Friends and Fellow Investors:
For December 2018, the fund was up approximately 0.3%net of all fees and expenses. By way of comparison, the S&P 500 was down approximately 9.0% while the Russell 2000 was down approximately 11.9%. For 2018 the fund was down approximately 17.7% while the S&P 500 was down approximately 4.4% and the Russell 2000 was down approximately 11.0%. Since inception on June 1, 2011, the fund is up approximately 64.4% net while the S&P 500 is up approximately 118.6% and the Russell 2000 is up approximately 76.7%.
Since inception the fund has compounded at approximately 6.8%net annually vs. 10.9% for the S&P 500 and 7.8% for the Russell 2000. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two; meanwhile, for existing investors, I continue to waive the annual management fee until the entire fund regains its high-water mark.
Since 2017 – when the Fed began raising rates in earnest and both the Fed and ECB announced timeframes to begin quantitative tightening – I’d been anticipating a bear market. It seemed obvious to me (and perhaps to you) that this entire bull market was based on artificially low interest rates used to justify egregious earnings multiples on stocks and to create those earnings via cheap mortgages, auto loans, debt-financed stock buybacks, etc., and that once rates began to normalize and excess liquidity was withdrawn, stocks would sell off heavily.
I also believed (wrongly!) that stocks would start discounting those higher rates and that liquidity withdrawal a while ago, and the fund thus suffered through two years of awful performance. However, after lamenting for much of that time in this space about being unable to find anything cheap enough to buy, I’m happy to report that thanks to Q4’s broad-market correction I was able to add multiple new deep-value microcap long positions to our portfolio (all discussed below).
As to where the broad market goes from here, I think the answer is”probably lower” as the economic slowdown is still in its early stages, yet on a short-term basis the market is very oversold and therefore a rally before new lows wouldn’t surprise me. Thus, in mid-December (a bit too early!) I closed out our IWM short position, not wanting to give back the hard-earned gains we had from it. (I did not, however, reduce our Tesla (NASDAQ:TSLA) short position and don’t expect to until TSLA = ZERO.)
But if I think stocks are eventually going lower, why am I buying here? Three reasons:
1) The companies I bought were so cheap and so beaten down (40% to 50% off their 52-week highs and even further from their all-time highs) that I think they’ve likely bottomed. If I’m wrong and they get cheaper (absent fundamental change), I’ll buy more.
2) Due to the federal government’s massive deficit spending and a ratio of household debt-to-income that’s at a 16-year low (albeit at 100%, not particularly “low” on an absolute basis) I don’t expect the looming recession to be particularly severe.
3) Broadly speaking, stocks are no longer that expensive, with a trailing S&P 500 GAAP PE ratio in the 19s (the oft-quoted non-GAAP one is much lower), which I expect to drop into the 18s once Q4 2018 earnings are reported – definitely not “cheap” but no longer in “bubble territory.”
And now to the fund’s specific positions; as we’ve got lots of new longs, let’s start with those…
New to the fund this month are shares of Westell Technologies Inc. (NASDAQ:WSTL), a telecom equipment maker (primarily small-cell repeaters that should benefit from the looming wave of 5G cellular deployment) that’s in turnaround mode. This company has a 43%gross margin and is roughly cash-flow break-even with over $1.80/share in cash (and no debt) vs. our $1.97/share average acquisition cost. In fact, we bought Westell at an enterprise value of less than 0.07x (i.e. 7% of) revenue!
The “hair” on the company is a long-term decline in revenue (which should halt with the looming 5G deployment), a cash pile that could potentially be squandered on dumb acquisitions (a risk with all cash-rich companies) and – perhaps most annoyingly – a dual share class, with voting control held by descendants of the founder. However, the company is so cheap on an EV-to-revenue basis that if management can’t start generating meaningful profits it seems primed for a strategic buyer to acquire it. An acquisition price of 1x revenue (on an EV basis) would be around $4.70/share.
Also new to the fund in December are shares of Aerohive Networks (NYSE:HIVE), a cash-flow positive maker of enterprise level wi-fi equipment with a 65% gross margin and a massive amount of net cash on the balance sheet (over $1.30/share of our $3.28/share purchase price), for which we paid just a hair over 1x annual gross profit (on an EV basis). Aerohive is a “busted IPO” from 2014, abandoned by the market due to a disappointing lack of revenue growth, but at the price we paid the high-margin revenue is so cheap that – as with many of our long positions – it makes an attractive target for a strategic buyer if the company is unable to grow itself.
An acquisition price at an EV of just 1.5x revenue (reasonable for a 65% gross margin company with 29% subscription revenue) would be around $5.60/share. By way of comparison, Brocade bought Ruckus Networks, Aerohive’s most direct competitor, for around 2.5x revenue in 2016, and although at that time Ruckus was still in “growth mode,” it was earnings and cash-flow negative.
Also new to the fund in December are shares of Greenlight Capital Re., Ltd. (NASDAQ:GLRE) and Third Point Reinsurance Ltd. (NYSE:TPRE), reinsurance companies with portfolios that mimic the holdings of David Einhorn’s Greenlight Capital and Dan Loeb’s Third Point (hedge funds), but sell at massive discounts to book value. In theory these companies could be liquidated tomorrow for over 50% more than we paid for them, based on our $8.80s (for Greenlight) and $8.90s (for Third Point) per-share basis vs. their estimated per-share book values in the $14s.
These are also bets on a “comeback” by Einhorn, a truly great long-short value investor who (like me!) had his performance crushed by the recent stock bubble, and a resumption of historical outperformance by Loeb. So there are two ways to win here: the gap between the market value and the book value of these companies can close and/or their managers’ performance can bounce back and their book values will increase (which in itself would undoubtedly be a catalyst to eliminate the discount).
We continue to own the PowerShares DB Agriculture ETF (NYSEARCA:DBA), which I first bought late in 2017 because agricultural products were the most beaten-down sector I could find (the “DBIQ Diversified Agriculture Index” on which DBA is based is at its lowest level since 2002) that wasn’t a “buggy whip” (something on the way to obsolescence) or cyclical from a demand standpoint. In November, I added to the position, anticipating a bounce following a favorable outcome from the Trump – Xi Jinping trade summit in early December, but that bounce hasn’t yet materialized because although China agreed to immediately resume some agricultural purchases, the amount bought (so far) has been nowhere near enough to absorb the market’s excess supply. Nevertheless, I remain confident that a U.S. ag-favorable deal will occur during the current 90-day negotiating period with China, as Trump is very conscious of the fact that farm states constitute a significant part of his political base and isn’t shy about demonstrating that on Twitter:
And this past weekend Trump indicated that real progress was being made:
Meanwhile, ag prices are so beaten down that I don’t think there’s much downside from here; however, if no trade deal is made with China I’ll likely reduce the position size.
We continue to own Aviat Networks, Inc. (NASDAQ:AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in November reported a weak Q1 for FY 2019, with revenue up 7.7% year-over-year but, as was pointed out to me by one of our eagle-eyed LPs, that was entirely due to a new GAAP-mandated change in revenue recognition practices from ASC 605 to ASC 606; under the old standard revenue would have been down by 11%.
Nevertheless, for FY 2019 the company guided to $255 million of revenue and non-GAAP EBITDA of at least $12.5 million, and because of its approximately $332 million of U.S. NOLs, $10 million of U.S. tax credit carryforwards, $214 million in foreign NOLs and $4 million of foreign tax credit carryforwards, Aviat’s income will be tax-free for many years; thus, GAAP EBITDA less capex essentially equals “earnings.” So if the non-GAAP number will be $12.5 million and we take out $1.7 million in stock comp and $6 million in capex we get $4.8 million in earnings multiplied by, say, 16 =approximately $77 million; if we then add in at least $30 million of expected year-end net cash and divide by 5.43 million shares we get an earnings-based valuation of just under $20/share. However, the real play here is as a buyout candidate; Aviat’s closest pure-play competitor, Ceragon (NASDAQ:CRNT) sells at an EV of approximately 0.7x revenue, which for AVNW (based on 2019 guidance) would be around $209 million. If we value Aviat’s massive NOLs at a modest $10 million (due to change-in-control diminution in their value), the company would be worth $219 million divided by 5.43 million shares = around $40/share.
And now for the fund’s short positions…
We remain short stock and call options in Tesla, Inc., which I consider to be the biggest single stock bubble in this whole bubble market. The three core points of our Tesla short position are:
1) Tesla has no “moat” of any kind; i.e., nothing meaningfully or sustainably proprietary.
2) Tesla will again soon be losing a lot of money and has a terrible balance sheet despite relatively light competition, but will soon be confronted with massive competition in every aspect of its business.
3) Elon Musk is extremely untrustworthy.
For several years now (in hindsight, several too many!) I’ve been arguing that TSLA bulls are confusing “luxury electric car loyalty” for “Tesla loyalty,” and that once superior European alternatives are available Tesla drivers will flock to them. Among those relatively near-term alternatives (out in late 2019) is the Porsche Taycan, and according to Porsche’s surveys guess who’s most interested in buying it? Yes, Tesla drivers. After its U.S. tax credit price advantage over Tesla (whose credits will be gone at the end of 2019), the stunning, Autobahn and Nürburgring-tested Taycan will cost just a few thousand dollars more than a base Tesla Model S and, among innumerable other advantages, will charge 2 ½ times as quickly. Hmm, Tesla or Porsche… Not a tough choice!
The Taycan is just part of an onslaught of luxury EV competition about to rip the face off sales of Tesla’s most profitable models, the S & X, and this month came the first reviews (ahead of late-December European and April U.S. availability) of the Audi e-tron, an all-electric SUV with a bit over 200 miles of range vs. the 237-mile base Model X but with a much nicer interior and a price that’s over $9000 lower than the Tesla’s before the Audi’s $1875 to $7500 tax credit advantage. The Audi received solid reviews (here, here, here and here), and three more electric Audis will follow the e-tron:the Sportback in late-2019 and, in 2020, the spectacular e-tron GT that recently debuted at the L.A. Auto show, as well as a small electric crossover.
Meanwhile, available immediately is the new Jaguar I-Pace electric crossover (which received fabulous reviews, handily beating Tesla in comparison test after comparison test) and is $14,000 less than the Model X and $8000 less than the Model S, gaps that (as with the Audi) widen by an additional $3750 when Tesla’s tax credits begin phasing out this week and escalate to $7500 in January 2020. I’ve driven the Jaguar and can assure you that no objective person will say it isn’t much nicer than any Tesla.
The Mercedes EQC all-electric SUV will be available in Europe in mid-2019 and in the U.S. in early 2020, with an EPA range nearly equal to that of the base Tesla Model X (an estimated 225 miles vs. 237 for the Tesla) at a cost that’s approximately $26,000 less, as the Mercedes will probably sticker at around $65,000 and get a full $7500 tax credit while the Model X starts at $84,000 and will get no tax credit when the Mercedes arrives. And by 2022, Mercedes will have ten fully electric models, covering nearly all its model lines.
And let’s not count out BMW; here’s a fascinating interview with their head EV powertrain engineer.
Less expensive and available in early 2019 are the excellent new all-electric Hyundai Kona and Kia Nero, extremely well reviewed small crossovers with an EPA range of 258 miles for the Hyundai and 238 miles for the Kia, at prices of under $30,000 including the $7500 U.S. tax credit. I expect these cars to have an immediate and severely negative impact on sales of Tesla’s Model 3 and a future severely negative impact on Tesla’s so-far unseen Model Y small crossover (assuming, of course, the latter makes it to market before Tesla declares bankruptcy).
In October, Tesla reported the best quarter it will ever have (a GAAP profit of $312 million), and in 2019 it shall return to its money-losing ways. My October and November letters explain why Tesla’s 2019 GAAP loss will be at least in the hundreds of millions of dollars and perhaps over a billion dollars; rather than repeating that analysis here, please email me if you haven’t seen it and I’ll send you those letters. And to kick off Tesla’s awful 2019, here’s a great explanation as to why Q4 2018 (the one we’re in now) will be worse than Q3, and here’s a great take on how really bad Q1 2019 will be.
But lest you believe Q3 really did mark a significant and lasting turnaround for Tesla, keep in mind that no group has a better grasp of a company’s prospects than its executives, yet their massive exodus continues with the steady departure of multiple key accounting, production, and engineering people including, in December, the replacement of Tesla’s General Counsel with a prominent securities fraud criminal defense attorney. (Read into that what you will!) Rather than listing the never-ending stream of executive departures here, please use this link to see the astounding full list.
Many of these people left millions of dollars in unvested stock on the table, and one must ask why. Do they assume that stock will wind up worthless? Were they asked to do things they were “uncomfortable” doing? Or is Elon Musk just so difficult to work for that it isn’t worth the millions of dollars they left behind? None of the answers to those questions are favorable to Tesla. While a couple of low-level whistleblowers have come forward publicly to report on internal dirty deeds at Tesla, with that many high-level departures I have no doubt that myriad more significant whistleblowers are doing the same.
Perhaps the most important ongoing Tesla story is the evaporation of North American Model 3 backlog. For proof, here’s a shot of Tesla’s website from today, December 31st(!) showing immediate availability…
… and a desperate tweet from Fraud-Boy himself on the 31st, carnival barking like a late-night infomercial salesman…
… and finally from the 31st came this story from one of the Tesla shill-blogs…
I’ll take “the over” on that “over 3000”!
Many people argue that “truly massive” Model 3 demand will be unleashed if Tesla offers a shorter-range, lower-priced version in 2019; here’s why I think that’s wrong: first, I can’t see any way that a short range (approximately 220-mile) base car can be priced at less than $40,000 (including Tesla’s $1200 delivery charge) vs. Tesla’s original promise of $35,000 (a price which has now been scrubbed from Tesla’s website). After all, the unoptioned long-range rear-wheel-drive base car (recently discontinued) with an 80 kWh battery sold for $50,000 (including the delivery charge) and probably cost Tesla around $45,000 to build and sell. If Tesla cuts that battery size by 1/3 it will only save around $5000, so just to break even it would have to price the shorter-range car at around $40,000 (before options). Now let’s put that in perspective…
Tesla recently sat with piles of unwanted long-range (310 mile) rear-wheel drive Model 3 inventory at a net customer base price of $42,500 ($50,000 minus a $7500 tax credit); in fact, after it ran through over two years of order backlog in Q3, demand became so low for that model that Tesla eliminated it completely, mandating the purchase of all-wheel drive with the largest Model 3 battery pack. So if a small-battery Model 3 with 90 fewer miles of range will cost $40,000 (my estimate) and only come with an $1875 credit beginning in July (and no credit at all beginning January 2020), why would there be door-busting demand for a $38,175 ($40,000 in January 2020) 220-mile car when there was a glut of 310-mile cars at $42,500? When financing a car, who wouldn’t pay an extra few thousand dollars for an extra 90 miles of electric range? And yet Tesla’s North American backlog of those buyers is gone. The real mass-market Model 3 demand was for a $35,000 car with a $7500 tax credit-a fictional product that Musk lied about to do massive capital raises in 2016 and 2017.
Meanwhile, the Model 3 continues to reveal itself to be a complete lemon (one that’s particularly disastrous in the winter), with the latest survey from True Delta ranking it dead last among all available vehicles. And in September British magazine What Car? ranked overall Tesla reliability so low that it’s in “a league” of its own. And speaking of lemons, although the latest Consumer Reports survey doesn’t have enough Model 3 data to provide a reliability estimate other than “average,” it downgrades the Model S to “worse than average” and thus “unacceptable” while the Model X is once again rated “much worse than average” and makes the “coveted” “10 Least Reliable Cars” list.
Also in December, Tesla appointed two new SEC-mandated “independent” directors to its board, neither of whom know anything about manufacturing or distributing cars and both of whom (you can’t make this stuff up!) had major Theranos involvement, either personally (Larry Ellison) or corporately (Walgreens, from which Kathleen Thompson hails). And one of these “independent” directors (Ellison) was recently quoted as saying “I am very close friends to Elon Musk and I am a very big investor in Tesla.”That’s some real independence right there!“Zero Hedge” wrote a perfect summary of this debacle as did my friend Anton Wahlman.
Also in December, Musk made a hilariously defiant (of the SEC) appearance on “60 Minutes”; here’s a great summary, Tesla’s “China factory” that was allegedly going to be producing cars in 2019 was revealed to be nothing more than dirt, and the Wall Street Journal broke a story about how Musk diverted SpaceX funds into his dumb-ass tunnel company without telling SpaceX investors. (Hello jail!) And if you’re getting bored with my monthly “short case for Tesla” letters, here’s a terrific ten-point argument from Credit Bubble Stocks. And finally, Tesla is increasingly besieged by a wide variety of lawsuits for securities fraud, labor discrimination, worker safety, union-busting, sudden acceleration and lemon law violations, and new ones appear on a regular basis. In fact, one could even argue that Tesla is a criminal enterprise.
Meanwhile Tesla continues to downsize its SolarCity division while a civil securities fraud case accusing Musk of using Tesla to bail out his (and his family’s) interests there proceeds; Zero Hedge included an excellent summary of the suit by Twitter user @TeslaCharts in this story about SolarCity’s latest retrenchment which will undoubtedly help fuel that fraud case, as will this later story describing how Tesla sales people have no idea when the solar tiles or PowerWalls used to justify that merger will ever be available. (Remember that when Musk was promoting that merger he used fake solar tiles on a fake house at a movie studio… How appropriate!)
So here is Tesla’s competition in cars (note: these links are continually updated)…
AUDI E-TRON GT FIRST DRIVE: LOOK OUT, TESLA (available 2020)
240-Mile Kia Niro EV Arrives January 2019 at Under $40,000
And in China…
536 HP Nio ES6 Midsize Electric SUV Launches With 317-Mile Range (at 1/2 the price of Tesla X
Here’s Tesla’s competition in autonomous driving…
Here’s Tesla’s competition in car batteries…
Here’s Tesla’s competition in storage batteries…
And here’s Tesla’s competition in charging networks…
Yet despite all that deep-pocketed competition, perhaps you want to buy shares of Tesla because you believe in its management team. Really???
So in summary, Tesla is losing a massive amount of money even before it faces a huge onslaught of competition (and things will only get worse once it does), while its market cap tops that of Ford (NYSE:F) and GM’s (NYSE:GM) despite selling approximately 300,000 cars a year while Ford and GM make billions of dollars selling 6 million and 9 million cars respectively. Thus this cash-burning Musk vanity project is worth vastly less than its roughly $70 billion enterprise value and-thanks to its roughly $31 billion in debt and purchase obligations-may eventually be worth “zero.”
Elsewhere among our short positions…
We continue (since late 2012) to hold a short position in the Japanese yen via the ProShares UltraShort Yen ETF (ticker: YCS) as Japan continues to print 6% of its monetary base per year after nearly quadrupling that base since early 2013. In fact, of the world’s three largest central banks (the Fed, ECB and BOJ), the BOJ is now the only one not on a path to tightening. One result of this insane policy (in 2018 the BOJ bought approximately 67% of JGB issuance and in 2019 anticipates buying 70%!) is there are days when no 10-year JGBs trade in the cash market! The BOJ’s balance sheet is now larger than the entire Japanese economy – it owns approximately 44% of all government debt and over 75% (!) of the country’s ETFs by market value:
Just the interest on Japan’s debt consumes 9.2% of its 2018 budget despite the fact that it pays a blended rate of less than 1%. What happens when Japan gets the 2% inflation it’s looking for and those rates average, say, 3%? Interest on the debt alone would consume over 27% of the budget and Japan would have to default! But on the way to that 3% rate the BOJ will try to cap those rates by printing increasingly larger amounts of money to buy more of that debt, thereby sending the yen into its death spiral.
When we first entered this position USD/JPY was around 79; it’s currently in the 109s and long-term I think it’s headed a lot higher-ultimately back to the 250s of the 1980s or perhaps even the 300s of the ’70s before a default and reset occur.
We continue to hold a short position in the Vanguard Total International Bond ETF (NASDAQ:BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 1.04% at an average effective maturity of 9.3 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest asset bubble in history, as with Eurozone inflation now printing just under 2% annually these are long-term bonds with significantly negative real yields.
In October, the ECB reduced its bond buying program from €30 billion/month to €15 billion and has now eliminated it completely, thereby removing the biggest source of support for those bonds’ bubble prices. Currently the net borrow cost for BNDX provides us with a positive rebate of approximately 1.5% a year(more than covering the yield we pay out) and as I see around 5% potential downside to this position (vs. our basis, plus the cost of carry) vs. at least 20% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.
Happy New Year, and here’s to a much better 2019!
Thanks and regards,
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.