Trade Wars: Portfolio Hedges

“It’s easier to hold your principles 100 percent of the time than it is to hold them 98 percent of the time.” — Clayton M. Christensen

“Character, like a photograph, develops in darkness.” — Yousuf Karsh

In this week’s piece we discuss hedges to provide some portfolio protection under the different potential outcomes to the US-China trade dispute as the 1 March deadline to reach an agreement approaches. Also this week, we discuss 3-D printing — the one time darling and now much maligned corner of the technology sector — and consider potential long ideas within the segment.

US trade representative, Robert E. Lighthizer, and US Treasury Secretary, Steven Mnuchin, are heading to Beijing this week, ahead of the 1 March deadline to reach an agreement and prevent a further hike in tariffs. As part of the on going negotiations, the Trump Administration is demanding China to (1) reduce its trade surplus with the US, (2) stop enabling the theft or forced transfer of intellectual property and trade secrets from US businesses operating in China, (3) ease restrictions on foreign investment and foreign ownership of Chinese companies, and (4) put an end to industrial subsidies and the preferential treatment given by the Chinese government to state-owned enterprises.

In broad terms, we think there are four possible outcomes to the on-going trade related negotiations between the US and China. These outcomes are:

A compromise much akin to kicking the can down the road whereby China agrees to reduce its trade surplus with the US and increases its purchases of US products and services. Nothing else of material consequence is agreed upon and both parties make assurances of negotiating over unresolved matters in the near future.
Both parties make some concessions and meaningful progress is made on trade, giving Corporate America greater access to the Chinese market and intellectual property theft by China.
One of the two parties capitulates. In the case of China capitulating means agreeing to an overwhelming majority of the Trump Administration’s demands. While the US capitulating means most demands unrelated to the China’s bilateral trade surplus are dropped.
There is no agreement and a hike in tariffs goes ahead as planned.

The type of hedge a portfolio may need depends on how said portfolio is positioned.

A portfolio positioned for an amicable resolution to the trade dispute needs hedges for the first and fourth scenarios briefly outlined above. While a portfolio positioned for a prolonged trade war requires hedges under the second and third scenarios.

Positioned for an Amicable Resolution

Given China’s ambitions on the technology front and the Trump Administrations to rein Chinese technological through use of national security measures and export controls, the semiconductor industry is likely to be a key battleground in the dispute.

Investors positioned for an amicable resolution to the trade dispute can hedge themselves, we think, by going long South Korean semiconductor companies — China will need to turn to them in the event export controls are imposed on US semiconductor companies. Investors can further hedge themselves by shorting Taiwanese semiconductor companies because, if China’s thirst for semiconductor supplies is as strong as we think it is, the risk of annexation of Taiwan by China to secure supply rises significantly in the event of a less-than-amicable end to the negotiations.

Positioned for a Prolonged Trade War

Investors positioned for a prolonged trade war can hedge themselves, we think, by going long US agriculture commodity producers — one of the simplest ways for China to shrink its bilateral trade surplus is to increase purchases of agricultural commodities from the US.

3-D Printing: Inflection Point?

At the beginning of 2018, Bugatti revealed it had developed the first series-production 3-D printed brake caliper for use in its vehicles. In December last year, the Volkswagen Group released a video of the finished product in action.

In October last year, Dutch robotics company MX3D completed the 3-D printing of a steel bridge and announced that it will be installing the bridge across a canal in Amsterdam during 2019. Two months later, the Marines from the 1st Marine Logistics Group at Camp Pendleton, California – with the help of the Marine Corps Systems Command Advanced Manufacturing Operations Cell and the Army Corps of Engineers — successfully 3-D printed a concrete bridge on site as opposed to in a factory setting.

NOWlab, the innovation arm of German additive manufacturing company BigRep, unveiled NERA — a fully 3D-printed motorcycle – in November 2018. All parts of the motorcycle — excluding the electrical components that power the bike — have been 3-D printed, including the tyres, rims, frame and seat.

In January, Relativity Space — a rocket-building company founded by former SpaceX and Blue Origin employees — revealed that it has been granted permission by the US Air Force to launch its, almost entirely 3-D printed, rockets from Launch Complex 16 at Cape Canaveral in Florida. And just last week, UK-based space startup Orbex publicly unveiled its Prime rocket — the world’s largest 3-D printed rocket engine — at the opening of its new headquarters and rocket design facility in Forres in the Scottish Highlands.

The Innovation S-Curve

Many investors have turned their backs on 3-D printing after exhibiting irrational exuberance towards the technology over years past. After a failed promise of endless growth, and a bursting of the stock price bubble that sent shares of publicly traded 3-D printing companies tumbling, we wonder if interest in 3-D printing stocks may be rekindled as the potential benefits of the technology begin to be realised?

Everett Rogers, previously professor of communication studies at the University of New Mexico, popularised the theory of diffusion of innovations in his book Diffusion of Innovations. The theory is amongst the oldest theories in social science.

The theory postulates that the adoption of an innovation within a social system is determined by four factors, namely:

The innovation itself;
Communication channels;
Time; and
The characteristics of the social system.

Over the years, the innovation S-curve has been popularised a means of measuring the adoption of existing technologies. The innovation S-curve is an application of Professor Rogers’ theory.

Source: ideagenius.com

3-D printing has gone through its early adoption phase. The recent delivery of a number of innovative solutions based on 3-D printing makes us wonder if 3-D printing technology is now at an inflection point within its innovation S-curve and ready to enter a phase of rapid growth? If indeed it is, many of the publicly listed 3-D printing stocks could, in a few years time, trade at many multiples of the prices they trade at today.

3-D Printing Stocks

Below we highlight two 3-D printing related stocks that caught our attention upon initial screening,

The ExOne Company $XONE

$XONE is a micro-cap stock with market capitalisation of US dollars 172 million. Short interest in the stock is high at more than 27 per cent of free float.

The company was spun-off from Extrude Hone Corporation, a global supplier of precision nontraditional machining processes, 2005.

$XONE is a global provider of 3-D printing machines, 3-D printed products and related services to industrial businesses operating across the aerospace, automotive, pumps, heavy equipment and energy industries. The company’s product and services offering revolves around industrial strength sand castings and moulds and directly printed metal parts.

Following a transition year in 2018, during which the company took measures to improve operating efficiencies and reel in costs, the company’s management expects net income and operating cash flows to be positive in 2019. Further, the company will be introducing larger format 3-D printing machines during the year to increase the size of its addressable market and to up sell existing clients.

Stratasys Limited $SSYS

$SSYS has a market capitalisation of US dollars 1.4 billion. Short interest in the stock stands at almost 12 per cent of free float.

The company manufactures 3-D printers used by designers, engineers, and manufacturers for office-based prototyping and direct digital manufacturing to visualise, verify, and communicate product designs. Engineers, for example, use Stratasys systems to model complex geometries in a wide range of thermoplastic materials such as polycarbonate.

$SSYS’s CEO, Ilan Levin, resigned in May 2018 and its Chairman has been serving as its interim CEO since. Levin’s exit came after the company posted losses of of almost US dollars 40 million in 2017 and US dollars 13 million during last year’s first quarter.

The company has been witnessing growth in 3-D printing system orders since the second quarter of last year and management expected this trend continue into 2019. They are also see their customers moving from experimenting with 3-D printing to deploying and expanding the capacity of these systems in true production environments.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.