Investing

I'm going to be in Las Vegas from 3rd Feb to the 10th and then in LA on the 11th (Friday) and 12th (Saturday) of February. If any US readers would like to catch up to have a chat about value investing or specific ideas then please send me an email or leave a comment.

I sold out the last of my EROC position in the last few days. I first wrote about EROC in mid July 2009 - Eagle Rock Energy Partners (EROC). I first pegged the value between $7.66 and $8.90 when EROC was trading around $3. In late July 2010 I posted an updated Valuation of Eagle Rock Energy (EROC) post transactions. This pegged a reasonable valuation, based on a weighted average of managements estimates contained in SEC filings, at $9. As EROC is now at around $9.40 I’ve closed all my positions in the stock and warrants.

When EROC was trading at $3 there was a forced seller and a belief that they could violate bank covenants. The forced sellers had purchased EROC for yield and the distribution had been cut to 2.5c per quarter. In reality the bank covenants could not be violated as the company had control over their hedges which provided a backdoor mechanism to remain in compliance. EROC subsequently announced a series of transactions to affect a recapitalization. There was a lot of controversy over the transactions. Kerrisdale Capital launched a site fair-eroc.com to vote down the proposal. Kerrisdale do good work and I bet they have a terrific run rate. However, this time they got it at least partially wrong. Kerrisdale outline their concerns at fair-eroc.com;

“So what remains? In our view, NGP is essentially canceling (sic) its subordinated units in exchange for $29mm (plus associated rights/warrants if they receive the fee in shares). These subordinated units are not worth $29mm+. With $1.65+ of arrearages ahead of them, the subordinated units will be underwater for 5+ years. We at Kerrisdale believe they are worth very little.”

In fact they were worth around $40M. I contacted Kerrisdale about their methodology for calculating the value. They had not calculated a value for those units but held a belief that the value was so far in the future that the uncertainty would wipe out all the value (sounds like an option doesn't it!). I calculated an undiscounted cashflow of nearly 400M and a discounted value of $40m. EROC was paying $35.5M for them. Kerrisdale did manage to bring about some minor changes in the plan and I appreciate their efforts to put management on notice.

As a result of the initial offer I valued EROC at $8.58 which was then updated by a few percent after the revised transaction was announced. 

In Kerrisdale’s 8/10/10 post on their activism efforts (login required) they note

“In the end, however, unitholders voted in favor of the plan. We’re not exactly sure why – the restructuring was clearly less than ideal, and we’re confident that NGP would have sweetened the offer if holders had rejected the initial proposal.”

The answer may lie in Behavioural finance. There is a famous experiment called the Ultimatum Game in which two volunteers participate. “The first player proposes how to divide the sum between the two players, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal. The game is played only once so that reciprocation is not an issue”. In many cultures a 50/50 split is offered and an offer below 20% is usually rejected. The most economically rational decision is to keep $19 and offer $1. The 2nd volunteer is still $1 better off but a 19/1 split is usually rejected. In this case NGP developed a proposal that offered value far from 50/50 but probably at around the 80/20 line (80 to NGP of course!). The reality was that EROC holders were offered incremental value, just substantially less than the value to NGP. Kerrisdale may well be right that NGP would have come back with a better offer but the offer on the table was accretive to shareholders.

At $9.39 there are a number of risks to EROC. Natural gas prices, interest rates, refinancing and capital investment risk. There are lots of ways EROC could be worth less than $9.40 and far fewer ways that it could be worth substantially more.

Finally, as this seems to have turned into the Seahawk (HAWK) blog it’s interesting to note the EROC timeline with a Seahawk overlay. The Seahawk closing prices are shifted to match my initial purchase of both HAWK and EROC.

If HAWK takes as long to play out as EROC then there are still 15 months to go. I have no particular insight that this is an appropriate timeline. However, if your timeline is substantially less than 1-3 years  then you are unlikely to see this play out before you (have to) close your position.

I first wrote about the Australian Dollar PPP in October 2008. The AUDUSD had fallen to .62 on it’s way to .61 a couple of days later and was 40% undervalued (all over/under valuation is compared to USD). The crux of the October 08 post was to invest in AUD assets at that time because there was a substantial headwind in other currencies if your base is in AUD. Similarly in other currencies you had the chance to be buoyed by AUD appreciation. The work was based on the Economist Big Mac index. There is substantial research that a few simple metrics often out perform larger models and Purchasing Power Parity (PPP), the idea that representative goods should trade at similar prices world wide, makes sense. There was a belief in Australia, in late 2008, that the AUD was going to keep falling. I had dinner around Christmas in 2008 and discussed this with an IT company CEO and a senior manager at an international oil company. They both thought an appreciation of the AUD was quite unlikely; they were wrong and PPP was right.

Where are we now

John Hempton of Bronte Capital, a blog I strongly recommend, has noted “And early is wrong. At least if you are an Australian and you took your cash offshore at 80c or less to the USD.”. Today the AUDUSD is 1.0 with a high of 1.03 reached recently.

The October 2008 list of major countries who’s currencies were more undervalued than Australia’s was;

• South Africa
• Malaysia
• Hong Kong
• Philippines
• Thailand
• Indonesia
• China

Now It’s somewhat larger!

30-50% under Hong Kong China Malaysia Thailand Philippines Russia Indonesia Taiwan

0-30% under Mexico South Africa Poland South Korea Singapore Hungary Chile Argentina Czech rep Britain Peru

0-13% over Turkey New Zealand Japan Canada

The Australian Dollar is now 16% overvalued compared to the 40% undervaluation in October 2008. Hong Kong and China are still nearly 50% undervalued. The Euro, Canadian Dollar and the Australian Dollar are all 10-20% overvalued with the Yen at around purchasing power parity.

An Insurance Trade

The Australian dollar has an excellent track record of falling to greatly undervalued levels in times of crisis. This is very supportive of insurance trades from current AUDUSD levels. The table below shows the AUD P&L for shorting a hypothetical US index in USD where your record currency is AUD. The trade is

1. Short Index
2. Receive USD Cash
3. Buy back index
4. Convert USD Profit or Loss in to AUD

AUDUSD	Index=100	Index=50	Index=150
1	0	50	-50
.6	0	83.33	-83.33
1.4	0	35.71	-35.71

In the case where global markets fall and the AUD falls your gains are magnified. In the case where the AUD keeps rising and the US market keeps rising the losses are diminished. The risk in this trade is where a very country specific event happens to Australia causing the AUDUSD to fall and the US market still has a substantial rise. In that case your losses are magnified. Of all the cases, this one is relatively unlikely and as an insurance trade there is potential for the losses to be offset by your gains. I'm not proposing this is a great outright trade, only that it’s great insurance with a free kicker that grows when you most need it.

Hong Kong Dollar

Jim Grant has an excellent discussion of opportunities in Asian currencies and especially ways to profit from an eventual rise in the HKD, in his free summer break Vacation Delectation from August 2010, under the heading “Three-dollar tale”.

“In preview we expect the Singapore dollar to appreciate and the Hong Kong dollar to appreciate-or, just possibly, to depreciate. Holding a certain kind of currency option, one would be paid in either case”.

“Or taking an agnostic view you could buy a strangle with strikes set 10% out of the money on either side,…, two years out for 33 basis points”.

Jim has done a better job than I ever could describing the situation and the trade he proposes has an excellent risk reward. I favour a substantial appreciation of the HKD over time but as both Jim Rogers and Jim Grant point out, the short term direction, on revaluation, could go anywhere. I wrote about REIT investments in Singapore and Hong Kong in July 2008. I made some investments and the subsequent drop in the AUD diminished the losses. Prosperity REIT was trading at HKD 1.5 in July 2008 when I wrote about it or .20 AUD (AUDHKD 7.50). By January 5th 2009 it was trading at 97c or 18c AUD (AUDHKD 5.50). The loss in HKD was 35%, in AUD only 10%. It closed today at 1.79 HKD and has paid 5 dividends totalling .30 since for a total return of 40% in HKD – not bad for a REIT (current AUDHKD is 7.74 so the AUD returns are 35% or 15% annualized). Receiving 15% a year while you wait for a revaluation isn’t bad but Jim’s trade is $0.33 to make $40 best case, if PPP is reached within 2 years!

Portfolios with AUD (CAD or EUR) base currency

This is a sound time to investing in USD assets and an excellent time to invest in HKD denominated assets. Cheap assets, of course, as always! With the HKD you get all the insurance benefits of a USD investment and the potential upside of a currency revaluation. It’s also a good time to re-orient portfolios out of your home country because the headwinds have moved there. This applies to the Australian Dollar, Canadian dollar and to a lesser extent the Euro.