Peter Morris has written an interesting article noting the principal-agent problem as it relates to investors in private equity. Peter spent 25 years working in financial services and is the author of a report written for the Center for the Study of Financial Innovation (CSFI) called Private Equity, Public Loss? Peter and others have pointed out the disparity between low returns earned by private equity investors and the ample compensation earned by the managers of those investments. The principal-agent problem Peter notes is not unique to private equity of course, but he makes a good case for much greater transparency around results for such investors and challenges the notion that “sophisticated” investors are well equipped to make well informed decisions in this arena. Investors in hedge funds have suffered through similarly poor results as Peter also notes, and he kindly refers to a book I have written called The Hedge Fund Mirage which explores this issue.

There are interesting public policy issues surrounding this entire area, in that public pension funds are increasingly allocating capital to alternative investment strategies in the hopes of reaching the 7-8% return targets they need to meet their obligations. Ultimately, a failure to meet those goals will have consequences for taxpayers throughout the developed world as workers retire if pension plan returns fail to met expectations.

In sorting through the wreckage of the past quarter’s bear market, I’ve spent some time reviewing Comstock Resources (CRK). We own CRK – we liked it at $30 a share truth be told, although we did have the good sense to lighten up the position at those heady levels. CRK is a natural gas E&P name drilling for shale gas mainly in East and South Texas and North Louisiana. We’ve long liked natural gas as a replacement for coal in fuelling America’s power plans. It is cheap, abundant, clean(er) and here, in the U.S. But the very abundance of natural gas has depressed its price for some years now and forced the E&P companies exploiting it to operate at successively lower costs. CRK qualifies, in that it has estimated extraction costs of around $1.26 per MCF (thousand cubic feet) although that continues to fall. It also has manageable debt. They operate in a similar area to Petrohawk, which was acquired earlier this year by BHP Billiton. We think CRK may ultimately be acquired, although today’s market environment offers much less immediate prospect of that given the difficulty of financing acquisitions.

Meanwhile, CRK’s stock price recently sank as low as $14 (and even now has only rebounded to just over $16). At current prices you can buy the entire company for less than $800 million. Assuming they can realize $1.25 per MCF on the proved reserves of 1.05 TCFE (trillion cubic feet equivalent), and after adjusting for debt net of cash the company is trading for approximately the value of its proved reserves alone.  This doesn’t account for their reserve potential which could be 3-5 times as much again. CRK’s problem is that the market always worried they won’t have enough cashflow to fund their drilling program and as a result will need to come to the market for additional equity , and this along with the disappearance of any imminent takeover explain the precipitous drop in the stock. The company believes they will fund all their capex needs from internally generated cashflow, and they expect to spend $610 million on capex (i.e. drilling new wells) in 2011 for which they don’t expect to tap the equity market.  In addition they have $400 MM in unused credit through their bank revolver.

I’ve met Roland Burns and chatted with him several times over the past year. We think this stock offers an attractive risk/return at current prices, and will be looking for opportunities to add to our position.

Disclosure: Author is Long CRK

The good news from UBS today is that they expect to post a modest profit for the third quarter.  This is in spite of losing $2.3 billion through the unauthorized trading of Kweku Adoboli. On top of that, the woefully inadequate risk oversight that Mr. Adoboli so painfully exposed has forced UBS to hasten the shrinking of their investment bank, incurring restructuring charges. However, in spite of these twin blows to their results, UBS expects to include a $1.5 billion Swiss franc profit from widening credit spreads on their debt. That’s right, because the company’s self-inflicted wound has soured investors on the bank’s prospects and therefore raised the yield on their debt, in the topsy-turvy world of accounting this is counted towards their profit. The green eye-shade logic is that because UBS owes money (on the bonds they’ve issued) the lower price for the bonds implies the value of what UBS owes has gone down. It’s the same as if the investors in those bonds just decided to forgive 5% of the face value.

Of course, UBS still owes the same amount of money, and borrowing just became more expensive for them. But the Looking Glass world of liability accounting regards this differently. So when UBS announces a profit for the third quarter, remember that it came about through the market’s recognition of their weak risk management structure.

The equity risk premium (as defined as the earnings yield on stocks minus the yield on the ten year treasury note) is wide for good reason. 2012 consensus earnings for the S&P 500 of $105, which implies an earnings yield of 9.3% (September 30 S&P 500 at 1131) and a spread over the 1.90% yield on the ten year treasury of 7.4% is wide by any measure. It last reached these levels in 1973, during the Yom Kippur War and the OPEC oil embargo. Today’s problems are different and maybe far worse. An assessment probably depends as much on whether one’s philosophy of life is optimistic as on how the macro issues will play out. For our part, we are cautiously constructive and maintain equity exposures at neutral, believing that current valuations offer a sufficient discount for the risks.
While respectable cases both for and against equities can be made, the absence of value in bonds seems far less contentious. No doubt for most of those holding this view (like us), they held it at higher yields than these and so far it has not been right. At the risk of being stubborn, lower bond yields simply make it more right than it was. The latest Federal Reserve plan to shift its purchases of bonds to longer maturities (“Twist”) has perversely caused short term rates to drift up somewhat even while the Fed’s prospective buying (and coincident negative economic outlook) has driven long term yields down. In fact government bond markets are increasingly manipulated by governments, and therefore look less appealing places to invest. Even without a view on whether inflation in five years will be sharply higher, lending to anybody for ten years at less than 2% doesn’t seem much more compelling than holding cash. For the taxable investor assuming a 40% tax rate, 2% pre-tax is 1.2% after tax which over ten year  turns $100 into just under $113 (and unless inflation averages no more than 1.2% over the same period guarantees a loss in purchasing power). The economic environment that would make today’s buyer of 2% yielding government bonds happy in ten years’ time is unlikely to be kind to most types of credit risk. High grade corporate bonds linked as they are to government bonds offer only modestly better prospects. So today’s buyer of corporate bonds desires many years of economic misery to contain inflation but not so much so as to damage corporate creditworthiness, a fairly precise forecast that doesn’t leave much room for error in either direction.
Virtually all investors have an allocation to fixed income in one form or another. While bonds have not looked cheap for a long time it does seem that today’s low yields, distorted as they are by government intervention, demand a robust response from investors. Since public policy is to make the goal impossibly narrow, maybe it’s time to take your ball and go home. If an investor shifted $100 out of fixed income and allocated $80 to 0% yielding cash, the remaining $20 invested in risky assets (such as equities) need only grow at 6% p.a. pre-tax to generate the same $113 of ultimate value as in the ten year treasury example above (assuming a 15% tax rate on dividends and capital gains).
To illustrate with some brief Math: since dividend yields are 2%, this only requires 4% of annual growth. 2% dividend yields imply companies are paying out only 2/9ths of profits (as earnings yields are 9%). The remaining 7/9ths that’s retained would need to earn a return on equity (ROE) of only 5% to generate the 4% dividend growth noted above (dividend growth = % of earnings retained X ROE; 7/9ths of 5% is approximately 4%). A 5% ROE is around half the current cost of equity implied by the S&P500’s 9% earnings yield. To summarize without the Math – being more pessimistic than this probably isn’t the winning side of the trade over the long run. In the short run, anything can happen.

The 80/20 Cash/Stock substitute for fixed income doesn’t need to jump very high to clear the performance hurdle that’s been set. It incorporates some attractive upside, in that dividends may grow faster than 4%. And one day in the far distant future, maybe cash will even sport a yield again as it once did. This strategy also provides the flexibility to invest some of the cash at a later date, perhaps when the economic outlook is clearer and when bonds would presumably have to be sold at a loss.
We don’t yet have the requisite Newsweek cover announcing “Why You Should Only Invest in Bonds”, but the Math is starting to look compelling. Alternatives to bonds include MLPs (currently offering around 6% tax deferred yields with a solid history of distribution growth); stocks with long histories of reliable dividends; bank debt, and the cash/equities barbell described above.

Many perverse things are happening in financial markets beyond the easily visible carnage in equity markets. Take Bank of America (BAC) for example. Credit insurance for one year through a credit default swap (CDS) costs 4.35% (according to Bloomberg). One year LIBOR is 0.85%. How does Bank of America function in today’s money markets, where presumably nobody will lend to them at anything close to prevailing rates when the cost of insurance is five times as much. Presumably the only inflows they are receiving are those small enough to qualify for FDIC insurance (i.e. under $250K).

Author has no position in BAC

We’ve recently started investing in some closed end funds that buy senior loans. The sector became quite overpriced in the Spring and several funds were trading at a premium to NAV. The last couple of months has reversed this, and now it’s possible to buy funds at discounts to NAV of 5% or more. On top of that, the values of the underlying securities have dropped too, so the result is a sector that is 15-20% cheaper than it was six months ago. The ING Prime Rate Trust is an example – this chart shows how its price has dropped and swung from a premium to a discount. It yields about 6% and holds the potential to appreciate if the U.S. economy avoids a recession, which we think it will. We think this is a sector worth considering, and we plan to add on weakess.

Disclosure: Author is long PPR

Yesterday a court ruling in Pennsylvania cast doubt on the title of thousands of shale gas leases, as reported in Bloomberg . Range Resources (RRC) is as heavily invested in the Marcellus shale area, which includes Pennsylvania, as any other company out there. The company is well run and we like the management. The stock has also been exceptionally buoyant recently on takeover rumors. However, this news will likely put any potential acquisition on hold until the title issues are resolved, either by the Pennsylvania State Supreme Court or through state legislation. We are not currently invested in RRC although had been invested until recently when the U.S. Geologic Survey revised down their forecast of total reserves available in the Marcellus (which runs from NY State to Tennessee). This may create an opportunity to invest at lower prices once the story has had some time to play out.

There always seems to be something to say on this topic. Although natural gas E&P companies typically represent 15-20% of our Deep Value Equity strategy, they provide disproportionate volatility but have also provided very good returns. The U.S. Geological Survey (USGS) is a Federal agency that gathers information and publishes research on the environment and natural resources A week ago they published a report on the amount of natural gas in the Marcellus Shale, an enormous area which runs from New York State to Alabama. They estimated that the “mean undiscovered natural gas resource” in this region is 84 TCFE (trillion cubic feet equivalent). They use the mean because the science isn’t certain and they have various forecasts with different levels of certainty. 84 TCFE is a lot of gas, roughly four times annual U.S. consumption. But this estimate is sharply lower than previous ones, and as a result the Energy Information Agency (EIA) whose job it is to forecast available energy resources, said it would slash its previous forecast of Marcellus availability by 80%. The EIA is deferring to the scientists at the USGS.

Range Resources (RRC) has long been a core holding of ours. The company is largely focused on extracting natural gas from the Marcellus Shale where it was one of the early movers. We like the company very much. It’s run by smart people who understand their business and is focused on increasing shareholder value. RRC has among the most efficient operating structures of any of its peers, and perhaps the cheapest F&D (Finding and Development) costs in the Marcellus. Current President and COO Jeff Ventura will be taking over from John Pinkerton as CEO in January in what will probably be a seamless transition. Jeff has an engineering background and has led their successful activities in the Marcellus to this point.

RRC reports total resource potential of 40-56 TCFE, of which 22-32 TCFE is in the Marcellus (and mostly in Pennsylvania). When the EIA was forecasting around 400 TCFE in the entire Marcellus area, this seemed fine. However, the revised 84 TCFE figure probably can’t be reconciled with RRC’s forecast (which is an estimate of resource potential, not proved reserves). We wouldn’t bet against RRC. They’ve been extracting increasing volumes of natural gas from this area for a long time and know the geology well. But Chesapeake Energy (CHK) estimates they have 93 TCFE of potential (“unrisked, unproved” is their definition). Something’s going to have to give. An intriguing possibility is that if the Marcellus ultimately delivers less than expected, other shale plays could be substantially more valuable given the resultant drop in long term natural gas supply. For our part, while we continue to like RRC we recently shifted into Devon Energy (DVN), which provides more diversified natural gas exposure and is also a very well run company. DVN’s market cap is approximately equal to its proved reserves (i.e. potential reserves are not reflected in the price). They have very little debt, are buying back stock and should earn $6-7 per share next year which makes an attractive multiple given their $67 price. DVN is in many different unconventional natural gas areas, but not in the Marcellus. The Marcellus Shale story no doubt has more chapters to come.