Close, but no cigar!

Exactly a month has passed since I ventured head first into a 500-word expose on the virtues of BP’s common stock as a potentially lucrative investment opportunity (see http://www.juliovildosola.com/2010/06/bp-classic-value-or-major-trap.html.) Furthermore, a $25 limit order at was set for a sizeable purchase (by my standards that is), as the stock hovered around $27 to $28.

By now, it should be clear that said price was never reached as the market’s gross overreaction to the Deepwater Horizon disaster came to a sudden halt right around that precise date. Judging whether the recent 35% rise to its current $36 price tag represents a return to investing common sense or simply a further knee-jerk reaction on the part of jittery speculators, might seem to be nothing more than an interesting academic exercise but for me it has served up a great lesson.

Putting aside a considerable, though manageable, sense of regret at the missed opportunity, I take great comfort to see my investment thesis confirmed in such a short space of time. Clearly, companies no matter how unpopular, do not trade at 4x earnings for long, especially not those with rock solid balance sheets and deep war chests.

Whilst there is obviously no price for being almost right, I don’t walk away form this experience “empty handed”. By the way, for those of you who may remain curious, at $36, BP equity no longer has a margin of safety so compelling as to merit a purchase at this price.

The downside to today’s message however, (there’s always a flip side), is that after seeing this once-in-a-while idea evaporate, there are none to replace it. Current valuations across asset classes, and geographical locations assume a return to peak earnings and minimal debt defaults in the near future. Such over optimistic assumptions do not bode well for returns and leave little margin for error.

Given how poorly the odds are now laid out, it’s unlikely that opportunities of BP’s calibre will be on display for all to see. Be that as it may, I’ll continue to keep in mind one of Benjamin Graham’s timeless maxims in the search for winning bets.

“The market is there to serve you, not to guide you”.

Reading for results

As a young kid I never quite saw the fun in reading and books were not the most rewarding of birthday gifts for a 10 year old. Despite being surrounded by some keen bookworms in the family, most notably my father and elder brother, it was not until my late ‘20s, early 30s as I settled into married life, that the “bug” caught on.

Having said that, once it caught on, there was no going back. In more recent times, some 30 to 35 books per year have been perused, analysed, underlined, read and sometimes later quoted. It may be a cliché, but I honestly and whole-heartedly agree with those who claim that reading makes one a better investor. Just as importantly, it seems that business and investing books do not suffice and it takes a more rounded bibliography to “do the trick”.

A recent article detailing a conversation between Charlie Munger (the other half of Berkshire Hathaway’s phenomenal management duo), and renowned value investor, Li Lu, drove this point home eloquently as it referred to Mr Munger, 86 years old the time of the interview, “as someone who is never found without reading material”. Appropriately, these materials cover all manners of science and other field such as sociology and history.

Mr Munger is not alone in his approach. Virtually all successful investors claim to spend a disproportionate amount of time reading, some surely to tune out the “noise” from other sources of “mis”-information like CNBC or their ubiquitous Bloomberg terminals, others more likely to expand their cumulative knowledge base. In this respect I found an amusing reference shared by an anonymous fund manager who after being invited to spend a week of his summer holidays in the vacation home of Bill Ackman (of Pershing Square Capital), gave the following account of Mr Ackman’s holiday routine:

“he reads financial statements all day, as he always does”

Surely reading on its own is not enough.

Entering what Charles Ellis labelled the “Loser’s Game” in his eponymous book and expecting to emerge unscathed requires both a thorough understanding of business dynamics coupled with a cool and detached mind. Whilst the latter is hard to acquire due to its intrinsic nature, the former is not so and can be gleaned from our daily professional experience and supplemented with masses of reading.

Approaching the investment universe as a search for temporary pricing anomalies to be exploited constitutes the essence of value investing. I for one, see no better way to identify these valuable opportunities than to scour multiple data sources with the help of a rounded, well read and inquisitive mind.

BP: Classic value or major trap?

Back in February 23^rd 2010, in a post titled “Skin in the game” I somewhat publicly, committed to “walk the talk” and initiate the composition of a stock portfolio. Some 4 months have passed and I feel the appropriate time has now come to at least take the first steps.

In short, I have placed a buy order for US-traded ADR shares of the much-maligned British Petroleum (ticker: BP). For full transparency I will let it be known that it’s a 25 $ market-type order and as such the position is not open as of the date of this post. Furthermore, in the spirit of relative concentration this single bet will represent a substantial 4% of my current equity portfolio.

First and foremost let it be said that I realise that there’s much wrong with BP as a corporation, not least its obviously poor safety record and its ill-handled reaction to the April 20^th spill and subsequent human and environmental disaster. In this respect, the abysmal performance of its common stock over the last 8 weeks seems fairly logical. Adding insult to injury for most holders is the suspension of its once mighty dividend payout, thus depriving several million savers on both sides of the Atlantic of a key source of financial security.

Furthermore, the creation of an independently managed (not BP’s) $ 20 Billion escrow account as a form of financial guarantee to cover potential liabilities poses additional challenges. This approach is a first after an environmental disaster and effectively removes BP’s ability to manage the timing of some of the eventual payouts. Just as critically it serves to quantify the magnitude of this tragic event.

And yet, in spite of the remarkable level of uncertainty surrounding the spill (remember the oil is still gushing out, and as of yesterday, June 24^th, now reaching the shores of the Florida “pan-handle”), my analysis tells me there’s considerable value in BP at its current market price. Allow me to elaborate:

1. Although the size of potential liabilities (the total sum of fines, compensation, lost production, repair fees and lawsuits) remains unknown, a conservative estimate can be made on the basis of both historical precedent and “back-of-the envelope calculations). My calculations point to a worst-case scenario of around $35 B which represents about 18 months of BP’s normalised free cash flow.

2. The previous estimate of liabilities is extremely conservative as it assumes that all responsibility rests with BP, which is unclear as its drilling and exploration partners will surely assume (or be forced to bear) some of the financial pain

3. BP’s balance sheet is equally healthy (as its Income Statement), no significant debt repayments as scheduled for the next few quarters. Moreover, BP has already began the process of further capitalising its balance sheet with the unpopular but wise suspension of the dividend and the publicly announced intention to reduce CAPEX to the tune of $ 2 Billion per year. Adding further non-core asset sales will bring some further $ 10 B into play.

4. From a Price-to-Earnings multiple, the risk/reward trade off seems to come with a hefty margin of safety. 10 year EPS (including periods with oil at $ 28 a barrel) is $ 4.6. Plugging in a conservative 9x multiple (v. a 10 year trailing average of 14x) would suggest that today’s 4x PE ratio is a steal.

5. Assuming an almost disproportionately conservative earnings shortfall of 30% to $4.41 per share points to an intrinsic value of $40 in the low range of the PE ratio and a more attractive $61 once “normal” multiples resume. In any case from its current price, the potential upside is at minimum 42%.

6. Supplementary reasons such as diversified revenue sources, both geographically and sector wise (it is the largest natural gas producer in the USA…), together with deep pockets and little leverage will act as a back-stopper to any fears of bankruptcy.

In short, odds favour the patient investor and never more so than in this case. I am ready for a fun but bumpy ride. Are you?

Active vs. Passive (Index) Investing

These are testing times, with no clear direction in the markets, having just come off a horrendous 5 weeks in most western stock markets, which put a halt to a 14 month bullish spree since originating in March 2009. The so-called “perma-bears” such as Nouriel Roubini and Marc Faber are back in vogue once again, continuing their warnings. But it’s not just the usual suspects that are showing concern.

Even investors that have done remarkably well in the recent past by venturing into oversold assets as of early 2009 are swelling their cash balances in the absence of opportunity. Recent interviews suggest that cash balances, a.k.a. “dry powder among value funds stands as high as 20 to 25% of assets.

Is it hence the time to heed the advice of index investing advocates?

There’s much to be said for it, indeed recent reading of Charles Ellis’s “Wining the Loser’s Game- Timeless Strategies for Successful Investing pointed me in these direction… On the same note, a recent talk by my former MBA Professor of Finance, Javier Estrada, provided a wealth of data to support the virtues of an equity-weighted, index-wide, geographically diversified, long-term, buy & hold strategy.

Admittedly, obtaining the returns of a market-wide benchmark over a long period of time, say 15-20 years is an attractive proposition under any scenario.

And yet despite all of these sound arguments and substantiated research I can’t bring myself to just track the market. Why does this happen? Haven’t we learnt our lesson? Is it not yet clear that we as investors are the market and as such any sustained out performance requires sustained under performance by equally informed and trained counterparties? What is it that makes us (or at least me, in this case) think that we can do better than the rest?

Call it what you will, but for me it comes down to a competitive nature and the remarkable and defining impact of human emotion.

Personally I have over time, though not always, increasingly relished in acting in a way that is contrary to conventional thinking in matters economic. From renting real residential estate in a market where said action is deemed almost a social failure, to investing in equities throughout 2008 and 2009 when the world “stood on the brink”, to borrow for the Economist.

Throughout this period and to this day, I can’t lay claim to performing deeper research than full time professional investors or to have access to more complete data than other investors. My sources of information are not only free and non-proprietary but more importantly, widely available to any potential investors. As such the opportunities I review and act upon are readily available to any interested party.

Where I think the difference lies however, between myself and other stock market players, both active and index investors is in our emotional interpretation of the context surrounding securities pricing. Let’s take an example that has been front-pager news for some 6 weeks now:

British Petroleum’s (BP) massive Gulf Cost spill.

How do we react to BP? When is the price drop large enough to discount even the worst-case scenario? (Dividend removal included!). When do we allow the numbers to take the front seat as opposed to the Congressional grilling of BP execs or worse still, the underwater web cam and its relentless images of a real-time environmental tragedy?

I say about now!

By consciously opting to:

1. Remove the noise. i.e. turn off the TV and just gather the facts

2. Ignore the crowd. i.e. see above

3. Look into the few key numbers (e.g. long-term trailing average cash-flow generation) and compare this to both potential downside and long-term value of the enterprise.

All effort should be aimed at determining if there is a substantial gap between BP's current price and its cycle-resisting intrinsic value. Should the answer be positive, this surely represents the triumph of overcoming emotions and actively exploiting other's errores over conceding to a passive index strategy.

Time, as always, will tell.

Taking the pragmatic approach

Approximately a month ago, I began a metaphorical journey to relax my rather narrow-fitting investing thought corset. In writing “Learning by Doing”, posted on April 29^th, I ventured into the world of economic cycles and their inevitable consequences for investors around the world. Since that date, two additional posts have made references to the economic cycle. I’m afraid given the state of affairs in my home country of Spain and indeed in most western economies, this topic will also form the backbone of today’s exposé. Talking to or more precisely, listening to, experts in the dismal science has left me with a sense of not only unease but defeat.

Various academics and macroeconomic sages are openly venturing the idea that the once unthinkable is now likely. Indeed the possibility of a sovereign debt default by Spain and, some even argue, by the USA as early as 2013 is not to be underestimated. For us Iberians, it looks as if this scenario is all but inevitable and our efforts at this juncture would be best directed to “getting used to be treated like a pariah of the credit markets for years to come” as a close friend of mine succinctly put it.

Be that as it may, I remain thankful that, as a nation living in suspended disbelief, most Spaniards willfully continue to ignore the obvious warning signs. From a truly selfish and short-term point of view, this unfounded optimism and happy-go-lucky attitude so prevalent in our nation, is actually a bit of a blessing. After all, we’ve had plenty of scare-mongering from the Roubini’s and the Marc Faber’s of the world since 2008…

The flip side of this “ignorance is bliss” attitude is nonetheless a major concern. Both as an investor and as an ordinary citizen concerned with the progress of my immediate circle there’s plenty to be concerned about. First and foremost, if history serves a purpose (which I sometimes wonder…) no course of action (or as the case maybe, inaction) that I can envisage could possibly be more pernicious. Burying one’s head in the sand is not a wise idea. And yet that is precisely what is being done in Spain.

Sure, some fairly dramatic measures were hastily dawn up and narrowly approved in parliament last Friday. In any case, said measures as limited in their scope and one-sided in their impact. Drawing a parallel between macro-economic policy and security analysis with the subject being the Spanish economy, the actions taken to date serve only to reduce costs whilst doing absolutely nothing to enhance private sector revenues.

Am I too pessimistic? Apparently not. According to a recent study performed by Hussman Funds in their weekly commentary of late May 2010, the path to recovery after major financial crises is clearly laid out, though by no means is it easy to follow.

Using the example of the approaches to various severe financial downfalls in Sweden, Norway, Finland and Japan since the early 1990s some clear and useful conclusions can be drawn. Faced with capital-light structures as a result of ever-lower lending standards (sound familiar yet?), banks in these nations almost collapsed triggering off country-wide credit crises.

In dealing with this situation 2 very different approaches were followed, one by the Nordics and the other by Japan. Sweden, Norway & Finland opted for the pragmatic approach, exposing the true extent of the problems upfront, soliciting debt restructuring assistance and winding down troubled loans, whilst capitalizing their balance sheets.

Japan on the other hand, enforce lax accounting rules destined to render non-performing loans less transparent and continued to lend money to the wrong. By now, we all know how this played out for the Nikkei index over the next 20 years! But how did the Nordic economies and their stock markets perform after 1990?. Only 5 years later, the stock markets of these nations recovered to pre-crisis levels.

Whilst the nature of the 1990’s Nordic banking crisis and today’s macro picture in Spain and beyond may differ, there’ a lesson to be learned in applying a direct, face-on approach.

Unfortunately, for investors and regular citizens alike, recent actions by the Spanish government do not bode well in this sense.

Danger ahead

"I'm more worried about the world broadly than I've ever been in my whole career”

These words were uttered just a few days ago at a CFA conference by one of the most consistent investors of our time, none other than Seth Klarman of Baupost Group, who for over 25 years has delivered consistent 20%+ annual returns to his fortunate investors. When someone of this caliber and usually cool, detached demeanor makes so bold a statement, we’d better listen.

The fact remains that macro concerns are almost too numerous to mention. Our governments and central banks have tampered with the wrong levers and more worryingly in the wrong direction. Since the first signs of stress made their way into full public view in early ’08, the actions taken by those with political, monetary and fiscal clout have been, for the most part, misguided.

Some argue, rightly perhaps, that the risk of no intervention at the point of maximum stress (i.e. Sept, 15th ’08) as Lehman Brothers collapsed and credit markets froze, would have led us to a complete meltdown. Be that as it may, the aptly named “stimulus” packages brought on to re-vive the dying patient, (western economies in this case), have been in place well beyond the required duration. In the same way that methadone serves a purpose for a recovering drug-addict, there’s always the risk that the replacement medicine further exacerbates the addictive nature of the patient.

As I write these lines, some 20 months after the nadir reached on Sept’08, both the macroeconomic landscape AND the investment picture look awfully bleak.

On economic terms, most major industrialized economies have delivered meager upticks in GDP. Most of these however, are directly derived from the extraordinary level of public sector spending. Growth of this type can hardly be considered healthy, dependent as it is on external and by definition temporary forces. More serious are the consequences of said public sector debt frenzy. To put it bluntly, throwing good (and expensive) money after bad money was never a good idea and this time it’ll be no different.

Except it will. It will be even worse.

Adding the burden of public sector debt to escape from a situation where debt had been the originator of the crash, strikes me as deadly dangerous. From an investment point of view you’d think these would be the jolliest of times in the value-seeking crowd. Mr. Buffet himself taught us to be “greedy when others are fearful and fearful when other are greedy” and it holds that when thinks look the bleakest the seed of great investments is often sown. So what’s the problem then?

Well, the time for greed actually was terribly short-lived and lasted the 4th quarter of ’08 and the first half of ’09. This was a period of pessimistic contagion and, for once, reasonable valuations. Today, however the general state of the economy is only marginally better than then, (we may not be about to fall off a cliff but we remain awfully close to the proverbial edge!), but equity prices have rallied as if it were 2006 all over again!. Once again the wise words of JK Galbraith come to mind:

“There can be few fields of human endeavor in which history counts for so little as in the world of finance”.

All in all we may be heading into another “lost decade” in stocks and potentially a negative returns scenario for long dated bonds if, or should I say, once inflation returns.
Amidst all this gloom and doom it pains me to end the post on a negative note. Therefore I urge would be investors to search long and hard for areas of opportunity, which, given the erratic and emotional nature of our would-be trading counter-parties, will continue to arise.

Keeping one's head

As I write this lines, we are witnessing extreme volatility in both equity and debt markets. Just yesterday saw the largest single day rise in Spanish stock market history, up over 14%, only to be followed by today’s steep drop of 5%. At times like this, it’s all too easy to lose one’s nerves or worse, one’s head. Lest not forget, this comes after a 14 month rally of gigantic proportions which in turn follows the largest index-wide equity price drop in developed markets since the 1930s.

Remaining a committed long-term investor in these circumstances requires an almost heroic sense of perseverance. Not surprisingly some of Wall’s Street’s most famous sayings point in the opposite direction. “Don’t’ fight the tape” and “the trend is your friend” are popular mantras in the capital markets and are held dear by most participants.

Notice however that I said “most participants” and not “most successful participants”. My own experience, entering the equity markets via the allocation of a very significant portion of my entire net worth in mid-2007, has served to reinforce my belief on the undeniable benefits of a clear conviction and a cool head. Since that time I have seen the price of my holdings decline by almost 50%, literally decimating my hard-earned savings only to subsequently rise again above the original price paid, and thus earning a considerable “paper” gain.

Throughout this experience I restrained myself from the temptation to “cut my losses” by focusing on the value of the businesses I invested in and not on the random pricing offered by desperate and cash strained sellers of stocks.

For sure it has not been fun!. Many a times I’ve had to explain to others and sometimes even to myself that what matters in investing is not price but value. Convinced as I was that value had not been impaired I only wished I had additional cash at the time to further buy into great bargains. Along this tortuous period I also took considerable comfort from the alignment of my views with those of true experts boasting long and successful investing track records and for whom the ’07-’09 market dislocation was a merely a re-run of previous crises…

Along these lines, Seth Klarman of Baupost Group fame (over 20% annual returns for 25 years) was quoted as saying:

“We at Baupost prefer lost opportunity to lost capital”

Which I think highlights the rationale for avoiding the euphoria that characterizes long-running bull markets. On a similar note, Jean-Marie Eveillard of First Eagle funds defended his below-benchmark returns in ’97-’99 as he refused to buy high P/E tech stocks by stating:

“I would rather lose half my clients than half my client’s money”.

As it happens, Mr. Eveillard almost stood alone in his conviction and indeed lost half of his clients and very nearly closed his fund. However, vindication came as for the next 10 years , First Eagle delivered over 138% gross return while the overall market remained flat!.

Amidst the turbulence, wild price oscillations and often catastrophic macroeconomic predictions touted by analysts and journalists alike, there remains room for the calm, cold and reflective business appraisers out there.

And it’s not just me saying this!.