For TLM - Things Might Get Worse Before They Get Better

Given the depressed natural gas price, one cannot help but wonder if the window of opportunity for buying into the natural gas stocks is opening.  The current natural gas price is at around $2.5 per thousand cubic feet, which is about the lowest point in ten years, largely due to the oversupply caused by the success of hydraulic fracturing.  A subsequent upward price cycle may provide substantial profits in the future for those who buy into the natural gas stocks now. 

Chesapeake Energy Corporation (CHK), one of the largest natural gas companies in the US, is a natural bet for those who want to gain exposure to natural gas.  However, the news that Aubrey McClendon, the CEO of Chesapeake, runs a hedge fund betting on the same commodity Chesapeake is selling does not exactly inspire investors’ confidence in the corporate governance of the company.  The lack of confidence in the management’s commitment to the best interests of Chesapeake’s shareholders makes the risks of investing in CHK particularly uncertain. 

For those who are interested in establishing a position in natural gas stocks, but uncomfortable with CHK, Talisman Energy, Inc. (TLM) is worth a look.  TLM at $11.2 is 50% down from its 52 week high of $22.6.  Its forward PE ratio 10.8 is among the lowest in the company’s history.  Its PB ratio 1.29 is also among the lowest in its history, and compared favorably to many of its peers.  The company’s trailing-twelve-month operating margin, profit margin, and ROA (33%, 17%, and 7.3%, respectively) all beat those of CHK.  In addition, it pays dividends currently at a yield of 2.3%.  TLM might just be the preferable alternative to CHK. 

Upon a closer look, TLM’s current price seems to be justified by comparing to its peers.  While TLM’s forward PE ratio 10.8 is higher than CHK’s 8.3, besides the corporate governance issue, TLM’s higher valuation might be justified by TLM’s much higher concentration of production in oil and natural gas liquids than CHK.  Comparing to Exxon Mobile Corporation (XOM), which also has substantial exposures to both natural gas and oil, TLM’s forward PE ratio 10.8 is in line with XOM’s 9.5.  It appears that TLM, compared to CHK and XOM, is priced justifiably at this moment. 

Going forward, things might get wore before they get better for TLM.  One thesis for investing in TLM now is to purchase a share of its oil and gas reserves in taking advantage of its low price-to-book ratio, and wait for the upswing cycle of the natural gas price in the long run.  However, in the short term, TLM will be under the pressure to sell some of its assets to meet its cash flow requirements.  Given the weak natural gas price, there is a good chance that TLM will have to sell some of the assets at a loss.  This happened in 2011.  If this happens in 2012, with everything else being equal, its balance sheet will deteriorate, making it less attractive at the current price.    

TLM seems to be reasonably priced compared to its peers at this moment, might experience some headwinds due to the weak natural gas price and the unfavorable environment of asset disposal in the near term, and might return substantial profits in the long run to inventors who establish a position in the next several quarters, if the natural gas price moves up significantly in next several years. 

MSB: A Pricey Inflation Hedge

For those interested in commodity stocks, it may be worthwhile to look at Mesabi Trust (MSB), a publicly traded royalty trust that distributes cash to the unit holders quarterly. MSB is created for conserving and protecting the trust estate, which includes certain rights to royalty payments derived from mining activities carried out by Northshore Mining Company, a third party operator, on the land of the estate, some cash, securities, and other assets. Under the trust agreement, MSB cannot actively engage in any business activities, mining or otherwise, nor does it own the title to the land.

Pros

MSB provides investors with exposure to commodities, and therefore can be utilized as a hedge against anticipated inflation. Not only does MSB derive its royalty revenues from iron ore shipments, but the royalty rate is also inflation adjusted according to the agreement between MSB and Northshore, the company that actually mines the land. In the current environment where there is much fear for inflation in the near term due to the government’s stimulus spending, easy liquidity on the market, and emerging economies’ increasing demand for raw materials, MSB has the right story to attract investors’ attentions. In fact, as of April 26, 2010, MSB is traded at $22.91 per unit, with a year-to-date capital appreciation of approximately 80%. As long as the inflation story is still intact, it may have the potential to go even higher.

In addition to its appeal as an inflation hedge, MSB is also an income investment that distributes most of its royalty revenues to the unit holders. Its cash distributions for the first and second quarters in 2010 are 55 cents and 12.5 cents, respectively. This represents a range of annualized yield from 2.2% to 9.6%.

Cons

Although MSB has its appeals, they do come with risks. Since MSB has no ownership rights to the underlying land, in the event where the trust terminates, the unit holders will be left to split the trust estate essentially consisted of a bundle of beneficial interests, amounting to only a small faction of its current market value. MSB has a current market capitalization of $300 millions compared to its reported book value of $1.13 millions as of January 31, 2010. This would expose investors to greater risks than bonds, which can be redeemed on the face value at maturity, and other common stocks, which are typically traded at only a few times of their book values.

MSB’s distributions can be quite volatile and unpredictable. MSB has no control of the decisions made by Northshore as to whether or not to mine the land, and how much. As a result, in the past year, MSB could go from making no distribution at all in one quarter to 55 cents in another. Moreover, the revenues received by MSB in one quarter can be positively or negatively adjusted by Northshore in the following quarters. For example, in the midst of the generally recovering economy in the first half of 2010, MSB’s cash distribution was cut from 55 cents per unit in the first quarter to 12.5 cents per unit in the second quarter, due to MSB’s paying back part of the excessive royalties it received in the past. Unless the adjustment scheme is transparent and clearly understood, an accurate prediction of its future distributions will be difficult to make.

The Bottom Line

Although MSB can be a hedge against inflation, its downside risk cannot be ignored. For those who like to invest based on the fundamentals, MSB at the current price may not present an attractive investment opportunity. For those who believe that market perception and speculation are as real as the fundamentals, MSB does have the potential to keep riding on the commodity and inflation story. In such case, I’d think that it is a good idea nonetheless to buy some put options to limit the downside risks.

Buy and Hold or Time the Market?

There are generally two schools of thought when it comes to investment in the stock market. There are those who believe that they can time the market, and there are others who prefer to buy stocks and hold them for a long time. The buy-and-holders doubt the reliability of the market-timing strategy in producing consistent and superior returns. Warren Buffett is probably one of the most famous buy-and-holders who have built extraordinary wealth by picking stocks carefully and holding them for a long time. Does this strategy work equally well for everybody else? Are we simply to buy stocks randomly, hold them for years, and expect to make a lot of money?

Had you invested $100 in an S&P 500 index portfolio at the beginning of 1990 and sold it at the end of 1999, you would have made a return of $316. However, had you invested $100 at the beginning of 2000 and sold it at the end of 2009, you would have seen you dollars shrink to $76, a total 24% loss. If, instead of putting you $100 in the stock market, you bought a 10 year treasury bond that paid 2% coupon at the face value and reinvested all the proceeds in the bond over the period from 2000 to 2009, you would have made $122 in return. That is 60% better than investment in the stock market. Timing does matter.

One strategy to circumvent the timing issue is to set aside a fixed amount of money and invest it in the stock market at all prices periodically over a long period of time. This way, the ups and downs of the stock purchase prices would even out over time. This strategy limits both the downside risk and upside potential. It also requires a lot of discipline, and most importantly, time.

If you have little patience, are risk-tolerant, and believe that great profits can be made from timing the market, you may want to look at the stock market’s P/E ratio for the information of market valuation. There are several different definitions of market P/E ratio. One popular definition is to take the current S&P 500 index value divided by the earnings per share of the market in the trialing twelve months. Comparing the current P/E ratio with the historical average may provide information of whether the current market is under or over valued. For example, say, the mean of historical S&P 500 P/E ratio is 16. With everything else being equal, a current P/E ratio of 12 may suggest that the market is undervalued, and now may be a good time to buy.

One caveat here is that the trailing twelve month P/E ratio can be misleading, and should be looked at carefully before drawing any conclusions. For example, on March 31, 2009, the S&P 500 index was at 797 points with a P/E ratio of 116. If one were to conclude from the P/E ratio that the market was overvalued at the time, he would have missed a great ride in which the S&P 500 index increased to 1169 points in the following year. The unusual high P/E ratio on March 31, 2009 had to do with the extraordinarily depressed earnings in 2009 Q1 and 2008 Q4, due to the stock market collapse triggered by the housing market meltdown. As it turned out, the S&P 500 earnings went back up quickly to their normal levels in 2009 Q3 and Q4, which in turn dramatically lowered the P/E ratio. If one were able to predict the forward P/E ratio correctly, he would have concluded that March 2009 presented a great buying opportunity.

Although P/E ratio provides a quantitative measure of market valuation, interpreting it invariably requires looking deeper into the stories behind the numbers and exercising your judgment of what the future will hold. After all, this is still an art.

Nuclear Renaissance?

After nearly three decades of silence, there has been much talk about the nuclear renaissance lately. Is it for real or just a fairy tale?

Without government subsidy, nuclear power is not cost competitive enough against coal or natural gas-fired power generation. According to a 2007 Congressional Research Service Report, the projected annualized cost of nuclear power in 2015 is 5.6 cents/kwh, whereas the costs of the coal and natural gas electricity are 4.5 and 4.6 cents/kwh, respectively. The higher cost of nuclear power is due to, among other things, its complex design and stricter safety requirements. A nuclear power plant takes about 6 six years to build, whereas a coal or natural gas power plant takes only about 4 years. After the nuclear power plant is built, a regulatory review will be conducted to determine if an operating license is going to be issued. This process can take several years.

So, are we to conclude that nuclear power is inferior to coal and natural gas, at least from the business stand point? Not so fast. Powerful forces are building and pulling for the nuclear energy.

The Energy Policy Act of 2005 provides a 1.8 cents/kwh tax credit for up to 6,000 megawatts of new nuclear capacity for the first eight years of operation. According to the CRS Report, the tax credit brings the cost of nuclear power down to 4.2-4.7 cents/kwh, on par with power generated by coal or natural gas. As a result, many players, such as Constellation Energy and TXU, have applied for licenses to build new nuclear reactors. The table below lists the applicants as of March 9, 2007.

The Department of Energy has also allocated $18.5 billions of loan guaranties for nuclear reactor construction projects. On February 16, 2010, president Obama announced allocating $8 billions of the loan guaranties toward building two new nuclear reactors at an existing power plant in Burke, Georgia. The loan guaranty program takes away many of the financial certainties due to the regulatory hurdles and popular resistance that have discouraged many investors from investing in nuclear projects in the past three decades.

As the general public is getting more concerned about the global warming, nuclear power has attracted many interests for its advantage of zero carbon emission. This will put the nuclear power as a contender among other renewable energies in competing for a bigger role in the US energy mix. If the US passes any type of carbon-trade regulations, the fossil fuel based power will become more expensive, and the nuclear power will become more competitive.

Of course, the public fear for a Chernobyl-like nuclear disaster is still well alive. There is still much public resistance against nuclear power. However, the current policy trend seems to be pulling for the nuclear power. This is true not only for the US, but also for other countries in the world. In China, 20 new nuclear reactors are under construction, and 37 have obtained government approval or major funding. As the costs of fossil fuel are projected to go up continuously, nuclear power is gaining ground. With all the incentives in place, perhaps, the nuclear renaissance has already come.

Uranium May Be the Next Hot Commodity

On February 16, 210, president Obama announced $8 billions loan guaranties for building a new nuclear power reactor in the US. As the president indicated, new clear power was going to play a more important role in the country’s transitioning from relying on the fossil fuel energy to the cleaner alternative energies. As an investor, I’m interested in how the policy announcement is going to impact on the nuclear energy segment in general and the uranium suppliers in particular. Here is what I’ve found.

In spite of president Obama’s announcement, the spot price of uranium (U3O8) has dropped sharply from $135 /lb in 2007 to $42 /lb at end of 2009, according to Ux Consulting Company, LLC. Part of the price decline has to do with the decrease in demand as a result of the global recession started in 2008. The US government’s selling its excess uranium inventory on the market also contributed to the softening price through out 2008 and 2009. However, the current uranium production capacity falls short of the current demand, and the gap between them is filled by other sources.

According to the World Nuclear Association, the world has 436 nuclear reactors generating 372,693 MWe as of February 1, 2010. There are 53 new reactors are under construction, with 51,115 MWe of projected power output – a 13% increase from the current level. The number of planned new reactors is 142, or 156,422 MWe in terms of power output. This is another 42% increase from the current level. Although it is possible that those planned reactors will never become reality, it is safe to say that the demand for uranium is going to significantly increase in the years to come.

With everything else being equal, the increasing demand for uranium suggests that the price of uranium has a realistic potential to go up in the next few years, so does the earnings of uranium mining companies, such as BHP Billiton Ltd (BHP), Rio Tinto plc (RTP), Cameco Corp. (CCJ), SXR Uranium One (TSE: UUU), USEX, Inc. (USU), and Fronteer development Group, Inc. (FRG).

Another factor that may play into uranium mining companies’ favor is the general expectation of inflation. Since 2008, governments of major economies have dramatically increased their money supplies in order to combat the recession. The US alone has increased its M1 money supply from approximately $1 trillion at the end of 2008 to about $1.3 trillions in March 2020. According to the Congressional Budget Office, the 2010 US federal budget deficit is about $1.7 trillions. The deficit may persist for many more years to come, even thought the office projects a steady decline. As a result, the federal government will need to borrow and print a lot of money in order to finance its excessive spending. With no sign of the tightening of easy liquidity, the money supply is likely to grow continuously, and therefore adds to the pressure of inflation. Under those assumptions, uranium, as a commodity, may be perceived as an inflation hedge, and therefore benefited from the inflation pressure.

As everything else in life, timing is everything. Although no one really knows what tomorrow will bring, the boom story of uranium seems to hold water at this moment, and may provide opportunities for inventors to profit in the years to come.

Wealth Is Created by Doing What You Do Best and Keeping Your Promises

How is value created? I like to think about wealth creation as a process in which people make one another better off by doing what they do best, and what they said they were going to do.

Jane grew up watching the Food Network and knew everything about cooking. Jane wanted to run a restaurant, but had no money. Joe, on the other hand, had money, but knew nothing about running a business. So, Joe gave money for Jane to open a restaurant in return for her promise to repay the money plus a handsome amount of interest. Through talent, dedication, and hard work, Jane’s restaurant turned out to be a success. She kept her promise and paid back her loan. Not only Joe and Jane were richer, they couldn’t be happier.

In a more realistic world, Joe and Jane needed a middle man to make the deal happen. Joe found a banker, and gave $100 to him in exchange for a promise that he could withdraw the money any time on demand. Wanting to keep the money longer, the banker offered to repay Joe $110, if he could have the money for one year. Joe agreed, and left a happy man, thinking just in one year he would be $10 richer than today. The banker knew that Jane cooked well and worked hard. He turned around, and proposed to lend $100 for Jane to open a restaurant in return for her promise to pay back $120 in one year. Jane jumped at the opportunity. Fast forward one year, Jane’s business boomed. After she paid back $120 to the banker, she still had $10 left from the revenue of the business. The banker paid off the $110 he owed to Joe and also pocketed $10 profit. Joe, as he had expected, made a nice $10 return on his $100 investment. What a beautiful world.

The problem came when someone broke the promise. Say, Jane, instead of using the borrowed $100 toward her restaurant business, spent it on a nice gift to herself that did her nothing more than a short-lived, satisfactory sensation. With no money left, she defaulted. As a result, the banker had nothing to pay back Joe. Joe went ballistic, and swore to do everything he could to make the banker pay. The banker blamed it on Jane and vowed to get even. All the sudden, the world wasn’t pretty anymore.

I know the story could’ve been that the banker, instead of Jane, failed to keep the promise. But, you get my idea.

In a modern economy where our claims and obligations toward one another are so tightly intertwined, a broken promise sends a shock wave through the system and shakes everyone in it. When borrowers default on mortgages, banks lend money to people who they know will not be able to repay, and our government keeps the interest rate near zero for so long to incentivize the banks to borrow cheap and lend high even to the ones they know who will not be able to repay, they (or we) collectively create a financial tsunami destroying much of the wealth we all have worked so hard to create. All it takes to start the chain reaction is a simple broken promise.

A little advice - be careful about who you trust, as one who doesn’t keep promises will surely destroy your wealth.