Transocean (RIG), the world’s largest operator of deepwater drilling rigs, has just provided a breathtaking example of how to destroy shareholder value. As I pointed out yesterday, when they bought Aker Drilling in August at a substantial premium they expressed confidence that they could finance the acquisition without diluting shareholders. They reaffirmed this a few days later in a presentation and as recently as November 2 during their earnings call chose to downplay any possibility of issuing equity. In fact, the company asserts that their shareholders want management to invest capital in accretive projects.

So the way they’ve managed their shareholders’ capital is to invest $2.2BN in a high-priced acquisition when their stock price was above $50, and then finance it by issuing equity three months later at the lowest price RIG has traded in 7 years. But they are still paying a dividend, although the secondary offering of shares just about covers it (not including an investor’s taxes).

The chart below tells the story. So we own a small position in RIG, because we think the value of their assets is north of $70 but in spite of the people who run the company. In fact the stock dropped yesterday far more than was warranted by the dilution from the new shares (after all, they did receive over $1BN for them). We calculate that the share price should have only dropped by $0.40, to $45.50 using Monday’s closing market cap and then adjusting for the increased share count plus cash received. The further $5 discount that was required to place the new shares is now added to the “Newman Discount” (Steve Newman is the CEO). In the months ahead we’ll see if the value of the business is up to the challenge presented by its stewards.

Disclosure: Author is long RIG

Warren Buffett has commented in the past that as an investor you should buy a company so strong that it could be run by an idiot, since someday it will be. The management of Transocean (RIG) is busy providing evidence in support of this rule.

Their stock is already reeling from a likely large settlement related to the Gulf oil spill last year. It trades at a substantial discount to the value of its assets. Ensco (ESV) trades at 2 X tangible book value, whereas RIG (following today’s announced secondary offering) is trading at tangible book value. No doubt its unknown Macondo liability is a factor, but even a $1BN cash settlement wouldn’t be that hard for a company their size to manage. It would represent around $3 a share and is in any case approximately equal to their annual dividend. Management continues to profess confidence that all such liabilities are manageable, but the uncertainty clearly warrants a discount on the price.

On August 26 RIG agreed to pay $2.2BN buy Aker Drilling ($1.4BN in cash and $0.8BN in assumed debt), a 60% premium to its prior 30 days average price. RIG said they expected Aker to be immediately accretive to earnings. As recently as November 3 on their quarterly conference call, the company expressed confidence that they could finance this acquisition and maturing debt with cash on hand and operating cashflow. Today, a company whose management is a serial disappointer on quarterly operating performance and who has expressed an intention to return cash to shareholders, announced a secondary offering of 26 million shares (with a possible increase of 3.9 million). The purpose is to finance the acquisition of Aker and to pay down convertible debt.  So in effect they are financing the Aker acquisition by issuing more equity at what they would surely argue is a very low stock price.

Steve Newman and his corporate finance whizkids are basically diluting long-suffering stockholders at a depressed price, and rather than returning cash to stockholders they’re asking for more. Oh, and they’re helping Uncle Sam at the same time, since U.S. stockholders will receive an annual $1BN dividend taxable by the Federal government at 15% (plus state taxes for most U.S. residents) and then reinvest $1BN if they wish to retain their ownership percentage.

This is the kind of company that keeps Carl Icahn busy. Instead of making acquisitions and diluting equity holders, they ought to be selling rigs and using the cash to buy back depressed stock. Fortunately our investment in RIG is small (persistent operational mis-steps had made us cautious). We’re now waiting for more shareholder-friendly, activist investors to get involved and put things right. Steve Newman and his friends have already sent the invitations.

Disclosure: Author is Long RIG

My book, The Hedge Fund Mirage, will be out in early January. Its one sentence description is that all the money ever invested in hedge funds would have earned a higher return in treasury bills instead. It’s not that there aren’t some great hedge fund managers out there – of course there are. And there are some investors who have done very nicely too. But the aggregate results are not so pretty. Hedge funds have been highly profitable – it’s just that those profits haven’t found their way to the clients. When I describe the book’s premise to people in the hedge fund industry, they invariably chuckle and note that they’re not surprised. The Math is hard to refute. But the message is more positive than that.

It is possible to invest in hedge funds and earn attractive returns. One of the ways is to select smaller funds – the vast majority of hedge funds did better when they were smaller, and so did the industry as a whole. The Financial Times has an article showing the results of some research they carried out. Investing in smaller funds (which they define as having assets under management below $500MM) does not assure success, but they found it was a good place to start. Careful due diligence was necessary to ensure the quality of returns, valuation procedures and other qualitative metrics were acceptable. It illustrates that investing in hedge funds the old-fashioned way, as it was done in the 90s, is the way to earn old-fashioned returns. You have to look beneath the radar screen, to go where most investors are not going.

Barron’s also ran an article suggesting that fees are beginning to moderate. It’s certainly about time the “2 & 20” was adapted to better reflect the return outlook. But my favorite line in the article is a quote from Larry Powell,  deputy chief investment officer of the Utah Retirement Systems, who notes that not all hedge fund investors view the world the way he does by commenting,  “There are a lot of smart investors; however, there are a lot more dumb ones.” The world needs more smart investors. I hope Larry finds my book helpful.

As the Euro Crisis Express trundles down the track to the cliff, for those of us old enough to have been trading during the October 1987 Crash, it’s all starting to seem eerily familiar. As was once said, history doesn’t repeat but it rhymes. This time is different in many ways, but what is the same is the feedback loop of lower confidence driving European sovereign yields higher which further hurts confidence. The evidence of real economic damage is beginning to show through. Steven Odell, Ford of Europe’s CEO, noted that “Contagion is already here” as he announced layoffs at a plant in Valencia, Spain due to slowing demand. Every step policymakers take is deemed to little, too late. There is a growing possibility of a real disaster – and yet there remain some compelling investment opportunities. Here’s the approach investors should take:

1) Don’t borrow any money. Leverage is inconsistent with long-term investing – it’s really for people in a hurry, looking for tomorrow’s returns today as well as today’s. If you have no leverage you always have the luxury of waiting for security prices to bounce back.

2) Don’t invest in companies that borrow excessive amounts of money. For corporations owning profitable assets, some modest leverage is acceptable assuming the returns they can earn from their invested assets are comfortable above the cost of debt. We don’t invest in highly leveraged companies, and typically look for debt:equity ratios of not much greater than 1:1. In this way, even if business turns down it’s unlikely the bondholders will wind up owning the company at the expense of the equity holders.

3) Don’t lend any money. Seriously. What you don’t have in equities, keep in short dated treasury securities. Lending to the U.S. treasury is not going to make you any money but it remains the safest place to park cash. France may be rated higher than the U.S. for now, but that simply reveals the absurdity of the rating agencies and no insight on their part. Short dated high-grade corporate bonds (excluding government agencies) may be an acceptable alternative to treasury bills.

Excessive debt caused today’s problems, and is being used to try and get us out. In the long run it may be inflationary – since more voters are borrowers than lenders, over time we do think the risks are for a quiescent Federal Reserve to accept creeping inflation as a way to devalue the real value of debt to the benefit of the debtors. But in the near term, even German debt carries some risks, in that the much discussed issue of Eurobonds (probably the only solution left) will likely pressure their finances. And the other problem is that if you buy German bonds you can’t even be sure what currency they’ll repay you in.

But equities are attractively priced for the long run. The challenge is finding a way to take advantage of that opportunity. We believe the answer is to modify the traditional approach to portfolio construction of equities, fixed income and cash to one of modestly more equities, sharply less fixed income and more cash. A barbell approach of stocks and cash with no borrowed money and not much lent money.

Consequently, we like companies include: Kraft (KFT), $23BN of long-term debt and showing the benefits of their 2010 Cadbury’s acquisition, maintaining operating margins of greater than 13% and with 2012 consensus EPS of $2.50 following double digits earnings growth offering an earnings yield of 7.4% (P/E 13.5). KFT also provides many different points of exposure to emerging economies. Microsoft (MSFT), perennially disliked but still growing earnings at 10%+. Net of cash (after deducting long-term debt)  on  balance sheet trades at less than eight times current year’s earnings. Aspen Reinsurance (AHL), likely to benefit from the reduction in reinsurance capacity following a series of catastrophe payouts (Japanese and New Zealand earthquakes, U.S. weather) and trading at 55% of book value.

It’s important to own companies whose long-term prospects are diverse and unlikely to change overnight. We own no banks – in fact we never invest in banks. They operate with too much leverage. In so many ways, debt is becoming a four letter word.

Disclosure: Author is Long KFT, MSFT, AHL

Contemplating the unthinkable long ago became a necessary tool for analyzing the euro sovereign debt crisis. Today’s failed Bund auction is another step on the road to Berlin. The 1.98% yield is hardly attractive, and one could quite understand investors avoiding such paltry returns for ten years under most circumstances. But the Euro’s uncertain future has done what miniature German interest rates have not, and that is cause a shortage of willing buyers. Only 65% of the offered bonds were desired by private investors, and as a result the Bundesbank became the unwilling holder of over €2.3BN of the €6BN auction. They apparently plan to sell these in the near future when markets are calmer. They probably will – but this episode represents another step towards the cliff with seemingly no clear plan of action from policymakers to turn away from the brink.

The € seemingly has no good options. The best prospect for the currency to strengthen is in the event of a surprising and dramatic plan to solve the crisis. No such event appears plausible, but regardless of that all the likely solutions are negative for the currency:

1) slower growth through the austerity of reduced government budgets

or

2) a compromise of the ECB’s single focus on inflation as it buys unlimited amounts of debt.

And there’s always the possibility of neither of these, which is most likely worse.

The relationship between the € and the S&P500 (SPY) has grown steadily tighter in recent months. The correlation of returns between the S&P500 and the € over the past year is 0.6, whereas over the past month it’s 0.84. The slope of the regression line has gone from 0.27 to 0.4, and the relative volatility has risen from 0.4 to 0.9. In layman’s terms, they’ve become more linked but in addition the € has become increasingly sensitive to moves in the S&P500. What this means is a growing asymmetry between a portfolio of long equities and the main transmission of potential losses, the €. The statistics and our assessment are that a peaceful resolution to the crisis should lead to higher equities and a (perhaps only temporarily),  stronger € whereas a disaster will cause a sharply lower € with weaker equities. There is some positive convexity to owning equities, which are generally attractive long term investments facing huge macro uncertainty, and being short the €. This is our position – long a selection of equities that will still be profitable companies in virtually any scenario  – names such as KFT, MSFT, BRK, and short € through owning EUO.

Disclosure: Author is long SPY, KFT, MSFT, BRK, EUO

One year ago AR Magazine published an article I wrote which revealed how poorly hedge fund investors had done in aggregate. Today, AR revisited the topic. Over the past 12 months the hedge fund industry has continued to deliver steadily mediocre results (although there are certainly some bright spots) and investors have continued to plow money into the biggest funds. 2011 will be the ninth consecutive year that hedge funds have failed to outperform a simple blend of 60% equities and 40% bonds. It’s convenient timing for my book, The Hedge Fund Mirage.

Greece has been warned by the troika (EU, ECB, IMF) that personally signed pledges from key political leaders are required before the next tranche of the bailout is released. Greece apparently has enough cash to last 20 days. The threat is that failure to comply will result in Greece being allowed to default. Well, at least Greek CDS contracts should finally have some value. At this poker table, who really believes the troika holds a strong hand? Both sides continue to avoid their Lehman moment. At this stage, with no clear strategy to avoid contagion, forcing Greece into bankruptcy simply isn’t a credible threat. The troika will find a face-saving way to provide the needed funding.

The Super Committee has done nothing remotely super, and as a result leaders of both parties assert that the $1.2 TN in automated spending cuts will take effect in 2013 absent an earlier negotiated settlement. $1.2 TN, cut equally from Defence and Entitlements. Who really believes that will happen? Congress wrote the law and can re-write it. There are several paths resolving the U.S. fiscal deficit may follow, but automated cuts immediately following a general election is not credible.

It’s becoming harder to figure out who holds a strong hand on either of these issues. Investors with no leverage, invested in quality companies and with some available cash probably hold the best cards. For our part, we have been defensively upgrading quality and raising modest amounts of cash. Equities remain an attractive investment, but government paralysis on both sides of the Atlantic looms ever larger over the economic and investment landscape. In Fixed Income we continue to like senior loans and hold BHL and PPR. In Deep Value Equities we have modestly lowered our exposure to natural gas E&P names, although our largest position remains Devon Energy (DVN). We also increased our position in McMoran Exploration (MMR), who will report on their Dave Jones flow test by the end of the year at which point the company’s prospects should be much clearer. And we continue to be short the € by holding EUO.

Most of the government players at this poker table need stronger hands.

Disclosure: Author is Long PPR, BHL, DVN, MMR, EUO

Barron’s ran an interesting article on places to go for higher income than high-grade bonds. The writer pointed out quite accurately that ten-year treasury bonds do not provide sufficient income to preserve after-tax real purchasing power. The Federal government doesn’t believe its creditors should earn a real return, and has adopted a policy to prevent that. The thinking investor’s response is to look elsewhere and to keep more money in cash waiting for better opportunities.

Closed end funds, which Barron’s highlights in their article “How to Get Safe Annual Payouts of 7%”  can be interesting if they trade at a discount. However, much of the market is characterized by funds that pay distributions in excess of their earnings in order to maintain a high “distribution yield”, even though they are in part giving investors back their own money. Closed end funds are best owned if they’re mispriced, in combination with a hedge to neutralize the NAV movements. We have owned Boulder Total Return Fund (BTF) for some time. The fund has a substantial holding in Berkshire Hathaway (BRK), and its second biggest holding is Yum Brands (YUM). BTF doesn’t pay a distribution, an omission that has caused traditional closed end fund investors to shun the stock. Consequently, it trades at a 21% discount to NAV. The PM and affiliates own over a third of the shares. One day they may reinstate the distribution or engage is some other value-creating exercise. In the meantime, it represents attractively-priced exposure to BRK or can be hedged to focus on the discount narrowing.

Another area we like is Master Limited Parterships.  Six per cent tax-deferred distributions with a reasonable expectation of 4-5% distribution growth. MLPs have historically outperformed stocks, bonds and REITS but remain an under-invested asset class. K-1’s deter many potential investors. But MLPs, particularly the midstream firms that invest in pipelines, storage facilities and refineries have only modest exposure to energy prices and toll-based fee models that create earnings stability. We think of MLPs as a good substitute for high yield bonds. Historically similar levels of price volatility but more attractive return profile.

Many high-dividend stocks are attractive. In some cases large companies with stable earnings growth offer dividends higher than their own debt. Johnson & Johnson (JNJ) and Pepsi (PEP) are both examples, and are names that we own in our Hedged Dividend Capture Strategy, where a diversified portfolio of such names is combined with an equity market hedge seeking to profit from dividends with reduced market volatility.

The “Fracturing of Pennsylvania” was another in a series the New York Times has been running on shale gas and potential environmental damage from its extraction. We like natural gas E&P names – shale gas represents an enormous source of fuel for the U.S. in the years ahead. It’s far cheaper than oil on a BTU-equivalent basis and it’s here in the politically stable U.S. But it needs to be mined safely. The issue of toxins leaking into drinking water remains a vexing one. So far the science strongly suggests that the risks are extremely low. But the number of stories of undrinkable water and high levels of metals in residents bloodstream is growing. The evidence that fracking is to blame is inconclusive at best, but it’s not an issue to ignore for investors or the landowners who sell drilling rights to their land. Range Resources (RRC) appears to have reacted professionally, which doesn’t shock me at all having met the management. We continue to like the company but believe the stock is expensive. We prefer Devon Energy (DVN), which trades closer to the value of its proven reserves.

The news from Europe remains a poker game. We are short the € through owning EUO. Kyle Bass has a thought provoking perspective.

Disclosure: Aithor is Long BTF, BRK, JNJ, PEP, EUO, DVN

Kyle Bass, who runs a hedge fund called Hayman Capital Management in Texas,  is gaining notoriety as an investor with the foresight to anticipate today’s growing sovereign debt crisis. If eurozone governments ultimately write down their debt because the weight of supporting their banks becomes too great, Kyle Bass will go down as one of the earliest to recognize and position for that. His worldview is dire, and it’s apparently prompted him to take some strange precautions such as acquiring $1 million nickels (20 million coins) because their 6.8 cents value as scrap metal exceeds their monetary worth. I listened to an interview yesterday on BBC Radio HardTalk in which he defended his views. The UK media tends to take a more populist stance with regard to hedge fund managers. It’s now 14 years since George Soros’s bet against Sterling preceded their leaving the European Monetary Union and ultimately declining to join the €. How fortunate that decision looks today, but at the time UK tabloids blared that George Soros had “broken the Bank of England” and financiers have never been fully trusted in the UK ever since. So the BBC’s interviewer adopted a combative stance, for instance accusing Bass of causing the collapse in Greek bonds through his bets on credit default swaps. Her attempts to portray him as a manipulating hedge fund manager exploiting opportunities for no benefit but his own were deftly handled with facts and figures. Kyle Bass has a point of view worth considering.

I went back and reread Bass’s investor letter from February, “The Cognitive Dissonance of it All”. He reaches a similar conclusion to Jim Millstein in Tuesday’s FT, although he focuses more on government revenues, debt and interest expense. Japan, given its shrinking and aging population combined with high levels of debt could not afford to borrow at the levels of other AAA-rated nations (such as France) because their total interest expense would exceed their revenue. As Bass says, “The ZIRP trap snaps shut.” (ZIRP is Zero Interest Rate Policy, pretty much what we have in the U.S. currently). I know people have been betting on a disaster in Japanese bonds for literally twenty years, and it has so far been a disastrous bet. But it does increasingly look as if it still is just a matter of time before we reach the tipping point. After reading what Kyle Bass has to say it’s hard to feel comfortable owning long-term government bonds issued anywhere in the world.

A perverse but totally understandable consequence of the current crisis is that even though it was an excess of debt that got us here, the cost of borrowing is about as low as it could get – at least in the U.S., thanks to the Fed’s confiscatory monetary policy. But in Europe, the cost of borrowing is rapidly reflecting the unfortunate reality that there’s just been altogether too much of it.

On Tuesday, the FT ran an Op-Ed piece by Jim Millstein, “Europe’s largest banks have become too big to save”. I can’t stop thinking about it. He makes the point that Europe’s biggest banks and governments are now so intertwined that one cannot fail without the other. Europe’s banking system is much larger relative to its economies than in the U.S., in part because European corporate debt markets are far less developed. Banks are also loaded with government bonds, an unfortunate consequence of the old BIS capital rules assigning no risk weighting to sovereign debt of any developed country. Bankers loaded up on peripheral European debt because it yielded more than German and French bonds but owning it didn’t require any greater capital. This is really the cause of today’s problems; the common currency simply eliminated the foreign exchange risk, but the capital rules made the build up of risk virtually free and bankers suspended critical judgment.

So what we have today is a symbiotic relationship. Europe’s governments sell bonds to their banks. Those banks, now sagging under the weight of mark to market losses on bonds are having to raise capital at a time of depressed equity prices. This creates the potential for Europe’s governments to need to support their own banks because they already own too much of their government’s debts. It’s a spiral, and the standard austerity prescription from the Germans may be starting to wear thin. The New York Times notes this in an article and wonders whether, as rising bond yields spread to northern Europe (France’s 10 year yields are currently 3.76%), the focus on deficit reduction may lose support. “All this underscores the ongoing nervousness about Europe generally and the banking sector specifically,” says my friend Barry Knapp from Barclays.

It’s not clear where it ends, and Jim Millstein’s piece leads quite logically to just about the worst outcome. So what’s an investor to do?

Well, as dire as things seem, timing equity markets is never easy and although the U.S. will inevitably be dragged down by Europe’s travails there is a world outside the eurozone and many stocks provide attractive return potential. We continue to be short the € in our hedge fund.

Within our Deep Value Equity Strategy we don’t invest in banks (too much leverage for my taste) and natural gas E&P names are no doubt cyclically exposed although it’s hard to see how much lower the price of domestic gas can drop than the $3.40 per MCF it’s at currently. Among the large E&P names we like Devon Energy, which is all domestic, has an attractive exposure to liquids and trades close to the value of its proved reserves. McMoran Exploration (MMR) is a smaller and highly speculative position that will likely resolve itself by the end of the year when it gets results from its Davy Jones Flow Test. MMR had some mildly positive news earlier in the week from their Lafitte Ultra-Deep Exploration Well but this company’s future will likely be driven by Davy Jones. MMR will move up and down with the European debt crisis but its value really has absolutely nothing to do with the price of Italian bonds.

We’re avoiding obvious risks such as financials, and using bottom-up analysis to manage top-down risks.

Disclosure: Author is Long EUO, DVN, MMR