Case Study: Embraer Investment Post Mortem

One of the most vexing problems in the world of investing is that of distinguishing luck from skill (spoiler alert: it is nigh on impossible). This is an issue of paramount importance. It is, in a sense, the whole ball game. Morgan Housel calls luck “the flip side of risk:”

[E]xperiencing risk makes you recognize that some stuff is out of your control, which is accurate feedback that helps you adjust your strategy. Experiencing luck doesn’t. It generates the opposite feedback: A false feeling that you are in control, because you did something and then got the outcome you wanted. Which is terrible feedback if you’re trying to make good, repeatable long-term decisions.

In investing, a huge amount of effort goes into identifying and managing risk. But so little effort goes into doing the same for luck. Investors hire risk managers; no one wants a luck consultant. Companies are required to disclose risks in their annual reports; they’re not required to disclose lucky breaks that may have led to previous success. There are risk-adjusted returns, never luck-adjusted returns.

As someone who evaluates investment managers for a living, I am acutely aware of this issue. Particularly as it relates to repeatable, long-term decisions. The hedge fund graveyard is littered with the remains of dudes who got one big bet right then proceeded to nuke their fund with the next one.

The way I deal with this in my personal portfolio is to keep an investing journal. The purpose of the investing journal is to document key decisions and conclusions: research; trade and position sizing rationales; emotional triggers and strategies for dealing with them. All this is documented for later review so I can at least attempt to understand the role of luck and skill in the outcome.

You may recall my old post on trading Embraer (ERJ) using a mix of technicals and fundamentals. On 04/03 I sold the remnants of my ERJ position for a decent gain. Below is my investment post mortem. You will have to forgive me the rough edges as this is only lightly edited from the investing journal itself for grammar and clarity.

ERJ Investment Post Mortem

Below is my original model for ERJ. This would have been done in Fall 2017 (I am lazy about the dates). Obviously the numbers are rough. I am not one of those people who agonizes over precision in a DCF model where a couple basis points on the discount rate will move the valuation by $500 million. My format is blatantly ripped off of Professor Aswath Damodaran’s DCF template. Knowing his philosophy on teaching I trust he’ll take that as a compliment.

The point of the exercise is to get an idea of the upper and lower bounds on the business’s value so a position can be sized. ERJ is subject to a high degree of uncertainty due to the capital intensive and cyclical nature of the business. Even though the model produced a point estimate of the per share value I think of a range of possible outcomes. For ERJ playing around with the numbers led me to believe the base case business value would fall somewhere between $24 and $30 per share. So decent upside appeared to be on offer from an entry price in the mid-18s.

ERJ_Model
Source: Demonetized Calculations

My initial experience with the name is laid out in the trading post linked above. So we will pick up later in 2017. In 3Q17 I wrote:

The theme of the 3Q17 call could perhaps best be described as “under promise and over deliver.” See the above graphic from the presentation slide deck for all the summary you need. They are guiding down in 2018 due to all the factors highlighted in gray bubbles. This more or less holds 2017 results flat and has no impact on the investment thesis. In fact, today the shares traded down further.

The 190-E2 program looks to be on track with the first delivery set for April 2018. They expect about 10% of 2018 deliveries to be 190 E-2 jets.

Meanwhile order activity continues in the legacy book. 12 Super Tucanos were ordered (6 by the US for Afghanistan and 6 by an undisclosed customer). The Super Tucano also passed the initial qualifications required for the US OA-X light attack plane evaluation program. 45 E-175 jets were ordered by SkyWest which is a nice bridge order.

For the time being I like this as a 5% position. I would add opportunistically again below $18/share, assuming no fundamental challenges to the thesis. Need to keep an eye on the order book (they didn’t break out the order book in the presentation material).

On December 21, after ERJ-BA merger talks were announced, I wrote:

ERJ closed up about 22% of the day on the back of news that it and Boeing were in merger talks. This was confirmed by both companies a couple hours after WSJ broke the news. WSJ said the discussions involved a significant premium for ERJ but the sticking point is that the Brazilian government has to bless the deal.

This is a huge validation of the investment thesis and argues for sizing up the position. Considerations:

Analysts think the deal is likely to break. Of course, no one saw it coming anyway so not sure how good their read really is. Skepticism seems to center on the fact that Boeing had been dismissive of Airbus’s move with Bombardier’s regional jet business (although, when you think about it, why would Boeing give public props to its competitor?)

I actually think the deal makes more sense than the analysts. Airbus has clearly gone out of its way to validate the regional jet market. These deal talks do the same. Plus, Boeing and Embraer already have cooperation agreements in place related to the KC-390 tanker.

However, the Brazilian government is a total X factor and I have no desire to try and handicap its actions.

Given the uncertainty, I think it makes sense to hold at current levels and size up opportunistically. If the deal talks stall, ERJ will drift back down toward $18-20 and present an opportunity to add incrementally to the position. The validation of the deal talks clearly is a tremendous boost to the ERJ investment thesis. If the deal breaks, on the other hand, the price will fall quickly back to $18-$19.

I do not think it makes sense to sell out of the position now and bank gains. That would be a short-sighted trade versus what I am really trying to accomplish with core positions. I would rather have Boeing take me out at a higher price (I think this deal gets done between $25 and $35 if it goes through) OR size the position up after the talks collapse and wait for value creation according to the original investment thesis.

No trades placed today but need to keep a weather eye on ERJ’s price.

On 1/5/18 I trimmed the position:

Sold shares of ERJ today @ $26.17. This reduces the position to about 3.3% of the portfolio. The cash on cash return for these shares is about 30% with an IRR in excess of 70%.

Rationale:

Negotiations between Boeing and the Brazilian government are ongoing. Brazil doesn’t want to give up control. Boeing wants control. Allegedly Boeing will not settle for a JV (this process has been leaky and I suspect both sides are strategically leaking info in an attempt to enhance their negotiating position).

This is more or less impossible to handicap. The Brazilian government is not operating purely on economic considerations.

What changed today was that it was leaked that Boeing’s offer for Embraer was $28/share on an informal basis. This is smack in the middle of what I think the likely value of the equity is today (about $25-$30/share). At $26/share the risk-reward skew just isn’t that great anymore.

But why not sell the whole position?

It is possible a deal goes through at $28/share or even higher.

If a deal does not go through, it is possible the shares sell off but to a level well above cost. If this occurs, there is an option to accumulate a bigger position. I am not sold that Boeing won’t accept a JV if it is the only option. It seems stupid for them to walk away all together given the Airbus/Bombardier arrangement. A Boeing JV would be a tailwind for the business and in any event this arrangement validates the long-term investment thesis for Embraer which should enhance conviction.

If a deal does not go through, and there is no JV, the shares should sell off back to around $20 or so. In this case I would accumulate back to a 5-6% position and add opportunistically over time. With 2018 a transition year there is a good chance for an earnings or guidance disappointment that will create further opportunity to accumulate additional shares.

In sum, I feel good about this trade. It feels like a balance of offense and defense. This is a perfect example of why I like to retain the flexibility to actively size positions to  manage risk and return. The key is not to be “trading scared” based on loss aversion. The focus has to be on the business fundamentals and the risk/reward skew.

On 4/03/18 I closed out the position with the following rationale:

Sold the remainder of my ERJ position.

I had intended to wait longer to exit this position in hopes of eking out a little more performance. However, in reviewing the overall portfolio it seems clear there are better opportunities on offer.

This is the first example of me liquidating a position to redeploy the capital into a better idea. Really what appears to be on offer from ERJ in the shorter-term is a merger-arb type return–a fairly small bump (maybe another 10%) with deal break risk. As a residual position it just can’t contribute that much relative to what it would detract in a deal break scenario. This is more of a value pattern investment even though ERJ has a good track record of capital allocation. So ultimately in looking at the risk/reward seems prudent to take the win and move that capital into a better opportunity.

I used the proceeds from the ERJ sale to build my CBOE position above the 10% threshold to bring it to Core Weight.

What Worked

  • Modeling appears to have been validated by subsequent market action and alleged Boeing negotiating position.
  • Trading around this position worked well (85% IRR vs. 43.3% cash return).
  • Disciplined exit.

What Didn’t Work

  • Position was sized too small. However, I can’t really knock myself too hard for this as the Boeing takeout clearly surprised the entire market. I suppose it might have been possible to foresee a deal after Airbus and Bombardier announced their partnership. But that is subject to significant hindsight bias. And anyway, I don’t want to leave myself in a position where I am relying on someone else to take me out for an investment to work. These aren’t supposed to be merger-arb trades.

Luck vs. Skill

  • The Boeing merger talks served as a catalyst which was not underwritten at all in the original investment case. So I get no credit for that.
  • From a risk management POV I think I can take credit for prudent position sizing. Remember that at the time the Bombardier-Airbus partnership was seen as a significant threat. Also the business performance outlined in the 3Q17 presentation was in line with my expectations for a rocky transition to the E2 Series.
  • Luck did not “save me,” but it certainly got me paid on an accelerated time horizon.
  • I do give myself some credit for thinking of the whole portfolio and not just this name in deciding to exit the position.

Learnings

  • Not too much to take away from this one. Looking back I don’t think there is anything I could have done different without the benefit of hindsight. Probably the biggest takeaway from this position is not to attribute the quick payday to my own analysis. The position was properly sized but my actual investment case did not play out (the investment was underwritten for a much different time horizon).
  • I will keep an eye on things with ERJ to see how they play out. For one thing it could make for a good investment again in the future. For another, it will allow me to compare my investment case to what actually plays out, and assess whether redeploying the capital into CBOE was really the right decision.

Conclusion

I hope you enjoy reading this. Feedback is always appreciated. I will share more of these in the future.

 

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