Monday, August 24, 2015

August 24 2015 Special: Volatility + Fear is a good combination for long term investors

What exactly happened today? Near the open, the futures were pointing to a negative start to the day but nothing too extreme. The S&P 500 was down 2-3% but the decline accelerated to near 5% at the opening bell. Stocks rallied heavily until losses were less than 1%. However, by the closing bell, stocks began to show losses again with major indices closing about 4% lower. A ride of down 5%, up 4% and then down 3% in a matter of 6.5 hours is not normal. It's no wonder that the CBOE VIX Index, nicknamed the "fear gauge", soared to levels not seen since spring of 2009 (even higher than the U.S. debt ceiling crisis in 2011). Fear was evident in the market.

Potential Explanations:
Most market commentators and analysts would point to China, which set the stage for today's turbulence. The Shanghai Composite lost another 8.5%, erasing most of the gains it made this year. The fact that the government was unable to stop the market from declining, even with hundreds of billions of dollars pumped into the system, made investors extremely nervous. With the recent Yuan (RMB) devaluation and a slowing PMI number that came out late-last week, investors worry that a Chinese economic slowdown would significantly impact global growth. 

Investor's fear about China also leads them to evaluate some of the other potential negatives in the market such as weak earnings growth and the negative effects from oil's rapid decline from $60 (late June) to below $40. The large capital expenditure reductions by many energy companies have been impacting growth numbers in Canada and as well as United States. The high yield market has also been hurt by the increased distress in energy names and we just saw the bankruptcy of Samson Resources last week. 

Investor's confidence was pretty shaky to begin with. After a 8.5% decline in Chinese markets and the continued decline in oil, many investors would prefer to sit this one out and run for cover. 

A Lehman Moment:
Some analysts argued this could a Lehman moment brewing. I think that's an overstatement. 

First, the fact that the Dow dropped 588 points - more than the 508 point it lost on September 15,2008 after Lehman was bankrupt - doesn't mean we're in a crisis. The index was at a much lower level back then and in percentage terms, today's 3.6% decline was much lower than the 5% decline on September 15, 2008. 

Second, it's important to understand that the Lehman failure caused a credit crisis, not a stock market panic. The credit crisis stopped the credit market from functioning properly, a key criteria for a prosperous economy. When money markets, which are suppose to guarantee your principal, lose money (due to Lehman debt), that's when credit/bond investors get really nervous and essentially refused to re-finance the money market, which eliminated liquidity of many corporations. With no liquidity to pay bills, even corporate giants like GE and Honeywell faced bankruptcy even with enormous assets and future cash flow generation ability.  

It is worth noting that a credit crisis is less likely now because:
  • Better Bank Balance Sheets: Due to the new Basel III banking regulations, the need to deleverage balance sheet became important. Many banks already got ahead of regulator's time schedule of the Leverage Ratio (basically an asset to capital multiple) implementation and sold off risky assets to meet that new rule. Because banks are important credit and liquidity providers to the financial system, healthier banks means lower chances of a credit crisis. 
  • More liquidity at the banks: This point is very important. Before the financial crisis, many banks borrow extremely short funds in the repo market. When the credit markets froze, they couldn't refinance and faced a cash crunch. However due to new Basel III rules on the Liquidity Coverage Ratio, banks are holding liquid assets enough to fund cash outflows for a minimum of 30 days to a maximum of 1 year. This new rule reduces the risk of bank failures and decreases of credit in the economy. 
  • High Yield Spreads Looks Reasonable: High Yield spread provides a good signal to credit distress. Before the Lehman failure, the BoAML High Yield Masters II's OAS was about 850 basis points. Today, it was only 586 basis points before the big drop today. After factoring the credit distress of certain energy names, the overall high yield spreads looks reasonable.  
  • Libor-OIS spread also OK: The Libor-OIS is one of the best indicator of credit conditions. Libor is the interbank interest rate paid by banks while OIS is the Overnight Index Swap that is based on risk free instruments like the Federal Funds Rate. Despite the recent controversy with Libor, it still showed the cracks of the financial crisis of 2008 way before Lehman's failure. The spread was well over 150 basis points before Lehman failed. It's now at 30 basis points. While that figure is slightly high, it is not high enough for a credit crisis. 
While there is spillover risk from China, I think the Chinese government can be more effective stabilizing the economy than the stock market. It'a command economy and the government controls major credit sources like the banks. The reason that it failed to stop the stock market decline was because it was simply too hard to stop emotional retail investors (90% of the market participants) from rushing out at once. Chinese retail investors are clearly panicking but investors in developed market should be more mature and not let the panic in China cloud their judgement. 

A Logical Course of Action:
"Be fearful when others are greedy; be greedy when others are fearful"                    Warren Buffett 
After seeing the markets down over 5% with some names down more than 10%, my first reaction was to pull out cash to buy. Crazy? I don't think so.

My contrarian reaction was built over time. I was quite scared during the financial crisis seeing stocks dropping more than 10% in one day.  However, as I observe the market fluctuations over time and understand a company's fundamentals more, I have more reason to believe that investors should listen to Buffett's famous quote.

The illogical course of action would be to sell during these large market panics, provided that your holdings are of good quality. The illogical course of action was actually a result of our primitive senses.  Back in the caveman days, when one person sees a crowd running for whatever reason, that person would assume that the crowd is right. For the person that ran with crowd, he or she could have avoided being someone else's dinner. Even in present day, this social proof effect is still powerful as shown by Robert Cialdini (highly recommend his book "Influence"). Thus in the financial markets, when an investor sees everyone selling, the most logical sense is to sell as well. But that's exact the wrong course of action.

The reason is a stock is not a ticker that trades on an exchange. A stock is a fractional ownership in a business that produces cash flow and profit. Most of the time, a major stock decline does little to impact company's future earnings power in the long run.

It's also worthwhile to review my favourite paragraph from Ben Graham's The Intelligent Investor about "Mr.Market":

Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
Today, Mr. Market decided that some of the stocks I like are suddenly valued 10% lower because he was a bit moody. Most of time I do nothing but I did what Ben Graham said an Intelligent Investor should do when there is high market volatility such as a day like today's:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies. . (P.205) 

In sum: Volatility + Fear  = Opportunity

As Ben Graham stated many years ago, price fluctuations' main purpose is for investor to buy cheap and sell dear. It is not a negative thing as many investor think. In fact, if you are not close to retirement and in your accumulation stage, you should prefer declines over advances. If you love a 10% sale in the mall, why is that feeling different in the stock market? 

Of course, not all stock is a buy but today's selling was pretty wide spread, even in high quality stocks. Selected buying based on fundamental and patience will reward investors in the long run. Instead of viewing the high volatility as a negative thing, I think investors should change their prospective and think that Volatility + Fear = Opportunity. Of course, the volatility won't end that quickly and declines may continue but patience will be key riding out the storm.  

I'll end with an excerpt from Buffett's 1997 letter in a section called "How We Think About Market Fluctuation":

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.  
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices

Sunday, July 5, 2015

BlackBerry 2015 Annual Meeting and Latest Quarterly Result

Although I tried to keep this blog mostly focused on investment strategy, I do want to comment on BlackBerry (BB/BBRY) because it is one of the my larger positions. I have held it for about 2 years. Despite significant improvements in the company's financials and operating performance, the stock price continues to languish because of extreme viewpoints between the bulls and bears on the company and its stock price. Moreover, the latest NASDAQ short report shows 91 million shares are shorted, a figure that no doubt has gone up since the June 23rd earnings report, 

When I traveled to Waterloo on June 23rd for the annual shareholder meeting, I summarized the whole meeting into three takeaways, which I will explain below. Readers can view a recorded version here

Takeaway #1: Original Plan On Track
"The company continues to anticipate positive free cash flow. The company continues to target sustainable non-GAAP profitability some time in fiscal 2016." BlackBerry FQ1 2016 Outlook Statement 
The outlook statement issued two weeks ago is much more positive than the one issued a year ago (see below). The " flow" has been replaced with "positive FREE cash flow" [caps for emphasis]. 

FQ1 2015 Statement:
"The Company anticipates maintaining its strong cash position, while increasingly looking for opportunities to prudently invest in growth. The Company is targeting break-even cash flow results by the end of fiscal 2015."

Furthermore, readers should take note the use of the word "sustainable" in the outlook statement. From his past interviews, Chen has indicated he would follow the same playbook he used at Sybase before. When he has achieved profitability after stopping the bleeding, he wants it stay there. He has achieved 55 consecutive profitable quarters after stabilizing Sybase and the progress he made at BlackBerry has been impressive. He is carefully laying the that strong foundation to support sustainable profitability. 

With services revenues (SAF revenue) continues to decline at a rapid pace of 15% per quarter, execution risk is high. However, Chen's report card shown at the meeting displayed a good track record of execution in the past year. 

  • FY 2015 Break-even cash flow: Achieved. Of course, the cash balance increased significantly during the year from $2.7 billion to $3.1 billion by the end. However, since most of that was due to the land sales, the proper way to see the cash flow is consider the following:
    • Reported FY 2015 Cash Flow from Operations was $813 million
    • Capex consist of the $87 million for PP&E additions and $421 million for purchases of intangibles. Total $508 million.
    • Land sales (from the Proceeds from PP&E sale line) was $348 million. 
    • Net cash outflow was $43 million. While still negative, it is a remarkable improvement from the first quarter when Chen here when he had to report a quarter (2/3 of the quarter he wasn't in charge) with cash outflow of $1 billion. It should be noted that the purchases of intangibles has been reduced to $11 million or 90% on an annualized run-rate basis in the latest quarter (FQ1 2016). 
  • FY 2015 Cost Reductions:  Costs are down 58% (ex non-recurring items like restructuring charges) since Chen arrived. The cost base is well position for sustainable profitability. I expect it'll be around the $350 million level going forward. 
  • Launch New Products: Launched three new phones last year with new software offerings such as BES 12, Blend, VPN authentication, BBM Protected and BBM Meetings. 

Chen has been consistent at delivering results. Although he gave hints he would like to see more revenue, he never formally targeted for revenue growth. The tone of the MD&A has been for "revenue stabilization", which quite different from outright growth. The rate of decline has slowed, which is encouraging. 

Takeaway #2: Shifting Gears to Software 

Chen showed a pie-chart of the revenue mix in the recent FQ1 2016 quarter with 20% in software revenue. He said he'll need to "grow the size of the pie" since he understands the importance of replenishing the lost services revenues that are rapidly disappearing. While analysts were disappointed that the majority of the $137 million in software revenue was due to a patent licencing deal, $137 million in revenue (with gross margin around 90%) is still $137 million earned. 

Chen has shown he has many ideas on how to get to his $500 million software goal for this fiscal year. First, he has grown the customer list of BES by another 400 customers, stealing notable customers like RBS from key competitors like Mobile Iron.  Second, Chen told analysts that number of gold customers was roughly half of the installed base, which is a higher conversion rate than most expect. Expect those new gold customers to contribute to the future company. Lastly, the monetization of the patents could add considerable profitable dollars even if they are delivered in big lumps. Therefore, investors should watch that software line. 

Takeaway #3: Watch IOT

Chen has been straightforward about his strategy of leveraging the company's security and productivity strength into the IOT. There is now over 60 million, up from the 50 million figure released in January, cars using the QNX software and there could be billions of more potential devices need a BlackBerry solution to connect safely and securely. While IOT is a promising trend, there has been many resistance against this trend because of privacy and security concerns [The Globe and Mail has a good article series on IOT which document this concern].  Since BlackBerry is known for its "privacy" and "security", I think it'll be a major player if it can partner with the right tech companies to deliver IOT solutions. It announced a partnership with Intel on a more advanced connected car system and I expect to see more of those going forward. Chen has utilize partnerships well on many fronts to improve the company's financial position and reduce internal resource needs. 

In Sum:

Overall, I think Chen has the right strategy but the market has not rewarded the strategy yet because the revenue growth is still negative. He has executed well last year despite the tough operating environment. I look forward to his execution in fiscal 2016, which could be a key turning point in this BlackBerry turnaround. 

What now after the 10%+ Share Price Decline After Earnings and Annual Meeting? 

The stock declined on what has been perceived a weak earnings in the first quarter of the new fiscal 2016. However, I believe it was a decent quarter and the stock price decline is unjustified. I initially had a more negative view but after reading the MD&A and thinking about it from a second level, I believe the results aren't as bad as they appear. I will address two top concerns. 

About that Software Revenue....:

The stock initially rallied on the solid $137 million software but the stock dived when most of that number was revealed as licencing revenue, which are described as lumpy by Chen.

The concern here is about so called "core growth". Here is the math that Chen and his team fumbled a bit on the conference call:

  • Looking the revenue lines, software revenue was $54 million in FQ1 2015. Chen said the BES business, one that analysts consider "core", grew 23-24% in FQ1 2016. That would get the $54 million figure up in the range of $66-68 million, which is lower than $74 million reported in the previous quarter (FQ4 2015). 
  • Although Chen is comfortable with the number, analysts don't like the negative Q/Q growth from $74 million to $66-68 million.
Although I would like to see growth above the $74 million last quarter, I am pleased to see the 400 new customer additions. They will no doubt add revenue in the following quarters and I was also pleased with the conversion rate from silver to gold. In the past the mix was 30/70 for gold/silver and now it's at 50/50. I know the analysts are in the rush to see revenue results but I think they should read the section on pg 19 of its 40F filed in March:

"..Customers typically undertake a significant valuation process...can result in a lengthy sales cycle.". For the readers familiar with accounting, GAAP rules say you can only record revenue when the sales cycle is complete.

Also, like I mentioned above, the extra $70 million or so of licencing revenue is significant. It shows BlackBerry has a deep patient portfolio that can generate a stream of cash payments from established tech companies like Cisco . Chen is hinting for more deals later in the fiscal year. 

The hardware revenue is ridiculously low: 

The hardware revenue of $263 million was disappointing given it was down from $379 million in the same quarter last year. However, hardware was operating with positive gross margin and there is limited inventory risk. 

Here is another important point to consider:

  • In the last quarter before Thorsten Heins resigned, the hardware had a gross margin (my estimate) of -28% with 1.9 million devices recognized and ASP of $250. That means a gross profit of -$133 million on the hardware side. Even former Jim Balsillie admitted in a recent public appearance that "People thought we [RIM/BB] made money on handsets. It was all services money." 
  • In the latest quarter, the hardware had a gross margin of 2% with 1.1 million devices recognized and ASP of $240. That implies gross profit of $5.3 million. I would prefer $5.3 million than -$133 million but investors are not viewing in terms of gross profits. They prefer to see in revenue terms where the $475 million (1.9M x $250) is better than the $264 million (1.1M x $240). 

As Jim mentioned, the old model was building devices and earn the service revenue. However, since Chen realized this is not a viable strategy anymore, he has to optimize the device business to make it at least slightly profitable, which meant it had to get smaller and rely on partners like Foxconn to reduce fixed costs. He is now improving those efficiencies by partnering with Wistron and Compel, which could be a sign of plans to ramp up future production. Moreover, he is also right that BlackBerry should not sell the device business because it is a key offering that complements its security value proposition and act as "first gate" to the enterprise customer as Chen likes to say.  

A short technical note I would add is that the 90% year-over-year reduction in purchases of intangibles in the cash flow line. This means the cost of devices business, liscencing costs, has reduced significantly to reflect lower volumes. Since these costs are amortized over 2-3 years, the lifespan of the phone, the income statement's amortization line is much higher than in reality.  

Overall Conclusion:

In a press release announcement the share buybacks, Chen inserted a quite interesting phase. I asked him about this the Shareholder Meeting but he won't directly comment on the undervaluation of the shares but he does indirectly hinted that he standby the statement below. I agree and I'll wait patiently. The biggest asset for an investor is patience. As Ben Graham said, "You don't want to turn this basic advantage into your biggest disadvantage."

"We intend to take advantage of our strong cash position to purchase our shares when the market price does not reflect what we view to be the underlying value and future prospects of our business, without adversely affecting our strategic initiatives" 
John Chen  

Disclaimer: The author is long BB (TSX-listed shares). The author has added BB in the past 2 weeks and will continue buy if prices remain low. 

Saturday, February 28, 2015

On 2014 Berkshire Special Letter: Buffett's Confessions and Lessons

Berkshire released its annual chairman letter to investors today. This edition is a special 50th anniversary edition that included two special sections. These two sections are commentary written by Bufffet and his partner Charlie Munger on Berkshire's past, present and future. The letter overall is a great read and I highly suggest everyone to read it.

Below are some of my own commentary on the key points in Buffett's section, which included several lessons he learned and the lessons he wanted readers to comprehend. I will write a separate post for Munger's section. 

Lesson #1: Don't focus on eighth or a quarter of a point
Buffett is a better storyteller than me so I won't go into all the details but he got himself into a lot of trouble when he decided to put more money in a sinking ship (Berkshire) because he was offered 1/8 ($11.375 instead of $11.50) for the shares he owned in a tender offer. Angry over 1/8th of a dollar, he bought more shares (more than doubled his initial position) and went on to sack the CEO and tried to "turnaround" the company by appointing new management. Buffett found out that the extra money he plowed into Berkshire was hardly earning anything. It would be a miracle just to avoid losing money. All this trouble was due to a temporary anger over 1/8th of a dollar. If he had sold his shares, which he bought for $7.50, at $11.375, then he could have used the proceeds to invest in other assets and the money would have grown into vast sums given the law of compounding and his investment record of achieving returns of 20% per annum  (doubling every 3.5 years). 

What's the lesson here for investors? Never focus on the tiny quarter of a point. If you want to purchase stock X because it looks very attractive, it's tempting to wait until the stock drops before buying. However, if you feel stock X is worth $20 and the stock is $10, why wait till it drops $0.25 or $1? Paying attention to these small amounts can cause you to miss large gains. The point is also valid when considering selling positions. Overall, step back and you'll realize that some of these small things never really matter. 

Lesson #2: Don't mix good business with bad ones 

"When you mix raisins with turds, they are still turds" Charlie Munger

The best decision in the early days of Berkshire was Buffett's decision to buy National Indemnity (NICO). This was the first step into Berkshire's success by entering the lucrative insurance business, which provides interest-free cash up-front that can be used to invest. This was one of Berkshire's secret sauces. Use interest-free float to generate more money through investments than the potential future claims cost. 

If the purchase of NICO was a right decision, why did Buffett admit it was a mistake? His mistake was not regarding the acquisition but how he structured the acquisition. He merged NICO with Berkshire, allowing Berkshire's legacy shareholders to own 39% of the combined entity. By trapping lucrative cash flows in Berkshire's junky textile manufacturing business, growth of the combined entity was limited by the large bleeding within Berkshire's legacy business. The opportunity cost of this drag was estimated at $100 billion (with a B) by Buffett. Although he eventually closed Berkshire's textile business in 1985 (20 years too late by the way), the funds that were sunk into the textile business would have generated significant cash over time, through compounding, if he had just the nerve to close the business when he gained control. 

What's the lesson here for investors? Investors should avoid even the most wonderful businesses if they make terrible acquisitions by buying terrible businesses with low returns and suck cash out of the parent (requiring high re-investment with no free cash flow generating potential). Forget the "synergy" pitch (a.k.a. 2+2 = 5)  or the "cost savings" pitch (a.k.a. firing workers) management give investors when doing an acquisition, investors should always focus on the cash generating potential of the acquired asset. Although the monetary costs in present dollars may be small, the opportunity costs of mixing good businesses with bad ones can be huge in future dollars, especially because the funds used to buy the poor businesses could have been invested in other productive assets that compound over time. Buffett admitted that the attractive purchase of Waumbec Mills (another texile company) in 1975 fits this bill perfectly and added to his initial Berkshire mistake. 

Lesson #3: A good business can be wonderful
Buffett has mentioned plenty of times that his partner Charlie Munger has turned him into a better investor by buying "wonderful businesses at a fair price." The change took a while but was needed. As he admits in this letter, a cigarbutt approach (buying cheap businesses and selling them when they start to recovery) was fine for small amounts of capital but for larger sum of capital, a "good business" approach was needed. It's also something I think most fund managers need to understand. Their niche strategies - whether it is arbitrage, net-net, or spin-offs/corporate restructuring - may work well with small amount of AUM but cannot work at a high AUM figure. To perform successfully, buying good businesses with stable earnings, low leverage, and growing free cash flow is needed.  

Buffett always used See's candy as the example and I did too in a prior post. He reported that since Berkshire (or the predecessor Blue Chip Stamps) purchased See's in 1972, the business has earned $1.9 billion (or $1.25 billion assuming a 35% tax rate). That number is significantly bigger than the incremental $40 million that was plowed back into the business during the same time period. But wait, that's not all. These funds was re-invested in other assets so the overall future value of those cash flows are worth much higher than the sum of the cash flows received.

An investor who is investing in these kind of businesses would see exponentially higher dividends (more cash to re-invest with) or share repurchases (increase ownership and hence the claims of that company's future free cash flow) which enhances the value of their holdings. 

Lesson For the Reader: How to evaluate M&A and the dark side of M&A
To build on the lesson discussed above, buying bad businesses and mixing them with good businesses is especially dangerous when management use their own "stock" as currency. It doesn't make sense trading one $100 bill for four $20 bills. Yet management of corporations do that all the time because they focus on trading for the number, not the value, of the bills. The number in question is the "earnings per share" (EPS) that sell-side analysts and fund managers care about. Management even created a fancy term to justify their actions called "EPS accretion". 

Even Buffett himself was not error-free in this case. He bought a company called "Dexter Shoes" with Berkshire stock in the 1990s. That mistake was extremely costly because it diluted the shareholders and received essentially nothing for that pain. 

Furthermore, don't forget that management may become extremely sensitive to short term factors and become servants of the capital markets instead of the shareholders. Capital market participants, whether be the investment bankers or the corporate raiders (ahem...I mean activist investors), want a share of corporations' success by "encouraging" them to consider "strategic alternatives".  As Buffett outlines in the letter, there is so much indirect frictional costs that shareholders never benefit fully from the success of the companies they own. It is surprising how companies pay 20-50% premium for business T and then spin it off later as business S. Companies like Kraft, which was bought by Philip Morris and then spun out (first as Kraft and then it was separated again into two more pieces), is a good example of the pattern Buffett described. Another example is BHP Billiton. The 2001 purchase of Billiton was completely reversed after its recent announcement to spin them off as South32. 

The "helpers" - the bankers, consultants, lawyers - who propose the strategic alternatives will probably make more money than the shareholders in the company that undergoes such process. Companies should focus on the long term instead of considering all those strategic alternatives when the helpers come knocking at their doors.  

It is fine to use acquisitions as vehicles for future growth but it has to be part of a long term strategy. In fact, many businesses will have to use M&A as a viable future growth path. Therefore, investors should evaluate the acquisitions decisions of the companies they own. Do they make sense in terms of strategy, culture (this one is commonly forgotten) and of course the price. The price is essential because you don't want to pay more than what you receive. The evaluation on the price is hard especially for stock transactions that require an intrinsic value estimate for the buyer as well as the seller. Thus, dig deeper than common first level details such as "synergies", "cost savings", "EPS accretion", or "revenue growth".   

Lesson For the Reader: Capital Allocation and conglomerate
Buffett has gave a great lesson on conglomerates in this letter. On the surface, the structure is hardly efficient at all but there is a method to utilize its advantage. It is something that not many managers understand: capital allocation. 

Good capital allocation practices use free cash flows generated from stable businesses and re-invest them back into the most profitable opportunities. It's not rocket science: use free funds, that are generated from existing businesses,  to invest in companies/subsidiaries that can generate the highest returns. The glue that sticks the subsidiaries together at a conglomerate is the culture. Berkshire's culture is unique because every subsidiary is an independently-run business with no interference from head office in Omaha. Buffett has given his managers the mandate to manage their own businesses with the independence they need and shield them from the short-termism of the capital markets. He often tells his managers that the businesses they run is not for sale and its the only asset they have. With that kind of mindset and culture for achieving long term success, it's no surprise that Berkshire flourished. The success snowballs because Buffett wrote in this letter that Berkshire has become home to many wonderful businesses that would rather be owned under Berkshire than under an owner such as a private equity firm. Thus, with many good businesses to re-invest in and the large amounts of float generated by its insurance subsidiaries, Berkshire has the ingredients it needs to be successful. 

The lessons for investor here is good capital allocation and a strong culture is critical for any company. Berkshire won't have succeeded if it did not shut (although it was late) the cash bleeding textile businesses and re-allocated capital away from bad businesses. Moreover, Berkshire won't have succeeded if it did not have a cohesive culture that focused on the long term and ignored the noise from the short-term oriented capital markets. Investors want to invest in companies that can allocate capital efficiently and have a strong long term oriented culture. 

Lesson For the Reader: Preparing for the Future 
In his outlook for the next 50 years, Buffett said he is confident that the business he built is strong enough to outlive him and succeed. For more on this topic, please see Lawrence Cunningham's new book called "Berkshire Beyond Buffett: the Enduring Value of Values ."

One interesting point I want to direct readers is his point on cash. In many companies and even investment funds, managers want to minimize cash because it is an un-productive asset yielding near 0% or even negative percent in case of European cash equivalence. On the contrary, Buffett argues that cash is the best asset especially as insurance to protect the unknowable future. I fully agree with him. There is nothing wrong with a portfolio of 10% or even 20% cash in a portfolio. Future is inherently uncertain and I have realized over the years that forecasting the future with precision is a fools game. Quoting Howard Marks: "You can't predict but you can prepare." Investor can prepare by having some cash in their portfolio. Berkshire is preparing for the uncertain future by holding at least $20 billion in cash all the time. 

There is a lot of insights in Buffett's letters and his 2014 one isn't any different. Read it, study it and apply it. I'm sure readers will become better investors if they do. 

Sunday, January 18, 2015

How To Evaluate Opportunities After The Oil Price Slump

I apologize to my readers for not writing in a very long time but I will try to write a couple of insightful posts within the next week. Please stay tuned. 
The biggest surprise in 2014, other than abnormal rally in the long term treasury market, was the 50% decline in crude oil price. Whenever I see a price decline of such large magnitude in a very short amount of time, I investigate to see if there are opportunities to pick up cheap stocks. Since I'm a fundamental based value investor, I only buy if I see the intrinsic value of the business significantly higher (>33%, preferable >50%) than the current price. Thus, I need to estimate roughly what the intrinsic value is. Note, I used the word roughly. No one can know exactly the value of the underlying business. I prefer to be "approximately right than precisely wrong". 

This article will explain the NAV model, the most widely used method to value oil and gas companies. Then, I will explain why I believe the key input of the model is flawed. Finally, I will share with readers my methods to evaluate oil and gas stocks.

NAV Models: 
Analysts and industry professionals use a NAV (Net Asset Value) model to determine the intrinsic value of an oil and gas company. The NAV model is just a variation of the commonly used DCF model. The NAV model discounts annual free cash flows until the reserves of the company reach zero to calculate the present value of the operations. The value of equity is the sum of the present value of operations and net working capital minus all outstanding liabilities (bonds, short term paper and decommissioning liabilities).

The Most Ridiculous Input: The Long Term Commodity Assumption:
The most ridiculous input, in my opinion, into analysts' NAV models is the"long term" commodity assumption. For oil and gas valuations, it is the long term assumption for WTI Crude Oil (Or Brent) and NYMEX Gas (Henry Hub). This long term assumption is often used for year 3 and beyond in the forecasting model, which will have a significant impact on the intrinsic value estimate since around 90% of the NAV model's value depend on the cash flows from year 3 and beyond.

How is this long term oil assumption determined? Using economic theory, a commodity like oil should trade around the marginal cost of producing one addition unit. However, many professionals discard this theory and place more emphasis on the current price. Succumbing to anchoring and availability biases, analysts input these inappropriate price assumptions into their models to justify their current price targets. I can't blame them for using current prices. It is much easier to justify your financial model in front of institutional clients by using an oil price that is not too far away from the current one. It is the most available snapshot of crude prices and a good anchor to use. However, I believe too many investors fall for this anchoring bias by focusing on prices that are easily observable.

When oil peaked at $147 in 2008, some analysts had $150 as the long term oil assumption. Conversely when oil bottomed at $32 six month later, the long term oil assumption dropped to near $50. The meaning of long term is probably 12 or 24 month in the eyes of the most analysts compared to the theoretical meaning of 30 or even 50 years down the road.

My Method of Valuing Oil Companies: 
How do I value an oil and gas company? Since I'm not an expert in that field and isn't an engineer, I pay extreme attention to what strategy players pay for oil and gas companies. The multiples in those transaction can be calculated and I use those multiples as a starting point to estimate intrinsic value. The trick here is to choose relevant transactions. For example, transactions in early 2014, when oil was well above $100, may not provide the correct intrinsic value multiple. However, a transaction that caught my attention was the $13 billion takeout of Talisman (TLM) by Repsol in December when oil was near $50. Despite the outlook for oil was extremely dire, Repsol decided it was time buy. The assets acquired wasn't high in quality and 70% of the asset mix was natural gas, which was extremely surprising to me. Nonetheless, the multiple paid , on an enterprise basis, was $50,000 per production (BOE/d) and $12 per 2P reserves (BOE).

Second, I try to look at potential hidden items on the balance sheet. One item I look for is land holdings that may possess resources that are not converted into reserves. Since analysts only model value based on reserves, potential future conversion of resources into reserve is one catalyst for higher share appreciation. This analysis is a difficult one but data is widely available for the discovered resources and reserves in major oil plays such as Montney, Cardium, Shaunavon, and Viking in Canada or Permian, Bakken and Eagle Ford in the US. Another balance sheet item is debt. Debt-heavy oil and gas companies have been hit harder than peers that have less debt. Nevertheless, every company's debt is different and it is wrong to evaluate a company's debt level purely on financial ratio such as Debt-to-equity or Debt to cash flow. The covenants should be examined to see if the debt is cov-heavy or cov-lite. The former is significantly different than the latter. A relatively debt heavy company is still a feasible investment if it has plenty of assets. The two options would be either sell certain assets or sell the whole company. Talisman had a lot of debt but it still managed to sell itself due to high quality assets in North American (outweighing the poor quality of its Asian and North Sea assets). The low valuation for Talisman was a bonus too.

With the transaction multiples and the balance sheet analysis, I can roughly estimate the intrinsic value of the company. The last step I do is a rough NAV model but with more realistic assumption for oil long term oil prices. Let's not forget the concepts taught in  Economics 101. In a perfectly competitive industry, the price of the good should equal to its marginal cost, which is about $70-80 for oil. As oil prices reach below the variable cost (cash costs in the oil business), firms will close down, thus bring the market into balance. In the long run, market forces will balance out so price will reach near marginal cost. The industry has already slowed down with the number of rigs in North American dropping to the lowest since early fall 2014 according to Baker Hughes data. However in the short run, prices can be extremely volatile. Hence, the balance sheet must show strong signs that the company can at least survive a low price environment (e.g. having a good hedge book) for the next year or two.

The rapid decline in crude oil price since June last year has created an excellent opportunity to pick up a few beaten down energy stocks. All oil and gas stocks were sold, regardless of quality, valuation or potential hidden assets on the balance sheet. Thus, there are definitely few good names to buy.

I adhere to my motto: "Misconceived risk equals opportunity, miscalculated risk equals fiasco" as mentioned in my previous article. Misunderstood risks create opportunities but I need to complete a full analysis to make sure I didn't miscalculate any risks.