It has been difficult for me to accept that I should be buying stocks with high P/E ratios, high P/B ratios, and mediocre management teams. Quality rarely comes cheap and without warts. But, I’ve been trying to move away from deep value investing dogma because I want to figure out what actually works. As part of that, I’ve been keeping a model portfolio of 30-35 large cap stocks since October 2017 that you can view in real-time here. It has outperformed the S&P 500 by ~5% annually since October 2017 (!). This is a surprising amount of outperformance for large cap stocks (e.g. large cap mutual funds would be incredibly happy with 2% outperformance).
While it is possible that I am confusing luck with good stock picking, I have to live with imperfect information. I would prefer the feedback from a 30+ stock portfolio than the feedback from a focused portfolio with <10 stocks. Going forward, you should expect me to be heavily biased towards quality companies.
In this blog post, I’ll give my thoughts on industries that will almost certainly see many bankruptcies. In general, the stocks with the most bankruptcy risk have some combination of the following:
- A fall in revenues because consumers don’t want to go out in public and possibly die. Some industries will continue to be impacted even after a vaccine is developed (if it is developed).
- Fixed cost leverage. Some businesses such as restaurants are locked into leases that will cause them to burn a substantial amount of cash.
These situations may be very difficult to analyze. However, there may be opportunities in the mispricings such as going long restaurant franchises and shorting airlines, E&Ps, and the lowest quality lenders. If an industry such as airlines has high bankruptcy risk, I will also talk about related industries even if they do not have high bankruptcy risk.
While this manufacturer of nitrogen fertilizers has sold off in the recent stock market crash, it is largely unaffected by COVID-19 and is positioned to see a small benefit from it. Regardless of how well COVID-19 treats CF (or not), the company will continue to be the lucky beneficiary of the shale revolution. CF is a low-cost operator simply because most of its manufacturing plants have access to cheap natural gas. Further advances in shale technology will improve CF’s profitability.
Keep in mind that CF is in a cyclical industry. I believe that the industry is set for another bull market run as there is very little new capacity being brought online.
While there are many people who don’t take the coronavirus pandemic seriously, there are some people who want to see the government take quick and decisive action on COVID-19. But here’s the problem with the decisive action camp: the people who believe in decisive action don’t realize how bad their healthcare system is. Everybody is assuming that the coronavirus will somehow magically go away because developed countries are supposed to have first-class healthcare systems. The reality is that most developed countries are far, far behind China and South Korea. That idea may be difficult to accept. But the stock market is not going to reward investors for making the same mistakes that everybody else is making.
I apologize for repeatedly writing about COVID-19. But, it’s worth writing about because people aren’t getting it.
(Unfortunately I did not have the time to fully research this.)
Improvements in shale extraction technology and a glut of capital have basically destroyed oil and natural gas prices. While Exxon’s management is ok, the company cannot defy commodity prices. Its upstream assets aren’t worth that much anymore because they’re inherently leveraged to oil prices. But despite the dramatic decline in oil prices, Exxon’s share price remains high.
The put options are interesting to me since implied volatility is low (20-30%+) and the company is overvalued. The options are barely more expensive than SPY puts (in terms of implied volatility), except that oil prices fell by half and America’s GDP did not.
A back of the envelope calculation puts Exxon’s private market value at <$129B versus a market cap of $359B.
From what I can tell, practically all stocks’ oil and gas reserves will have a Net Present Value of roughly 2-7 times the trailing twelve months’ cash flow. One relevant article is titled: “The Valuation of Oil and Gas Properties: Are They Really Worth 3x Cash Flow?“. For conventional wells, the 3X rule of thumb should come fairly close to the NPV in most cases.
I use this shortcut to get a quick sense of whether or not an E&P is massively overvalued. Currently I only short E&Ps and am not seeing any undervalued E&Ps even though these stocks have fallen a lot.
Since January 2015, I’ve been using a research platform called Sentieo (website). The main attraction of Sentieo is “Document Search”, a tool that searches through EDGAR filings, investor presentations, and conference call transcripts at the same time. It allows me to find key pieces of information that I otherwise would not find.
For short selling, Sentieo is incredibly useful since almost all of my short selling involves tracking down scumbags. Much of my work is spent searching through SEC filings for names of people, company names, and addresses.
Kinder Morgan does have some problems:
- Under its new CEO, Kinder Morgan has been stretching its numbers slightly.
- The big drop in oil prices will hurt the CO2 business.
- The big drop in commodity prices will lower infrastructure demand in the short term.
However, I think that the 60%+ drop in the share price YTD is a little overdone. Kinder Morgan’s problems don’t seem that bad compared to other companies.
In the past, Arthur Berman and his colleague Lynn Pittinger wrote about shale reserve estimates at The Oil Drum. The 2011 post “U.S. Shale Gas: Less Abundance, Higher Cost” pointed out potential pitfalls from using analogy wells to determine decline curves.
Type curves that are commonly used to support strong hyperbolic flattening are misleading because they incorporate survivorship bias and rate increases from re-stimulations that require additional capital investment.
Here are some ways to do it:
- Generally, a number of estimation methods are allowed: decline curve analysis (DCA), analogy, reservoir modelling, volumetric, pressure, or some combination of those methods, etc. You can cherry pick among those methods to choose the one that yields outlier numbers. The least time-consuming method is to use DCA, with Arps equations, with a high b-factor and with a low Dmin value.
- For DCA, you can use the analogy method for the underlying assumptions to “supplement” your wells’ production data with historical data that goes further back. Like #1, the optionality in methods allow you to cherry pick.
- You could use the analogy method on wells that have undergone significant capex/opex spending on enhanced oil recovery techniques. However, because you likely do not have access to those wells’ capex+opex figures, you could over/underestimate the economics of your own wells.
- In Canada, you are allowed to use commodity price forecasts that are well above the futures curve. (*Things were very different in the early 2000s.)
- You could book reserves for non-producing wells, e.g. wells that are shut-in and wells that were not completed due to poor economics. Theoretically, these wells could be NPV positive with higher commodity prices.