July 31, 2019
Friends and Fellow Investors:
For July 2019, the fund was down approximately 4.8% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 1.4% while the Russell 2000 was up approximately 0.6%. Year-to-date 2019 the fund is up approximately 11.8% while the S&P 500 is up approximately 20.2% and the Russell 2000 is up approximately 17.7%. Since inception on June 1, 2011 the fund is up approximately 83.9% net while the S&P 500 is up approximately 162.9% and the Russell 2000 is up approximately 107.9%. Since inception the fund has compounded at approximately 7.8% net annually vs 12.6% for the S&P 500 and 9.4% 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 and please note that individual partners' returns will vary in accordance with their high-water marks.
The fund remains very net short, as I continue to believe we're about to enter a bear market for U.S. stocks as the U.S. economic slowdown worsens. Here are some charts explaining why:
…while global negative yielding debt (a sign of a massive looming economic slowdown) has broached the insane level of nearly $14 trillion:
Anticipated 2019 Fed rate cuts of 50-75bp (starting with today's 25bp) will do little to prevent this slowdown; here's how things look now relative to the peak of the last bull market, in September 2007 when the Fed did a 50bp cut:
And for those who think that low interest rates necessarily mean higher PE multiples, here's an excellent rebuttal to that in a single chart (although this is somewhat distorted by the fact that the U.S. has more growth stocks):
And keep in mind that much of the U.S. bull market's rise came from corporate buybacks, and those tend to slow drastically when the economy does. As the looming recession unfolds and those buyers disappear, look out below.
On the other hand, our current, short-lived era of net "quantitative tightening" among the big three central banks (the Fed, ECB and BOJ) is over. The Fed's balance sheet contraction stops in August, and it's rumored that in October the ECB will resume printing money to buy still more bonds (while, the BOJ continues doing so). I'm very aware of the effect these moves may have on already grossly inflated asset prices, and thus am a bit more cautious in my short bias than I had been before the new European QE was telegraphed at July's ECB meeting. On the other hand, this ECB stupidity may blow up its banks and perhaps even the euro, resulting in all kinds of stock market carnage. After all, if printing money is the solution to economic stagnation, why bother collecting taxes and having government budgets? (There's no need to answer that-it's a rhetorical question!) So we're short, but a bit more cautiously so.
Seeking the most overvalued of all stock indices (and the one least likely to be bought by overseas investors with their newly printed yen and euros), we thus remain short the Russell 2000 (NYSEARCA:IWM), which has a trailing twelve-month GAAP PE ratio of 40 on what I believe are peak earnings, while 35% of its constituents lose money. I also put on a short position in the S&P 500 (NYSEARCA:SPY) last Friday evening, immediately after Trump said it's likely China won't make a trade deal until after the 2020 Presidential election. As rumors of such a deal have been a huge positive driver of stocks and international trade is much more important for the constituents of the S&P 500 than it is for those in the Russell 2000, I think this position is worth a shot with a tight stop set at SPY's all-time high, just 25bp above our short basis.
Elsewhere in the fund's short positions…
We remain short stock and call options in Tesla, Inc. (NASDAQ:TSLA), which I consider to be the biggest single stock bubble in this whole bubble market. The core points of our Tesla short thesis are:
1) Tesla has no "moat" of any kind; i.e., nothing meaningfully proprietary in terms of electric car design or technology, while existing automakers-unlike Tesla-have a decades-long "experience moat" of knowing how to mass-produce, distribute and service high-quality cars consistently and profitably.
2) Tesla is losing a ton of money and has a terrible balance sheet.
3) Tesla is now a "busted growth story"; demand for its existing models is only being maintained via continual price reductions, and it will have to raise billions of dollars to produce new models in a market soon to be saturated with enormous competition.
4) Elon Musk is extremely untrustworthy.
In July Tesla released a disastrous Q2 financial report, with a GAAP loss of $408 million despite higher-than-expected deliveries of a bit over 95,000 cars. In fact, due to massive price cuts to maintain demand, Tesla actually booked significantly less revenue than it did in Q4 2018 when it sold nearly 5000 fewer cars, and despite multiple price cuts since January 1, Tesla's estimated U.S. deliveries dropped by 43 percent in the first half of this year vs. the second half of 2018, and overall deliveries were down by 9% despite this year's introduction of Model 3 sales to Europe & Asia where it was unavailable in 2018. And to kick off Q3 (the quarter we're in now), Tesla cut prices yet again!
Keep in mind too that Tesla's Q2 loss would likely have been $100 million greater if it were providing adequate customer service. The internet is filled with complaints from aggrieved owners who can't reach anyone to fix their myriad problems within a reasonable timeframe, thereby resulting in real-time brand destruction. Yet due to the high cost of batteries, Teslas are inherently unprofitable, and thus improving the ownership experience would only increase the company's losses. In other words, Tesla is truly a non-viable business.
In Q3 & Q4 2019 the "growth company" known as Tesla will show significant revenue declines vs. Q3 & Q4 2018 (so much for those "year-over-year comps"!), and its 2019 full-year GAAP loss will be nearly $2 billion.
The party's over, folks. With no profitable growth, massive ongoing losses and tens of billions of dollars in debt and purchase obligations, the equity in Tesla will eventually prove worthless. Yet as the stock miraculously closed today at $241.61/share, I shall continue…
For those of you looking for a resumption of growth from Tesla's (supposedly) upcoming Model Y, by the time it's available in late 2020 or 2021 (if Tesla is still in business), it will both massively cannibalize sales of the Model 3 sedan and face superior competition from the much nicer electric Audi Q4 e-tron, BMW iX3, Mercedes EQB, Volvo XC40 and Volkswagen ID Crozz, while less expensive and available now are the excellent new all-electric Hyundai Kona and Kia Niro, 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 inclusive of the $7500 U.S. tax credit. Meanwhile, the Model 3 sedan will have terrific direct "sedan competition" in 2020 from Volvo's beautiful new Polestar 2 and the premium version of Volkswagen's ID.3.
And if you think China will be the saving grace for Tesla, I have bad news for you: first, the competition there for EV market share is becoming a vicious dogfight (see the links further down in this letter). Second, Tesla currently sells approximately 35,000 Model 3s a year in China; how much would that increase with a domestically produced car and a 15% price cut (the tariff savings)? Even more than doubling sales to, say, 80,000 a year would likely keep its new Chinese factory unprofitable and be a drop-in-the-bucket vs. the expectations built into the stock price. And then there's the fact that Beijing is now switching its subsidies to hydrogen fueled cars, which it perceives as better than EVs.
Meanwhile, Tesla has the most executive departures I've ever seen from any company and July was no exception, as this month the company's co-founder and Chief Technology Officer J.B. Straubel left, as did a big chunk of the Autopilot team; here's the astounding full list of escapees. These people aren't leaving because things are going great (or even passably) at Tesla; rather, they're likely leaving because Musk is either an outright crook or the world's biggest jerk to work for (or both). Could the business (if not the stock price) be saved in its present form if he left? Nope, it's too late. Even if Musk steps down in favor of someone who knows what he's doing, emerging competitive factors (outlined in great detail below) and Tesla's balance sheet make the company too late to "fix" without major financial and operational restructuring.
In May Consumer Reports completely eviscerated the safety of Tesla's so-called "Autopilot" system; in fact, Teslas have far more pro rata (i.e., relative to the number sold) deadly incidents than other comparable new luxury cars; here's a link to those that have been made public. Meanwhile Consumer Report's annual auto reliability survey ranks Tesla 27th out of 28 brands and the number of lawsuits of all types against the company continues to escalate-- there are now well over 600 and the whistleblowers keep on coming!
So here is Tesla's competition in cars (note: these links are regularly updated)…
AUDI E-TRON GT FIRST DRIVE: LOOK OUT, TESLA (available 2020)
Mercedes to launch more than 10 all-electric models by 2022
And in China…
Here's Tesla's competition in autonomous driving…
Here's Tesla's competition in car batteries…
Here's Tesla's competition in charging networks…
And here's Tesla's competition in storage batteries…
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 is larger than Ford's and over 75% of GM's despite selling only around 350,000 cars a year while Ford and GM make billions of dollars selling 6 million and 8.4 million vehicles respectively. Thus this cash-burning Musk vanity project is worth vastly less than its over $50 billion enterprise value and-thanks to roughly $34 billion in debt, purchase and lease 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 (NYSEARCA:YCS) as Japan (despite having substantially tapered its QE) continues to print 4% of its monetary base per year after quadrupling that base since early 2013. In 2018 the BOJ bought approximately 67% of JGB issuance and in 2019 it anticipates buying 70%! In fact, the BOJ's balance sheet is now larger than the entire Japanese economy:
…and it owns nearly 78% (!) of the country's ETFs by market value.
Just the interest on Japan's debt consumes 8.9% of its 2019 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 nearly 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 108s 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 0.52% at an average effective maturity of 9.7 years. As I've written since putting on this position in July 2016, with Eurozone inflation now printing 1.1% annually I believe this ETF is a great way to short what may be the biggest asset bubble in history. Currently the net borrow cost for BNDX provides us with a positive rebate of nearly 2% 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 of this insanity.
We also have relatively small short positions in Netflix (NASDAQ:NFLX) due to its egregious valuation within the context of increasing cash burn and competition (particularly from Disney), Square (NYSE:SQ) due to its egregious valuation and a stock-dumping CEO who so effusively praises (and enables) Elon Musk that I suspect he's equally untrustworthy (and indeed in June the company fired its auditor), Carvana (NYSE:CVNA) due to a laughable business model with escalating losses and a founder with a sketchy past who's dumping stock steadily and Wayfair (NYSE:W), an egregiously bad on-line furniture business with yet another stock-dumping CEO.
And now for the fund's long positions…
New to the fund is a long position in Communications Systems, Inc. (NASDAQ:JCS), an IOT ("Internet of Things") and internet connectivity & services company. The company's multiple divisions are best explained by the slide presentation from its annual meeting and this terrific new contract, and its recently improved performance is highlighted in its Q2 earnings report; what attracted me to JCS is its great balance sheet and how cheap it is on an EV-to-revenue basis. At our average cost of $3.04/share and assuming $62 million in annual revenue, $17.8 million of net cash and 9.32 million shares outstanding, we paid just a bit over 0.17x revenue for this roughly break-even company with a gross margin of 37% and climbing.
We continue to own Aviat Networks, Inc. (NASDAQ:AVNW), a designer and manufacturer of point-to-point microwave systems for telecom companies, which in June reported an interesting deal to be the exclusive North American distributor for NEC's microwave products. In May Aviat reported a lousy Q3 for FY 2019 (with revenue down 13% year-over-year), but guided to a very strong Q4 (ending June 30th) with revenue and income up substantially year-over-year. For all of FY 2019 the company cut guidance to $246-$251 million of revenue (a $4 million reduction from previous guidance) and non-GAAP EBITDA of $11-$12 million (a $1 million reduction), and because of its approximately $330 million of U.S. NOLs, $10 million of U.S. tax credit carryforwards, $214 million in foreign NOLs and $2 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 $11.5 million and we take out $1.7 million in stock comp and $6 million in capex we get $3.8 million in earnings multiplied by, say, 14 = approximately $53 million; if we then add in approximately $29 million of expected year-end net cash and divide by 5.4 million shares we get an earning-based valuation of around $15/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 0.6x revenue, which for AVNW (based on the low end of 2019 guidance) would be 0.6 x $246 million =$148 million + $29 million net cash = $177 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 $187 million divided by 5.4 million shares = just under $35/share. And here's a new report explaining "the growth story."
We continue to own Westell Technologies Inc. (NASDAQ:WSTL), which in May reported a terrible FY 2019 Q4, with revenue down 12.5% year-over-year and a drop in gross margin from 45.5% to 37.6% and negative free cash flow of around $1.4 million. About the only good news here is that the company ended the quarter with $25.5 million in cash and no debt, and (as gleaned from the conference call) normalized FCF burn at Q4's revenue level is "only" around $900,000. Westell now sells at an enterprise value of less than 0.1x (i.e., less than 10% of) revenue, so on that metric it's clearly dirt cheap but the business needs to stabilize and grow. On the conference call management was confident that later this year there should be enough revenue growth to cut quarterly burn to around $500,000 but "break-even" now sounds like more of a "next year" possibility. Westell also suffers from a dual share class with voting control held by descendants of the founder; however, management has often stated that the controlling family is open to merging the two share classes, and 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 just 0.8x run-rate revenue (on an EV basis) would be around $3.70/share.
We continue to own the PowerShares DB Agriculture ETF (NYSEARCA:DBA) as agricultural products remain the most beaten-down sector I can find that isn't a "buggy whip" (something on the way to obsolescence) or cyclical from a demand standpoint, although I reduced the position size considerably in July when near-term hopes for a trade deal with China fell apart and terrible weather in the farm belt was unable to move prices meaningfully higher.
Thanks and regards,
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.