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Millennium Cub off to Strong Start; Bullish on Steel as China Curbs 'Zombie' Industries
For Lee Bressler, his trading career at Carbon Investment Partners got started with a bang. Along with partner Brandon Bradford, CEO of the firm, the two have transitioned from the gilded world of : Millennium Management plunging into the reality of running a small hedge fund start-up. Bressler and Bradford, former “cubs” of legendary hedge fund manager Israel “Izzy” Englander, had key investments pay off in the hedge fund’s first month, according to a letter to investors reviewed by ValueWalk.
Carbon Investment Partners want to start with a bang
Categorizing the first full quarter of Carbon Investment Partners performance as “exciting” and “a great success,” the fund points to the good news: up 5.7% in November net of fees and expenses. In the first two months of their existence the fund is up 6.1%.
“Our results indicate that our process of researching and sizing our big and small ideas is working,” Bressler and Bradford explained in a January 17 letter to investors. The fund is brimming with excitement as the letter notes investor meetings scheduled and building the business from its start-up size of $10 million in assets under management.
“Our returns have been broad-based from a large number of ideas,” the letter explains. Looking forward, the industries they like harken back to an industrial era and a commodity-based economy.
Carbon Investment Partners – Watch for steel supply to decrease as China reforms
While much of the hedge fund world has been looking to China from an economic engineering standpoint, Carbon Investment Partners looks at the region’s steel production to ascertain one of its macro investment themes.
The supply-side reforms in China have hit at a preponderance of “zombie” industries. This is particularly true of steel, which isn’t earning profits in the region, is polluting the environment, causing social unrest and is “unhealthy” on bank balance sheets.
The regional goal is to restore profitability to the steel industry in part by constricting supply. This means closing down inefficient plants and reducing steel output, with the current government target to reduce 150 million tons of steel production capacity by 2020. Producers who remain must conform to a higher environmental standard.
This is a realistic target, Bressler and Bradford write, saying the consensus is wrong in doubting the Chinese government projections. In 2016 capacity was cut by 82 million tons alone.
What emerges from this tighter supply picture coming out of China is an investment into one of the old guard of an industrial era: US Steel. Carbon explains the thesis:
As steel supply tightens, prices will continue to rise, and steel companies around the world will benefit. We believe there is substantial room for further increases in steel prices, and we remain bullish on steel stocks. To be clear, this is not a thesis based on increased infrastructure spending in the US under President-elect Trump. We find that to be theoretical and hard to predict. Our thesis is about supply, not demand. We continue to see US Steel (X) as the most attractive way to invest in this theme. X is highly levered to domestic steel prices, has an excellent management team that is taking strategic actions to improve the company, and has exposure to several strong and improving end markets for steel. Using a multiple of 5.5x – 6.5x EBITDA, in line with historical levels, X is worth $45 – $55 per share, representing upside of 42 – 72% from last sale. As these supply reforms continue, we expect to see a series of positive price increase announcements throughout 2017 that will help move earnings estimates and X’s stock price higher.
Carbon Investment Partners – Like steel, alumina prices could rise
It is not just steel set to rise in value, but tightness in Alumina supply, due in large part to the same performance drivers, could create higher aluminum prices.
Alcoa is one of those stocks where a “unanimous hatred of this business on both the buy side and sell side” existed.
But Carbon Investments think this “hatred” is a little emotional and misses the point. Supply is tightening and there is an expectation China could engage in supply-side reforms similar to the steel industry, as the fund’s thesis outlines:
We see two ways to invest in this idea – first is in Alcoa, and second is in Alumina LTD, the Australian subsidiary that produces alumina and of which Alcoa owns 60%. The price of alumina has increased to $343 / ton, yet sell side estimates for Alcoa are modeling $250 / ton. The leverage to stronger alumina prices is so great that we expect Alcoa to earn over $2bn in EBITDA this year, compared to consensus estimates of $1.3bn. We see upside for Alcoa to a price of $62 – $75 / share, over 112% from last sale.
Increased production efficiency on the farm is flooding corn market with supply, lowering prices
Tightening supply is helping steel and alumina markets, increasing productivity on the farm has potential to create a negative market environment. This is happening with US corn production.
The increased efficiency of the US farmer has been historic since the 1970s, but it is also a cause for pain on the farm. In the 1970s corn yields were approximately 90 bushels per acre, and moved just 10 bushels higher over 20 years, averaging 100 bushels per acre in the 1990s. Then during the technological revolution, yields jumped to 140 bushels per acre in the 2000s and is now 175 bushels per acre.
This dramatic rise in production is likely to reduce the economics on the farm as corn prices drop. “When farmers don’t make money, they don’t buy tractors,” the letter said, indicating a “hangover” will negatively impact the stock of John Deere, introducing a short thesis.
This article was originally published in ValueWalk.
Photo: Daniel Hollister