Finance – Page 12

What’s a good earnings multiple?

The traditional financial metric has the P/E ratio being some amount over the risk-free rate.

For example, if the long-term government bond yield is 5%, then the equity valuation would be a premium over this, say 8%. The spread is the risk you take for an equity investment compared to a guaranteed payout on government debt.

The above example means you’d pay 1/8% = $12.50 for each dollar of cash flow, or also a price/earnings of 12.5.

This is a gross approximation, and does not take into a myriad of factors, especially future earnings growth/decline over time and the balance sheet condition (leverage distorts the above calculations).

As a most trivial example, Microsoft, which can be reasonably anticipated to be around for the indefinite future, is estimated to earn $10.66 in their fiscal year ended June 2023. If this extrapolates forever, at the current $300 share price, you are getting a 3.6% return, or 28 times earnings.

Considering the 30-year government bond is 2.7% at present, this is not much of a premium to take risk. Obviously there is some anticipation of earnings growth at Microsoft (at a minimum, one can expect them to be able to raise prices for inflation).

Either way, investors are accustomed to buying non-high flying companies at reasonable valuations, say 9 to 30 times earnings, depending on the perceived stability and earnings power of the company.

However, in the cyclical industries, the earnings factor over time is very volatile. Nothing exhibits this better than commodities.

Canfor (TSX: CFP) is a good example of this.

We take a look at their historical earnings, which is extremely choppy:

Just on the basis of historical earnings, if you took the past four quarters, Canfor, at $22.69, is trading at 1.87 times earnings, or a 53.6% earnings yield!

Of course, things are not that easy in commodity-land. There was an obvious windfall opportunity in lumber in the aftermath of Covid-19.

Despite that, analysts are projecting a 2023 earnings of $5.08/share, which is still 22%.

The issue is that this is a stale estimate. If raw lumber prices continue to drop, this estimate will surely drop, along with the share price. Indeed, the share price itself is a reasonable signal that this estimate is likely high.

The other factor is the duration of the earnings. Cyclical companies are, by definition, ones that go through boom-bust cycles as investment kicks in and supply starts to flood the market. The lumber market in this respect is a lot quicker than some other resources that require half a decade to open up infrastructure.

If this level of earnings is projected to last further in time, then the current price will rise. Conversely, if the earnings deflate quicker than expected, the share price will drop.

Either way, it is gut-wrenching to sell a company that seemingly is trading at such a low multiple. Sometimes, selling at a low single digit multiple is a correct decision!

However, unlike the much more stable Microsoft, an investor is rewarded much more for getting the earnings picture correct for a cyclical company – correctly projecting the future in an earnings-volatile environment is much more rewarded.

Does this mean that Canfor, at 2x or 4x or whatever, is a better investment than Microsoft because it is so seemingly ‘cheap’?

This brings me to the original question on the title of this post – what is a good earnings multiple?

The answer is there is none.

How to hedge against hedges

An annoyance of mine in the oil and gas space is the action of management hedging against changes in commodity prices. They engage in this activity for various reasons. A valid reason is if there is a financial threat that would be caused by an adverse price move (e.g. blowing a financial covenant is something to be avoided). A not-so-valid reason is “because we have done so historically and will continue to do so”. An even less valid reason is “I’m gambling!” – that’s my job, the job of the oil and gas producer is to figure out the best way to pull it out of the ground!

One additional problem with hedging is that you will get ripped off by Goldman Sachs and the like when they place positions. Your order will always be used against you. There are always frictional expenses to getting what is effectively a high cost insurance policy.

Such policies look great in a dropping commodity environment, but in a rising environment they consume a ton of opportunity cost to maintain. For example, in the second half of last decade, Pengrowth Energy managed to stave off its own demise a year later than it otherwise should have because it executed on some very well-timed hedges before the price of oil collapsed. Incidentally, the CEO of Pengrowth back then is the CEO today of MEG Energy (TSX: MEG).

MEG Energy notably gutted its hedging program after 2021 concluded. They lost $657 million on that year’s hedging program, just over $2/share.

Let’s take another example, Cenovus Energy. I have consistently not been a fan of Cenovus Energy’s hedging policies, especially since it is abundantly clear that they will have been able to execute on their deleveraging. In their Q4-2021 annual report, digging into their financial statements, you have the following hedges:

For those needing help on their math, if you ignore the minor price differential between the buy and sell, it is approximately 66,666 barrels per day that is pre-sold at US$72, up until June 2023.

As I write this, spot oil is US$103. That’s about $1.1 billion down the tubes.

So today, Cenovus fessed up and said they’ve blown a gigantic amount of money on this very expensive insurance policy:

Realized losses on all risk management positions for the three months ending March 31, 2022 are expected to be about $970 million. Actual realizations for the first quarter of 2022 will be reported with Cenovus’s first-quarter results. Based on forward prices as of March 31, 2022, estimated realized losses on all risk management positions for the three months ending June 30, 2022 are currently expected to be about $410 million. Actual gains or losses resulting from these positions will depend on market prices or rates, as applicable, at the time each such position is settled. Cenovus plans to close the bulk of its outstanding crude oil price risk management positions related to WTI over the next two months and expects to have no significant financial exposure to these positions beyond the second quarter of 2022.

As this hedging information was already visible, the amount of loss can be reasonably calculated, so the actual loss itself isn’t much of a surprise to the market. The forward information is they’re reversing the program.

However, even if they did not, an investor can still reverse their decision in their own portfolio, using exactly the same West Texas Intermediate crude oil contracts that Goldman and the like will use. As an investor, you can take control in your own hands the level of hedging that an oil/gas producer takes.

For instance, using the above example, it works out to 2 million barrels of oil a month (net of sales and purchases) that is being hedged. Note each futures contract is good for 1,000 barrels of oil.

If you owned 100% of Cenovus Energy, you could sell 2,000 contracts of each month between the January 2022 to June 2023 WTI complex. Obviously you wouldn’t want to hammer such a size in a two second market order, but there is enough liquidity to reasonably execute the trade.

I don’t own 100% of Cenovus, but the same principle applies whether you own 10%, 1%, or whatever fractional holding of the company – you just reduce the proportion of the hedge.

The only impractical issue to this method is the 1,000 barrel size per futures contract sets a hefty minimum. You need institutional size in this particular case. For instance, just one futures contract sold across January 2022 to June 2023 would correlate with the ownership of approximately 1,000,000 shares of Cenovus Energy. Anything more than this and it would be positive speculation on the oil price (which is what one implicitly does when investing in such companies to begin with!).

The same principle applies for companies that do not employ the desired amount of leverage (debt to equity) in their operation. Assuming your cost of financing is the same as the company (this factors in interest, taxes, covenants, etc.), there is no theoretical difference between the company taking out debt versus you buying shares of the company on margin to achieve the desired financial leverage ratio.

Going to back to crude oil, deciding to un-hedge only works when you assume there is a rising commodity price environment. Management’s actions, no matter which ones they take, are implicitly a form of speculation on future prices and if you disagree – if for whatever reason you don’t want to sell the company outright (e.g. continuing to defer an unrealized capital gain) you can always hedge yourself by going short those crude futures. The power is always in your hands as an investor!

SPR release comments

Gas prices are the most visible price displayed on the entire planet. It is the most transparent price in the world – you go near a gas station, prices are posted and visible a hundred meters out.

With visibility comes politics. Especially in Canada, it is a perennial occasion to read of news articles claiming price collusion, and politicians claim to act in the public interest against price gouging, etc.

Cue in the headline that the US administration is deciding to release 1 million barrels a day out of the US Strategic Petroleum Reserve for the next 6 months.

If fully executed, this will drain about a third of the reserve.

However, telegraphing this move allows traders to take advantage of the situation. You see this with a re-shaping of the oil futures curve (it was more dramatic when the preliminary news came out a couple days ago):

Back in 2020 during the middle of the Covid crisis, this curve was in the inverse direction – short term oil was priced much cheaper than longer-term oil. The reaction by the market was to store oil on tankers (bidding up tanker companies in the process) and arbitraging the time.

This is an inverse of that situation – sell spot oil (which is about $15 over 1-year out pricing), and long future-dated oil, and perform an arbitrage on the price difference. This is assuming that the inventory will actually be refilled in the future. This is a big assumption.

I do not think it will be that easy. Energy is highly in demand, and supplies will be more and more difficult to procure, especially within North America, where we have mal-invested in our energy production for quite some time.

If anything, this decision is a sign that my bullishness on fossil fuels was too low an estimate.

Having a strategic reserve reduces price volatility as if things really hit the fan (e.g. if the Saudis for whatever reason couldn’t export anymore) you had some time to work with. Every million barrels that gets pulled out of the reserves reflects an increase in future volatility since the price curve for fossil fuels is highly inelastic.

This is not to say that the upside will not continue – we could see a quenching of demand in our rising interest rate environment, or if we get into a recession. High energy prices also have a way of reducing energy usage.

But recall that world oil consumption only dropped from 100 million barrels a day to 91 million barrels in 2020 (the Covid year), when everything was virtually shut down in most places for at least 3 months. A recession will not drop total consumption by 9 million barrels a day – it will be far less than that.

It doesn’t take much of a supply imbalance to change prices – the fossil fuel market is inelastic. But right now, the price pressure is most certainly on the upside, and the SPR release is something to cause one to be more bullish of, especially since it is easy to see the political motivations behind this decision – the Democrats in congress right now are looking like they will be smoked in the upcoming November mid-term elections and high fuel prices, being as visible as they are, is one reason why.

A quick primer on the impact of interest rates on capitalized value

This is taught in first year finance, but is an excellent reminder.

I will give an advance apology for the CFAs reading this, it is remedial material.

While the finance math here is simple, the applications are enormous in the realm of valuation, because your input variables have a huge determination on the output.

This math is as fundamental as the formula which drives much of accounting, which is “assets equals liabilities plus equity”. An entire professional body is driven around this very simple formula.

Likewise, in finance, learning how to capitalize a cash stream (and vice versa) is a fundamental calculation.

The value of a perpetual cash stream can be expressed as a single number in present value. You simply need a projection of cash flows, and you need to apply a rate of interest to account for the time value of money.

This is best expressed in an example.

Say you are promised $50 in two sums, $50 today and $50 in a year.

But you are offered a deal. I’ll pay you $80 today, lump sum.

If you do not care about the time value of money (an interest rate of zero), you would reject the deal. After the deal you’d have $80, but without the deal, you’d have $100 in a year. No way you’d take it.

We now bring in the concept of the interest rate, which is how much you’re willing to pay for money today versus money tomorrow.

Let’s say you think you can make 100% on your money. Clearly taking the deal is beneficial. Instead of $150 at the end of the ‘no deal’ scenario, you would instead be sitting on $160 if you took the deal.

It gets even more complicated if you think you can make 100% on your money for the first 6 months, and 25% thereafter. The rate of interest is a function of time, in addition to the cash flows. When it comes to valuations, both the cash flows and the rate of interest are never as black-and-white as these examples make them to be. There is significant uncertainty to deal with.

There is a break-even point where you would be theoretically indifferent between the two options. Your counterparty will have different interest rate expectations, and thus their break-even will be a different number and this is where markets are formed.

Implicitly when engaging in the market, we are guessing what the shape of the cash flow and interest rate function is, and trying to interpolate that into a capitalized value, which is traded in present day.

The more exciting part is the cash flows (is company XYZ going to make $$$ EPS in the next few years???) and, in general, the rate of interest is a more neglected variable.

The rate of interest has a huge impact on the temporal aspects of global decisions, whether to invest in projects, or to take deals (bird in the hand vs. two in the bush).

Let’s say you are a forestry company and your trees are growing biomass at 4%, and the interest rate is 3%. It makes sense to keep those trees in the ground. At an interest rate of 5%, it makes sense to harvest.

In general, higher interest rates force one to be more presently oriented, while lower interest rates afford the luxury of being future oriented.

This is evident in a couple examples. One is in highly inflationary economies (e.g. Argentina), hard assets are held precious. Investments in the future must have large payouts today and very short recovery periods. Commodity investing is great in high rate environments, especially if you already have a producing asset.

Another example is the (hopefully) fictitious example of a planet-killing asteroid hitting planet earth in a couple decades (there was a recent horrible movie regarding this, please erase this out of your mind when thinking of this example). Upon the discovery of the asteroid, interest rates will rise dramatically, but it wouldn’t be insane like if such a discovery was obviously an irrevocable impact in a year – the cash flow function would have some expectation after the two decade mark because we might be able to avoid the collision. Either way, the present becomes much more valuable.

Let’s fast forward to 2022, in the present.

Historically, especially since 2008, short term interest rates have been kept to a minimum, and long term interest rates have also been to record lows.

This dramatically increases the present value of future cash flows. Companies with “future promise” are valued higher as a result.

This is starting to reverse for various reasons.

It has been about 40 years since the financial markets have had to deal with a sustained amount of inflation and a rising interest rate environment.

The playbook is fundamentally different. Things that worked in the past will no longer work in the present. The monetary base itself, the measuring stick for performance, is starting to change, which creates its own layer of uncertainty.

All of this is part of “the turn” that I have alluded to. Those that do not pay attention will be investing with one eye blindfolded.

Checking in after a month – Miscellaneous thoughts

I’ve been on radio silence lately on this site, but suffice to say world events over the past month have dramatically changed the calculus. Similar to how Covid-19 (or rather the policies and psychological reaction in response to Covid-19) accelerated certain prevailing trends, the invasion of Ukraine by Russia is doing likewise.

This is a miscellaneous post. I had intended to write “The Turn” but this work is being preempted by geopolitics, and indeed it is pretty sad since I have made predictions on a draft post which is already coming to fruition, so I’ll have to strip out that spicy content.

I consider it quite instructive that my own personal calculation of an open-air nuclear detonation this year has moved from near-zero to around 2%. One such detonation will significantly transform the psychological landscape and indeed open a Pandora’s box that will accelerate trends beyond anybody’s imagination. A very long time ago in a previous life, I took a couple courses on radiation biophysics and have brushed off the dust from my memories. Better to be prepared today to interpret the Geiger Counter when it tells you you’re exposed to 10 microsieverts per hour, caused by the Cesium-137 ash blowing in your direction… is it safe to eat the food on your table or not?

I have been noticing the commodity complex has received a considerable amount of attention from speculator-types. One stock in particular that I own (ARCH) is being traded around like a dot-com company like it was 1999. Indeed it is obvious there is a rotation of demand going on, and has been going on since last December – technology/SaaS issuers into “stuff”. This trend is likely to continue as “stuff” becomes more and more precious. Electrons (aside from those generated from power plants) are not nearly as precious as they were back in November.

Readers will also note I have been diligently updating the DCOGI Index. All companies have reported their Q4-2021 results. While spot oil as I write this is about US$110/barrel, for modelling purposes I try to level each company at US$75 equivalent (not a prediction, rather a margin of safety). Even at this deflated level, these companies are trading well below a EV/FCF of 10x, which still prices in extremely negative sentiment in terms of market expectations. All of the companies have reduced the level of debt (adjusted for acquisitions) – CNQ is the leader in the group with a $7 billion reduction. All of these companies, with the exception of Peyto, are in the process of either jacking up dividends or buying back stock – the latter of which should be exceptionally accretive to existing shareholders. If you assume US$100 as your baseline, the valuation metrics become even more ridiculous.

Be warned these sorts of conditions do not last forever. But they can last longer than most people expect. Resource companies can produce commodities today and sell it at spot – and a bird in the hand today is slowly being valued more and more than the two in the bush due to the upcoming rising short term interest rate.

The Bank of Canada raised rates a quarter point last week and all indications suggest that another quarter point rise is in the cards for April 13, June 1 and July 13, which will bring the summer short term rate to 1.25%. The next meeting is September 7, after a 2.75 month break, where I think they will evaluate conditions and determine whether to continue raising rates. The question will be what happens to longer term interest rates – will the central bank invert the yield curve by year-end?

Also, it is an interesting intellectual exercise to model out M2 in Canada for the past little bit, and there is an obvious rise in the curve which does not help the inflationary situation. This M2 curve is even worse (steeper) in the United States. Both central banks will be trying to quench the creation of money supply and QT is bound to occur. Similar to 2017-2018, it will take some time for the true impact for these monetary decisions to be felt. But the punch bowl is being taken away, bit by bit. Do not be the last person at the party. It is likely not an ideal time to take on additional leverage. We might get a good rally or two from here, but definitely we’ve reached an inflection point of sorts – until the next calamity that hits.