Sometime ago, I started writing investing memos. These are unedited, almost āstream of conciousnessā like pieces that help me gain clarity on the market, strategy, positions, etc. I write these when Iām overwhelmed with thoughts and need a place to spill them over into. The memos also serve as documentation of my investing journey and a place to look back to when I think āwhat was I thinking 5 years ago when I made that trade?ā Below is the first memo I wrote back in August. Again, itās unedited and might be poor quality so sorry for that in advance.
In this memo, I plan to outline my investment framework, my view on the current state of the market, and resultant moves I will make with regards to my portfolio.
My investment framework has been shaped by books, memos, thoughts, etc. from multiple great thinkers, namely Warren Buffett, Peter Lynch, and Howard Marks. Each individual offered me new insights that altered how I think about the market. Buffett buys quality cash-producing assets at a discount to their intrinsic value. His buy decisions are often triggered by market shortsightedness and overreactions. He prefers long holding periods insofar as fundamentals remain intact. Lynch and Marks are also contrarian value investors similar to Buffett, but they offer more specific investment strategies in their writings. Lynch sees great opportunity in boring, disgusting, uninvestable sectors that Wall Street analysts havenāt caught onto. Small-cap companies that funds overlook due to either a) size or b) uninvestability present terrific opportunities for individual investors. By employing such a strategy, investors can garner large returns on small amounts of capital. Buffett agrees that while beating the market becomes tougher with larger amounts of capital, achieving outsized returns with smaller amounts of capital is realistic. Marks discusses market cycles and timing, which most value investors stray away from. Attempting to make investment decisions exclusively on market timing is a foolās game, but understanding where we lie within different market cycles offers important insight. Investors should balance aggressiveness and defensiveness as broader market cycles oscillate. Iāve read other books and listened to other great investors as well, but Buffett, Lynch, and Marks had the greatest impact on me. The greatest lesson Iāve learned from them and others is synthesized below:
To be a successful investor, you need an edge; you canāt beat the market by doing what everyone else is doing. HFT funds have algorithms and proximity to exchanges as their edge. Most Wall Street funds have an information and influence edge. What edges might an individual investor have?
- Contrarianism. By identifying contrarian investment opportunities, you are by definition going opposite the crowd. Large, generalizing narratives often hide nuanced contrarian investment opportunities that the diligent individual investor may identify. Funds cannot always invest in opportunities that completely oppose conventional wisdom because they are at their clients' mercy. They have limited flexibility in where and how they can deploy capital, which gives individual investors an edge in their ability to be contrarian.
- Time. Individual investors can weather long periods of volatility and wait years to receive the ultimate prize of asymmetrical returns. Fund managers have to report earnings quarterly and are held accountable to their clients, making it hard for them to retain an exclusively long-term market outlook.
- Scale. Individual investors deal with small amounts of capital. Funds deal with tens to hundreds of billions of dollars in assets under management. By definition, they cannot deploy large amounts of capital into small-cap equities, which leaves entire sections of the market untouched by Wall Street.
Individual investors do have an edge and it is thus possible for them to achieve large non-random returns. My investment framework is simple and meant to maximally exploit the edges that the individual investor has: I am a contrarian value investor that searches for asymmetrical opportunities in the market.
Iāve laid out my investment framework, but effectively deploying capital according to that framework also requires an understanding of where we lie in the market cycle. A healthy mix of the bottom-up (value individual equities and buy at a discount) and top-down (current state of the broader market) approaches are required for investment success.
The broader US equities market remains overvalued. CAPE (cyclically adjusted PE ratio) sits at ~40, the combined market cap of stocks with a P/S ratio of above 15 is at all-time highs (800 billion. From a macro-economics standpoint, inflation is raging onwards. Its exact causes are unknowable, but are likely a mix of money printing during COVID-19, sustained low-interest rates from the Fed, and supply disruptions in commodities. The Fed will likely keep interest rates low as long as possible because inflation is in their best interest: itās the only effective method of servicing debt. However, eventually, interest rates will have to climb back up and would likely āpopā the bubble. I donāt mean to predict an exact catalyst to pop the bubble or time the market, because those endeavors are futile. Rather, I mean to show that a) the broader market is overvalued and b) catalysts are in place for the bubble to pop. Overvaluation cannot continue forever, and a crash is inevitable.
While the broader market seems precarious, select sectors seem to be dramatically undervalued, for example, energy and commodities. Thermal coal is hitting all-time highs and equities are still trading at 2-3 times cash flow. Oil is projected to go into a structural supply deficit for the first time in decades but the market isnāt seeming to price it in. Demand for metals like copper, platinum, etc. is expected to increase dramatically over the coming years, but equities continue to trade sideways.
The conclusion is that we are in a seriously bifurcated market. The bulk of the market is overvalued, but opportunities are out there for those who are watching closely. At the same time, it would be naive to assume that undervalued sectors will necessarily outperform during a market crash, because they may be perceived by the rest of the market as riskier. A prime example is uranium, which I will discuss shortly. The resulting advice for investors is that now is the time to be defensive. Increase position in high-conviction investments and de-risk by cutting off losers or lower-conviction investments. Maintain a healthy cash reserve and be ready to pounce if a crash does occur.
Returning to the undervalued sectors I previously mentioned: what sector is poised to provide the greatest returns over the next 3-5 years? Uranium. Hereās the basic thesis:
- Uranium has traded at a supply deficit (mined supply vs demand) for 4-5 years now. Remaining demand is made up for by utility inventories and secondary supply (spot market).
- Utility inventories are projected to run out soon (next 2-3 years). Security of supply is essential for utilities because they are running nuclear plants providing 14% of electricity for the world. The logical conclusion is that uranium mines must come back online to resolve the supply deficit.
- Due to nearly a decade of underinvestment in the uranium sector, the bare minimum break-even price for most miners is $50/lb. In order to run economic projects, the uranium price needs to be in the $60-70/lb range.
- Uranium prices currently sit at ~$33/lb. Uranium prices need to move 50-100% to incentivize mining. We haven't even discussed the possibility of a price overshoot (like 2007) or the [[sput|Sprott Uranium Physical Trust]], which has the potential to catalyze long-term contracting and provide miners negotiating leverage. Uranium price moving 50-100% is as close to a sure thing as you'll see in the market.
- Low-risk: Buy physical uranium through Sprott Uranium Physical Trust. Sprott will track spot price and offer 50-100% upside in even bearish scenarios. With a price overshoot, 200-300% returns would not be surprising.
- Medium-risk: Buy first movers - i.e. producers and near-term developers. Miners offer torque to uranium price so they will experience greater returns with 50-100% moves in uranium price. Buying quality producers/near-term developers offers leverage to Uranium price whilst not exposing investors to the great level of risk associated with juniors.
- High-risk: Buy a diversified basket of small-cap and nano-cap uranium companies. Juniors (developers and explorers) have the greatest room to run and this strategy requires strong belief that all uranium miners will "ride the wave" of increasing spot price even if many may have low-quality projects.
My ideal portfolio revolves around balancing the low-risk and medium-risk strategies. Note that the delta between low-risk and medium-risk in this context is larger than the terms ālowā and āmediumā might imply. The downside risk specific to buying physical uranium is limited to a high premium. The downside risk specific to buying producers and near-term developers includes dilution, increasing capital and operating expenses, long timelines, poor management, etc. In this way, the medium-risk strategy involves a huge jump in risk relative to buying physical. The most important question then becomes: is the reward profile of producers and near-term developers large enough to justify taking additional risk relative to investing in physical?
To answer this question, we first need an objective framework by which to assess the reward profile of miners. Then, we can weigh risk/reward for physical and medium-risk miners to determine which should be overweight. At a high-level, my framework to assess the reward profile for miners is as follows:
- Mandatory criteria: Qualitatively determine whether the company has what it takes to succeed in the uranium space (whether by getting into production or buyout) and reward its shareholders. Look at things like management (promotional vs realistic and motivated), dilution, cash burn, jurisdiction, timeline, presentations (macro vs project), etc. It should be straightforward to determine if you are looking at a low-quality or high-quality company. If you're uncertain, then it probably means the former.
- Valuation: Find the company's intrinsic value. Use conservative inputs for models like DCF or exploration assets. Make sure to discount back to present day. Then, assess EV/NAV to see if the company is trading at a discount. See how EV/NAV (and thus upside potential) changes as uranium price increases or decreases. How is it influenced by multiple expansion? Sensitivity to changes in CAPEX or OPEX? This quantitative analysis will give you a good idea of whether the company is cheap or expensive.
While the risk/reward of medium-risk miners has worsened, the risk/reward of physical uranium has strengthened with premiums hitting under 2% and volatility leading to SPUT occasionally trading at a discount. Since the risk/reward of buying physical uranium outweighs the risk/reward of buying medium-risk miners, my conclusion is to go overweight physical.
The most important quality successful investors possess is the ability to stick to their investment framework no matter the state of the market. By doing this, they remove emotion from their decision-making process and are able to make rational investment decisions. I believe this memo demonstrates (to my future self or anyone else reading it) an effort to choose an investment framework I am comfortable with and stick to it regardless of external conditions. Itās not easy to be a contrarian but having a structured process for investment decisions can reduce the natural emotional and psychological burdens of going against the crowd. Hopefully, by sticking to my strategy and making rational investment decisions, I will see decent financial returns over the coming years.