Posted by Davy on January 6th, 2009 in Enlightened-American Portfolio, Investment Strategies, Reader Questions
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Before I get to the questions, check out this morning’s WSJ for details on the latest Chesapeake (CHK) $412M VPP deal.

First question comes from Neil:

Hi Davy,

I enjoyed reading your article on CHK. I am also a value investor and I’m grappaling with a problem that I think you have too. I hope you’ll indulge my rather long question.

It’s well and good to know the IV of CHK but it’s entirely dependent on natural gas prices. As you say, Investing in Natural gas via an ETF would not give you any guidance as to whether or not to sell as you can’t caluclate the IV. However any valuation of CHK obviously has NG as an input.

If your current valuation target is met then you would recalculate your IV based on updated NG values. On this basis you may not sell because CHK is again undervalued. What if in this case NG has become overvalued and then falls, CHK would fall with it and may remain undervalued throughout the fall based on the NG prices of the day. A company could go up 500% then down again all the time being undervalued (based on the spot/forward NG prices).

I encountered a similar issue with a coal stock I own. It was very undervalued with coal at around $50 and the company at around $2. The company hit my target of $7 but coal had then gone up to around $100. So I redid my analysis with a $20 price target. Then when it reached $20 coal had gone up so my valuation went to $30. Then the price of coal dropped and the company fell with it.

At all times the coal stock was undervalued based on the coal price. At $2, $7, $20 still undervalued and then now back at $7 it’s still undervalued.

Many pure value investors stay away from commodity stocks because of their need to have an opinion on the commodity price.

How do you deal with this?

Well, I do have somewhat of a problem with selling discipline but I’ll try to answer your question best I can.

When I calculate IVs, I use a price range to help me get a VERY ROUGH NAV range. The range is pretty wide — last year, I was using oil @ $60, $80, $100 and natgas @ $5 $7.5 $10. This is a very blunt tool and doesn’t take into account things like fixed costs, i.e. companies start losing money w/ $5 nat gas. But it does give me a sense of which companies may be undervalued.

Once I have a rough range, it takes a little bit of subjective judgment to determine what IV range is appropriate. Then I start looking at actual operations, quality of assets, costs, cash flow, etc. Some companies may look cheap but have assets in areas subject to resource nationalization, high cost production, etc. Many times, these red flags scare me off but if not, I dig in and try to put it all together to get at an IV range. Before the big crash, I was using fairly small margins of safety at 25% or better but now am widening it out a bit.

I am also very hesitant to move the price ranges. When oil ran up to $120, $130, $140+, I did not adjust the price range. If oil had stayed there for a year or two, maybe I would have. In the case of CHK, I changed my IV based on their new find in the Haynesville and other parts. For DVN, I did not change my IV and sold when they hit it, even as the greed factor was pounding away in my head (I sold at $105 even though my head was telling me that it hit $120 earlier in the year).

I would be hesitant to move the IV target based on rising prices. I think investors in commodity stocks have to evaluate each company for its particular situation and as the share price moves closer to the target, understand that the margin of safety initially established is narrowing even if the actual margin of safety isn’t clear. Once the share price moves high enough, investors should always keep in mind that commodities are volatile and get a sense of when they’ve moved from having an undervalued position to speculating on the commodity price.

This is definitely a lesson I won’t soon forget. For much of the year, I was speculating on oil/gold prices with my DVN & AEM position. CHK is different because for a brief spell in the summer, they’ve been chronically undervalued due to profligate management.

As for having an opinion on commodity prices, I do think investors can (and need) to get a sense of the commodities market, if for no other reason than to judge costs in other industries. I don’t know if value investors necessarily establish an IV for oil or gas, per se, but I think once an understanding of the reserves and production scenario is attained (and this is easier to analyze than market prices), investors can get a feel for whether $30 oil or $5 gas makes sense. People like Bruce Berkowitz, Seth Klarman, & Robert Rodriguez all have “value” (pure?) reputations and have invested in commodity companies.

Warren Buffett has held well-publicized, non-arbitrage positions in PetroChina and ConocoPhillips. I don’t know if he has a view on what energy prices should be but it’s clear to me that he has an informed opinion on the state and future of the energy industry, just as he has one for, say, the newspaper industry. Both he and Munger have commented at the Berkshire annual meetings that energy will be harder to produce going forward. I believe his play on BNI is based on this view (that rails will become more vital as motor transport gets too expensive).

Next question comes from Nick:

I was wondering if you could take a moment to explain how the conversion process works for CHK preferred stock. FYI, the document showing the details has moved to

http://www.chk.com/Investors/documents/Preferred.pdf

From what I can gather, the conversion price was set at the price of CHK common when the offering took place. The conversion rate is then fixed, and would represent how many CHK shares you would get for each share of CHK-PD. But then does the conversion price fluctuate with CHK-PD?

And why did you choose CHK-PD over CHK-PE… is it because of the mandatory conversion clause? I have never dealt with preferred stock before… I do like CHK though, in addition to holding a small amount of common, I have been selling out-of-the-money naked puts each time volatility spikes really high.

Thanks for the correction on that pdf, Nick.  Good call on the volatility plays. I know, as value investors, we are supposed to ignore short-term trading but my trades in CHK & NOV naked puts really helped buffer my portfolio in the back end of last year.

The conversion process works as you decribed and the conversion price does not fluctuate with the preferred share price. The conversion price does adjust if the common stock dividend moves beyond $0.06/share, which is currently the case. According the the company’s IR, they update the above-linked pdf to adjust the conversion price but the adjustments are very small at this point (and I don’t anticipate the dividend increasing anytime soon).

I chose the D shares over the E shares for several reasons:

1. The conversion price was much higher for the D shares and closer to my (original) IV estimate.
2. I found the yield of 8-9% on the D shares very attractive and sought to prolong that income stream as long as possible.  The E shares actually pay higher interest but with the lower conversion price (and mandatory conversion), any good-sized recovery in the shares could have led to me being put in the equity side at relatively low prices (~$32/share) and a puny yield.

Keep in mind, I paid a higher conversion premium to get into the D shares. A strong case could have been made for getting into the convertible bonds as well — check out my previous post here. And remember Ben Graham’s advice: Never convert a convertible.  Either hold it or sell it.

As a value investor, I look at stocks as shares in an underlying business. But never forget Marty Whitman’s warning that shareholders are as much a nuisance to many management teams as they are owners. As we’ve seen, paper wealth can evaporate quickly and investors should always look for the (cash) pay-off.

This leads into the news story referenced at the top of the post points out, CHK have been very good at closing deals and bringing in money to company coffers but common shareholders, unless they sold last summer at a discount to the company’s NAV number, have been left with nothing but losses. My position has been to take “defensive” action and make sure I get paid for however long it takes for Aubrey McClendon to show shareholders the money.  This is even more important since McClendon was margined out of all of his CHK holdings last year and may lack the same motivation as before.