Investing

QUARTERLY RESULTS
Mincor and Panoramic Resources have just released their quarterly reports. Unfortunately, in Australia, quarterly reports do not have detailed financial data. However, there is a lot of good information. I've updated a number of metrics on both PAN and MCR since my last posts (prior PAN post, prior MCR post).

FINANCIAL METRICS
My buy price was loosely based on cash and cash equivalent backing net of liabilities. Roughly what Ben Graham called a net net or what Marty Whitman would call readily ascertainable net asset value.

In the case of Mincor this number has held quite steady at .52c per share down from .58c per share in the prior quarter. I don't believe that there is a particular trend downwards in these numbers. In the case of PAN, however, we are down to around .59c from .90c in early November; this is also the number used in my prior post.

The key financial metrics are presented in the table below. You may have to click on it to see all the figures.



VALUE AND TARGET PRICES
It's interesting to note that MCR has higher leverage to the price of Nickel but unfortunately also to the AUDUSD. Unfortunate, because I think the AUD will strengthen. MCR reports net working capital, PAN only reports net cash and receivables so I've estimated payables.

Since my prior posts I've also developed a long term Nickel price target. At US$7.75, It's lower than the one mentioned in my prior posts on PAN and MCR. I've gone back over analyst's reports from the prior 6 months and used that number to aggregate fair values.



I've then developed a blended fair value and compared the current price to it along with net current assets and book value.

By all of these metrics Mincor is the better buy. It has almost the same upside leverage, is much closer to net asset backing, has higher leverage to the Nickel price and is at a larger discount to book value. Mincor has managed their net current assets better than Panoramic and have a lower cash cost. Mincor seems like a slam dunk buy at .58c and a sell at $1.79. Panoramic would be a buy at .59c and a sell at $2.60 (though it would have 4 times upside from .59c). I also worry that PAN may be in a downtrend in terms of net current assets.

The quote below is from the Barron's 2009 Roundtable. Scott Black from Delphi talks about StealthGas (GASS). I have marked the offending portion in bold. He claims that their ships are worth $335M net of debt.

Aggresively they may be worth $30M as scrap and that's NOT net of debt. They have about 80k light displacement tons and each ton sells for between $205-$250USD in the scrap market.

This may or may not be a good buy but it's not "an asset play"!

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Barron's 2009 Roundtable:

"Black: My last pick is an asset play, atypical for Delphi. ROE is only 10%, but the stock, StealthGas, is cheap. The company owns tankers that transport liquefied petroleum gas, or LPG. It's based in Athens. The stock is 4.73, there are 22.3 million fully diluted shares, and a market cap of $105 million. It pays a 75-cent dividend, for a 15.8% yield, but they may not continue to pay it. Some shareholders think they should buy back shares or knock down debt instead

Schafer: What's the book value?

Black: Book is $14.23 a share and there is no goodwill, so price-to-book is 0.33. For 2008 I figure they earned $1.35 to $1.40 a share on revenue of $112 million. The company already has contracted for 67% of its voyage days for 2009 and 34% for 2010.

Schafer: How much stock does management own?

Black: About 6.5 million shares out of 22 million. The company has 39 boats. Day rates should come down a bit, to $7,000 from about $7,600. They get $21,000-$22,000 a day on three of their product carriers, so total 2009 revenue could be $124 million. Operating expenses will go up. We assume a 5% increase, to $5,760. They have $241 million of debt. Subtract about $94 million in expenses from $124 million in revenue, and you get estimated earnings of $30 million, or $1.35 a share. Street estimates are $1.42 to $1.45. Analysts have a higher revenue estimate. The stock sells for 3.5 times my earnings.

StealthGas specializes in short-haul, or feeder, boats. They come into a harbor in, say, Singapore or Thailand or the North Sea and offload their cargo. Four customers account for 60% of revenue: Shell, Statoil, Petredec and Vitol. Many contracts are for three or four years. The company's net debt-to-equity ratio is 0.71 to 1. Management says it has access to credit. Borrowing is done ship by ship.

Gabelli: What does a new ship cost?

Black: A new LPG tanker is about $18 million, and a product carrier is about $57 million. The fleet is only 10.8 years old. On a scrap-value basis the LPGs are worth about $500 million and the product tankers, $60 million. That's $560 million, less net debt of $225 million, for a total of $335 million or $15.09 a share, conservatively. After this year StealthGas will be cash-flow positive because it has finished building its fleet. That's it for me."

A follow up to yesterday's post on incremental costs of various commodities. The chart below is from CIBC StrategEcon January 23, 2009 it shows that crude has rarely traded below the marginal cost of production and has always rapidly bounced back. Looking at the graph, it would seem to show that crude has traded about 25% above the marginal cost of production since the early 80's. CIBC claims that $90 a barrel is the marginal cost "for production from a new Canadian integrated oil sands mining and upgrading facility these days". That would indicate a price of about $112 as fair value for crude.

I've been looking at long term commodity prices to develop an average price to use in valuation. Here are some long term averages for LME Nickel (click for larger image).



Here are averages for Australian Thermal Coal, Copper and Crude Oil (simple average of three spot prices; Dated Brent, West Texas Intermediate, and the Dubai Fateh).



There are lots of implications. These prices were higher than I expected for oil, lower than I expected for Nickel and about right for copper and coal.

It's worth mentioning the corresponding spot prices as of January 23rd (USD):

• Nickel - 5.18
  
• Copper - 1.47
  
• Oil (sample average as above Brent, WTI & Dubai Fateh) - 46.17
  
• Australian Thermal Coal - $81.46

An equally important metric is the marginal cost of production (USD unless noted).

• Oil US offshore - $69.75, Average Western Hemisphere - $47.63
  
• Copper Marginal Cost - $1.8
  
• Australian Thermal Coal (based on Credit Suisse research) - $70-$80 AUD, $80 USD to meet project hurdle rates
  
• Nickel Marginal Cost - $6.8

Putting it all together:

• Nickel and Copper look to be the most undervalued against their average range and spot prices
  
• Crude oil is much lower than the marginal cost of production but is within it's long term average range.
  
• Australian coal is well above the long term average and fractionally above the marginal cost of production.

Looking at long term averages assumes that supply and demand are relatively constant over long periods of time. It is worth considering that China and India may have permanently increased the demand for these commodities at a given price. It is also worth considering that decades of underinvestment, depleting resources, political instability and environmental laws have shifted the supply curve such that there is now a lower supply at a given price.



I do believe that this is what's happened BUT most importantly I'm not investing on that basis. The key here is to invest in commodity companies that are valued based on commodities priced at or below the marginal cost of production and long term average prices.

When to sell

Given that buying is relatively easy, how do we decide when to sell. I'm going to choose price points for Nickel, Crude, Coal and Copper.

NICKEL
Nickel - $7.75 USD. Nickel can be replaced in Stainless Steel manufacturing by Nickel Pig Iron at about $8 USD for Nickel. The $7.75 is the 2000-2008 average. This is the number based on long term economics that draws the line between investment and speculation. I would expect to sell most of my Nickel stocks once they become priced based on $7.75 Nickel.

OIL
Oil - $85 USD. I need to keep an eye on the marginal cost of production and depletion rates. This article puts current marginal cost at closer to $85-90USD based on Goldman Sachs. I'm going to place my initial long term oil price at $85USD and I'll continue to monitor the situation. I would expect to sell some oil exposure once my oil stocks become based on that long term price.

COAL
Coal - $80 USD. Based on Credit Suisse's research, Thermal coal at $80USD and Coking coal $90USD (which is Russia's marginal cost versus Australia's at $100AUD) are good price points. Based on energy equivalence thermal coal would sell for around $130USD with oil at $85 USD. Thermal coal is very tightly tied to long term oil prices and energy demand. I will watch changes in oil prices and energy demand closely but I would expect to be reducing my coal exposure once long term thermal prices of $80USD are factored into coal equity prices.

COPPER
Copper - $1.80. I don't own any copper equities but it would seem that any companies reflecting $1.47 or worse copper would be a great buy right now. Once equities reflect $1.80 copper, it will be time to reduce positions.

The answer to what's going to happen with a buyout of Felix Resources is containted in an interview with Citigroup’s China analyst Huang Yiping.

"Number one is they certainly don’t want the Chinese companies to go out and invest prematurely. There was a concern last year, for instance, if the Chinese want to go invest overseas whether or not these investors understand the cycles of the market and there was a lot of discussion whether we have the international experiences for making a judgement on the current situation. "

"What they really want to avoid was making an investment where the asset price dropped significantly the next day. These kind of incidents already caused a lot of political pressure on investors as well as the government and so they're trying to discourage it a bit when people are not sure where is the bottom and so that's I think the first thing. They're probably trying to discourage investing over the near term a bit."

The Chinese government is going to make Chinese companies wait until there is a confirmed bottom before making any investments. As silly and un-Buffett like as that sounds, I'm sure it's the thinking of BHP etc as well.

This pretty much guarantees no transaction until FLX is trading above $14 or so for a number of months.

That's fine, I can wait.

I've spent some time looking into Strike Resources Limited (SRK) after seeing that they were a major holding of Orion Equities Limited (OEQ) which is trading at about 1/3rd of book.

At face value Strike (SRK SRK.ax) is a resource company selling for 2/3 of cash of hand. They have an iron ore tenement that may have been worth as much as 400M to them at the peak along with a coal mine that will nearly pay for itself in one year of cash flow. This is what attracted me. On the downside here is some history of the founders:

• Farooq Khan and Victor Ho are both executive directors of Strike. They founded a company called FAST SCOUT LIMITED which started trading in March 2000. They almost immediately announced that they were going to attempt to list on the NASDAQ in the US. They had no product or revenue. In their first year they were involved in court case. By 2003 their principal business was Employee Internet Management and management of share investments. They lost 11M in 2002 and 1.7M in 2003.
  
  
• By 2004 their principal activity was Virtual Web internet filtering, the pursuit of other internet technologies and the management of investments. They lost another 1.6M. They also became involved in yet more litigation this time with Rivkin Financial Services Limited. Fast Scout were accused of insider trading though the judge found no merit in the case.
  
  
• In 2005 they announced a proposed change in business activity to the resource sector. They lost a further $1.7M in 2005 and changed their name to Strike Resources as well as raising new capital.
  
  
• By 2006 they were a resource company with Iron Ore, Uranium, Gold and Copper exploration opportunities. They lost $2.2M.
  
  
• In 2007 they IPO’d their uranium portfolio as Alara Uranium Ltd (which is now trading at 3c). They made 2.3M in profit including the IPO profit from the Alara IPO. Aside from that non-recurring item they lost 4.4M. They removed uranium from their business description.
  
  
• Farooq Khan and Victor Ho took $2.4M in compensation, including equity compensation, in FY 07, remember this is against a loss from continuing operations of $4.4M. Directors in total took $6.2M including equity compensation.
  
  
• OEQ - Orion Equities Limited also has Farooq Khan and Victor Ho as directors along with Yaqoob Khan who was originaly a director of Fast Scout. OEQ owns a substantial numer of SRK shares. OEQ sold the Berau Coal Project to SRK in exchange for shares in SRK and options. This allowed OEQ to show a $17.5M gain albeit non-cash. Farooq owns 50% of OEQ though Victor Ho owns none. At face value, selling the coal assets to SRK is a transfer of wealth from SRK shareholders to OEQ which is 50% owned by Farooq. It's worth asking yourself why OEQ sold Berau Coal when it did.

Strike is now locked in litigation in Peru and criminal charges have been discussed. Of course SRK's management insists that the claims are without merit. Peru is a good location for mining. The independent Fraser Institure has published an index of locales. Peru scores about 55 along with New South Wales and Victoria! Their Iron Ore tenement may really be a valuable asset.

As for their coal mine; Indonesia scores a 15 out of 100 as a mining jurisdiction and is 7th from the bottom of the list. Another mining company executive is quoted as saying “Indonesia: No security of tenure, transparency, etc. Shame, as it is technically one of the best countries in the world to explore.”.

It is critical to understand that $40M USD of capital expenditure or $57M AUD would leave $16M AUD if they don’t spend another cent on any other corporate activity. That expenditure will be in one of the worst mining jurisdictions in the world. That is assuming that the capital expenditure is really only $57M AUD. If it goes over by 25% then SRK is out of cash.

To value Strike you have to look at their cash and what it’s going to be used for. If the Indonesian mine goes ahead next year then there will be little to no cash left in the bank. So it isn’t reasonable to value SRK based on today’s cash when they have already planed to spend it.

All in all the origins of this company are very shaky. They’ve never really made money and the founders look like professional promoters switching from hot sector to hot sector while spending time every few years in court. Their new directional shift to Indonesia probably continues their money losing tradition and in 2 years time they’ll be explaining how the mine isn’t producing anywhere near forecast due to political issues. They’ll also have used up the cash they need for their one great iron ore asset in a secure jurisdiction. Finally they are paying themselves substantial amounts of shareholder money (cash and equity) while continuing to lose money.

I’m tempted buy at 38c but I have to pass.

In my previous post I mentioned a couple of reader questions. This answers the second question.

I want to invest in gold, I love junior miners but with such a decline in the Australian dollar are Perth mint certificates worth considering?

My answer for gold is quite similar to the answer on shorting US dollars. I think the best position is in gold mining shares. They will benefit substantially from the drop in input costs (steel, fuel, rubber etc) and gold isn't down much. The equities have been hammered and that doesn't reflect the overall value in the gold stocks. I was buying Novagold but stopped after their announcement regarding cash flow problems. As of Friday these have been resolved on awful terms to existing shareholders. However the price of Novagold, now, with their cash problems resolved, is attractive.

I like Northgate Minerals (NXG NGX.TO), Western Goldfields (WGW WGI.TO), First Magestic Silver (FR.TO) and Silver Standard Resources (SSRI). These are all producers or about to be producers. The interesting thing about gold/ silver mining is that inputs and outputs are in large part determined by global forces so currency fluctuations don't matter as much. The US miners are going to benefit from a falling USD as it will lead to some costs decreasing as compared to the price of gold. That makes them somewhat attractive even if you're buying in CAD or AUD. If you buy an Australian mine then input costs will decline with a rising AUD but so will realized gold prices.

Given that exchange rates mostly even out for gold producers and quite a few other commodity producers, the best criteria (aside from value which is obviously paramount) is politically secure reserves.

Perth Mint Gold certificates in AUD or USD bought with a 3rd currency (such as CAD) will perform identically as certificates purchase in that 3rd currency (such as CAD). The gold versus exchange rate movements all cancel each other out. ABN AMRO Markets offer something called a QUANTO certificate which takes the USD movement in gold and applies it to another currency. Primarily Euro of CHF. You could probably create such an instrument with GLD and currency options.

It is reasonable to assume that worldwide government reaction to the financial crisis will be inflationary. Warren Buffett has said as much. Buying gold mining shares selling at substantial discounts to net asset value (which is relatively easy to determine) is a good way to benefit though it's important to realize that input costs will also rise.

I received a couple of questions that I thought a broader audience may be interested in reading. The first question regards the US dollar and the second on gold. I'll post the gold answer later.

What is the best way to short the US dollar

There are probably five primary ways to do this.

1. Through forex ETFs or mutual funds. I think http://www.merkfund.com/ has some that might be interesting. I think one of his funds does currencies and gold. All of these are implicitly short USD and long something else

2. Currency futures. Your risk reward is the same as a regular forex transaction except instead of daily interest you receive interest in a zero coupon fashion through the price paid. A forex position has no expiry whereas a futures position does.

3. Currency future option. This has a well defined risk, never more than the option price paid. The upside is the same as the currency futures position. This loses value over time as do all options.

4. Forex position. This is effectively borrowing in one currency to buy another. This is really no different to taking a 100k loan from your bank, converting it into another currency and then depositing it in that currency. In fact, that is the mechanism that is used. This can be achieved with an extremely low margin value (2%). Therefore the upside can be substantial compared to your margin but you can also easily get wiped out unless you fully fund the transaction (i.e. don't use margin). You earn interest in the long currency and pay interest in the short currency. If you make money on the spread then it's is said to have negative cost of carry and conversely there is a cost of carry.

5. Investing in productive assets in foreign countries. This is simply investing in foreign countries. If you are US based then it might be investing in Europe, Australia, China etc. If you can find undervalued assets in these countries then you get the double whammy of currency appreciation and price appreciation. You also receive dividends in the foreign currency which over time should grow. This is ultimately what Buffett ended up recommending after taking type 2 or 4 positions previously. He realized that the cost of carry created a situation whereby he needed movements to occur in a certain time frame.

You need to be careful that the company you are investing in overseas doesn't cancel out your forex position. A retail business would have expenses in foreign currency (buying products from china) and in local currency (staff) and all profit would be made in local currency. A service business would likely have both profit and loss in local currency. A gold mine would have profit in foriegn currency (based on the USD gold price) and costs largely in foreign currency (USD price of tractors, diesel etc).

As I am investing with Australian dollars and I expect the AUD to appreciate against most currencies then I am forced to primarily invest in Australia. As I expect to lose money on any foreign positions based on Forex movements. I have somewhat hedged this with out of the money currency futures options but they have a cost which is unfortunate. If I earned or invested based on USD today then I'd be almost entirely invested outside the country.

As a value investor the most business like approach here is to invest in productive assets overseas. Have those assets grow and create earnings in foreign currencies over time. The problem with all the alternatives is the ongoing costs and the requirement to not only be right but to be right in a specific amount of time.

If you were determined to make a speculative bet on currencies I'd recommend options. Just make sure that you have sufficient funds to roll positions over for a few years and the discipline to actually do that. I've bought quite out of the money AUDUSD options at below 1% of face value because I believe when the currency moves occur they'll be quite significant and because I don't want to use much capital in case it takes a long time.