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