tuvalahiti listening station

I have just returned from visiting relatives in Vancouver. I mostly stayed in West Vancouver with my retired aunt and uncle but also stayed in outer-suburban areas with my police-officer cousin.

I was looking for a bubble - after all Vancouver is a notorious property bubble - but - speaking as someone from Sydney I could not see one. Everything was so cheap. Houses especially. Cars too.

A Mountie and his drug-rep wife had a material standard of living that would match a partner in a second tier law firm in Sydney. House prices seemed impossibly low.

The only place where my material standard of living was markedly higher than the outer Vancouver middle class was that I have a decent surf beach locally and the local restaurants and coffee shops are much better in Sydney. Also alcohol is cheaper in Sydney - which is in part taxes and in part protection. (Alcohol is much cheaper in parts of the USA.)

To offset the beaches and restaurants, my cousins had a ski resort up the hill. And food (other than dairy) was cheaper. Quality was high. Dairy seemed to be another industry-protection issue.

And housing was much cheaper and much higher quality.

I remember thinking that Sydney was in a bubble when it got as expensive as Vancouver now is. But then housing prices doubled. After that they seemed to drift upwards.

I have given up predicting the end of the Sydney property bubble. It will happen. It feels like it might happen now. But it has felt like that before. And before that. And before that.

I would rather be short Sydney property than long it (though my wife might object). And that stance has cost me money in the past.

There is a scene in Crocodile Dundee where a New Yorker pulls a switch blade on Dundee. He pulls out an Australian bush knife which is far more impressive.




That is how I felt about Vancouver. You call this a bubble? I am an Australian. I can show you a bubble. Vancouver - that is just kids having fun.



John

The very long set of transactions entered into by Gulfport Energy with Wexford Capital was surprising to me as well as to a couple of readers.

One question though was (and I am paraphrasing): are these transactions large with respect to Gulfport Energy? Is that the reason you are short?

I can answer the first question simply: yes - related party transactions are important in Gulfport. That is easily seen by looking at their assets as mapped on their home page:


The company has interests in the Canadian Oil Sands, the Niobrara Shale, Thailand, the Permian Basin, Southern Louisiana and the Utica Shale.

Lets go through them individually.

The Canadian Oil Sands operations are held through Grizzly Oil Sands. The proxy tells us that Gulfport own a "24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford."

The Niobrara Shale is "effective April 1, 2010 ... an area of mutual interest agreement with Windsor Niobrara LLC, which we refer to as Windsor Niobrara, to jointly acquire oil and gas leases on certain lands located in Northwest Colorado for the purpose of exploring, exploiting and producing oil and gas from the Niobrara Formation." That agreement provides that each party must offer the other party the right to participate in such acquisitions on a 50/50 basis. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement." Gulfport is "the operator" of the Nobrara acreage - but the partner - Windson Niobrara is controlled by Wexford.

The Thailand assets are in two parts - Tatex Thailand II and Tatex Thailand III.

Gulfport have a 23.5% ownership interest in Tatex Thailand II, LLC. The remaining interests in Tatex II are owned by other entities controlled by Wexford.

Gulfport have a 17.9% ownership interest in Tatex III. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford.

Windsor, an entity controlled by Wexford, is the operator of all Gulfport's assets in the Permian Basin.

The Permian Basin Assets were (at year end) subject to an agreement with Windsor which provides that each party must offer the other party the right to participate in 50% of each such acquisition. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement.

In other words Windsor owned 50 percent of these and operated them. There is an interesting post-year end transaction which may be the subject of another blog post.

The Southern Louisiana assets (known as West Cote and Hackberry) are not owned by Wexford but Wexford entities provide barging, drilling and pressure control services.

The Utica Shale assets are operated by Gulfport but like the Niobrara and Permian assets they are subject to a 50-50 sharing agreement with a Wexford controlled entity.

In other words Wexford is integral to the running or ownership or both of every asset controlled by Gulfport. The Chairman of Gulfport (Mike Lidell) cements this link. He is the operating member and in some cases an officer of many of the Wexford entities.

Wexford knows more than anyone else about this company

As we have shown Wexford is either a major owner or operator or supplier to every Gulfport Asset. The Chairman of Gulfport is also (at least in part) a Wexford man.

Wexford is a big fund - according to its website it has $5.6 billion under management.

It is worth knowing what Wexford is doing with their stake. The answer is selling. And selling. And selling some more:

Trade Date	Symbol	Company Name (Issuer)	Trade Type	Shares	Price ($)	Value ($)
2012-03-13	GPOR	Gulfport Energy Corp	Sale	245,000	32.80	8,035,020
2012-03-08	GPOR	Gulfport Energy Corp	Sale	329,670	32.53	10,723,835
2012-03-09	GPOR	Gulfport Energy Corp	Sale	370,422	33.17	12,285,416
2012-03-12	GPOR	Gulfport Energy Corp	Sale	150,000	32.43	4,864,200
2012-03-07	GPOR	Gulfport Energy Corp	Sale	381,968	32.32	12,347,115
2012-03-06	GPOR	Gulfport Energy Corp	Sale	50,000	31.23	1,561,700
2012-03-05	GPOR	Gulfport Energy Corp	Sale	59,000	32.18	1,898,797
2012-02-29	GPOR	Gulfport Energy Corp	Sale	17,000	34.50	586,585
2012-03-02	GPOR	Gulfport Energy Corp	Sale	17,200	33.75	580,534
2012-03-01	GPOR	Gulfport Energy Corp	Sale	459,000	34.11	15,657,408
2011-12-05	GPOR	Gulfport Energy Corp	Sale	1,150,000	27.84	32,016,000
2011-03-30	GPOR	Gulfport Energy Corp	Sale	2,760,000	30.56	84,345,600
2010-12-17	GPOR	Gulfport Energy Corp	Sale	3,910,000	19.40	75,854,000

Still they have 5.3 million shares left - and these have a not-inconsiderable value. Moreover almost all the sales have been at prices far above the current price. Their ownership position (including capital raises) has far more than halved.

I take a highly knowledgeable and very rich seller selling aggressively at prices around $30 as a good sell signal at prices around $30.

It is less good a sell signal where we are currently trading (at prices around $20). The reasons I am still short will need to wait for another post.




John

Gulfport Energy is a reputable Oklahoma based oil and gas company with widespread interests including in Canadian oil sands (via Grizzly Oil Sands) and in the Utica shale. It trades on the NASDAQ and has a market cap of a little over 1.2 billion dollars. The ticker is GPOR.


Wexford Capital is a reputable hedge fund and investment group based in Greenwich Connecticut with (according to the website) $5.6 billion in assets under management. That is more than 100 times what we manage.


The principal of Wexford is Charles E Davidson. He has a fine CV which I have cribbed from the website:

Charles E. Davidson, 59, co-founded Wexford in 1994 and serves as its Chairman and Chief Investment Officer.  Mr. Davidson has primary responsibility for the overall strategic direction of Wexford’s investment activities and serves as the senior portfolio manager for the Wexford Spectrum Funds and the Wexford Catalyst Funds.  From 1984-94, Mr. Davidson was a General Partner of Steinhardt Partners, L.P. where he was responsible for all fixed income arbitrage, risk arbitrage, private equity, distressed/bankruptcy and special situation investments of the multi-billion dollar hedge fund.  From 1977-84, Mr. Davidson was employed by Goldman Sachs & Co. where he was the head of domestic corporate bond trading and proprietary trading.  Mr. Davidson holds an MBA and a BA in economics from the University of California – Los Angeles.

Last week I read the proxy for Gulfport Energy which goes through the relationship with Wexford. There, properly disclosed, are many related party transactions.


The hedge fund I run is (apart from the management contract) involved in no related party statements so I find complex related party transactions surprising. However, as I said, they are properly disclosed. Here are a list of related party transactions from the last proxy:

... Based solely on Form 4 filed with the SEC on March 13, 2012 by Charles E. Davidson. Represents 5,336,526 shares of common stock held by CD Holding Company, LLC. Mr. Davidson is the manager and a member of CD Holding Company, LLC and the Chairman and Chief Investment Officer of Wexford Capital LP...

... We are a party to administrative service agreements with Stampede Farms LLC, which we refer to as Stampede Farms, Everest Operations Management LLC, which we refer to as Everest, and Tatex Thailand III, LLC, which we refer to as Tatex III. Under these agreements, our services include professional and technical support and the fees for such services can be amended by mutual agreement of the parties. Each of these administrative service agreements may be cancelled (1) by us with at least 60 days prior written notice and, (2) by the counterparty at any time with at least 30 days prior written notice to us and (3) by either party if the other party is in material breach and such breach has not been cured within 30 days of receipt of written notice of such breach. We did not provide services under any of these agreements in 2011 and received no reimbursements thereunder. Each of Stampede Farms, Everest and Tatex III is controlled by Wexford Capital LP, or Wexford...

... We contract with Athena Construction, L.L.C., which we refer to as Athena, to provide barge services in our West Cote Blanche Bay, or WCBB, and Hackberry fields located along the Louisiana Gulf Coast. For the year ended December 31, 2011, we paid Athena $3,389,000 and owed an additional $676,000 for such services at that date. Athena is controlled by Wexford...

... We have a 23.5% ownership interest in Tatex Thailand II, LLC, or Tatex II. The remaining interests in Tatex II are owned by other entities controlled by Wexford. Tatex II holds 85,122 of the 1,000,000 outstanding shares of APICO, LLC, or APICO, an international oil and gas exploration company. APICO has a reserve base located in Southeast Asia through its ownership of concessions covering two million acres which includes the Phu Horm Field. During 2011, we received $870,000 in distributions from Tatex II. 

We have a 17.9% ownership interest in Tatex III. Tatex III owns a concession covering approximately one million acres in Thailand. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford. During the year ended December 31, 2011, we paid $3,794,000 in cash calls to Tatex III. 

We own a 24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford. As of December 31, 2011, Grizzly had approximately 754,000 acres under lease in the Athabasca region located in the Alberta Province near Fort McMurray. Grizzly Holdings Inc. entered into a loan agreement with Grizzly effective January 1, 2008, under which Grizzly borrowed funds from us. Borrowed funds initially bore interest at LIBOR plus 4% and had an original maturity date of December 31, 2012. Effective April 1, 2010, the loan agreement was amended to modify the interest rate to 0.69% and change the maturity date to December 31, 2011. Effective October 15, 2010, the loan agreement was further amended to change the maturity date to December 31, 2012. Interest was paid on a paid-in-kind basis by increasing the outstanding balance of the loan. During the year ended December 31, 2011, we loaned Grizzly approximately $3,182,000 and recognized interest income of approximately $147,000. Effective December 7, 2011, Grizzly Holdings Inc. entered into a debt settlement agreement with Grizzly under which Grizzly agreed to satisfy the entire outstanding debt and accrued interest of $22,325,000 by issuing additional common shares of Grizzly with no effect to the ownership structure of Grizzly. 

During the third quarter of 2011, we purchased a 25% ownership interest in Bison Drilling and Field Services LLC, or Bison, at a cost of $6,009,000, subject to adjustment. In April 2012, we increased our ownership interest in Bison to 40% for an additional payment of $6,152,000. The remaining interests in Bison are owned by entities controlled by Wexford, including Windsor Permian LLC, or Windsor. Bison owns and operates drilling rigs. 

During the fourth quarter of 2011, we purchased a 25% ownership interest in Muskie Holdings LLC, or Muskie, at a cost of $2,142,000, subject to adjustment. The remaining interests in Muskie are owned by entities controlled by Wexford, including Windsor. Muskie holds certain assets, real estate and rights in a lease covering land in Wisconsin that is prospective for mining oil and natural gas fracture grade sand...

China Medical Technologies – a Chinese diagnostic, medical testing and genetic tools company which I am short – is possibly the strangest story in our portfolio. Here is the official “business description”:

China Medical Technologies, Inc., a medical device company, develops, manufactures, and markets immunodiagnostic and molecular diagnostic products. It uses molecular diagnostic technologies, including fluorescent in situ hybridization (FISH) and surface plasmon resonance (SPR), and enhanced chemiluminescence immunoassay (ECLIA), an immunodiagnostic technology in the development, manufacturing, and distribution of diagnostic products for the detection of various cancers, diseases, and disorders, as well as companion diagnostic tests for targeted cancer drugs. The company offers immunodiagnostic products, such as ECLIA analyzers and reagent kits for various clinical applications, including anemia, cardiac diseases, food safety, growth disorders, hepatitis, HIV, infertility, liver fibrosis, metabolic function, reproductive endocrinology, SARS, thyroid disorders, and tumors tests. It also provides FISH probes, a molecular diagnostic IVD reagent for the prenatal diagnosis of various genetic diseases; detection and prognosis of various cancers; and identification of cancer patients. In addition, the company offers HPV(human papillomavirus)-DNA chips, a molecular diagnostic biosensor chip, and SPR analyzers for the diagnosis of HPV infection and genotyping of HPV. It sells FISH probes and SPR chips to large hospitals through its direct sales force; and ECLIA reagent kits to small and mid-size hospitals through distributors. The company was founded in 1999 and is based in Beijing, the People's Republic of China.

The old ticker for the company was CMED but the company has been delisted, trades on the pink-sheets and has gone completely silent. They issue no SEC filings, pay coupons on none of their debt and do not answer questions from investors or regulators. The ticker is now CMEDY.PK.

According to their last published accounts they had roughly 100 million US dollars in cash, 20 million US dollars (118 million RMB) in quarterly pre-tax profits and were under absolutely no financial stress. They did however have $396 million US dollars in convertibles outstanding. At a high stock price those converts would convert. At a low price they would pay in cash so if the stock price was low enough the company might have had to refinance. However with 20 million per quarter in profitability it was hardly going to a problem.

Well it looked like it was not going to be a problem.

Some shortsellers thought that the company was using its cash to purchase assets from undisclosed related parties. More florid allegations went around but I have verified none of them.

Still the stock went down.

It went below the conversion price for the convertible which meant the above-mentioned covert would be due in cash. And then – strangely – the company put out a press release stating they intended to restructure this debt. Here is the key release:

BEIJING, Dec. 13, 2011 /PRNewswire-Asia-FirstCall/ -- China Medical Technologies, Inc. (the "Company") (Nasdaq: CMED), a leading China-based advanced in-vitro diagnostic ("IVD") company, today announced that the Company intends to implement a debt restructuring plan to improve its balance sheet. The plan may include, without limitation, a debt-for-debt exchange with existing holders of the Company's convertible notes maturing in August 2013 and December 2016, which may potentially involve holders receiving new debts with different interest rates, maturities and principal amounts compared to the existing debts or other alternatives to be agreed. Holders of the Company's convertible notes are requested to contact the Company's Cayman legal representative, Thorp Alberga at cmednoteholders@thorpalberga.com, which will collect contact information from such holders to facilitate their communication with each other to form a noteholders' committee to liaise with the Company. 

This was truly remarkable. The company – at least on the stated balance sheet – had enough money to pay the debt (at least for a while). It certainly did not need to default on trivial coupons – but it defaulted.

Worse – it did not even tell anyone it defaulted. The bond trustee notified holders and that is all. And since then the company has been completely silent. It does not answer any questions from investors or regulators. It has just disappeared.

So what happened?

There are two hypotheses: (a) this really is a fraud or (b) this is a real company and the management are playing “silly buggers” to restructure the balance sheet to their liking (or even to steal the company).

A lot of people believe the second thesis. In this a solvent company simply stopped paying its debts and are hoping the convertibles covert (at $10 a share) and sell the stock in market (at $2 a share) to recover what money they can. And the insiders (who are talking to nobody) are buying the stock at $2 a share (perhaps with cash from the company) and in the end they will really own it.

There are other theses – including that the company is being taken private surreptitiously through a shadowy arrangement with a small American mutual fund group. This furthered the spike in the stock.


Read the Yahoo! chat board and you can have another twenty theses some implying honest management and lying short-sellers and some implying awful things about the management. There is very little way of telling them apart. Management answer no questions so all speculation is in a knowledge vacuum.


We were short but we were worried that this might be the good Chinese company thrown out by a fraud allegation - we are always wary of being wrong. And the stock was going up which is never comfortable for a short seller.

So whilst the stock hung in the air much the same way bricks don't we hired someone with genuine expertise in diagnostic tests to look at the technical specifications of the medical tests they had on their website. (Our expert can read Chinese.)

Here was their response:

They have three product lines: ECLIA, FISH, and SPR. I am a bit busy doing other stuff, so I will do this in three parts, one product line per part. Here is the first part on ECLIA: 

ECLIA instrument and assays are proprietaryECLIA Product brochures have no product specification Sensitivity of instrument is stated as 10^-19, but no units givenCan’t find any patents that belonged to the company 

ECLIA is what they call Enhanced chemiluminescence immunoassay. The company said it is a closed system, i.e. proprietary instruments and diagnostic assays. The assays cannot be used in 3rd party instruments, and the instruments cannot be used for 3rd party assays. This is very strange because cost is important in diagnostics based on chemiluminescense technology. A closed system means higher cost, smaller volume, but you hope to make up for it on price, i.e., differentiate products based on quality. Indeed, they claim that their instrument is very sensitive, 10^-19. But 10^-19 of what? They don’t specify the unit. Regardless, whether it’s molar or ng/ml, 10^-19 sounds very impressive. However, I am used to nano or pico scale, and 10^-19 is one million times more sensitive than pico scale. This seems impossible. Not only impossible technically, but also business wise –  what diagnostic applications would need this kinds of sensitivity? I can’t think of any. Also, I don’t think sensitivity matters for the type of assays they sell. 

Chemiluminescence immunoassay is the technology found in pregnancy tests sold in drug stores. This is an old and cheap technology. In general, you use this technology to get yes or no answers quickly and cheaply. The sensitivity of  chemiluminescence immunoassay is usually below 0.5ng/ml, i.e., already very sensitive. Regardless, for in vitro diagnostics, most of the technology should be in the assays, not in the instruments. And here is where I found strange - the company does not have product specification for its assays on the web. On the other hand, lots of Chinese instrumentation and diagnostic assays products sold on Alibaba show no product specification at all.  The only immunoassay technology that is known for its sensitivity is radioimmunoassay, but it is a niche product specific for detecting allergen for allergy diagnostic. If CMEDY’s technology is real, then it's ECLIA products have a very small niche and it probably has no sales - the company has only one test for allergy – total IgE.

We remain short this stock. CMEDY is a good ticker – add an 0 (which is where I think the stock will wind up) and you get COMEDY. That is good for a laugh.


John

I never got to ask a question at the Berkshire meeting. I was a little awed and did not even ask until about 2pm (which was silly). There was a lottery ticket system to determine who got to ask a question anyway.

So here goes (and for the most part I genuinely do not know the answer).

Insurance companies sell promises to make good real goods and services some time in the future for cash now. For example they promise to pay someone's medical expenses or a nursing home bill say 10 years after a premium has been collected. 

They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks. 

Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies. 

Can you run through the major Berkshire insurance businesses (GEICO, Gen Re, Ajit Jain's business and others) and tell us what damage inflation will do and why?

Answers are gratefully accepted - especially from Uncles Charlie and Warren (who I somehow doubt read this blog).




John

PS. I should disclose because people are doubting it - that Bronte Capital is LONG Berkshire stock.

J

I am in Omaha and have just been to the Warren and Charlie show. It has been on my "to do" list for my whole adult life and I am strangely disappointed.

It is of course blasphemous to be disappointed in Charlie and Warren. These octogenarians could teach me plenty - they just did not. It was annoying to be in the presence of people so smart and to learn so little.

I have read various notes from the meeting for almost twenty years so I had a fair idea what to expect. I could expect - questions on politics and economics, questions from young people wondering what to do with their life and questions from hedge-fund managers using 25 thousand rich people in a room as an opportunity for self promotion.

I got all this - and for the most part I got the usual homily answers. (The same questions were asked last year and the year before and the year before that. Answers can be got from meeting notes.)

This year we got multiple questions from hedge fund managers who were concerned about the stock price. Charlie Munger in frustration tartly observed that if one (nameless but well known) hedge fund manager was that concerned about short term matters he wasn't really welcome in this room. This got general applause but could (like many of Charlie's answers) be a little more diplomatic.

But with the above exceptions the questions were better than I expected. Much better. We had serious questions from competent Wall Street analysts who mostly asked about insurance, underwriting and regulatory issues - issues that cut to core of what Berkshire is and Berkshire's ability to route money to the parent company (where it can be used unencumbered) and to pay insurance claims. The detailed answers to these questions were largely squibbed.

One analyst for instance made the obvious observation that the organizational structure is "challenging" and wondered why the railway (BNSF) was owned by a regulated insurance subsidiary. Charlie and Warren squibbed it - arguing that BNSF provided more resources for paying claims - noting roughly $5 billion in pre-tax profits. But throughout the meeting Warren argued that one advantage of BNSF was that it was going to be allowed to invest vast sums (far in excess of depreciation) at acceptable regulated returns. In other words BNSF is going to absorb cash. How does this mean the insurance sub is going to have more cash to pay claims? Can claims be paid in steel rails or railway bridges?


This wasn't an atypical squibbed answer. Warren (correctly) argued that General Re was a good asset now but that previously it lost its way. Charlie wasn't going to let Warren get away with this - it was thoroughly lost when Berkshire purchased it (and paid a huge price). However the details of how General Re was brought back into order were simply glossed over. Warren observed that Gen Re had a very nice life reinsurance business. That surprised me. Swiss Re has a sort-of-OK life reinsurance business but life reinsurance is a business that has produced a few disasters one of which I followed closely*. I was struggling to understand what made the life reinsurance business a good business.

Warren also noted - as a throwaway - that they had a long term care reinsurance business that he wished they had less of. Again there was no explanation as to why. But this time it is inside my field of competence so I am going to explain myself.

The disaster of long term care insurance

Long term care insurance has bankrupted almost everyone that ever touched it. It is the insurance against the need to go into a nursing home and it has mostly been sold by insurance agents on commission.

Here is what a commissioned agent does.

They make friends with people who run nursing homes.

When the kids (now middle aged) visit a nursing home they might put their (elderly) parents into the insurance broker is notified. The insurance broker then sells them a policy for their parents.

Of course the policy is going to be used. The people who buy long term care insurance are precisely the people who are going to claim. It is a disaster.

Eventually the policies become so expensive (to cover the losses) that people who won't claim never buy a policy. Adverse selection becomes total.

Long term care insurance is the worst business I have ever seen.

Warren of course never told us that - but somehow he wound up re-insuring it.

I guess he did not want to explain his stupidity.

But then long term care doesn't need to be that awful. Indeed there is (at least) one company that does it well.

That doesn't make long term care a good business - but it might make it an acceptable business.

That company is (and this will be a surprise to many of my readers) Genworth. The same Genworth that was a spin-out of crappy long-tailed insurance businesses from GE Capital. It includes a mortgage insurance company (with what is probably a toxic Australian exposure) and a long term care business.

Here is what they do to make the long term care business acceptable.

They employ a sales force of 60-65 year old people on salary not commission. Because they are on salary not commission they have no incentive to write bad risks. They do not troll for business in nursing homes.

This sales force visits the home of leads and has a cup of tea or coffee and a social chat. They might spend twenty minutes having a chat.

They will find out what the lead's husband or wife is doing.

They will find out whether the lead is doing the New York Times crossword or reading sophisticated books.

And whether they play golf or do some exercise.

They will look for pictures of the grandchildren and ask questions about them.

They will observe and ask about the pile of toys and children's games in the corner.

And only then will they ask anything that looks like an underwriting question but they will have already decided whether to underwrite the business.

Here is what is going on.

People who have stable relationships into old age tend not to wind up in nursing homes. They look after each other. Singles are the biggest risk and asking about a spouse is the critical question.

Doing the New York Times crossword or reading sophisticated books indicates no Alzheimer's disease. That removes another major insurance risk.

Golf suggests some physical fitness - and removes more risk.

The children's toys however are - after a solid marriage - the next largest risk mitigating factor. If the grandparents look after the grandchildren that creates a reciprocal obligation. The children are far less likely to put granny in a nursing home if granny is a part of their own kid's lives.

Warren knows all this. He knows why some insurance businesses are better than others. He knows why their life reinsurance business is good (I have no idea). He knows why their long-term care reinsurance business is bad (and after this post so do you).

But Warren told us surprisingly little. And for that I am disappointed.




John


*I was once obsessed by the collapse of Annuity and Life Re.

Post script: in all except a very bad year or a very high cap-ex year the depreciation plus profits of BNSF will probably be less than cap-ex so there are likely to be distributable funds. One exception may be if a catastrophe removes many of the bridges or damages the rails or closes the line for an extended period. That however may well be a big claims year for the insurance company so the situation can still be problematic.

Huabao - a Chinese flavours and fragrances company in Hong Kong - has suspended trading after falling on a short-seller report. To quote a Business Week article:

Huabao International Holdings Ltd. (336), a maker of flavors and fragrances used in cigarettes, suspended trading in Hong Kong after the stock plunged on a short-seller report that questioned its finances. 

Huabao fell 8.1 percent to HK$3.98 at the close in Hong Kong yesterday after short seller Anonymous Analytics said the company “reports absurdly high margins, which industry sources say should not be possible.” 

The company didn’t give a reason for the suspension. In a Hong Kong stock exchange filing late on April 24, Huabao said it wasn’t aware of any reasons for the changes in its share price and trading volume.

Readers of this blog should be familiar with the stock as I blogged about it here. I also blogged about the (now in excess of a) billion US dollars the CEO had cashed out and the derivative transactions that she had used to do so.

The suggestions in my blog post - and a few other things - were covered in the short-seller report.




John Hempton


Disclosure: We remain short this company - albeit in modest quantity.

Just asking. I am visiting.

Send me an email through the blog.

It is the holiday part of the trip and I was strolling through the back-lot footpaths of Venice with my twelve year old son. We were doing out best to get lost (surprisingly easy) and I had given up worrying that my wife had (dangerously) gone shopping.

It was four hours chatting to the boy about business and history and life without the interruptions of computers, phones or video games.

We talked about the trading history of Venice, the closure of the Venetian constitutional system (La Serrata of 1286 to 1297) and the subsequent relative decline. We talked about the expenses of the nearly endless series of wars against the Ottoman empire.

We even mentioned the rise of double-entry accounting. We got as far as the collapse of the Venetian State at the hands of Napoleon.

We also talked at length for the first time about our business. We run a hedge fund. Our job is simple: make rich people richer through investing, trading in financial markets.

Half of that is relatively easy to explain: we buy shares in good companies. My son wanted to know why I was not interested in buying Facebook (he thought the shares are going up). I told him that it had 4 billion in revenue, 1 billion in profits and a market cap that was likely to edge 100 billion. The numbers are from memory (I am on holidays). That seemed expensive. However it was only about $200 per regular user which does not seem so expensive. I did not think I could analyse it well. This was the beginning of a discussion about price.

But then the area our fund is best known for came up. I am a short seller.

I went through the mechanics of short-selling. I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up.

Then I got to the nub of the issue: I am a short-seller of frauds and stock promotes. I look for people in the stock market who have fake accounts and who are stealing from gullible shareholders (also known as marks, dupes, fools, day traders or mutual fund managers). There is a torrent of money being ripped off (many billions of dollars for instance in the case of the Chinese frauds a surprising amount of which came from Fidelity). Through short-selling I stick up my sail on my little boat in the hurricane of theft and some of that loot drops into the cabin.

He asked me how I find all these fake accounts and fake companies and I told him a few of our methods (we have many).

He asked if I ever dobbed the scammers in to regulators and I said I did sometimes but it was mostly not a satisfactory experience. To be a good short-seller I only need to be right about 90 percent of the time. If most the companies I short-sell have fake accounts I will do fine. However if I dob them into regulators I need to be absolutely right in that it does not bode well to dob an honest person into the authorities. So mostly I keep my gob shut and express my opinion (and it is an opinion) in a bet in the financial market.

Moreover talking about which stocks you think are frauds is a dangerous thing. Regulators sometimes (even foolishly) have been known to investigate short-sellers for telling the truth. (Being  short Lehman Brothers and vocal about it was a good way of getting an SEC investigation for talking truth to power.) Also crooks sue short-sellers giving you nasty and expensive legal bills.

Silence is altogether a better strategy.

But then he came to the nub of the issue. The easiest scammer to find is a repeat offender. We actively seek out people who promote dodgy stocks and who who are repeatedly involved in dodgy companies. The slogan is “once a scumbag, always a scumbag”. That slogan is probably not strictly accurate -  but we only need to be right 90 percent of the time to be fantastic at this business – and the recidivism amongst scammers is surprisingly high.

In that sense long sentences for people like Bernie Ebbers are not in my interest. I would prefer slime-bags to be back-in-business rather than in prison. More opportunities for me.

So, perceptively my son asked whether it was in my interest to dob scammers into regulators – he asked whether the reason we did not do it much was because of the reasons stated above or because we liked the scammers to be free and profitable. Alas – and I had to confess it – at least part of it was that being a successful short-seller required that regulators were inadequate to the task of policing fraud.

I did not talk about this with him – but it is becoming harder under Mary Schapiro. The SEC is getting better at their job – and that is not good for me. It would be better if regulators stayed hopeless. Alas they are getting better.

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you?

Sheepishly I confess yes.

And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.





John

PS. A long time ago I promised Felix Salmon an economic defence of short-selling. I did not deliver – but it is sort of written in my head. I think I owe it to my son too.

On my travels I found myself in a fine hotel in Central Milan. I came in about Midnight the previous night from London (courtesy the atrocious service of Easy-Jet*).

At 6.15AM I was up for my morning meeting - via a fast-train to Bologna. My shirt was clean courtesy the expensive London laundry. I just wanted an ironing board to press out the wrinkles.

There was not one in the room - so I rang reception. I asked them to bring one up. They said "impossible" which I found peculiar. An ironing board is a pretty standard service in a 4 star business hotel.

Then they explained that they could not get one before 7.30 (which was just before my train left). I said this was a bad fail for a business hotel.

Then they said something that was so stereotypical Italian it left me breathless. They told me it would be against the law to bring an ironing board to my room before 7.30 am.

I told this to my Bologna business contact and he scoffed. Of course somewhere in the 10 million lines of Italian code there is - of course - something that talks about ironing boards. Dysfunctional government (at least by the standards of OECD countries) is an iconic feature of Italy - but this was not government as a problem - it was government as an excuse.

At least Easy-Jet don't blame the government for their bad - even rude - service.



John


*If anyone knows why European discount carriers are so horrible but Southwest (surely a similar model) is so pleasant (at least in a relative sense) let me know. In the USA I will fly Southwest in preference to any other airline. In Europe I am learning to avoid the discount airlines.

-------------

A post script is warranted: Part of my dislike of Easy-Jet had to do with a ridiculous overcharge of GBP12. Trivial really. However when I complained at the counter the discussion had the tone of "I can see you are right but our computer won't let me refund the money so sorry". Silly stuff that indicated process over service. And I had 90 minutes at an airport and was frazzled. Not a good combination. I did not raise my voice - just walked away frustrated.

In frustration I wrote a (nasty) letter to them. I do not think they linked me to this blog - but they refunded the 12 pounds. I think that marks them as several steps better than Ryan Air. I have not quite forgiven but I think I am prepared to give them another go.

I do irregular (but extended) business travel. (It comes from living in Australia – when you travel it is usually more than a week.)

And so I find myself needing to wash and iron business shirts and press a suit. Nothing complicated – but strangely the price and procedure changes by country. In New York I usually stay in Brooklyn and my walk to the subway takes me past a Chinese laundry which is breathtakingly cheap – my bag usually costs under $12. That is about a quarter what I would pay in Sydney (which is an expensive city for almost everything) and a third London. Brooklyn seems cheaper than other US cities.

This low-cost laundry (clearly a benefit to me) is made possible by a near-sweatshop centralised Chinese laundry where (immigrant) workers work hard for what may or may not be minimum wage.

When I wrote a post about that I was criticised for daring to state the obvious about income inequality in the United States. It is a taboo topic. In my defence several readers noted that investment bankers regularly press their own shirts in London. I certainly do in Sydney.

When I stayed in a friend's house in Chicago I discovered much to my surprise they did not have an ironing board. I thought it worth a blog post. And whilst the underlying tone was that income inequality was not the finest attribute of a society I have to say it is not entirely a bad thing. The couple I stay with in Chicago are a monstrously successful husband and wife team with children. Very few married women with children pull that off in Sydney – and the reason was obvious. The wife's work life (high profile but only moderately remunerative) relied more than a little on the two nannies and the implied low-wage workers (such as the staff at the local laundry) who relieved her of the mundane house-work that fills many (mostly female) lives in Australia.

This was feminist achievement made possible by income inequality. But it was achievement at a very high level and the USA is better for it.

This trip I stayed at a friend's apartment in Hong Kong. Nice place – not huge – but half-way up the Mountain on Hong Kong Island with an expansive view of skyline (when you can see through the pollution).

I asked to borrow an ironing board. My friend said he could do better. He knocked at a small door past the closet next to the kitchen and out popped a Filipino house-keeper maybe 20 years his senior. She cheerfully laundered my clothes and left them neatly pressed. She also made me breakfast, cleaned up my dishes and made my bed when I went to work.

I made a point of trying to work out her story. She had been a migrant worker throughout her life – mostly in Hong Kong but also in Dubai (which she found harder). She was thinly educated but thought her children (who she had spent years away from) were better prepared than her. The reason for migrant work was to educate her children (though I know nothing about their prospects – the Philippines are not a highly functional place). Unlike Harry Potter she did not show any unhappiness in living in the “cupboard under the stairs”. Instead it was a step-up for her and (especially) for her family. And it was better than Dubai.

But it made me deeply uncomfortable. Migrant workers are a profoundly anti-democratic institution – they provide a class of very-low income people who don't vote. The ethos of democracy is something burnt into my consciousness. In this ethos we are “created” equal (and thus have an equal vote) and dint of luck and hard work (or coming from the right womb) produce inequalities (some deserved, some otherwise). But the vote (hopefully a secret ballot) is one of the great equalisers – and acts to create a more harmonious society (albeit one that will interfere with income distribution to some extent). The woman who cheerfully lived in the cupboard under the stairs challenged what I thought was right in the world.

But then I was in Hong Kong (that is China) and another low-wage worker who does not vote in China seems – well – somewhat irrelevant. And my world view was out of place. Moreover the woman's children were clearly better off for her migrant work. And the Philippines would be a true basket case without remittances.

And low-income workers are a gift to those who get to employ them. They make the Feminist achievements of my above-mentioned Chicago friends possible. They can free productive people to work on things that were productive.

And that was clearly the case for my friend – consciously trying to pick up additional commercial languages (think India), improve his computer processing skills (python) and read a book per week. His ambition to build himself into as fine a thinker (and with as many diversified mental models) as Charlie Munger. Human capital development made possible by the profoundly undemocratic institution of migrant work.

But that was not the only thing people do with their wealth in Hong Kong. Hong Kong Island has become a pastiche of office towers for financial businesses and shopping malls selling the global standard set of luxury goods. Interspersed amongst that are stylish but ultimately vacuous bars where you can get wasted in the time you would have otherwise spent ironing your clothes and doing the dishes. It is not far (just a subway) from Kowloon where you can experience the smells and sounds of Asia – but they joke on Hong Kong Island that you need your passport to go there.

This is a world very different to mine – with some amazingly productive people – their productivity made possible by the institutions of China. Interspersed amongst that the most dilettante hedonistic lifestyle of an elite who can think of nothing better to spend their loot on than Swiss watches and French Brandy.

Whatever: I am going to make a confession. I liked having someone launder my clothes and the stylish bars are very cool. Freeing up all that time to read an extra book per week – that would be very cool too.




John

This is from the guy who took a $113 million loan from a fund he managed for his clients.

His vehicle - Lightsquared - owned a bunch of satellite spectrum. It was zoned for satellite - allowed to be used for low powered devices that did not interfere with users of adjacent spectrum.

He got its use changed - so that he could use it for high powered devices - that is a terrestrial LTE network. There was a condition. That his devices did not interfere with adjacent devices - namely GPS receivers.

This condition was clear right from the start.

Tests were conducted to see whether Phil's network would interfere with the GPS system.

And it did. And how. The devices could jam GPS at many miles range.

OK - so Phil was not allowed to build his LTE network.

He still owns satellite spectrum. What he started with. The FCC took nothing from him.

But he wants the FCC to give him spectrum he is allowed to use - spectrum more valuable than the stuff he previously owned.

“They can’t just leave us without some alternative to build a network,” said Jeff Carlisle, Lightsquared's EVP for regulatory affairs and public policy, at a briefing with media on Friday.

Yes they can. And they should. Of course I could lobby the FCC to get them to give me 10-20 billion dollars worth of spectrum I am not entitled to.

I could. But I am not that brazen.

If the government wants to give away that much spectrum they should auction it and the money should be used for the benefit of all taxpayers (say by paying off debt).

Make no mistake about it. If you are an American taxpayer Phil Falcone is trying to loot assets that rightly belong to you.

You should not let him. And you should despair if he gets away with it.



John

1. What are your organisation’s total global assets under management in US dollars? 

Under $50 billion
$50 billion to $99 billion
$100 billion to $499 billion
$500 billion to $999 billion
$1 trillion or more

6. In your opinion, which of the following is the most important factor driving decisions among institutional investors in today’s environment? Select one. 

Yields
Diversification away from mainstream asset classes
Regulatory complexity / uncertainty
Risk aversion
Other, please specify

8. What are your organisation’s expectations for increasing assets under management over the next 24 months? 

0%
1% - 3%
4% - 7%
More than 8%
Don’t know

15. What are the greatest data management challenges to the asset management industry today? Select all that apply. 

Achieving sufficient scale with in-house systems
Providing a high level of detailed and quality data to clients
Safeguarding investor data
Providing accurate data to regulators and auditors in a timely fashion
Don’t know

16. Which of the following will contribute to your organisation’s ability to expand globally over the next 12 to 24 months? Select the top two. 

The strength of our infrastructure
Relationships with key market participants
Brand recognition
Competitive advantage in niche markets
Other, please specify
We currently have no plans to expand globally

I wrote a post yesterday which impinges on American politics. I simply observed that the alleged New York Madam who is being locked in solitary for failure to find $2 million in bail money was being denied her constitutional rights.

(I also criticized the recent executive grab for power by Eric Holder.)

I said I thought that the State abrogating Constitutional Rights was an unfortunate trend.

What pleases me is that (with the exception of a second amendment fundamentalist who objected to my off-hand assertion that the provision was antique) I have had almost universal agreement with this observation from both the left and the right.

I have gun-toting law-and-order right wing readers. They agree.

I have liberal readers. They agree.

I have libertarian readers. They agree.

I haven't seen this much agreement in any US political matter for a long time.

That is hopeful.



John

PS. As far as I know I don't have many Christian-fundamentalists who want a Christian State type readers. As I was standing up for the constitutional rights of a woman who is alleged to have provided women for prostitution I suspect there is a fracture line there. I did not see that in comments or emails received.

I am a resident of a country without a bill-of-rights in our constitution. Whilst I think some of the rights are antique (second amendment, implied right to privacy in the fourth amendment which looks very difficult in the era of "digital papers") it is - I think - an improvement on our system.

That said, it is only an improvement on our situation if the constitution is not ignored.

This week we have seen an amazing power grab by the US Attorney General. To quote Eric Holder:

“Due process and judicial process are not one and the same, particularly when it comes to national security. The Constitution guarantees due process, not judicial process.”

Here is what the constitution says (Fifth Amendment):

No person shall be held to answer for a capital, or otherwise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or public danger; nor shall any person be subject for the same offense to be twice put in jeopardy of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

I have - for the benefit of the Attorney General - highlighted the relevant section.

Incidentally I have quite a deal of sympathy for extra-judicial execution of a dangerous criminal. "Wanted, dead or alive" posters have been part of the American mythology for a reason. But I gather there was a valid arrest warrant for the person and if the person surrendered there was a legal process. These are I presume "processes of law" rather than (say) a process of the executive. The executive claiming that their process is sufficient to execute someone is - politely - novel.

But it is not the big cases that worry me about America. Its the little cases because through the little cases you can see the erosion of the liberties that made America great affecting ordinary citizens.

Linked is the New York Post article about Anna Gristina - the alleged New York madam with a roster of high class clients. Sure I was reading it for salacious details of who the clients might be. However I found myself getting more annoyed at the process.

You see she is innocent until proven guilty - and she is being locked up in solitary confinement on Rikers Island. Seems rough. But it was the statement that she was being held in lieu of $2 million bond that got me. She is a mother of four with deep connections to the United States. It is going to be hard to argue she is a major flight risk.

But somehow a $2 million bond (way more than most people could post) has been asked. This leads me to the eighth amendment:

Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punishments inflicted.

Somehow we have come to the conclusion that $2 million is not excessive bail. That I am puzzled by. When did America come to the conclusion that unless you were very rich you should be locked up pending trial for victimless crimes? What is it about the new American culture that does not think that $2 million bail is excessive?

Does anybody care or is Anna Gristina just another person arrested by police and hence guilty until proven innocent?



John

PS. If I had to guess the bail for a similar case in Australia - it would be bailed on her own surety (that is zero dollars). Australia's lack of a bill of rights looks pretty good here.

Houston American is an oil-and-gas explorer which had enough cash for one speculative well in Columbia. Just one speculative well.

It had to work.

Alas recently their (down-hole) tool failed and their stock dropped 35 percent. The stock has since drooped a little more. But it was - as the CEO pointed out - a promising well. They had approximately 200 feet of "net resistive sands" which my readers helpfully point out means sandstone with low electrical conductivity and hence possibly saturated with hydrocarbons.

But they did not get to test those sands (yet) and tool failure meant they could not test the well at its target depth (and they had to plug the lower part of the well).

The question arises though - why didn't they fix the well? Why didn't they do what "big oil" does when it has problems (that is throw money at them). The answer is that they do not have much cash.

The 10K just came out. The first thing I looked at was cash balances. Unescrowed cash was 9.9 million compared to 26.6 million a year ago. At the end of September cash was 15.1 million. Most of the well expense has probably been incurred after year end and the cash balance is almost certainly low single digit million.

Which is not what you want when your tool breaks and it is going to cost a lot of money to fix it. Or even a fair whack of money to test the "net resistive sands".

Still the company is straight about it. The auditor did not give them a "going concern statement" which surprised me. But the company disclosed the problems anyway. Here is the disclosure from the 10K.

While our development costs were funded during 2011 with funds on hand and cash flow from our other producing properties, our funds on hand at December 31, 2011 and anticipated cash flow from operations in 2012 are not sufficient to fund our 2012 drilling budget. Accordingly, unless we are able to secure additional financing or substantially increase our operating cash flow, we may be required to curtail our drilling plans. We do not presently have any commitments to provide additional financing to support our 2012 drilling budget. If we are unable to secure additional financing, we may be unable to meet certain contractual commitments regarding the development of our properties and, as a result, may incur penalties or risk losing some or all of our interest in properties for which we fail to satisfy our funding commitments.

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

Most of the comments posted wound up revolving around SuperValu - the grocer that owns Albertsons and others and which has been distressed and whose stock price reflects that distress.

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

Here is the last quarterly balance sheet for SVU:

	December 3, 2011				February 26, 2011
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	196			$	172
Receivables, net			747				743
Inventories			2,616				2,270
Other current assets			226				235
Total current assets			3,785				3,420
Property, plant and equipment, net			6,226				6,604
Goodwill			1,306				1,984
Intangible assets, net			887				1,170
Other assets			581				580
Total assets		$	12,785			$	13,758
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities		$	2,720			$	2,661
Current maturities of long-term debt and capital lease obligations			396				403
Other current liabilities			643				722
Total current liabilities			3,759				3,786
Long-term debt and capital lease obligations			6,203				6,348
Other liabilities			2,078				2,284
Commitments and contingencies
Stockholders’ equity
Common stock, $1.00 par value: 400 shares authorized; 230 shares issued			230				230
Capital in excess of par value			2,860				2,855
Accumulated other comprehensive loss			(379	)			(446	)
Retained deficit			(1,450	)			(778	)
Treasury stock, at cost, 18 and 18 shares, respectively			(516	)			(521	)
Total stockholders’ equity			745				1,340
Total liabilities and stockholders’ equity		$	12,785			$	13,758

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.



John


*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.

Wayne Swan the Treasurer of Australia (in UK parlance the Chancellor of the Exchequer, in US parlance the Secretary of the Treasury) has been publicly criticizing the new Australian billionaires and their political influence warning that they are a risk to the Australian ethos of the "fair go".

He is quoted as follows:

"A handful of vested interests that have pocketed a disproportionate share of the nation's economic success now feel they have a right to shape Australia's future to satisfy their own self-interest."

Swan's critics have accused him of "class warfare".

This will be highly familiar to American readers who have got used to living in a world where lots of money gives you better access to speech. I have barely met an American who disagrees with this sentiment but mainly when the said pile of money disagrees with them.

To liberals in America the Koch brothers are evil incarnate.

Several conservatives think the same thing about Warren Buffett when he argues the rich should pay more tax. Governor Christie's comments were just plain angry. George Soros induces apoplexy in some conservatives.

And most Americans think there is something unseemly about K-Street and the influence peddling lobbyists of Capital Hill.

Money politics - American style - is settling in in Australia. Wayne Swan knows it.

But in Australia it is potentially much more dangerous than in America. Our new-era Australian billionaires - the ones Wayne Swan rails against - are all billionaires from resource extraction. They all get their money by digging up things that potentially belong to all Australians and selling them to foreigners. And they railed against the resource rent tax (a tax whereby the rest of us got paid something for their bounty). As well they might. And they rail against carbon trading schemes.

Indeed American style money politics in Australia is far more insidious than in the US because our billionaires are far less diverse. A diversity in billionaires (and in the way they make their money) gives us a diversity of billionaire opinion. You can get the Koch Brothers and George Soros in one system - and to some extent their opinions (and the money with which they foist them onto the rest of us) offset each other. The balance is preserved.

Here we risk no balance. And so I am writing a post to tell you just how important Frank Lowy has become. Frank is an opinionated billionaire who made his money from property management and shopping centres. He is "Mr Westfield". He is also highly opinionated and funds his own think-tank (the Lowy Institute). I have in the past disagreed with him strongly - but at the moment I am just darn pleased that he is there.

Lowy is fighting with Clive Palmer (a resources billionaire) about of all billionaire disputes - the business of owning football teams. But I hope that is just the start of it. He is our most opinionated non-resource billionaire, one with a global perspective - and suddenly he is part of the future of Australian democracy.

Frank Lowy (despite the high quality think-tank) has never shown the intellectual depth and breadth of vision of George Soros. I am just as familiar with his influence on local councils (getting his projects approved and his competitor projects rejected) than I am with his global vision. But Frank is all we have got. Billionaire visions are pretty thin around here.

I never thought I would say this. Frank Lowy - your country needs you.




John

PS. I am a hedge fund manager. My job is to find rich people, invest their money and make them richer. The rise of an Australian plutocracy is thus in my interests but I would prefer a plurality of plutocrat clients.

Houston American Energy yesterday announced a problematic exploration well. They had (drilling) tool failure. The stock fell 35 percent.

I read a lot of press releases: this one is amusing.

HOUSTON, March 1, 2012 /PRNewswire/ -- As reported in Houston American Energy Corp's (NYSE Amex: HUSA) Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 and in Form 8-K on December 19, 2011, drilling operations on the Company's first well on the CPO-4 block in Colombia, the Tamandua #1, with a projected target depth of 16,300 feet, commenced in July 2011 and was subsequently sidetracked to address drilling issues associated with high pressure and inflows of hydrocarbons and fluids into the well bore. As of December 19, 2011, the sidetrack well had been drilled to 13,989 feet and efforts were ongoing to control the well bore while continuing drilling to the target depth.  

Subsequently, and as of March 1, 2012, the Tamandua #1 sidetrack well had a 7 inch liner run to 13,913 feet and was drilled to total depth ("TD") at 15,562 feet.   Upon drilling the well to TD, the well encountered Paleozoics which was a clear indication that the TD had been reached.    

While the well exhibited oil shows while drilling, and other indications of hydrocarbons such as log analysis that indicate possible productive sands, hole conditions have prohibited sufficient testing on the bottom hole sections.  There have been many attempts to evaluate the well resulting in tool failures and stuck pipe, and current conditions are such that the operator has made the decision not to try to reenter the bottom hole sections.  As a result of these developments, the decision has been made that without the ability to effectively test the lower zones, the most prudent course of action is to plug back the well and to further evaluate the C-7 and C-9 Formations.  As previously reported and indicated by the Logging While Drilling data, the well encountered approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation (resistive sands do not necessarily mean pay).  

Results of the further evaluation of the C-7 and C-9 formations will be announced as soon as they are available.  After attempting to complete the well, the rig is expected to be moved to one of two locations that are currently permitted and ready to receive the rig.  In addition, the Operator has five additional locations that are in various stages of permitting, location and construction. 

John

And a follow up question: can anyone explain to me what is meant by "net resistive sands"? The phrase does not appear anywhere in the Google database not linked to this company.

Post script: There is a Bloomberg article which quotes the CEO as follows:

“I would like to make it clear to our investors that the Tamandua #1 well is not being abandoned,” John F. Terwilliger, chief executive officer of Houston American, said in an e-mailed statement today. 

“Current ongoing operations are to make a completion attempt in the C-9 and C-7 sands,” he said. “As previously reported, the Tamandua #1 well exhibited hydrocarbon shows in the C-7 and C-9 sands, and logged approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation. We are eagerly awaiting the results from these completion attempts.”

This corrects a previous article which unambiguously suggested the well was dry.

I run a small hedge fund.

Most people that do that want to use their (lack of) size to find (and exploit) value-priced small cap stocks.

The problem is that almost any company with a market cap of $200 million to $5 billion has teams of private equity (PE) buyers looking at it.

The competition is fierce.

The PE guys have two advantages I do not. They have access to cheap loan funds in quantity. And when they do a transaction they can get inside the company, look at the books and do proper due diligence.

Those are winning advantages - advantages that I would not want to compete against.

One arguable offset to those advantages is that many PE executives are surprisingly inept. They look good in their suits - but I have met a few along the way who really are empty suits. You know the type - straight out of their big-name business schools but without the depth of experience and the humility to know that business can be difficult. For the purposes of investing they are stupid.

Their stupidity however is masked because mistakes are not marked-to-market. A bad transaction can be buried a long time and a few good ones (with lots of leverage) can offset a lot of ills.

I don't understand why so-called "value investors" are drawn to small caps. Trying to find cheap stocks against stupid people backed by seemingly limitless cheap funds and no market discipline does not seem like a good way to construct a value portfolio.

I consider myself a bit of a Buffettphile - but I did not even know Berkshire had a sizeable agricultural machinery operation. Sure agriculture has been good and because the capital equipment is a lean off that it has been very good. But this throw-away quote from the annual letter is astounding:

Vic Mancinelli again set a record at CTB, our agricultural equipment operation. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash. Vic has made a number of bolt-on acquisitions over the years, including a meaningful one he signed up after year end.

The one thing we know about the solar panel industry is that it is glutted. Solar panel prices are collapsing as has been observed many times on this blog.

Trina Solar reported yesterday. Bad numbers as expected. To quote them as to the glut:

Despite this achievement [which in Trina's case was increased sales], growth in worldwide module capacity and peaked channel inventory resulted in significantly lower product prices which adversely affected our bottom line results, whereby our cost reduction was not sufficient to offset lower ASPs [ie average selling prices].

I promise you I am not telling anyone anything new here. If you are an investor in the solar-panel industry and have not noticed a supply glut then you are completely non-observant.

What is strange though is that despite the supply glut the capital expenditure in this business - that is building new plant and machinery - goes on regardless.

Here is a line from the balance sheet:

Trina Solar Limited
Unaudited Consolidated Balance Sheets
(US dollars in thousands)
		December 31,		September 30,		December 31,
		2011		2011		2010
Property, plant and equipment		919,727		783,328		571,467

Property plant and equipment at Trina went from 571 million to 920 million in one year. And in the year when the industry became hopelessly oversupplied.

Moreover the rate of increase accelerated in the fourth quarter when the oversupply was obvious to anyone to see - when anti-dumping cases against loss-making Chinese solar panel makers became vogue.

There are lots of things that might be going on here. The company might have a great new technology which is worth investing in even though the industry is glutted (indeed the company points to its "honey" technology). Or the company might be insane. I have my thoughts but I do not have enough knowledge to be certain.

But one friend suggested that this is just an analogue for all of China. Who cares if office buildings are glutted? Just build more. Who cares that the high-speed-rail between two cities you have never heard of, a railway line that consumed valuable steel and concrete by the millions of tonnes is mostly run at a third capacity with empty trains? Build more.

"Build it and they will come" may be the Chinese mantra. Usually only works in Hollywood films.



John

PS. I should disclose that Bronte still has a short-biased straddle on Trina - but it is a much smaller position. We closed a fair bit for profit - but traded that bit not so well. I should have covered the short end more aggressively when the stock was $6.

There is a story in the Sydney Morning Herald today about Titanium Asset Management - a funds manager in Western Sydney that operates as part of the Titanium Financial Group.

Titanium has been on my must-look-at list for some time. I found them when researching Astarra/Trio - a funds management fraud shown to me by one of my readers which I reported to the regulatory authorities. Titaninum had agreed a white-label deal distribution deal with Astarra, a deal which to the best of my knowledge was never consumated with real money. Titanium said that there was no relationship with Astarra but one Titanium entity wound up in the hands of the Astarra/Trio liquidators. [Someone has suggested in the comments that the Titanium entity in the hands of the Astarra/Trio liquidators is not related to the Titanium financial planners and that no money ever changed hands with the agreed white-label deal linked above. I see no reason to disbelieve that - especially as the article is dated within a month of the demise of Astarra/Trio.]

What amazed me though was the returns of Titanium Asset Management. It was limited according to its documents to being long-short the stocks in the ASX200 (an index of the top 200 companies in Australia). These were the monthly returns as reported:


These returns are astounding. 40 percent in October 2008, 20 percent in February 2009. Magic numbers really.

So I rang the fund manager - Peter Rice - to try and work out how he did it. I did not understand - at least it did not make sense to me so I reported my concerns to ASIC.

I did make an effort though. I found an interview with Peter Rice on Sky News (repeated below). That made no sense either.



Anyway I put it out of my mind.

A couple of weeks ago I looked again. Here are later returns.


The early months had all gone. (No more 40 percent months!)

The return in February 2009 had gone from plus 20 percent to minus 7 percent.

I was puzzled.

I rang the auditor as listed in the original product disclosure status. He sounded sorry for me - wondering if I was an investor in the fund. He told me he had never been the auditor and had gone to some lengths to let the regulator know that he was falsely listed as the auditor.

I rang Peter Rice and he told me the original returns came from "paper trading". I wondered why he did not tell me that the first time I rang and he said that he did not believe he was under an obligation to disclose that. (Indeed when I rang him the first time he told me that he had an independent back office and used Citigroup as his prime broker - both things that would not occur if the profits were from paper trading.)

I sent it all to the Sydney Morning Herald. (My job is to manage money - not explore these things...)

I think Michael West did a great job of the story.

He also pointed out something that truly surprised me. Andrew Blanchette who controls Titanium (at least is listed on the license and is the owner of the domain names) was once the boyfriend of Sydney model Caroline Byrne. She was found dead at the bottom of Sydney suicide spot The Gap. Maybe suicide. Maybe murder.

Caroline's death was the subject of much gossip in Sydney - the prime suspect was Gordon Wood. Wood was Caroline's boyfriend at the time of her death and was also the chauffeur to Rene Rivkin a colourful Sydney stockbroker. Rivkin has since committed suicide.

Wood was convicted but since then Australia's highest profile current affairs program has thrown that conviction into doubt.

This mostly proves that Sydney is sometimes a very small town. No more.



John

I have an old computer under my desk. Its a Toshiba laptop from about 1998. I run Puppy-Linux on it because it can't run anything more powerful.

Its good for purpose - a low powered device.

I am told by the physicists that if I use it for high-powered uses I will blow circuits and destroy my the local network.

So I go to the Department of Defence and say can I swap my old low-powered device for your high-powered supercomputer?

Of course they would laugh.

Now the WSJ is reporting that Phil Falcone has a Lightsquared Plan B. He wants to swap his spectrum which is specifically only available for low-powered use for the Department of Defence's spectrum, spectrum which is available for high powered use.

The Department of Defence should just laugh.

If this gets past the just-laugh stage I worry for American democracy. If this actually happens we know the scope for corruption in America is unlimited.

If the DOD wants to part with its valuable spectrum just auction it. Giving billions of dollars to fading - soon-to-be-bust hedge funds. That is beyond any semblance of decency.

Phil, for the sake of decency and because you are ultimately a patriot - just put Lightsquared in Chapter 11. Leave the corrupt obtaining of public assets to Chinese billionaires and Russian Oligarchs. You are better than that.



John

Alan Sokal, a Professor of Mathematics at University College London and a Professor of Physics at New York University published this in Social Text - a peer reviewed left-wing journal of post-modern thought published by Duke University Press.

But deep conceptual shifts within twentieth-century science have undermined this Cartesian-Newtonian metaphysics1; revisionist studies in the history and philosophy of science have cast further doubt on its credibility2; and, most recently, feminist and poststructuralist critiques have demystified the substantive content of mainstream Western scientific practice, revealing the ideology of domination concealed behind the façade of ``objectivity''.3 It has thus become increasingly apparent that physical ``reality'', no less than social ``reality'', is at bottom a social and linguistic construct; that scientific ``knowledge", far from being objective, reflects and encodes the dominant ideologies and power relations of the culture that produced it; that the truth claims of science are inherently theory-laden and self-referential; and consequently, that the discourse of the scientific community, for all its undeniable value, cannot assert a privileged epistemological status with respect to counter-hegemonic narratives emanating from dissident or marginalized communities. These themes can be traced, despite some differences of emphasis, in Aronowitz's analysis of the cultural fabric that produced quantum mechanics4; in Ross' discussion of oppositional discourses in post-quantum science5; in Irigaray's and Hayles' exegeses of gender encoding in fluid mechanics6; and in Harding's comprehensive critique of the gender ideology underlying the natural sciences in general and physics in particular.7

It was of course a hoax, part of a long and very funny article titled "Transgressing the Boundaries: Towards a Transformative Hermeneutics of Quantum Gravity".

To Sokal the article was a modest (though admittedly uncontrolled) experiment: Would a leading North American journal of cultural studies -- whose editorial collective includes such luminaries as Fredric Jameson and Andrew Ross -- publish an article liberally salted with nonsense if (a) it sounded good and (b) it flattered the editors' ideological preconceptions?

The answer was unfortunately yes.

And it was self-evidently nonsense. The quote I give you above includes that physical "reality" [and note the "scare quotes"] no less than social ``reality'', is at bottom a social and linguistic construct. Sokal invites "anyone who believes that the laws of physics are mere social conventions to try transgressing those conventions from the windows of [his] apartment. (He lives on the twenty-first floor.)

I will observe when the physics has something useful to say and its an argument between left-wing social theorists and conventional physics the physicist wins. Conventional physics is (at least within the distances and energy levels we can measure) very settled science - and to say novel things you need to go to minute sizes or massive energy levels (as per the Large Hadron Collider).

The Sokal hoax was funny - but it was hardly necessary. The social sciences whose response to hard science is to deny it are best ignored. Unless you have Alan Sokal's sense of humour it is not even that much fun teasing them.

Anyway - this sort of anti-science based obscurantism has historically been the province of the Left. I mean who other than a left-wing loopy intellectual would think that the reality described by conventional physics is a social construction - a conspiracy of physicists. And a physical reality they can save you from by deposing the hard (and testable sciences) so they can install themselves as a priest-class who understand this social construction stuff (not to mention the obscure jargon in my opening quote).

Oh I know who gives these self-indulgent and self-important left-wingers a run for their money. The new anti-science conspiracy theorists are on the right. Evolutionary biology is a conspiracy of godless liberals who want to undermine God's laws. Climate change is a conspiracy to allow Government more control over your life.

It is funnier when it is a bunch of academics. History has a way of sending the loopy ideas of academics to the obscurity they deserve. It is less funny when it is politicians.

But this is not a blog about the anti-science elite in politics and academia. Its a blog mostly about financial markets and their goings on and all the crappy things you can invest in.

When people in financial markets behave that way - believing their socially constructed reality over physics - then it is time to go short them.

There are few technology companies out there (and sorry I will not name names because I don't want to make the shorts crowded) whose basic premise seems to conflict with the second law of thermodynamics. [Not understanding the second law of thermodynamics is to science what not being able to read is to literature.]

But when you see this stuff in markets you have just got to short it. I know rich people who are usually smart who invested in Blacklight Power. I just could not work out a way of shorting it.

It requires a special-brand of delusion to construct your world such that basic science does not apply to you. Its the brand of delusion that the fools from Social Text have. Its the brand of delusion that some of America's more loopy right-wing politicians have.

Alas it is also the brand of delusion that Phil Falcone has. It was the brand of delusion which powered Lightsquared.

The physics of radio interference is settled. This is physics at ordinary distances and ordinary energy levels. (To find non-settled physics you need to shorten the distances and raise the energy levels as per the LHC.)

We know this stuff.

We know that if you put a low power radio station near a high powered radio station the high-powered station causes interference. We understand resonances between different frequencies.

As I said - this stuff is settled.

But that did not stop Phil Falcone investing his clients money in a loophole - an attempt to take spectrum which was allocated to low-powered devices (satellites) and wish to use it for high-powered devices (mobile phone towers) and to think everything would be OK. I wrote about it recently - but have had the view for some time. And it was in contradiction to physical reality (and this time I did not put "reality" in scare quotes because that reality is really real).

Phil Falcone is almost certainly smarter than the idiots who edit Social Text. But years of success and the strange cocoon of being a Wall Street billionaire got Falcone to the point that he thought that reality did not apply to him.

He became just like the most loopy of left-wingers.

Still Lightsquared is dead - the FCC has now determined that the conflicts with GPS are not able to be resolved. That is a fatal blow to Lightsquared (and I am glad). It means that parts of the government (like Defence who value their GPS) still have a say and that anti-science obscurantism is not everywhere - just on the far-left, far-right and in the minds of some particularly self-indulged Wall Street types.

There is hope in the world.



John