Archive for April, 2010
First Quarter 2010 Client Letter
Apr 9th
April 7, 2010
As you know, I pen a letter each quarter that updates you on what has happened recently and gives you some insight into what may lie ahead. This quarter, I am stealing from a website that is dedicated to financial advisors. The website is www.horsesmouth.com and each quarter they provide examples of quarterly letters that advisors can use or borrow from. I have never used any of their past letters, but this month the website had one particular letter that just captured my outlook on the markets as well as our philosophy in managing money. I have made some modifications to tailor it for your accounts and my speaking “voice”, but much was done for me (thank you Horsesmouth). So, without further ado, my quarterly letter to you all.
“I have no idea what the stock market will do next month or six months from now. I do know that, over a period of time, the American economy will do very well, and investors who own a piece of it will do well.”
– Warren Buffett in a CNBC interview, Oct. 10, 2008
After the market roller coaster of 2008 and 2009, the first quarter of 2010 has been blessedly uneventful by comparison. The markets ended the first quarter up only about 4 – 5%, although up almost 60% from their lows of a year ago. That said, there is still a cloud of uncertainty that is making many investors nervous. Even with the stabilization of the global economy, there is no shortage of short-term causes of concern:
- Continued questions on the direction and timing of the economic recovery in the United States and Europe
- U.S. housing prices that are staying stubbornly low and unemployment levels in North America and Europe that are stubbornly high
- And in late March, the deputy director of the International Monetary Fund made headlines as he talked about the need for advanced economies to cut spending in order to reduce deficits (http://www.nytimes.com/2010/03/22/business/global/22imf.html?scp=2&sq=IMF$st=cse).
The good news is that there are offsetting positives, even if the media headlines that feature them aren’t quite as prominent:
- On Monday March 22 of this year, the Wall Street Journal ran a story about dividend hikes as a result of rising profits by U.S. companies. The article also mentioned that cash on hand on U.S. corporate balance sheets was at the highest level since 2007.
- On the same day, the Financial Times ran a similar story about dividend increases in Europe
Whether you choose to focus on the positives or the negatives, there’s broad agreement that the steps taken by governments stabilized the financial crisis that we were facing a year ago, and there is almost no talk today of a global depression. So, the issue is not whether the economy will recover, but when and at what rate – and whether there might be another stumble along the way.
If you look for investing advice in the newspaper or on television, the discussion tends to revolve around which stocks will do well in the immediate period ahead – this week, this month, this quarter. We refuse to participate in that speculation. When it comes to short-term prediction – about the economy or the stock market – there’s only one thing we can say with virtual certainty: Most predictions will be wrong. Quite simply, no one has a consistent track record of successfully forecasting short-term movements in the economy and markets. Which is why, in uncertain times such as today, one of the people I look to for guidance is Warren Buffett.
In one of his annual letters to shareholders, Buffett wrote that it only takes two things to invest successfully; having a plan and sticking to it. He went on to say that of these two, it’s the “sticking to it” part that investors struggle with the most. The quote at the top of the letter, made at the height of the financial crisis, speaks to Buffett’s discipline on this issue.
I try to apply that approach as well, putting a plan in place for each client that will meet their long-term needs and modifying it as circumstances warrant, without walking away from the plan itself. Boom times such as we saw in the late ‘90’s and scary conditions such as we’ve seen in the past two years can make that difficult, but those conditions can also represent opportunity. Indeed, in his most recent letter to shareholders, Buffett wrote that “a climate of fear is an investor’s best friend.”
On balance, I share Buffett’s mid-term positive outlook, not least because many of the positives that drove the market optimism two years ago are still in place. In the meantime, here are five fundamental principles that we look for and that drive the portfolios we believe will serve clients well in the period ahead.
- Concentrate on quality. The record bounce in stock prices over the past year was led by companies with the weakest credit ratings. Some have referred to the last year as a “junk rally,” with the lowest-quality companies doing the best. That’s unlikely to continue – and that’s why I’m focusing our portfolios on high-quality companies. We are concentrating on companies with low debt levels and good cash flows such as P. H. Glatfelter Co.; Ennis, Inc.; and PepsiCo.
- Look to dividends. Historically, dividends have made up 40% of the total returns of investing in stocks and helped provide stability during market turbulence. Two years ago, quality companies paying good dividends were hard to find. One piece of good news is that today it’s possible to build a portfolio of good-quality companies paying dividends of 3% and above. Some stocks, such as pipeline companies Buckeye Partners and NuStar, which are in several of our client accounts, pay over 6%, most of which is tax deferred income.
- Focus on valuations. Having a strong price discipline on buying and selling stocks is paramount for success. History shows that the key to a successful investment in ensuring that the purchase price is a fair one. Investors who bought market leaders Cisco Systems, Intel and Microsoft 10 years ago are still down 40% to 70%, not because these aren’t great companies, but because the price paid was too high. We will continue to focus on buying stocks that are selling at a 30% discount to what we calculate as the intrinsic value.
- Build in a buffer. Given that we have to expect continued volatility, we identify cash flow needs for every client and ensure that this cash is set aside in safe investments. We also use asset allocation – spreading investments between stocks, bonds and prudently using options and other “alternative” investments – to help cushion portfolios. This buffer protects clients from short-term volatility and reduces stress along the way.
- Stick to your plan. In the face of economic and market uncertainty, another key to success is having a diversified plan appropriate to your risk tolerance and then sticking to it. It can be hard to ignore the short-term distractions, but ultimately that’s the only way to achieve your long-term goals with a manageable amount of stress along the way.
In closing, let me express my thanks for the continued opportunity to work together. Should you ever have questions, or if there’s anything you’d like to talk about, I am always pleased to take your call.
Sincerely,
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC
(336) 306-5496
(866) 857-4095
P.S. If you’re interested, here’s a link to Warren Buffett’s 2010 letter to his investors: http://www.berkshirehathaway.com/letters/2009ltr.pdf
TAT’s Very Interesting….
Apr 7th
Recently I was asked to look into a particular stock by a couple of clients. It was a sort of “whisper” stock – the kind you heard from a reliable source that this is a good thing because… Sometimes rumors pan out, but more often than not, they don’t. That doesn’t mean they shouldn’t be looked into though. So, with that being said, the stock in question my clients mentioned to me is TransAtlantic Petroleum (ticker: TAT) and the source (as far as my clients were concerned) was their colleague’s broker who heard that T. Boone Pickens was buying shares. I actively encourage my clients to bring ideas to me and I promise them I will research their suggestions. This blog provides a forum to follow up on the research for all to read.
First, let me give you a little background on the company. TransAtlantic Petroleum is what is known in the business as an E & P company – exploration and production. The company is in the business of drilling oil wells and bringing them into production. They sell the oil to refineries rather than refining the oil themselves. They have wells in four major areas – Morocco, Romania, Turkey and California. Yeah, that last one threw me for a loop, too.
The company has only recently undergone a fundamental shift in strategy. TAT previously was involved in finding oil in “countries that are under-explored and have low corporate tax and royalty rates and established petroleum systems”. In late 2008, the company underwent a shift in focus when they sold a 56% interest in the company to N. Malone Mitchell 3rd through a number of firms he owns or controls. As a result of Mr. Mitchell’s taking control of the firm, the company has purchased Longe Energy from Longfellow Energy, a company that is indirectly owned by Mr. Mitchell. TransAtlantic also bought 100% of an Australian oil company, Incremental Petroleum, including purchasing just over 15 million shares of Incremental owned by, you guessed it, N. Malone Mitchell 3rd.
The tangled web that Mr. Mitchell has spun throughout TransAtlantic seems a bit troubling. To his credit, Mitchell does have a good track record. He started a company called Riata Energy. He sold a majority interest in Riata to Tom Ward, a co-founder of Chesapeake Energy, for about $500 million back in 2006. Riata was then renamed SandRidge Energy and its stock trades on the NYSE. SandRidge is an oft-rumored takeover target and Mr. Mitchell still owns a significant portion of that company. A bit troubling is the fact that Mr. Mitchell purchased Longfellow Energy from Sandridge (back when it was still Riata) by exchanging 2.5% of the shares outstanding for 100% ownership in Longfellow. Since none of the directors of Sandridge at that time were independent and Mitchell had a majority ownership in the company, it’s impossible to say whether he got a steal or if it was a fair deal. It’s certainly obvious that it was not an “arm’s length” transaction.
That all being said, we now come back to TransAtlantic. This is the oil company that is now largely owned and run by Mr. Mitchell. So what makes this company so attractive and to whom? One thing that stands out as a potential attraction is the access to more “exotic” locales. When one thinks of oil, rarely does Morocco or Romania pop into mind. Indeed, in the most recent annual report, there were no oil assets listed in either of those countries. In fact, the only assets of interest were in Turkey. The company is relying heavily on Turkey as the make or break place to drill. Current production is somewhat limited in Turkey, The company is required to estimate the amount of oil and gas they could find in their known fields and to assess a ‘net present value’ to their oil reserves. In the most recent annual report, the value they assigned – all to their Turkish reserves – amounted to $250 million.
In their press release, they went a step further, revealing not only their “proved” reserves (an estimate of the amount from wells currently in production), but also provided a “probable” amount of reserves that effectively doubled their proved reserves and, for good measure, added a “possible” estimate that was 150% of proved reserves. In other words, the company is estimating they have 12 million barrels of oil, with another 11 million barrels of oil probable and 15 million barrels of oil “possible”. If we assume a best case scenario in which all of this oil production comes true and the company gets the price they estimate, the current value of all of this future oil production would amount to about $750 million. Now, match that up against the company’s current market value of $900 million and it appears the firm is at least fairly valued if not overvalued a bit.
Now, with that “back of the envelope” analysis out of the way, just who is interested in TransAtlantic Petroleum and why? Well, the one “who” that seems to have generated some interest is relatively easy to answer. As I mentioned at the outset, T. Boone Pickens – he of Mesa Petroleum fame – bought shares. Actually, his investment company, BP Capital, bought shares in the fourth quarter of 2009. So how many shares did Pickens snap up? He bought a whopping 2 million shares, or just over one-half of one percent.
Actually, there is another person of some interest who bought a significant interest in the firm. A company called MSD Energy Investments, LP, who bought nearly 16 million shares in the fourth quarter of 2009. What? You say you’ve never heard of MSD Energy Investments? Well, that’s simply one part of Michael Dell’s – yes the Michael Dell of Dell Computers – fortune being invested. I wouldn’t put much stock (pardon the pun) in his buying a large percentage of the company. And Boone Pickens seems to be just nibbling at the stock. Perhaps he admires Mr. Mitchell’s work (his BP Capital also owns shares in SandRidge Energy).
So is this company a keeper in terms of investments? Probably not, because the company is rife with risks. From the multiple and tangled “related party transactions” to the huge loss (over $62 million in 2009) and negative cash flow, this company has red multiple red flags. There are some long-term potentials in Turkey, but it would be more prudent to see if new wells can be brought on line and production ramped up to the level the company rosily predicts.
That being said it may, however, be an interesting short-term trade. From a purely technical standpoint, the stock has broken above its 50-day moving average. This is one popular signal that folks who stare at charts for insight look for in a stock. So, if someone is interested in trading in this stock – and recognizes the need to sell if the stock price falls below its moving average line – this could be an intriguing play.
Since 2007, there have been five times when the price has moved above a 55-day moving average. This is significant only because the infamous “Turtle traders” used a 55-day moving average as a trading signal. Of these five “buy” signals, all were profitable, though one only barely so (up $0.03 in two weeks). Most of the signals lasted for extended periods of time. The average length of each trade was 90 days or about three months. If you feel like following in the footsteps of Boone Pickens, this could be an interesting trade, but it would be wise to watch the moving average and bail out if the stock price dips back below the 55-day moving average. Happy hunting!
Disclosure: Aerie is long a small position in TAT for clients.