalued 23.7x Shiller PE at 1,975. Still well above the long run average of ~16x. 

Now back onto the subject of gold. 

The question one must ask oneself is; given gold was for a long time the standard of global trade and currencies should I hold gold instead of currency cash in my portfolio while being defensive and seeking out equity value opportunities? 

What would be the reason for doing this?

Well if we assume all governments want to remain popular I think we can assume that as the US enters a new recession and global markets sell off pricing in weaker earnings - I think we should also assume a renewed round of quantitative easing will take place as well as a fiscal stimulus to blow the bubble back up again. This is because the only alternative is a massive depression.

I have no interest in what Trump has said about the Dollar and strengthening the US and cutting their trade deficits - 

Trump has only one principle and that is 'how much do people adore me.' When he says to crowds 'I love you' he means 'I love this' adoration. 

Therefore Trump will do and say anything to remain popular and it is highly likely a massive stimulus will be announced. If the recession goes global (also likely) then here in the UK we can expect similar massive quantitative easing. And all this increase in currency is likely to lead to a decline in the real value of my cash in the portfolio. 

Trading Economics: The Fed balance sheet

Now my assumption here is that by the time the real QE kicks in equity valuations will already be on the floor pricing in recessionary earnings and I will want to be fully invested in equities again. But before this happens I expect gold to outperform the value of my GBP and USD cash in the portfolio in anticipation of further monetary easing. 

So at this point is seems prudent to move a proportion of cash in the portfolio into gold exposure. I will start with 5% into a physically backed ETF. I don't plan to get my gold out with a physical ETF - although I note SGBS offers this! - butI have no interest in futures backed ETFs because the rolling etc makes them less efficient and muddies the exposure.

Why an ETF and not a gold mining stock?

Simply because I will need more time to analyse the sector in order to select miners with the appropriate bottom up characteristics I want from my equities. And I am but one analyst. Furthermore if I am holding gold as a cash proxy the point is to then be able to be fully invested at a time offering better bottom up valuations for equities in general.

Something tells me I should really assign more than 5% of the portfolio cash to gold - but I will look for trading opportunities to move perhaps 10-15% of the my portfolio into gold and gold equities in the medium term.

Why not bonds instead of gold?

Treasury bills would be the other obvious alternative. But given it is likely the government will issue substantially even more of these in future they continue to lack the scarcity of physical gold. Also they are currently already at elevated prices (especially in the UK) with record low yields.

Trading Economics: UK 10 year yield

From the perspective of personal financial management the best things to own today seems like real assets; Houses, cars, land (maybe not boats - they are cyclical!) and a ready supply of cash to put into the stock market when times seem at their darkest.

For now all we have in global trade is the dollar standard. Until we have something else I struggle to foresee a better way.

plus ça change, plus c'est la même chose

Disclaimer: I have no interest in Gold of Gold backed ETFs at present although I may do in the future. These are opinions only, not investment advice. If in doubt read my disclaimer.