PHIL TOWN

BP - AN EXAMPLE OF A RULE ONE COMPANY FOR ME

One of my blog readers, Montie, commented that he'd like an example of what I've invested in and why.  I don't talk about anything that I'm still buying but I'll show you guys one I bought last year and go through the why of it in detail. 

In June 2010 BP's stock had fallen from $60 to $27 because of the gulf oil well disaster and there was no end in sight.  In fact, there was great fear that the business would go bankrupt. Here's my analysis of BP at that time broken down into the 4Ms - the categories of analysis for RuleOneInvesting - Meaning, Moat, Management, Margin of Safety and updated for what's happened since.

MEANING:  

BP is in a critical industry - energy production - and is one of a handful of super-nationals, companies that work all over the world.  The industry that BP competes in includes oil, gas, wind, solar and ethanol.  They are one of the leading companies in all of these sub-industries but their major focus is in finding oil in hard to get places like deep water, frozen tundra and inaccessible wilderness.  Oil, in my opinion, will continue to be a critical energy resources for the foreseeable future, 20 years out, at least and more like 40.  Driven primarily by automobile use, oil demand will increase as the third world, China and India in particular, begins to demand the same standard of living, including autos, as the first world.  Factoring automobile demand for 3 billion more people with a rising standard of living, means demand will increase.  However, supply may not.  Oil is getting harder to find and the quality is getting worse.  The result of increased demand and lowered and more expensive supply is that price will go up. In addition, the first world has run up debts that it will pay off by monetization - printing money- with resulting inflation similar to what we saw from 1970-1985.  In that time period, the price of gas, responding to both inflation and (artificially) reduced supply skyrocketed from $0.34 to $1.34 - 2 doubles in 15 years, about 10% per year compounded annual price increase.  The equivalent result in the next 15 years would move the price of gas from, say, $3 today to $12.  This is an industry that has a huge triple tailwind behind it - rising inflation, rising demand and declining supply.  The beneficiaries will be those companies like BP which have the oil.  That's the essence of what investing in this industry is all about.

MOAT:

A moat is a durable competitive advantage. BP's moat is simple: They are one of about 5 companies in the world with the know-how and resources to find oil in the places in the world where it hasn't been found yet and as a result they have a huge storehouse of yet untapped oil in the ground that they control.  In addition, what it takes today to find big amounts of oil is the credibility to form international alliances with foreign governments, the financial strength to invest hundreds of millions of dollars to drill the well (off-shore rigs cost upwards of $500,000 per day to rent) and the specialized know-how to do it successfully.  Each of these contributes to BP's brand, toll bridge and secrets moats.  Brand is particularly important.  If I had $100 billion to compete with BP its not likely I could do it, at least not for many years.  Foreign governments are not going to take a chance on a new guy, not when the downside is a Macondo well sized problem.  BP has been there and done that and has the t-shirt to prove it and, ironically, as a result, is one of the few companies of choice for many national governments including India and Russia.  

Their Moat numbers have to be adjusted for the Macondo well disaster.  Assuming a similar ratio between sales and earnings as in 2009, here are the adjusted long-term numbers:

10 year earnings growth: 7%

10 year BVPS plus dividends growth: 11%

10 year sales growth: 9%

10 year operating cash growth: 9.5%

These numbers are right at the edge of Rule One requirements of 10% across the board but I'm persuaded by the key number - Book Value Per Share growth of 11% - to like this company. The tailwind for BP exists in the expected long-term commodity price rise of gasoline of 10% per year.  That means BP could grow its business at that rate without doing anything new at all except to keep producing oil it has rights to in the ground at the current rate.  I'm going to use that number, 10% overall growth for the foreseeable future, based on its long term 11% BVPS growth rate and an optimistic expectation of oil price inflation at 10% per year on average for the next 10 years, to calculate its value.

MANAGEMENT:  

The CEO, Robert Dudley, and the team he is surrounded by are deeply experienced in the business, passionate about what they do, honest and owner-oriented.  And they may be the most born-again environmentalist management team in the business with an added passion for safety as a result of their recent gulf horror show.  All the key management numbers look quite good (adjusted for the Macondo well issues):

10 year ROE: 17%

10 year ROIC: 14%

Debt: < 2 years of Earnings

MARGIN OF SAFETY:

Price is where the rubber meets the road; I can get everything in this analysis wrong but if I somehow get the price right, I win in the long run.  And that's what really attracted me to this company. Based on Meaning, Moat, Management all being good, I could move on to try to find the value of the business. Here's what it looks like given a 10% expected growth rate and using 2009 earnings:

You can see that the 'retail value', 'intrinsic value', 'value' ... what I call 'Sticker Price' ... is at $68.  That's what this business should sell for in a good market to a willing buyer.  This is a bad market so I wouldn't expect an offer at that level but that's how we play the game of valuation at RuleOneInvesting: good market - Mr. Market all happy and optimistic - and a willing buyer. (By the way, in the recent negotiations with their Russian partner, TNK-BP, the TNK side offered $53 per share to buy out BP's interest and was turned down.  But that happened 10 months after I bought.).

The 50% discounted MOS is $34.  The price for BP's stock was $27.  That looked very good.

My second check on value is what I call the "Payback Time", the time it would take me to get all my money back from the earnings if I bought the whole company.  Anything under 8 years is usually an excellent deal.  In this case, if I bought BP for the MOS of $34, the Payback Time is less than 6 years. That means that in less than six years, I could theoretically own 100% of BP and have zero investment in it.  I'd be playing with house money.  You can hardly buy a good laundromat for less than a 6 year payback time much less a world renowned oil company.  With a sub-six year Payback time, $34 was a low price for BP.  And it was selling for $27, a Payback Time of less than 5 years.  That was very good.

And my final check on value is to consider the book value of the business, what its worth as a dead business, the liquidation value.  In this case, the liquidation value was $30 per share so I could buy it, liquidate it (theoretically) and make 10% ... and it looked to me like the assets were undervalued on the books.  I might be able to liquidate and double my money but in any case a price of $27 was excellent.

To sum up: I could buy a wonderful business for $27 with a liquidation value of $30 or more, a huge MOS below the intrinsic value and with a sub-5 year Payback Time.  

That's what I look for, a huge discount to the real value of the business. I felt that at $27 I was getting that.

Okay, but in this case wasn't I worried that the business would go broke over the Macondo well?  

No, I wasn't.  

The media is genetically incapable of downplaying a thunderstorm much less a true disaster.  It must declare the clouds on the horizon to be a killer storm approaching so it goes absolutely nuts when something real is happening. (Which is why reporters get cynical - they know they are writing a lot of sensationalist bs.)  

Here's how I saw it at the time: I regarded BP's potential downside as similar to the problem American Express had in the 70's.  Amex saw their book value go nearly to zero but all the while the basic business model was unaffected.  That's when Buffett bought it.  I saw a similar thing here.  If the cleanup and litigation of the Macondo well cost BP $50 billion, was that the end for BP?  I thought surely not.  Their basic business, drilling oil wells, was only marginally affected by that one well.  With half their equity gone, they could still continue to earn about $20 billion per year from what was left.  In addition, I thought the actual value of BP's assets that it might have to sell could be far greater than the value being carried on the books.  So even if they got stripped of much of their equity, the business still had 4Ms and still had value of $68 per share because that value was all in the future. That's what I was buying - the future earnings of the business at a major sale price.  

Sure, I could have been wrong but I had a great hole card: Unless BP was shown to be massively negligent, the law restricted the amount they'd have to pay to far less than what they were already talking about paying voluntarily and in no other spill in the world had any business been forced to pay what BP was already committing to.  I just didn't see how those facts could lead to bankruptcy.  And finally, it was in no one's best interest to bankrupt the company.  I was quite certain it wasn't going to happen.

You'll notice that I was buying BP when a lot of smart people were selling.  I was buying when there was a great deal of fear.  I was buying when the news was bad.  RuleOneInvesting is simple.  Buy Fear.  Sell Greed.  Ask Buffett, Lampert, Berkowitz, Einhorn, Greenblatt, Graham.  They all know that's how to do it.  

Is it hard to do RuleOneInvesting?  Not if you do your own work, stick to an area of the market you understand, insist on a great price, and have the conviction based on that rational work to buy when others are in a panic.

How did I know that $27 was the bottom?  I didn't.  In fact, I hoped the price would keep dropping so I could buy more at ever lower prices.  If you can't look at it that way, you can't do this kind of investing because no one knows that bottom price.  You have to want to get in at a great price and then buy more if the price keeps going lower.  That's the key.

Today, BP has done a great job of cleaning up the Gulf and being a good citizen.  It has a great year last year in spite of the disaster.  Its sitting on top of trillions of dollars of oil.  And its selling between $41 and $49.  And I think that some day the price will be in the high 60's where it belongs.

I hope that helps.

Now go play.

 

AT 27% GROWTH AMAZON MUST BECOME A $40 TRILLION COMPANY

One of my readers, Heber, wrote this about Amazon: "I was amazed to find a comment here that Amazon is overpriced. Amazons current EPS is $2.31 Their equity growed 27% last year, over three years at 74% and over five years at 91%. It is slowing down, but it is still way high. According to morningstar.com the analysts expect a 26.6% five year growth. I am using the 27% as an expected growth rate. The current PE is 80, so for the sticker price I am using 54, twice the expected growth. That gives me a sticker price of $336.56, or an MOS price of $168.28 Currently Amazon is selling at $186.13. That is very close to the MOS price and well below the sticker price. I am tempted to buy...."

First, I have to remember that blindly using the analyst's growth rate without looking more deeply can be a problem with our estimates of value.  Analysts are often quite optimistic about a company's future growth rate because it encourages those companies to work with the analyst's investment banking group.  If you're an analyst you don't want to be the only guy who says bad things.  Also they are only looking out 5 years.  I have to look much farther than that.  

Current earnings are $2.31 per share.  If I use Heber's (and the analysts numbers) Amazon must grow those earnings at 27% a year for ten years.  If that's right, the earnings in 2021 will be over $25 per share.  With a PE of 54, Heber is thinking he can sell for $1361 per share.  That will value the business at over $11 trillion.  

Remembering that the most valuable business in the world is priced at $400 billion today, isn't that asking a lot from Amazon?  But it gets even tougher for this poor company: That estimate of value demands Amazon double the market cap of its 2021 gigantic operation almost twice more to about $40 trillion by 2026.  

Amazon is a great company.  I think Heber has that part right.  It has great management, a huge moat, and its the gorilla in its industry.  But price is everything for an investor.  It does us no good at all to buy wonderful companies if we pay too much for them.  We might as well put our money into a mutual fund where the fund manager does that sort of investing every day.

Granted, Heber is wisely discounting by 50% but these huge future numbers make me think he doesn't have the value, the sticker price, right.  If he doesn't have the sticker right, his margin of safety price is an illusion of safety, not the real thing.  We really do want the real thing for an MOS.  There is so much that can go wrong that we have to try to put a real sticker price on the business, not a sticker that requires the company grow to become the largest business the world has ever seen.  (And I'm not saying Amazon can't do it - just that doing so would be unexpected).

Even assuming great growth for Amazon for the next 15 years, say 20% with a 40 PE, my tools say its too expensive.  According to the RuleOneTools, it has a sticker today of $141 and an MOS of $70 with an MOS Payback Time of 10 years (see below).  

That's bad news for Amazon investors who are looking for a deal.  Even if I pay $70, the time it would take me to get my money back from earnings is 10 years.  That's a long time.  Right at the edge of what's acceptable.  As much as I like the business, I can't pay Mr. Market's asking price of $186 and expect a great return for the next ten years.  Not unless I expect an even bigger fool to come along and buy it from me later.

If it helps, remember that any obviously great business is likely to be overpriced much of the time.  Be patient.  Rule #1 depends on it.  Wait for Mr. Market to freak out.  It happens regularly enough.  Buy when there is fear, not when everything is looking pretty good.

Now go play

HEADING DOWN SO WHAT AM I GOING TO DO?

I'm a valuation investor.  That's really what being Rule One investor means - investing in things when their prices are far below their values.  Give me a value I can verify and a price that's half of that and I'm a buyer in most any kind of market.  

I like to wait for an event to trigger a big emotional mistake by Mr. Market.  That is often how a price gets so far away from a value.  I'm waiting now as emotion builds in the US markets.  Good things were supposed to happen in the US economy.  Good things started to happen but now the good stuff is petering out; unemployment is sneaking back up, we're going to need QEIII by December, there is no possibility of a balanced budget between two totally opposite philosophies of government before the 2012 election and even then the stalemate could continue and meanwhile our debt grows by $40,000 per minute.  

In fact, check out this debt clock.  http://www.usdebtclock.org/index.html.  Look closely.  Watch what we owe to China go up at a $1000 a second.  Look at what our government spends ($6.8 trillion) versus what we make, ($14 trillion).  And look at what we owe when Social Security, Medicare, Medicaid and Prescriptions commitments are included in our debt - $54 trillion.  

If we balance the budget tomorrow.  We'd still owe $50,000 a year per family in interest payments on the existing debt.

How will we pay this debt off (assuming we've already balanced the budget)?  

There are three ways:

1.  Raise taxes and pray businesses and producers don't leave the country. The best way to do this is to eliminate the IRS and replace it with FairTax.

2.  Continue what our Federal Reserve calls 'quantitative easing'.  The rest of us call it 'printing money'.  Unfortunately, our creditors will not lend us more as the debt comes due so we'll face foreclosure (Greece is in this position now) or have to raise rates which will exacerbate the problem.

3.  Devalue our currency like Argentina.  This will happen suddenly as in Argentina.  You go to bed with a 401(k) worth $1,000,000 and wake up with it worth $100,000.  Our debt will also be 1/10th of what it was.  Again, more screams from creditors and no more lending to the US.  We will have wiped out our debt and be forced into a balance budget.  And we'll be faced with massive unemployment and probably a world-wide depression followed by war between China and India.

Of these, only #1 gets us through the night and its not likely to happen.  

Which is why optimism is disappearing, everyone is starting to smell smoke and the Big Guys are slipping out of the theater.

So what to do?  Get ready to buy when the fear is highest.  Cash ain't great but I'm only in it temporarily while expecting to see some great companies on sale.

But aren't our problems too horrible to invest in?  No.  Not if you buy really good companies - businesses with big moats, great management and on sale at a great price.  Standard Oil in 1932 was a really good deal.  So were railroads.  Big Phama.  And many more.  Know the value.  Buy at half off.  Sit tight.  Even with a depression and a world war if you bought Coke in 1929 you would have made 10% compounded for 80 years.  $1000 became $2.2 million.  If you bought it two years later, you would have made 12% compounded - about $11 million.

Great companies are great investments even when the world nearly tears itself apart.  

Now go play.

WATCH OUT BELOW

I watch the Big Guys make big turns in the market to get a clue about where its all going.  I use three tools set to specific periods: MACD, Stochastic and MA.  I set them to very long term periods.  These are the tools I used to make the call to get out in August 2007 (along with looking at the Macro situation) and the call to get back in in March 2009 (purely value versus price market wide).  I'm now seeing the same technical tools signaling to get out and there is plenty of bad Macro building up as well.  

Be very careful out there if you are an index investor or a mutual fund investor.  You could be looking at a 20% to 30% drop.  There is just no way this economy recovers before real estate recovers and it looks to me like the Big Guys are starting to lose confidence in Keynesian monetary policy and they're heading to cash in anticipation of more bad economic news coming down the pike.

Now go play.  Carefully.

THE RULE ONE WAY TO VALUE A BUSINESS

The essence of great investing is to buy something at a price well below its value.  Wouldn't you think knowing the value of the business would be central to all investment decisions?  For most investors, its not. If investors knew the value of the business they bought they'd be hoping the price would go down, not up, so they could buy more at an even lower price.  But that isn't how most investors think, is it?  And yet, for many companies, knowing the value is pretty easy.  The 'Value', by the way, is the amount of money this business will sell for if someone decides to buy all of it in a good stock market.  Here's how you do it:

Before you begin:  Collect 3 pieces of information from MSN Money or some other financial website (or from my tools starting next fall):  The trailing twelve months earnings per share, the analysts estimated earnings growth rate for the next 5 years and the average PE ratio.  You can use 2X the growth rate if you don't know what the average PE ratio is. While you're there looking at data, make sure the data is consistently growing - that it looks predictable.  (If the data isn't predictable, then all bets are off about the value.)

Step 1:  Calculate the estimated earnings per share for ten years from now by using an Excel spreadsheet formula: FV.  Plug in 10 for nper, the analyst growth rate for rate, the trailing 12 months eps for PV and calculate.

Step 2. Multiply the future earnings per share by the historical PE ratio.  This gives you the future value of the stock ten years from now.

Step 3: Divide the future value of the stock by 4.  This gives you the present value.  My default assumption is that I want at least a 15% compounded annual rate of return which, if everything goes as planned, will require I buy the stock for 1/4 of its 10 year sale price.

Does this work?  Not really.

There's one more step before you can buy: Cut the value in half and don't pay a cent more than that.  That gives you a big margin of safety so that you can make mistakes and still come out okay long-term.

Now go play.

TWO WAYS TO MAKE MONEY (OR NOT LOSE MORE) AS THE PRICE DROPS

Whart happens if you own stock and the price is falling?  Should you buy more?  And if so, when?  There are a couple of pretty slick ways to deal with dropping prices and these questions.  Both require some learning.  Both are used by day traders and are therefore, by definition, risky.  Beware, the saying, "A little knowledge is a dangerous thing" applies here.  

Remember, the first way to go is simple - stockpile like I wrote about in Payback Time.  But please, be sure you know the business, you know why the stock is at or below the MOS and you're sure you're getting a deal.  This requires real work.  Do the work.  If you aren't excited that the price is going down, you've probably left out a step or two.  Now for the two more sophisticated (read: complicated) ways to go:

1.  Use advanced charting techniques to determine a downward trend.  Don't stockpile until the price breaks out of the trend.  I wrote a bit about this in Payback Time.  Its advanced trading stuff and you should take study charting and do it on paper a lot to get comfortable.  The good news is that if you got the MOS right there isn't really anything you can do wrong if the price is below the MOS.  Worst case you pay more than you would have if you waited or if you didn't.  In the long run, you bought at a great price or at an even greater price.  Either way you're golden.

2.  Sell Calls against the trend.  This requires a real understanding of charting and options and is not for amateurs.  It also requires a real understanding of why the price is dropping.  Advanced stuff but it can work wonders to protect your equity as the price drops if done correctly.  It can also wipe out your equity if you do it wrong.  Still, where there are dangers, there can often be great reward.  Do this right and a stock you own can drop 50% and you both lose nothing and still can buy more at the lower price.  But again, not for amateurs.  I'm just telling you because its a cool thing to know.

Now go play

WSJ - SEC INVESTIGATING CHINESE AUDITORS

More on China.  According to the WSJ article (see link below) Chinese companies are catching a lot of heat from the SEC.  Particularly their auditors.  Here's the heart of it.  There are about 200 some companies that are Chinese ADRs.  Most of these became public by buying a shell and are being audited by small companies that often use Chinese companies to actually do the audit.  Since there appears to be a law in China against the auditor actually showing up on the premises ... yeah, read the article ...  mind blowing I know ... the American auditors can't really do their job.  Which accounts in part for why there have been about 40 accounting scandals on Chinese ADRs.  That's a lot.  About 25%.

http://online.wsj.com/article/SB10001424052702304563104576361422372121248.html?mod=WSJ_hp_LEFTWhatsNewsCollection

Like I said, when you get it right investing in a Chinese company can be the best investing experience of your life.  But get it wrong and it could go to zero.

Now go play.

INVESTING IN CHINA IS LIKE SNOWBOARDING AN AVALANCHE CHUTE

Essentially, I think investing in China is like backcountry snowboarding down a steep avalanche chute in deep powder.  Its the best by far but if you don't know what you're doing, eventually you're gonna get killed.

More on China from some of my readers:

Kristo (kristoPQ@gmail.com) has left you a comment:

Phil, China, in general, seems very risky when a company such as Yahoo (with an executive on the Board in their China investment) isn't aware when their significant China company moves ownership of its prized asset without benefit to Yahoo shareholders.http://www.pcworld.com/article/227799/alibaba_transferred_alipay_ownership_without_yahoo_approval.html THey key quote is: "The restructuring was needed so that Alipay could obtain a license from authorities in China, which is requiring third-party online payment services of nonfinancial institutions to be domestically owned." In China, there is the appearance of market controlled capitalism similar to appearances in the western world. Reality is different. I don't think this was a fraudulent transaction, but it is no easier to invest under such circumstances. Even Yahoo was caught on this and they are the direct investor. Of course, Yahoo shareholders are left holding the bag...but it's almost empty.

Jason Klein Same goes for China Biotics

Now go play.

 

ONE GOOD REASON TO NOT INVEST IN CHINA

I have 4 major criteria that must be met before I can buy a stock for my long-term portfolio:

1. Meaning:  I must understand the business
2. Moat:  I must know that the business has a durable competitive advantage
3. Management:  I must know the CEO is honest, passionate and owner-oriented
4. Margin of Safety:  I must know the value and be able to buy at a much lower price

Understanding the industry, how the business makes money – that’s pretty straight forward.  But good companies with big moats have big moat numbers and crooked management can fake those numbers and sucker in good investors.  Those numbers are critical to calculating a value of the business because most of us calculate value based on an estimate of future earnings.  Faked past earnings means wrong earnings growth estimates and a wrong TTM EPS starting point which leads inevitably to a very wrong estimate of current value.  What that means is a bad boy CEO can turn your investment into a bad nightmare.

And that’s the catch with a lot of ADRs from China.  Too many of them may be run by CEOs who don’t feel the need to tell the truth to American investors. 

I see Chinese companies every day that appear to have wonderful meaning, moat and management numbers and are massively on sale.  The problem is the numbers might be lies.  The problem is the management might be liars.  And from that, the problem is the margin of safety is an illusion.

Apparently I’m not alone in this.  According to the article below, it appears that few hedge funds are big on China.

http://seekingalpha.com/article/267586-top-china-picks-of-hedge-fund-gurus-invested-in-china-stocks?source=msn

These are usually pretty smart guys.  You’d think if there were values to be had in China, they’d be all over them.  But during the last few weeks investors in two Chinese ADR companies (Chinese companies that are listed in the US) appear to have been scammed by their own CEOs and provide a case in point why hedge fund managers are being very choosy with China ADRs.

Puda Coal (PUDA), for example, recently and suddenly stopped trading.  A SeekingAlpha writer accused the CEO of transferring all the assets of the company into his own name, selling half at a fraction of the market cap of the company, pocketing $32 million, indebting Puda for $400 million and then transferring the unsold half back to Puda encumbered by the debt.  He did all that, apparently, and thought nothing of it.  The company now owes an interest payment that is larger than its entire net earnings of last year.  And its shareholders are likely to take a huge loss if the company ever opens trading on its stock.  Check out the numbers on this thing.  Awesome.  Perfect really.  And completely wrong.

Wrong numbers.  Wrong valuation.  It looks great but looks (and lying CEOs) and deceive.

The numbers created by the analysts following it and in the imagination of the CEO result in a value of over $340 per share for a company trading at $6 when trading was frozen.  What a steal, except what was being stolen was your money.

And the CEO of Sino Clean Energy (SCEI) may be running a little scam of his own on US investors that was caught on video by a researcher in China who wrote up his findings in this article:

http://seekingalpha.com/article/268659-evidence-proves-scei-chairman-fabricated-production-videos

According to the researcher, SCEI is doing only a fraction of the business they claim in their accounting filings.   His people staked the plants out and videoed the total lack of activity for days and days.  In response the company released its own videos showing slurry trucks departing the company on a regular basis.  Unfortunately for this CEO, he may have run the same two trucks through the scales multiple times for the camera in an effort to show activity.  And he did it when it rained, which meant his dates were most likely phony, too.  

Here’s the thing about Rule One Investing – the historical and current numbers are critical.  Which means the integrity of the CEO is critical.  Scams like Health South, Enron and World Com were perpetrated by lying CEOs (or CFOs or both) right here in America.   They got away with it for years.  But how much easier is it to run a scam on a bunch of investors half a world away?  Answer – it’s a lot easier.  

Conclusion: If you haven’t been there and kicked the tires, if you can’t get someone you trust to do it for you, then you can’t know if the CEO is running a scam.  Both of these companies were being followed by analysts and both had experienced investment companies raising money for them.  Other people don’t care as much about your money as you do and are willing to be careless with it.  If you don’t know you can trust the CEO, be very cautious about making an investment in a Chinese ADR.  

Having said all that, if you have a Chinese ADR you KNOW is great, let me know and I’ll see if I can blow a hole in your thesis.  If I can’t, I’ll buy some, too.

Now go play.