When we think the facts of an investment case have changed so abruptly that there is not only limited upside but potentially significant downside to a stock price we are also prepared to short previous favourites. This investment volte-face can be highly contentious, emotionally difficult and fraught with reputational risk if it doesn’t pay off. On the popular American hedge fund drama, Billions, Axe Capital in-house psychiatrist and performance coach Wendy Rhoades terms this investment manoeuvre as the “180” degrees pivot[1]. We performed our own “180” on the wind turbine industry this summer, not only selling out of previously lucrative long positions in turbine manufacturers Vestas and Siemens Gamesa but subsequently building up significant short positions.
Fig 1: Wendy Rhoades, Axe Capital Psychiatrist
It seems to have become more consensual in recent times that there exists a single superior buy-and-hold process of stock market investing to which all fund managers should aspire involving identifying companies with superior qualities; investing in those companies and holding onto the stock forever with blind loyalty. We have never believed in one-decision stocks that you can buy and tuck away forever. Aside from the fact that the quality style doesn’t always lead to investment performance[2], our biggest objection to “buy and hold” is that it is axiomatic that the qualities of a company will change over time; competitive advantages erode and demand tailwinds can abruptly change direction. To us the notion of a “forever” investment is bunk: our job is to notice when the facts change and to be prepared to sell winners and certainly never fall in love with our stocks.
We had made our original investments in Vestas in January 2014 (at an average price of DKK180!). By the summer of this year the stock had advanced to DKK600 as analysts’ forecasts for profitability had consistently proven too low (see Figure 2: Vestas earnings upgrade cycle 2014-2017) with Vestas management having extracted significant manufacturing cost efficiencies to improve gross margins on top of accelerating demand for more powerful turbines led by indirect or direct government subsidies. We had also made an additional investment in Spanish manufacturer Gamesa, when Siemens reversed its wind turbine business into the stock on what we thought were very good terms for Gamesa shareholders, including a generous special dividend and the further promise of revenue and cost synergies.
Source: Bloomberg, Argonaut Capital, 13th November 2017
Figure 2: Vestas earnings upgrade cycle 2014-2017
Then in late July this year the multi-year wind turbine industry earnings upgrade cycle was broken by a profit warning by Siemens Gamesa in which it announced that the Indian market, which had previously accounted for up to a quarter of the combined group’s profits, had unexpectedly and spectacularly ground to a halt owing to a change in the tendering process for new projects from feed-in tariffs to market auctions[3]. Following an unconvincing conference call, it seemed to us that Siemens Gamesa would now likely miss its 8-10% EBIT margin profitability target, particularly as Indian margins were thought to be much higher than group average, and that there were further risks ahead with a changing global demand environment and stock specific risks on merger integration. Despite a 17% fall in the share price the next day we sold out of our position in the stock and would subsequently initiate a short position a week later.
This got us thinking about Vestas. The stock was barely changed after the first Siemens Gamesa warning owing to its zero exposure to the Indian market and analyst views that the problems were likely stock specific. But was this really the case? And even if as was generally agreed Vestas was the higher quality company, would its own profitability be dragged down by weaker competitors like Siemens Gamesa who might be tempted to start a price war on turbines to fill their factories as they coped with the air pocket in demand caused by the Indian market? Moreover, although Vestas had no exposure to India, it derived around 30% of its revenues from the German market where we learnt that changes in wind auctions would likely result in a significant downturn in installations over the next two years. We decided that Vestas now had asymmetrical downside as an investment and began selling out of our positions. By mid-September we would be short.
The next few weeks saw a flurry of Siemens Gamesa announcements on order wins. They had won an auction in Turkey, but at such a low price that it suggested irrational pricing. Subsequently large orders were announced in Germany, France, Argentina, China, Norway and a massive 780MW order from the United States, where Vestas was supposed to have a strong lock on the market[4]. When their Investor Relations finally stopped postponing our post-results catch up call, they confirmed that market conditions had changed and that all markets were now seeing double digit pricing declines, although also denying that they were the cause of a potential price war[5]. Then on a quiet Friday evening in mid-October, Siemens Gamesa sneaked out another profit warning: guiding down near-term EBIT margins to 7%, writing off inventory, announcing senior management changes (including changing the CFO who had only been in place since April) and postponing their upcoming capital markets day until 2018[6]. This suggested to us an ongoing deterioration in both the stock and the industry outlook.
Yet, almost without exception, every sell-side analyst we spoke to on Vestas continued to believe that Siemens Gamesa’s problems were stock specific. Some even suggested that Vestas would prosper as its competitors grew weaker. We understood that Vestas with its industry leading EBIT margins of 12-14% was the higher quality play, but those margins suggested to us that the company could be over-earning, particularly in the event of an industry price war. When we had put this directly to Vestas back in September they pointed to their “highest margins in the industry” but qualified this by saying that “there is a limit in achievable gap relative to peers”[7]. Whilst we were listening, it appeared the market was not.
Although Vestas had grown to be the market leader in the US ahead of GE, ultimately wind developers would purchase turbines based on bang-for-buck. Even though the quality of the product was important there was always a trade-off against price. Whilst market consensus seemed to believe that although there might be pricing pressure in individual markets, this was thought to be localised and not global and certainly would not affect Vestas in its lucrative American market. This view was completely at odds with our own research which suggested that pricing in the US market had recently collapsed. On its Q3 conference call in late October, US wind developer Avangrid observed that it was “seeing some discounting of wind equipment by large wind OEM’s, which is somewhat surprising”[8].
Another Friday night bombshell was to hit on November 3rd. As part of President Trump’s Tax Reform proposal, it was proposed that the generous tax relief which wind developers were to receive as part of the Production Tax Credit (PTC) programme 2016-2020 would be immediately abolished rather than phased out in 2020 and that relief would also potentially be abolished retrospectively for projects which had already begun in 2016[9]. Whilst we were and remain sceptical that this proposal will be enacted, we thought that the bill would have immediate repercussions with the uncertainty created, potentially causing an additional air pocket in demand for US turbine orders in the forthcoming, traditionally lucrative Q4 period. We added to our short positions the following Monday on the tax reform proposal and in anticipation of Siemens Gamesa reporting that evening and subsequently Vestas on Thursday morning.
It is often said that profit warnings “come in threes” and Siemens Gamesa did not disappoint with its third negative guidance revision since July and a proposal to shed 28% of its global work force[10]. The company had, however, managed to generate a record high order book for onshore turbines over the quarter, despite further denials about initiating a price war. Moreover, although Siemens Gamesa was explicit on low double-digit pricing declines across its markets, including the US, this continued to be dismissed by Vestas bulls as stock specific.
It is not normal for a short investment thesis to go exactly to plan, particularly as most management teams either avoid confessing to bad news or leak it slowly into the market hoping to dull the impact. Despite high conviction in our investment thesis and belief that the risk to the stock was asymmetrically negative, I felt mild apprehension before the Vestas report was due to be released at 7.30am on Thursday. Then the headlines hit the screen:
- VESTAS 3Q EBIT EU355M, EST 418M
- VESTAS SEES FY ADJ EBIT MARGIN 12% TO 13%, SAW 12% TO 14%
- VESTAS SHARES INDICATED TO FALL 15% IN COPENHAGEN[11]
Remarkably not only were many of the Vestas bulls expecting the company to beat Q3 guidance and perhaps raise FY guidance, but market consensus was expecting 14% EBIT margins in 2018 driven by increased US volumes. Beyond the Q3 miss and the narrowing of guidance, the report noted that the wind OEM turbine market was seeing accelerated competition and decreasing profitability”[12]. In the subsequent conference call the Vestas CEO, Anders Runevad, was explicit that the company would not be immune from an industry price war:
“I’m happy about generating the best-in-class margins that we do. But, of course, we are also depending on what the competition is doing and what kind of margins that they feel are sustainable. So, of course, there is a relationship in the market between us competing for the orders in the market.”[13]
On further questioning, the CEO noted that prices were “coming down quicker during this year, for sure, and also quicker in this quarter” [14] which led some analysts to berate the company for not highlighting these pressures previously. This seems to us as unfair: the collapse in turbine prices has been a relatively recent phenomenon and we had certainly noticed a change in the tone of communications from the company over the previous few weeks. Perhaps had analysts and investors not had their judgement clouded by emotional attachment to the stock this could have been picked up on by reasonable channel checks of industry peers and customers?
Are there any wider implications of our successful 180-degrees pivot on Vestas? Most obviously the necessity to keep an open mind to the facts changing on any investment no matter how previously lucrative the trade. More importantly, the necessity to carry out our own research, think independently and not be reliant on the opinions of third parties no matter how “expert” they might seem. Moreover, a good investment idea – which is a stock thesis with asymmetrical risk reward – requires conviction and capital, without which it is simply another lost opportunity. Every working day Argonaut conducts its own similarly in-depth research across a range of existing or potential single stock positions across European stock markets. Not all will pay off so spectacularly but enough do to make the process statistically significant for generating investment performance. Our ability to discover short as well as long alpha is crucial to delivering lowly correlated returns.
A few weeks ago, I attended a “Quant” investment conference during which speaker after speaker suggested that fundamental investors like Argonaut were doomed if we did not adapt to an investment world where quant companies could - for a price - provide datasets that would give enlightened fund managers the necessary edge to compete and survive. These snake oil salesmen could not envisage a world where it was possible for anyone other than sector specialists with access to proprietary data to generate alpha. Our lucrative wind turbine investment pivot is a stark example that alpha generation does not require access to proprietary data and that industry experts and sector specialists often completely fail to see the wood from the trees in the handful of companies that they follow. In normal markets which reward stock pickers, it continues to be perfectly possible for generalist fund managers who do their own research, spot opportunities and ask pertinent questions to thrive.
Barry Norris
Argonaut Capital
November 2017
[1] http://www.vulture.com/2017/02/billions-recap-season-2-episode-2.html
[2] We believe that the primary driver of returns is always corporate earnings, or rather positive or negative surprises on the trajectory of company profits. Our suspicion is that higher quality companies perform best in overall anaemic growth environment in which profit growth for average companies is difficult and where a low interest rate environment supports higher multiples for long duration assets. This accounts for the outsized returns from the quality style since the great financial crisis and the unnatural degree of its current popularity.
[3] Source: Siemens Gamesa Q3 Report and Conference Call July 26th 2017
[4] Source: Siemens Gamesa/Bloomberg
[5] Source: Argonaut
[6] Source: Siemens Gamesa/Bloomberg October 13th
[7] Source: Argonaut
[8] Source: Avangrid Q3 Conference Call 24th October 2017
[9] Source: MAKE November 3rd
[10] Source: Gamesa November 6th
[11] Source: Bloomberg November 9th
[12] Source: Vestas November 9th
[13] Source: Vestas November 9th
[14] Source: Vestas November 9th
