Saturday, December 31, 2011

Canadian Business & IBM

Well it appears I was quoted over at another major news publication, Canadian Business.  To read the article click below.

I must apologize... I have been very busy with work lately and haven't been able to post.  In short I am transitioning into a new role back at the parent company from a subsidiary.  I have really enjoyed my time at the subsidiary as it was much smaller (than the parent) and working through the unique business challenges we faced has definitely helped me become a better investor. 

One key point I have learned is how sticky business and business relations are.  Things don't change drastically over time.  In fact many companies resist change because of fear of the unknown.  For example, if you changed suppliers how can you trust the new products, quality, or service?  From this perspective you can see how Warren Buffett likes the stickiness of IBM.  IBM's competitive advantage is the relationships they have built with hundreds of businesses around the world. 

Speaking of IBM, shortly after Buffett announced his purchase of IBM stock he also mentioned one other detail.  It was that he read the book, Who Says Elephants Can't Dance? Inside IBMs Historic Turnaround by Louis V. Gerstner Jr., not once but twice before buying the stock.  That was I needed to hear so I quickly got my hands on the book. 

The book is an account of some of the steps Mr. Gerstner took to save IBM.  Back in 1992 IBM was on the brink of failure, bleeding cash, and left for dead by wall street.  Kind of sounds like Blackberry, except Blackberry isn't even close to losing money yet.  Basically, IBM became a victim of their own success and seemed unwilling to adapt to the changing computing world. 

The most interesting fact in the book is Mr. Gerstner's background. It is definitely not what you'd expect for a CEO of a computing giant.  He had worked for McKinsey & Company (consulting), American Express, and finally was the CEO of RJR Nabisco before coming to IBM.  Although he was educated in engineering he went straight into Harvard for an MBA and had zero experience in computers, software or IT. 

Despite his unusual background Mr. Gerstner did turned transform IBM into one of the most successful IT companies in the world prior to his retirement in 2002.  He transformed not only their competitive position but radically transformed the culture to become customer centric and customer focused.  These and many other good leadership principles are discussed in the book. 
Anyway, I have been working on a few new posts and how to be back soon with some good new content and discuss some stocks for the year ahead. 

Happy New Year!

Disclosure - I own shares in BRK.b, thus I indirectly own shares in IBM.

Monday, December 12, 2011

Home Prices Are Crashing in China

I hate doing this type of post...but the title really says it all. 

Anyone who is still long commodities needs to give their head a shake.



Tuesday, December 6, 2011

Economics - Why Oil Prices Will Fall

I posted a while back Five Reasons Why Oil Prices Will Fall.  I want to follow up with the Number One Reason why Oil prices will fall over time. 

It appears the shale gas revolution that has been on going in North America has dramatically changed the energy landscape for Natural Gas (NG).  I would point to this blog post (Click Here) on NG over at Carpe Diem blog.  The shale gas revolution has dramatically transformed the energy picture from where North America was running out of NG five years ago to being awashed in NG today. 

NG production in the US just reached a new all time last week according to the EIA (Click Here).  You can also see the dramatic increase in production in the last five years due to the shale gas paradigm shift. 

With NG prices currently around $3.25/mcf in Canada, and $3.40/mmbtu in the USA, NG is very, very cheap relative to Oil.  (You can consider a mcf approximately equal to mmbtu)

On an energy equivalent basis natural gas has 1/6th the amount of energy as a barrel of oil.  So to compare apples to apples we need to multiply our NG prices by six to compare correctly. 

So at current prices, NG is available as an energy source for roughly $19.50/bbl or you can get the equivalent amount of energy from a barrel of oil for $101/bbl (WTI).   That is over 5 times the cost for the same amount of energy. 

Can you imagine how much cheaper our vehicles would be to run if we used NG instead of oil?  As  Scott Grannis has said, "It is hard to underestimate the degree to which cheap and abundant natural gas is going to transform U.S. manufacturing and energy generation in the years to come".

Now NG is cleaner a much more plentiful energy source than many oil.  Since the cost is over 80% cheaper than Oil, NG will eventually become a very common energy source.  It's hard to justify paying 5 times more for the same amount of energy in the long term. 

Of course utilizing NG as a common energy source will take years happen.  We would need new technology and infrastructure.  The infrastructure will take time to build, but given the economics the ball has already started rolling.  If you think this is all fanciful thinking, Click Here to see what Encana thinks about the future. 

Paradigm shift are hard to spot and some people deliberately stick their head in the sand and refuse to accept the change.  I must admit that I wasn't a believer in the shale gas revolution until very recently.  The stubbornly high production data is simply too overwhelming to neglect. 

What about the Big Energy Picture?

I read an interesting short booklet almost 10 years ago, called the age of energy gases or something like that.  While I found the little booklet kind of stupid, it did take a philosophical look at the form of energy man has used throughout history.  If you go back a couple hundred years or so we used 100% solid energy sources.  These would be wood, coal, and other solid forms of energy (typically burned).  Once we got onto liquid energy forms like oil, the percentage of our energy consumed from solid forms has constantly fallen.  We currently use a very little amount of solid energy as a percentage of our total energy sources. 

Today Oil is by far the largest energy source, but as the book pointed out it will never reach 100%.  The book drew something like a bell curve with energy liquids reaching somewhere around 60-70% of our energy needs and then eventually entering a terminal decline just like energy solids.   

Finally, the book described the age of energy gases.  In this phase both solid and liquid forms of energy are in decline and energy gases become the most common energy source, eventually reach 100% of our energy usage. 

While I found this historical study of our sources of energy quite stupid at the time, I am wondering if the guy who wrote it isn't such a quack after all.  We seem to be able to access more and more gas reserves every day.  If we could unlock unconventional gas sources we would be accessing huge energy sources. 

My only question that remains is how atomic energy (uranium) fits into the big picture. 

Kevin Graham

P.S - Here is an interesting article that sums up my thoughts above:

Monday, December 5, 2011

China's Hard Landing

China is in big trouble, something I have been saying for a while.  Individuals and governments cannot defy economic gravity.  When you monkey around with the FREE MARKET this is what you get:

I particularly like this quote.

China is a poster child for the Austrian school of economics' theory of the business cycle. After undertaking the biggest stimulus program the world has ever seen in response to the global financial crisis, the country is drowning in unproductive investments financed with credit.

You cannot legislate your way to wealth or prosperity.  Every attempt in the past or in the future will be met with the same result.  Otherwise we would all be filthy rich by now.  Real wealth comes from savings, good investment, and increased productivity on the supply side.  The more we produce (directed by consumer preference, not government regulation) the more wealthy we become. 

Enough with the Crony Capitalism. 

I wonder how much further ahead (and less wasteful) we would be if the business environment was unencumbered by artificial demand created by some politician who thinks they know better?  (Think interest rates, cash for clunkers, energy rebate programs, tax breaks for certain companies, pet projects, etc, etc)

Best Regards,

Saturday, December 3, 2011

Bank of America & Europe

We'll I know it's been a while since my last post, I do intend on making up for lost time shortly.  When a guy goes away for a week (with no phone or email), it leave quite a bit of work when you return.  We'll I was poking around over at Corner of Berkshire and Fairfax today and posted this reply to a comment on Bank of America (BAC).  To save money and use the shotgun approach, I am re-posting here to save time. 

Just so everyone knows, and to repeat from my first post ever, I don't enjoy rehashing the latest news and current events.  I strive to provide original content, full of facts and written in an enjoyable way.  This post does discuss Europe which I have been trying to avoid since it's not original, but I believe contains some interesting facts and puts things into perspective.  Enjoy!

My reply...

Can you please provide sources for your numbers?  For instance that the big 5 banks have CDS exposure of $244 trillion?  I think you might be confusing CDS exposure to total notional derivatives at the big 5 banks.  For instance BAC has $68.2 trillion in total notional derivatives outstanding.  What is interesting is 86% of these are interest rate contracts.  Specifically, looking at the CDS exposure, they have written about $2 trillion in CDS and have also purchased $2 trillion in CDS contracts.  Actual net exposure is about $100 billion CDS written and $100 billion CDS purchased.  At the end of the day netting CDS assets from liabilities gives an asset of $5.6 billion down from $6.6 billion and the beginning of the year. 

Now the real question is who/what are the CDS contracts written on AND who/what are the CDS contracts purchased on?  If you know I would like to know.  When people talk about banks being black boxes this is exactly what they mean (or should mean). 

Many say banks are black boxes because of the removal of mark to market (FASB 157), which is not true.  Mark to market still applies unless the market is illiquid or non existent.  For BAC Level 3 assets (the ones marked to fantasy) are 2.9% of total assets and 4.8% of risk weighted assets (RWA). 

Ironically, these are the best among the large US banks, including WFC, JPM, C.  So when pundits toot their horn saying you can't believe the balance sheet, this is the part they are talking about.  This brings me to my next point. 

Many people claim that JPM has a rock solid balance sheet.  This includes newspapers and the nut jobs running around over at seeking alpha that either post OR comment out of ignorance.  Level 3 assets are 5.0% of total assets and 9.3% of risk weighted assets at JPM.  That is enough to drive a truck through.  They also have the largest notional amount of derivatives outstanding and the largest amount of trading assets.  If anyone says JPM has a rock solid balance sheet (including Jamie Dimon), are talking their own book or don't know the facts.  The only company with a rock solid balance sheet is Wells Fargo, the only one that didn't need TARP.   

Now I am long BAC.  The reason why I am long is because the numbers just say they are too cheap.  If they earned 1% on assets or 10% on equity that would be $22 billion profits vs a $55 billion market cap.  Even if the market cap doubled to $110 billion that still would only be 5 times average earnings.  The math isn't hard.  But i'll be honest; the reason why BAC is a crappy company is management.  How many screwups in the past year?  You can't even count them on all your fingers and all of your toes. 

Anyway getting back to the CDS stuff, it's not nearly as big as you think and if you have any details on who/what then that would be of value.  From what BAC has broke out on Europe in Q3 they have $1.5 billion in derivatives outstanding on Italian sovereign debt (likely CDS written) and have purchased $1.2 billion in CDS protection.  The net is about $300 million or not enough to worry about.  They also have some exposure Portugal and Spain in the tens of millions, but they are totally covered by CDS protection purchased. 

Just to put the European debt crisis in perspective, the US debt crisis was $15 trillion of bad mortgage loans against a $15 trillion dollar economy.  Huge.  If you add up all the sovereign debt of the PIIGS, it's $4 trillion at risk against a $15 trillion dollar economy (European union).  In my opinion, Italy and Spain won't default and they contribute $2.2 trillion and $0.9 trillion respectively to that $4 trillion total.  So the rough $1 trillion that's left isn't as much as the pundits make it out to be.  Now if the creditors accept a 50% haircut that further brings it down to $500 billion, something still very large but not unmanageable.  The real reason why Europe is a mess is because of the political structure and the inability to run a printing press to bail them out. 

Best Regards,


Disclosure - Long WFC and BAC

Tuesday, November 29, 2011

Moose Hunting Photo's

We'll I just arrived back from Moose hunting and I am sorry to report that we harvested no moose this season.  We actually saw very little action until our last day, Saturday.  That day my hunting partner was caught right in the middle of a chase between a couple of wolves and a cow moose.  He only saw one of the wolves and it was within 50 ft of him.  We are not able to hunt cow moose during the season we hunt.  I don't think the wolves caught the moose since the amount of snow we have gave the moose an advantage. 

Just to give you an idea of what it's like to moose hunt, I am including a few of photo's of our hunt.

A typical view heading into the forest.  The forest is a mixture of Pine, Spruce, Birch, and Poplar.  Most of the areas we hunt we're major logging camps dating back to the 1940's, and some of the more recent logging happened during the 1980's. 

This is the portable hunting cabin we stay in during our hunt.  It is 12ft x 18ft (216 sq ft) and can sleep three comfortably and four people if required.  It has insulated wall sections and an insulated tarp roof.  It was designed by my father-in-law and all packs nicely into a 6 ft x 8 ft x 2 ft steel box that stays up in the forest.  We take a small generator to run interior and exterior lights and propane tank to run our coleman cook stove and a lantern if required.  A wood stove provides heat.  If you look closely the door you will see the cabin is appropriately called the "Attack Shack". 

This is a picture of a sunrise early in the week. I climbed up about 50-60 ft up a really, really old spruce tree that was over 100 ft tall. The base circumference of the tree was so large if I put my arms around it my fingers couldn't touch. I'm sure some of the really old trees measure 3 ft in diameter.

This picture was from Thurday afternoon (yes afternoon).  The temperature warmed up from -30°C (-22°F) to 0°C (32°F) and hoar frost made everything look white.  Other than the first couple days, the weather was quite nice. 

I went for a walk near sunset Thursday in familiar territory without my GPS.  It was amazing how quickly disorientated I became without the sun as a reference.  I honestly couldn't tell you which direction was north.  All I knew was that if I stayed on the skidoo tracks I would make it back to a main trail.  Needless to say, I don't leave the cabin very often without my Garmin. 

Here is a picture of a whitetail deer (doe) that I took.  I saw about a dozen deer including one fairly large buck I could have shot.  He had a decent 3 x 3 rack, fairly wide.  I am fairly fussy on deer and I am only looking to shoot a 150+ buck.  I have a 5 x 5, 160+ class mounted in my basement and I am only looking to shoot something larger.  If you have done any hunting you will know that deer always look bigger through the scope on your gun.  Once they hit the ground they horns shrink by about a third. 

As for the markets they continued to zig and zag.  No new news of substance other than the US economy is quite strong despite the rampant pessimism.  A number of bargains are currently available in high quality large cap stocks.  Given how low interest rates are stocks are obviously cheap.  This will become more clear in the years ahead.  Hopefully everyone is enjoying the buyers market.  As much as you may not like the low prices, it really is good for a number of the businesses I own that are actively buying back shares.  Every day the companies I own become more valuable even though the market prices don't reflect that reality.  In the long term the market will figure it out. 

Best Regards,

Sunday, November 20, 2011

Gone Moose Hunting

We'll I have been a little slow posting of late.  I had an extremely busy week getting ready for a big moose hunt.  Today I will be leaving for a week into the north to hunt big game.  Here is a sample of what I will be looking for:

Or this guy:

The second photo was taken by my brother in-law's trail camera approximately 15 miles from my house.  We do have some huge deer up here in Canada.

Just to give you an idea of what we do, we drive to the edge of civilization and then get on skidoos (or quads) and travel into the forest.  We pull sleds packed with all kinds of gear (generator, ropes, food, clothes and guns).  We the travel into the northern forest for a couple hours and set up base camp.  This will be my fourth year.  Like I said last year it takes lots and lots of patients hunting moose. 

I will try and post some pictures next weekend when we return  (Click here for Pictures)

Best Regards,

Saturday, November 12, 2011

Investment Idea - Berkshire Hathaway

Yesterday I gave you a number of quotes from the Oracle of Omaha, Warren Buffett.  The last quote was the following:

Your goal as an investor should be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.

So I got thinking to myself, are there investments available today that meet Mr. Buffett's criteria.  I was originally going to post on another company that is significantly undervalued and will most likely be taken out at a premium over the next year or two for reasons that would become clear upon investigation.  I had come to the decision that I wasn't going to invest but the stock has recently gotten cheaper and I do some buying.  The stock isn't overly liquid but the company is fairly large.  Anyone want to make a guess? 

Upon further reflection the best example that I could think of today that meets Mr. Buffett's criteria is his own company, Berkshire Hathaway.  Today Berkshire Hathaway represents a very asymmetric investment opportunity.  The downside is very, very low and the upside is very, very significant.  My argument for investment won't rely on any facts or figures but simply a statement recently issued by the company itself. 

It stated, "Our Board of Directors has authorized Berkshire Hathaway to repurchase Class A and Class B shares of Berkshire at prices no higher than a 10 premium over the then-current book value of the shares. In the opinion of our Board and management, the underlying businesses of Berkshire are worth considerably more than this amount, though any such estimate is necessarily imprecise."

So what we have is hat tip from Mr. Buffett who is clearly signaling that he believes his stock is cheap.  Not only does he believe it is cheap, but worth considerably more than a 10% premium to book value.  The 10% premium is likely to reflect the fact that they don't believe a significant portion of their principally deferred income taxes, listed as a liability, is really a liability.  Some other minor balance sheet modifications could also be made. 

Secondly, downside is limited to 110% of book value or currently $71/share (Class 'B' share).  So, for the sake of argument, let's assume Berkshire is worth 1.75 times book value or about $115/share.  So at recent prices you have around 8% downside and 50% upside making this opportunity very asymmetric.  Besides the very attractive risk/reward scenario you are buying a business that owns a number of fantastic businesses from Dairy Queen (a personal favorite) to GEICO.  They also have some fantastic equity investments in growing companies like Coca-Cola and Wells Fargo.  Nearly all of the Berkshire companies earn exceptional returns on equity. 

So lets run down the checklist from Mr. Buffett's quote above: 

1) Rational Price?

Check - Mr. Buffett has told us it's not only undervalued, but significantly undervalued.

2) Easily Understandable Business?

Check - Although Berkshire is a complex conglomerate of many businesses and equity investments, most all of these businesses are quite simple and provide valuable goods and services that people use everyday. 

3) Are the earnings are virtually certain to be materially higher five, ten and twenty years from now?

Check - Wholly owned business have increased per share earnings by 20% annually for the past decade.  Those companies will be providing the same goods and services 20 years from now as they are today (very low technology risk).  Examples would be bricks, carpet, insurance, ice cream, razors, soft drinks & candy.

4) Would Berkshire be a good company to own for the next ten years?

Check - I can't think of another company I would be more happy to own for the next ten years.


What does Mr. Buffett recommend you do when you find a company that meets all of his requirements and is available at a reasonable price?  You should buy a significant amount of stock.  Enough said, the writing is on the wall. 

My recommendation is to buy some Berkshire and forget about it for at least ten years.  When you check it again, it will be worth much more than what you paid.  No need to get a daily stock quote or read every single news update out of Europe.

Lastly, by investing in Berkshire, you will benefit not only from earnings per share growth but also from a market that will value the company in a more optimistic mood in the future.  In the short term if the stock does get cheaper realize that is in your best interest for Berkshire to buy back as many shares as possible.  Just remember to use Mr. Buffett's assessment of fair value and ignore what the market says.

Best Regards,

Kevin Graham

Disclosure - I am long BRK.b

Friday, November 11, 2011

Warren Buffet on Market Fluctuations

Recent market movements will have caused many "investors" to be scared.  Yesterday I talked with a coworker who said she very upset that her mutual funds were down significantly in September.  I have received emails from fellow investors who have said the recent market movements have made their stomach's churn.  I have heard some say that you should sell your stocks and wait for the mess in Europe to sort itself out. 

In times like these it becomes clear who who should and shouldn't be managing money.  I'm sure many of my readers will have read many of the quotes below but quickly forget them and act differently when markets go crazy.  If you read my first post on this blog (Are You a Value Investor?) I made the case that many understand value investing but don't practice it. 

During times like these it is always good to review some Warren Buffett quotes on market fluctuations.  I hope they help you put things in perspective. 

  • We’ve long felt that the only value of stock forecasters is to make fortune tellers look good. Even now, Charlie and I continue to believe that short term market forecasts are poison and should be locked up in a safe place, away from children and also from grown-ups who behave in the market like children. 
  • The most common cause of low prices is pessimism – sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It is optimism that is the enemy of the rational buyer. 
  • Success in investing doesn’t correlate with I.Q… Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing
  • The stock market serves as a relocation center at which money is moved from the active to the patient
  • Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greed and greedy when others are fearful
  • You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
  • Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.
  • Stop trying to predict the direction of the stock market, the economy, interest rates, or elections. (or Greece)
  • Much success can be attributed to inactivity. Most investors cannot resist the temptation to constantly buy and sell.
  • Lethargy, bordering on sloth should remain the cornerstone of an investment style.
  • Wild swings in share prices have more to do with the "lemming- like" behaviour of institutional investors than with the aggregate returns of the company they own. 
  • Remember that the stock market is manic-depressive
  • As far as you are concerned, the stock market does not exist. Ignore it.

If you struggle in turbulent markets, like those of the past few months, print this last quote off and read it every day. I would also recommend reading it every time you feel like you are getting hijacked by your emotions. 

Your goal as an investor should be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now. Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock. You must also resist temptation to stray from your guidelines: If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.

So do you practice what Buffett preaches or do you just agree intellectually? It is a natural human tendency to ignore flagrant inconsistencies between what we profess to believe and what our actual behavior implies. Being intellectually honest is difficult. Our egocentric tendencies make ourselves the easiest person to fool. 

Perhaps you have the business valuation side down and struggle with the temperament side of investing. By constantly reminding yourself of the concepts above and using a checklist you can avoid a lot of pitfalls in your investing.

Happy Remembrance Day,

Kevin Graham

Disclosure - Long BRK.b

P.S. If you are Canadian, I would encourage you to reflect on the 110,000 people who laid down their life so we can enjoy the freedom we enjoy today.

Wednesday, November 9, 2011

Five Reasons Oil Prices Will Fall

Someone recently emailed me and asked the follow:

I juxtapose your thinking with the thinking of a blogger with a similarly named blog; when I read each of you, you each seem to be right to me but then this simply can't be so- at least about near term oil prices. Wondering how you see Fairfax purchase of SandRidge, and perhaps how I reconcile 2 variant blogs.

To eliminate any confusion I thought I would post my response here.   My apologies for being so long.

If you look into recent history you will find I am not the same as the other blogger you are referring to.  We have intensely debated in the past.  That said I do regret picking a name similar to his blog as it is confusing.  For the record, I never read his blog before starting mine and haven’t read it since.  I read a few articles on another site and thought they were high on opinion and lacking in facts.  He doesn’t have much to offer other than mainstream thinking.  Original ideas are hard to come by and it is why I believe my blog has been so successful.  I refuse to rehash the daily news.

When we debated PBG/PBN it became clear he doesn’t understand O&G and had never read the reserve report. He doesn’t understand how the reserve report is determined and doesn’t understand how an O&G company makes money. He believes that all an oil company has to do is buy a bunch of land and then start shooting fish in a barrel. I can assure you it is much, much harder than that.

Many of the companies he has recommended are very speculative and many have generated little to no real economic return. I don’t know what he’s saying now because he charges for his content.  If history is any guide most of his ideas are small speculative O&G companies.  Many don’t generate real returns but merely only turnover their cash flow and are at best asset plays. By asset plays, I mean you are essentially betting on the underlying commodity prices. 

If that is “value investing” then he needs a new definition. It’s really speculation, be honest. You and the company have absolutely no control over the price of their products; you are a “price taker”. How do you make reasonable estimates about the future revenue and earnings?  If we go to the other side of the spectrum, Coca-Cola is a company with huge “pricing power”. An increase in price doesn’t affect demand. Moreover, Coca-Cola increases the price of their products every year and sales continue to climb.

As for the price of oil, I am aware we disagree on where it is going. He is a believer in peak oil and I am not. What are the reasons that oil will go up further? I would like to know them. Is it just because it’s gone from $11/bbl to $100/bbl during the past decade?

If you have read my blog for any amount of time you will be aware that I am a firm believer in “reversion to the mean”. As Prem Watsa says, “Trees don’t grow to the sky.” Simple extrapolation of short-term trends will hurt you more in investing than anywhere else.

Five Reasons Oil Prices Will Fall

I have discussed my bearish position on oil for some time now, let me highlight five reasons. 

1.  Oil has had a tremendous run over the past decade and I doubt it will continue indefinitely. Reversion to the mean will happen. The reason for the run is mainly because of very accommodating fiscal policy both in the US and BRIC nations (Brazil, Russia, India & China). The Chinese stimulus has carried the commodity trade for the past two years. 

2.  China cannot defy economic gravity. Despite what the pundits say, real estate bubbles rarely have soft landings (Read Michael Lewis, When Irish Eyes are Crying). It is almost unbelievable that people still believe today that you can command control an economy. I mean look at the US. According to the Federal Reserve Chairman everything was great in 2006/2007. Then the crash comes and they say, “trust us” we are in control and can get us out of this mess. Let’s be honest it’s comical. Let me be blunt… You cannot command control an economy. This is the 21st century and we should have learned this lesson by now. 

Reasons for the US Housing Bubble

To further explore how you cannot command control an economy, let me list my reasons for the US housing bubble (Let me know if you agree or disagree).

A)  US government policy encourages home ownership and because they intervened in the “market”, people responded to the incentives. The creation of the GSEs (Fannie Mae, Freddie Mac), the tax deductibility of interest, and non recourse mortgages are all interventions that alter behavior in the housing market. Thus the housing market was no longer a “free” market.

B)  The Federal Reserve dropped interest rates after the internet bubble and kept them too low for too long.  Here the incentive was cheap money and it further encouraged home ownership and fueled the early speculation. This is another example of how intervention altered people’s decisions in the market. Thus we did not have a “free market” but a market full of incentives. 

C) Finally, people believed in the sound premise that “real estate only goes up”, acted on the incentives, and then the price action took over.  Finally in the late stages of all bubbles the focus is almost entirely on the price action.  Once the price action took over, the bubble exploded and speculation become rampant. Stories about how your neighbor just flipped a house and doubled their money in one or two years become common.

Warren Buffett has said one of the most important things he learned from Ben Graham is that “you can get into more trouble with a sound premise than with an unsound premise.”   If you understand what he's saying it so true. 

Back to our Discussion 

So China will not be able to defy economic gravity. They have some serious mal-investment in real estate.  Because they consume 40-50% of the world’s commodities, once the game us up commodities will get hit hard.  Back in 2008 the Chinese stimulus was something like 23% of their GDP. This resurrected oil and nearly every other commodity that fell hard back then. 

3)  Commodity prices do not reflect reality. Copper, although off its highs, is still selling for much more than the marginal cost of production.  Copper is selling for $3.50/lb and it cost $1/lb to get it out of the ground. Have you looked at the returns the mining and metal companies making? I’m sure you have heard it said that profit margins are at record highs and are bound to fall to more normal levels. Well this is a sector that will have some significant margin contraction. If you look at commodity related equities, they have fallen much more than relative to the fall in commodity price. Why is this?  Clearly the market (investors) are signaling a further fall in commodity prices.  When commodity prices fall, oil will fall likewise. 

4)  I don't believe in "new era's.  I also don’t want to take any unnecessary risks. If you step back and look at the price of oil you have to believe this is a “new era”.  The market has numerous other opportunities so don’t box yourself into one sector.  

5)  On the flip side, what is the bull case? The bull case is we are running out of oil. While that may be true but isn’t it interesting US oil demand has fallen since 2005 (Click Here). High oil prices have also led to an onslaught of new technologies and energy sources. If you have a free market economy and someone has a need (in this case energy), someone will find a way to meet that need. Thousands of engineers are working on it everyday (Click Here for an Example). 


I’ll keep this short. I looked very, very briefly at Sandridge. I'm not interested in owning an oil company and I didn’t see anything appealing so I took a pass. That said I believe Fairfax has invested because of two reasons. One is management and the second is hedging. I have heard Prem Watsa say that the speculation in commodities is out of hand and that he knows of only one company that hedges their prices. I took that statement to refer to Sandridge although I don’t know their hedging policy. If SandRidge has significant hedges that is smart and is likely the reason why he’s invested. Many companies won’t hedge.  You want to know why? Because they are speculating that prices will go even higher. People never learn and never change. They constantly reach for risk & yield with little regard for the downside. 

Prem understands this well and he never reaches for unnecessary risks or yield without adequate compensation. He wants to earn 20% on every investment that Fairfax makes. When he does that he leaves himself a large margin of safety. 

Best Regards,


Disclosure - Long FFH

Tuesday, November 8, 2011

Buffett was Buying in Q3 - Were You?

It's funny, the first thing I noticed as I flipped through BRK's 10Q this past weekend was the cash flow statement.  Significant buying of fixed income, equity and other investments to the tune of $22.5 billion.  The financial news quickly picked up on this and and it made headline news for about one day.  Then they were all quickly back to the issues in Europe.  Who can blame Buffett as stocks sold off during the quarter?

That said, how about some personal reflection and intellectual honesty.  Did you feel fearful and sell during Q3?  Did you buy during Q3?  Were you worried about Greece and sold off some holdings?  Be honest what did you do during the third quarter?

If you are honest and reflect on what you did you can learn a lot about yourself.  Humans are natually egocentric and to reflect on mistakes is a sign of strong intellectual ability (and leadership).  This exercise will also demonstate your self esteem.  Are you secure enough in your mind to be honest with yourself?  So what did you do during the quarter?

I'll be honest with everyone reading this.  I bought a tiny amount of BAC class A warrants in the quarter.  I didn't sell anything.  I must admit though, I felt like day trading when the swings were getting out of hand but I resisted doing anything foolish. 

Now that we know Buffett was buying during the quarter... any guesses on what he bought?  I would be willing to bet that Buffett bought more Wells Fargo.  Furthermore, I would be willing to bet he purchased over a billion dollars worth of Wells.  Anyone want to make me a friendly bet?

Best Regards,

Disclosure - Long BRK.b, WFC and BAC

Postscript - Buffett didn't buy a billion in Wells Fargo.  I wish to retract my offer.  HT:Cord

Postscript2 - I also purchased some GE and JNJ for a family member in a retirement account.  Both were being offered at a 4% dividend yield. 

Sunday, November 6, 2011

Occupy Wall Street

I find it humerous that the occupy wall street crowd doesn't really know what to protest.  I personally believe the real heart of the issue is the envy.  Just listen to the lady in this interview.

You can just hear the buzz words in the background... Corportism, Un-Regulated Greed, & We Need Government to Protect Us.  What these people need to do is go back and read what Thomas Jefferson wrote in the delaration of independence. 

These people are angry because they are drowning in debt.  They lived a lifestyle that was beyond their means and now they are slaves to those who lent them the money (banks).  People need to realize that to wealth doesn't come from consumptions but from underconsumption.  Capitalism works and it works well, it's just that the current generation that doesn't have a clue what capitalism is. 

I don't know about you, but the "we are the 99%" signs make me sick.  If you make the average wage in Canada, $25/hr or $50,000/yr, you are in the top 5% in the world for income.  These people claim they are the 99%?  What these hypocrites really want is more money because they are the greedy and envious of those who have even more. 

Perhaps these people should voluntarily give up three quarters of their annual income for the real 95%?.... hmmm, I'm quite sure the average greedy, self indulgent, selfish wall street occupier wouldn't give up a dime.


Canadian MoneySaver Magazine

Here is some personal confirmation bias.  I have said a number of the points mentioned in the article below.  What is interesting is Mr Hodson comments come from someone who earn their living from working in the financial services sector. 

I stumbled across an interesting article by Peter Hodson (Click Here To Read).  While I never really liked much of what that came out of Sprott, Mr. Hodson has left and has now purchased Canadian MoneySaver Magazine.  With Mr. Hodson's other business he seems committed to helping individual investors.  What I particularly found interesting in the article is a number of things I have said over and over.  Here are a few of my favorite quotes: 

Every time there is a crisis, investors re-discover the fear of the unknown. As investors, of course we do not know when the current crisis – whatever it may be – is going to end. The problem, though, is that investors act as if the crisis will NEVER end.

Even the Greece/Eurozone crisis will come to an end even though everyone is acting like it's the end of the world.  No need to buy gold and ammo. 

In the 2008 credit crisis, for example, S&P reported than more than 1,100 companies actually traded below their net tangible cash balances. Investors were so scared, effectively, that they were willing to give away cash, literally.

As an investor you much be able to separate you emotion from your thinking.  My current employer has placed a strong emphasis on critical thinking and teaches every supervisor critical thinking skills.  Recent we have been discussing how our Amygdala (part of the limbic system in our brain) can be hijacked and our rational faculties disappear.  When subjected to a threat, either physical or psychological, our natural tendency is to fight back or take flight.  If you have spent anytime reading or understanding human behavior you will know what I am talking about. 

One example we discussed was what we do when we hit our hand with a hammer.  What is our natural tendency?  Often people would throw the hammer and express some verbal anger.  That is an example of an Amydala hijack.  Is throwing the hammer rational? 

The same goes for investing.  Some investors immediately hit the exits during a crisis because their thinking has been hijacked and they aren't think clearly.  Emotion and adrenaline take over.  Selling something for less than tangible cash is not rational. 

The good news for value investors is that isn't going to change any time soon, so enjoy and take advantage of the wild market swings. 

A similar investment lesson involves brokers and research analysts. In my cynical viewpoint, changes in brokers’ recommendations and target prices are designed to do only one thing – generate trading activity

I don't think much more need to be said.  Much of what analysts say is useless drivel.  I have a friend who is an analyst in the O&G sector and he has told me it is difficult to continually come up with something to say when nothing has really changed. 

Finally... watch out for conflicts. Everyone, it seems, makes money in the investment business, except the individual investor. Advisors earn fees, investment bankers earn fees, fund managers earn fees, traders earn fees, and analysts get bonuses.

Always ask what is in it for the other guy.  If research was truly independent it might be useful, but due to the inherent conflict I would avoid most of what they say.  

Lastly, it's funny how many people complain about how much money is made in financial services, but here's the thing.  People are continually paying for these services so until people speak with their money and avoid the fees nothing is going to change. 

Enjoy the entire article at the link above. 

Best Regards,

Saturday, November 5, 2011

Problems in China

Fascinating couple of articles on the Globe and Mail today regarding the problems in China. 

You can read them here:

Bank of America Issues Jittery China Forecast

And here:

China's Vanishing Factory Bosses


China consumes 40-50% of the worlds commoditites.  When the music stops, and these articles are definite warning signs, Canada and every other commodity producing country will get hit hard.  Nearly every commodity (except natural gas) has gone up in a parabolic curve over the last few years.  The TSX will likely be worth half what it is today when this is all said and done.  If you look at the margins and returns these commodity producers are earning it's a clear sign that it is not sustainable. 

So what is the individual investor to do?  First, if you look at many of the commodity companies in Canada, many are already priced for a significant fall in commodity prices.  I would recommend selling every commoditity producer, especially speculative ones.  If you have a good way of shorting actual commodities like copper, iron, and cement let me know.  Shorting marginal oil producers will also be a good way to make money. 

Owning some Fairfax Financial is also a great way to protect yourself.  I have a signficiant amount of my net worth in the company.  They are currently 100% hedged and own some derivative contracts that will pay off handsomely if we have any deflation over the next 9 years.  They don't own anything commodity related and in fact the CEO Prem Watsa has been bearish on commodities and China for a while now.  I have commented on this before.  Read the letter to shareholders for the past couple years to read about Mr. Watsa's concerns. 

On the topic of FFH, I have read every single shareholder letter since 1986.  I made some condensed notes about each and every market call Prem Watsa has ever made since starting Fairfax.  One would be very wise to listen when Mr. Watsa says something.  If you are interesting in these notes send me an email. 

I would also suggest telling friends and family how to protect themselves, if they will listen to you.  At least you've done your part.  The TSX is predominately a commodity index and with financials making up the next biggest chunk.  Very dangerous. 

Best Regards,

Disclosure - Long FFH

Tuesday, November 1, 2011

Bellatrix Exploration

I was recently asked by a visitor to my blog on my thoughts on Bellatrix Exploration. I was away last week on business and wasn’t able to respond.  I have decided to write the response here for everyone to enjoy.


Bellatrix is an E&P company that formerly was called True Energy Trust. True was a created in 2005 via the arrangement with TKE Energy Trust (formerly TUSK Energy) for those who remember back that far. 

Now, just for the sake of a history lesson, True Energy Trust was a disaster from a financial point of view. Since 2005 till the end of 2009 when they changed back to a non-dividend paying E&P company they had cumulative losses of $390 million dollars. In fact they only turned a profit in of $14 million in 2005, and losses were $234 million, $24 million, $20 million, and $127 million, in 2006, 2007, 2008, and 2009 respectively.

So obviously they weren’t good explorers, but then again most income trusts weren’t good explorers. Most were legalized ponzi schemes whose distributions consisted entirely of return of capital.

Bellatrix 2010

In 2010 the company transitioned back into an E&P company. Company started getting into some plays such as Cardium oil and Notikewin gas wells. Losses in 2010 totalled $28 million dollars, bringing the cumulative total to $418 million since 2005.

Bellatrix 2011

In 2011 the company continued pursuing oil in the Cardium and liquids rich Notikewin gas. Of interest, shareholders should be aware that upon transition to IFRS accounting the company incurred impairment of $44 million. You know a few million here and a few million there... these losses are starting to add up.

Now the good news is the company is starting to turn a profit. In Q1 2011 the company would have recorded a profit of $2.4 million if we neglect the $10 million loss on hedging (actual loss was $5.5 million). In Q2 2011 the company would have realized a profit of $5.1 million if we neglect the $10 million gain on hedging (actual profit was $12.3 million).

So if we isolate profits actually attributed to operations in the first half of 2011, the total is approximately $7.5 million (assumes hedges are a wash in the long term).  We have to keep in mind that oil prices were over $100/WTI bbl in Q2 and they have declined somewhat.

Now if we make the assumption Bellatrix can maintain the level of profitability they had in Q2 and annualize the results, annual profits would run about $20.4 million. Shareholders equity was $359 million at the end of Q2. This gives an annualized return on equity of 5.7%. This is nothing to write home about.  Because the company employs leverage the return on total capital is even less.


Net Asset Value (NAV) for proved reserves is around $3/shr and NAV for proved and probable reserves is around $4.75/shr.  The price deck for WTI oil used in the reserve report was $100/bbl till 2015, which is quite aggressive in my opinion. I am pessimistic on oil prices going forward.  

Secondly I estimated their netback to be around $25/boe with all in finding and development cost of $15/boe (Please note that you cannot use managements numbers that don’t include future development capital). This gives a recycle ratio of 1.7 times, which is nothing to write home about. At the end of the day you need to be consistently above 1.5 times if you want to add any value.  

Book value for the company is $3.11/shr at end of Q2. Considering they can earn about 5-6% on equity capital with $100 oil, I wouldn’t consider BXE a fantastic business.


One thing I noticed when reading BXE news releases and other information is that it really isn’t shareholder friendly. For example, they like to quote finding and development costs excluding future development cost.  Whenever you see that, don't let management pretend your some sort of fool.

Secondly, I found the graphs of the share price increases of predecessor company run by current management to be quite humorous. First, Meridian Energy was acquired by True Energy in 2005. Given the level of losses occurred since that date the takeover was obviously a failure for True shareholders and a gain for Meridian shareholders. Secondly, oil and gas prices increased significantly during the years 2002-2005 so it wasn’t some sort of magic that caused Meridian’s share price to compound at 104% annually. Any idiot could have purchased assets during that time and watch the value magically increase due to the increase in commodity prices. 


Bellatrix is at best a mediocre company that has been performing a little better as of late. Given the track record of the company (current management has been in charge since 2007), I wouldn’t invest in such a money losing operation if you paid me.  I would want to purchase the assets at a significant discount to book value or NAV to protect myself from potential issues down the road.

I rely heavily on good management with a solid track record and I don’t get that with Bellatrix.  Instead with the name change from True Energy into Bellatrix, all you get is lipstick on a pig.

The current price for a share of Bellatrix doesn’t offer any downside protection if oil prices fall.  I happen to feel oil prices will fall over the next few years so buyer beware.  You know I may well be wrong on oil prices, but if you step back and take a look at the forest instead of the trees you will see how high many commodities are today.  The nice thing about the markets is that you can totally avoid the potential bubbles and crazy asset prices. 

I know many of my critics will say the same thing about the bank stocks I own.  Don't worry, I'm well aware of the issues.  It's just that those stocks just happen to be very cheap right now and in a few years todays the market will be singing another tune.  A good rule of thumb I tend to ask myself is this, has the sector done very well or very poorly over the past five to tend years?  If the sector has done poorly I like to look for cheap stocks to buy and if it has done well I tend to look the other direction. 

Reversion to the mean is a hard lesson some people never seem to learn.  Some people just don't have what it takes to own companies that the masses consider to be trash.  Separating the facts from the emotional fiction is what value investors enjoy doing. 

Best Regards,

Disclosure – none

Saturday, October 22, 2011

Globe & Mail - Me and My Money

I was interviewed recently by Larry McDonald from the Globe & Mail.  It was published yesterday and you can read the article here:

If I could make one tiny clarification.  It says,"Mr. Graham is now an adherent to “deep value investing,” which involves looking for stocks trading close to, or below, their “intrinsic value.” "

I actually look for stocks trading substantially below their "intrinsic value", preferably 50% or more.  This provides a margin of safety.  If I am wrong about part of the analysis or the future doesn't turn out quite as I expected, the result should still be satisfactory.  Preventing a permanent loss of capital is paramount. 

If I could make one other comment regarding value investing.  It seems that today everyone wants to be a value investor.  I mean, who wouldn't?  Warren Buffett has made it an investing catch phrase and his success is what everyone tries to emulate.  The problem is this, who is going to publicly state their investment is fair or overvalued?  Nobody.  Everyone want capital appreciation.  Thus, every investment is justified as a "value investment" to somebody.

So buyer beware.  Next time someone tells you that a stock is cheap take it with a grain of salt.  When I started blogging I read an article that Petrobank & PetroBakken were "excellent risk/reward scenarios".  The problem was the article was big on future hype and very lacking in facts and figures.  When I subsequently did my research, I came to quite the opposite conclusion.  In fact I said it was a, "terrible risk reward scenario."  To read the article and back and forth Click Here.  You see the other fellow was going off of an analyst's report which is very dangerous.  Petrobank and Petrobakken are down around 75-80% since our debate around a year ago. 

The other problem with valuing a stock is that you have to make predictions about the future.  These are never going to be accurate.  This is why a margin of safety is required.  If you look back over history Buffett prefers to minimize this risk by buying companies that have predictable operations.  This allows an analyst to much more accurate predictions about the company.  Buffett also sticks to companies that are NOT effected by technological change and produce products that we have consumed for the past 100 years and will consume 100 years from now.  He has often said that change is the enemy of the investment analyst.  Examples would be razors (Gilette/P&G), ice cream (Dairy Queen), machine tools (ISCAR), insurance (Geico), paint (Benjamin Moore), Bricks, (Acme Brick), and Candy (See's Candy/Kraft) to name a few. 

So remember, always buy at a large discount to intrinsic value. 

Best Regards,

Kevin Graham

Disclosure - Long BRK.b, JNJ, KFT (Personally or For Family)

Wednesday, October 19, 2011

Peak Oil - Price or Supply

About a year ago I wrote an article on my thoughts regarding peak oil.  To read the article, Click Here.

It appears others either read my article or are warming to the idea of peak prices and not peak supply.  Economics will apply in the oil market, like any other.  You can read the Jeff Rubin piece here:

Best Regards,


Tuesday, October 18, 2011

Wells Fargo - Q3 Earnings Release

Wells Fargo announced earnings yesterday that misses somebody’s “target” by $0.01/shr.  Earnings were $0.72/shr.  The company subsequently sheds $12 billion in market capitalization in one day or down 8.5% (It recovered some today). 

Who says the market is rational?

I find it humorous, these types of market swings.  Obviously the concern is that revenue isn’t growing and was in fact down.  I then got an email news alert that said the following (I added some emphasis, & my comments are in brackets):

U.S. bank top lines aren't growing at all

Three of the four big U.S. banks have reported their third-quarter earnings, and the big story so far has been that accounting gains are boosting their bottom lines.

But the more important story centres on the other end of the income statement: revenue. Over the past two years, the top lines at Citigroup , JP Morgan Chase  and Wells Fargo  has barely moved. They can play with accounting gains all they want, but if their top lines don't grow, they're eventually going to run out of ways to re-jig their earnings.

Dating back to 2009, these banks' quarterly earnings have shown almost no trend (I believe he means revenue, not earnings). They've flatlined (Think dead). Looking at earnings over the last twelve months at each quarterly reporting date, Citi has averaged about $80-billion for the last two years (or about $20-billion per quarter over the last twelve months). JP Morgan's growth is also flat, though it's at least generating more revenue, with a LTM average of about $100-billion each quarter.  

Wells Fargo, on the other hand, is actually seeing its top line trend down. In 2010 it had a LTM average of about $87-billion each quarter. That's fallen to $81-billion.

On of that, revenue prospects aren't promising. All their exotic business lines are being curtailed by Dodd-Frank, and core business lending isn't expected to ramp up any time soon, because even the Fed expects weak economic growth for the next two years (The same Fed that forsaw the recession, right?).

That's why the banks rely on accounting gains, like debt valuation adjustments. Yet once credit spreads move the other way, these adjustments will come back to haunt.

I almost don’t know where to start with my knife to dissect this nice piece of work.  First I believe the writer is referring to revenue not quarterly earnings as stated in third paragraph.  Secondly, Wells Fargo didn’t rely on any accounting gains in their reported earnings.  Third, what investor uses one time gains and losses to value a company?

I’m not ignorant of the fact that revenue isn’t growing and that eventually profits can’t grow if revenue doesn’t grow.  The question I asked myself if this… If Wells Fargo didn’t increase revenue what could earnings be in a normal charge off environment?  I ran my estimates and believe they can earn around $3.50/shr.  That assumes no revenue growth. 

Wells Fargo can be purchases for a 12% earnings yield (annualized quarterly profit/stock price).  If the Fed wasn't interfering, the normal dividend yield could be 5.3% (45% of current earnings).  Similarly, based on my normalized earnings Wells Fargo is selling for a 14.3% yield with no assumed revenue growth.  Dividends yield would be 6.4% normalized with now revenue growth. 

Does anyone really think that revenue (think loans) will never increase at Wells Fargo?  The have some huge capacity to increase lending today, but they are having trouble finding credit worthy borrowers. 

The hatred for the banks has to be reaching a tipping point.  The banks have been accused of a lot of things, so add “re-jiged earnings” to the list.   

Does anyone else find it contradictory that Citi and other banks are being accused of “creative accounting” by recording these credit valuation charges on a mark to market basis while out of the other side of the mouth the banks are accused of using changes to fair value accounting (FASB 157) to juice their balance sheets?  By the way, mark to market account never went away.  Fair value accounting allows for alternate valuation methods to be used when the market for the security is illiquid or non existent. 

In other news, earnings at Wells Fargo were up 20% year over year (in case anyone was interested).   

Best Regards,


Disclosure - Long WFC

Saturday, October 15, 2011

Encana - Getting Cheap

Today I want to highlight a fantastic business that is definitely cheap.  Encana was at one time the largest natural gas (NG) company in North America.  Encana was formed back in 2002 by the merger of Pan Canadian and Alberta Energy Company (AEC).  In 2009 they spun off Cenovus which contained the conventional oil, oil sands, and the mature NG assets.  Encana kept all of the best NG assets and pushed forward to become a senior high growth focused NG company. 

Over the past three months the stock has sold off 27%.  What really caught my eye was the $1.4 million of insider buying since August 1st with no insider sales in the past year. 

So what makes Encana a compelling investment today?  I believe it's twofold.  First the company is selling for less than book value and tangible book value.  Secondly, natural gas prices are at multi-year lows leaving the opportunity for very materially asset valuation increases if gas prices increase. 

Some may find it crazy that I mention book value and tangible book value with respect to a resource company.  True, it doesn't serve any purpose or tell us if the assets the company are worth anything, but it does tell us how much equity capital the owners have in the business today.  Today you can purchase Encana for less than the equity that the owners have employed in the business.  The market is saying the assets developed with that capital isn't worth what they paid. 

While on the topic of the balance sheet, it is also interesting to note that shareholder's equity is predominately retained earnings (84%) with the remainder being shareholder (paid in) capital (14%).  Encana essentially started with $2.3 billion in shareholder's capital and has been very successful exploring and developing assets.  The accumulated profits on their investments have been $14.2 billion (all figures US$).  I don't look highly at a company that grows buy issuing more and more overpriced equity and have little to nothing to show for profits.  Good examples would be Crescent Point (CPG) and Petrobakken (PBN).  They are really exploiting ignorant shareholders who don't know better and listen to the investment houses who peddle their shares.  Despite record oil prices over the past 7 years CPG has an accumulated deficit of $1.7 billion.  I honestly think both of these company's employ a high dividend policy to keep the share price high and play the equity issuance game.  With Crescent Point, investors should be aware they are not being paid out of profits but from new shareholders.  It's return of capital, not return on capital... big difference.  It's almost like a legalized ponzy scheme.  It appears that PBN downfall has been it's operational problems in Southern Saskatchewan.  What will eventually take down CPG?  I believe a large and sustained drop in oil prices will likely be it's downfall. 

(I'm probably going to have to hide from the upcoming assault from CPG and PBN shareholders for those comments).  Let's get back to our Encana discussion. 

Natural Gas Prices

The single largest driver of the profits and associated investment returns at Encana will be the price of NG.  Here is a chart of Henry Hub NG prices ($US/MMBTU)

It's easy to see NG is a good investment today as the price is at multi year lows.  Prices haven't been this low since 2002.  Just for the sake of curiosity here is the price of West Texas Intermediate ($US/Bbl).

Now you don't have to be a rocket scientist to see what is wrong with that picture.  If you believe it's a "new era" or "it's different this time" go ahead and think so.  It may be different this time but that just isn't a risk I would touch with a ten foot pole.  The oil business has been boom to bust for the past century and like the bumper sticker says, "Please God, just give me one more oil boom.  I promise not to blow it next time."  Graphs like the one above shouldn't just scare you it should cause you to run in the opposite direction. 

The Chinese consume 10% of the worlds oil production and if you add up all of the oil used in the mining and materials industries it's a lot more.  Those industries are currently supporting the housing bubble over there, let's just say demand has the potential to fall significantly.  As Jim Chanos has said, "China is Dubia times 1000."

Wow, I'm really getting off topic today...  Back to Encana.

Encana's Asset Valuation

If you take the net present value of the 2P reserves, subtract long term debt and working capital deficiency, add a portion of the exploration and evaluation assets, and finally divide by the diluted shares outstanding...  I come up an asset value of US$34.20/shr ($US, before taxes, discounted at 10%).  This compares favorable to the current US$20/shr market price (40% discount) and is likely a good reason why insiders are buying the shares.  Encana's NG assets are very high quality and generally low cost to both find and operate.  The prices used the the discounted cash flow (a key assumption), range from just over US$4.39/MMBTU increasing to US$6.00/MMBTU in 2015.  These are reasonable price assumptions.  Futures for November delivery is US$3.70/MMBTU. 

Let me put that analysis a different way.  If you purchased the entire company and only developed the current drilling inventory and then went into blowdown mode, you would earn roughly 12% on your investment after corporate taxes (16% before tax).  If NG prices rise, these returns would be much, much higher. 


In conclusion it appears that Encana seems to be a very reasonable investment at the current price.  The company is selling for less than book value, tangible book value, and much lower than net asset value.  The current share price of US$20/shr is a 40% discount to net asset value (2P, before taxes, discounted at 10%).  Natural gas is currently selling for multi-year lows and offer good upside if NG prices increase.  This gives an investor a good margin of safety against falling commodity prices, especially when compared to oil. 

I believe this a case where the baby is being tossed out with the bathwater.  Many commodity companies are selling off.  The major drop in the XEG index is a belief that oil prices will fall.  It appears the NG industry is falling alongside Oil and Mining sectors.  The only difference is NG prices are already at the bottom while commodities like Oil, Copper, Gold and Iron are all still ridiculously priced (think bubble).  This means Encana may still fall further, but the further it does more of an opportunity it will become.  In the long term Encana will do fine, in the short term the share price may be volatile.

Encana has a proven management team and has strong technical knowledge in the exploration and development of NG assets.  This has been clearly demonstrated in the profitability of the company.  Encana has some of the best assets in the industry.  Management is very focused on generating high returns on capital. 

Best Regards,

Disclosure - none

Monday, October 10, 2011

Happy 1st Birthday!

Well, Canadian Value Investing reached a milestone today.

It has been quite the journey.  I've posted 90 times, had some very lively debates, and most of all I have been able to meet a number of like minded investors.  A special thanks to those who emailed during my intense debates.  I thoroughly enjoy lively debate and all I ask is that you bring facts not conjecture.

While I have no idea what the next year will bring, I am looking forward to some out sized returns when the US economy returns to some sense of normalcy.  Housing will turn the corner eventually as 500,000 housing starts just isn't going to cut it over the long term.  When will this happen?  I couldn't tell you, but I know it will change sooner than later. 

I am worried about Canada and the long term implications of the commodities bubble.  If it does pop quickly the restructuring would be hard on our economy.  For that reason I am bearish on Canadian Real Estate, Canadian Banks, Oil & Gas, Mining & Materials.  It's funny how many of the O&G, mining and material stocks are already pricing in much, much lower commodity prices.  I may well be wrong about this, but the great thing about investing is I'm not forced to invest in those sectors.  Unfortunately for many Canadian baby boomers this crash may come at a terrible time... right before retirement.  I can only hope that the turning of the US housing market occurs at the same time that air is let out of the massive 10 year commodities bubble. 

Hope for the best, prepare for the worst. 

Best Regards,

Sunday, October 2, 2011

Comment on PetroBakken Reserves

I commented on another blog regarding PetroBakken (PBN) and received the following question.  Since the response explains some of the technicalities of reserve reports, I have posted it here for educational purposes. 

Thanks very much for reading and making a comment: it is very useful to consider a problem from all angles, to be sure. Therefore, could you please tell me how you arrived at the number of $49.40/boe as three year cost. Do you know for sure that it doesn’t include interest and G&A–and can you prove that point?
On your own blog (“PetroBakken – 2010 Annual Review“), you wrote:
In conclusion, it is vital that potential investors calculate returns on a per share basis and avoid the headlines in most press releases. I could have spent more time getting into how the PDP reserves (the BOE’s actually on production) cost $64.47/boe to find, develop or acquire, but why bother? The company nets around $42/boe for each barrel produced (Revenue less cash costs). Usually you want to find the barrel of oil for less than you can sell it for.
It appears to me that the production cost per barrel, between Q4 2010 and today (presumably Q2 2011) has dropped (by your calculation) 64.47-49.40 =$15.07 boe. That is a very dramatic difference. Could it possibly be explained by the metrics in the chart above, which makes it clear that initial production will be much more costly and as more wells come online, the legacy production will continue at a lower rate for many years. Thus we would expect that number (cost per barrel) to come down regularly in the months to come.

My Response

This is the last free analysis, and my last discussion on this subject.   I don't want to beat a dead dog.

How did I arrive at my number, it is calculated using the net change in proven reserves over the last three years divided by the capital spent. 

Do I know for sure that it doesn't include interest and G&A?  This is a silly question... Yes I know for sure and No it doesn't include those items.  You want proof?  Go to PBN's website, and download the Q2 financials.  Go to page 2.  Revenue less royalties less production expenses is your operating netback (transportation should also be deducted).  This is the cash left over after you produce a barrel of oil and sell it.  With that money you have to pay normal business expenses and hopefully find another barrel.  You need a recycle ratio of around 1.3 to just breakeven. 

Next problem.  The $64.47/boe is for a proven developed producing (PDP) barrel.  These are the reserves at are actually on production (producing oil or gas) as of the date of the reserve report.  The $49.40/boe is for a Proven (1P) Barrel.  Proven reserves (1P) are ones that are very highly likely to be recovered.  However 1P reserves includes PDP reserves (already mentioned) + proven developed non-producing + proven undeveloped reserves (PUDs).  Proven developed non-producing are wells that are drilled but need to be tied in to production.  PUDs are wells that are not drilled but planned on being drilling usually within a year.  PUDs are typically wells that are drilled in-between two known wells in a field (infill drilling) and therefore have a very high likely hood of containing the estimated reserves. 

Further, 2P reserves included 1P reserves plus fringe wells that haven't been drilled and may or may not be economic. 

The PDP cost of $64.47/boe is very high but can't be taken in isolation.  The three year average proven reserves is a good number but not as conservative as PDP for the reasons mentioned above.  You have to understand the proven reserves contain a number of assumptions.  These assumptions include what the reserves of the PUDs will be and what the actual capital cost will be to bring the well into production.  When the PDP is consistently higher than 1P reserves cost over a 3 year period you can know one of two things is happening.  One is either the reserves are not what they forecasted or the capital cost have been much higher than estimated.  For PBN I would guess it's a combination of both. 

If you don't understand these things I would strongly recommend consulting a professional for investment advice. 

Best Regards,

Saturday, October 1, 2011

Fighting Confirmation Bias

I have already said (Here) anonymous comments will not be allowed. So don't be surprised when you comment anonymously and it doesn't get published.  People like to remain anonymous to save face in case they are wrong.   

That said, I made an exception today.  Instead of taking this guy behind the woodshed I hope everyone can learn an object lesson from it. 

Anonymous said...

Got to love a guy who thinks "value" is in financials, but think commodity plays are untouchable - it would be laughable if not so pathetic.

Say, how's list of "top 2011 investments" working out? BAC, WFC, GE, GS all hitting it out of the park? Or are they all striking out?.

You proclaimed they were significantly undervalued when they were twice their current value at the beginning of the year - talk about delusional.

Don't quit your day job...

My Observations and Comments

First it is obvious that this guy is long commodities and took exception to my idea that commodity plays are a bad idea. Secondly he insults me. Thirdly none of his comments are fact based. None of those companies were twice their current value, except BAC. 

It is an innate human tendency to ignore facts and evidence that contradict what they "believe" to be true. On the flip side, they run to facts and evidence that confirm what they "believe". This is called confirmation bias.

Fortunately the stock market is full of guys like this who cannot separate their feelings and emotions and thus their thinking is blurred (and they don't even know it). This creates opportunities everyday.  \

If you want to feel the full fury of emotion from investors just write some negative comments about a "popular" company. Similarly write something good about a "unpopular" company and you get scoffed. These people won't debate fact but instead attack your credibility. Fortunately I don't derive my self esteem from what other's think about me. In fact I could care less. 

People who have poor critical thinking will buy a stock and immediately watch the price action to see if other people agree or not. As Warren Buffett has said, "Your neither right or wrong because the crowd argrees with you, your right (or wrong) because your fact and your reasoning is right."

Fact Based Discussion

I could offer pages of facts and reasons why those financials are cheap but you could care less. You would just go back to the comfort of your newspaper that says they are all terrible. Time will tell whether or not they are good investments. Now when PBN goes down 80% in one year and there are good reasons why, don't just stick your head in the sand. 

As for my investments I would love some fact based discussion on why they are terrible investments. With BAC I recently reviewed the putback risk with rep and warranties (again) to see if I could see anything else. I have my estimate of what ultimate cost will be and strongly believe they are more than 50% on the way out. I have also commented recently on why the legal risks with respect to lawsuits will be contained. 


As for commodities let me just say this. The S&P/TSX capped energy index (XEG) is nearly retesting 2008/2009 lows. Other material and base metals indexes have seen the floor drop out from underneath them. Is it really just fear? What are people fearful about? Europe?  Something else?

Greece is 2% of eurozone GDP and their debt ($475 billion) really isn't that much in the grand scheme of things. Greece 2 year bonds current sell with a 70% yield. If you own them you've already recorded huge losses. Now if European banks are holding those bonds on their books and not marking them down significantly that is another issue. Ireland has way, way, way, way more debt compared to irish GDP than Greece. Their 2 year bonds were selling with a 23% yield back in July and are now back below in the 8-9% range. The Irish have implemented strong austerity (living below their means). The only other problem is Portugal ($200 billion) as their short term borrowing rates are just below 20%. To make a long story short, Europe will sort this out. 

I don't believe the real story is Europe but China. That is all I will say.  People need to understand the assumptions that underpin their investment ideas. I would strongly recommend staying free and clear of commodities until the dust settles.  Odds are high that Canada will enter a significant recession. Canadian real estate will fall, particularly in Vancouver but also any local region that is highly dependant on commodites.

I hope I am wrong and yesterday Warren Buffett said he does not believe the USA will enter another recession. I sure hope he is right. 

Don't get me wrong, I don't look highly upon macro economic calls. I will not try to predict GDP next month or next year, it's useless. However macro bubbles are a different story and larger trends can be spotted. Always important have your risk radar on high alert. 

Everyone has their own investment thesis and invest accordingly. I'll end with this. If believe in peak oil, world demand for oil is growing, and oil prices are reasonable, I would seriously review your assumptions. Fight your confirmation bias and go on a treasure hunt to look for why oil prices will fall. (The same can be said for base metals and materials)

Best Regards,


PS. - I would be willing to make a friendly bet that Warren Buffett bought another billion dollars (or more) of WFC during the third quarter. Any takers?

Disclosure - Long BAC, WFC, GE & GS