Category: Equity

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.

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.

Market places a premium on yield

I have had this ongoing theory that the market is bidding up yield-bearing assets beyond what is rational.

Nothing is as good an example as today when a small asset management firm, Integrated Asset Management (TSX: IAM) announced that they were resuming an annual dividend – 4 cents a share.

IAM is a very illiquid company, but I have had the advantage of considering them as an investment candidate a couple years ago, but never invested because of valuation (too high). This turned out to be a money-saving decision (notwithstanding the economic crisis!). They had previously given out 4 cent dividends on a semi-annual basis (which was unsustainable), but in order to build up their equity they suspended dividends in early 2009.

Their balance sheet otherwise is quite clean – they have a small cash cushion (about 36 cents a share) and no debt.

Yesterday, the company closed trading at 62 cents a share on 1,500 shares of volume (that is about CAD$930 that traded hands, which is about half of its historical daily volume). Today, they are presently trading at 90 cents a share, and I see about 135,000 shares that have changed hands.

Suffice to say, a 45% price increase because of a dividend announcement is a good indication that the market is valuing yield above everything else.

In terms of actual valuation, it was my belief that before this announcement that IAM was trading at the lower end of my valuation range, but not quite at “buy” territory. In addition, the illiquidity would have made it prohibitive to accumulate a position with any speed and thus illiquidity translates into a lower valuation.

The company itself is an asset manager – they claim to deal with “alternative assets”. At the end of their last quarterly report, they reported nearly $2 billion of assets under management. Their year ends on September and 2009 was a very poor year for them, but it was also the case with every other financial institution. In a more “regular” year, the company should be earning around 6 to 7 cents a share, so their dividend payout schedule will be around 2/3rds of their income.

The dividend announcement shouldn’t change what the company earns, so it is puzzling to see it rise so much after the announcement. It also makes you wonder how many other yielding securities have their prices elevated strictly due to dividends and income distributions, rather than earning economic profits through their operations.

An astute trader can also try to time these announcements in other securities. I will leave this to an exercise for the reader.

Manulife valuation

I have spent many hours, spread over about a week, understanding and performing a valuation on Manulife Financial (TSX: MFC).

Readers that track TSX 60 stocks should know that Manulife (and its chief peers, Sun-Life, and to a lesser degree Great West) has gotten hammered over the past year (-40%) and two year (-65%) interval.

Lower equity valuation is not a sign that the stock is worth purchasing – it could perhaps reflect the fact that the equity was over-valued in the first place. Or maybe it is a signal to purchase.

Unfortunately, I have done enough work on the matter that I won’t be giving too much away (i.e. what my “price range” would be for the equity), but I would suggest to people that get into a similar endeavor to realize that Manulife is not solely in the insurance business.

The other point that people should be aware of is that accounting treatment is crucial in properly understanding the line items listed on the consolidated and segment data. This may make comparisons to US-based businesses not an apples-to-apples procedure.

Finally, investors should realize what implicit “macroeconomic” assumptions they are making before investing in the equity. It is similar to making an implicit bet on the price of oil when you purchase shares in Suncor – obviously you won’t be investing in oil companies if you believe the price of oil is going down.

Cinram International Valuation

I notice that Susan Brunner is doing a brief on Cinram (TSX: CRW.UN). It is in the very boring and low-margin business of printing and distributing physical media such as CDs and DVDs.

I did some fairly serious research on this company earlier this year, and came to the conclusion that while they were likely to continue to be cash flow positive, there was no way that they would overcome their debt situation without a significant recapitalization.

The primary hit in the past year was on February 1, 2010 when 28% of their revenue stream announced they were terminating a contract. The units dove about 2/3rds and got my attention when I did research.

Their big problem is that the company, as of June 30, 2010 has a $379 million bank loan (secured) and only $125 million in cash, with a business that is not generating a whole lot of cash. The bank credit facility expires on May 5, 2011. It is more than likely that the secured creditors will take over the equity, which implies that the current value of $1.00 per unit (total market capitalization about $54 million) is vastly overpriced.

I would only start looking at the company more seriously if they traded below 20 cents, and with the recognition that the catalyst for an equity purchase would be a bank giving them a sweetheart extension deal that wasn’t too punitive to unitholders. At this point you are really gambling as opposed to investing, which is why I am not really going to look at Cinram in the future other than as a curiousity to see how their story resolves.