Our Kind Of Market—Cheap Small-Caps
-Excerpts From A Recent Investment Newsletter
Small and mid-cap stocks should not be confused with lower quality stocks no matter their price
or capitalization. Witness all the so-called “blue chip” large-cap stocks that have been
decimated, including Lehman Brothers, Bear Stearns, Merrill Lynch, AIG, General Motors, GE,
Nortel. We appreciate, more than most, after an ugly year-and-a-half, that small-caps inhibit
our ability to trade.
But we believe we have come through a rare period of panic and that we
should not abandon the philosophy that worked so well for so long—trading off liquidity for
ultra-value—for lower risk and much higher return. So we continue our commitment to the
high quality small-caps we hold, including Corridor, Orca, St Andrew, Sterling and Petrolifera,
together representing about half of most growth accounts.
Our 3-year targets for just these five
companies suggest returns above 40% annualized which should justify any wait.
Though Corridor Resources has appreciated 150% from its March low, it still represents
extreme value.
It remains 72% below its '08 high mostly because smaller-cap Canadian
resource stocks are still, on average, 60% off their highs and the price of natural gas is also way
below its high. Based on current cash flow prospects and the value of its existing Hiram Brook
proven and probable reserves, Corridor is undervalued.
The stock should continue to rise from the recovery in natural gas prices and the continued drilling of Hiram Brook wells which should add to production, cash flow and reserves.
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In early September the company announced improved flow rates from its first two wells
fractured with a new propane technique. Both wells were boomers. And while it’s unclear as to
whether the initial high flow rates (about 4 times that previously experienced) were attributable
to the new propane methodology or simply better geology, the results have the ability to make
the company’s economics even better.
At the old flow rates, and assuming $6 gas (where the
forward curve is now), the company’s IRR on each new well drilled was an already respectable
19% per annum. The new flow rates push this substantially higher—and though thus far it’s
only been two wells with the enhanced flow rates, it could be a complete game changer.
In July, independent consultants estimated Corridor’s shale gas potential in the lower Frederick
Brook formation at a whopping net 59.1 TCF of gas-in-place.
This naturally fractured, very thick shale resource could be one of the best in North America and is being looked at by larger players as potential joint venture partners who could bring capital and expertise to develop it.
With the enhanced flow rates from the Hiram Brook and recent higher gas prices, Corridor is
likely closing in on its ability to develop the Frederick Brook.
The company also has a potential valuable Salt Springs gas storage facility, a 2 billion barrel
potential oil prospect in the Laurentian Gulf (“Old Harry”), and its Anticosti Island prospect.
Old Harry alone, which could start drilling in a couple of years (after regulatory approval), also
likely with a partner, could add significantly to the company’s value. All worth the wait.
Orca Exploration has also recovered from its 52-week low, up over 80%, but it still trades at
less than one-third of its growing $11 net asset value.
The company’s earnings should begin to
ramp up over the next few quarters. In the meantime, Orca trades at only 4x 2010 estimated
earnings. The company may seek opportunities to grow through acquisitions, but ultimately we
expect its Tanzanian assets to be sold, much in the same way as its Chairman, David Lyons,
maximized value for the shareholders of Pan-Ocean Energy. We’ll wait patiently for this
reward. Former colleague, money manager John Clark, once said, “A value investor can often
wait 5 years, only to make his money in an hour.”
Sterling Resources landed a farm-in partner for its Breagh field in late July selling one-third of
its working interest in the Breagh field and surrounding interests for CDN$103 million. The net
asset value thereby increased and is nearly double Sterling’s current share price. Sterling
remains undervalued, with significant exploration potential that could drive its underlying value
even higher.
We are awaiting an imminent production announcement from St Andrew Goldfields. The
company won its royalty dispute over its Holt property and, though it was appealed, the
company will likely produce from Holt in 2011. Meanwhile, initial ounces will come from the
Holloway mine and its Hislop open pit. We expect at least 85,000 oz in 2010 providing the
company substantial free cash flow.
Once Holt is added the company should produce
110,000 oz in 2011. With a cost of about US$500 per oz and tax pools over $160 million, its
free cash flow should justify a substantially higher share price. Exploration success and higher
gold prices could be an added bonus.
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We’ve waited a long time for the payoff from St Andrew and now everything seems to be
falling into place. Worth its wait in gold.
Petrolifera Petroleum raised $50 million in August to reduce a good portion of its debt and
allow its capital spending program to continue. We participated in the issue at $.88 for a share
and a half warrant too. The La Pinta-1 exploration well in Colombia, the producing Argentinian
assets and the prospective Colombian and vast Peruvian properties justify a value over $3 per
share.
After selling about two-thirds of our Ruby Tuesday position following the stock’s nearly
800% climb from its March 9th low, the stock subsequently sold off and we began adding to the
position again when our SVA™ work gave the buy signal. The shares trade at a very attractive
20% free-cash-flow yield.
The company raised $65 million in July to repay debt and recently
announced earnings ahead of expectations. Restaurant traffic growth is now positive and
customer satisfaction is scoring very well.
At 8x free cash flow, Ruby’s fair value is about
$11 today, and should rise to $18 in three years compared to its current $6.88 share price (a
prospective 38% per year return). We continue to believe the shares are very undervalued and
have been adding to the position on the most recent pullback.
Our Kind Of Market—Cheap Big-Caps
Interestingly, because stocks got so low in the Panic, lowest quality stocks outperformed
2-to-1 year to date. In this process, many high quality U.S. blue chips, including safe-
dependable stocks, have become abnormally cheap relative to their fair market values and the
overall market, trading at levels not seen for many years. And we have begun buying them
because we really know their natural growth will continue, they will ultimately be reappraised
higher, and though based on our 2-year targets they offer relatively lower prospective
annualized returns of about 25% compared to our small-caps, overall returns could be higher if
targets are reached sooner. In addition, we may be able to enhance returns by trading them
using our SVA™ work. This cohort includes Aetna, Clorox, CVS Caremark, and Kroger.
And we currently monitor a universe of other undervalued big-caps to add whenever they reach their “floors”—buy points in our work. For clients who have contributed new funds we have also
added Johnson & Johnson, Burger King, Berkshire Hathaway, Becton Dickinson and
Wal-Mart—all with prospective annualized 2-year returns above 20%.
Uncertainty presents opportunities for those willing to turn over enough rocks to be able to
distinguish between short-term uncertainties and long-term risks. Unemployment and deflation
uncertainty, anathema to grocers, is a short-term phenomenon that we have recently sought to
exploit.
This uncertainty has driven sentiment towards U.S. grocers to near cycle lows as
evident by the group’s trough multiples and near 52-week low share prices. We recently
initiated a position in Kroger, undoubtedly the best run U.S. grocer thanks to its organic growth
history, which has created a store culture unmatched in food retailing.
Given its diversified store base, both geographically and demographically, Kroger is able to effectively compete against Wal-Mart. The higher food costs and lower unemployment we perceive in the coming years will provide considerable tailwinds for Kroger’s earnings and improve investor sentiment.
At today’s valuation we can afford to wait. We forecast $2.50 per share of annual earnings in
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2 years even if there is minimal inflation and little improvement in employment. At
14x earnings, Kroger’s fair value is roughly $32 today and expected to be $37 in two years for a
potential 27% annualized rate of return including the dividend.
We also recently bought Clorox—the U.S. consumer products supplier of name brands such as
Clorox, Ajax, Liquid-Plumr, ArmorAll, Pine-Sol and Glad for 13x earnings, though it almost
always trades right around our fair market value, now about $78 or 18x earnings, and growing
by at least 9% per year. And we collect a 3.4% dividend while we wait. So, at a minimum, we
should get the growth rate of 9% plus the dividend yield of 3.4% for an aggregate 12.4% per
year. Should the stock revert back up to fair market value in short order, as it should do from
this very unusual occasion where the share price has detached so far from reality, then we will
enjoy a considerable capital gain.
Our 2-year expected rate of return is 31% per year.
We still hold a position in Aetna, which in our view is the best run national health insurer with
the best plan designs and top underwriting standards. Yet even though Aetna still meets our
required rate of return, trading well below our fair market value appraisal (trading at 8x 2010
free cash flow versus our 14x fair value assessment), we recently sold one-third of our position
as our SVA™ work gave us a sell signal indicating at least temporary potential weakness in the
stock.
But the undervaluation is extreme and provides a margin of safety offsetting
uncertainties regarding healthcare insurer profit margins from President Obama’s healthcare
reform. We are encouraged that the U.S. government may not include a “public-plan option” as
part of its proposed healthcare reform. That increases our confidence in our fair market value
assessment of Aetna which we still expect to garner at least 8% operating margins (versus
11% 2004-2007) or $4-$5 of annual earnings per share. Aetna’s fair value is in the mid-$50s
today and we expect it to grow to the mid-$60s in three years versus its current $26.65 share
price. A 37% annualized return.
Merely by waiting. We are anxiously awaiting the
opportunity to buy back the shares we sold when the SVA™ work provides a buy signal. We
continue to be attracted to the U.S. healthcare space and also hold a sizable CVS Caremark
position. In the case of CVS we recently added to our position on a pullback to an SVA™ buy
point. CVS also offers a potential 2-year annualized 28% rate of return.
We recently divested our entire McKesson position (other than in the Trapeze Value Trust
where we sold call options against our position, earning options premium which effectively
reduces our cost—a conservative strategy we’d like to employ more widely for clients) because,
after the stock’s recent appreciation, upside relative to our fair market value no longer met our
hurdle compared to other opportunities.
A “Short” Wait
We have one short-sale position, recently initiated—overvalued mobile handset manufacturer,
Palm. Unlike our Kroger and Clorox investments, we are shorting a highly uncertain and
extremely high risk business that is exceedingly expensive. For those that haven’t seen the Bell
or Sprint advertisements, the perennial second-tier Palm recently rolled out a new mobile
handset called the Pre. Sell-side analysts and industry commentators have championed the new
device propelling Palm’s shares over 500% (to $18.09) since the beginning of the year.
We are not wagering that the Pre is a flawed device, rather that the odds of success are stacked against 8 Palm and, even if wildly successful, the company was more than fairly priced. Competition is fierce from incumbents such as Research in Motion (Blackberry) and Apple (iPhone). Plus new entrants fueled by Google’s mobile platform as well as others with proven vendor relationships (Nokia and Motorola) have pre-Christmas launches pending. Increased competition should limit handset shipments and lower Pre’s already reduced selling price. Sprint recently lowered the Pre’s price by 25% only 4 months after its launch while Palm lowered sales volume guidance for its upcoming quarter.
Perversely, the stock remained within 10% of its 52-week
high when we shorted it and sentiment was hugely bullish. Our short-term target for the stock is
$11.
We will continue to seek out other overvalued short-sale opportunities, particularly as the
market rises to fair value.
Glad We Waited
Etruscan Resources and Firstgold were the last two of our holdings where we were concerned
about the company finances and, thankfully, both found financing opportunities. Etruscan
raised $43 million from Endeavour Financial (a resource based merchant banker) leaving
Endeavour with a 54% stake in the company.
The deal allows Etruscan to pay down debt,
remove most of its costly hedges and breathing room for its operations at its Youga mine, now
finally running closer to its target capacity. Firstgold has had an offer from Northwest
Non-Ferrous International Investment Company, the subsidiary of a Chinese mining
conglomerate, to acquire 51% of its shares and all its debt obligations.
The transaction is
expected to close by mid-December, finally allowing a critical path to proceed for its Relief
Canyon mine in Nevada to start production early in 2010.
There were several other positive material changes for other smaller holdings recently. Malaga
completed a rights issue (in which we participated) providing the funds to double its production
from its current 250 t/d to 500 t/d by next spring, justifying a value 5 times its current share
price.
The resulting increased cash flow should allow the company to drill off its considerable
tungsten veins, likely driving the value even higher.
At the end of September, Cano Petroleum announced a merger with Resaca Exploitation. The
combined entity will have greater scale and the two companies are highly complimentary, both
being secondary and tertiary recovery operators with mature, long-life oil production.
We did sell some shares on the immediate and substantial increase after the announcement though we believe the true value is much higher and ought to be realized as the combined entity shows substantial growth over the next couple of years—the proven reserve value alone is 3 times the current share price. And higher oil prices should increase that value.
Canoro Resources had a senior management change with Robert Wynne, the former CFO of
Pan-Ocean, taking over as CEO of Canoro. We welcome a reenergizing of the company whose
share price still languishes at less than one-quarter of its reserve value.
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TG World Energy settled a lawsuit with its partner and can now move more freely ahead with its
drilling plans. In the meantime, the company still trades for less than the cash on its balance
sheet. Combining the cash per share with our conservative appraisal of TG’s business, we value
it at over 3 times the current share price.
Income Accounts—Paid While You Wait
Finding quality income investments with meaningful yields is becoming challenging as bonds—
which fluctuate in price too—at these historically low rates should probably generally be
avoided. The debt of high quality, well-known corporations is yielding annual returns of only
4%-6%. Which is why we are looking at lesser known companies.
We added the 10.5% Secured Notes of gold miner Jaguar Mining in the quarter just ended. We
purchased the debt at a roughly 10.3% yield to maturity, which was extremely attractive relative
to the company’s 14x interest coverage, 10x asset coverage and considerable equity market
value ($900 million) relative to the $85 million debt issue. It was the only debt of the company
and maintains a first claim on the company’s Brazilian assets. Subsequent to our purchase,
Jaguar announced a new 4.5% convertible debt issue of which some of the proceeds will be used
to retire our Notes in mid-November at $105 giving holders a premium over par.
We still think the royalty trust, Pizza Pizza Royalty Fund, and high dividend paying (12.5%)
Student Transportation of America are both solid holdings with double-digit current yields and
the potential for strong capital gains over the next 3 years as each trades well below fair market
value today (hence the high yields). And each provides recession proof necessaries—food and
school busing.
There are also some higher yielding, yet safe, U.S. corporate bonds which we’re now analyzing
given the ascent of the Canadian dollar which is removing much of the risk of exposing
ourselves to U.S. dollar based income assets—to date we have not wanted to offset any U.S.
bond gains with a depreciating U.S. dollar.
In the last few quarters we marked down to market the prices of a number of our income
positions. Most of our income positions are not publicly listed and as the prices of comparable
high-yielding income securities were falling, we marked our income securities down in price
too, to comparable yields. As well, the rough economy and very poor capital markets impaired
the assets of some of the businesses.
With material positive changes anticipated, we should be
able to mark positions back up as asset values rise or as positions approach maturity (most
mature over the next 2 years). The only security subject to further markdown in both the second
and third quarters was Richards Oil and Gas debentures.
Lately, there have been positive material changes for the businesses of most of the other income
holdings.
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Specialty Foods Group is enjoying very strong year-to-date earnings and has considerable cash
on hand relative to our debenture which is the only debt outstanding. St Andrew’s anticipated
production should bring in enough free cash flow to easily retire all our 12% debentures at
maturity in December 2010. As well, we believe the company is likely to beat its earnings
hurdle triggering an extra 10% bonus payment under the terms of the debenture. The warrants
held by the debentureholders, exercisable at $.44, are also now in the money. Avcorp Industries
just completed its financing which should fully fund its business and afford the breathing room
until the larger contracts kick in over the next couple of years. The First Metals and Blue Note
Mining reorganizations were completed and we received cash and freely tradeable shares (plus
new debentures in the case of First Metals).
The High River Gold takeover bid allowed
Severstal Resources, its majority shareholder, to boost its stake to 62%. We’re confident that
our small debt portion, due in 2011, will be paid off in full at maturity. Lanesborough REIT
continues to sell assets, the proceeds of which are freeing up capital to be used to repay our
debentures due next February.
Arctic Glacier Income Fund just settled a lawsuit with the U.S.
Justice Department for much less than the market expected which doubled the unit price.
We think our income portfolios, which have a current income yield of about 10% per year,
should also provide a few percent per year of capital gains over the next 2 years as most recover
to par at maturity, for a potential 15%-20% total annual return from our income holdings.
Waiting Calmly
Because of the inordinately low returns currently available on income securities, we think, as a
preferable alternative, accounts seeking lower risk investments could currently consider an
equity component of the defensive, safe-dependable U.S. stocks that are now unusual bargains.
We can now buy world-class companies such as Kroger, CVS Caremark and Clorox—all of
which have decent growth rates (the latter two at double digits) and reasonable dividend
yields—with a margin of safety as they trade below market multiples whereas each normally
trades at a premium. We think each of these, and others that are similar, should provide a 20%+
annual rate of return over the next 2 years—an unusual opportunity to get blue chip and growing companies at 75¢, or less, on the dollar, especially so since the overall market has now
recovered to about 90¢ on the dollar.
These safe-dependable businesses grow relentlessly as evidenced by their underlying fair market value growth throughout the current recession. Their share prices fell less and therefore
recovered less, thus far.
The icing on the cake are the tax implications. Bonds yielding 4%-6% leave an investor with a
paltry 2%-4% after-tax, versus profits on stocks which are subject to capital gains taxes rather
than income taxes, with nearly 80% of the gain as an after-tax return.
In other words, the after-tax return on, say, Clorox could be over 20% per year over the next 2 or 3 years, well above the meager after-tax return that can be earned safely on bonds.
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The Virtue Of Patience
Successful stock investing requires patience. Value investors trade off risk for patience. The
biblical figure, Job, could have been a value investor. In the past we’ve held individual stocks
that provided little return for lengthy periods, even as the business prospered, only to make a
large gain from some market event—the company being “discovered” or taken over. Patience is
especially required in the case of lesser known names, such as Orca for example, a very low risk
investment which trades “by appointment”, but which we believe could be a triple just to reach
its current fair value, not even accounting for future growth.
It has long life reserves, increasing
production profile, no debt and is cheap on every metric including expected cash flow and
earnings and net present value. All one needs to do is wait.
Hopefully for a more attenuated
period given the recent market recovery and our belief in its continuation.
Herb says he feels most comfortable feeling lonely and holding what’s unpopular. And having
to wait for recognition.
Therefore, natural gas. St Andrew. Republicans. Narrow neckties.
His Nobel Peace Prize.
The famous speculator of the 1920s, Jesse P. Livermore said, “…
I’ve found that the big money was never made in the buying or selling, the big money was made in the waiting.”
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