Industry & Market

East Asia: The World’s Next Economic Power

East Asia: The World’s Next Economic Power

East Asia – constituting China, Japan, North Korea, South Korea, Mongolia and Taiwan – may be set to replace the United States as the world’s foremost economic power. This presents powerful opportunities for sharing in the growth of the region.     A staggering 1.7 billion people are living in East Asia (UN Estimates, 2023). Modern humans began settling in this region as much as 60 000 years ago (Stanyon, Sazzini & Luiselli, 2009). Historically, East Asia became such a point of growth for three reasons:   - River systems: Large river systems, such as the Yellow River, present a source of irrigation, transportation and fertile land. This served as a basis for settlement. These river systems continue to support enormous populations today (Szczepanski, 2019). - Climate: For the most part, the climate in East Asia is temperate or subtropical: well-suited to agriculture to enable a stable food supply (Climate Centre, 2021). - Economic development: East Asia has been a hub of economic growth at various points in time. This is the case right now – it is the most rapidly urbanising region in the world (World Bank, 2018).    

What has East Asia achieved since the 1950s?

  - Poverty reduction: East Asia has transformed spectacularly from a state of severe poverty before the 1950s. By 2015, the region had reduced its poverty rate to around four percent. China alone has lifted 850 million people out of poverty since the 1970s (World Bank, 2022).     - Massive shares of global GDP: Currently at 44%, the Asian share of global GDP is expected to be over 50% by 2030. This is, in large part, due to the massive current and future projected growth of the Chinese GDP (World Economics).     - A powerful middle class: East Asia’s middle class makes up half of the global middle class (Ahnsan, 2018). China’s middle class is the fastest growing in the world. The Chinese middle class is shaping consumption trends worldwide, encouraging investment away from mature markets in the West to China (Sandal, 2023). The growing influence and capability of East Asia – particularly of China – can be compared to the boom years of the United States. After World War Two, the United States saw massive increases in GDP growth, consumer spending, production, housing, employment and education (Pruitt, 2020). This catapulted the United States to dominant superpower status: a status East Asia is rapidly chasing.    

When the United States is compared to East Asia

  - East Asia already has a cumulatively larger GDP: In 2021, the combined GDP of East Asia was $23.9 trillion, compared to $23.3 trillion in the United States (World Bank, 2022). - China grows far more quickly: Over the past ten years, the United States' share of global GDP growth was 9.7% compared to an impressive 31.7% from China. If current growth continues, the GDP of China will be more than double that of the United States by 2030 (World Economics, 2023).     - Average income per capita is higher in the United States: The average GNI per capita of the United States was $70 930 in 2021, compared to $11 880 in China and $42 650 in Japan (World Bank, 2023). Chinese median household income has, however, grown by over 800% from 2000 to 2020 (NBSC, 2021). Median household income in the United States grew by only 11.5% over the same two decades (US Census Bureau, 2021). - East Asia has faster-growing foreign direct investment: In 2021, inward foreign direct investment in the United States amounted to $4.98 billion compared to $3.58 billion in China and $1.91 billion in Hong Kong SAR (UNCTAD, 2022). China has experienced an increase of more than 200% from 2000-2020, compared to a 48% increase for the United States (UNCTAS, 2021) (Bureau of Economic Analysis, 2020).     - East Asia saves more: Gross domestic savings amount to 24.7% in Japan, 35.7% in South Korea and 45.7% in China. This is much higher than the 17.4% savings rate of the United States (World Bank, 2021). East Asia is nearly on par with the United States and growing far more quickly. The boom in East Asia looks a lot like the growth that pre-empted the economic rise of the United States.  

East Asia has been here before

  What is today China, Mongolia and South Korea were thriving economic strongholds until 1700. Powerful empires like the Tang Dynasty (618-906), the Song Dynasty (960-1279) and the Mongol Empire (1206-1398) were once the largest economies in the world (Baum, 2021).     Four key advantages made these empires so powerful – strengths which are just as relevant today (Baum, 2021): - Trade routes: Collectively known as the Silk Road, China’s intricate overland routes were used to assemble technology, goods and services that no other region could access. This trade legacy has stuck around: in 2021, China was the world’s largest exporter and second-largest importer (OEC, 2023). - Superior technology: East Asia employed and regularly innovated irrigation techniques that were not yet used by other regions. This allowed for an agricultural surplus. Today, East Asia is a world leader in technological innovation, particularly in the e-commerce, artificial intelligence and fintech industries (Sedik, 2018). - A taxable farm surplus: China had the world’s first civil service system, which collected tax revenue from the agricultural surplus. China has upheld a civil service system throughout its history. Its modern-day taxation and protocols are, in many ways, on par with that of the West (Jarrett & Huihan, 2009). - Skilled traders: A rigorous education system provided a specialised class of highly skilled artisans. The East Asia of today has an equally impressive system. East Asia houses seven of the world’s top ten education systems. These are centred around deep learning for the 21st century (IMF, 2018).     At present, East Asia faces a few key challenges: territorial disputes, environmental degradation, rivalry with the United States and hindrances to free trade (Mishra, Balatchandirane & Tiwary, 2021). However, the region’s longstanding history of overcoming challenges – enough so to maintain economic dominance for over one thousand years – is a telling indication of its resilience in the face of adversity.  

Work ethic and a culture of efficiency

  East Asia is not only resilient as a region: it is home to some of the hardest workers in the world. China’s work ethic is based on a Confucian principle calling for status hierarchy, collectivism and consistent hard work to achieve perfection in outcomes (Kan, Matusik & Barclay, 2017). Its ‘996’ technological business culture prescribes work from 9 a.m. - 9 p.m., six days a week (Schwartz, 2021). Japan and South Korea have very similar requirements for perfection and overtime (Samson, 2017).     This culture is very different from the West, where, in the United Kingdom, four-day workweek trials are being performed (Christian, 2023). The East Asian work ethic may become central to outperforming the rest of the world.  

What East Asia could mean for Investors

  There are ways to share in the fast-paced growth of East Asia. Currently, companies like Tencent and Alibaba, the Whatsapp and Amazon equivalents of China, trade much more cheaply than their Western counterparts. These companies are effective monopolies in the world’s most populated region – a region which may soon be the next global economic powerhouse.  
Update: Heritage Insurance

Update: Heritage Insurance

We released our first article on Heritage at $1.4 per share, currently, HRTG is at $3 per share.

What does the future look like for Heritage Insurance Holdings?

  From FIU News "Florida’s insurance rates have almost doubled in the past five years, yet insurance companies are still losing money for three main reasons. One is the rising hurricane risk. Hurricanes Matthew (2016), Irma (2017) and Michael (2018) were all destructive. But a lot of Florida’s hurricane damage is from water, which is covered by the National Flood Insurance Program, rather than by private property insurance. Another reason is that reinsurance pricing is going up – that’s insurance for insurance companies to help when claims spike. But the biggest single reason is the “assignment of benefits” problem, involving contractors after a storm. It’s partly fraud and partly taking advantage of loose regulation and court decisions that have affected insurance companies. It generally looks like this: Contractors will knock on doors and say they can get the homeowner a new roof. The cost of a new roof is maybe $20,000-$30,000. So, the contractor inspects the roof. Often, there isn’t really that much damage. The contractor promises to take care of everything if the homeowner assigns over their insurance benefit. The contractors can then claim whatever they want from the insurance company without needing the homeowner’s consent. If the insurance company determines the damage wasn’t actually covered, the contractor sues. So insurance companies are stuck either fighting the lawsuit or settling. Either way, it’s costly. Other lawsuits may involve homeowners who don’t have flood insurance. Only about 14% of Florida homeowners pay for flood insurance, which is mostly available through the federal National Flood Insurance Program. Some without flood insurance will file damage claims with their property insurance company, arguing that wind caused the problem. "

Florida Insurance Risks

  The first reason is just a risk shareholders must be comfortable accepting, because that is where the earnings come from. Premiums should naturally risk in tandem with risks. The Second reason is the private-reinsurance market. Increased prices making it more and more expensive for insurance companies to reinsure massive losses was eating into margins, and forcing insurance companies out of business. The new re-insurance fund will help Heritage, but not by much as reported in their latest quarterly earnings call transcript.   The third reason (abusive claims) is most favorable towards insurance companies in Florida. This has the potential to significantly reduce the number of claims paid to policyholders, thereby reducing loss ratios across the industry. The scope and magnitude of the abusive claims are uncertain, but it was enough to prompt HRTG's management to completely disinvest from certain areas in Florida. We are quite excited to see the impact this has on future loss ratios. We are still seeing some *Token insider buying by management. Interestingly enough, Raymond T. Hyer increased his exposure when Heritage dipped from $3 to $1.96. It is currently back at $3, but he was also buying at $3+ earlier last year (2022). We are unsure of Raymond's connection to Heritage, we only know that his company Futura Circuits Corp's headquarters is located 12min (drive) away from HRTG corporate office. We believe he knows the management, but we have no evidence.     We remain bullish thanks to the reform we have seen and due to further insider buying from Hyer. It will be interesting to see what the next year brings for Heritage. If they do NOT have abnormally bad weather we may see income that approximates market cap.
Jackson Financial

Jackson Financial

There are many ways to think about investing, whether it be a stock, bond, or some derivative. However, the decision to buy or not consists of two factors. The potential return (which is largely subjective) and the probability of the outcome (which is also largely subjective). I say these factors are subjective because, for example, you may find an excellent company with a market-dominating product, but that is not to say it will continue to perpetuate its dominance into the future. Your data can only take you so far in quantifying risks and rewards and after that it is your ability as an investor to weigh that data properly and come to a decision on whether to act, or not. This ability is curated after many years of looking at different companies, and how they performed. More research helps make these two factors less subjective, but everything cannot be known which is why investors rely on concepts like margin-of-safety and why investors need to diversify. The Great investor will try his or her best to understand the main risks and then weigh them against the potential reward. The harder it is to understand the risk, the greater the margin-of-safety (or reward) required. Jackson Financial is in the business of risk.  

Variable Annuities

  The variable annuity business comes with a lot of jargon. So I will keep this simple. A client buying a variable annuity will put down a lump sum with Jackson Financial. This lump sum is invested into funds of the clients choosing (Jackson offers the widest flexibility in its industry), and at some specified time in the future, the client can begin withdrawing from it. When the client starts withdrawing, they do so at a fixed percentage (let’s call it 5%) of the value of the account at the time of withdrawal. Jackson guarantees this 5% until they die. Jackson makes most of its money on the fees charged on the account value which can rise with the market, and the fee is based on the account value so as the market rises so do the fees. Jackson does not compete on price, they compete on having a wide and flexible range of offerings. Below is an example of what the cash flows look like for an annuity assuming 0% market returns. Jackson will make fixed fees on the value presented in the maroon bar below, as well as income on their investment portfolio. Their risks here, amongst others, are that actuarial assumptions regarding mortality rates are wrong. As the market rises, Jackson is able to pay out over a longer period of time (the coverage can extend past year 20). “Higher levels of equity market return can reduce or eliminate Jackson’s payments.”   Annuity  

History & Industry

  Jackson Financial is the largest seller of variable annuities in the United States, recently spun off from Prudential Financial. Yet the company is valued lower than all its competitors on almost every multiple, a phenomenon quite common amongst spinoffs. It survived the global financial crisis in 2008 without any assistance from Prudential (its Parent at the time), or the government and even gave cash back to Prudential the year after. The market is struggling to understand Jackson. The future of its business distribution in variable annuities looks bleak and how the company hedges its variable annuities is confusing because Jackson Financial says they use futures, options, and other derivative contracts custom-designed with big banks like JP Morgan Chase. When you delve into the world of derivatives, especially on such a large scale things can get very messy. In order to fully understand Jackson Financials’ hedging strategy you would need to work in the company and be involved in the modelling of their book, and the structuring of their derivative contracts.  

Distribution (sales channels)

  Jackson independent broker dealer   Jackson's biggest distribution channel is through independent broker-dealers (IBD), but IBDs are becoming smaller and more concentrated in number and the end client has moved more towards doing business with registered investment advisors. Registered investment advisors will move their clients toward ETFs because of their extremely low fees, think of your vanguard S&P ETF – it boasts an expense ratio of 0.03% or 30 basis points. When advisors look at Jacksons' annuities they see much higher expense ratios on the underlying funds - Jackson wants to slap on upwards of 60 basis points on a contract at the minimum (for the asset management). Products they have been creating for RIAs specifically are not selling, and it’s not just Jackson, its industry-wide. The RIAs are a massive growing distribution market, and the variable annuity industry isn’t positioned to get any of it. According to LIMRA (The life insurance marketing & Research Association) traditional variable annuities have been struggling in recent quarters. In the third quarter, traditional VA (variable annuity) sales fell 37% to $13.7 billion, the lowest quarterly results since the third quarter of 1995. YTD (year-to-date), traditional VA sales totalled $48.5 billion, down 25% from the same period in 2021. LIMRA projects traditional VA sales to fall more than 20% in 2022 and not recover to 2021 sales levels ($86.6 billion) for more than five years.” -LIMRA.  

Hedging

  Jackson has the widest range of variable annuity products. Clients can choose from an expansive range of underlying funds when they pick their variable annuity. What this means is that Jackson needs to hedge the underlying funds to protect the guaranteed minimum withdrawal. When you have a book (an investment portfolio) with so many different funds that need to be hedged it can get tricky because not every fund has the same characteristics. Jackson seems to have a replication strategy whereby they create a synthetic hedge on the underlying instrument using a combination of custom-made options. They have the blessing of being big enough to be able to get the best deals on their hedging, and they state that before they offer a specific fund on their variable annuity they will first make sure it's economical from a hedging perspective. Remember, Jackson does not lead on price they lead on their product range. Also, if an underlying’s characteristics begin to perform in such a way that they cannot hedge it economically, Jackson reserves the right to remove the underlying. The guarantee will still be there. Also, funds that begin to change to become uneconomical will most likely be the more exotic types- which will have the benefit of being a smaller part of Jacksons' overall book.  

Jackson Valuation

  adjusted earnings  

Adjusted earnings

  We normally like to tease management who use “adjusted” earnings because they add back all sorts of things to paint a prettier picture of the company, but in Jackson’s case (due to their hedging swings) their adjusted operating earnings is the number we can use to best understand their performance. Their “Adjusted Operating Earnings” which is an after-tax measure has been hanging around $2BN per year for the last 8 years. This is significant on their $3.8Bn market cap.   jackson comparison   Jackson is the cheapest in its peer group, and your first question is probably- why are all of these companies so cheap? I believe it’s due to two factors. The variable annuity businesses is losing market share to registered investment advisors who are more sensitive to expense ratios (fees on investments). And, the hedging strategy that Jackson uses is quite hard to understand, so analysts are very unsure of where the risk lies. We have no argument for or against the variable annuity business losing market share to RIAs. It is just a fact. Jackson has introduced new products, which are growing fast but have a long way to go to get to the point where they diversify Jackson’s revenues significantly. The other factor- the confusion around the hedging can be thought of a bit differently. It is one thing to understand a strategy, it is another thing to see it stress-tested. For example, would you rather drive a car with safety features you understand or would you rather see the car after the result of a major accident to see how it performed? I would see the car after the accident (or multiple). In Jackson’s case, it survived the global financial crisis without needing any capital from the government or its parent (Prudential) at the time because its hedging strategy worked. The global financial crisis had every combination of risks pushed to the max. And Jackson has also performed well in the many mini-crises we had since then. The biggest risk Jackson faces from a market-price perspective is if markets go nowhere for 10 years. Because then the fee base doesn’t increase and Jackson will miss all its targets. Pay-out policy Jackson’s pays out in the form of share buybacks and dividends with a 60-40% split, respectively. They pay out when their RBC (risk-based capital) increases above 400%. It is currently at 500-525% as per their latest presentation. Jackson payout history   This is a wonderful pay-out policy, because it means that even if the shares of Jackson do not appreciate, the dividend yield will get bigger and bigger until it forces the market to reprice the shares.   jackson return history  

Conclusion

Jackson is a very unique company. It is difficult to understand but has a compelling history. The variable annuity industry is going through changes and Jackson will have to adapt but revenue has not dropped off significantly except in the most recent quarter. Higher interest rates may help their business as people search for a more secure retirement income stream. The company is cheap on every multiple and compared to its peers. Its capital structure also offers a margin of safety from business risk. We are comfortable enough with the hedging risk due to the fact that the company has survived many adverse business conditions without requiring additional funding. And finally, we believe the company is undervalued.
Inflation in the 1970s

Inflation in the 1970s

The world seems to be breathing a sigh of relief as the United States’ abnormally high inflation is falling – and fast. But one thing we have begrudgingly learned over the past three years is that nothing is ever that easy. There was a time, forty years ago, when inflation peaked unprecedentedly and fell just as fast. Only to rise again, nearly 3% higher than its first peak.   1970's inflation   After an unprecedented rise of 6.2% between October 2020 and 2021, the United States reached an inflation level of 9.1% in June 2022. Inflation was the highest it had been since 2008. Thanks to intervention from the Federal Reserve, price shocks abating, and supply chains untangling, the inflation rate is now falling quickly, hitting 6.5% in December 2022.   inflation bar graph   Are we about to see inflation shoot up again? How did this happen in the 1970s? What looks the same and what looks different? (Besides smoking in offices – different - and ABBA at every party - the same). How did the Great Inflation happen? Some of the highest CPI peaks in the history of the United States occurred during the 1970s; a period we now call the ‘Great Inflation’. In 1974, yearly inflation peaked at 11.05%, then declined only to rise again to 13.55% in 1980. The American economy experienced stagflation – high unemployment, low growth and increasing debt while prices continued to skyrocket.   the great inflation   These were the causes of the first peak of 1974: -Supply shocks in the 1970s. Thanks to the OPEC cartel, the price of oil tripled overnight in 1973. This was at a time when the world was particularly fuel reliant. Along with oil, food prices rose 29% between 1973 and 1974. (Blinder, 1982) -Disharmony between the central bank and the government. Richard Nixon’s government pursued maximum employment as its foremost economic goal. This was at the cost of what was presumed to be moderately high inflation. The Philips curve, however, is not stable: ever-higher inflation is needed to maintain low unemployment. This left Nixon with both soaring prices and a hit to the job market. (Bryan, 2013) -Political pressure. Arthur Burns, the widely unpopular chairman of the Federal Reserve at the time, experienced significant political pressure from Nixon to keep interest rates low. And so, Burns kept interest rates low in a climate that was already inflationary. (Abrams, 2006)   Nixon inflation   Nixon’s politics exacerbated the inflation of the supply shocks. When these shocks were not repeated in later years, however, inflation could decelerate - hence the trough from 1974 to 1977.

Why then, the second peak?

The second peak followed (shockingly?) another round of price disruptions. Between 1977 and 1979 food prices rose by 22%. Political unrest in Iran had the consequence of yet another oil shock. The average cost per barrel of imported oil rose from $15 to $33 between December 1978 and March 1980. A third shock was to mortgage interest rates, which rose from 9% per annum in 1977 to 10% by the end of 1978. (Blinder, 1982)   opec cartel   How did the Federal Reserve bring inflation down? At first, they didn’t. In his paper, The Anguish of Central Banking (1979), Arthur Burns himself expressed skepticism at the power of central banks to control inflation. Thus, during the 1970s, US prices were largely at the mercy of supply shocks. This is not the case now – today, controlling the price level is what makes for a successful central bank. There were two attempts to bring down inflation before 1980 (Bryan, 2013): -Wage and price controls. Set by the Nixon administration between 1971 and 1974, these controls only temporarily slowed price hikes and ultimately worsened shortages. -Gerald Ford’s ‘Whip Inflation Now’ (WIN). After succeeding Nixon in 1974, Gerald Ford had no better luck with controlling inflation. A compelling name was just about as far as this program went. In short, WIN was a drive to encourage consumers to spend more sparingly.   whip inflation   To the Nixon administration, unemployment was a real evil. Inflation? An inconvenience. The public proved less willing to make this trade-off. By the mid-1970s, public confidence hit real lows: inflation was viewed as the primary cause of stagnation. And so, Ford and his successors made tackling inflation the country’s foremost priority. Paul Volcker, who took over as Chairman of the Federal Reserve Board in 1979, would serve this priority. Volcker acted as follows (Bryan, 2013): -He made bringing down inflation his primary concern. Volcker reframed bringing inflation down as serving the dual mandate, even if the process would temporarily increase unemployment. -The reserve growth rate was slowed, and interest rates were increased. Introducing greater control over the money reserve and growth had the successful, albeit slow, effect of bringing down inflation. This was complemented by credit controls and tighter regulation as a result of the 1980 Monetary Control Act.   volcker cigar   It took years for Volcker’s policy to produce real results. The US was hit with a recession in early 1980 and another from July 1981 to November 1982. Despite this, Volcker’s interest rates remained persistently high. Eventually, the Fed’s unwavering commitment to reducing inflation gained credibility. What followed was a decline in unemployment and an end to the recession. The Federal Reserve has committed to a stable inflation rate ever since, earning its status as a credible inflation fighter. (Bryan, 2013)   volcker killed inflation  

Is history repeating itself?

The accelerated rise in inflation to June 2022 and its similarly speedy drop has many drawing similarities between inflation today and the disaster of the 1970s. Will inflation shoot up again despite this recent decline?   powell   These are the circumstances giving economists déjà vu (Kose, Ohnsorge & Ha, 2022): -Supply shocks are to blame for modern-day inflation. As was the case in the 1970s, shocks to prices are driving inflation today. Overall price hikes, as a result of disruptions to production during COVID-19, are one contributor. Another is the Russia-Ukraine war and the resultant increase in the fuel price. -Monetary policy was extremely accommodative before the shocks. Interest rates were low to stimulate employment. This, too, was the case in the 1970s. The concern here is that it requires policy to be tightened quickly and drastically to combat inflation. This could lead to another recession – as was the case when Volcker acted in 1980.   neutral rate   There are, however, important differences between the way the Federal Reserve acts now and what was possible in the 1970s. For one, even Jerome Powell wouldn’t take out a cigar in front of Congress.   volcker with cigar   Here is what looks different (Kose, Ohnsorge & Ha, 2022): -The supply shocks are smaller. In real terms, present oil prices are only around two-thirds of what they were in the 1970s. -The second peak was a result of a repetition of shocks. With no further pandemic or invasion (fingers crossed), we will not see another dramatic rise in the CPI. -Monetary policy is not what it was in the 1970s. The Federal Reserve looks very, very different from what it did then. Since the 1980s, it has been credible in its commitment to keeping inflation low: it operates transparently and with justification. -The Fed learned lessons from the 1970s. Namely: solving the time inconsistency problem. Anchoring inflation at a target of 2%, as was done twenty years ago, fixes consumer expectations to 2%.   oil rig   The Federal Reserve acted swiftly, in keeping with its reputation, to lower inflation following a dramatic rise in CPI. Without further supply shocks, the world will not see another sudden peak. Even if the worst happens, the lessons learned from the Great Inflation have fundamentally changed the way the Fed operates. Keeping interest rates high will, as it did in the 1980s, come with short-term recessionary consequences.   fed fights inflation  

What's next?

With a keen eye on risks to price shocks, which could come from the Ukraine-Russia war or China reopening the outlook for inflation is not as clear cut as the market seems to believe. A combination of price shocks and the easing of financial conditions that we have seen in the Financial Conditions Index could lead to inflation that persists at a higher than 2% level. As the stock market rallies and financial conditions ease, the risk that inflation troughs or remains at a higher level increases. A trough in inflation would shock the Fed into real action.
Reitmans

Reitmans

Reitmans is a family-controlled business (via ownership of a controlling share class) that was founded by Herman and Sarah Reitman. The company was inherited by Stephan F Reitman who is currently the president and CEO. Most retailers were decimated by the pandemic, and Reitmans was no exception- the company entered into CCAA (Companies’ Creditors Arrangement Act), a form of Chapter 11 bankruptcy. However, the company emerged in better shape than ever with very preferential lease agreements and cash flow that almost approximates its market cap. Even before the pandemic retailers were losing market share to online businesses, and again, Reitmans was no exception; for 6 years prior to the pandemic, it only generated an average operating income of $4.5 million CAD. A significant amount of cash flow was unlocked when consumers moved to e-commerce during the pandemic. Reitmans, for the first time, started disclosing e-commerce sales, which in Q2 of 2022 were at 25% of total sales and moved up to 26% in Q3. E-commerce is a much higher-margin business and it seems that these excess cash flows are sustainable. According to my calculations, 80% of the new excess cash flow is coming from Reitmans' e-commerce business, with 20% coming from the preferential lease agreements. Cash is building up on the balance sheet, and with no debt and no reinvestment happening in the company, shareholders have a high chance of getting paid out. Before we look into Reitmans let's compare it quickly with a competitor: Roots Corp. Although not a perfect comparison the discrepancy in value between Roots Corp and Reitmans is more than significant. Roots Corp sells Apparel, leather goods, and some furnishings. It has 1/4th as many stores as Reitmans, a similar revenue per store, but a market cap that is almost the same as Reitmans?   Reitmans Roots Corp comparison   It is worth noting too, that Reitmans is currently trading at half of its book value. The discrepancy in value here is large enough to drop jaws. This image itself screams buy, including or excluding the comparison to Roots Corp. In 2022, for the 39 weeks that ended October 29, 2022- Reitmans had a free cash flow (excluding changes in working capital) of $84 million, or 60% of its current market capitalization. One needs to wonder- prior to COVID this company was doing $4.5 million on average in operating income. How now do we get $84 million in 9 months?  

E-Commerce

The shift to E-Commerce during COVID played a significant role. Management disclosing e-commerce sales as a % of revenue for the first time is a clear sign of this. Revenue per store increased from $1.2 million to $1.6 million when you include sales from e-commerce. My calculations indicate that revenue per store has not actually increased and that the excess revenue is coming straight from e-commerce. Selling, general, and admin expenses per store have remained the same. So the value has been unlocked here. I calculate that their e-commerce business has an operating margin of close to 30% while their retail stores are more like breakeven. In Q2 of 2022 management disclosed, for the first time, that 25% of total sales were coming through e-commerce. Q3 of 2022 (or 2023 financial year reporting) shows that total sales from e-commerce moved to 26%. The shift to e-commerce created by COVID seems sustainable. I sent the CFO a query regarding the lease agreements and was told that I was not missing anything. Which is short for “we didn’t disclose the information you actually wanted”. The information I want is: how long will these preferential lease payments last? The financial statements and the management discussions say nothing regarding how long these preferential agreements will be in place, only that they benefited the quarter's results.   Reitmans free cash flow to lease payments     Revenue financials

Risks?

  1- The share classes keep the Reitmans in control of what happens to the free cash flow. Will they be kind to shareholders? 2- The most predicted recession ever is looming. 3- Retailers have been struggling for years. 4- How long do these preferential lease payments last?  
On recommendation of HG-Research, Heiden Grimaud Asset Management has not yet taken a position in Reitmans and may or may not do so at anytime in the future, however;

None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product, or financial instrument, to make any investment, or to participate in any particular trading strategy. The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Heiden Grimaud Asset Management. Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding the accuracy or completeness of any information or analysis supplied. The authors and HG-Research are not responsible for any loss arising from any investment based on any perceived recommendation, forecast, or any other information contained here. The contents of these publications should not be construed as an express or implied promise, guarantee, or implication that readers will profit or that losses in connection therewith can or will be limited, from reliance on any information set out here

Rethink The Atom

Rethink The Atom

For many, the word ‘nuclear’ conjures up grim ideas of radiation, mushroom clouds and war. Scientific developments have these sentiments changing rapidly to abundance, sustainability and peace. Nuclear is more reliable than any other energy source. It is also among the safest and most environmentally friendly of them all. Despite this, the world is moving towards reactors at a maddeningly slow pace. These are the concerns hampering public support for nuclear energy:
  • The fear of nuclear power. The same reaction that is currently used to generate energy in a nuclear reactor can be used to make a nuclear bomb. The majority of the public does not separate feelings about nuclear energy from the devastation of the bomb.
  • The possibility of a reactor meltdown. HBO’s wildly popular series, Chernobyl (2019), is just one way in which high-profile nuclear accidents have continued to weigh on the minds of the public. This is despite the thoroughly regulated safety standards that have been introduced following tragedies such as Chernobyl in 1986.
  Death rates per unit of electricity production   Nuclear energy is, in fact, second only to solar as the safest of all energy sources (factoring in Chernobyl, Fukushima and every other nuclear disaster). • The issue of nuclear waste storage. Radioactive waste is generated when nuclear energy is produced in reactors. There is, at present, no ideal long-term solution for the safe disposal of this waste.  

Enter nuclear fusion

  A nuclear breakthrough has the world once again engaging in the clean energy debate. It may be the key to destigmatising nuclear energy and reaping its benefits. In December 2022 a nuclear fusion reaction resulted in a net energy gain. Since the 1950s scientists have been trying to fuse atomic nuclei with a release of energy larger than the input energy requirement. This dream is now a reality.     What we know to be nuclear energy comes from nuclear fission, not fusion, process. Within nuclear reactors, a heavy nucleus is split to release energy. It is nuclear fission that releases radioactive particles and it is the nuclear fission process that can be used to make weapons.   fusion   Nuclear fusion delivers four times as much energy as nuclear fission and releases almost no radioactive particles. The fusion reaction also cannot be used to make nuclear weapons. It is the key to abundant clean energy. Although this step is encouraging, the world is still far from being powered by a functioning fusion reactor. Until then, we have fission. What does nuclear energy, as it currently exists, have to offer? Are countries earnestly moving towards clean energy? And is it time to rethink the atom?  

Comparing Energy Return On Investments (we are not in Texas in 1901)

  Accessing oil today is not what it was one hundred and twenty years ago. We’ve all seen the cartoons: a man in a cowboy hat steps a little too firmly in a Texan canyon and is rewarded with a towering spout of black gold. Soon there are pipes, spades and drills, with every American scrambling to get their share. Until, of course, the evil oil company steps in. Suited businessmen wearing sunglasses lead in trucks mounted with drilling rigs. The cowboys and their tools are swept away by bulldozers. Big Oil is born.   Little texan oil man   The initial success of these companies seems obvious: they were better equipped to extract the oil. Using their tools and the benefits of their size, they could access more of the energy source at a lower cost. But these rigs have been drilling for more than one hundred years. Oil is non-renewable – a reserve can run out. When this happens, either new machinery is needed to go deeper or new reserves need to be found. Both options require more energy and a larger investment.   oil rigs   We can relate the amount of energy produced by a source to the energy it takes to harvest the source with Energy Return On Investment (EROI). EROI puts energy in real terms. It considers what we really care about when we compare oil to solar to nuclear. The fall of the cowboys to the suits and the suits to Mother Nature comes down to just this. The oil rig could extract oil with less effort – energy - per unit than a Texan with a spade could ever hope to do. However, fifty years after this nearly all discovered shallow reserves had been depleted. Seventy or so years after that? More input energy than ever is required to discover shallow reserves or extract from deep under the ground. The Sustainability Research Institute of the University of Leeds calculated the EROIs of fossil fuels oil, coal and gas in their finished fuel stage. The results were a 23% decline in EROI over a period of 16 years. We are using up limited resources and it is taking increasingly more energy to access them.   EROIs for Major Energy Sources   Almost every facet of modern society relies on energy generation. The decline in the EROIs of fossil fuels leaves renewable energy as the only viable way to maintain life as we know it. There is a clear winner among these green sources. In fact, among all major energy sources. This is nuclear energy, coming in hot with an EROI of 75. How does nuclear energy compare to other green sources? Not only does nuclear energy have a higher EROI than other renewable sources, it is also more reliable. For an energy source to be reliable means that it can provide energy in the exact quantity that is needed at the exact time it is needed. Picture this: a fierce blizzard hits the city. In every house, families are shutting their doors, grabbing their blankets, and turning on their internal heating. Why, then, do their houses remain cold? Because snow is falling on the municipality's power source.   Solar panel covered in snow   Hydro, solar and wind power need their sources to be guaranteed in order to be reliable. There is no guarantee when it comes to weather or water, especially in light of climate change. Evidence of this can be seen in the United Kingdom and Germany right now, where a so-called ‘wind drought’ is exposing the dangers of overconfidence in the turbines. This drought pulled the share of the UK’s electricity provided by wind down to 3.4% from its previous 28%.   UK wind drought   The reliability of energy sources are measured by capacity factors: how much energy a plant produces compared to the maximum amount it can produce. Wind and solar sources have low capacity factors. Bureaucrats prefer fossil fuels because they have higher capacity factors. This makes them more reliable sources of energy.   Capacity Factor of energy   Fossil fuels are, however, not as reliable as nuclear energy. Nuclear energy has a capacity factor of 92.5%. This means that nuclear is not only the most reliable green source: it is the most reliable source of all.  

How serious are countries about green energy?

  Nuclear energy is clean, environmentally friendly, and reliable. But it is also expensive. Going nuclear means a steep initial capital cost. Solar and wind energy are the cheapest sources, but they are not reliable. This leaves fossil fuel options like coal: affordable, reliable but greenhouse gas machines.     According to Climate Council (2022) there are some countries acquiring huge portions of their electricity from renewable sources: Scotland is at 97% and Costa Rica, Norway and Uruguay are at 98%. Yet two of the countries that can best afford turning to renewable sources – the United States and China – are considered the top two greenhouse gas emitters.   total greenhouse gas emissions   Despite its undesirable status as a leading polluter, the United States, alongside the United Kingdom and the European Union, are granting developing countries aid to transition to renewable energy. Yes, you read that right. They are asking countries with instability, humanitarian disasters and water sanitation problems to start using paper straws. One year after $8.5 billion was granted to South Africa for this very purpose, the United Kingdom opened a brand new coal plant. An ancient, heavy duty polluter that could make you choke up coughing at the sight of it. This was done with less than 15 years to go before the country’s commitment to be free from fossil fuels.   UK approves coal mine   If this knowledge makes your stomach churn, you can sleep a little more soundly knowing that the United Kingdom is in an energy crisis of their own. This problem is centred around gas – the fossil fuel that accounts for more than 50% of the country’s electricity supply. The United Kingdom’s energy crisis and energy in Europe When the world began to recover from the Covid-19 pandemic, the global demand for gas did too. Demand for gas has shot up and gas prices have followed. Despite relying heavily on gas, the United Kingdom has few capabilities for storing it. This makes it uniquely exposed to price fluctuations. This, combined with an effective wind drought, seems to have left the United Kingdom desperate enough to relive the glorious, coal-powered Industrial Revolution.   Gas pipelines   The gas price problem was made even worse for Europe when Russia invaded Ukraine. In recent years, Europe has become dependent on Russia as a provider of oil and gas. The economic sanctions and uncertainty of the war has left the continent’s energy supply vulnerable. According to BBC, since the onset of the war Russia has decreased its supplies of gas to Europe by 88%.  

Embracing the atom

  Relying on fossil fuel providers has given rise to an energy crisis in Europe. It should follow, then, that it is now an excellent time to turn to alternatives – alternatives like nuclear energy. This is not what is happening. In the midst of the European energy crisis, Belgium has decommissioned a nuclear plant in perfect working condition. This is in response to a public anti-nuclear movement insisting nuclear power is unsafe. Except, of course, the numbers say it isn’t.     A nuclear reactor is expensive to build and maintain. In the wrong hands, the fission reaction can be deadly. Until we have fusion reactors, there is also the problem of the long-term disposal of radioactive waste. Is this enough to warrant the public rejection of reactors as an option? Nuclear energy provides clean, safe and reliable energy. It may be time to rethink the way we view the atom.
South Africa turns grey as FATF threatens to put them on the naughty list

South Africa turns grey as FATF threatens to put them on the naughty list

As of October 2021, South Africa is at risk of being placed on the grey list by the Financial Action Task Force (FATF). This news has inspired a fearful uncertainty as to the fate of our financial sector. And that of our retirement plans. What would being grey-listed mean for South Africa? Is there a way for South Africans to soften the blow? And what possible connection could exist between the FATF and a JoJo water tank? Grey Listing In the 1970s rolling blackouts hit the United Kingdom. This brought the country to a near standstill. Hair was cut in the streets, university students were repurposed as firewood choppers and the government implemented a three-day workweek. Nothing close to this has been seen since. Except, of course, in South Africa. Daily. The only difference? Our hair salons run smoothly, our students are studying, and the 9-5 remains fully operational. One cannot mistake the resilience of the solar panel-bearing, electricity generator-wielding South African people. What of when the drought was announced in the Eastern Cape? Well, then we took up JoJo tanks, wells and, borehole water as naturally as irrigation specialists. The challenges that plague our country may be severe, but we continue to tackle each one ingeniously. South Africans are tough as nails.   south african solar panel  

Who is the FATF, and what does it mean to be grey-listed?

  The FATF is a formidable body: the international watchdog on financial crimes. When this watchdog barks, you listen. Unless you’re a money launderer, then you run. Grey-listing means singling out a country for having poor protective measures against financial crimes. The grey-listed country is put under restrictions and closely monitored. As a watchdog, the FATF has sharp teeth. A country on the grey list is labelled a risky nation: its financial institutions are not entirely trustworthy.

How does this affect the average South African?

  The effects will not be "felt" immediately by the average South African. There will be no FATF dog barking at your gate or gnawing at your shoe. It is more akin to a restaurant losing its food and safety rating - nobody wants to eat at a restaurant that has cockroaches in the kitchen! Grey-listing plummets South Africa's credit ratings, discourages foreign investment and ultimately stifles GDP growth. South African consumers will be directly affected by decreased employment, unfavourable exchange rates, and possibly higher inflation. In 2021 the FATF began firmly biting at the heels of the South African financial system. If appropriate rectifications are not made, South Africa will be grey-listed by February 2023. The grey list cloud began gathering over South Africa when it fell into the clutches of state capture. State capture is right up there with load-shedding as a word we wish we didn’t need to know. When not used as a curse word, it is a form of corruption in which the private interests of individuals infiltrate the government. This means bribery. It also means money laundering: concealing the origins of money generated from criminal activity. These are financial crimes (queue barking noises). In its October 2021 report, the FATF argued that South Africa is not doing enough to proactively bring the state capturers to justice.  

What does the FATF require?

  The FATF listed 12 priority actions that were suggested to address this issue. These actions require a substantial, coordinated, and government-wide effort to implement. By October 2022, only 2 of the 12 priority actions had been satisfactorily implemented. The remaining actions are still being targeted. However, there are three other notable actions on which no notable progress has been made.

The failure to fix our ‘big three’:

1. Transactions across the borders

2. The Hawks

3. The private sector

is likely to be the nail in the coffin.

  Commission of inquiry  

Are the important "Priorities" being addressed?

  The borders. The first entirely unmet priority action is the required improvement in the effective detection of illegal transactions made across South African borders. Enhanced cash declaration systems have been proposed, but cash thresholds are yet to be set. Even if they were set, the national rollout of this would take time: something we no longer have. The Hawks. Another failure is in the capability of the Hawks. The Hawks were created to deal with serious crime. They are the police of the state capturers. A natural assumption, then, if state capturers are still running around, is that the Hawks are not equipped to do their job. The Hawks have shown a failure to successfully investigate and construct financial crime cases. Building a capacity to do this and demonstrating its success to the FATF, once again, will take time. The private sector: Finally, the FATF requires the scope of supervised business to be broadened to more non-financial businesses, such as gambling institutions. These businesses will be forced to comply with South Africa’s Financial Intelligence Centre (FIC) regulations. This is another priority action on which no notable progress has been made - it is expected to take two to three years before supervision will be effective. South Africa’s fundamental problem is in the capacity and capability of its financial policing institutions. These organisations are short-staffed and overburdened. Without well-functioning institutions, it will be nearly impossible to achieve the 12 priority actions. To capacitate these institutions, we need time and resources. We currently have neither. This is why it is extremely likely that South Africa will be grey-listed in February 2023. If this news makes you want to climb into your JoJo tank and cover it with your solar panel so that you can float far, far away across the Atlantic Ocean – no judgement, we’ve all been there.    

How do you prepare for this?

  There is, however, a way South Africans are mitigating this, sort of like an electricity generator for grey-listing. Importantly, this alternative is not to stop investing altogether. Cashing the entirety of your wealth to store in your couch, although tempting, is not the solution. If our exchange rate decreases, imports will become more expensive and prices will rise. The money in your couch will not grow with inflation and you will be less wealthy. Instead, the smart alternative is offshoring investment: investing money outside of one’s home country. Choosing countries that do not face the same economic uncertainties significantly reduces your investment risk. South Africans can take R11 000 000 out of the country annually (by applying for a foreign investment allowance), and it is easier than ever to do so. Just like solar panels have allowed independence from the Eskom schedule and JoJo tanks from the municipality dams, investing offshore is providing independence from SABC News. Giving a serious incentive for the government to end the misuse of its funds is beneficial for us all.  South Africans are, however, showing that even this challenge is not insurmountable. We face clouds every day – all while maintaining our hair, educating our students, and working five days a week.
Heritage Insurance Holdings

Heritage Insurance Holdings

Heritage Insurance holdings has a potential 450% upside. Insurers use probabilities to price insurance policies. Investors use probabilities to value companies. Meteorologists use probabilities to try and forecast the weather. In an unlikely event such as this one, we meet with probabilities from all 3 of those areas, insurance, investing, and meteorology. Heritage Insurance Holdings is a Florida-based insurance company that mainly insurers catastrophic and weather-related losses caused by hurricanes. The stock (HRTG) traded at above $10 per share for most of 2020, and only at an average of 7% below its book value until the probabilities started lining up in the wrong way. During 2021 and 2022 the company saw an increase in losses stemming from “weather losses” that were much higher than the years prior. Then, in November 2022, Hurricane Ian made landfall and caused the second-highest insured loss ever recorded after Hurricane Katrina. And to put the cherry on top, the stock was punted from multiple Russel indices which added renewed selling pressure. The costliest Hurricanes to insurers Now trading at around $1.4 per share and with an adjusted book value of $6.65, it is hard not to think of the company as a small nugget of gold, hidden amongst the rubble left from a major Hurricane. However, it seems that we are not the only investors greedily eyeing the company- in May 2022, Raymond T. Hyer bought up more than 6% of the outstanding shares at above $3 per share. He recently dipped in again, increasing his holdings at a price of $1.3 and $1.4 per share, and now owns 12% of the company. We are unsure of his connection to Heritage Insurance Holdings and its management but we do know that his company- Futura circuits, is only a quick 20-minute drive away from Heritage Insurance’s office. He probably knows someone who knows something.
Heritage Insurance Holdings location

The distance from Futura Circuits Corp (owned by Raymond) to Heritage Insurance in Florida.

The founding of Heritage Insurance Holdings

On March 14, 2010, the Florida Council of 100 published a paper titled “Into the Storm: Framing Florida’s Looming Property Insurance Crisis”. The quote below, which is found on the second page of the paper neatly summed up Florida’s property insurance problem. Heritage Insurance Florida property insurance The state-run non-profit Citizens Property Insurance Corporation (CPIC) became Florida’s biggest residential property insurer. But they were charging “rates that are not actuarially sound”, leading to a massive potential shortfall that they, or their reinsurers, were unable to cover should Florida be hit by a major hurricane. To address this issue, in 2009, the Legislature started passing measures to come to a more economical solution. Two important changes were made; Citizens started offloading policies into the private sector so that well-capitalized private insurance companies were able to assume the risk. And, private insurance companies were allowed to charge higher rates than previously allowed by regulation. Heritage Insurance Holdings was one of the companies that benefitted from the new legislation. In 2012 Heritage Insurance Holdings was founded, and offered a $52 million incentive to assume policies from Citizens. The incentive was criticized by state leaders because in 2013 Heritage made a $110,000 donation to the re-election campaign of Governor Scott. Alex Sink, who chairs the board of Florida Next Foundation, claimed that the deal was too good to be fair and allowed Heritage to “cherry-pick” policies from Citizens while not assuming the full risk of the policies. Since its founding, Heritage Insurance Holdings was doing well and generating a handsome profit off of these cherry-picked policies from Citizens. They survived Hurricane Irma in 2017 by increasing their retention before the storm, and have recently survived Hurricane Ian, and Nicole which made landfall in November. The company started diversifying into different states to better its risk profile, but it still makes the majority of its income from those Citizen's offloaded policies. What does it look like as an investment?

An investment perspective

Heritage insurance holdings (HRTG) would be termed an “asymmetric bet” in the investment industry because its upside is far greater than its downside. The cost to play this bet is the current share price of $1.40. The maximum loss is likewise, $1.40 per share or 100%. But if the stock were to trade at its book value (which it historically has traded at) it puts the upside of the bet at more than 450%. Put down $1.40 and stand the chance to make around $6.00. But, what are the odds? What are the chances that we will make $6.00? This is what makes investing fun, at its most fundamental level, it is a game of probability. There are a few reasons we think the odds are in Heritage Insurance Holdings' favor so that the stock will realize the upside, at least in the short term. The first reason is that the Hurricane season is over. Hurricane season Hurricane season typically starts in August and ends in November. This gives Heritage Insurance some time to raise premiums which they have already started doing, and to earn on those premiums- further increasing book value per share above $6. The second reason is that management understands how to unlock intrinsic value through share repurchases. The most tax-efficient way to return money to shareholders is through share buybacks and Heritage Insurance has a history of repurchasing shares when the stock traded below its book value. Buybacks made below book value compound the advantages as they are essentially an investment into a company management know better than any other, at very low prices to intrinsic value. Currently, the stock has never traded so far below its book value. The company still has the capacity to repurchase $18.3 million worth of common shares before December 2022 or around 50% of shares outstanding. The third reason is that management has been investing and moving the business outside of Florida. In 2020, and 2021 the company saw above-average weather losses in Florida. Management has been actively moving risk to different areas.

The risks

What are the odds we realize the $1.4 loss? The probability that South Florida will be hit by a major hurricane in a single year is 6.25%. The image below shows the return periods for major hurricanes. A return period of 20 means that during the previous 100 years a major hurricane passed within 50 nautical miles of that location 5 times. Hurricane probability Hurricane Ian made landfall recently on the 24th of September, 2022, and caused an estimated $40 million net retained loss on Heritage’s books. The biggest risk Heritage faces now is that another Hurricane makes landfall, it would most likely wipe out their equity. The chances that HRTG goes to 0 are higher than 6.25% because even consecutive weather losses in 2023 could cause enough damage to wipe out Heritage, and they would not be categorized as a major hurricane and would not fall into Catastrophic risk, which would reduce reinsurance retention. However, the odds are still in favor of this not happening. We believe that this investment ultimately carries a great risk-reward ratio. The upside is enormous, and the company is coming out of Hurricane season with raised premiums.
On recommendation of HG-Research, Heiden Grimaud Asset Management recently bought exposure to HRTG on the 20th October and 15th of November at $1.45 and $1.43 per share respectively. At the 15th November, the position made up 5% of the Fund’s portfolio, however;

None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product, or financial instrument, to make any investment, or to participate in any particular trading strategy.

The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Heiden Grimaud Asset Management.

Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding the accuracy or completeness of any information or analysis supplied.

The authors and HG-Research are not responsible for any loss arising from any investment based on any perceived recommendation, forecast, or any other information contained here. The contents of these publications should not be construed as an express or implied promise, guarantee, or implication that readers will profit or that losses in connection therewith can or will be limited, from reliance on any information set out here

Warner Brothers Discovery

Warner Brothers Discovery

The boy whose story spread across continents, cultures, and languages. A story that sold more than 120 million copies worldwide, and inspired the imagination of children and adults across the world. Harry Potter gripped the hearts of millions, and not by magic, but by selling the fight of good versus evil, love versus hate, and bravery versus fear. The story of the boy who lived will live on forever in time. A great story is an asset to behold. We are not sure if there is a fight for good and evil in the Warner Brothers Discovery story. But there is surely a fight. A fight that will turn into a war over which entertainment platforms will dominate eyeballs for years to come. Let us now embark on the tale of Warner Brothers Discovery’s history and the industry it competes in so we may hope to glean something valuable when we attempt to peer into its future.

A short history of content and distribution

As technology changes, so does the battlefield: historically, consumers gorged their eyeballs on cable TV. Cable companies, like AT&T or Comcast, often own their own cable TV services and bundle up different TV networks to sell to consumers. They either pay the TV networks for programming rights or they own the TV networks. TV networks (Turner, CNN, ABC, Universal Kids) generally have a mixture of their own content, and acquire rights from production companies like HBO, Disney, Fox, to use their content. The streaming platforms changed the game quite a bit. The industry labels it as DTC (direct-to-consumer). There is no need for a streaming platform to go through a cable TV service provider to offer content to its viewers. Cable TV is dying.

Below is the share of respondents who subscribe to a cable TV service in the United States.

Kids today will probably never understand television. They won’t understand why anyone paid for a product where you had to flicker through channels looking for something to watch. Households in the future will all have a smart TV with 3-4 of the best streaming platforms. Netflix, Disney, HBO Max, and probably Prime Video from Amazon. The others will die out and their content will be acquired by the big 4. Then the big 4 will start raising prices. This wonderful infographic below from Reviews.org leads us to the next part of the battlefield we need to understand. The hours displayed are not completely accurate, but they are in the right ballpark. Who are the current players? Netflix, Prime Video, Disney, and HBO Max are the obvious top competitors. How do they compare to each other and what do they offer the consumer? Before we ignore this sentence to look at the pretty picture below, we need to understand something: below are the hours of streaming content offered not owned by the platform’s owners. Warner Brothers Discovery, which owns HBO Max, actually owns over 200,000 hours (we added these numbers in the image below for effect) of content – did your eyes bulge when you read “200,000 hours”? If not, why not! It’s not certain whether Warner Brothers Discovery will offer all 200,000 hours of content in its new platform, but more on that later. Netflix has been aggressive in producing its own content as well as paying for licensing rights from other producers. Amazon recently acquired MGM studios in an effort to bolster its owned content, but that is a small step on a long road compared to how many hours competitors own. Disney only offers a few hours of content, but of very high quality. Warner Brother Discovery leads in quantity. Quality over quantity? Let’s look at a comparison of the different content the platforms offer. Warner Brothers Discovery with its larger-than-life library also owns quality, quality brands. Harry Potter, Game of Thrones, DC (Batman and Superman), The Lord of The Rings (licensed out to Amazon). It has a diverse range of content. We now have a good strategic overview of the battlefield and an understanding of who the dangerous players are as well as what they offer so, it’s time to take a closer look at Warner Brothers Discovery (WBD).

Warner Brothers Discovery

Warner Media and Discovery Inc have merged to create a content behemoth; Warner Brothers Discovery. The new platform with content from Warner Media and Discovery is set to launch in 2023. The two goliaths combined own an incredible amount of content as seen below. WBD with 200,000 hours of content. Netflix has 36,000 hours. Since the end of 2006, David Zaslav has been at the helm of Discovery Inc. He steered the company towards becoming more content-focused but was late in the race to stream the content. Discovery+, Discovery’s own streaming platform, launched in 2021 compared to Netflix’s launch in 2007. Owning all their own intellectual property, Discovery Inc. was making around $3.4 billion in operating cash flow, adjusting for amortization on the cost of their content and using it as a proxy for future content spend, Discovery was making a free cash flow of around $2 billion per year. Before the merger with Warner Media, Discovery traded at around a $14 billion market capitalization, or at a free cash flow yield of close to 15%. If the numbers are confusing, just know this- Discovery Inc was profitable and had a decent cash flow.

David on the left, John on the right.

Discovery Inc. run by David Zaslav was a well-run, profitable company and David Zaslav is a CEO with extensive experience in the media business. Now at 62 years of age, the man is in his business prime and has a close relationship with John Malone. John Malone owned a controlling interest in Discovery Inc. before the merger and he was a media tycoon in his prime and still owns interests and sits on the board of many well-established media companies like Lions Gate Entertainment Corp and Charter Communications. John Malone now owns a substantial amount of Warner Brothers Discovery (WBD) and offers a bridge into future partnerships for the new company. Now, let’s look at how WarnerMedia, and more specifically HBO, fit into the picture. WarnerMedia launched its own online service called HBO Go in 2010. The service differed from a conventional streaming platform as we know it because users needed to be subscribed to the cable service to gain access to the online platform. In this regard, WarnerMedia was also late to the streaming game and had a lot less content to offer. HBO Max was only launched in May of 2020 and is still not available in most parts of the world but it already boasts 77 million subscribers. It should be quite apparent to everyone where this is headed - a single streaming platform with all their respective content combined. David Zaslav spoke to this in the second quarter earnings call of 2021, just after the merger went through. He spoke of offering a single combined platform, with paid, advertising, and ad-lite subscription options that Netflix also just adopted in their most recent earnings call and that led to a 20% bump in their share price. A business model that works well. So, as an end result, we will have a streaming platform with premium content from Warner Media, laid-back viewing content from Discovery +, and a mixture of other content suitable for all viewers.

The investment perspective

The plan for Warner Brother’s discovery is a simple one; one streaming platform. The road there? Laden with debt, and a messy, restructuring. We are extremely confident that the streaming platform will be a success due to the reasons we spoke of above, so that leaves us with 2 main areas we need to focus on; the debt, and the restructuring. As per its most recent filing, Discovery has $50 billion of fixed-rate debt and a negligible amount of floating-rate debt. The debt in isolation is meaningless, what matters most is the company’s ability to repay it. We focus on what Warner Media and Discovery Inc. were generating before the merger because we do not have enough financial data post-merger. Below we can see the operating income of the respective companies before they merged. Operating income of above $8 billion combined. This puts Warner Brothers Discovery at a net leverage ratio of 5 times (Net debt divided by the last twelve months of EBITDA). A leverage ratio of 5 is quite high. Fortunately for investors, David Zaslav is about as ruthless as Edward Lewis from “Pretty Woman”, and has been sawing the fat off of the new company with a chainsaw. He has been canceling new and old productions that were not financially viable in an effort to focus on paying down the debt faster. Here it is straight from the horse’s mouth: “If a repeat of Two and a Half Men or BIGBANG does three times the reading of a brand-new show that was spending another season that we greenlit of a show that's costing us seven and a half million dollars. We're going to cancel that show.” Q3- Earnings Call. With all hands-on debt, we are quite certain they will be able to reduce the burden via cost cuts, selling content, and increasing revenue generated from the existing HBO Max streaming platform. It will become clearer after at least one year of restructuring. A last side note on the debt: with increasing interest rates across the world, the market value of Warner Brothers Discovery’s debt has decreased which makes it cheaper for them to pay off the debt. Netflix’s market cap is much larger than Warner Brothers Discovery’s, so much so that we believe Warner Brothers Discovery to be quite undervalued. Due to the large amount of debt WBD has post-merger, a better way to compare it to Netflix is using Enterprise Value. The enterprise value of a company is what you would pay if you wanted to acquire the entire company to take control of its assets – so, you need to pay off its debtors first then buy its assets. Enterprise value is calculated as Market Cap + market value of debt – cash. The difference between the market caps of the company is so large in part due to the difference in their capital structure - Warner Brother’s Discovery has a large amount of debt from the merger, while Netflix’s debt is insignificant. Enterprise value alone tells us nothing. It must be compared to something, and that ‘something’ is operating income or EBITDA. Warner Brothers Discovery (before the messy restricting/merger) has a higher operating income than Netflix but does have a different business model. We must compare the operating income to the Enterprise value. Below we look at Enterprise Value divided by operating income (EBITDA). The lower the multiple, the ‘cheaper’ the company. Think of it like this; an acquirer buys the company for the enterprise value amount and then uses its operating income to pay off the purchase. The lower the number the sooner the acquirer can pay it off. Comparing market capitalizations of the two companies doesn’t work when one is so loaded with debt, but when we use EV/EBITDA multiple, Warner Brothers Discovery is revealed to be valued much lower relative to its earning power than Netflix. It seems that the market is very unsure that Warner Bros. Discovery will be successful in paying off its debt and launching a popular new platform leading to it being valued much lower than Netflix. We are strongly convinced that David Zaslav is the right man for the job, his actions have proven that. The company has a strong cash flow to pay off the debt and the launch of the new platform will create a tailwind for the debt to be paid down faster. After all the uncertainty the market will be forced to reprice the company, and the company will be able to use its vast range of assets to launch exclusive content on its platform. We expect the company to be valued more fairly after this uncertainty has passed, possibly in 3 years or longer. We will end with a quote from David Zaslav in the most recent earnings call, his voice full of passion: “As we said last quarter, our focus is on delivering $1 billion of EBITDA in streaming by 2025. And we expect to make significant progress toward this goal next year. Profitability, not purely sub-count is our benchmark for success. While we've got lots more work to do, and some difficult decisions still ahead, we have total conviction in the opportunity before us. Warner Bros. Discovery, we've got the best assets in the industry, a reach that extends from premium, basic pay-TV and free-to-air to theatrical streaming, consumer products, and gaming, exceptionally talented people across this great company, and the right strategy and financial framework to set us up for long-term success.”
Heiden Grimaud Asset Management initiated exposure to WBD before the Discovery Inc. and Warner Media Merger. At the time of this writing, WBD has a 5% weighting the the Fund's portfolio.

Heiden Grimaud Asset Management holds shares in Warner Bros. Discovery, however;

None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product, or financial instrument, to make any investment, or to participate in any particular trading strategy.

The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Heiden Grimaud Asset Management.

Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding the accuracy or completeness of any information or analysis supplied.

The authors and HG-Research are not responsible for any loss arising from any investment based on any perceived recommendation, forecast, or any other information contained here. The contents of these publications should not be construed as an express or implied promise, guarantee, or implication that readers will profit or that losses in connection therewith can or will be limited, from reliance on any information set out here.

An opportunity made in China

An opportunity made in China

After the Global Financial Crisis in 2008, the financial catastrophe that almost brought the world’s financial system to kneel, it was surprising that only one poor sole in the private sector was held accountable. Wall Street Bankers who were instrumental to the problem, whose ignorance and greed had devastating consequences on the working class, got off with bonuses and bailouts. In the aftermath, it may have at least consoled the common American citizen to see a headline like below which refers to the founder of the Evergrande Group in China. China index trade Unfortunately, the United States government found only one banker guilty – Kareem Serageldin from Credit Suisse, who in the judge's own words was, “a small piece of an overall evil climate within the bank and within many other banks”. In China’s own housing market crisis, things have played out very differently and executives have been held fiercely accountable. In China, it is extremely important to own a house. It is of cultural importance, and it is important to status. During China’s economic reform, led by Deng Xiaoping, Chinese citizens amassed a large amount of wealth. A large portion of this wealth was invested in property. Demand for property in China was torrential. Growing household balance sheets and a growing population meant that property developers couldn’t keep up. Housing prices rose at break-neck speeds only to take a slight breather in 2008 before continuing. Those who did not own a house wanted one, and those who did wanted another one, the demand was so strong that the government restricted households from owning more than a certain number of houses which even led to couples divorcing to bypass the law, and to buy another property. “Investing” to the average Chinese citizen, means buying a house. As speculation, real estate in China ticked all the boxes. To quench the thirst for housing, Chinese property development groups like Evergrande bought land from local governments, built high-rises, sold them off to investors, and plowed the money back into more land. It worked well until it didn’t. China’s population decline and misallocation of capital led to ghost cities and a real-estate bust that has taken out almost every big housing developer in China. Evergrande’s CEO has been forced to sell his private properties to plug the massive gap, but it’s a drop in the ocean. Citizens in some places are refusing to pay their mortgages on unfinished houses and the government has stepped in to try and gain a handle on the reins. It was inevitable that the housing bubble would burst, and some very bright minds were even quick to put a timer on it, but what happens next? Times have changed, houses are oversupplied, and a more educated workforce is about to inherit wealth from a generation who benefited from the great economic reform. Where will the money flow? Possibly to a Chinese stock market that is now at record lows, levels not seen since 2008, or 1999? Probably. The stock market does not give the Chinese enough credit. In China, Children begin learning English at afterschool classes from as young as 5 years old. Before the government intervened in 2021, children would finish school only to head to after-school classes without a break in-between. The government all but banned after-school classes in 2021 citing that children should not be under such pressure. The pressure stems from the nationwide university entrance exam; the gāokǎo (高考), directly translated to mean “higher exam”. The results of the exam will, to a large extent, determine what you are allowed to pursue in tertiary education and creates a huge amount of competition amongst school children and their parents who will spend abnormal amounts of money to ensure their child gets the best odds.

Cue: Pink Floyd – Welcome to The Machine

What did you dream?

It’s alright we told you what to dream.

Welcome my son.

Welcome to the machine.

The competition does not cease after the GaoKao, the job market is equally as fierce. Young workers must stand out amongst their peers as they fight for top jobs at renowned companies. This fierce competition birthed the term Jiǔ Jiu Liù (九九六) meaning to work from 9am to 9pm, 6 days a week. The Chinese culture, its dense population, and its economy have spawned a system of ultimate efficiency. What capitalist in China wouldn’t want such devoted labor? Yet the stock market is currently priced as if China’s economy will never get over its long-covid! It is impossible to deny that China ticks the boxes in so many categories from a macroeconomic perspective.

Where is the fear coming from? Why is China’s stock index trading at such a low?

We could spend an entire page writing reasons to fear and then our imaginations could come up with some more. The truth of the matter is that China’s economy is in a much stronger position than it was many years ago. Since Deng Xiaoping, China has become the manufacturing hub of the world. Supply chains sprawled out like veins around manufacturers are not so easy to move. Aside from the politics, businesses still know that China is the cheaper and more reliable manufacturing option. It has taken many years for China to develop the infrastructure it needed to cater to the world’s consumption demands, and it will take many years more for that to happen in competing countries. China’s woes are mostly priced in but the upside is not and there are many levers where growth could come from. Just an opening of their economy will create significant momentum in the future. As the economic reform in China took place many Chinese didn’t have the option or the know-how to invest in equities, so most money again flowed into housing. Compared to the rest of the world, and due to mostly cultural reasons, the Chinese invest most of their savings into property. Post-real-estate market collapse it has been seen that more households are investing in equity markets. After many years of rapid population growth, China’s population is now in decline. New policies to incentivize births are having little effect. An oversupply of housing and a change in sentiment will lead the Chinese to look for other ways to invest.

The opportunity

The Hang Seng now trades around the same level it did during the global financial crisis in 2008, the 2000 dot-com era, or even during 1997 when China’s GDP was almost half what it is now. Hang Seng Index at decade lows The Hang Seng index, which has constituents like Tencent (7%), Alibaba (7%), MeiTuan (7%), some Chinese banks, telecoms, energy, and others now trades at a P/E (price to earnings) of 8. Since its inception, the Hang Seng has traded at an average price-to-earnings multiple of 14. The price to earnings is half of what it historically has been. If you are investing for the long-term, this is the kind of opportunity you have to take. The reward far outweighs the risk at these levels. The risks that were previously hiding in the shadows are now in the middle of the government’s spotlight. The sentiment is at an all-time low and investable funds will need a new place to go. China’s relations with the U.S, although on shaky ground, seem to be improving as their interests warrant mostly mutual cooperation.
On recommendation of HG-Research the Heiden Grimaud Group on the 27th of October, the 1st of November, and the 23rd of November Heiden Grimaud Asset Management initiated and increased exposure to the MCHI ETF, and KWEB ETF. At the last purchase, the positions accounted for 10% and 5% of the Funds portfolio respectively.

Heiden Grimaud Asset Management recently bought exposure to two different ETFs that track the Chinese stock market, however;

None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product, or financial instrument, to make any investment, or to participate in any particular trading strategy.

The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Heiden Grimaud Asset Management.

Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding the accuracy or completeness of any information or analysis supplied.

The authors and HG-Research are not responsible for any loss arising from any investment based on any perceived recommendation, forecast, or any other information contained here. The contents of these publications should not be construed as an express or implied promise, guarantee, or implication that readers will profit or that losses in connection therewith can or will be limited, from reliance on any information set out here.

Onesoft Solutions – A General Sherman Sapling

Onesoft Solutions – A General Sherman Sapling

Within the Sierra Nevada Mountain range, lives the biggest tree in the world. It is almost as tall as the Big Ben at a height of 84 meters. The General Sherman was seeded between 700 BC and 300 BC. It has survived changing climates, fires, the introduction of invasive species, and far more. It is no small feat for a tree to grow as big as the mighty General Sherman, but its legacy is explainable. The giant sequoia sits on the Sierra Nevada Mountain range. Snow falls on the mountain range in winter, melts in spring, and is then carried through streams and a vast groundwater network, passed the General Sherman who surely takes his fair share. General Sherman Tree For a tree to get as big as General Sherman, it requires more than an adequate water supply. It needs sunlight, undisturbed by neighboring trees, soil with enough nutrients, the right genetics, the right climate, and a myriad of other blessings. Other saplings growing in a similar environment should do similarly as well. In our search for companies to invest in, we would ideally like to find a General Sherman sapling. A company with the right genetics, in the right location, undisturbed by neighboring trees, and enough water and nutrients to grow up big and strong and hopefully last the next 2000 years.

Onesoft Solutions

As we ventured through the forest in search of a General Sherman Sapling, we came upon Onesoft solutions - a little SaaS (software as a service) company with 0 known competitors. The company’s seed was dropped in an ideal location, and a number of fortunate events, partnerships, and an excellent management team have accelerated the company and its product, to where it stands today. Before we explain how this company is going to make tons of money and grow extraordinarily big exceptionally fast, we need to understand the company and its industry.

Oil & Gas Pipeline problems

There exists 2.7 million miles of Oil & Gas pipelines in the United States. Estimates say that per mile of pipe it costs $7,700 to inspect and maintain. (Remember this $7,700 number it will be important for you later). The extensive process of maintaining and monitoring a pipeline is referred to as Integrity Management.  Of the 2.7 million miles of pipe, approximately 660,000 are “Piggable”. Oil & Gas operators use things called PIGs (pipeline inspection gauges) to collect data, clean, and maintain their pipelines. In an activity called “PIGGING”, they will insert the device into the pipeline where it will move through the pipe pushed along by the product (gas/oil). Whilst the PIG is in the pipe, it will clean the pipe and collect data. There are different types of PIGs, some clean, some collect data, but most work in government. ‘Inspection’ PIGs will collect data like temperature, pressure, corrosion, metal loss, bends, and curvature. Pipeline Inspection Gauge (PIG) Once all this data is collected it is then extracted, compiled, and analyzed by engineers who must detect anomalies, leaks, and anything else that may indicate there is something wrong in the pipeline.  Most operators depend on internally built systems that output the data from the PIGs into excel spreadsheets. These systems are old, ‘legacy’ systems, and engineers are then depended upon to analyze the data, which can take months as in the picture below. One Bridge Onesoft collects this data and analyses it using machine learning in a matter of minutes or seconds outputting far more accurate results that can save oil & gas operators months of work and millions of dollars. The results allow operators to act on the most critical parts of the pipeline faster than before. If your knowledge of machine learning is rough, go read up on Google’s DeepMind AI which is able to accurately predict protein structures from their amino-acid sequence- something humans had to do manually, often got wrong, and took ages. After being fed a gigantic amount of Data, Google’s DeepMind is now able to quickly and accurately solve protein structures. This was a huge accomplishment and shows the practicality of machine learning and AI. Now that you are smarter for understanding a bit about AI, let’s get back on track. Onesoft Solutions, through its subsidiary OneBridge, has created a software program called CIM (Cognitive Integrity Management) that has been fed large amounts of data from pipelines and is able to interpret pipeline data gathered from PIGS all the more effectively. The practical use case is astounding as humans are no longer required to interpret the data, only to act on it. On top of this core product, CIM is bunching together other modules that can perform risk management functions, corrosion detection, compliance, and regulatory services to form CIM into an all-in-one platform. Data can be nicely arrayed into reports for audit, compliance, and savings solutions. These additional programs are referred to as “modules” and will create additional revenue for Onesoft in the future. Cognitive Integrity Management The CIM Platform as produced by Onesoft Solutions analyses the data for the engineers and outputs actionable solutions. The major value add is that it uses machine learning to analyze the data- the actionable output is far more accurate than an engineer’s manual output. Machine learning finds patterns where humans don’t even know to look and can tell pipeline operators where the most critical problems lie.

The investment case

As much fun as it is to learn about pipelines and their internal processes, it’s a lot more fun to make money off of it. Does our little sapling have what it takes to be another General Sherman? Will there be adequate water, nutrients, space to grow, and a lack of competition? It is impossible to accurately place a value on what Onesoft should be worth currently; it is growing extremely fast, but the speed at which it grows will fluctuate wildly leaving our models inadequate. Its profit margins will also change as the company matures. We have a rough idea of what the total addressable market is from what the company gave us but it also assumes much. Let’s take a look at what we do know: 2022 Revenue should come in at $5m CAD and the company has a gross profit margin of 75%. They recently went cash flow positive and they have grown revenues at 77%+ annually since the rollout of their main product. CIM Revenue by Quarter Most SaaS (software as a service) companies traded at an average multiple of 8X their next twelve months' revenue (NTM) for the past 10 years. But most SaaS companies are also not growing at 77% per annum. Let’s assume Onesoft’s NTM revenue is $7m (a very conservative estimate given how fast they are growing). They should be priced at 8X7= $56m CAD. A very close figure to their actual market cap of $64m~. So, the company trades at 9 times NTM. But we have been conservative, we have not taken into account how fast they are growing, surely they should trade at a higher multiple given their growth? When does this growth stop? Oil & Gas Estimated TAM USA & Global Onesoft’s management has been kind enough to provide us of their estimate of the total addressable market. Their capturable market is currently around $100m+, and they are currently working on modules to add to the CIM platform which could take it further. When working with predictions so far out into the future, it pays to be conservative. So Onesoft has ample room to grow for the next 5 years but its total addressable market is not as gigantic as one would hope, we will also have to wait and see with regard to its pricing power. If it can easily charge more than $100 per mile of pipe it could trade a lot higher. We would say the company is cheap at its current multiple, and it has wonderful prospects, we will keep this sapling under our watchful eye. If we are lucky and the volatility of the current market persists, we may be able to add this company to our collection at a very reasonable price.
Heiden Grimaud Asset Management has no exposure to Onesoft Solutions. It is, however, being closely followed and a trade execution may take place at a lower price level.

Heiden Grimaud Asset Management does not own shares in Onesoft Solutions, however;

None of the information contained here constitutes an offer (or solicitation of an offer) to buy or sell any currency, product, or financial instrument, to make any investment, or to participate in any particular trading strategy.

The information and publications are not intended to be and do not constitute financial advice, investment advice, trading advice or any other advice or recommendation of any sort offered or endorsed by Heiden Grimaud Asset Management.

Any expression of opinion (which may be subject to change without notice) is personal to the author and the author makes no guarantee of any sort regarding the accuracy or completeness of any information or analysis supplied.

The authors and HG-Research are not responsible for any loss arising from any investment based on any perceived recommendation, forecast, or any other information contained here. The contents of these publications should not be construed as an express or implied promise, guarantee, or implication that readers will profit or that losses in connection therewith can or will be limited, from reliance on any information set out here.

 

Subscribe to HG Research to get access to all Reports and other subscriber-only content.

Subscribe Now

 

A subscription gets you:

  • Access to hidden treasure stock reports.
  • Access to industry insights from people who work in them.
  • Access to understanding the broader market.