Monthly Archives: May 2010

ValueFocus Newsletter Issue 12 Released

Our 12th issue of ValueFocus, our monthly newsletter for premium members, has been released. For more information see HERE

A Constructive Criticism of Value Funds

The month of May has been particularly difficult for value funds, which widely underperformed major indices. Their underperformance, in my opinion, should be a warning sign to investors of these funds, as it is not entirely clear that value managers have learned from the mistakes made in 2008.

Although I am a big believer in value investing, there are several things about value funds that seem contrary to common sense investment principles. Not only have these well-known value funds underperformed, but in most of the cases they have done so significantly.  According to Tickerspy.com, their May performance looks like this:

To the credit of most of these funds, they have performed well historically, and their investors have been rewarded handsomely in most cases, some even achieving triple digit returns since inception. However, as an avid follower of the strategies they employ, I have spotted several weaknesses and somewhat disturbing trends:

1)    More Preaching Than Doing

 Unfortunately, a lot of value managers spend more time preaching value investing than actually practicing it. From writing books to spending a significant amount of their time on TV, it seems that a lot of managers wave the value investing banner to attract capital rather than to deploy it. Consequently, there are more funds which label themselves as following a “value” strategy than actually doing so.

2)    Blind Following of Warren Buffett and Berkshire Hathaway

Make no mistake, Warren Buffett is the best investor of all times, and Berkshire Hathaway is an amazing cash generating machine which competitive advantage is firmly built within the company’s high-quality (and low cost) float. If someone is looking for billions of dollars to deploy effectively, Berkshire is probably the best bet.

However, given the small size of most value funds, it is absurd in my opinion for these funds to own shares of Berkshire Hathaway. It is absurd because small funds have the ability to invest in thousands of other companies with better profitability and growth prospects than Berkshire. If Buffett was running his partnership today, would he invest in Berkshire Hathaway himself? I think the answer would be no. Because of its large size, Berkshire cannot possibly offer small investment partnerships investors the 20%+ annual returns that smaller companies could achieve.

Contrary to the thinking of most value investors, Berkshire is not a substitute for cash. For example, Mohnish Pabrai explained back in 2008 how he considers Berkshire Hathaway as a kind of money market account, something akin to cash. After Berkshire dropped 50%, he was forced to change his strategy.  To this day, top value funds hold Berkshire with the expectation of achieving above-market returns.

 3)    Blaming Capital Losses to “Aberrations” and “Dislocations”

 Abnormal market conditions should not be an excuse. In fact, because the value strategy is dependent on always investing with a margin of safety, I would expect value managers to outperform by the greatest margin at times of abnormal market conditions. Why blame the market for your mistakes? For an example of what NOT to do, see latest letter to investors by Scottwood Capital, a $900 million hedge fund in Greenwich, CT which lost big-time during the month of May.

4)    More Copying Than Developing

Most value managers copy what previous value managers have said and done to justify their strategy rather than developing their own methods. It is my view that they confuse value investing as a strategy, and not an investment framework. The structure of hundreds of value funds is often an exact copy of previously existing funds, such as the Buffett Partnership. The result has been a bunch of Buffett-like funds in terms of structure, but with an investment performance far below those achieved by the Buffett Partnership. Additionally, a lot of funds keep the same proportion of cash to equity that Berkshire does without realizing that what’s good for Berkshire may not be good for their funds. This lack of self-identity is something that plagues a lot of value funds.

An example is hedge fund manager Sardar Biglari, who runs Indianapolis-based fast-food chain Steak ‘n Shake. Under the “Buffett” banner, Biglari wants to diversify away from burgers and milkshakes and transform the company into an all-purpose investment vehicle similar to Warren Buffett’s Berkshire Hathaway. In what I believe to be a show of arrogance, Mr. Biglari renamed the company “Biglari Holdings”. He is even quoted as saying

“if an artist created a masterpiece, it would be absurd to ask him to not put his name on it”

While Buffett generated a high stock price for Berkshire through sheer growth, Mr. Biglari decided to create a high stock price through an artificial 20-to-1reverse stock split. And that was all before increasing his salary from $300K to 900K. Even Biglari’s company website looks suspiciously similar to Charlie Munger’s Wesco.

Again, this is not an attack on value investors, it is a call for more self-identity and originality. Value investing is not a strategy, it is a framework. Instead of resorting to copying what Buffett and other investors built through their lives, value funds should abide by what Graham once said:

If you can really beat the market by charts, by astrology, or by some rare and valuable gift of your own, then that’s the row you should hoe. If you’re really good at picking the stocks most likely to succeed in the next twelve months, base your work on the endeavor. If you can foretell the next important development in the economy, or in the technology, or in consumers’ preferences, and gauge its consequences for various equity values, then concentrate on that particular activity. But in each case you must prove to yourself by honest, no-bluffing self-examination, and by continuous testing of performance, that you have what it takes to produce worthwhile results.

 

First-Half 2010 ValueHuntr Performance Update

The ValueHuntr Portfolio was up 18% for the first half of the year, compared to -2.3% for the S&P500. The portfolio is currently comprised of 3 long positions (GE, RIG, RMCF), and 2 short positions (BP, IOC). Although we’d like to add more bargains to the portfolio, we have not been able to find as many as same time last year. You can be sure that we will be on the lookout.

The Dow Jones ended May down 7.92%, its worst May performance since 1940. In contrast, the ValueHuntr Portfolio returned 2% for the month.

Since inception in April 2008, the portfolio has returned 145%, relative to -19% for the S&P500. In total, we have taken 16 positions, of which only two have been losing ones: EDEN (-8%) and BP (currently down -2.6%). Our performance compares favorably with well-known value funds, which struggled in May for the most part.

David Einhorn’s Ira Sohn Conference Speech: “Good News for the Grandchildren”

May 26, 2010

Einhorn Disclaimer: The views expressed in this speech reflect our opinions about certain companies or industries in which Greenlight Capital has a position or may take a position in the future.

Have you ever heard people bemoan the idea that we are passing on our debts to the next generation? If I were Jon Stewart running the Daily Show here, I would show a video montage of every leader we have had saying variations on that. Leaders scold and scoff and then they keep borrowing and spending and making long-term commitments to do the same.

President Obama more or less knows what he wants to propose on nearly every topic. But, when it comes to the long-term budget problem, he kicks the can down the road by setting up a commission to brain storm without even committing to implement the commission’s suggestions.

Politicians value staying in office more than they value the long-term health of the country. Spending money in the short-term buys votes. It’s not good politics to take on the obvious long-term insolvency of popular programs that transfer wealth from the young to the old. The elderly reliably show up on Election Day. Children have no voice at the polls. The AARP is an extremely powerful interest group. There is no similar organization lobbying on behalf of ten year olds.

I have titled today’s talk Good News for the Grandchildren. By that, I mean that I do not believe that there is a need to worry that today’s debts will be passed on to our current youth.

Before this recession it appeared that absent action, the government’s long-term commitments would hit a wall in a few decades. I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation — not our grandchildren’s — will have to deal with the consequences. If we do one thing, let’s stop bemoaning the fate of our grandchildren on this topic. We might take the issue more seriously if we realize that our own future is at risk.

According to the Bank for International Settlements, the U.S.’s structural deficit — the amount of our deficit adjusted for the economic cycle — has increased from 3.1% of GDP in 2007 to 9.2% in 2010. This does not take into account very large liabilities the government has accepted by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future — whether they are social security benefits or loan guarantees — do not count in the budget until the money goes out the door.

A good percent of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has permanently increased the base level of government spending. A very large amount was dedicated to preserving government jobs. How different is the government today from where General Motors was a decade ago? Government employees are high cost and difficult to fire.

Bloomberg reported that from the last peak businesses have let go 8.5 million people or 7.4%of the workforce while the government has only cut 141 thousand workers, or less than 1%. Public sector jobs used to offer greater job security but lower pay. Not anymore. According to a 2009 CATO Institute study the average federal civilian salary with benefits totals $119,982 compared to $59,909 for the average private sector worker and the disparity has grown enormously over the last decade.

The situation at the state and local levels is no more comforting. The excellent superintendent of the public school in the town next to mine just “retired” at age 58. He had a fully vested public pension but was not interested in quitting work. So, in addition to beginning to collect his pension, he moved to New Jersey to take a similar job and to begin earning a second public pension in that state. While there is no reason to begrudge him for operating within the system, there are consequences to arrangements such as this. His is not an isolated story — articles describing “retire and rehire” of public officials can be found in many local newspapers around the country.

There has been a lot of scoffing in financial circles about Greek civil servants earning 14 months of pay for 12 months of work. While the details are different, civil servant pay appears to be as big a problem here as well. I doubt it will be easier to reform this than other government entitlements. And, there are so many government workers that they are an important voting block that helps elect officials who won’t challenge the current arrangement.

The question is how long can we travel down this path without either changing direction or having a crisis. The answer lies in two critical issues; first, how long will the capital markets continue to fund government borrowings that may be refinanced but never repaid on reasonable terms, and second, to what extent can obligations that are not funded through traditional fiscal means be satisfied through central bank monetization of debts — that is, by the printing of money? The recent U.S. credit crisis came in large part due to capital requirements and risk models that incorrectly assumed AAA rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behaviors of borrowers and lenders become distorted. It was once unthinkable that “risk-free” AAA rated institutions could fail, as they recently have. Their CEOs probably didn’t realize when they crossed the line from highly creditworthy to eventual insolvency. Surely, had they seen where the line was, they would to-a-man have stopped on the solvent side.

Our government leaders are faced with the same risk today. What is the level of government debt and future commitments where government default goes from being unthinkable to inevitable, and how does our government think about that risk? I recently posed this question to one of the President’s senior economic advisors. He answered that the government is different from financial institutions because it can print money and statistically the United States is not as bad-off as some other countries. As an investor, these responses do not inspire confidence.

Finally, he said the government needs to focus on jobs now, because without an economic recovery, the rest does not matter. This point is worth discussing, but is not an excuse to defer addressing the long-term structural deficit. If we are going to spend more now, it is imperative to lay out a credible plan to avoid ultimately falling into a debt trap and the ensuing crisis it would cause. Even using the administration’s 10-year forecast that assumes a robust and sustained economic recovery, we will have problematic deficits for the next decade, which ends just as our commitments to baby boomers accelerate.

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. The government doesn’t know, nor do the credit rating agencies. One obvious lesson from the crisis should be that we get rid of official credit ratings that inspire false confidence and, worse, are pro-cyclical. Congress has a unique opportunity in the current effort of regulatory reform to eliminate the credit rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and the big bond buyers have told Congress they want to continue the current ratings system.

As Bill Gross put it in his last newsletter:

Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the Status Quo. It would be better to have each market participant individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be centralized in the hands of a couple of rating agency committees.

Consider this description about the sovereign rating process an S&P analyst offered in an interview aired by the National Public Radio Morning Edition earlier this month:

S&P analyst: For any country we have two analysts who go to a country for that rating. Never send just one person because you need a second pair of eyes.

 

NPR interviewer: I think there are people listening to this who would say “just two?” Shouldn’t you be sending seventy to rate a country’s government?

 

S&P analyst: To be fair, what we are looking at is fairly narrow. Can you pay your debt fully and on time? What is your ability and willingness to do so? You know, I think two

people…this has been our practice. It has worked well.

 

NPR reported that after interviewing some government officials, business people and journalists for a few days, the S&P analysts fly home and write a report. A five person rating committee debates the issue and holds a vote of hands.

S&P analyst: We always want an odd number because we don’t want to have a tie and do the whole thing again.

 

NPR interviewer: How long does that take?

 

S&P analyst: Even if you are doing like a Canada which is [a] relatively boring rated AAA, you still have to go through all the steps. So two hours is sort of average.

 

That is about as long as it takes to watch a hockey game. We have just watched the pro-cyclical behavior of the ratings agencies foster a private sector credit crisis. By continuing the official use of this system, public sector borrowers will experience the instability caused by rating agencies at the worst possible moment. Now, European leaders are learning the hard way that it isn’t a good thing to have rating agencies declare that things are stable even as risks build and then, as problems reach a critical stage, accelerate the loss of confidence by declaring that things are not so good after all.

When Secretary Geithner promises that the U.S. will never lose its AAA rating, he chooses to become dependent — effectively putting all of his eggs in one basket — on the whims of the S&P ratings’ committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a future crisis where just as the Treasury Secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency exacerbates the problem with an untimely downgrade, triggering massive additional sales by existing bondholders. This has been the experience of many troubled corporations, where rating agency downgrades served as the coup-de-grace.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero risk weighting, which means holding it requires no capital. As a result, European banks loaded-up with Greek debt and sold sovereign CDS and now need to be bailed-out to avoid another banking crisis. As we first saw in Dubai and now Greece, it appears that the response to Lehman’s failure is to use any means necessary to avoid another Lehman-like event.

This policy transfers risks from the weak to the strong — or at least the less weak — setting up the possibility of the crisis ultimately spreading from the “Too-Small-to-Fails” like Greece to “Too-Big-to-Bails” including members of the G7.

We should have learned by now that every credit — no matter how unthinkable its failure would be — has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA rated CDOs, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior — leading to an even larger crisis.

I remember hearing that the rating agencies would never downgrade MBIA or Fannie Mae. Mr. Geithner may learn that never is a long time. The next crisis might very well rhyme with the last. Greenlight continues to hold short positions in the common stock of the rating agencies, Moody’s and McGraw Hill (owners of S&P).

I don’t believe a U.S. debt default is inevitable. On the other hand, I don’t see the political will to make voluntary efforts to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.

Some believe this could be avoided by printing money. Despite Mr. Bernanke’s promises not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics. That the recent round of money printing has not led to headline inflation may give central bankers confidence additional quantitative easing can be put in place without inflationary consequences. However, printing money can only go so far without creating inflation.

Now, government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. For example, under the current method, when the price of chocolate bars goes up, the government assumes people substitute peanut bars. So chocolate gets a lower weighting in the index when its price rises. Even though some of the changes may be justifiable, the overall effect has been a dramatic reduction in calculated inflation.

According to www.shadowstats.com, using the pre-1980 method CPI would be over 9%, today compared to about 2% in the official statistics. While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that does not match the real world cost of living.

For example, we all now know that healthcare, which is certainly a consumer good, is about one-sixth of our economy and its cost has been growing at a rapid pace. So what is the weighting of healthcare in the CPI? About 6%. The government doesn’t count the part which the consumer doesn’t pay out of pocket. So, if your employer has to pay more for your health insurance, it doesn’t count, even if it means you have to accept lower wages.

Similarly, Medicare cost increases don’t count, even though everyone has to pay higher taxes to fund them. Income and payroll taxes, which are part of the cost of living, are not counted in the CPI either. On the other hand, one-fourth of the index is comprised of something called owners’- equivalent-rent. This isn’t something that anyone actually pays for. If you own your house, the government assumes you are foregoing rental income. The amount that you could receive from a hypothetical renter — the government implicitly assumes you rent it to yourself — is counted in the basket. So, rising taxes, which you do pay, don’t count; the fast rising cost of healthcare, which someone else pays on your behalf, doesn’t count; but hypothetical rents which you don’t pay, and conveniently don’t rise very quickly, have a huge weighting.

The simple fact is that if your goal is to never see inflation, you won’t see it until it is rampant. Low official inflation benefits the government by reducing inflation-indexed payments including Social Security and Treasury Inflation-Protected Securities. Lower official inflation means higher reported real GDP, higher reported real income and higher reported productivity.

Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have an accommodative monetary policy to fight unemployment, which in a new trickle-down theory it believes can be addressed through higher stock prices. The Fed hopes that by keeping rates low, it will deny savers an adequate return in risk-free assets like savings deposits and force them to speculate in stocks and other “risky assets” to generate sufficient income to meet their retirement needs. This speculation drives stock prices higher, which creates a “wealth effect” where the lucky speculators decide to spend some of the gains on goods and services. The purchases increase aggregate demand and lead to job creation.

Easy money also aids the banks. Arguably, we still have many inadequately capitalized or insolvent banks. There has been so much accounting forbearance and extend-and-pretend loan collection that it is difficult to get an accurate gauge on the health of the system. However, each week the FDIC seizes more failed banks and when it does so, there are very large losses to the deposit insurance fund. In most cases, the failed banks’ most recent financial statements claim that they were solvent which implies that the banks’ balance sheets are not stated conservatively. It probably isn’t just the banks that fail that are taking advantage of accounting forbearance.

As a result, the Fed prefers to keep rates extraordinarily low in an effort to help banks earn back their unacknowledged losses. However, this discourages banks from making new loans.

If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread walking down the yield curve, then they have little incentive to lend to small businesses or consumers. Higher short-term rates could very well stimulate additional lending to the private sector. Given the enormous gains in the prices of bank stocks, it might be quicker to have banks deal with their questionable assets through additional equity offerings and more aggressive loss reserving than waiting for years for profits from an easy money policy to repair the balance sheets.

Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers including the government to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise. I believe that the Japanese government has already reached the point where a normalization of rates would create a fiscal crisis.

While one can debate where we are in the recovery, one thing is clear — the worst of the last crisis has passed. Nominal GDP growth is running in the mid-single digits. The emergency has passed and, yet, the Fed continues with an emergency zero-interest rate policy. Perhaps, an accommodative policy is still appropriate, but zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. Further, it was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.

Easy money policy has negative consequences in addition to the obvious inflation of goods and services and currency debasement risks. It can feed asset bubbles, such as the internet bubble and the housing bubble. We know that when such bubbles collapse, there are terrible consequences.

Nonetheless, the Fed has a preference to inflate bubbles. Sometimes Fed officials tell us that there is no bubble or that bubbles are hard to identify. Afterwards, they tell us that monetary policy was not to blame. Earlier this year, Mr. Bernanke said that the housing bubble was not caused by monetary policy. Essentially, he did a statistical analysis which found that there are many times when extraordinarily easy monetary policy has not led to a housing bubble. As a result, he argued that one can’t generalize that easy monetary policy causes housing bubbles in all circumstances. From this, he reached the dubious conclusion that easy monetary policy was not responsible for the housing bubble he presided over. He must feel it is important to disclaim responsibility for the last bubble at a time where the Fed appears to have a desire tofoment a fresh asset bubble.

In recent years, we have gone from one bubble and bailout to the next. Each bailout reinforces moral hazard, by rewarding those that acted imprudently. This encourages additional risky behavior feeding the creation of a succession of new, larger bubbles, which then collapse. The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury financed bailout seeded a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of LTCM’s counterparties spurred the internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt despite the fiscal strains created by the bailouts.

The Greek crisis may be the first sign of the sovereign debt bubble popping. Our gold position reflects our concern that our fiscal and monetary policies are not sufficiently geared toward heading off a possible crisis. In addition to owning gold, we have recently added African Barrick Gold (ABG on the London exchange), an operator of gold mines in Tanzania to our portfolio. It was brought public in March through a 25% carve-out by Barrick Gold, the world’s largest gold producer.

We think ABG is much cheaper than all the other gold miners because it trades at about half the value of its peers on just about every valuation metric including less 6 times 2010

EBITDA, less than $200 per ounce of reserves and a 10% FCF yield. ABG management incentives are well aligned with shareholders, since they recently received stock options and share incentives so that much of their compensation depends on the performance of the shares.

Further, we believe ABG is likely to be added to the FTSE All Shares index and may even be added to the FTSE 100 index as well in mid-June. The added index buying that should accompany this inclusion could represent a meaningful percentage of the free float of this company which we see as an added near-term positive to the longer-term story.

We own gold and some gold stocks for our investors and ourselves. We will worry about the grandchildren later.

Einhorn: Short on Moody’s and S&P

Hedge fund manager David Einhorn, who had questioned the health of Lehman Brothers four months before its collapse, said yesterday at the Ira Sohn Conference that he is still shorting Moody’s Corp, citing the short-term approach it uses in its assessments.

Shares of the rating agency plunged 6.6 percent to $19.50 in after-hours trade, following Einhorn’s comments.

Einhorn, whose Greenlight Capital manages $6.5 billion, reiterated that Moody’s Investors Service continues to use a short-term outlook — only 12 to 18 months — to analyze data to assess countries’ abilities to finance themselves. He spoke before some 1,200 hedge fund executives at the annual Ira Sohn Investment Research Conference.

Einhorn last fall had criticized Moody’s, saying it “…makes five-year medium-term qualitative assessments for each country, but does not appear to do any long-term quantitative or critical work.”

Standard & Poor’s, the rating agency owned by McGraw-Hill’s, shares the same problem, Einhorn said.

He thinks the euro zone debt crisis could cause more problems for the rating agencies.

What’s more, Einhorn said the credit debacle in Greece and its euro zone neighbors could be a prequel to what might occur in the United States.

The Greek crisis might be the first sign the “sovereign debt bubble” is “popping,” adding that the United States still has many inadequately capitalized banks and it is difficult to get an accurate gauge on their health.

With the instability in the banking financial system along with poor government policies, Einhorn has increased exposure in gold and gold securities.

Einhorn says his fund recently bought shares of African Barrick Gold because it is cheaper than other gold miners.

Einhorn said last week at Greenlight Capital Re’s investment meeting that he still holds physical gold. “We tend to think of gold as a currency,” he said, adding, “I think there’s going to be a lot of inflation.”

Is Shorting Consistent With Value Investing Principles?

Bruce Greenwald, director of Columbia’s Center for Graham and Dodd Investing, discusses shorting in the context of a value investment strategy.

Introducing the ValueEdge Newsletter

The next issue of ValueFocus will be published exactly 6 days from today. In the meantime, we are pleased to announce the launch of our new monthly newsletter: ValueEdge. This newsletter serves as a time-efficient investing tool for institutional investors, professional investors, and hedge fund managers. The research-driven process focuses on several long and short categories, which are especially helpful to professional investors looking to uncover value-based actionable ideas. The newsletter is designed to be the first step in the idea generation process of any serious investor. 

 Click below for a sample issue.

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Transocean Ltd (NYSE: RIG), BP plc (NYSE:BP)

We are adding Transocean Ltd to our ValueHuntr Portfolio as an opportunistic and contrarian buy. At the same time, we are adding BP as a short.

It is our view that the uncertainty surrounding the Deepwater Horizon incident has caused RIG to trade far below a reasonable price. Meanwhile, we believe that most liabilities for cleanup will legally fall under BP. Even if RIG’s reputation is adversely affected by this incident, the company is the top deepwater driller in the industry. Unlike BP and other companies, RIG’s competitive advantage is its capability to operate in some of the harshest ocean conditions in the world.

Company

Transocean Ltd is a leading international provider of offshore contract drilling services for oil and gas wells. As of February 3, 2009, the company owned, had partial ownership interests in or operated 136 mobile offshore drilling units. The fleet consists of 39 High-Specification Floaters (Ultra-Deepwater, Deepwater and Harsh Environment semisubmersibles and drillships), 28 Midwater Floaters, 10 High-Specification Jackups, 55 Standard Jackups and four Other Rigs. In addition, the company has 10 Ultra-Deepwater Floaters under construction or contracted for construction.

Valuation

The company is now trading at some of the lowest multiples throughout its history. The company trades at P/B of 0.88, relative to industry average of 2.44. Additionally, the company is now trading at EV/EBITDA of 5, the lowest ever for the company.  A word a caution is that although these numbers look attractive, their attractiveness is dependent on the effect the Deepwater Horizon incident has on the company’s operating income. As we discuss below, we believe RIG will be able to cover its liabilities without permanently impacting the company’s future operating income.

Deepwater Horizon Incident

On April 28, 2010, in connection with the Deepwater Horizon incident, one of RIG’s subsidiaries was notified by the U.S. Coast Guard that, under the provisions of the Oil Pollution Act of 1990 (“OPA”), Deepwater Horizon had been designated as a source of oil discharges and the subsidiary has been designated as a responsible party under OPA.  In the notice, the U.S. Coast Guard noted that its information indicates that oil discharges resulting from the incident include discharges from Deepwater Horizon on or above the surface of the water and ongoing discharges from the well head.  Because the ongoing discharges from the well head are occurring nearly a mile below the surface of the water, for which RIG believes it has no responsibility under OPA, the company has responded to the U.S. Coast Guard’s notice and denied our subsidiary’s designation as a responsible party to the extent of any underwater discharges from the well head. 

While RIG’s potential liability in the oil cleanup is not understood with 100% certainty, there are several points that indicate that RIG’s liability is limited:

-       RIG was fully insured for the Deepwater Horizon and has received $401MM to cover damages (see http://www.chron.com/disp/story.mpl/business/6992073.html )

-       The total insured value of the rig is $560 million. But Transocean’s insurance also provides up to $1 billion in liability coverage, subject to deductibles, for personal injury claims and possible claims related to wreck removal.

-       Although more than 100 lawsuits have already been filed in many states and courts, Transocean is petitioning that the limit of its liability be $26.76MM, as the entire value of its interest in the rig does not exceed this figure. Limitation of Liability comes from 150 year-old maritime law allowing US ship owners to limit their financial liability.  Under the Limitation of Liability Act of 1851, a vessel owner is liable only for the post-accident value of its vessel and cargo, as long as the vessel owner can show it had no knowledge of negligence in the accident.  Certain types of drilling rigs, such as MODUs (Mobile Offshore Drilling Units) like the Deepwater Horizon are considered vessels under U.S. maritime law because they are capable of being navigated.

Disclaimer: This is not a recommendation to buy or sell any securities. We do not personally own shares in RIG, BP.

Why One Legendary Investor Is More Worried Than Ever

By Jason Zweig (WSJ)

Seth Klarman is worth listening to, especially when markets go mad.

Mr. Klarman is president of the Baupost Group, an investment firm in Boston that manages $22 billion. His three private partnerships have returned an annual average of around 19% since inception in 1983—and nearly 17% annually over the past decade, as stocks went nowhere.

To measure Mr. Klarman’s importance as an investor, you need only see the value his rivals place upon his words. You could have earned at least a 20% average annual return since 1991—better than twice the performance of the market—merely by buying and holding Mr. Klarman’s book, “Margin of Safety”: Published that year at a cover price of $25, hard copies now fetch up to $2,400.

But the professorial Mr. Klarman speaks in public about as often as the Himalayan yeti. He made an exception last Tuesday, when I interviewed him in front of a standing-room-only crowd of 1,600 financial analysts at the CFA Institute annual meeting in Boston. He then made another exception, speaking with me over the phone later to clarify points that he feared had been misconstrued.

Mr. Klarman specializes in buying securities that nauseate other investors. As the credit crisis exploded, he put more than a third of his assets into high-yield bonds and mortgage-related securities. I asked him what he had meant, in a recent letter to his clients, when he compared the financial markets to a Hostess Twinkie. “There is no nutritional value,” he said. “There is nothing natural in the markets. Everything is being manipulated by the government.” He added, “I’m skeptical that the European bailout will work.”

Some members of the audience gasped audibly when Mr. Klarman said, “The government is now in the business of giving bad advice.” Later, he got more specific: “By holding interest rates at zero, the government is basically tricking the population into going long on just about every kind of security except cash, at the price of almost certainly not getting an adequate return for the risks they are running. People can’t stand earning 0% on their money, so the government is forcing everyone in the investing public to speculate.”

“We didn’t get the value out of this crisis that we should have,” Mr. Klarman told the audience. “For our parents or grandparents, it was awful to have had a Great Depression. But it was in some ways helpful to carry a Depression mentality throughout their later lives, because it meant they were thrifty with their money and prudent in their investment decisions.” He added: “All we got out of this crisis was a Really Bad Couple of Weeks mentality.”

You could have heard a pin drop as Mr. Klarman proclaimed, “I am more worried about the world, more broadly, than I ever have been in my career.” That’s because you can make good investing decisions and still end up with bad results if you reap your profits in currencies that do not hold their purchasing power, he explained.

“Will money be worth anything,” asked Mr. Klarman, “if governments keep intervening anytime there’s a crisis to prop things up?”

To protect against that “tail risk,” said Mr. Klarman, Baupost is buying “way out-of-the-money puts on bonds”—options that have no value unless Treasury bonds plummet. “It’s cheap disaster insurance for five years out,” he said.

Later, I asked Mr. Klarman what he would suggest for smaller investors who share his worries.

“All the obvious hedges”—commodities and foreign currencies, for example—”are already extremely expensive,” he warned.

Especially gold. “Near its all-time high, it’s a very hard moment to recommend gold,” said Mr. Klarman.

Mr. Klarman pointed out that his own ideas “on bottom-up opportunities in undervalued securities are more likely to be accurate than my top-down views on what’s going to happen in the world at large.” In other words, while you might want to insure against a disaster scenario, you shouldn’t bet the ranch on it.

And, said Mr. Klarman, one of the best ways to protect against a decline in purchasing power is to buy whatever is “out of favor, loathed and despised.” So forget about gold or other trendy hedges. Instead, wait patiently for markets—European stocks, perhaps—to get so cheap that they turn most investors’ stomachs. Then you can pounce.

As Mr. Klarman put it, “Sometimes, when you can’t figure out a good defense, the best thing to do is to go on offense.”

ValueHuntr Model vs. Greenblatt’s Magic Formula

We recently checked the robustness of the ValueHuntr model presented on yesterday’s posting by examining whether there is any commonality between the stocks chosen by the model and those chosen by Joel Greenblatt’s “Magic Formula”.

The Magic Formula was introduced in the book “The Little Book that Beats the Market” as an investment strategy developed by Joel Greenblatt for his firm Gotham Capital. According to investment records of the firm, this strategy has been able to generate roughly 40% annualized returns over a 20 year period.

The commonality between the two methods is striking, as 10 of the stocks in the ValueHuntr portfolio (30%) also show up on the “Magic Formula” screen. This is a surprisingly high number, considering that there are 16,000 stocks to choose from in US exchanges. Below, we chose the top 30 stocks chosen by the ValueHuntr model. Stocks also chosen by Greenblatt’s “Magic Formula” are highlighted.