I recently had the opportunity to talk with founder and Chief Investment officer of Sachem Cove Partners, a hedge fund that invests solely in uranium and nuclear fuel cycle companies, newsletter writer and someone who has spent 20+ years in the hedge fund business as an analyst, portfolio manager and partner, Mike Alkin. Below you’ll find the first part or our two-part interview series.
In this part you’ll learn how to manage a commodity investment over a long cycle, factors to look for when a commodity market is turning and why the uranium market is so unusual.
Part 2 of the interview is published tomorrow.
What got you first involved in commodity markets?
I love commodities because its a play on human nature. The narrative gets extended one way or another at the peaks and troughs. Complacency sets in. I find it as a useful way to pick off human psychology sometimes.
Most of my career in the hedge fund industry I was a short seller. By that very calling it means you are a contrarian in that you are betting against conventional wisdom. When you are looking for short selling opportunities you can looking for businesses that are slowing down yet the market hasn’t figured it out yet.
People want stocks to go up but not all the fundamentals warrant that. So when you are thinking about commodities you are looking to find inflexion points. The commodities business is one where you tend to find highs and lows, its cyclical. I believe there are very few businesses that are not cyclical in nature. When prices are really good they bring on more capacity, and conversely when they can’t make money they are shutting off capacity. But it’s hard to see that at the time when the trend is going one way, it’s easier to adopt the narrative of that trend. The trend is your friend as they say. But I find the longer a cycle runs on the more complacency sets in.
That’s what attracts me to commodities itself. Then of course within commodities there are cycles that are more elongated than others, we tend to see in uranium there are deep cycles with peak troughs and peaks.
As markets become dominated by algorithms is taking the long term view and focusing on niche markets the only way that human investors can compete?
Having spent as many years as I did in the professional hedge fund environment you see how the tools that the professional investor has are far superior to what an average investor has. A Bloomberg terminal may cost $25,000 per year, Capital IQ $10,000, experts to speak to may cost you $50,000-$200,000 per year. So all those great tools don’t substitute for the one thing that average investors have. And that’s time.
There is such great pressure for hedge funds to perform on a daily, weekly monthly basis that it takes away their ability to arbitrage time. If you identify a market that’s going to turn and you’ve got time on your side that’s a nice luxury to have. But running a professional fund you don’t just need to know if it’s going to turn but when. And sometimes you have to overlook great value because you [the hedge fund manager] don’t have the time.
Twenty years ago when I started in the hedge fund business most investors were high net worth individuals and you used to send out a letter to them maybe quarterly, definitely every half year and you might tell them about the positions you held. Fast forward to the Asian financial crisis and after the Internet bubble hedge funds outperformed very nicely as they had short exposure. It saw a wave of money coming into the sector, pension funds, endowments and they hired experts to go analyse these hedge funds. They have to do all their due diligence and they have to put you in a box – large cap, small cap, value investor. But there’s a lot of granularity that goes on, sometimes weekly performance reviews. If you are down 10% now in a month all hell breaks loose.
As dollars can walk out the door tomorrow it really compresses your time horizon. You’re really going for what’s working now. And what’s working now is what everyone knows is working now, it’s already priced in, and so asymmetries are hard to find. I find commodity cycles you can find asymmetry in that risk-reward. People have quit a sector and its left for dead, or conversely its going gang busters and everyone wants in and so it’s all priced in to the market
How do you maintain that patience over long cycles?
I think sizing is important. If you imagine a portfolio as a pie, how much the pie do I devote to any one sector or stock? I want to diversify that pie so not only do you need to identify your risk-reward but you also need to know the catalysts that are going to come to fruition. If I have a fabulous risk-reward but the ‘when’ portion of it is a little elongated I might have less exposure to that sector and this way it gives me the opportunity that if there is weakness I can buy the dips. For individual investors it’s very important how much you want to devote to equities, fixed income etc. How much am I comfortable to lose? It’s so individual and that’s what drives the market, its human emotions. Being a hero can hurt.
What factors do you look to say hey people are starting to take interest, time is getting close?
What I like to see is that a number of the sell-side firms have abandoned a sector; relating it to uranium, investment banks have cut their trading desks, they have reduced the amount of research analysts since their not generating commissions and so it’s not a good investment for them. So, I find when there is reduced exposure from the City or Wall Street that’s when it gets exciting.
When the number of companies involved in the sector starts to shrink, when we get bankruptcies, when we start to see companies just giving up that is also a good sign. And I love to see supply discipline. Until you start to see that there is no reason for the commodity price to turn.
Thinking about uranium, we’ve seen Cameco and Kazatomprom shut in production and yet the price of uranium has barely budged. If you introduced that same scenario to other commodity markets you would have expected a much stronger reaction. Why has the price reaction been so muted?
In all the commodity markets I’ve never seen one like uranium. There are so many factors. The first is that it’s hated. The end market – nuclear power – is a pariah. I think there is a misunderstanding in the role nuclear power plays in the world, for instance it is the safest form of electricity generation, and nothing is even close; coal, natural gas, renewables etc. But we hear about Fukushima, Chernobyl and Three Mile Island.
I do what I call the BBQ test. This past summer when we had BBQ’s at our house, I asked people what percentage do you think the US has in nuclear power generation? And the response is, “I don’t know, do we even do nuclear power even more?” In the US 20 percent of homes are powered by nuclear power so I think there is a general disdain for it, misunderstood also.
The reality is that it’s growing 2-3 percent per year and that it is a developing world story. I don’t say this proudly but a large percentage of Congress don’t have passports and so many Americans don’t tend to think outside of their borders. If you haven’t travelled much then you might not be familiar with the air quality issues that affect many countries such as China. That’s the demand side, there’s a lot of misunderstanding.
On the supply side it’s very opaque. And markets that are more opaque than not tend to create opportunity. So with the sell-side having abandoned the sector with the exception of a couple and most of these guys have been barking to own a part of the sector and they have been wrong
In an opaque market it’s hard to get data – new mines, nuclear power plants. When you think about it the largest uranium supplier in the world, Kazakhstan they are not public so they don’t have to give you a lot of information. Its opaque, it takes a lot of time. Time that professional investors don’t have. If you’re a professional investor your normal course of action will be to go to the sell-side and say show me the reports you have, your research, can I see your model? By this point you will be thinking this is going to take a lot of time to get up to speed, I’m going to look at another sector. And I think this is what makes the uranium sector unique as it does take an awful long time to understand supply and demand.
I also think that the long-term nature of the contracts play a big role. Most contracts between the power plants and uranium miners are 7-10 years. So, despite the commodity falling off in price dramatically, many of the miners were able to produce at much higher prices-for years. This led to what I like to call “supply-side” complacency”. The miners assumed Japan would come on-line much sooner, and that enrichment underfeeding (which adds secondary supply to the market) wouldn’t be nearly as bad as it is, so they figured by the time the contracts roll-off pricing will be much higher.
And here we are. 7 years-on from the beak, mired in a horrific downturn, the price is at $22 per lb and it costs most of the miners $50 per lb all-in to pull it out of the ground. It doesn’t require an MBA in business for a CEO to know that math doesn’t work.
And here we are, supply discipline is finally entering the equation.
The utilities that have needed supply have been able to rely on the spot market to top off their needs. That’s about to change as 30% of their contracts roll-off in 2020. And it takes two years to get uranium as a fuel form the time it is ordered.
I think this year is the inflection point. The combination of supply cuts and uranium demand form utilities i think should drive the price markedly higher.
That’s a barrier to the average investor though also isnt it? They might hear what you’re seeing and recognise the potential for opportunity. But then the next obstacle is who do I talk to, who isn’t just selling me a hole in the ground?
The mining business itself isn’t a good business. Most of them are consumers of capital. If they’re exploration companies 1 in every 3000 holes turns into something. I always say biotech companies are in the business of finding cures, but they are also in the business of issuing equity to stay in business. Many mining companies including the majors do the same thing.
Being able to understand supply and demand is just fourth-grade mathematics. If someone has the time and inclination they will go to the various sources of data. Now here’s where it breaks down for many people. Thinking about the formula for supply and demand, on the supply side I need to know how many mines are producing something, what’s their cost of producing it, where is the price versus the cost to produce, is there enough incentive for them to continue to do so and then I want to know whether there is secondary sources of supply? I also need to know what the inventory levels are. In the case of uranium it’s just going round to each of the companies that produce it, searching for industry data, figuring out secondary supply, examining inventories at the global utilities, and just reading and then putting those numbers into a spreadsheet. It’s doable, but a lot of work.
Prospective supply is the final thing to understand. If you are drilling for natural gas for example, and there’s a shortage and the price rises, how long does it take for new supply to come on? In the case of natural gas not very long. In the case of a commodity, and using uranium as an example I go to everyone to the websites of every uranium mining company and I look at what their prospective projects are. When these companies publish their technical reports as part of their investor relations they list all the projects, here is where we are in our licensing permitting, here’s what it costs to pull it out of the ground and here’s how long it will take. None of that is high finance.
On the demand side you can just look on the internet and see how many reactors there are in the world – the size and how much they use per year. And then I want to know what plans they have for new reactors, what’s in the pipeline? Again, the data is out there, it’s very simple. It just takes time. Which countries are reducing their reliance on nuclear power? We know its France, the USA, Germany. And then taking those reactors out of the model in the years to come.
All very time consuming. It took me a couple years to build that, but that gives me a comfort to know what’s going on. In the case of an opaque market like uranium people take snippets of information, and I see it on Twitter all the time, and they run with it. But in reality it may not be meaningful at all, very interesting but probably already priced into the market.
If people are doing their own investing the thing people have to be careful of is many-newsletters. Many newsletters are written by people who want to sell newsletters, not all are like that, but many. When something is hot that’s what they’re going to sell. When the cycle’s turning their going to come out with it. But what’s that based on? I’m very suspicious of sell-side research. I operate off of what are their financial incentives? Why did most of the sell-side cut most of their exposure to uranium research? It’s because they can’t generate banking fees, there are no mergers, there’s no trading commissions.
That’s the premise of my book!
The power of incentives right!
I watch this a lot with uranium and nuclear power. The US is 30% of all nuclear power in the world, there are 99 reactors and some of them are not economical with gas prices as low as they are. The fuel buyers of nuclear power plants in the US hear about these closures in the papers every day and all they’re thinking about is hoping to get to the end of their careers. The question I ask is what is the financial incentive for that individual to walk over to his boss and say we need to buy uranium because I think its bottomed and here is the work I’ve done to support this view. If he’s right does he participate in the upside of that in any meaningful way? No. If he’s wrong could he look like a fool and lose his job? Yes, he could. There is comfort in crowds, so what’s the incentive for that person to pull the trigger and make a decision?
Remember back in the 1980’s there was the saying, back when IBM was relevant that a chief technology officer never got fired if he bought IBM. If it didn’t work he wouldn’t get fired since everyone else was doing it.
I’ve done a good amount of work in understanding the psyche of these buyers in talking to them and going through my analysis of the market with them. They don’t do the same analysis, they use consulting firms and they pay a great deal of money to understand what is going on in the market.
Let’s take that power of incentives one step further. If I’m one of the two consulting firms that advise the nuclear power industry I could get subscribers from either the nuclear power plants or the miners. Well, the miners can’t afford to pay them, so who pays them? The nuclear power plants.
So much of this is stepping back and understanding human nature. In industries where you have a very elongated cycle it’s very easy to capture the narrative and run with it. I’ve gone to so many idea dinners as an investor where six or eight hedge fund guys will get together and chat about what’s going on. And I call it the ‘head-bob’ when someone is pitching an idea and everyone at the table is nodding saying that makes sense. Everyone is feeling good about that investment. Well, that’s because everyone knows about it! Who’s not heard about it? What’s my risk-reward? Probably not great as everyone’s heard about it.
When you go and pitch an idea and everyone’s like you’re out of your mind that’s when things start to get interesting. Taking uranium as an example I drill down a couple layers and I can quickly start to tell that they’re headline reading. And that gets me excited.