Category: Equity

Don’t invest in corporate largesse

Putting a long story short, the board of directors of Cheasapeake Energy, in their infinite wisdom, decided that it was worth $12.1 million of its corporate assets to purchase antique maps from its CEO.

The only thing you can do when you see such a waste of corporate resources is selling your shares if you own them, and not buying them if you don’t.

I should take this opportunity to point out it was exactly the same company and its CEO that in November 2008 faced a margin call on his own stock, forcing him to liquidate 5.4% of the company in a very rapid transaction.

I said the following back in November 2008:

Some might think this would represent the best buying opportunity – cashing in on the misfortune of somebody’s financial errors. Unfortunately in the case of Chesapeake, the last company I would want to invest in would have a CEO that got caught by a massive forced liquidation like this one – first of all, his incentive to perform well has just disappeared (having no more equity stake in the company) and secondly, one would wonder whether he’d make a similar miscalculation with the company’s finances.

It appears that the CEO is just as reckless with the company’s finances as he is with his own – any prudent investor should blackball the entire Board of Directors of Chesapeake Energy – if any of them serve on a corporate board (or heaven forbid, management) of a company you are invested in, it would be a yellow flag.

This is why the iceberg theory of bad news is applicable – if there is a small piece of bad news, chances are there is a lot more to go with it. In the case of Chesapeake, this is the last energy company I would want my dollars invested in.

Ability to remain irrational longer than ability to remain solvent

John Hempton at Bronte Capital writes another high-quality piece about how having superior information doesn’t necessarily translate into stock market returns. It is just like people that shorted the stock market in 1999 because of insanely high valuations (or shorting Amazon in 2009 at $100/share!) – even though they might be correct, the market can remain irrational longer than your ability to remain solvent.

It is always frustrating in markets to be right, but to get the timing incorrect. This is why option markets are always so brutal to those don’t get the element of market timing to be correct. It is also an indication that even when betting against the majority, you will only be able to win if some of that majority decides to see the world your own way – this process can take years, just like it did for the former Dow Jones Industrial stock Eastman Kodak, or for the poor fellow (Alfred Wegener) that developed most of the geological theory on plate tectonics – he was completely correct, but ridiculed in his own scientific community and died before he was proven correct about 40 years after he proposed the theory.

You can also see other stocks that are on their death throes, such as nearly anything involved in newspaper or paper-based publishing. It also makes you wonder what industries today that aren’t visibly dead will be on their deathbed in the next 20 years – look around you and see what you use today, and wonder if it will be replaced with some substantial technology innovation that is just in its infancy today. Maybe this is why Amazon is trading so highly – maybe they will be exterminating conventional retail shopping?

I remember back in the late 90’s, back in the days when I started investing and didn’t know too much other than technology companies, that I did a lot of research on flat panel displays. Back then, 17″ CRT monitors were still about $500, but it was imminently clear to me that flat panel displays would be the way of the future – if anybody tried lifting up a 21″ CRT monitor you would end up breaking your back trying to move the thing. It lead me to two companies, Genesis Microchip, which did semiconductors in FPDs, and Photon Dynamics, which made diagnostic and factory equipment for the manufacturing of FPDs.

Both of these companies didn’t skyrocket like I anticipated them to and I never even invested in them, but it was worth noting that despite the fact that flat panel displays became the future of computer displays, I never was able to financially capitalize on it in the marketplace.

Present cost of portfolio insurance

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.

Harvest Energy takeover finalized

Harvest Energy has finalized their takeover with KNOC, so their units will be delisted as follows, per the press release:

As a result of the acquisition the Harvest trust units will be delisted from both the Toronto Stock Exchange (“TSX”) and the New York Stock Exchange (“NYSE”). The NYSE has advised that the trust units will cease trading on that exchange on or about December 23, 2009 and the TSX has advised that the trust units will cease trading on or about December 29, 2009.

This is an interesting delisting schedule, mainly because if you own the Canadian version of the units, you have a tax election. If you are sitting on unrealized losses, you want to liquidate the shares immediately so that way you can claim the capital losses on your 2009 tax return. If you are sitting on capital gains, you can defer capital gains taxes to your 2010 tax year by selling the units on December 28, 2009.

(Update: I had failed to account for the fact that December 28, 2009 was a statutory holiday in Canada and the exchanges were closed this day, but the trust units were still traded on December 29, 2009, which means the election above was still available.)

The best stock pick for the past 10 years

It is always interesting to pour over historical data and ask yourself how you could have figured this out had you not had the benefit of hindsight. Everybody calls this “the next Microsoft”, but these days, they are not turning out to be revolutionary software companies.

The largest gainer in the past 10 years turned out to be Green Mountain Coffee Roasters. Back in the beginning of the year 2000, they were $0.88/share, split adjusted. Today they are $69 a share. So $1,000 invested in this company back in the beginning of year 2000 would have resulted in a cool $78,400 today.

What does Green Mountain Coffee do? While their business at the beginning of the century used to deal with selling coffee, they made an acquisition of Keurig in 2006 which turned out to be a major value-added acquisition on their part. The rights to the Keurig coffee machine, and selling the K-Cup packs has been incredibly profitable. It is a razor and blades business model, where the coffee machines take K-Cup packs. Each K-Cup is good for a serving, and typically costs about 50-100 cents to purchase for each serving.

The trick is getting as many of the machines in the public, and then collect royalties on K-Cup sales. They appear to have done that.

My only experience with the K-Cup was in the Air Canada Lounge in LAX airport. They had a K-Cup machine and it made coffee, but I wouldn’t have sold my soul for it. The fact that the machine also creates a lot of disposable junk turns me off somewhat. But somehow GMCR has managed to get enough of its razors into the marketplace, and has enough consumer adoption that they are making huge money off the blades.

In terms of the stock price, I think it is safe to say that we won’t be seeing another 78 times appreciation over the next 10 years, but it will be interesting to see whether GMCR can grow its business to the level that the stock price suggests.

How could have one seen this 10 years ago? Nearly impossible. Even 3 years ago when they took over Keurig, instinctively I would have thought “Who in their right mind would pay 60 cents a pop for their own home coffee machine when you can just as easily grind your own beans?” I’m guessing that cost wasn’t the factor, rather convenience of having to not deal with the messy parts of good coffee making. If I thought that the coffee it produced was vastly superior to the traditional methods, then perhaps I thought the company would have a chance. But I guess convenience trumps cost in this case.