Thursday, May 6, 2010

On value investing, BP oil spill and Australia 40% mining tax

I pen this post in reply to a good friend of mine working in one of Wall Street blue blood institutions.

We were having a discussion on sector/company specific events, and their impact on long term prospects for a long term value investor like me. (In exact words). Having said that, 2 recent examples were thrown out and I decided to share them with the readers.
  1. BP oil spill 
  2. Australian 40% super mining tax 
I shall attempt to answer the query as best as my small mind can afford to.
Please note that I will not answer it in some Graham and Doddsville style of low price to book or low price to earnings and end up pissing a whole bunch of Buffett hate fans. The key to value investing is once again I emphasis not in low ratios. 

Furthermore, value investing is not = long term. It is synonymous with long term because most of the time, value guys invest due to catalysts and that takes some time to materialize so people can hold out andsit on their positions versus traders who lever and cannot afford to sit out. Warren Buffett is long term not because he likes it but simply his size does not allow him to move in and out easily. Can you imagine trading US 10 billion worth in a single day, you will probably be the only buyer or seller with psuedo self fulfilling returns but yet definite losses.

So my reply was:
  1. For the BP oil spill, it was unfortunate the incident happened and that President Obama said that all cost are to be borne by BP.
    • Spills do happen and many of currently "blue chip" names have suffered a loss of reputation and are doing fine now. Examples would be Exxon Valdez and Shell's Sakhalin projects
    • Investors tend to overreact to news
      • Although it is true that they have certainly severely damaged the environment and carry a liability for the clean up, most of the time, the sell off is overdone
      • BP tanked 16% over 4 days, losing est. £19 billion market cap (From £650 to 548 )
      • BP lost over £6 billion on 29 April itself
    • One has to see if the event is mis priced, i.e is the spill cost over stated? 
      • One has to refer to past events, find out from industry people and estimate the approximate cost of cleanup
      • This can never be a clear cut method as there may be contingent liabilities from numerous environmental groups or even US government itself
    • BP leaks 5 kboe / day and 9 days passed (Rig sank 22 apr), 45 kboe are in the seas. 
      • News stated one of 3 holes is capped
      • However leak volume stays the same, only variable is the amount of time saved
    • Given 7 days used to cap 1st leak, >14 days will be needed to cap the other 2 leaks
      • Since the remaining holes are larger, we assume 40 - 50 days required (2 months)
      • Giving rise to 5 kboe per day * 40 - 50 days = 200-250 kboe
      • So approx 245 - 295 kboe will be floating on the Gulk of Mexico
      • Valdez spilled approx 260 kboe of oil (1 boe = 42 US gallons)
      • So on the surface, it seems BP spill even after over compensating for the time to seal the hole the spill is slightly worse to Valdez and not much worse that most claimed
      • The only variable now is if unexpected delays occur such as sealed hole leaks again or explosions in the well
    • Now Exxon spent US$ 2 bn in clean up, US$1 bn in civil and criminal charges
      • Actual damages of about US$ 287 mn
      • Compensatory damages of about US$ 500 mn 
        • Both were awarded after a series of appeals spanning 20 years
        • US$ 5 bn in punitive charges were in the end limited by supreme court ruling
      • Total US$ 4.5 (PV) + 0.787 = US$ 5.2 bn of legal liabilities assuming inflation of 2% p.a
      • Note Exxon claimed most if not all of clean up cost via insurance as it was an accident
        • Hence actual cost is likely to be US$ 2.7+ bn 
        • BP will likely be able to claim as there will be insurance for rigs, Link HERE
      • Compare this with the fall in market value of £19 bn of BP, now it seems a little overdone
        • Even if BP spill is 2X larger, payments will be in the range of US$ 6-7bn or £4-4.6
    • Lastly, check on the health of BP as an investment 
      • From a Wall street journal column by BrettArends 
        • BP is 0.6x sales vs. Exxon and Chevron of 1x 
        • BP is 5x operating cashflow vs.Chevron 8.5x and Exxon 9.6x 
        • high dividend yield of 5-6% vs others 2-3% + strong balance sheet 
    • SO IS BP A BUY?
      • It is clear that on basic assumptions, the sell off is overdone
      • However do note that there may be possibilities of BP understating the leaks /day or other force majure events happening that may put the calculations out of whack
      • However with US$ 28bn stock loss versus a likely less than US$ 10 bn payout
        • Its worth a very close look but more work needs to be done 
      • This is a preliminary framework to think about 
  2. Australia 40% mining super tax affects all miners from BHP Billiton, Randgold, Xstrata
    • This case is more tacky since it is hard to prove the impact on the bottom line quantitatively 
      • Affects not only miners but ultimately, cost will be passed to the end users (Think China!)
      • It depends on a case to case basis for each company on how they are geared to bottom line in terms of operating leverage, some firms will get hit worse than others 
    • Company individual financial strength and cheapness of the stock is of utmost importance 
    • Investing is not speculation, in this case the tax laws are being proposed and not finalized 
      1. The rule seems rather draconian and some miners are starting to write in to oppose the ruling 
      2. The proposals still have to pass Australia's parliament, where several recent major laws have failed to get through the Senate, where the government lacks a majority
      3. Also noted as mentioned in Wall street journal :
        • Tax system review - headline corporate tax rate reduced 30% to 28%
        • Royalty that mining companies pay to state governments will be rebated, reducing the net effect of the tax changes below the headline rate of 40%
        • Combined with company taxes and after allowing for extraction costs and recouping capital investment, companies will pay a statutory rate of around 58%, according to a Treasury estimate
    • As a whole, not a clear case, however working along this lines, if you once again find any firms sold off beyond logical analysis of the figures, it is probably worth a look
      • This case is slightly more political in nature and a good understanding of it is crucial 
      • It may be too early to act on unfounded news and / or data 
  3. The last point is that when you look at things from a bottom up perspective, do note that having an awareness of the surroundings is important too.
    • Markets are selling at the slightest news because most  if not all are fairly priced in 
    • Do your homework to ensure not getting stuck in a massive sell off or at least you can stay certain of the position when it occurs 
    • Short term events should not affect your decision and views, especially changes in the stock prices unless there is/are new developments that will significantly impact the value of the investments and/or materialization of the catalysts
    • If it is outside your circle of competence, just avoid it, opportunities will be around



    BP makes a mess wherever they go.

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