Tag Archives: cash

Buying Stocks Trading Below Net Current Asset Value Vs. Market Timing

Given the fees derived from selling funds to the retail public, financial institutions have little incentive to be bearish on the stock market. These financial behemoths want euphoric investors believing that Wall Street is Lake Wobegon , where every day is a sunny day and all of the stocks are above average. Following the investment strategy of remaining fully invested in stocks and not attempting to time the market does have merit. An academic paper written by Nobel Laureate William F. Sharpe showed the difficulty associated with market timing [i] . Over the study period of 1934-1972, investors who made the decision at the start of every calendar year to be in either cash or stocks had to bet correctly 83% of the time in order to outperform the Standard & Poor’s 500 Index (S&P 500®). That is a difficult hurdle to overcome. Given these poor odds of timing the market with such precision, betting black on the roulette table at a casino in Vegas looks attractive by comparison, with free drinks to boot. Should investors heed the warning of Dr. Sharpe by buying a stock index fund and abandoning any attempt at market timing? ​Let us take a step back for a moment before going “all in” on stocks. Is there a third way to outperform a broad market average other than choosing cash or an index fund with near-perfect timing accuracy? An alternate investment path to consider is Benjamin Graham’s value investing philosophy for the enterprising investor. Graham showed superior portfolio performance by selecting securities trading below net current asset value (NCAV). The NCAV calculation subtracts all liabilities , including preferred stock, from the current assets (the most liquid assets) on a company’s balance sheet. The NCAV calculation is converted to a per share figure, comparing the value to the company’s share price. If Mr. Market quotes the stock price below the NCAV calculation, it can be considered a buy. The chart below shows the long-term performance of restricting stock purchases to ones trading below NCAV and comparing the results to that of the S&P 500®. (click to enlarge) * Portfolio average return calculations include only stocks trading below 75% of NCAV, with no more than a 5% weighting in any one stock. Dividends and transaction fees are included in all of the calculations. ​As indicated on the chart, NCAV stocks outperform the index by around six percent on an average annual basis. These stellar results do not require an investor to be permanently in stocks all of the time or to engage in market timing. In approximately three of four years, part of the NCAV portfolio remained on the sidelines sitting in a money market fund. Unlike remaining fully invested in the S&P 500®, investors who restrict their stock purchases to ones trading below NCAV will at times have a portion of capital remaining in cash. These idle time periods out of the stock market due to the lack of NCAV investment opportunities occur in both advancing and declining calendar years. If the stock market moves higher for the calendar year and few stocks trade below NCAV, the portfolio will lag a fully invested index fund. If the stock market has a good year, sitting in cash turns out to be a mistake. As indicated in the chart above, temporary time periods where the NCAV remains idle in cash does not result in long-term underperformance in comparison with the S&P 500® broad market average. Embracing this form of deep value investing has the added benefit of being agnostic regarding the direction of the overall stock market. Market timing is not an issue when it comes to purchasing only stocks trading below NCAV. Investors can ignore what prognosticators on Wall Street think stocks are going to do in the future. ​ The efficient market hypothesis implies that greater portfolio volatility must be accepted in order to achieve a greater average rate of return. There is truth to this argument. Markets are generally efficient, and the NCAV portfolio does fluctuate more than the S&P 500® does. If our measure of risk changes from portfolio volatility to worst-case return, a wrinkle in the market efficiency gospel bubbles up to the surface. We know from behavioral finance research that losses are far more painful to investors than is the satisfaction derived from an equivalent-sized gain. Using a worst-case annual return as our alternate measure of portfolio risk makes sense if money lost is more important to investors than money won in the stock market. As shown in the table below, using the worst annual stock market loss as our measure of portfolio risk, the NCAV portfolio does not suffer through as bad of a drawdown. For many years over our study period, the NCAV portfolio was not fully invested in stocks. When a portion of capital remains on the sidelines for the NCAV portfolio, it makes sense that a worst-case calendar year loss is less severe in comparison with a fully invested stock index fund, such as the S&P 500®. As already shown, this more limited exposure to stocks by investing only in securities trading below NCAV does not result in the average compounded return falling below the S&P 500® over the long term. (click to enlarge) Market timing is an exercise in futility for individual investors. As I pointed out in a previous blog , focusing on individual stock selection using a time-tested value-investing criterion, such as NCAV, is a far more productive use of an investor’s time rather than attempting to figure out the future direction of the overall stock market. Stocks trading at a deep discount to NCAV not only outperform the market over the long term but also benefit from limited downside losses when knee deep in a bad year for stocks. Although not shown in the chart, the second and third worst annual returns of the S&P 500® had a deeper drawdown than the index’s matching year NCAV portfolio return did. A patient investor willing to endure temporary time periods when deep value investing falls out of favor can still do well over the long term. This holds true without the additional requirement of prescient forecasting on the future direction of stocks. [i] Financial Analysts Journal. “Likely Gains from Market Timing” by William F. Sharpe – March/April 1975, Volume 31 Issue 2 pp. 60-69.

Karoon Gas – Give Me $1.00, I’ll Give You $1.20 And 2 Significant Oil Discoveries

Summary Karoon is a depressed stock trading 20% below cash backing due to a low oil price, and several major shareholders exiting the stock. A major selloff has resulted in Karoon being significantly undervalued. Provides fantastic long term exposure to a rising oil price with 85 mmbbls of 2C reserves from 2 recent oil discoveries. Karoon Gas is currently in the process of buying back up to 10% of stock on issue. Overview Karoon Gas (ASX: KAR, OTCPK:KRNGF , OTC:KRNGY ) is an Australia-headquartered oil and gas company with exploration opportunities focused in North-West Australia, Peru, and Brazil. With a set of great oil prospects, and no major gas prospects, they should consider changing their name to Karoon Oil. Of all the sell-offs in the oil and gas sector, this one has intrigued me the most. On a market cap of AU$450 (US$319) Million at the current share price, they sit on cash of AU$550 (US$390) Million. This cash came from their recent sale of their Browse Basin permits to Origin for the following: An upfront payment of US$600 Million (Received) A deferred cash payment of US$75 Million payable on FID A deferred cash payment of US$75 Million payable on first production A deferred cash payment of US$5 Million for every 100 BCFe of independently certified 2P reserves exceeding 3.25 TCFe Reimbursement of the costs associated with drilling its 40% held Pharos-1 well. (Received) So why are they trading so low? Apart from the oil price, I think it is primarily due to these 3 factors: Several major investors have exited the stock over the last year. IOOF Holdings, Future Fund Board of Guardians, and Paradise Investment Management all ceased to be substantial holders, selling out a major portion of the stock. The company has some corporate governance issues. There are concerns that family members of the chairman Bob Hosking are appointed on key positions at the company, as pointed out by the activist hedge fund manager Pegasus. The majority of shareholders may or may not agree with this, and I myself have questions regarding it, but none of the three candidates that Pegasus put up for election were voted in. A lot of Australian companies have corporate governance issues, and activist investment is much lower than in the US. Like any market risk, this is a risk that must be weighed against the benefits. Speculators pushed the price up to obscene levels, and then pushed the price back down in fear Despite these issues, Karoon has a great track record of increasing the long-term value of shareholders when you normalize for the boom and bust cycle. Past speculation during the boom had driven the share price as high as $12.10 – it currently sits at $1.81 at the time of writing. Karoon is, at present, up over 950% from 2004 and has managed to unlock plenty of cash for the exploration and appraisal of their major Brazil operation in the Santos Basin. (click to enlarge) ( Google Finance ) Offshore Brazil (Two Significant Oil Discoveries) The map below shows the Kangaroo and Echidna resource as well as the Bilby oil discovery dating back to 2014. (click to enlarge) ( Source – Karoon Annual Report 2015) Kangaroo went through further appraisal in 2014, production testing at rates that signaled a single vertical well could flow 6,000-8,000 bopd from a net pay of 135 meters ( Source ). It needs to be noted that Kangaroo 2 also had two side tracks as part of the appraisal that indicate that this may be a complex reservoir which would enhance the cost and difficulty of production. Despite the complexity, it remains a significant find that has a great chance of commerciality. Echidna followed up the Kangaroo discovery with a 103 meter net oil column and a facility constrained flow test 4650 bopd, further enhancing the chance of a commercial discovery for the region. (click to enlarge) ( Source ) From an operational perspective , Karoon is looking at a variety of options for producing the Echidna and Kangaroo discoveries that are less than 50km apart. The lowest capital cost method includes a Floating Production Storage and Offloading Vessel (FPSO) producing roughly 20,000 barrels of oil per day (bopd), then expanding that to 50,000 – 70,000 bopd once the field has been proven. Discussions for the development of Kangaroo have also involved Petrobras for an integrated oil hub in the region, which could be economic as low as $43/bbl according to Citigroup ( Source ). The same article also denotes the drop in costs which could make the project economic at even lower prices “Because it’s a distressed market now worldwide, we are looking at redeployed assets, for example, a redeployed FPSO [floating production storage and offloading vessel]. The labor market is getting cheaper, the labor is getting cheaper; we see there’s a lot of cost savings for us.” One of the primary reasons for investing in Karoon is that there is almost no value attributed to the Kangaroo and Echidna discoveries. After writing off Karoon’s AU$105 (US$76) million tax liability against its cash reserves, the 2C reserves equate to a value of AU$0.41 (US$0.29) /bbl. However, investors must keep in mind that production isn’t likely oncoming until 2018 at the earliest while Karoon moves through engineering and approvals, and this may hold the share price back for the medium term. Offshore Peru and Offshore Australia After all this, Karoon still has more to offer. A possibility of more major discoveries exists offshore Peru and Australia. Nearly 27000 square kilometers of permits sit on the acreage outside of Brazil, with significant long-term potential for Karoon. They have a habit of bringing in joint venture partners to free carry them through the initial drilling stages to minimize the capital outlay from Karoon. These are likely to sit for several years during the current supply glut, however, they provide some great upside for an oil recovery. (click to enlarge) (Karoon Annual Report 2015) Share Buyback One of my favorite things to see a company do is an all-cash share buyback – specifically when their share price is trading at an all-time low. Karoon has bought back 9.4 million shares at $3.27 over the last 12 months as well as announcing plans to buy back a further 25 million shares. That comprises up to 10% of the company’s ordinary shares on issue and will further expose investors to the upside of an oil price recovery in 2-3 years. On top of all that, Karoon has a significant amount of built up exploration expense of $AU485 Million that can be written off against future cash flows. Risks and Uncertainties Karoon is in the early stages of several significant oil discoveries. There are plenty of issues that need to be sorted out, and a significant amount of cash that needs to be spent to bring these oil fields into production. Production is not likely to begin for several years, and the oil price currently sits at levels that would make these projects uneconomic. Most investors would agree that the current supply glut will not extend out to 2018, however, it is possible and poses a significant risk as Karoon spends more on the appraisal process. Karoon also has no source of cash flow, and Origins deferred payments are unlikely in the current environment. Conclusion Having several major investors exit the stock over the last 18 months has left the share price in the doldrums. While Citigroup has calculated a combined development for Kangaroo and Echidna would be economic as low as $43, I would not expect the project to go ahead unless oil moved well into the 60’s – unless the resource is found to be much larger than current estimates. There is plenty of unrealized value in this stock with hardly any value attributed to the Kangaroo and Echidna discoveries, and no value to the significant amount of exploration expense that Karoon can write off against future cash flow. Karoon’s cash reserves can be used to develop these discoveries and increase shareholder value at the same time the share buyback is increasing investors oil exposure per share. As for the remaining Australian/Peruvian blocks, Karoon will likely delay drilling as much as possible to preserve cash for the Kangaroo and Echidna discoveries. Overall, there is a significant amount of risk around Karoon going forward. They are in the early stages of appraising these reservoirs while the oil price has crashed. However, a crashed oil price means cheaper drilling, completions, procurement, and construction. Karoon would not be likely to produce oil until 2018 at the earliest, and there is plenty of time for the oil price to recover in that time period. As the Financial Review quoted from an RBC Capital Markets report “Whilst high risk, this is a freebie and success would open a significant new oil play.” I love Karoon as an asymmetric bet on an oil recovery, and I can confidently see an upside of well over 100% in the next 3-5 years in the event that the oil price recovers. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Terraform Power: Buying When There Is Blood On The Streets?

Summary Terraforma Power shares collapsed over the past few months. Liquidity concerns and the funding of future commitments are worrying investors. I will dig into the liquidity issue to assess whether the company is a good investment opportunity at current prices. Terraform Power: buying when there is blood on the streets? The original quote is attributed to Baron Rothschild, who apparently made a lot of money by buying assets amid the panic that followed the Waterloo battle against Napoleon. Can we apply the same concept to Terraform Power (NASDAQ: TERP )? Only one thing is certain. There is a lot of blood on the streets. The stock is down almost 80% from 40$ in July to 8.4$ at the time of writing. A bit of a background may help those not familiar with the story. The company owns and operates clean power generation assets (solar and wind in particular). In a nutshell they buy the assets, they structure the financing, they negotiate power purchasing agreements (if they do not come already with the assets) and they distribute the income once operating costs and financing costs are repaid. A very simple business model. Two things make it complicated: Liquidity: in the good old days of a stock trading between 30$ and 40$ they signed agreements for acquiring a significant amount of assets knowing that they had a lot of options to finance deals (project financing, corporate bonds, loans and equity issues). The stock decline worried investors to the point that the liquidity issue is becoming a self-fulfilling prophecy: the stock goes down, cost of equity and debt goes up, they have fewer options available for financing and therefore the stock goes down even more. Issues at Group level. TERP is partially owned by its sponsor, Sunedison (NYSE: SUNE ), a developer of solar plants whose stock price has crashed even more due to high leverage, significant commitments to buy new projects and incredibly difficult to read financial statements, with a mix of recourse and non-recourse debt and questions on the future solvency of the business. In this report I will try to assess the current situation of TERP and the future commitments in order to establish whether the market overreacted to the liquidity issues and is mispricing the stock. A good starting point is the presentation of Q3 results. On slide 17 the company shows the most recent capital structure adjusted for the latest deals announced: (click to enlarge) Source: Q3 2015 Earnings presentation The company shows cash of 796 mln and a combination of recourse debt (two bonds for 1.25bn) and non-recourse debt (project financing for 1.3bn). The net financial position including all debt is therefore 1.76bn. This debt is against a 2016 ebitda run rate for the current portfolio of approximately 400 mln with a net debt / ebitda of 4.4x and against a portfolio of renewable energy facilities valued at approximately 4bn in the balance sheet. If we were talking about real estate we would say that the loan to value is 44%, a reasonably low level. Remember that we are talking about assets with highly predictable cash flows and long term power purchasing agreements in place (average life of 16 years). The status quo shows one thing: the company is currently under levered given the type of assets they held. One important supporting factor is the recent (November 6th) renegotiation of the debt on certain assets in the UK, the results of which are in the pro-forma figures showed above. The company managed to refinance those UK assets at a 4% all-in interest cost with non-recourse debt. That figure shows how – at an asset level – TERP’s portfolio is seen as extremely high quality. Now let’s look at the commitments. Here things start to become challenging. TERP committed to buy 1,453MW of solar and wind assets from Invenergy and Vivint as part of a deal structured by its parent Sunedison. The total cost of those assets is approximately 3bn. From the 10Q we can also see that the company has commitments to buy additional energy facilities from Sunedison for a total of 1,080MW (1.4 bn). Let’s analyse how the company is thinking about those commitments. On slide 18 of the Q3 presentation the company offers a picture of the current status of the financing plan for the Invenergy and Vivint acquisitions, showing 1.7 bn completed and 1.3bn in progress. (click to enlarge) Of the “in progress” part of the financing we have three components: Vivint Term Loan or TERP bond (250 mln) Project finance debt (726 mln) 3rd party infrastructure capital (300 mln) During the Q3 conference call the management stated that they are making good progress on the financing. My personal take is that a TERP bond is not realistic (the yield would likely need to be above 10% given the sentiment around the stock) while all other options appear credible. In particular the largest chunk is project finance debt and the company showed earlier this month that they can successfully raise that kind of capital at very good terms. Infrastructure capital should also not be a serious problem in a market full of yield hungry investors. I will let you make your judgement on this but I believe we are not talking about an impossible task for the company. Remember, all assets are cash generating with 15 years plus of revenues under contract with primary standing counterparties. Moving on to the commitments to buy the Sunedison facilities the company states in the 10Q that on October 26th SUNE entered into a purchase and sales agreement with a JP Morgan fund that agreed to buy three of the assets that are part of those commitments. Upon closing, expected on the fourth quarter of 2015, TERP will have a reduction in its commitment to buy SUNE assets from 1.4 bn to 580 mln. The company intends to deal with these commitments through a combination of project finance debt, company cash, assumption of current debt and the involvement of third party infrastructure investors. While TERP is currently working on securing the financing, SUNE is also looking for third parties that may be interested in taking the projects directly. In case of a sale by SUNE the commitments for TERP would decline further. A final point that I would make on the liquidity issue is that the company currently has in place an unused revolver credit facility equal to 725 mln that is going to increase to 1 bn and can offer further flexibility in structuring the financing for the deals mentioned above. My final take on the liquidity issue: it is very scary when sudden lack of confidence hits a company. TERP’s 2023 bonds moved from 95 at the beginning of the month to current values of around 70. Capital markets are clearly closed for TERP at the moment. That contrasts a lot with what the company managed to achieve by financing at the asset level , like they did in the UK. I particularly like the fact that at the moment there is only 1.3 bn of project finance debt in place against 4 bn of assets and that suggests me that deals similar to the UK refinancing could soon take place in other parts of the portfolio. I am confident the company will work in this direction and will eventually be able to finance all the deals even though spreads will certainly be higher than a few months ago. Finally let’s look at the stock. What are you buying at 8.4$? I will make a very simple analysis here. Let’s assume no equity is issued and all commitments are paid for with new debt. Let’s also assume that the incremental debt raised and its amortization completely eats all of the cash flow produced by the assets. That’s very harsh credit conditions. Even in that case we would have a company that can sustainably keep the current dividend rate at 35c (in reality the plan is to increase it to 0.425 in 2016) based on the cash available for distribution from the current assets while building some additional equity in all those projects thanks to the amortization of the debt. That is a 16.8% yield + the build-up of some equity in the current projects. Not bad. Worst case / best case. The worst case scenario would be a bankruptcy of parent SUNE, with certainty of some messy agreements that would need to be worked through, and complete lack of financing. In this case I believe the equity would still be worth something (let’s say 3 / 4 dollars a share) based on a liquidation of all the assets owned + commitments at a 25% discount to book while repaying all debt at face value. A clear sky scenario would see the company providing for all the liquidity needs through external sources at reasonable terms. In that case the stock would rebound and, even though I believe the 30$ – 40$ range will not be reached for a long time, we would likely see TERP trade back to around 25$ (three times the current level). Conclusions: although risks are extremely high and volatility will continue to characterize the stock, I believe TERP offers a great asymmetric return profile. The downside is large in a worst case scenario and therefore position sizing should take that into account but, at least this time around, I am a buyer despite all the blood on the streets.