John Paulson's, the founder of Paulson & Co. (huge subprime bets) started his career as a investment banker and then worked as a risk arbitrager with Gruss Partners. He learned a very important lesson here that I'd like to reiterate: "Watch the downside, the upside will take care of itself". He also wrote a paper titled, "The 'Risk' in Risk Arbitrage", and its a must read! A caveat here is in order, risk arbitrage is very risky and should not be tried at home (as Joel Greenblatt would put it). The BCE buyout deal has been a non-stop soap opera for anyone who's watching. Today it was announced that the deal might be in jeopardy and the stock dropped 40% from around $37 to $24; the buyout price is $42.75/share. Arbitrage spreads in general have been very very wide over the last 3-6 months and for a good reason as deals have imploded left and right. While I am not going to talk specifically about the BCE deal, but will talk about arbitrage at the tail end of the buyout boom (and its common sense!).
But first, all this reminds me of something I read in the 1988 Berkshire Hathaway shareholder letter (which is also a must read for risk arbitrage). In that letter Warren Buffett explains arbitrage and his approach with relevant examples. Here's a synopsis: "To evaluate arbitrage situations you must answer four questions: (1) How likely is it that the promised event will indeed occur? (2) How long will your money be tied up? (3) What chance is there that something still better will transpire - a competing takeover bid, for example? and (4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?"
He goes on to explain a couple of transactions and but in the end the thing that I remember is, "Even if we had a lot of cash we probably would do little in arbitrage in 1989. Some extraordinary excesses have developed in the takeover field." He goes on further to talk about how he 'doesn't know' and 'no one knows', "We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them. But we do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs. We have no desire to arbitrage transactions that reflect the unbridled - and, in our view, often unwarranted - optimism of both buyers and lenders."
And this is the essence of it. Simply, do not engage in arbitrage at the tail end of the buyout boom. The ratio of collapsed deals to total deals has been very high this past year. It usually is when the buyout boom takes a form of its own, and the market values everything at private market valuations, exactly as WB said. It was high in 1988 and it was high in 2007 (read: Blackstone IPO). Michael Price once said that the folks who do risk arbitrage are the same ones that do distressed debt when the cycle turns, and this rings true today when a lot of hedge funds are unloading the risk arbitrage staff and beefing up their distressed debt teams (but just a little too late). If an investor as a rule refuses to participates in risk arbitrage during these times, a lot of pain and suffering can be avoided. When you are picking pennies (or dollars) in front of a road roller you really want to have the odds on your side.
Wednesday, November 26, 2008
Tuesday, November 25, 2008
Stock Idea: CBS Corporation
Although it is a monkey and a dartboard (stockboard?) market right now, you always hope you can beat the market. CBS Corp. (CBS), in my opinion is a safe and extremely cheap investment and if bought at these prices ($6.50/share) will beat the market and then some.
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
(1) Television - 66% of revenues, 60% of EBIT with 18% op margins;
(2) Radio - 12-14% of revenues, 24% of EBIT with 35% op margins;
(3) Outdoor - 16% of revenues, 14% of EBIT with 18% op margins;
(4) Publishing - 6% of revenues, 3% EBIT with 8% op margins.
CBS right now has a market cap of $4.5B and Long term debt ( 4.625% – 8.875% due 2010 – 2056) is $ 7.1B for a $11.1B in EV. With a TTM EBITDA of $2.9B the company is trading at a EV/EBITDA (ttm) multiple of 3.7x and a dividend yield of 16%. CBS is not a growth story, but a cash flow story and comes close to a Private Equity type investment. The company is a very stable cash generator and has generated, over the years on average around $2.6 billion in operating earnings (FCFF) and after $550 million in debt service around $2B in FCFE (not including growth capex) per year. So for a $4.5 B equity investment CBS is producing around $2 B in cash flow for a yield of 50%! The bull case is trivial, I will present the bear case here and try to refute the arguments.
Sumner Redstone: The CBS shares collapsed over the last few weeks and their collapse was made worse by the fact the company’s chairman and controlling shareholder, 85-year-old Sumner Redstone, was forced by lenders to sell a fifth of his family’s holdings in CBS to meet loan covenants for his holding company (NAI). He controls around 80% of the voting shares and therefore this company cannot be sold, unless he sells. I will not value CBS at a private market valuation. There is a concern that Sumner Redstone will take CBS private, but with margin calls n all, and the current debt refinancing environment, I don't think so! There is also an issue between Sumner Redstone and his daughter Shari Redstone. But really do I care? A part of the bid price today is because of 'forced selling', so this is a case of a broken stock not a broken company. I like I like.
Debt Maturity: $1,585.5 million in long term debt is due June 2010 and another $950 million is due 2011. CBS generates around $400-500 million of FCF every quarter and there are seven quarters left till the June 2010 maturity. With $500 million in cash and potential $2.8 B in FCF they should be more than able to pay the debt. One caveat thou: the dividend will have to be cut! The company is paying around $700 in dividends every year and that will need some cutting going forward (the market has already priced this in). This is all assuming the company cannot refinance at favorable terms in 2010.
Advertising environment: CBS is heavily dependent on advertising and this is supposed to be the worst advertising environment over the last 40 years (and the world is ending). CBS operates in segments that give advertisers the greatest bang for their buck and the stronger companies will advertise more in order to gain market share so net-net the effect would be minimal. These networks are like toll roads, where will the companies go? Even if I assume a 40% cut to the operating earnings (way too rich, management is expecting mid teens decline) the company will produce $1.56 B in FCFF and $1B in FCFE per year, and even this will be good enough to take care of the debt maturity and then some. The management is good, has good incentives to execute and is experienced and they know whats coming and have been and will manage the business accordingly. The loans seem covenant lite and I could not find anything in the 10K.
Pension Liabilities: This is a bummer, CBS has around $1.7 B in unfunded pension liabilities. The point here is that these are not loans and do not have a bullet payment. CBS is assuming a 7% long term return with 5.9% discount rate and has more than 80% of the assets in fixed income securities. I am not saying it does not matter, but this issue existed before the current decline. There is around $200-300 million that CBS will need to contribute to the plan every year, I've looked at the footnote and there is nothing that overly concerns me (esp. looking at the kind of cash flows they are producing).
I am sure there is something else, but net-net CBS is the number 1 rated network, is a strong cash flow generator which has produced strong returns on invested capital. Media companies have traditionally traded for around 10-12x EBITDA, have private market values of around 12-14x and after discounting the control by Sumner Redstone I am comfortable valuing CBS around 9x. In around 3-5 years, at 9x, the EV would be $27 B, and after debt and residual corporate costs (pension, operating liabilities) of around $11B (assuming moderate cash payments over 5 years) gives me an an equity value of around $16B - $18B or $22-25/share. The media sector is trading at very depressed valuations and these companies are cash flow cows. Prem Watsa recently increased his investment in Canwest Global, which is a similar investment but more levered. So in essence, more than the upside the important thing to consider in this type of an investment is what can impair your capital (and the upside will take care of itself)? In CBS's case I found no scenario (or only very low probability scenarios) that that could 'kill my investment'.
Disclosure: Long CBS
Monday, November 17, 2008
Bonds: Here's the Glory
There is a lot to be said about these instruments. They are 'safer' than equity no doubt, but do not offer the glory of equity returns (ok I admit that you have to look at more than a 10 year period). Distressed Debt investing however has its own charms, it offers 'lower' risk than equities but equity type returns. Looking at the quarterly filings by some of the gurus, there's one common element: distressed bonds.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
I will not explain how bonds work here or the different types of bonds, but offer a few examples of distressed investing and pepper it with my comments. The 2000-2002 period was also good for distressed debt investing. Warren Buffett bought bonds in L3 communications and Enron among others. Here's how Enron went, "in 2002-2003 we spent about $82 million buying – of all things – Enron bonds, some of which were denominated in Euros. Already we’ve received distributions of $179 million from these bonds, and our remaining stake is worth $173 million." (Some of the gain was due to the appreciation of the Euro)
Seth Klarman of the Baupost Group in September initiated a position on WAMU (again of all cos) covered bonds (a special type of bond secured by an over-collateralized pool of good quality mortgages) for 74 cents on the dollar. If WAMU survived they would have earned 15.4% yield to maturity in 2011. If however WAMU failed, the bonds were backed by good quality mortgages and could either be acquired by a buyer, become backed by cash placed in a trust or the bond holders would come to own the mortgages. Its really a win-win situation.
Today, Marty Whitman, one of the best (he was right there when Eddy Lampert was buying Kmart), is buying distressed bonds. This is what he bought: GMAC 7 3/4 Senior Unsecured Notes, Maturing 1/19/2010, Recent Price: $62, Yield to Maturity 53.42%, Current Yield 12.50%. In addition, he bought bonds in MBIA and Forest City and gives a lesson on distressed debt investing in his quarterly letter. Here is an expert, "It is important to understand that no one can take away a creditor’s right to a money payment unless he, she or it consents, or Chapter 11 relief is granted. What does this mean for a distress investor? If a company is going to avoid Chapter 11, a short-term maturity date gives the distress investor de facto seniority. If a company is to be granted Chapter 11 relief, seniority lies in the loan covenants; maturity dates for unsecured lenders become irrelevant." He explains his GMAC buy in the letter and assigns probabilities to the bonds remaining performing and the company defaulting. In any of the scenarios Whitman could not point out to a case which would lead him to take a loss on this investment.
In addition to the above mentioned managers, Francis Chou and Tim McElvaine are also bidding for distressed bonds. You can get your price by - A) forced seller willing to dump at any price B) genuine deterioration where the company is closing in on a covenant. Option A could be a no-brainer as long as you have done your DD (you will see a 'buy me' sign), but with option B there is a chance of Chapter 11. I am no expert at distressed investing, but from the little I know its bad to buy bonds of 'buggy-whip' manufacturers, but OK to buy bonds of companies that have a viable product but are in distress due to the debt burden. And again from my limited knowledge the Chapter 11 dynamics look like this: say a company has an enterprise value (EV) of $1.5 billion, with $1 billion in debt (at 6%) and $500 million in equity. The company needs $60 million every year to service the debt. Now lets say the economy deteriorated and the company can only service $50 million in debt. The creditors will force the company in Chapter 11, the equity holders will be wiped out and the debt will be restructured. The way debt would be restructured is the debt holders will now get say $700 million in newly issued notes (the company can comfortably service its debt now) and $300 million in newly issued equity. So if you paid 60-70 cents on the dollar for this bonds, you will be made whole and given an addition equity kicker. There are myriad scenarios and the process is very complicated.
Option A - the company doesn't default and the loans remain performing you get paid in full; Option B - the company defaults, you get debt and equity in bankruptcy and the price you paid ensures the safety of capital.
Friday, October 24, 2008
Lets use some WMFD's
Derivatives or Weapons of Mass Financial Destruction as they have been fondly called by Warren Buffet (WB). He talked about this back in 2002-2003 right at the same time Alan Greenspan was talking about less regulation. We are lucky that WB was just half right, because I cannot fathom where we would be if he was fully right (mushroom cloud type stuff). Having said all this, he has used derivatives where he found mispricing. It is not in the use of the derivatives that he has a problem with, its the unchecked use, the wild wild west type of environment (read: CDS).
Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.
Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!
Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..
Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..
Lets see what he did and what we can learn/use in this environment. First in March we heard news that WB sold puts on the S&P 500 and 3 foreign indexes. These puts expire in 15-20 years and gave him $4.5 billion in premiums. What this essentially means is that WB is betting that the markets in 15-20 years will be higher than what they were in March, 2008. Again in October 2008 he sold Puts (~5 million shares) on Burlington Northern Santa Fe (BNI), with a strike price of $76-$80 and collected premiums of around $7/put. His index Put selling strategy might be more of a play on collecting premiums, but the BNI purchase seems to be more geared towards him wanting more stock in the company (he already has a large stake). Now if BNI trades at $74 in the future he would have the option of buying the stock at $76, but he has already collected $7 for the put, so he is essentially buying the stock at $69 - selling Puts is another way of buying a stock.
Call and Put option pricing depends on a lot of things, but one of the major determinants is Vega (volatility). This is a time of unprecedented volatility where the VIX is at historical heights, and therefore these options are priced accordingly - high (and this is where an opportunistic value investor comes in). One of the strategies (derived from WB options activity) could be to sell Puts on indexs/stocks that you want to buy, make some money on premiums and if the they fall to your sweet spot, well then good for you!
Let me give you an example: the S&P 500 (SPY) is trading at around the $88.0 area; you sell $75.0 strike put options on SPY expiring Jan 2009 and collect $4.7 in premiums. If the index falls to that level or below you can essentially buy SPY for around the $70.0 level. If it doesen't then you still get to keep the $4.7 in premiums (but don't get to buy the index, which is a downside if that is what your sole aim was). If you think that S&P at 880 is not the bottom, would you be comfortable buying at the 700 levels? The market would be more than 50% off its highs, and the P/S, P/E ratios would be more in line with previous bear markets troughs. Another example could be Goldman Sachs (GS), the stock is trading at around $100, you can sell the $65 strike puts expiring Jan 2009 and collect $5 in premium, how would you like to buy GS for $60? or keep $5? There are myriad things that you can do with options, but selling options is something that can work well when the volatility is high. Also exactly which strike/time to buy depends on the situation and the goals..
Update: GS is trading at $55 today (19th November), so if you had sold the put option on GS you would have been forced to buy the stock. Again, selling options just for the premiums is a risky strategy, however if you want to own the stock after selling puts or are writing covered calls, that's a different story..
Wednesday, October 22, 2008
Stock Idea: Contango Oil and Gas
Contango (AMEX: MCF) runs on two principles:
(1) The only competitive advantage in the natural gas and oil business is to be among the lowest cost producers
(2) Virtually all the exploration and production industry’s value creation occurs through the drilling of successful exploratory wells
Kenneth Peak, the founder and CEO of Contango is the largest shareholder in the company, has never sold a share and is a very good capital allocator (Buffett type). He has 6 full time employees, all focusing on the highest ROI part of the E&P value chain – exploration. Every other service in the chain is contracted out to an expert that can provide better value for that part of the chain than MCF can. They work with some of the brightest and most successful oil and gas finders in the business. Contango collaborates with a network of about 10 geoscientists with four small, privately held alliance partners. In all their deals, the alliance partners have capital at risk and the deals are structured so that the partners do not make money before Contango makes money. This strategy has paid off - Contango made the largest Natural Gas find (Dutch and Mary Rose) in the Gulf of Mexico (GOM) in the last 2 decades, combing through old publically available data. Contango has the best balance sheet in the E&P sector, with approximately $50 million cash, another $50 million line of credit and $18 million in debt. They have 369bcf in proven reserves and 70 undrilled GOM leases. The Dutch and Mary Rose wells, when operating at full capacity, generate approximately $20 million per month in after-tax cash flow at $7 natural gas and $70 oil prices. The firm has also carved out some properties before and sold them for 10-15x their initial investments, all without paying tax (capital allocation).
The current stock price of approximately $43/share buys 22 mcf of Natural Gas and contemplates $4 natural gas prices and $50 dollar oil. I believe it is not possible for the price of natural gas to remain below $6 for a long period of time (I am not saying it will go up, but below $6 econ 101 will kick in) due to the high cost of marginal supply. MCF can purchase after-tax reserves on the open market, in the form of share repurchases, for approximately $1.75/mcf, which is about half of the cost of developing new reserves through drilling. The company has recently done some buybacks (again capital allocation) but any further buybacks will substantially increase the value of the company.
Warren Buffet has talked about the 'finding costs' as the most important factor in valuing Oil and Gas companies. Contango has total costs (including finding) of $2.18/mcf and is one of the lowest cost explorers in the GOM. The company’s PV-10 valuation with $7.00/mcf of natural gas and $70.00/bbl oil, NYMEX prices flat forever after 35% for projected federal income taxes is approximately $1.3 billion or $78.00 per share. The firm recently got an offer between $75-85/share just for the Dutch and Mary Rose fields (there are other fields, leases and a computer system worth around $10-20/share), but it fell through because of financing. Reserves in the GOM area have traditionally gone for $3.50-$5/mcf; with all these valuation metrics Contango is worth somewhere between $80 - $ 110/share. I am not saying this is the best deal in town (there are E&P companies which have 3-5x potential, but there's more risk) but that there is high visibility and therefore low risk. They have a tangible asset value that can be realized easily and the assets can be easily converted into cash without discounting them.
Mark Sellers has talked about this idea in the Value Investing Congress conferences many times. I researched it and always liked it but Contango never had the margin of safety before, now it does.
Friday, October 17, 2008
Where is the consumer?
This is unprecedented. The fact is that we have never seen a consumer lead recession in our lifetimes. The previous recessions in 73/74 – Oil; 80/81 – Interest Rates; 90/91 - S&L crisis; 2001 - Dot-Com collapse and 9/11 were all exogenous shocks to the economy that resulted in a contraction in business, but were not consumer lead. Every facet of the economy has enjoyed the pearls of leverage over the last 20 years. We were all operating at levels that were not warranted, levels that were sustained only by leverage on the household balance sheet. In order to pay this debt and get the household balance sheet in order, people have to work more jobs, spend less, and save more. Also, the unemployment rate after bottoming early last year at 4.4% is now close to 6.1%; this can easily go to 8-11% if history is any guide. Personal income drives consumption and with unemployment rising, personal consumption will go down. Furthermore, in all likelihood Senator Obama will become President of the United States; and he has talked about ‘taking responsibility’ and ‘saving’ etc. This is in stark contrast to the current administration’s message of ‘spend, it’s the American way’.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
The US consumer on average has a disposable income of $10 trillion/year and the saving rate over the last few years has been negative. If we look at the 25 years ending in 1985, the saving rate was 10%. I believe the savings rate would go up substantially; maybe not 10%, but something like 5% over the next 5-10 years and factor in the absent leverage – the consumer (75% of GDP) will be a huge drag on the US economy. I believe that were will be smaller engines in the form of Asian economies (slowing down) but the net result will still be negative - via a negative feedback loop. Now the economy either needs: 1) A Large War 2) Major Technology breakthrough. I place a very low probability of any one of them occurring. In essence, this will be a consumer led recession, is unique, will by all accounts severe and last a long (3-4 years) time. We know that the economy and the stock market are rarely in sync, but as an investor this matters because it is crucial to know where the consumer is when valuing a company.
Warren Buffett in a Fortune magazine article once argued that if there is one indicator he looks at, it is the ratio of the market capitalization of the market to the GNP (I am using revenues). The current P/S ratio of the S&P 500 is 1.22. The current ratio sits above the long-term average of 1.14 since 1975 and the median of 1.10; and is substantially higher than the ratio reached in the 1990 bear market of 0.77 and in the early 1980's of 0.50. There has been however, a permanent upward shift in the level of profitability (although the profit margins of 2006-2007 are unsustainable) in the economy, and the S&P 500 should be able to maintain a relatively higher price to sales ratio. S&P 500's median P/E ratio now is at 13.5 and has fallen to just below its long-term average of 14 and below its median of 15. It's near the valuation levels reached in 2002, but remains noticeably above the levels reached in 1991 - 11, in 1982 - 7 and in 1974 - 5. Taking the P/E and the P/S ratios into consideration the market has further to fall - S&P around 750-800; and might trade flat to down over the next few years with a few bear rallies. There are no predictions, only probabilities. I believe in buying stocks and not markets. Balance sheet strength is as important as ever, and investors should buy stakes in stocks they are prepared to average down on. Although I strongly believe in fundamental bottom up analysis (90%), I think it is essential to have a perspective on the relative valuations (10%).
Update: GMO's Jeremy Grantham has completed the first part of this Quarterly Letter, very interesting commentary. He essentially said that they are nibbling right now, they might be early and that there is risk of a 20% overrun to the downside.
Wednesday, October 15, 2008
Margin of Safety: Three Most Important Words
when it comes to investing! But what is it? What does it exactly mean? What we essentially hear is that it is buying $1.00 for $0.50, fair enough; but thinking about it over the last few days, I think there are two forms of margin of safety..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
Form#1: This is the pure Graham version, where he determines that ABC Corp. is trading for $0.50 while the Book Value of the company is $1.00, the book value is solid. Mr. Market then recognizes that the Book Value is solid and sends the stock price up to reflect that fact. Now IF the company grew by 10% in that year the new Book Value would be $1.10, so we can buy this company for $0.50 and sell it for $1.10, remember most of the money has been made because of the value differential.
Form#2: And this is the modern form. When the US economy moved to a service based economy, there were fewer assets required to produce cash flow. Value investors could not really reply on Book Value's and with the times had to move on to Discounted Cash Flow (DCF) models. The intrinsic value of a business is the Present Value of its future cash flows (P/E and other relative valuation ratios are basically derived from a DCF). Now XYZ Corp.'s is growing at 20%, according to a DCF and has a fair value of $1.20 and the company is trading for $1.00. A value investor will only pay $0.60 for this company while a growth investor might pay around $1.00-1.20 (i really don't know what they would pay!). The value investor is banking that the valuation gap between the fair value (his) and the market will decrease and the growth investor is relying on future growth. This is all fine and dandy but will Benjamin Graham do it this way?
I think not! Remember in our DCF we are implicitly factoring in growth in the cash flows. And this comes down to how value investor's today value securities (and there is nothing wrong with this). We mortals like to label the different type of investing methods, some are value some are growth and so on n so forth. Warren Buffett has said that value and growth are joined at the hip, the only different in the price, and by price we mean margin of safety. Anyways, If we were to use Form#1 in modern day valuation what we would do is value this business factoring in a zero growth rate or a GDP plus (5%) growth rate and then demand a price which is 50% lower than what we figured. If the firm does grow 20% good for us, but we are not making money banking on the growth; we are making the money as the valuation gap seizes. Just something to ponder..
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