Let me start this post today by showing a comment received from Hewitt Heiserman following last week’s post on Heiserman’s book, “It’s Earnings That Count.”
“Dear Dr. Allen –
Thank you for the generous review. As you know, I am a big fan of your book, and your investing track record is a testament to the quality of your book’s advice.
If Bill (above) or any other readers want a free copy of a presentation I have given to many groups, “Ben Graham and the Growth Investor,” e-mail me at Hewitt.Heiserman@gmail.com, and I am happy to send you a copy. This presentation has many powerful ideas to improve your analytic skills.
hewitt”
Some of you may have noted the comment and e-mailed Hewitt already, but I wanted to be sure that you were aware of his gracious offer. Thanks to Hewitt for sharing this information with us.
I’m sure you are well aware of the incredible collapse in commodity-based stock prices. Whether oil or gas, gold or silver, aluminum, etc. companies earning their living from such commodities are seeing their balance sheets being severely discounted (via stock prices) in the absence of dependable profitability to continually cover operating costs and meet the costs associated with debt demands. Commodity-based companies have the bulk of their assets in the form of fixed assets like drilling rigs, gold mines, and so on, and thus if there is little demand for the commodity involved, these assets can lose value quickly and translate into a cash worth of even pennies on the dollar.
While a purchaser of gas at the pump for his/her car may be delighted with a lower and lower cost per gallon, the macro picture is concerning today, in my view. A strong infrastructure of capital investment must be maintained for genuine economic strength to be present. Investment of this nature must be maintained and expand for the job market to be healthy.
At present, global economies are being propped up by government borrowing and spending, and the consumer. Government spending chokes off an economy in time and the consumer cannot multiply the economy alone. We can not live and flourish from the sale of cell phones, entertainment technologies and numerous other technical gadgetry. Yet our strong stock market of the recent past is driven by several tech giants. Most other companies run in place while, again, the truly capital intensive investing drivers of an economy are absolutely floundering as commodity prices have fallen off the proverbial cliff.
If demand picks up soon enough, perhaps infrastructure type companies will recover to give our economy the foundational support it needs. But I personally am keeping a close eye and plan to be conservative with how invested I remain toward stocks. As always, though, when I invest, I’ll look for deep value and potential outlook catalysts for recognition to be made of that deep value.
Have a wonderful week, everyone.
I ran an analysis on Gulfmark Offshore Inc.(GLF). If I did things the right way, as shown in your book, the adjusted floor price is $30.60. In light of what you have written regarding commodity based stocks, can this floor price be trusted? The stock is currently way below at $9.40. Thanks
p.s. I really enjoyed your book.
Hey William,
Thanks. Your question about whether the scorecard price on GLF can be trusted is highly relevant to this commodity issue.
The problem is not a failure of the scorecard, except with issue that there is no numerical formula that can account for anomalous (outlier) situations. This commodity environment is anomalous, to say the least and is very concerning for our overall markets, as I attempted to explain in my post. GLF is not nearly the only company that is in the oil services sector that is well below its Scorecard price at this time. Even some very large companies in the sector are trading well below their Scorecard prices.
In my book, I wrote about blending market expectations with the balance sheet. I also stated repetitively that earnings drive stock prices. So, we want to buy an equity position when it is on sale and we try to quantify that (via the Scorecard) but we also want to buy into a situation that we judge to have an earnings catalyst (I wrote a post by this name a while back) that is on the horizon, such that the deep value gets recognized by the market and the stock repriced higher in accordance. That is, we prefer to buy value with an outlook backdrop that is favorable or about to become favorable. Speculating about the outlook for commodities is almost impossible in my view, at any time.
In my book, I gave a couple of examples of dry bulk shipping companies where I bought well below the Scorecard number and yet I ended up losing a lot of money. These were commodity stocks, the ships being totally dependent on the demand for commodities like iron ore. The demand fell off a cliff and remained there and the ships lost all their worth, meaning the balance sheets were vastly overstated since most of the assets were “ships.”
As I wrote in this week’s post, these commodity service companies are unique and I learned it the hard way with dry bulk shipping companies. But it was a helpful lesson too. Commodity companies (including those servicing them) are unique in that most of their capital (money) is tied up in the property, plant and equipment (fixed asset) account. When there is little demand for the commodity, the balance sheet of a commodity company can become worth a whole lot less than what’s stated on the balance sheet because the cash value of those fixed assets can diminish rapidly. I mean, who wants to buy a drilling rig right now, for example? There’s just no market for it with crude prices so depressed, so if a company tries to liquidate a rig, it will have to sell it for much less than what’s on the balance sheet, most likely. GLF transports and services oil and natural gas drillers (including their personnel). It’s in the same boat (pun intended) as a driller. It’s a domino effect all through the sector. Where is increasing demand going to arise for GLF’s vessels and what kind of prices will they pay in the current environment?
If oil prices surge later and GLF manages to weather this storm, investors stand to make a lot. However, if this storm persists (oil stays down for extended time), some companies won’t make it as their cash will be depleted servicing their debt and paying operating costs while waiting on better days.
The catalyst for any commodity company is the demand for the commodity. It’s not like selling shoes or cell phones where you can build a better mouse trap and market it better and build your company positively. No, with a commodity company, you can manage everything well but if the commodity (in this case, oil) lacks demand, your ship can sink.
Because of the dry-bulk shipping experience, I prefer to invest in non-commodity based companies as assessing the potential outlook is more controllable by the companies as a rule. If I can find a commodity company or two at a time like this (very depressed stock prices) that have a lot of cash and little to no debt — evidence that they clearly can weather a lengthy malaise in commodity prices, I may indeed invest because the likelihood of a company failure is much lower and an eventual turnaround in oil and gas prices could lead to mega stock gains. But, again most balance sheets are heavily laden with fixed assets and significant debt supporting those under-demanded assets. So, one must be very selective, in my view.
I said in the book that a number can’t tell you everything. The scorecard can give you a price that recognizes when you are getting a lot of equity for the price. Yet, the scorecard cannot tell you what kind of company you are pricing, of course. A commodity company will typically do well when the commodity is being demanded and do poorly when the commodity lacks demand. Because, again, they are very capital intensive, my 90% of asset value (discounting of 10%) on my scorecard can easily be too optimistic; that is, it might be more like 25% of asset value for Property, Plant and Equipment when times are bad for commodities like the present times. Even then, the company still has to remain liquid long enough to keep servicing the debt until better times arrive. As mentioned in my book, my scorecard has greatly facilitated my own analysis and approach to investing but when I pull the trigger, it’s ultimately a judgment call. Judging a commodity company as “different” is rational and certainly is in this present “strange” environment we are experiencing.
Hope this helps, William
Paul
Let me add the following which might be useful to any who wish to follow oil:
If you don’t already follow this, USO is a ticker symbol for tracking significant oil stocks. It is an oil ETF and can serve as a proxy index relative to the general movement of stock prices across the sector. It really spells out how bad things are literally across the board of this sector. Note that we are sitting at the 52 week lows in the $15s whereas the high for the year was almost $38. Further, since the fund started in 2006, the $15s are the all time low for this ETF which sat at almost $120, when oil was sky high, back in July of 2008. Even when the overall market crashed, USO went no lower than the $22s which happened during February of 2009. So, to say this is an anomalous time in oil and gas is the understatement of a lifetime. I’ve not witnessed anything like this before. Who will survive this among the sector if it persists, I can’t tell you for sure, but it will surely include the strongest balance sheets (most liquid, least indebted ones).
Here’s a link where you can track crude oil prices daily (over to the right under commodities):
http://www.investing.com/equities/infosonics-corp
Paul