Understanding China

China has a highly unusual business environment- the government is currently holding 2 Canadians hostage to benefit a private company (Huawei).  Those with the right connections regularly use government resources for their own benefit.  As far as investing in Chinese stocks go, it is a trap for foreign capital:

1. Massive fraud.
2. The CCP encourages mainlanders to be racist, nationalist, and xenophobic.
3. Because of state-sponsored racism and xenophobia, there are far fewer (or no) consequences when somebody cheats a foreigner versus an ethnic Han Chinese citizen.
4. The CCP often exploits foreign capital and sponsors the theft of intellectual property.
5. Relations between the CCP and most developed countries will deteriorate because the CCP has been increasingly antagonistic towards other countries.  The resulting trade wars will hurt China’s economy and make the environment sketchier for foreign capital.

Hong Kong is dying

Hong Kong is a place where its residents have previously enjoyed economic prosperity and civil liberties.  That is coming to an end.  Through the proposed “national security” law, the CCP (China’s ruling party) has pretty much announced that it has given up on trying to win over Hong Kongers and will now proceed to act against them without their consent.  The CCP has indicated that its weird obsession with control will trump sensible economic decisions.

The Hong Kongers who choose to stay will almost certainly make the CCP burn with them.  The CCP will never control the Hong Kong people and turn them into obedient mainlanders who sing the Chinese national anthem instead of the Hong Kong anthem.  At the same time, the Hong Kong people will suffer a terrible price at the hands of the CCP much like the Uyghur Muslims, Tibetians, Falun Gong, etc.

The loss of freedom is in many ways worse than COVID-19.  Tanya Chan, a pro-democracy lawmaker, has described the day of the national security laws being introduced as the “saddest day in Hong Kong[‘s] history”.

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When life gives you lemons, make lemonade

COVID-19 is going to be awful.  Society will have plenty of assets (e.g. cruise ships) and unemployed people that will be fairly unproductive in the next few years.  But, while I’m extremely scared of what COVID-19 will do to most stocks, I think that now is the time to invest in stocks (*that won’t get killed by COVID-19).  What worked in the past will likely continue to work in the future:

1. Buying high quality businesses…
2. …at reasonable prices…
3. …that aren’t in shrinking industries.

COVID-19 has dramatically changed #2 and #3.  Many industries that were previously stable or booming may see a wave of bankruptcies.  But that’s ok.  I don’t have to own those stocks.  Nobody is holding a gun to my head forcing me to own airlines, movie theatres, department stores, etc.  There is still a small universe of stocks with low COVID-19 risk that I will concentrate my portfolio in.

Excesses in the mortgage REIT and securitized lending space

Here are the excesses that I see in the lending markets:

1. When investors put money into securitizations, they don’t pay attention to the underwriting quality of the loans that they own a piece of.  They allow charlatans to unload low-quality loans into securitizations.  Investors are ultimately buying into a pile of loans with inflated values.  Unfortunately, yield-chasing investors gravitate towards assets that they don’t understand.  This may be a desirable feature for the yield chasers- they will look smarter if others also don’t understand what the yield chasers own.
2. Certain instruments such as Credit Risk Transfers (CRTs) and the lower tranches of CMBS have a significant chance of being completely wiped out.  While the riskiest tranches of CRTs and CMBS have seen their prices drop 30%+, it doesn’t seem like investors are sufficiently scared about the senior CRT tranches in a COVID-19 environment.
3. The system of yield-chasing mortgage REITs financing themselves almost entirely with short-term debt does not work.  There are currently liquidity issues because lenders do not want to continue providing short-term debt (via repos / repurchase agreements) and the lenders also don’t want to sell the collateral.  A key reason why problems exist is because the banks accepted highly leveraged investments as collateral.

I don’t think that the mortgage REIT stocks are very interesting because (A) none of them are good longs and (B) it’s not a good use of time to research them as shorts.

Quality companies outperform by maybe 5% a year

It has been difficult for me to accept that I should be buying stocks with high P/E ratios, high P/B ratios, and mediocre management teams.  Quality rarely comes cheap and without warts.  But, I’ve been trying to move away from deep value investing dogma because I want to figure out what actually works.  As part of that, I’ve been keeping a model portfolio of 30-35 large cap stocks since October 2017 that you can view in real-time here.  It has outperformed the S&P 500 by ~5% annually since October 2017 (!).  This is a surprising amount of outperformance for large cap stocks (e.g. large cap mutual funds would be incredibly happy with 2% outperformance).

While it is possible that I am confusing luck with good stock picking, I have to live with imperfect information.  I would prefer the feedback from a 30+ stock portfolio than the feedback from a focused portfolio with <10 stocks.  Going forward, you should expect me to be heavily biased towards quality companies.

A coronavirus vaccine may not save us

If you read up on coronaviruses that affect livestock, you will quickly discover that some viruses remain a problem despite vaccination.  Chickens continue to die from IBV (Infectious Bronchitis Virus) despite being vaccinated.  While vaccines improve the chickens’ health overall, they are not good enough to fully solve the problem.  If a SARS-Cov-2 vaccine would be similar to our vaccines for IBV, then we will have to deal with the limitations of vaccines.

The simplest way to think about the current COVID-19 situation is that there will be a range of outcomes, with the worst outcome being a prolonged economic depression where a vaccine doesn’t exist (or that people die despite being vaccinated).  You can make your portfolio robust against COVID-19 risk by ensuring that you own “safe” stocks that will do fine in a world where social distancing is the new normal.

I apologize for my recent blog posts because they’re uncomfortable.  I want to believe that the world will be ok.  But the further I go down this rabbit hole, the more I realize that health authorities spread misinformation and ignore scientific evidence.  The most disturbing element of the current situation is that many Western scientific authorities promote bad science so that companies have a chance of profiting from the situation via drug treatments, the experimental use of invasive ventilators, and vaccines.  They stand in the way of science saving us.

Safe stocks to own in a coronapocalypse

Currently, the stock market is in a weird situation where most stocks have exposure to the systemic risk of COVID-19.  As it is highly likely that social distancing will become the new norm, a long list of businesses will be badly hurt: airlines, restaurants, movie theatres, music events, conventions, lenders, etc.

If the COVID-19 situation drags on for 3+ years, you don’t want your portfolio to blow up because of it.  It would make sense to put a good portion of your portfolio into less risky investments that will survive.  Because individual stocks can blow up, it is a good idea to diversify (e.g. 10-30+ stocks).  It’s also a good idea to avoid owning too many stocks with similar risks (e.g. stocks in the same industry, too much COVID-19 risk, etc.).

Stocks discussed: CNC, UNH, CHTR / LBRDA, TSN, HRL, COST, PGR, V, MA, MCO, SPGI, FB, GOOGL, IAC / MTCH, VRSN.

Industries that will face the most bankruptcies in these crazy COVID-19 times

In this blog post, I’ll give my thoughts on industries that will almost certainly see many bankruptcies.  In general, the stocks with the most bankruptcy risk have some combination of the following:

1. A fall in revenues because consumers don’t want to go out in public and possibly die.  Some industries will continue to be impacted even after a vaccine is developed (if it is developed).
2. Fixed cost leverage.  Some businesses such as restaurants are locked into leases that will cause them to burn a substantial amount of cash.
3. Debt.

These situations may be very difficult to analyze.  However, there may be opportunities in the mispricings such as going long restaurant franchises and shorting airlines, E&Ps, and the lowest quality lenders.  If an industry such as airlines has high bankruptcy risk, I will also talk about related industries even if they do not have high bankruptcy risk.

The stock market is wrong about a magical COVID-19 recovery

I was naive for believing that governments around the world would implement country-wide lockdowns once the bodies start piling up.  Now that people are dying, it is clear that many countries are not particularly interested in mounting an effective response against the coronavirus.  Countries are still being dragged down by their internal politics.  Given the rapidly changing situation, some of the current stock market valuations will be unsustainable.  Here’s what many investors haven’t yet figured out:

1. Social distancing is the new normal.  Mass testing and contact tracing are less effective against SARS-Cov-2 than other viruses.  We cannot rely on contact tracing alone.
2. Premature re-opening is a dangerous experiment that will end in body bags and bankrupt businesses.

I don’t mean to be a permabear or to be alarmist.  However, most investors are blissfully unaware about how difficult it is to fight this virus.  A segment of the stock market will be hit hard by the virus and you need to make sure that your portfolio will hold up.