Today, I have the pleasure to publish an interview with Iiro Varhia, a private finnish investor I got to know through Twitter (@artifex1986). He’s been investing for 15 years now, and runs a private research newsletter called Macrosleuth in which he aims to find well-researched profitable investment opportunities for his subscribers.
His strategy combines several different investment styles and approaches: top-down global macro analysis, bottom-up fundamental analysis for the stock picking and also pays attention to technical/chartist aspects as well as sentiment factors. Contrary to the current market trends, he stays away from “Quality” companies and “Momentum” stocks and focuses on very cyclical industries that have been left for dead. Natural resources, of course, fit well in this description, as you’ll see.
So, without further ado, here it is my conversation with private investor Iiro Varhia. Hope you find it interesting and useful for your investment journey.
Q. Please, tell us about yourself and your background.
Well, I’ve been investing for nearly 15 years now and I really love the whole investing world and the research process that goes into every investment decision I make. I've got my education at the Faculty of Law of the University of Turku in Finland and I still live in Turku, in South-Western Finland.
I come from a family of entrepreneurs so business and investing has always been part of my life. More importantly, being aware of business risks has always been part of my upbringing and it has given me a solid foundation to build my investment framework that fits my personality. I have been fortunate to have been able to travel a lot both in the West but also in the East and it has definitely given me perspective and more of a global view of investing.
Nowadays I work in real estate business and I run a private research newsletter focused mainly on European and North American equities but commodities and longer term options as well.
Q. What is your general investment philosophy?
I go anywhere I can find value. I am a value investor and I believe as an investor you need a strategy and you need to be flexible. You need to have an investment idea that makes sense both from a risk/reward standpoint and from probabilities standpoint.
In the hedge fund industry, my strategy would be called event driven combined with elements from distressed securities investing. I usually concentrate on industries or commodities that are facing headwinds but are about to turn and have a bright future ahead of them. I get excited if people fail to see what I see. That is when risks are the lowest and future expected returns the highest. But I need more than just an industry that is in a bear market. There needs to be value and a catalyst.
I want to get involved with a promising investment when most people are too afraid to allocate money in there. First, I do top-down sector analysis, and then if it looks promising, I dig deeper and analyze the players involved within the industry.
Last part of my process is that technicals need to be constructive to time the entry. Otherwise you risk being much too early. Your entry level is where you make your money. This is the most important part of my investment process. Do I have a level that offers me a good risk/reward with high probability? Sometimes everything else fits but I can't justify putting on a position because of this. Level is what gives me the odds and my position size so I sacrifice a lot of time trying to determine my levels.
Q. So it’s a combination of deep value with a catalyst, very negative sentiment and constructive technicals. In a way, it reminds me of the following quote:
"The best trades are the ones in which you have all three things going for you: fundamentals, technicals, and market tone. First, the fundamentals should suggest that there is an imbalance of supply and demand, which could result in a major move. Second, the chart must show that the market is moving in the direction that the fundamentals suggest. Third, when news comes out, the market should act in a way that reflects the right psychological tone."
Does it reflect your approach?
It definitely does. Only thing missing from that quote is your own self doubt when putting that trade on even though you feel confident about your investment. The reason why I use this approach is that probabilities get better when fundamentals, technicals and sentiment all come together. It all starts from my bigger picture view, though. I don’t blindly follow only sector fundamentals. Those can be misleading in isolation. You need macro level thinking combined with everything else. Most returns are generated from macro level events so you need to pay attention.
I’m looking for opportunities with tremendously skewed risk-reward in my favour. Usually these can be found at the market turns when the very best money is made. This kind of investing is very demanding from mental point of view but returns can be rewarding. As an investor, I also need good risk management because I do get things wrong from time to time.
Q. When dealing with risk management, what are your thoughts on portfolio diversification vs. concentration and what do you recommend retail investors?
This is a wide topic and we could easily have another interview only about diversification. But some guidelines. Your portfolio is not only your equity holdings, it is much more than that.
I would concentrate my equity holdings aggressively and use asset allocation to diversify my wealth. Equities should only be one part of your total wealth so think about it in this context.
Firstly, for asset allocation, you need to consider both developed and developing market fixed income, developed market equities and developing market equities. Then add direct real estate investments and direct private equity investments. Then if you are high net worth individual, you can add private equity funds and hedge funds. Then invest in things like REITs, agriculture, cash and commodities, including gold. This is usually how family offices diversify their holdings.
Source: Raymond Choi Associates.
Now that we have diversified our wealth we can have a more concentrated equity portfolio. I have quite concentrated equity portfolio myself. I never have a smaller position on than 5% or a bigger position than 25% of my public equity portfolio.
I bet bigger size when the odds are heavily in my favour, but you need to know your payout and probabilities to determine your position size and which instrument to use.
To answer your question about what retail investors should do, I would say think public equities only as a part of your portfolio and allocate only a fraction of your total wealth into stocks. Then you can concentrate your bets and be more aggressive.
Q. Once you’ve decided from the top-down analysis that an area of the market or sector is attractive, why not just go with the sector ETF?
ETFs are usually market-cap weighted. It gives a distorted view of the market because of overweighting towards bigger companies. I don’t want to buy large cap companies. Too many hidden risks. I rather try to find companies that are underweighted.
These sector ETFs create many opportunities too so I am not complaining. An opportunity just presented itself a few months ago when some LNG companies got delisted from an index and sector ETFs were forced sellers.
Another bad thing about sectors ETFs is that investors typically do not have a say in the individual stocks in an ETF's underlying index or if an ETF decides it is time to change the tracking index altogether. A sad example is the destruction of Global X Uranium ETF (NYSEARCA:URA).
This doesn’t mean I totally avoid sector ETFs. I have owned gold miner ETFs in the past.
Q. So, what features do you look for in the individual companies within that industry to invest in them? And what are the red flags that tell you ‘I won’t invest here’?
Depends on the industry. Shipping is different from mining and oil services are very different from consumer staples.
There are some similarities, though. Free cash flow generation and strong balance sheet. Ability to survive without huge dilution if things don’t turn around immediately and of course low valuation and relative valuation. But even after 15 years of trying to figure this one out, it’s still hard to give you a full list of what to look for. There are just too many variables.
For me some major red flags would be not answering specific questions and avoiding giving any details. Not bringing up negative developments if there are some or acting differently than previously communicated would be a red flag. A bad capital structure with a risk of restructuring would be a huge red flag. Just have a look at what happened to Bellatrix Exploration (OTCPK:BXEFF) not too long ago.
Q. What are your areas of interest in the broad investment universe right now?
Everything that is under-owned, hated or investors give no value for the assets.
I can only say where I put my own money. Energy sector and shipping sector are high on my list. Both offer tremendous value but investors refuse to see it. First, I need to say they have been correct so far. But for me who only gets interested after the sector has been destroyed, this has been a gift. There are such big bargains out there with solid companies that are borderline crazy.
In the energy space, oil & gas together with lithium and even uranium offer great risk/reward from here on.
I also hold a lot of cash right now waiting for the right opportunity.
Q. Let’s jump right into the different sectors you mentioned. First, the energy sector. What segments are you particularly interested in and what are you seeing there that the market doesn’t see?
The oil sector is interesting. Not every area, but there are some pockets of value there.
Some people would argue that we have enough oil. OPEC has cut production and can bring it back online whenever they want. It’s not that easy going forward, though. People don’t consider or understand oil production decline rates and depletion rates which are two different concepts by themselves. We haven’t really invested enough in upstream oil production in the last five years. Some estimates I have seen are saying we are facing a $2 trillion funding gap because of oil price crash. That makes funding necessary investments challenging. I see a big oil price spike coming in early 2020s because of under-investment in conventional oil production.
Offshore oil is one area of interest for me. We need to invest in offshore oil production. It’s finally starting to happen. Exploration budgets are going up after a couple of years of strong cash flows into E&P companies. Also, offshore oil projects have become cost competitive after cost cutting measures have been implemented. I see a lot of opportunities there.
When it comes to the growth of shale oil production, I think a better way to play it is via shipping.
Q. The shipping sector has been destroyed in the last few years. Some argue it’s such a terrible business that it’s not worth the risk. Why are you optimistic?
That is a common argument against the shipping sector. To be honest, I heard the same argument against gold stocks in late 2015, against dry bulk shipping in 2016 and against uranium stocks in 2017. Apparently, nobody likes when things are inexpensive. This is the time to get involved in shipping.
But there is a reason for that bad reputation and it is a real problem for the shipping industry. Shipping sector has been filled with bad actors and plagued with stupid decisions that have destroyed shareholder value. Corporate governance has been steadily improving lately and finally we are starting to see shareholder friendly actions in many companies. Shipping companies need to earn investors’ trust back by creating shareholder value. It will take some time.
But you also need to remember that you can make a lot of money in shipping when it turns. Let’s not forget that leverage works both ways. We just don’t remember good times during bad times. Shipping is a cyclical business and surely not meant for buy and hold type of investors. Timing is everything in shipping investments.
Main reasons to be optimistic about the shipping sector would be IMO 2020 disruptions, tiny orderbooks by historical standards across almost all sub-sectors and the fact that banks and investors are not willing to finance reckless growth plans after years of loss making and stricter banking regulations. And shipping stocks are cheap. You can find many companies with strong balance sheets that are paying 8% dividend with free cash flow. Stocks are trading at 0.5-0.6/NAV with asset values near record low levels.
Q. Changing gears to the uranium sector, this one is a very interesting play for me personally, too. Can you share your biggest bet here and the reasons why?
Energy Fuels (NYSEMKT:UUUU) is my biggest position. When I started buying in two years ago hardly, anybody was talking about Energy Fuels. Nobody was buying. They were talking about highly promoted peers, but I considered Energy Fuel’s assets to be superior to those of others. The White Mesa Mill by itself was worth many multiples of the total market cap. Valuation made no sense at all. My analysis turned out to be a correct one and the stock is up almost 200%. I find it still undervalued.
Today, investors consider Energy Fuels to be among the best and least risky bets, not only because of their vanadium income stream but also because of their assets and low debt. White Mesa Mill especially is strategically important as the only fully-licensed and operating conventional uranium mill left in the US. And then there is section 232 and the potential quota system to protect U.S. domestic uranium mining industry from cheap imports. Uranium sector is interesting going forward.
Q. Regarding lithium, what is the rationale and how are you playing it?
By 2030, the number of electric vehicles (EVs) may increase to 100 million, according to IEA. That requires a lot of lithium and cobalt for EV batteries.
This all requires huge increase in mining activities. If this doesn’t happen, the energy transition is not going to happen on the scale many governments are now planning. This energy transition requires major government intervention and EVs need to be technically successful and cost competitive as well.
The main risk about the EV growth projections is that the track record of government policies is poor overall no matter where you look at. But it doesn’t have to reach that 100 million EVs by 2030 to make lithium a great investment. You will make a lot of money if EVs reach only 50 million or even less by 2030.
All this leads once again to oil. EVs will take at least 10 years to have a meaningful impact on oil demand if all those projections come into reality. And even then total oil demand is going up from here. We will be in trouble long before 2030 if we are not investing in oil production now. My message is that you don’t need to choose between oil and EVs. It’s not a binary bet. EVs and oil will both make you money if you invest wisely.
I’d like to add a few words about geopolitics here. Look, according to European commission’s data, our primary production of certain raw materials by the EU member states is alarming: 0.1% for lithium; 1.1% for natural graphite; 7.7% for cobalt and 13.8% for nickel of global production. Industrial strategies in EU countries have to change because of global realities. Competition of raw materials is increasing and countries are getting more and more aggressive in securing their future needs. We have a lot of raw materials in Europe and long tradition of extraction activities, we have just lacked political will to support our industries. I want to be positioned well before that turn in strategic thinking really happens and there are signs it’s already underway.
About answering your question about how I am playing the lithium theme? I have a small position in Savannah Resources (OTC:SVNNF). But I’m considering further investments into the lithium space. Savannah Resources has their main asset in Portugal with high IRR and low Capex. It really looks promising with current low valuation. They have some additional lithium assets in Finland as well.
Lithium is a work in progress for me, though, and I’m not comfortable in giving a detailed opinion just yet.
Note: Lithium prices.
Disclosure: I am/we are long UUUU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.