Volatility Sources

The mainstream finance industry equates price volatility with risk and believes the market to be efficient. That is, prices of stocks are fairly priced, and therefore the only way to generate higher returns is by taking more risk (i.e. buying stocks with higher volatilities).

Value investors, of course, not only reject the fact that the market is efficient (for a terrific essay on the subject by Warren Buffett, see here), but also find flaw with the definition of risk. To value investors, risk represents the potential that the underlying business is or becomes worth less than anticipated, and this is often times completely unrelated to a stock price's volatility. Value investors believe volatility could be caused by the market's general level of fear, supply/demand characteristics of various securities at particular points in time, and other psychological factors unrelated to the underlying business.

A study by Richard Roll has attempted to quantify the various components that comprise a given stock's volatility. His findings are depicted in the chart below:

According to Roll, company specific risks play only a very small role in a stock's volatility. If this information is accepted, it seems ludicrous to believe a stock's volatility - rather than the fundamental business/financial risk of the underlying company itself - is what governs an investment's risk level. Investor confidence, interest rates, and the stage of the business cycle all play far larger roles when it comes to volatility!

Value investors who take advantage of volatility, rather than fear it by equating it with risk, position themselves for market beating returns!

The Value Of The Right Incentives

Value investors have no problem investing in a company in which the manager controls a substantial stake - as long he also owns a substantial stake. If his own capital is committed, a manager is likely to make decisions which are in the best interests of other shareholders. On the other hand, if that manager is making decisions without consequence to his personal financial position, the incentives are not properly aligned: he's just playing with other people's money, like a mutual fund manager.

This is one of the few areas where value investors and the mainstream finance industry are in agreement. But how much is the removal of a "control-without-ownership" structure worth? By looking at a recent example, we can come up with an estimate.

Magna (MGA) is a global auto parts supplier we have previously discussed. Last week, the company announced a proposed deal between Frank Stronach (founder and controller) and the remaining shareholders, which Stronach has agreed to and on which shareholders will vote. Currently, Stronach only owns about 1% of the company's shares, but controls 66% of the shareholder votes!

So what would Stronach receive in return for relinquishing control? Not less than $300 million in cash, and 9 million regular shares, which is more than 10 times the number of shares he owns now! This package is worth almost $900 million, and that's not the end of it.

In addition, Magna will contribute $220 million for a 73% stake in a venture Stronach will...control! In other words, the control-without-ownership is being purchased from Stronach in part by giving him another business (in the growing field of hybrid and electric vehicle technology) where he has control without ownership!

The value of control without ownership should not be underestimated. As seen in this example, control of a company without the accompanying capital commitment is worth a substantial amount! Furthermore, the terms described above do not appear to be an overpayment, as Magna's stock price reacted very positively to the news in an otherwise down market.

As an example of the type of shenanigans that can take place in such control-without-ownership situations, Stronach has instituted consulting contracts with companies to which he is affiliated whereby Magna pays out 3% of its pre-tax profits to these firms every year! To remove Stronach's right to execute such contracts, shareholders now have to pay dearly.

Disclosure: None

New Era Value Investing: Chapter 5

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

While RDY and RSPR (described in the previous two chapters) are great for identifying potential value stocks, the purchase decision must not be made until a company's fundamental factors have been looked at. After all, if the fundamentals are poor, a company could continue to appear cheap on a dividend or sales basis for many years to come.

Tengler discusses twelve fundamental factors she looks at for stocks that pass the RDY and RSPR screens. If a stock passes 2 of the 3 qualitative factors, and 5 of the 9 quantitative factors, it passes the test:

1) Are the company's products/services becoming obsolete? As an example, Tengler identifies JC Penny in 1998 as a company occupying a position in the retail market that no longer served a purpose.

2) Does the company have a franchise value? Nike and Gillette are cited as examples of companies with brands that help the company succeed. Other questions investors should ask to help answer this question include whether the company is growing market share profitably, and whether it can leverage its franchise to enter new markets successfully.

3) How good are management and the directors? Management should be accountable, should have low turnover, and should have their compensation tied to shareholder interests. Most directors should be independent.

4) Does the company consistently grow its sales? Sales growth serves as economic proof of the acceptance of the company's products.

5) What are the company's margins? Tengler advises looking at trends in operating margins over time and versus competitors.

6) What are the P/E ratios? Tengler looks at forward, trailing, normalized, peak and trough P/E ratios against those of competitors.

7) What is the company's free cash flow? Cash flow trends should be compared to those of earnings to establish the relationship there. Also, working capital turnover (using cash flow) should be examined relative to competitors.

8) What is the dividend situation? The payout ratio should be sustainable and in-line with the industry.

9) What is the asset turnover? Trends in this number should be examined to see if the company is paying too much for incremental sales growth.

10) What is the company's ROIC? Investors must determine if management is making good investments. Comparing the company's ROIC to its cost of capital should help in this regard.

11) Is the company over-leveraged? A company may be growing earnings only because it is utilizing leverage to grow its assets.

12) What is the company's financial risk? Off-balance sheet debt should be brought into the equation, and coverage ratios should be examined (e.g. EBIT/Interest).

New Era Value Investing: Chapter 4

As the chief investment officer at Fremont Investment Advisors, Nancy Tengler employed the value approach she describes in her book, New Era Value Investing.

Though Tengler claims the method described in Chapter 3 works, it is heavily reliant on the dividend. But as the market has evolved, the magnitude of the dividend as well as the number of companies paying a dividend has declined. As productivity has increased, companies have found more profitable areas in which to invest their earnings, and as competition has increased in what were previously slow-growth industries (e.g. telecom), investment in future technologies has become a key success factor. As such, to expand the investment universe, Tengler developed a valuation method that would not be dependent on the dividend.

The obvious and most commonly used factor associated with a stock is earnings. However, Tengler avoids using earnings due to the fact that it is subject to judgement (by management, in its determination) and because it can fluctuate tremendously (particularly for cyclical companies). Therefore, the factor Tengler prefers to use in her value approach is sales. Sales cannot be manipulated, and are also subject to far less fluctuation than are earnings.

The valuation method Tengler uses is therefore Relative Price to Sales Ratio (RPSR). A company's price to sales ratio compared to the market's price to sales ratio is computed on a historical basis. When the company trades at a low price to sales ratio as compared to the market's price to sales ratio on a historical basis, it becomes a buy candidate.

Tengler recognizes that these "relative" value approaches differ from the original Graham and Dodd "absolute" approaches. But she has found using relative valuation approaches more useful, as they can be employed during any market environment. In this way, she argues that the spirit of value investing can be employed to a much larger universe of stocks.

"Fore"midable and Low-Risk Returns

Just nine months ago, we discussed Adams Golf (ADGF) as a potential value investment due to the severe discount at which the company was trading relative to its net current assets. Since that time, the stock has rallied over 40%. But more impressive than the return (after all, the general market has rallied over this period) is the low risk at which this return was achieved, due to the use of the all-important margin of safety.

What is important to realize is that this 40% jump in the stock price did not arise because the company had some positive surprise. To the contrary, the company has continued to rack up quarterly losses, and even settled a litigation dispute pretty close to the worst-case payment it would have had to make had it lost in court (though it likely did save on attorneys fees by settling).

The reason for the large rise in the stock's price is due to the fact that the market was totally mis-pricing the stock to begin with. Nine months ago, you could buy this company for $19 million even though it had cash of $3 million, $23 million owed to it by its customers and another $23 million of non-perishable inventory (golf clubs etc.) against just $14 million of liabilities.

In the last few months, the company has had to sell some of that inventory at a loss, and has agreed to pay $5 million to settle a lawsuit. As such, its net current assets reduced from about $35 million to $29 million. Despite this, the stock price has risen dramatically, as the company's market cap has recently spent some time trading just under $30 million. The massive margin of safety on this stock 9 months ago has allowed the investor to profit despite the absence of any company specific positive news!

Now that the stock trades for its net current asset value, ADGF becomes the latest stock to move from the Stock Ideas page to the Value In Action page. But the lack of discount to its net current assets doesn't mean all value investors who own it should sell it, however. An opportunity may remain for those who know the company well, including its products and its position relative to competitors. In other words, it may still be cheap relative to its intrinsic value. But at this price point, the value investor should ensure that the company is firmly within his circle of competence to avoid undue risk to his principal.

Disclosure: None

Management Trolls

Investors who conduct stock research online (e.g. readers of this site, or those who use www.sec.gov to access annual reports, as opposed to waiting for their snail mail copies) have likely spent at least some time in a stock message board. Unfortunately, there is a lot of misplaced advertising, spamming, falsities, and trolling that takes place on these boards that renders them virtually useless for the serious long-term investor. As such, it would seem highly unlikely that senior management would see it fit to spend any time perusing such non-valuable, non-credible arenas.

But that assumption would be wrong. The following exchange illustrates Blonder Tongue (BDR) COO Robert Palle's response to questions about management on the Yahoo! Message Board for BDR:

ajofny says: Where is this company going? The Chairman and CEO is 79, the COO is 63. What is its strategy?

newkram says: There is no strategy. management (such as it is) is just treading water till they retire or pass on ( whichever comes first). This is a company that should never have been allowed to go public. It is essentially a privately-held/family-owned company masquerading as a public company.

gands2 says: The family owned/family run image was reinforced when Palle, the co's president and largest shareholder, wasn't on the last CC, with Ms Nikoo the chairman's daughter as substitute. Nepotism an investor's red flag imo.

bobpalle22 says: At BT we are in the process of grooming the next generation of management. The last CC was reasonably benign as the numbers were in line with expectations. I chose to allow Ms Nikoo to represent me on this particular call. I think she performed wonderfully. Did you have any questions she could not answer? re my ownership....Come on girls, I am a buyer, and still a buyer, but the SEC window must be open to buy. Bob Palle

The other conversers are listed as male, leaving a question as to why Palle is referring to them as "girls".

How do we know this is actually Palle, and not some faker? The company issued a release to basically cancel his statement: "...[P]lease disregard Mr. Palle's message posted this morning and review the Company's press releases and SEC filings."

So here we have a company whose CEO recently underwent personal bankruptcy, and whose COO is going around responding to message board trolls. Meanwhile, just one day earlier, the company announced a new $4.1 million contract (last quarter's revenue: $7 million) for one of its brand new products. What to make of this company?

Disclosure: Author has a long position in shares of BDR

Transocean Oversold?

Value investors often look for opportunities where temporary circumstances have caused the market to unjustifiably depress prices. One such value-minded investor, Frank Voisin, may have uncovered such an opportunity. The following is a guest post where Frank makes his case for Transocean Ltd, a company whose stock has been punished as the massive oil leak on the Gulf of Mexico continues.

Transocean Ltd (RIG) is an international provider of offshore contract drilling services for oil and gas. Transocean is the largest such operator, with 138 mobile offshore drilling units, including 44 high-specification floaters which command the highest day-rates for use in the deepest, harshest drilling environments, 26 mid-water, 65 jack-ups, and 3 others.

On April 20, 2010, a Transocean rig leased to BP plc (BP), the Deepwater Horizon, suffered an explosion and sank two days later. The Deepwater Horizon was in the final stages of casing a well (adding a cement reinforcement liner to the well) when the explosion took place. The well was approximately 1 mile beneath the ocean surface, and extended approximately 5 miles underground. The explosion appears to have been the result of the cement casing not being fully cured, resulting in the release of a massive amount of pressure from the oil reservoir up through the well. Explosions of this sort are supposed to be prevented by a Blow-Out Preventer, a massive device (16m wide) with up to 12 different fail-safe mechanisms that can be manually activated to close over the well to prevent leaks and withstand the pressure. In this case, the Blow-Out Preventer was designed and built by Cameron International Corp (CAM).

The market appears to be expecting losses from this disaster to exceed a present value of $30 billion. This is based on the fact that BP, Transocean and Cameron have suffered market cap reductions of $25 billion, $5 billion and $1 billion respectively.

To put this in perspective, the Exxon Valdez disaster in Prince William Sound, Alaska, which, in 1989 resulted in 250,000 barrels being spilled, led to a jury award (in Baker v. Exxon) of $287 million actual damages + $5 billion punitive damages. The Deepwater Horizon disaster would have to continue, at a rate of 5,000 barrels per day (the current official estimate), for nearly two months to yield the same oil spillage as the Exxon Valdez, and the market would still be pricing a loss equal to 6x the Exxon Valdez.

It is important to note that the original $5,287m loss expected for the Exxon Valdez disaster was subsequently reduced to approximately $500m, and this was paid out 19 years later after substantial litigation, when the Supreme Court of the United States ultimately limited punitive damages to a 1:1 ratio with compensatory damages. At a 10% discount rate, this translates to a 1989 Present Value of less approximately $81m.

Based on the quantum of damages ultimately awarded in Exxon Valdez, and the relative size of the Exxon Valdez disaster to the Deepwater Horizon, we would expect the present value of future losses to be substantially smaller. However, the fact that the Deepwater Horizon disaster took place in a more heavily populated area of greater economic significance could support an argument that future losses will be substantially higher. For the sake of conservatism, we can assume the losses are substantially higher – closer to the amount the market is currently pricing ($30b) and now turn to loss apportionment to determine who would be responsible for these losses.

There are at least three categories of expenses associated with the disaster:

1) Personal Injury/Deaths
2) Loss of the Deepwater Horizon
3) Environmental remediation
4) Loss of revenue

My investigation has led me to conclude that Transocean will be responsible for the first two categories, and that BP will be responsible for the third category.

Transocean is fully insured for the loss of the Deepwater Horizon. The rig has an estimated replacement cost of $700m. Transocean’s 2009 Annual Report shows that it has a deductible of up to $1.5m on the loss of any rigs, and that is has a $10m-per-occurrence deductible on crew personal injury liability and $5m-per-occurrence on other third-party non-crew claims. These deductibles are for a $950m third-party liability coverage exclusive of the personal injury liability. Transocean is reputed to also have $700m in environmental remediation insurance. Thus, Transocean is fully insured for the first two categories, and partially insured for the third.

Given that Transocean is fully insured for the first two categories, the market appears to be pricing in a loss of approximately $5b above the $700m environmental remediation insurance cap. Will Transocean be responsible for environmental remediation? The answer appears quite clearly to be no, and that BP will be responsible for environmental remediation both due to common law, statutory law, and contract law.

Common Law

Under Maritime Common Law, there is an Anchored Tanker precedent, which states that the owner of an anchored tanker is liable for any damage resulting from it, even if that tanker is hit by another ship that was behaving in a reckless or negligent manner. BP, as the lessee of the Deepwater Horizon, is the owner of the anchored tanker, in this case.

Statutory Law

After Exxon Valdez, the US government passed the Oil Pollution Act, which clearly shows liability for the environmental damage to be BP’s responsibility.

Section 1002(a) of the Oil Pollution Act states that the “responsible party” for a facility from which oil is discharged is liable for removal costs and other specified damages.

Section 2701(32)(c) of the Oil Pollution Act states that the “responsible party” means, in the context of offshore facilities, the lessee of the area in which the facility is located, or the holder of a right to use and easement granted under the Outer Continental Shelf Lands Act.

Thus, BP, as the lessee of the facility, is the responsible party, and as such is liable for removal costs under statutory law.

Contract Law

With respect to contract law, various reports online state that a typical drilling contract used in the offshore drilling industry specifies that the lessor (Transocean) is not liable for blowouts. All liability in such situations is the responsibility of the lessee (BP), and that the lessee (BP) will indemnify the lessor (Transocean) even if they are shown to be reckless, negligent, or had behaved with gross misconduct. There has been no evidence presented to suggest that BP and Transocean did not use a standard contract. Given BP’s initial attempts at deflecting blame, it would seem that such an obvious opportunity to point blame at Transocean would have been utilized if available. Given that it was not utilized, I conclude that it is unlikely the contractual relationship between the parties contains anything out of the ordinary.

What The Involved Parties Are Saying

On April 29th, during a previously scheduled analyst call to discuss 2010 Q1 earnings, BP’s CFO, Byron Grote said the following:

"As far as the Gulf of Mexico goes, you asked about contracts, I believe are a kind of code word for here for where does liability lie. … [I]n general, Transocean was responsible for the operation of the rig vessel and its equipment including the blow-out preventer and for drilling the well. In general, the lease owner that’s BP and our partners in the field, are responsible for the cause of regaining control over the well and handling the related environmental cost."

On May 3rd, BP’s CEO, Tony Hayward told Good Morning America his company is “absolutely responsible” for the cleanup.

Transocean does not have insurance for loss of revenue associated with a lost rig. In September 2009, BP extended its lease of the Deepwater Horizon for an additional three years, for $544 million, which equates to approximately $181m per year. This is approximately 1.66% of Transocean’s 2009 revenue. Assuming for simplicity that this represents a similar portion of earnings, this translates to a decrease in earnings of approximately $53m. Using a 9x P/E multiple (the approximate multiple being used prior to the explosion), this should have wiped $477m off of Transocean’s market cap.

Instead, the market priced in 10x this amount. This appears to be an overreaction. This would be the maximum rational drop in market cap, however this figure is mitigated by two items:

1) One of the potential solutions to the continuing leak is to drill new wells into the old well, deep below the ocean floor, and inject cement into the original well. This process could take several months, and BP has begun drilling already. Media reports state that BP has hired Transocean rigs to drill these new wells, which would indicate that Transocean’s loss of revenue will be mitigated to some extent.

2) Since the Deepwater Horizon disaster, the price of oil increased from $84/barrel to $88/barrel. If this is due to the disaster itself, then this would be a persistent increase. Persistent increases in the price of oil have translated to higher dayrates, especially amongst higher specification rigs. Transocean has some of the most sophisticated rigs in the world, and may ultimately be able to charge higher dayrates on its other rigs, which would mitigate the loss of revenue from this one rig.

Conclusion

It appears that all of the parties involved, as well as numerous analysts and commentators, are confirming what the law states: BP will be responsible for environmental remediation, which will constitute the vast majority of expenses relating to this disaster. For those expenses which Transocean is responsible for, Transocean is adequately insured. With regard to the loss of revenues, the ultimate loss, regardless of how liberal they are expected to be, seems to be dwarfed by the amount the market is pricing into Transocean’s current market cap. There appears to be little by way of justification for such a decrease.

The market is being overly pessimistic with Transocean. I expect shares to return to their previous 9x multiple in the near future.

Disclosure: Guest author has a long position in shares of RIG

Sources:
http://www.businessinsurance.com/article/20100423/NEWS/100429963
http://online.barrons.com/article/SB127267764941385119.html
http://blog.iongeo.com/?p=1961 reporting on an expert panel organized by Morgan Stanley’s Oil Field Services analyst, Ole Sorer.
http://www.businessweek.com/news/2010-04-21/transocean-says-blowout-may-have-caused-rig-fire-update1-.html