Wednesday, January 31, 2007

Slick Reality

Oil markets have been on a wild ride in recent weeks. After hitting a high of $77 last summer, oil prices have continued to fall and briefly dipped below $50 a barrel in intraday trading during the week of January 15th. Today oil zoomed past $58.

Numerous articles have been written about reduced oil demand due to high prices, pegging last summer as the tipping point. Others have tried to figure who will be hurt and who will benefit from the decline in prices. It is somewhat ironic that in the middle of all this volatility, the viability of alternative sources of fuel such as ethanol has come under scrutiny. Lower oil prices in conjunction with rising corn prices make ethanol’s economics much less attractive. But ethanol is another topic for another day.

Analysts and experts appear to be ignoring a multitude of signals and data points which should allay any fears of a dooms day scenario. Of course, this means Mr. Market may be providing us with a few attractive opportunities in the energy sector.

First, there is the share price performance of various publicly traded companies since the slide in oil prices began last summer. They have held up quite well and have even increased in some instances. For example, Exxon Mobil (NYSE: XOM) has appreciated about 20% in that time span. Indeed, even at these lower levels (see graphic from the Wall Street Journal to the left), Big Oil companies remain highly profitable cash machines. In fact these companies’ internal forecasts and capital budgets are predicated on much lower oil price assumptions than we are faced with today.

Second, there is the minor issue of supply and demand. Many opine that based on supply and demand economics alone, ignoring geopolitical factors, oil prices should be at $40. That may be accurate but good luck eliminating those risks altogether. If it was a forgone conclusion, President Bush would not have felt compelled to ask for a doubling of the U.S. Strategic Petroleum Reserves. Apart from this risk premium, the supply/demand imbalance is far from over. A recent guide provided by The Wall Street Journal titled “Unreliable Spigots, Mighty Thirsts” highlighted the precariousness of the world’s oil supply and the insatiable appetite for oil. The U.S. will remain the world’s largest consumer of oil and developing countries’ demand for oil will surpass that of industrialized nations in about two decades. Notwithstanding Peak Oil Theory, this oil will have to come from somewhere, putting a floor on prices.

Third, there is the flow of smart money into energy assets. General Electric (NYSE: GE) recently purchased oil services company Vetco Gray for $1.9 billion. Goldman Sachs (NYSE: GS) and Morgan Stanley (NYSE: MS) are teaming up to buy the oil and gas assets of Dominion Resources Inc. (NYSE:D) for $15 billion. And yes, there is Mr. Buffett’s $1 billion bet on ConocoPhillips (NYSE: COP). These investors should realize above average returns on their investments without requiring sky high oil prices. Indeed, current oil price levels would suffice. The U.S. Department of Energy’s forecast is for oil prices to dip to $47 a barrel in 2014, rising to $57 in 2030. Keep in mind these prices are well below oil’s 1980’s peak price on an inflation-adjusted basis.

Those three reasons have convinced my brother and I to build a position in ConocoPhillips over the last several months at an average price of $64. The stock trades at just 7 times 2007 earnings estimates. The knock against the stock is its heavy debt load compared to peers, its willingness to pay up for acquisitions and its exposure to such risky locales as Venezuela and Russia (ConocoPhillips has a 20% stake in Lukoil). Still, in the U.S., ConocoPhillips is the third largest oil company, the second largest refiner and the largest natural gas producer. Not bad and you get diversification to boot. We also recently took a position in Diamond Offshore (NYSE: DO) at just below $81. Diamond trades at around 9 times 2007 earnings estimates. The stock has declined as Mr. Market seems to be pricing in an inevitable decline in oil prices which would diminish demand for Diamond’s rigs. But the need to replenish reserves won’t go away anytime soon and Diamond has plenty of rigs to oblige. Diamond sweetened the pot today by announcing a $4 special dividend on top of its regular dividend for shareholders of record on February 14th. At today’s stock price, if you hold the stock for a year, you can lock in about a 5% yield on your investment and the rest, as they say, is gravy.

Monday, January 22, 2007

The Librarians

“Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
Warren Buffett, Berkshire Hathaway, 1994 Chairman’s Letter.

There is no shortage of investment disciplines, philosophies and methodologies out there. There are those who look at companies’ fundamentals, there are those who read charts and then there are the quants. The quants gather gobs of data, form hypotheses which are tested against historical data and tweak their computer models to forecast future returns. We all know how reliable past performance can be as a predictor of future returns. In his 1990 Chairman’s Letter, Warren Buffett wrote, “Beware of past-performance ‘proofs’ in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.”

To be sure, venerable quantitative shops such as Renaissance Technologies Corp. and D.E. Shaw have amassed enviable track records and kept their investors happy. One has to wonder though if the market has not ironed out the inefficiencies which have been exploited by these whizzes over the past two decades.

It is interesting that D.E. Shaw’s web site has a section on Qualitative Strategies noting that a large share of the firm’s attention is now spent on identifying “profit opportunities by human experts” and that such strategies “have accounted for much of the firm's growth over the years, and now represent an equally important element of its strategic focus.” Renaissance’s site is too exclusive to post any such information.

Then there was the recent Businessweek article, “Outsmarting the Market”, profiling Barclays Global Investors (BGI), the subsidiary and quant group of parent Barclays PLC. Impressive indeed. $19.9 billion of above market returns or “alpha” over the past five years. 2800 pension funds and institutional investor clients. Billions under management - $370 billion to be exact. Alas, all the fancy research, hypotheses and models for a mere 1.64% above market return on average. This is done by spreading bets across a wide numbers of investments. The idea of a concentrated portfolio is taboo to say the least since that would entail too much price volatility, which as we have discussed before, is wrongly equated with risk.

The quants don’t care much about the companies they are ‘investing’ in. Businessweek writes that the “whole sprawling human drama of business is of no interest to Barclays’ researchers, who never venture out to call on a company or tour a store or a factory.” I wonder if it was the same lack of analysis that lead to Barclay’s acquisition of BGI for $443 million in 1995.

Tuesday, January 02, 2007

AA Value Fund Update

I last updated you on the AA Value Fund in early August. Just a reminder that the AA Value Fund is separate from our Model Portfolio. The Fund is a super concentrated portfolio which I will update you on periodically.

The S&P 500 was flat from June to July and began its climb in August. The Fund actually ended August below its July level before mounting a comeback. As I had noted in my last update, the Fund was heavily weighted in the NYSE Group at the time(NYSE: NYX). While we made out OK with that position, we made the mistake of selling it too soon. Had we held on through the end of the year, the Fund's performance would have been stellar. Since August we also took positions in Mueller Water Products (NYSE: MWA) which is also a holding in our Model Portfolio and Harrah's (NYSE: HET) which I wrote about earlier. Mueller at below $14 was too good to pass on and the Harrah's story played as we anticipated with a winning bid of $90 being accepted by the company's Board.

For 2006, the Fund was up 59.7% vs. S&P 500's 13.6% increase. This brings the Fund's CAGR since the beginning of 2003 to 49.3% vs. S&P 500's 13.5% return. I have not made any additional capital contributions to the Fund since 2003.

Our current holdings include Intel (Nasdaq: INTC), Expeditors International of Washington (Nasdaq: EXPD), Leucadia National (NYSE: LUK) and Western Union (NYSE: WU).

The Dressing, The Dog and The Herd

The end of year provided for some very entertaining reading and tube watching. There were articles galore about end of year portfolio strategies – from tax loss selling to window dressing of portfolios by professional money managers. Among the stocks potentially being dumped, according to a December 26th Wall Street Journal article would be Corning (NYSE: GLW) which we have talked about before and is a holding in our Model Portfolio.

Then there was the Wall Street Journal article on December 2nd talking about the oh-so invincible hedge funds who felt they should catch up by unwinding bearish positions and joining the rally. Who says the markets are efficient?!

On another day in December, CNBC had a special on the Dogs of the Dow strategy. That’s the strategy which dictates you buy the 10 worst performing Dow stocks for the upcoming year. Unfortunately for the Dog people, as laid out in another December 26th WSJ article, real losers may be hard to find. Only 4 of the bottom ten actually finished below their 2005 levels. Intel (Nasdaq: INTC), one of our favorite picks and a Model Portfolio holding to which we added to recently, got the honor as THE worst performer of the Dow with a 19.55% decline.

Amid all of this, I wonder what Mr. Jon Brorson has been up to lately? Mr. Brorson was profiled in a rather amusing article in the WSJ on September 29th as the Dow was mounting a fierce rally from a July low of about 10,700 to 11,700. He has $2.3 billion under management and apparently has a knack for timing market turns. Oh boy. That’s a recipe for stress if I have ever seen one. The article notes Mr. Brorson’s day begins at 4:50 am and ends by going to bed by 9 pm – “I am wiped out when I get home each day,” proclaims Mr. Brorson. No wonder. Checking the leading sectors every hour and eyeing stock charts by drawing horizontal lines across the peaks and valleys can do that to you. Hopefully he didn’t cut back too much on that Phelps Dodge (NYSE: PD) position which ended the year 40% higher from its September levels after becoming a taekover target. Unfortunately, Mr. Brorson appears too worried about the herd and “knows that if the market keeps defying his expectations, he will at some point be forced to start buying the winners, or risk falling behind.”

I say hold the dressing, love THE dog and ignore the herd.

All the best for 07.