About that EGPT… The Process of Forming a Trade Thesis

EDIT: after you read this piece, please read the correction/clarification post I wrote.

 

Last Monday I mentioned a situation in EGPT where the ETF was trading at a level which implied a pretty serious rally in the underlying portfolio once Egyptian stocks reopen.  I spent the entire week trying to get this trade on (short EGPT), was unable to get borrow at my broker, and even went so far as to open a new brokerage account at a firm which seemed to have stock borrow (for shorting) available.  On Friday I officially gave up after I was unable to wire money into the new account in time, despite frantic efforts to do so, and the borrow became even tighter.

Let’s recap quickly what’s going on:  EGPT is an ETF which allows for cash creations.  That means that, unlike a “normal” ETF where authorized participants deliver shares of the underlying basked to the Fund in exchange for newly issued shares (creations), the EGPT allows APs to deliver cash to the fund in exchange for new shares.  When there’s a complete political overhaul in your country and the stock market closes for two weeks, this is problematic for tracking the intended index performance, since the Fund is now sitting on cash instead of stocks to back those newly created shares.

I believe that the holders of EGPT are mispricing and/or misunderstanding the mechanics of the ETF.  This isn’t surprising, but the situation is somewhat unique in that the  mispricing persists because the market lacks a way to correct it – the stock is almost impossible to borrow and thus cannot be shorted, and the creation/redemption mechanism is halted.  Let’s go to the numbers – don’t fear the math, this is easy stuff.

Van Eck (the ETF Manager) publishes a daily spreadsheet detailing the holdings of the ETF.  Looking at the spreadsheet and doing a little bit of research on our own, we can see that there are three “asset classes” in the fund: 1) cash, 2) actively marked stocks – these stocks trade in London or Canada and are not currently halted, 3) “static” stocks which trade in Egypt (halted) and are being marked to whatever Van Eck thinks their fair value is at the moment.  For simplicity’s sake, let’s just pretend that the static portion of the portfolio is marked at the last trades in Egypt, which are now more than 2 weeks stale.  They are actually marked slightly higher than that, but the “stale” assumption will give us an even more conservative result, and we have no idea how good Van Eck’s fair value marking system is.  Some of the Egyptian exchange stocks actually trade in other markets as well, which factors into Van Eck’s fair value marks, but again, assuming static marks will result in an even more conservative conclusion.

So, the three asset classes (cash, active, static) add up to the value of the portfolio, which as of Friday night’s Van Eck spreadsheet was $24.653MM.  The fund has roughly 1.55MM shares outstanding, and the last trading price of EGPT on Friday was $18.73.  Now, multiply $18.73 per share x 1.55MM shares and we can see that EGPT’s price is implying a value of $29.031MM for the underlying portfolio.  Now, let’s look at the value of the three portions of the portfolio, again, taking the data from Van Eck’s spreadsheet.

Cash is easy – it’s listed right at the top: $9.540MM

Next is the “active” portion – that’s the next 4 stocks in the Fund (name, ticker, shares, value):

Orascom Construction Industries ORSD LI 52,884 $1,997,634.45
Orascom Telecom Holding SAE OTLD LI 557,227 $1,865,166.37
TRANSGLOBE ENERGY CORP TGL CN 77,331 $1,181,178.24
Centamin Egypt Ltd CEY LN 477,174 $1,075,594.79

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The value of the active portion is the sum of those 4 values: $6.120MM

Then we look at the passively marked portion of the fund – the rest of it –  and see that static Egyptian stocks sum to a value of $8.992MM.

Finally, we just have to back into the implied value of the static portion of the portfolio, once it reopens, that we need to justify the $18.73 EGPT trading price.  We take our implied $29.031MM value that we calculated above (EGPT price x shares outstanding), subtract out the cash (cause it’s value won’t change, and the $9.54MM in cash will become $9.54MM in stocks once it is deployed), and then subtract out the actively marked London/Canada stocks:

$29.031MM (value needed) – $9.540MM (cash)  – $6.120MM (active marks) = 13.371MM (Egyptian exchange value implied).  That’s how much we need the (static) Egyptian trading portion of the portfolio to be worth once Egypt resumes trading.    The static portfolio value has to increase by 49%, from $8.992MM to $13.371MM just for EGPT holders to be getting their “money’s worth!”

Now, I’m no sort of expert at all on Egyptian stocks, Egyptian politics, or the Egyptian economy, but I’m inclined to believe that we are unlikely to see a 50% rally in EGPT’s Egyptian traded portion of their portfolio when trading finally resumes.  The important thing is that investors be aware of the math implied in the $18.73 EGPT trading price, and then make their trading decisions around that.  It’s easy to build a matrix showing what would happen if the EGPT traded exactly to its new NAV given different scenarios for the static portfolio price change:

If Egypt Rallies Static Egypt Value Total Fund Value EGPT NAV EGPT P/L
10% $9,892,105 $25,552,326 $16.49 -11.98%
20% $10,791,387 $26,451,609 $17.07 -8.89%
30% $11,690,669 $27,350,891 $17.65 -5.79%
40% $12,589,952 $28,250,173 $18.23 -2.69%
50% $13,489,234 $29,149,455 $18.81 0.41%

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In fact, EGPT has historically traded 1-2% above its NAV, so you can take that into account as well.

Let me mention a few more details and risks.  EGPT is very hard and expensive to borrow.  Borrow rates have increased from roughly 17% last week to 24% as of today.  This means that if you borrow EGPT and short it, you have to pay 24% annualized to carry the position.  This isn’t a huge deal expense-wise, as I wouldn’t expect the trade to last longer than 1 or 2 more weeks.  Which brings us to the main risk of the trade:  we’re still not sure when Egypt’s exchange will reopen.   Additionally, there will be numerous price circuit breakers instituted on the Egyptian exchange, which may result in more trading halts.  This in turn may result in more time needed for prices to stabilize, and for the ETF’s creation/redemption process to resume its normal functioning.   The longer a trader has to hold a position in a hard-to-borrow stock like EGPT, the higher the risk that the borrow is recalled, which could cause the trader to have to cover his short before he wants to.

It’s also possible, although I would guess unlikely, that Van Eck suspends creations and redemptions for an extended period of time.  If this were to happen, it would further impede the ability of market participants to rectify any mispricing of the ETF.  Once creations are resumed, however, the mispricing should be quickly corrected:  it’s easy to create new EGPT shares for cash and sell them into the marketplace.  Since the share price is much higher than the NAV (assuming we don’t see a monstrous rally in the Egyptian listed stocks), that’s a simple layup, and should happen rapidly.

When I moved my blog to this new domain name, I mentioned in my opening post that I don’t give stock recommendations and that I won’t make you rich with trading calls.  My goal in this post is to take you through the trading decisions you should be thinking about in all sorts of relative value trades, and give you an insight into my thought process on this specific trade.  Once you know how the process works, you can make your own decision about EGPT  – if you think that the Egyptian portion of the portfolio will double once it opens for trading next week, then you’ll be an eager EGPT buyer, as the ETF is pricing in a roughly 50% increase in those stocks.

-KD

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