The BP Saga is nearly over

The US government yesterday now allows drilling applications to take place in the Gulf of Mexico. There will be increased scrutiny with respect to contingency plans that will make the already expensive process even more so, but there will eventually be drilling back in the Gulf.

This nearly closes the saga on the BP oil spill – although you hardly hear of any further environmental consequences. The only story left will be a decade of litigation in court to determine who pays for the damages.

Be careful of people touting their horns – what I’m about to write will be a high magnitude of chest-beating.

Earlier, I gave a fairly accurate forecast of the financial consequences. I made a projection on June 16, after BP had cut its dividend, that if you were playing BP, one should purchase BP shares between $25 to $30/share. BP subsequently made it to $26.75/share, which would have resulted in a 65% fill. On July 15, stated that one should exit BP at $45 to $50/share (this is after it spiked up to $39/share), and July 27, I fine-tuned the price model to $42-47/share. I stated that BP should be around that price range by the end of the year.

Currently, BP is trading at $41.50/share, so it is within striking range of this price range where an investor should offload the shares. Indeed, the price risk from the oil spill has been mitigated to a degree from the stock, so investors in BP at this moment should be evaluating the company not with political risk in mind, but operational risk of the various businesses it controls around the world, and of course, the price of oil.

BP still looks undervalued strictly from an earnings and “price of oil” perspective – they have a huge amount of reserves and production going on, and will likely continue to make money in the foreseeable future. Analysts expect the company to earn about $6.51/share in 2011, which gives it a 6.4x P/E ratio, or about 15.7% yield from current earnings. By comparison, Exxon has a 9.7x P/E ratio on 2011 earnings. Even though it is an operational basket case, BP still looks dramatically undervalued.

Always keep in mind that analyst projects tell you what the market is pricing in – so in order to make money from the present, you have to believe the company will make more money than what the analysts are predicting. In theory, the analyst estimates are baked into the current stock price.

One prediction that has not come to fruition yet has been a June 16 prediction that the drillers will fare better than BP – right now, BP is leading the two drillers I selected by about one percent. When re-evaluating the drillers, I think BP is now the better deal.

There is a reason why I do not like large capitalization companies – many other eyeballs have spent time looking at the companies far longer than you have, which makes your potential advantage in properly valuing such companies to be less probable.

Annual report of Canada – 2009 to 2010

The Government of Canada released their annual report for the 2009-2010 fiscal year (April 2009 to March 2010). The headline number is the $55.6 billion deficit.

Although the report is a pleasantly short 30 page read, I will concentrate on the expenditure side of the budget. A lot of people have the impression that federal government spending can be easily slashed. Apportioned by percentage, the $244.8 billion of expenditures look like this:

Looking at the pie chart from largest to smallest percentage expenses, one can easily see how cutting expenditures is not politically feasible. For example, a full quarter of expenses are transfers to persons. These include Old Age Security, EI payments, and child-related transfers – all three would likely have massive backlash if there was a cessation of benefits.

The government in the 1990’s, when faced with a deficit crunch (when a third of the revenues went off as interest payments) decided to cut transfer payments – this goes to the provinces mainly to pay for healthcare. Again, this would be highly unpopular if the government did so.

The discretionary expenses that the government has a chance of implementing are on defence, crown corporations, and “the rest of the government”. This is approximately 29% of the 2009-2010 fiscal expense profile. Even if you were to decrease these expenses, it would make little progress at reducing the entire expense profile, which is ballooning as the population ages.

Every Canadian should be able to understand this document, but sadly, few ever read it.

Pay attention to index volatility

Now that Canadians are recovering from their Thanksgiving turkey dinners, it is time to pay attention to the marketplace once again.

One chart I will bring to your attention is the volatility index, VIX. It measures the implied volatility of the S&P 500 index. It is also equated with being the “fear index”. Implied volatility of the marketplace is highest during market crashes.

Historically, when the VIX goes under 18, it does not bode well for the marketplace – it’s a good rule of thumb (the lower the better) to watch out for complacency. Obviously since VIX is not a predictive index, you should not base your outlook on it, but it does convey the information that market participants are not betting on a crash (or a spike up) in the near term.

Traders that expect some form of volatility can bet on both sides of the marketplace – by purchasing a call and a put at a strike price, they will win if the market goes up or down a certain quantity. For example, right now with the S&P 500 at 1164, you can purchase a December expiry (December 17, 2010) call and a put, with a breakeven point of 7% movement (roughly 40 points in either direction). Conversely, you can profit if you sell the same options and the market does not move further than 7%.

Playing options are very difficult since you are fighting very good mathematical models, so I do not recommend them for casual investors. Most option-based literature I’ve found makes it sound like an easy game, but it is truly not. The only thing worse than playing a very difficult game is being mislead into thinking that the game you are playing is easy. This goes for the stock market in general, but especially option trading.

Deploying some capital

After some considerable investigation, my US equity research has finally hit some pay dirt this week, and I have been attempting to get a position in two equities – one relating to the defense industry, the other relating to oil and gas. One of the companies is a well-established player in the industry, while the other one is relatively newer. I would not consider either to be “speculative” in that both firms generate cash, but I do have a good idea why the market believes they should be trading at relatively low levels, and why the market is incorrect.

One has a dividend yield close to 1%, and the other does not give out a dividend. Investors in either company will not be “yield chasing”, so I am happy to not be paying for other people’s yield-chasing demand!

It always seems to be the case that when I place my orders the market suddenly sees my interest in buying a 0.0001% stake in the firm, and then takes the bid up 5%. This is frustrating, but both companies should hopefully regress in price and I will ideally receive a relevant fraction in my portfolio. Both companies have liquid stocks, so somebody of my volume will not move the price.

I will eventually be deploying the rest of my US-denominated currency from bonds to equities, but the bulk of it will happen in early 2011 when I can get rid of the bonds.

I am still investigating a couple other candidates on the US side. I have already rejected many other names – investing in the USA is becoming economically more and more dangerous because of their domestic economic situation. Investors need to be careful of the impact of silly government decisions.

SNC-Lavalin trumps the CPP

In an interesting development, SNC-Lavalin (TSX: SNC) has announced that it will be exercising its right to first refusal in purchasing the CPPIB’s 10% stake in the 407 Highway.

SNC is now forming a new corporation, which will sell shares in a company (Transaxio) that has its ownership interest in the 407 Highway.

The only reason why SNC would do this is if they suspect that the CPP’s purchase was undervalued – so it will be interesting to see what the corporation will trade at when it goes public.

This will also be the first time people can directly take an ownership interest (although effectively a non-voting interest) in the 407 Highway.