Crescat Capital Quarterly Investor Letter Q3 2014

Crescat Capital Research Letter & Performance Update

Over the long term, since each strategy’s inception, Crescat has delivered strong risk-adjusted returns based on high alpha, low beta, high absolute returns, low downside deviation, and low correlation compared to market indices and other managers. Crescat has endured and prospered for its clients, producing these results cumulatively through two of the worst bear markets in history: the Tech Bubble Crash of 2000 – 2002 and the Global Financial Crisis of 2007 – 2009. We plan to continue to deliver superior risk-adjusted investment performance by following Crescat’s time-tested investment process that combines top-down macroeconomic themes with bottom-up fundamental analysis.

As an example of our bottom-up fundamental work, Crescat analyzes the 2000 most liquid U.S.-listed global equities on a daily basis based our own proprietary regression and ranking computer model. The Crescat Fundamental Equity Model has been successfully developed, applied, and refined by Kevin C. Smith, CFA and his investment team for 17 years. The model identifies the companies with the best combination of quality business models, competitive advantages, attractive valuations, and near-term sales, earnings, and free cash flow growth catalysts. The Crescat investment team performs a deep-dive fundamental analysis on the stocks suggested by the model prior to taking any position.

To understand better how we do comprehensive fundamental analysis on individual equities, above and beyond our model, see the linked slide presentation on NVIDIA. We view NVIDIA as a free-cash-flow yield and growth machine, the type of company that we want to own in a diversified portfolio of such companies for our clients who are interested in growing and preserving wealth. NVIDIA is a stock that we recently purchased across all three Crescat investment strategies. It fits within the firm’s Digital Evolution theme. Kevin presented this idea to a group of money managers and analysts at the ValueX investment conference in Vail, Colorado last month. See the linked video of the NVIDIA presentation from the conference.

As an example of our top top-down macro analysis, our last quarterly letter highlighted the key points of our new India Policy Shift macro theme. Since then, elections have elevated Narendra Modi to prime minister as we predicted. A new budget has just been released that supports continued growth in the Indian economy based on Modi and his party’s pro-business, pro-economic growth agenda for the nation. The India theme has been a positive contributor to performance since we began investing in Indian equities four months ago. We trimmed our positions moderately into profits once about a month ago. We added back to our exposure recently on weakness because fundamentals remain extremely bullish for India for the next several years. According to India’s new finance minister, Arun Jaitley, we should expect $1 trillion of new infrastructure spending over the next five years. With a very low debt-to-GDP ratio compared to other developed and emerging countries, we see room for strong economic growth in India. In addition, there is an improving outlook for the rupee, including the current account deficit moving towards surplus.

India is one of the few emerging countries on the verge of a debt-to-GDP leveraging phase that will be positive for its real economy. India has also significantly expanded its foreign reserves (now 15% of GDP) and has an additional 50% of its GDP in gold reserves at its central bank, the highest official gold reserve-to-GDP ratio of any major economy. Crescat carefully weighs currency risks when investing in foreign markets and the factors mentioned above are bullish for Indian rupee. In addition, we are pleased with the appointment of Raghuram Rajan as Reserve Bank of India’s (RBI) as governor in the last year and the work that he has already done to establish credible monetary policy by moderately raising interest rates and bringing inflation down.

Crescat believes that investments in Indian equities represent the best way to profit from these major changes in the country. By owning Indian equities, we also gain exposure to likely rupee appreciation versus the U.S. dollar. Equity ETFs give us diversified exposure to several market sectors in India (Energy, Information Technology, Consumer Cyclical, etc.) and different company sizes with attractive market-wide valuations and strong growth prospects. The S&P BSE India Small-Cap Index for example only trades at 1.5 times trailing book value and 10 times 2015 estimated earnings, which may prove conservative. India’s large cap stocks, as measured by the National Stock Exchange CNX Nifty Index, trade at 2.8 times book and only 10 times projected 2015 cash flow from operations, which also may prove conservative. We also see growth opportunity and good valuations today in Indian banks, such as HDFC Bank, and ICICI Bank, which can be purchased as U.S. ADRs. Both of these banks have strong balance sheets, high returns on capital, and opportunities for healthy lending growth.

Another strong contributor to our Q2 and year-to-date returns has been our investments related to our New U.S. Oil and Gas Resources macro theme. Secular shifts are occurring in two of the world’s most-traded commodities, oil and natural gas, as demand for oil decreases in developed countries, and natural gas expands to new uses and markets. Meanwhile, rapid expansion of oil and gas production in the U.S. has created a medium-term supply and demand imbalance that has led to a historically extreme price differential between these two commodities that has persisted already for several years. On a dollar per BTU (unit of energy) basis, in the U.S., light sweet crude oil is currently about four times more expensive than natural gas.

We see a long-run convergence in the BTU equivalent price of the two fuels, its historical tendency, as longer term supply and demand shifts will put downward pressure on oil and upward pressure on natural gas price. For example, natural gas is increasingly replacing coal as fuel for power plants and replacing gasoline and diesel in fleet vehicles. Additionally, passenger cars continue to become more fuel-efficient, reducing the demand for oil. Renewable fuels are also gaining increased traction as a piece of the overall energy supply and demand pie at the expense of both coal and oil. The world’s energy mix is progressing towards cleaner and renewable energy, but we are also becoming more energy efficient, requiring fewer units of energy to generate more units of GDP. These important trends can be seen in the graphs below.

At the moment, we believe that oil service companies are some of the most conservative and profitable ways to play the oil and gas production boom in the U.S. Much of the recent increase in domestic oil and gas production has come from unconventional shale plays containing difficult-to-extract resources that necessitate engineering and geological expertise that the oil service companies possess. We prefer to own consistent free cash flow generators within the sector. Schlumberger and Halliburton in particular have been strong free cash flow generators with steady growth and good valuations. These companies have vastly outperformed the S&P 500 year-to-date and contributed significantly to Crescat’s returns.

A key factor driving the increased production of oil and gas in the U.S. has been capital expenditure (CAPEX) expansion by domestic exploration and production (E&P) and pipeline companies to produce and transport oil and gas from unconventional deposits. Many of these companies have been able to raise substantial new equity capital to finance this CAPEX through the promotion of new MLP (master limited partnership) units as tax-advantaged investments to compete with lower-yielding fixed income products in the low interest rate market. The MLP units pay “distributions” that are presented to investors as high yield investments. We are wary of many MLP companies as suitable investments for our clients due to lack of underlying free cash flow being generated by these highly capital-intensive business. Also, these businesses tend to be richly-valued and highly-leveraged. Furthermore, what the general partners of these MLPs deem “distributable cash flow” is a non-GAAP accounting measure that is highly fudge-able and directly correlated to general partner profit sharing incentives. Perversely, in the oil and gas MLP structure, general partners are able to add the majority of their CAPEX (the part of it they deem “growth CAPEX”) back to cash flow from operations in order to arrive at what they call distributable cash flow. What a prudent investor should really be interested in is free cash flow, which is arrived at by subtracting, not adding, CAPEX. MLPs are rife with accounting shenanigans that benefit the general partner at the expense of limited partners who are being sold underlying money-losing businesses as “tax advantaged” investments.

Healthy and sustainable companies pay dividends out of free cash flow. The oil and gas MLPs pay large distributions that look like dividends but are not covered by free cash flow. In fact, most oil and gas MLPs that we have looked at have been consistently generating negative free cash flow. The distributions to the unitholders have been made possible primarily from ongoing dilutive new equity and debt capital being raised by Wall Street investment bankers from retail investors. Yet, retail investors continue to be lured in by high yields, tax advantages, and past capital appreciation (momentum) in the MLP stocks. It looks an awful lot like a bubble to us. Several years ago, we had only $30 billion in market cap of MLPs; today, we have $750 billion market cap of MLPs and there is still a lot of money flowing into these businesses. The bubble could go on for a while, but it should inevitably end badly, particularly in a rising interest rate environment or in any cyclical downturn in the oil and gas markets. The combination of questionable underlying businesses that are generating negative free cash flow, high valuations, high leverage, suspect accounting, a misaligned principal-agent incentive structure, have us on the sidelines for now and looking for short opportunities. We have identified several good candidates already. Invest in oil and gas MLPs at your own risk.

Regarding our Domestic Banking Resurgence theme, we are optimistic specifically with respect to the regional banks and expect to remain bullish for the next several years. There are many reasons that point to an improving landscape for fractional reserve bank deposit and lending business in the U.S. Regional banks, in general, have seen a substantial improvement in the credit quality of their loan portfolios since the 2008 financial crisis. These banks have recently been able to significantly increase dividends. This is one of the few industry groups that are well below 2007 highs. We understand this is a cyclical theme, and that this is likely a great time to benefit from improvements in the cycle, particularly from improvements in net interest margins which are likely to bounce upward from recent historic lows. Moreover, possible higher treasury yields and a steeper yield curve could be positive drivers for the financial sector as the Fed transitions out of quantitative easing, even if the Fed only allows interest rates to increase a small amount under a moderately improving economy. On top of all of these bullish points, we maintain our conviction that $2.5 trillion of excess reserves in the U.S. banking system will provide ample support for new loan growth.

Regarding our China Currency and Credit Bubble theme, the Chinese economy is at high risk transitioning from a positive leveraging to negative leveraging phase in its debt-to-GDP cycle that we believe will ultimately lead China policy makers down the path of currency devaluation. Currently, China faces a real estate and infrastructure bubble related to credit excesses in its banking and shadowing banking sectors. The credit bubble is most evident in China’s official banking sector based on the size of its M2 money supply, which measures reserves plus credit in the banking system. As of 6/30/14, the size of China’s money supply was $19.5 trillion at the current exchange rate (6.202 CNY/USD). This compares with the U.S. M2 of only $11.4 trillion. In other words, the official Chinese M2 money supply is valued 71% percent greater in aggregate than the U.S. M2 money supply. There is an even greater overvaluation of China’s money supply that is evident when one considers that China’s GDP is only 56% the size of U.S. GDP, $9.4 trillion versus $17 trillion. These figures are shown in the charts below through year end.

We have shown above and in our prior work that China’s currency, known interchangeably as yuan (CNY) and renminbi (RMB), is extremely overvalued at current exchange rates. By considering both M2 and GDP in our relative currency valuation, we are able to challenge the conventional wisdom that for so long has asserted that Chinese have kept their currency artificially undervalued under a managed currency regime. Indeed, the Chinese government has essentially been pegging CNY to the dollar since the mid-1990s as shown below. However, the currency is no longer artificially undervalued based on China’s cumulative fiscal and monetary policies.

What is most worrisome to us about China is that it has been reporting cumulative surpluses in both its current account and its capital account for more than a decade. This goes against what we learn in economics textbooks that tell us that balance of payment accounts must annually and cumulatively net out to zero. The reason that current account and the capital account (including changes in foreign reserves) must net out to zero is to account for all foreign trade and capital flows in any currency between any single country and the rest of the world. The problem is that China’s reported balance of payments accounts do not balance. The omission of changes in foreign reserves, which now stand at $3.9 trillion, according to the PBOC, could be a reason that the accounts don’t balance. However, the National Bureau of Statistics of China in its description of its reported capital account balances series claims that they are already including the cumulative change in foreign reserves. If that is true, then based on our analysis and China’s numbers, there has been $9.4 trillion in CNY creation and net capital outflows from China since 2000 that is missing from China’s capital accounts. Ironically, financial commentators within China flaunt these imbalances as “twin surpluses” that are positive factors for the currency. If we assume, for sake of argument and to be conservative (as OECD seems to have done in its now outdated series), that $3.9 trillion in foreign reserves has not been included in China’s reported capital account numbers, then there is still a missing $5.3 trillion in cumulative capital outflows and money creation that are revealed in China’s balance of payments accounts since 2000. In either case, the level of unreported China foreign asset accumulation and PBOC money creation, the plug necessary to properly balance these accounts, is substantial, somewhere between $5.3 trillion and $9.4 trillion.

We believe the yuan is ripe for speculative attack today from large U.S. and global hedge funds because China needs to devalue its currency in order to spur its domestic economy and prevent a banking crisis. While China could use some of its $3.9 trillion in foreign currency reserves to defend its currency from a speculative attack if it wanted to, we believe that it will no longer intervene to protect its currency until it has already depreciated it significantly. All else equal, selling reserves would be akin to reverse quantitative easing (QE) in China which would certainly plunge the economy into a banking crisis and recession given the credit excesses in Chinese domestic banking system. China needs to increase its QE, not reverse it. Furthermore, selling reserves would put undue pressure on the economies of China’s major export partners, including the U.S., which would negatively impact China’s current account balance. China’s current account balance has already been moving towards deficit. Thus today, we believe China is left with no other rational choice than to back away from PBOC yuan intervention and let natural market forces drive a devaluation of its currency.

Today, posturing for the inevitable devaluation appears as talk by government officials of opening up the currency and loosening capital controls to ultimately freely float the currency and allow it to be a global reserve currency. In reality, China’s balance of payments accounting needs a lot of work before the currency would be fit to be a global reserve currency. At the moment, we believe China is only trying to lure more foreign flows into the currency under the false perception that it is cheap at the same time as it continues with domestic QE. These measures are necessary to continue China’s GDP growth while battling its internal credit bubble. We anticipate several forces converging to soon force a significant devaluation of the yuan:

    1. A continued weakening in China’s balance of trade
    2. Foreign investors easing their pace of investment in China as capital investment in the country loses its luster
    3. China domestic capital continuing to flee the country
    4. Ongoing domestic QE necessary to bail out domestic banks amidst China’s credit bubble

Large global hedge funds positioning themselves in the global capital markets to force the devaluation

In conclusion, we must note that our ongoing Global Fiat Currency Debasement theme has been one of our strongest performing themes in the portfolio year-to-date due to renewed strength in our precious metals holdings amidst valuations for gold relative to fiat currencies that are still at historic lows. About a year ago, after a selloff in precious metals, Crescat released an extensive Macro Presentation supporting this theme. Our in-house macro analysis laid out the value of the world’s above-ground gold relative to the global fiat monetary base across the world’s top 25 currencies and economies. Our analysis further revealed historic low valuations. In addition, we showed that precious metals continue to play a prominent role as a reserve currency among the world’s central banks. Importantly, after decades of gold selling by central banks, they have become steady net buyers of gold since the depths of the Global Financial Crisis in 2009. We expect this trend to continue as record unsustainable levels of global debt-to-GDP must ultimately be reconciled by future inflation. Gold remains a key hedge against future inflation that will inevitably follow this historic period of global QE. As it did in the decade of the 1970s, gold can perform extremely well under a period in which inflation is rising even faster than interest rates. We favor gold and silver in the commodity and ETF markets, as well as equities of financially strong royalty and mining companies in politically safe jurisdictions.

Crescat Portfolio Management LLC is an asset management firm headquartered in Denver, Colorado. The firm claims compliance with the Global Investment Performance Standards (GIPS®). Investors and prospective investors can access the latest GIPS compliant performance presentations by contacting or calling (303) 271-9997.


The Crescat Investment Team

Kevin C. Smith, CFA

Chief Investment Officer

© 2014 Crescat Capital LLC