The Altus Insight - February, 2016
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: February 29, 2015
FR: Forrest Jinks
RE: Opportunity Abounds
As promised, this month we will take a look at possible investment opportunities. Altus Equity is not a licensed investment advisor and nothing in this article should be construed as investment advice. This article is simply an exploratory look of possibilities that might exist in the current difficult investing environment.
There are a couple things to touch on before jumping into the meat of this article:
- The elections held on February 20th resulted in the worst possible outcome for my preferences, with my two least favorite candidates taking home wins in both South Carolina and Nevada (followed by more bad news when the primaries flipped parties). Truth be told those two candidates being at the bottom of my list is tied more to my core values than economic expectations. From the standpoint of Altus Insight it is the economic impacts of events, or the possible economic impact of those events, that is most important. Even if many elections have little true impact on short term economic conditions, the psychology around the results of those elections CAN have a large impact on short term economics. And, as we discussed here, over time politicians can greatly impact investment returns. But what is affecting the elections themselves? I highly recommend the essay here that discusses several studies recently done on the possible impact of search engines (and social media) on elections, with some commentary as to how they might impact the 2016 presidential election. Of greater interest to my investing mind is the impact to elections moving forward and how it might redirect the political and economic path of the country.
- The impact of Dodd Frank on the economy, and the future impact on the economy, just keeps getting worse and worse. I have already lamented the damage it has done to local banks in previous Insights. There are additional concerns about the massive reduction in trading liquidity, especially in bonds, due to other parts of the regulation. Now there is TRID. Enacted last fall it is the Dodd Frank regulation controlling the supply chain of residential mortgages. This topic will be covered in greater detail in a future Insight but input from people working on solutions for the problem feel like the regulation is likely to remove so much liquidity from the home loan industry that we could experience a repeat of the 2008 housing crisis, although it the process would occur much more slowly.
Most of the world economy is on its heels and parts of the US economy are teetering. Passive yields from quality assets have shrunk to the point where even retirees with decent size nest eggs can no longer live off the investment returns. Even with its retreat from record highs the stock market still appears to be overvalued by most matrices. The quality bond market, while producing very little yields, is priced in such a way that any move to increasing inflation could crush valuations while there is little room for additional pricing upside for taking on the downside risk of the investment. And yet timing markets is a fool’s errand that often results in passive investors ending up with a weaker total investment position than had they stayed invested (Note: this is far less true for active investors, especially in value investors (i.e. Warren Buffett or Howard Marks), and especially in alternative assets (distressed situations lead to negotiating opportunities). So if investment opportunities are overpriced and yet sitting on the sidelines isn’t usually a winning strategy, what is a person to do? Luckily, with enough patience, a long term investor’s mindset, and the intestinal fortitude to invest against market norms, there are still opportunities to be found.
- Individual Real Estate Opportunities: While not the only area of investment opportunity, it is Altus’ overriding expertise and it only makes sense for me to start here. There are ALWAYS opportunities in real estate and other real asset markets. Sometimes they are just harder to find than others. The massive mispricing that existed in the markets between 2009 – 2012 is mostly gone but great opportunities can still be found. While staying away from areas that will be hardest hit by the oil downturn (at least for the time being) there is still the rest of the economy that will continue to move forward. People need places to live and businesses need places to be based. As investors get scared value add opportunities will become more abundant, and possibly have richer margins. Granted, those margins may be more relative to a market’s total movement than absolute in nature, but since the reason to invest is for future capital appreciation or cash flow, relative returns are still a good thing. Additionally, interest rates are still historically low and are likely to stay there for the time being. Low interest rates with higher cap rates? Score! If absolute capital returns are desired (buy low/sell high) investors either need to have a very short or a very long investment strategy. The market pricing of real estate (which is different than value) could go any number of ways over medium length investment time horizon. While all markets, even overtly distressed markets, will have one off opportunities, finding those same opportunities in markets that appear to be improving/emerging could offer additional market created investment returns. The following are certainly not a comprehensive list of markets that are likely to move in an investor’s direction, but they are markets we like and are currently following:
- Reno: Tesla developing its battery manufacturing facility just outside of Reno wasn’t a game changer but it certainly was a game accelerator. Businesses continue to flow out of California but many still need a presence close enough to California to service the large coastal population areas. Despite wintery road conditions a few months each year Reno fits that bill. Businesses = jobs. A huge battery factor = more jobs. Jobs = people. People = housing. Buyer beware however. Despite strong long term dynamics that should provide great dividends for patient investors Reno has a history of price volatility that is not for the faint of heart.
- Oklahoma City/Tulsa: Despite Oklahoma’s economy having a reputation for being heavily dependent on energy, it is far more diverse than many realize and certainly more diverse than it was in the past. At the beginning of 2015 only 3% of the workforce in the Oklahoma City metro area were employed in the energy sector (although it produced 9% of the income in 2014). Further, after a brief increase in unemployment in the first and second quarter of 2015, the Oklahoma unemployment rate has been falling, down to 4.1% in OKC and 4.2% in Tulsa in December 2015, both considerably below the national average. One reason Oklahoma, and especially OKC and Tulsa have not been impacted like other oil and gas regions - North Dakota or Midland/Odessa as examples - is because most of the oil and gas jobs in Oklahoma are downstream from the wells themselves. Even if exploration and drilling slows down (and it has, severely) the existing wells continue to pump oil that has to be transported, stored, sold, manufactured, etc.. This isn’t to say that Oklahoma might not have further impact from the oil slowdown but with strong overall long term market and economic indicators we still like these markets for long term cash flow investing.
- Various Cities in Kansas: The great thing about the Midwest from an investing standpoint is that it never dealt with the crushing impact of the 2008 real estate crash that the coasts did. The downside to that is it also hasn’t had the price rebound that made so many people so much money on the coasts. Kansas, like Oklahoma but without the oil, has continued to plod along, attracting businesses and new citizens alike. As happened in Texas, pockets of technical innovation are springing up to supplement what has long been a strong agricultural, transport and manufacturing area. Please note, while it is technically not in Kansas, we are including Kansas City, Missouri as a potential market and heavily investing our time learning the market and trying to find opportunities.
- Northwest Arkansas: Not really a particular city, NW Arkansas is made up of several smaller cities. With better weather than most other parts of the Mid-South and beautiful scenery to boot, Fort Smith is expected to have 30% job growth over the next ten years while Springfield, Rodgers and Fayetteville all have population growth more than double the national average. The final 2015 GDP numbers for the area are not yet available but it is expected that NW Arkansas will end up with its third consecutive year of over 3% GDP growth, far outdistancing the national average. A recent report by IHS Global Insight forecasts NW Arkansas to average over 4% growth rate per year through 2020, the third highest MSA in the country behind only the Austin, TX and Raleigh, NC MSAs. Don’t let that the state is Arkansas fool you into pessimism. Despite the overall state rankings showing Arkansas to be lagging in education and poverty, NW Arkansas boasts much better statistics. Due to rapid population growth and its distribution spread across the four distinct city centers, large complexes are harder to come by and we have had difficulty gaining a foothold in this area. Due to new relationships and increased credibility within the market we feel optimistic 2016 will be the year we are able to make our first NW Arkansas investment.
- Various Texas Non-Oil Cities: Because Texas is such a hotbed for real estate investors, yields have been forced down as prices have increased. As a result we aren’t as active in pursuing opportunities in Texas as we are elsewhere. That definitely doesn’t mean we would turn down opportunity if it fell in our lap. With our large and growing network in the Mid-South it is not unlikely that it might happen. For the large cities we like Austin and Dallas (who doesn’t?) with San Antonio not far behind. We are more active in pursuing opportunities in smaller cities such as Lubbock and El Paso.
- Boise: Like many parts of the west, Boise has experienced intense cap rate compression over the past several years. With a growing population and business friendly government, Idaho is likely to continue to attract businesses and households. One thing to keep an eye on when investing in certain areas is that the business friendly governments translates into much easier/shorter development processes and areas with lots of land can end up with overdevelopment. Not to worry too much. The growth rate is so high that overbuilding is soon absorbed and the march continues.
2.Commodities: Commodities of all shapes, sizes, and colors have been getting crushed over the past few years. Despite its recent 20% bounce in price (in a month), gold is still down 38% from its peak. Copper is down 53%. Wheat is down 59% (and falling). Cattle is down 34% in the last 6 months alone (and falling). Much of loss of price in the commodities is due to the increase in the strength of the dollar after an initial inflation assuming rally from all the rounds of quantitative easing. The industrial metals, of which copper is one, are also getting hurt by slowing world economies. Why is this an opportunity? Remember, a 50% fall in price requires a 100% increase in price to recover to the original price level. 100% returns are very good. This isn’t to say commodities are going to rebound right away and go back to their cyclical highs any time soon, but it does show that there is a strong possibility for upside. Please don’t run out and buy the commodities. Pigs stink, cows take up a lot of space, and wheat will eventually rot. Plus, owning the commodities themselves doesn’t provide any investment return other than appreciation. I am not willing to bet on the timing of the recovery such that I am willing to have my money idling sitting locked up in grain, livestock or metals waiting for the recovery to come. Thankfully there is another way. Despite the fall in prices there are still companies focused on each of the commodities that are making money. When the prices recover they will be making more money. More money either results in higher dividends, higher stock price, or both. If a company is making money but isn’t paying dividends, your investment is still active because that income is reinvested into the company which should produce additional future income/value. Such an investment may not have the hockey stick type returns that a direct commodity investment could produce if your timing is right, but sure is a lot surer bet than betting on timing.
3.Oil/gas: Oil prices are 30% of what they were only 18 months ago. That is a 70% decrease and far below median oil prices. It is easy when there is this much carnage to get fixated on the immediate future, but think about this for a second. Where will oil prices be in 10 years? Yes, carbon based fuel usage may drop in the 1st world, but the second and third worlds are still in population growth mode. India has a huge population, only a small percentage of which own their own vehicles. Even increasing the vehicle penetration rate 10% results in a massive absolute increase. I would further propose that the low prices are likely to hinder the rate of renewable fuel development since in many cases renewable fuels were already working as relative financial losers compared carbon based fuels. Will oil prices recover over a 10 year period? A 15 year period? Less assume it takes 10 years for oil to recover to $100/barrel. That is roughly a 250% return on investment off today’s prices and a 13% IRR. If I knew I could make an investment that had high probability to produce a 10 year 13% IRR…I would look at it very, very closely. And a great thing about oil, assuming the ownership of the oil is through owning oil leases, is that it doesn’t go anywhere. Just because you own an oil lease doesn’t mean it has to be pumped. Why not sit and wait for prices to recover? One last point to consider. Because the strength of the dollar and the price of oil are inverse, if the price of oil is to stay suppressed for any numbers of years it likely means the dollar stays strong, which in turns means low inflation. Low inflation increases the value of nominal returns. I can hear readers protesting that the price may go lower. True, but how much lower can it go? No more than $30 for sure, so is it worth giving up $70 in upside for $30 in temporary downside? Don’t run out and buy a bunch of West Texas futures. For most of us there are better ways to invest. (By the way, none of this analysis takes into account the extremely generous tax benefits of certain type of oil/gas investments. I earned a 30% return on my investment in the first year through the tax credits I received).
a.My favorite, although it takes focused effort, is through the purchase of mineral rights and/or oil leases. The reason this is my favorite is that if it is uneconomical to pump, the pump can be shut down and the investor can wait until prices recover. The oil isn’t going anywhere. Finding the right opportunity is important but if one can be purchased that is currently producing profitably, and still has considerable resevse to produce into the future, WINNER!
b.There are also vulture funds, including at least one fund that went public last week, that have been formed purely for the purpose of purchasing distressed oil assets. While investments into most of those funds will be limited to accredited investors it is a far more passive route than trying to take direction ownership of the oil rights.
c.A third way to invest is through some of the distressed debt funds, such as the ones run by Howard Marks, who are feasting on the debt of the many oil and gas companies that got a little to overextended due to the massive misallocation of investment over the past few years. While this is an investment into the oil/gas industry it isn’t a true investment into oil/gas assets. The real investment is into debt. The hope is this debt continues to make payments and if not the assets are seized and then liquidated. There isn’t a long term benefit of asset ownership.
d.Lastly, the least sexy but easiest option is to investment in any of the many publicly traded companies in the space. Some of them won’t make it, at least not in their current form, while others will recover and end up with more market share. I would far prefer to own the hard asset but that type of effort isn’t for everybody and non-accredited investors will have trouble making those type of investments through a sponsor. The publicly traded company route may be the path of least resistance for non-accredited investors.
- Various and Sundry Stocks: I can tell you for sure I am not talking about the FANG companies previously discussed, but there are other companies, good companies, that have already taken a beating. At some point, maybe very soon, these companies will be worth owning. I have no idea where or when the exact bottom will be, but if I can find a company with good intrinsic value I should be okay with the pricing dropping farther since I can have confidence it will recover and be profitable in the future. There are many such companies out there. Stocks aren’t my area of focus and I don’t have the licensing to be able to share ideas with you but they are there, and there will be more of them.
In addition to the opportunities outlined above there are many many more that will be manifested in the coming months and years as we enter a time period of economic turbulence. When those times come the true question will be whether we have courage to act in opposition to the majority of the investing public. The only way to outperform the market is to act differently than the market.
Altus Equity Group, LP