Quarterly Outlook

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That the world’s a risky place has not escaped the recent attention of investors. The potential demise of the European single currency and perhaps with it European banks and the European project itself looms large over every investment decision, and has for many months. Economic slowdown in China, the uncertain consequences of the Arab Spring and more recently Iran’s nuclear ambitions all add to the global uncertainty. Within the U.S. a highly partisan Congress has led to legislative gridlock and no certainty about long term fiscal policy. It makes you wonder how investors get out of bed in the morning. And when they do, they are confronted with a choice of risky assets (such as equities) which may lose value immediately, or less risky assets (such as bonds) which will lose real value with certainty. That investors are choosing the certainty of lost purchasing power over the available alternatives reflects the seemingly poor choices on offer. Thus is the equity risk premium, the difference between the earnings yield (inverse of the P/E ratio) on the S&P500 and the ten year U.S. treasury yield, at its widest since 1974, a year that closed with the Dow Jones Industrial Average having dropped 45% from its peak only eighteen months earlier, and inflation at 12.3%.

Start with bonds. Today’s ten year treasury yield of around 2% assures even the tax-exempt hold-to-maturity investor of a loss in purchasing power if inflation over ten years exceeds 2%. The taxable investor of course will fare even worse. Even a portfolio of blue chip corporate bonds yielding around 4% will struggle to overcome the twin headwinds of taxes and inflation. But bonds have a big thing going for them, which is momentum. For those who draw comfort from investing with a tailwind, bonds are a warm and cozy place. The Dow Jones Corporate Bond Index has returned 10% per annum for the past three years including 8.5% in the most recent one.  Who’s to say that this won’t continue? And of course it may, although such forecasts will struggle mightily to overcome the Math; for bonds to return more than their current yield, their yields need to fall causing prices to rise. Corporate bond yields could drop from 4% to 3%, although such would presumably require a similar drop in treasury yields, to 1%. The world in which 1% ten year treasuries draws buyers is unlikely to be a friendly one for corporate credit, and at such a time credit spreads might be substantially wider, depressing the prices of corporate bonds. So, much as bonds investors might draw comfort from looking backwards, their best plausible outcome is that they’ll earn the current yield and suffer a steady depreciation in the real value of their assets.

In fact, relative pricing between stocks and bonds is such that $20 invested in the S&P500 yielding 2% will, assuming 4% dividend growth (and the 50 year average is 5%) generate the same increase in after-tax wealth as $100 in ten year treasuries. This assumes the $80 not invested in stocks earns 0% by sitting in cash, although holding cash provides the option to do something with it that might well earn a return later on. The Math works for corporate bonds as well (just change the $20 in stocks to $40).

So bonds have been good, but past performance is highly unlikely to be repeated. In fact, we believe there’s a strong case to be made for all investors to reduce their asset allocation to fixed income. Government policy is to maintain ruinously low interest rates while debtors rebuild their balance sheets. The Federal government is effecting a transfer of real wealth from investors to borrowers. This policy is likely to continue for quite a long time, not least because it’s popular (with those voters who contemplate such things). There are many more debtors than creditors, and regardless of how independent you think the Federal Reserve is, monetary policy is unambiguously populist, designed for the masses. The appropriate response is to allow the government’s voracious appetite free rein. If Chairman Bernanke likes bonds that much he can have the lot.

As a result, identifying alternatives sources of investment income is a task that consumes much energy on a daily basis at SL Advisors.

The stock market offers a risk to suit every taste. For those who like to wake without first worrying whether their holdings are solvent, many reasonably priced large cap companies with low levels of debt and a history of steady earnings growth are available. Kraft (KFT), Microsoft (MSFT) and Berkshire Hathaway (BRK-A) are all examples in our Deep Value Equity Strategy, along with less well-known names such as Corrections Corp (CXW) and Republic Services Group (RSG). Domestic energy exposure adds volatility and return potential through Devon Energy (DVN) and Comstock Resources (CRK). The former bond investor can allocate his new funds to a combination of stocks and cash (depending on risk appetite), or to other income generating strategies.

There are even examples of stocks whose dividend yield exceeds that on their own bonds – not because their fortunes have suffered and a high dividend yield reflects expectations of a cut, but because price-insensitive bond investors have driven bond yields low in their flight from equities. Johnson and Johnson (JNJ) is one such example. Our Dividend Capture Strategy consists of a diversified portfolio of such names combined with a hedge to eliminate most of the daily market moves. The result is a portfolio exposed to dividend paying stocks and dividend growth that is hedged against excessive moves in stocks.

Master Limited Partnerships (MLPs) are another attractive asset class for taxable investors tolerant of K-1s. I won’t repeat here the well-worn arguments that are familiar to regular readers, except to note that the sector’s unique structure renders it worth having in many income-seeking portfolios. MLPs offer tax-deferred distribution yields of 5-6% combined with growth expectations of 4-6% (suggesting a total return potential of 9-12% with no change in earnings multiples).

Disclosure: Author is Long KFT, MSFT, BRK-B, CXW, RSG, DVN, CRK, JNJ

Cheap Natural Gas is Creating its own Demand

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Last week the Environmental Protection Agency  (EPA) issued emission standards tightening the rules surrounding the output of mercury and other harmful pollutants. These standards will have the practical effect of making natural gas relatively more attractive than coal for electricity generation since coal-burning plants require the installation of expensive “scrubbers” to clean the emissions they generate. Converting older plants to operate more cleanly often fails to make economic sense and as a result new power plants are increasingly burning natural gas. The Wall Street Journal noted this in an article on Friday.

Of course the shale revolution in natural gas has produced a glut of the stuff, and at $3.13 per MCF it’s barely possible to drill for it profitably. That the price has fallen so low at the onset of Winter when demand typically picks up is testament to the success of the drillers. But it does emphasize the importance of being invested in companies with low costs of production since there’s little near term prospect of higher prices.

But the longer term outlook is increasingly positive. U.S. based natural gas is now cheaper than anywhere in the world outside the Middle East, and that is drawing interest from other industries that rely on cheap sources of energy. States that sit atop the Marcellus Shale (such as Pennsylvania and West Virginia) are competing with one another to attract ethylene production facilities. And a Brazilian textile company recently chose Texas over Mexico to build a new denim factory because of a 30% cost advantage in electricity. Over time cheap natural gas will lead to cheap electricity, drawing in additional industries and creating manufacturing jobs. And this increased demand will no doubt help support prices.

It’s not a sector to own for a trade, but companies with low operating costs and minimal debt are best positioned to benefit from what’s happening. We recently added Southwestern Energy (SWN) to our Deep Value Equity strategy since it meets these criteria. We continue to own Devon Energy (DVN) whose liquids business provides a usefully profitable offset to today’s soft natural gas prices. The natural gas story continues to have many chapters.

Author is Long SWN, DVN

Why We Still Prefer Equities over Bonds, Dollars over Euros and Devon Energy

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Barron’s has a couple of interesting articles this weekend. They lead with “Buckle Up”, and make the case for equities by highlighting the very wide equity risk premium (the S&P500 earnings yield of 8% minus the yield on ten-year treasuries of 2%) something we’ve also noted in the past. This spread is historically wide and, it can be argued, makes a compelling case for stocks. What seems more clear is that the spread will narrow but that could just as easily be through bond yields rising. We do think equities represent an attractive long-term investment but we are more sure that bonds do not. Public policy in the U.S. is to effect a transfer of real wealth from savers to borrowers, so while stocks look attractive bonds look positively ugly.

Of course noting that bond yields are low and can only really move up is scarcely a contrarian view. Randall Forsyth notes in Barron’s a solid agreement among forecasters that bond yields will be higher a year from now. While it makes a great deal of sense, presumably the Federal Reserve will respond to higher yields by increasing its purchases unless rising yields are accompanied by an upside surprise in GDP growth. They’re likely to maintain negative real rates of return for a considerable time.

A hedge fund, QB Asset Management, forecasts “face-ripping inflation”, a term likely to catch your attention. The output gap (such as the difference between current unemployment and the natural rate) seems too high for that – there still appears to be plenty of excess capacity in the labor force. It’s hard to see how inflation (at least as measured by the Bureau of Labor Statistics) can take off when so many people are available to be employed. QB could be right, but it hasn’t happened so far and without an increase in money velocity the jump in money supply isn’t likely to become inflationary. But similar to the wide equity risk premium, while low current inflation may persist it’s not worth betting on a continuation of the status quo.

Shorting Euros is another crowded trade. It’s just hard to see how any of the solutions on offer will promote growth within the region. The Real GDP differential is likely to be 2.5% next year in favor of the U.S. European governments are following pro-cyclical policies during a time of slowing growth. The Euro has weakened in recent weeks but really ought to be far lower. However, we run this risk in our hedge fund in combination with long equities from a number of different trades. We think the Euro will depreciate, but if we’re wrong it’ll most likely be in a scenario that is good for stocks. Borrowing Euros to buy U.S. equities represents an attractive  opportunity. Mike Platt, co-founder of BlueCrest, a global macro hedge fund, offered a most dire outlook on Europe and its banks. BlueCrest is one of the most successful hedge funds around, and the TV interview is worth a look. Platt is frustratingly vague about how he’s positioning for what he expects will be a continued deterioration but leaves little doubt about his overall view. If European banks valued their positions the way hedge funds have to they’d all be declared insolvent. I can’t really see why anyone would lend anybody in Europe any money, except perhaps in Germany and the UK.

Finally, I’d note that JPMorgan issued revised valuation estimates for large cap E&P names. Devon Energy (DVN) remains one of the  largest positions in our Deep Value Equity Strategy, trading at close to the value of its proved reserves. The continued shift from natural gas to oil production in the U.S. in response to relative pricing should work to Devon’s advantage given its asset mix.

Disclosure: Author in Long SPY, EUO, DVN

Why We Should Borrow in € and Invest in Natural Gas

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As the reality sets in of guiding 26 countries (i.e. the EU less Britain) towards agreement on a common set of revisions to the Treaty, the smug satisfaction of the tabloid press and at least a substantial minority of the British population is almost palpable even here on the U.S. side of the Atlantic. One by one, other member nations are commenting on the challenges of not only finding agreement but then achieving ratification through 26 parliamentary processes. The FT has a good synopsis of the growing acknowledgment of challenges ahead. The UK has to avoid any overtly self-congratulatory behavior, but the truth is that for those afforded the luxury of expressing opinions unburdened by the reins of government, seeing any project related to the French founder is never dull. And there’s many decades of suspicion of German power, even though the competition nowadays is thankfully economic and on the football pitch. I must confess I share many of these sentiments myself.

Michael Cembalest, CIO of JPMorgan’s Private Bank and an eloquent, insightful observer, put it well in a recent newsletter. Likening the ongoing Euro debt crisis to Bergman’s “Scenes from a Marriage”, Cembalest observed that, “Holding assets of countries suffocating themselves is not something that sounds very rewarding, unless prices get extremely cheap.” That’s the point. The prescription of austerity may be the right solution, but the widening differential in Real GDP growth between the U.S. and the Euro zone (2.5-3% in 2012) is scarcely likely to make Euro zone assets attractive. The € is becoming a funding currency – a currency with reliably low interest rates for the creditworthy (or those with good collateral). Borrowing in € and investing in U.S. assets – even risky assets like U.S. equities – has been the right position in recent weeks and events are unfolding in a way that’s likely to continue current trends. It’s hard to see why the € should rally much other than on the back of short-covering – and if it does, equities will surely move up as well.  As a result, we continue to be long U.S. equities. We like Microsoft (MSFT) in our Deep Value Equities Strategy, at 7X earnings after adjusting for cash on balance sheet. You’re unlikely to wake up worrying about their future, although there is always the risk of an over-priced acquisition with all that cash sitting around. And we are still short € through owning EUO.

Several weeks ago we switched our investment in Range Resources (RRC) into Devon Energy (DVN). We had liked RRC for a long time, but it had been looking less like a value stock as its price eventually doubled in a year. Shale drilling for natural gas is an area to which we’ve had some exposure for almost two years. Natural gas is likely to represent an increasing share of the means of power generation in the U.S. It is (1) far cheaper than crude oil on a BTU equivalent basis, (2) cleaner than other fossil fuels, and (3) here in the U.S., as opposed to having to be shipped through the Straits of Hormuz past Iran. RRC represents a concentrated bet on the Marcellus Shale, an enormous area that stretches from New York State to Tennessee. RRC strikes us as a well-run company, and we like the management. However, challenges to the shale gas story seem to be multiplying. In August, the EIA sharply reduced its estimate of the Estimated Ultimately Recoverable (EUR) amounts of shale gas in the Marcellus, causing a huge difference between the aggregate potential reserves from all the companies drilling there and the EIA’s estimate.

Recently the New York Times highlighted growing concern about the legality surrounding the transfer of certain drilling leases in Pennsylvania. Fracking, the technique by which drillers pump fluids (mostly water) into deep rock formations, imposing stress on rock formations that then frees up trapped natural gas, continues to be the target of environmental criticism. It has long been blamed for contaminating local drinking water (a movie “Gasland” was made to focus on this) and there have also been questions about how the fracking fluids (which are almost all water but do contain tiny amounts of very nasty chemicals) are disposed of. Just the other day the EPA blamed fracking fluids as the likely source of water contamination in Wyoming. And there’s even suggestions that fracking and the disposal of fluids deep under ground can cause minor earthquakes. Added together, there’s a growing source of potential problems for shale gas. Tighter environmental regulations around drilling would be fine – natural gas prices are so cheap that increased production costs across the industry would simply reduce some of the price advantage, so there shouldn’t be much problem with that. But the risk remains of some environmental disaster requiring expensive remediation. Not the most likely outcome, but a concern nonetheless.

As a result, in Energy our biggest holding is Devon Energy (DVN), which while focused on natural gas has a significant exposure to liquids and crude oil as well. They are all domestic and trade at around the value of their proved reserves (i.e. unproved and possible are thrown in for nothing). We switched our RRC holding into DVN some 2-3 months ago, and while we could have chosen better timing it’s currently looking like a good move.  We also own Comstock Resources (CRK), whose recent acquisition in West Texas was greeted positively by the market since it’s in an area where the company is already active with continued success. And most speculatively, we own McMoran Exploration (MMR), which has nothing to do with shale gas but which is pursuing shallow water deep drilling for natural gas in the Gulf of Mexico. Results from their Davy Jones flow test will be available soon and the stock will no doubt move sharply in one direction or another. The stock trades with a high beta which is not that meaningful since its ultimate value is a binary outcome based on the abovementioned flow test.

Disclosure: Author is Long MSFT, DVN, CRK, MMR, EUO

The € is Becoming a Funding Currency

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I spent a few days in London last week, meeting with investors and discussing my book. I also managed three separate TV appearances. I can tell you that if the € sovereign debt crisis appears to dominate the news in the U.S., it is an all-consuming obsession for the financial media in the UK. It is naturally more impactful on Britain, and the jingoistic response of the popular media to Prime Minister Cameron’s exercise of his veto over Treaty changes showed how shallow is the support in Britain for the European project. I’m sure if there was a way to shift Britain 1,500 miles to the west it would more accurately reflect the country’s center of gravity between European liberalism and U.S. mercantilism.

But wherever you sit, Friday’s EU summit was yet another all-too-small step towards finding solutions to the problems of too much European sovereign debt. The markets are now left to wait and see if the ECB will find enough to like in the commitments of the other 26 nations towards fiscal discipline so that it can become a significant buyer of high yielding sovereign debt. One has to assume they will do so if needed – sufficient private buyers are not yet there, although over the next 2-3 years the Carry Trade could become a source of recapitalization for European banks desperately in need of such. 7% Italian yields funded at 1% could replenish the retained equity of banks for a considerable time. It’s not a trade we would do ourselves, but it could plausibly draw substantial capital in the months ahead.

Indeed, the growing differential in Real GDP between the U.S. and the € zone looks set to be 2.5% in 2012 and could easily reach 3% if Europeans follow through on promised austerity while the U.S. delays such and extends the payroll tax deduction. The € is becoming a “funding currency”, the disrespectful moniker attached to a currency facing an extended period of low rates and little prospect of moving higher. Borrowing in € is looking increasingly like a cheap source of funding – after all, European sovereigns have been doing so for years with reckless abandon (hence the present crisis). The ECB is likely to keep rates low and in considering the solutions, whether they stay on the present course of  employing fiscal drag, utilize an increase in inflation or stumble into a disaster, it would seem that most plausible paths for the € are lower. It’s frankly part of the solution, to further stimulate exports and devalue the real value of debt owned by non-€ investors.

We think it’s one of the better trades available, but in combination with a long equities portfolio is becomes quite compelling. Stocks are reasonable long-term value and are compelling versus fixed income. A higher € would almost certainly be accompanied by higher equities and an altogether more friendly investment outlook. It’s not obvious how we’ll get there, but it’s certainly possible. The big issue restraining equities is the €. So borrow the € and buy US stocks.

As a result we remain invested in U.S. equities. Our biggest position is Kraft (KFT) an attractively priced name that provide exposure to global GDP in combination with their own positive story. KFT has seen almost 7% organic revenue growth through the first 9 months of 2011 and more than 5% of that has come from pricing, so they’re clearly able to push increases through the pipeline. They continue to enjoy operating margins of 12-14%. The Cadbury synergies are coming through, both in sales of Oreo cookies in India across Cadbury’s existing distribution infrastructure and through sales of Cadbury’s chocolate in South America where it had relatively small penetration. KFT’s break-up next year into a global snack business and U.S. grocery business should unlock additional value for investors, and at 14X next year’s consensus earnings with 11% YOY EPS growth we think valuation is not excessive.

We continue to like Aspen Insurance (AHL), trading at 60% of book value in an industry with reduced capacity given a series of reinsurance payouts over the past year (Japanese earthquake and so on).

We are long stocks such as these in our Deep Value Equity strategy, and in our hedge fund maintain long equities with a short € (long EUO).

Disclosure: Author is Long KFT, AHL, EUO

Transocean Buys High and Sells Low

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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

Carl Icahn, Transocean is Calling You

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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

Avoid All Debt and Look For Value – Why We Like Kraft and Microsoft

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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

When Everything's a Macro Trade, Look at Natural Gas

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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

Less Silver More Gas

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Yesterday we lightened up on some of our position in Coeur d’Alene (CDE). We’ve liked this silver mining company for quite some time – it’s been trading at a substantial discount to the NAV of its mining assets and represents a good way to invest in bullion at a discount. Earlier this year there were fears that Bolivia would change the terms under which CDE mines silver at the San Bartolome mine, but even though such fears were unfounded the stock persisted at a wide discount to its underlying assets.

With yesterday’s earnings release the valuation of the stock has largely retraced its steps, and while it remains cheap to its assets we don’t believe it’s as mispriced as it has been. We still own some shares but not as much as before.

We invested the proceeds in McMoran Exploration (MMR). How could you not invest in a company run by someone called Jim Bob? We’ve never met, but he sounds as if he grew up on Walton’s Mountain (a syrupy TV show from the 70s about a Depression-era family). Joking aside, MMR is engaged in drilling for natural gas and oil in the Gulf of Mexico (GOM). Shallow water (as little as 100 feet) but deep wells (up to 32,000 feet so far). The theory is that the geology onshore continues offshore. It’s worth checking out their recent presentation. If you’re not a geologist, it represents a high risk but potentially high return opportunity that will likely resolve itself within the next couple of months when they expect flow test results from Davy Jones No. 1. Jim Bob Moffett, MMR’s CEO, knows a bit about finding valuable minerals having founded Freeport McMoran which is perhaps best known for mining gold and copper at the Grasberg Mine in Indonesia.

The extraordinary depths at which MMR is drilling in the GOM require the development of new technologies to handle the high heat and pressure. There are some interesting and presumably well-informed shareholders, including Plains Exploration (PXP) who owns 23% of MMR’s shares and is restricted from selling until year-end. PXP’s CEO Jim Flores recently stated on a conference call that, “I think you’re going to hear some exciting things out of McMoRan in the next 3 to 6 months, about plans for 2012 that are mind-blowing.”

Admittedly that doesn’t look like detailed financial analysis. Short of having the technical knowledge and information access to independently evaluate MMR’s findings so far, it’s a story stock and not a solid investment. But the different moving parts add up to something interesting, and we have a modest position because we think MMR provides sufficient potential upside for the risk of failure.

Disclosure: author is Long CDE and MMR

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