Review of As I See It: The Autobiography of J. Paul Getty

As a business autobiography, I was disappointed by As I See It: The Autobiography of J. Paul Getty.

Getty inherited a small oil business from his father in 1930. The book gives you really no feel for Getty's path to success but based on the timing you can guess that the story is similar to The Big Rich: the Great Depression caused the major oil companies to slash their budget for capital expenditures like exploration, and this retreat left a vacuum for new entrants to fill.

It's more of a name-dropping anthology, i.e. "celebrities I have known". Getty apparently knew or met every celebrity during the 20th century. Of course, he was uniformly impressed and delighted with all of them - including every president except Johnson. [Get this: he was appalled by creeping socialism but loved FDR!]

The one redeeming bit was the history of the Malibu villa art museum. Truly, the two Getty museums are some of the best things to see in the L.A. area. And, unlike the rich today, Getty had pretty good taste.

This was a 2/5. Maybe some of his other, earlier books could be worth taking a chance on: The history of the bigger oil business of George F.S. F. and J. Paul Getty from 1903 to 1939, or How to Be Rich.

No Kidding: "Suntech: Investors Fret Over $541M In Debt Due 3/15" ($STP)

Forbes article.

"Suntech Holds Talks With Wuxi on Financial Support" ($STP)

What's the story with this silly Bloomberg article?:

"No Chinese solar company has yet received a bailout for its foreign debts. [...] 'The government can offer support through tax policies, credit facilities, negotiations and helping consolidation among companies, while it can’t intervene in companies’ operations directly ... How the bailout works will depend on the local economy and expectations of the solar industry by the local government.] [...] An official in the information office of Wuxi’s local authority declined to comment, saying talks with Suntech were confidential. Calls to Suntech Chairman Shi Zhengrong weren’t answered, and a company representative said Suntech won’t comment."

Hmm... this reminds me of Donald Rumsfeld: "anyone who knows anything isn't talking, and anyone with any sense isn't talking, therefore, the people that are talking to the media, by definition, are people who don't know anything, and people who don't have a hell of a lot of sense."

"Consolidation" means insolvent companies liquidate and survivors pick up the pieces.

P.S. The YTM on the bonds is now 4,400%!

Suntech Power Bonds Now YTM Almost 3,000% (STP)

It seems so long ago that they were only yielding about 900%.

Commercial Barge Line Company Announces Results for Quarter and Year Ended December 31, 2012 ($CNRD)

Press release:

• "We continue to see opportunities in the energy sector, as North American oil production continues to rise. Tank barge capacity in the industry continues to be in tight supply, so we are confident that we will be able to quickly realize the earnings benefit of the new tank barges that will be completed by Jeffboat during the first half of 2013.
• The manufacturing segment's external revenue backlog at the end of 2012 was $52.4 million, representing 2013 production backlog compared to a backlog of $101.2 million as of December 31, 2011. More recently, the external revenue backlog has increased to approximately $140 million as the remainder of 2013 production capacity, beyond the completion of the oversize tank barges currently in production for the transportation segment, has been committed for sale to third parties.

GMX Resources Announces Hiring of a Financial Advisor ($GMXR)

The Company is continuing to explore and evaluate options for its capital needs, as well as continuing to evaluate and finalize its 2013 budget for capital expenditures based on its available liquidity. In connection with its evaluation, the Company has retained Jefferies & Company Inc., a financial advisor, to assist the Board and senior management in its ongoing exploration of a variety of financing alternatives, including a potential restructuring of the Company's balance sheet in light of its current liquidity and cash needs.

GMX Resources Reserve Report ($GMXR)

GMXR published its reserve report in its most recent 8-K filing, showing estimated future revenue and expenditures attributable to the production and sale of net proved reserves as of December 31, 2012.

The PV-10 of proved developed producing (PDP) reserves is only $77.984 million. That is quite simply astonishing. The company spent $272 million on capex in 2011 and probably about $100 million in 2012, and has very little to show for it. Of course, the company had negative retained earnings of $856 million as of Q3 last year.

The PV-10 of the proved undeveloped reserves (PUD) is only $2.1 million according to the reserve report, and it would require $356 million in additional capital expenditure even to realize those. 

Granted, the value of the reserves is levered to natural gas price increases - the company gives an estimate of the total proves reserves using futures prices for gas instead of the 12 month average (SEC guidelines). That gives a PV-10 of $195 million, which would still mean that only the secured debt is in the money.

P.S. If there is a "Change of Ownership or Control" of GMXR by a person or entity other than a "Qualifying Public Company," they will be required to redeem the Series B Preferred Stock ($79 million outstanding), in whole but not in part, within 90 days after the date on which the Change of Ownership or Control has occurred, for cash.

A "Change of Ownership or Control" shall be deemed to have occurred on the date (i) that a "person" or "group" (within the meaning of Sections 13(d) and 14(d) of the Securities Exchange Act) becomes the "beneficial owner" (as defined in Rules 13d-3 and 13d-5 under the Securities Exchange Act, except that a person or group shall be deemed to have beneficial ownership of all shares of voting stock that such person or group has the right to acquire regardless of when such right is first exercisable), directly or indirectly, of voting stock representing more than 50% of the total voting power of the total voting stock of our company; (ii) that we sell, transfer or otherwise dispose of all or substantially all of our assets; (iii) that we permit or suffer a change in our key management, meaning the continued active full time employment of each of Ken Kenworthy, Jr. (as Chief Executive Officer) and Ken Kenworthy, Sr. (as Chief Financial Officer); provided, however, that the cessation of active employment of one such officer due to death or disability, or the retirement of Ken Kenworthy, Sr. (as Chief Financial Officer), shall not be considered a “Change of Ownership or Control” so long as we hire or promote a replacement officer within four months; or (iv) of the consummation of a merger or share exchange of our company with another entity where our shareholders immediately prior to the merger or share exchange would not beneficially own, immediately after the merger or share exchange, shares representing 50% or more of the outstanding voting stock of the corporation issuing cash or securities in the merger or share exchange (without consideration of the rights of any class of stock to elect directors by a separate group vote), or where members of our board of directors immediately prior to the merger or share exchange would not immediately after the merger or share exchange constitute a majority of the board of directors of the corporation issuing cash or securities in the merger or share exchange. “Voting stock” shall mean stock of any class or kind having the power to vote generally for the election of directors.

A “Qualifying Public Company” is defined as a company with common stock that is subject to a national market listing, which, on a pro-forma combined basis with us, had an EBITDA(X)-to-Interest Expense Plus Preferred Dividends ratio of at least 2.0-to-1.0 for the 12-month period ending as of the end of the Qualifying Public Company’s fiscal quarter immediately preceding the Change of Ownership or Control.

Paper: "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?"

Quantitative Trading posted a link to a paper about using option volatility smirk as a way to pick longs and shorts called "What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?" [pdf]. Volatility "smirk" is the difference between the implied volatilities of out-of-the money (OTM) put and at-the-money (ATM) call options.

This is in the same vein as the paper we posted last week, "The Information Content of Option Demand," which showed a relationship between stock returns and option demand imbalances caused by investors with information on the underlying.

The smirk paper finds that by ranking according to volatility smirk, forming a long portfolio consisting of stocks in the bottom quintile and a short portfolio with stocks in the top quintile, and updating weekly, there is an annualized excess return of 9.2%. The theory is that informed traders are buying OTM puts when they anticipate bad news, thereby driving up the implied volatilities of the puts relative to the ATM calls.

What if I told you that the implied vol of a Suntech Power March OTM put is 263 and an ATM call is 145, for a skew of 118? By comparison, the skew for Apple is about 6.

Also, related to the other option demand paper, there is an open interest of ~100k Suntech put contracts for March versus only about 20k call contracts - five times as many.

Two Papers on the Principal-Agent Problem in Public Companies

These are both coauthored by Shleifer who we mentioned in the previous post. The first is "What Do Firms Do with Cash Windfalls?" by Olivier Blanchard, Andrei Shleifer, and de Silanes.

They were interested in what happens if a company receives a cash windfall in the form of a won or settled lawsuit. They screened and came up with 11 firms that won lawsuits that gave them cash but did not change their investment opportunities.

They wanted to study empirically whether "selfless managers acting in the interest of all shareholders" would return the windfalls to shareholders. (Which they call the "asymmetric information model".)

The alternate hypothesis, which the principal-agent conflict model would predict, is that even firms without attractive investment opportunities do not spend the windfall on dividends or share repurchases. Also, the share repurchases that do take place under that model would be targeted at large shareholders or the management, rather than small shareholders.

What they find is that two of the firms pay out large percentages of the award to the shareholders, but both of these firms have very large management and family ownership and a substantial fraction of the dividend goes directly to controlling shareholders.

They conclude generally that "dividends are used mainly when managers stand to collect a lot themselves, and share repurchases are used to eliminate potential challenge to insiders' control from large shareholders," and that "managers strive to ensure the long-run survival and independence of their firms with themselves at the helm. They do this by keeping the resources inside and investing them in unattractive projects just to avoid giving up cash or having an outsider lay a claim on it".

Corporate governance is a huge problem! It's why I'm so skeptical of some of the value trap tech firms like Microsoft that trade at ostensibly cheap valuations. They show little inclination to return cash to shareholders, rather doing crazy things like buying Skype for $8.5 billion. Even Apple is mysteriously reluctant to return cash! It's as if they know the good times won't last forever.

The second paper is "Agency Problems and Dividend Policies Around the World" by Rafael La Porta, de Silanes, Andrei Shleifer, and Robert Vishny. One way of looking at dividends is a way to address the principal agent problem. Since the severity of the principal agent problem obviously varies worldwide according to the protections for minority shareholders, they look at whether the way dividend policies vary is consistent with the agency theory of dividends.

They find that companies operating in countries with better protection of minority shareholders pay higher dividends. Another test was whether fast growing firms pay lower dividends than slow growing firms in countries with better protections. They do, which suggests that investors in these countries are willing to wait for dividends (and allow companies to reinvest earnings) when investment opportunities are good. In countries with poor protections for minority shareholders, they find that shareholders prefer to take whatever dividends they can get, regardless of investment opportunities. 

P.S. Something else interesting is that between them, these papers have fewer than 300 downloads on SSRN. The first one has been cited 368 times and the second 113 times. I'm not sure if the CFA curriculum even mentions the principal agent problem, but if it does it is certainly much less than the EMH-assuming capital asset pricing model.

Paper: "Contrarian Investment, Extrapolation, and Risk"

This paper, Contrarian Investment, Extrapolation, and Risk by Josef Lakonishok, Andrei Shleifer, and Robert Vishny, was also written up on the Greenbackd blog. Shleifer puts out some good papers, and he and his wife are actually in the hedge fund industry.

The authors provide evidence that value strategies have higher returns because they exploit other investors' mistakes, not because they are fundamentally riskier (which is the EMH view). They define value strategies as "buying stocks that have low prices relative to earnings, dividends, book assets, or other measures of fundamental value."

There is a bias among many investors in favor of glamour stocks that have performed well in the past and are expected to perform well in the future. The behavioral, non-EMH hypothesis is that value stocks are mispriced because they have performed poorly in the past and therefore are expected to continue to perform poorly. Contrarian value investors are in the business of betting on the value stocks and, either explicitly or implicitly, against the glamor stocks.

Pretty much everyone agrees that this works, but EMH advocates believe that the value investors are taking greater risk. The problem for EMH advocates is that they are essentially arguing that risk is increasing as prices go down, and vice versa, when any businessman could tell you that the opposite is the case.

The EMH advocates have to argue that, of course, or the value anomaly would sink their ship. Meanwhile, remember the great paper from last year (a 5/5) which hypothesized that "agency issues create demand by professional investors and their clients for highly volatile stocks. This demand overvalues the prices of volatile stocks and suppresses their future expected returns." It found that low risk stocks outperform within all observable markets of the world. This paper has only 2,000 downloads in the last year! Something like 40k people sit for the Level I CFA exam!

Anyway, the Contrarian Investment paper tests the idea that value stocks are fundamentally "riskier" by measuring the frequency of inferior performance by value strategies as well as their performance in market crashes and recessions. They find nothing to suggest that value strategies are fundamentally riskier.

A variety of strategies that involve buying value/out-of favor stocks have outperformed glamour strategies over recent market history. Also, there are optimism/estimation errors being made by the market and other investors generally, where they consistently overestimate the prospects of the glamor stocks relative to value stocks.

One major behavioral problem that the authors point out is that people "just equate well-run firms with good investments, regardless of price." This is obviously common with retail investors (when they aren't buying worthless stocks), but institutional investors like the glamour stocks because they appear to be prudent and are easy to explain.

Many institutional investors also seem to prefer momentum strategies that can make money now, rather than value strategies that take "too long" to work - which causes career risk. Just another example of the ever present agency problem.

The problem with the glamour stocks that causes subsequent underperformance is that investors get "too excited about a performance of a company that is doing well for a prolonged time period, as did Cisco, Microsoft, etc., [and] extrapolate past performance too far into the future and push prices up too high".

That describes Apple perfectly. How do we know that they will continue to make $40 billion a year? What makes them immune from competition? I like the Einhorn preferred stock idea, but I think Apple was the wrong company to try it with. And when he says on slide 43 that it's "difficult to imagine Apple burning cash or losing money" I see a troublesome failure of imagination and recency bias.

Speaking of Amazon - Ultimate Factories

Amazon wouldn't be much without UPS. A correspondent writes in with this National Geographic Ultimate Factories video:

Review of The Innovator's Dilemma: The Revolutionary Book That Will Change the Way You Do Business by Clayton M. Christensen

Clayton Christensen says that after Intel blew Cyrix and AMD out of the water with the Celeron processor, its CEO Andy Grove gave a speech at the Academy of Management conference where he held up The Innovator's Dilemma and said, "I don’t mean to be rude, but there’s nothing any of you have published that’s of use to me except this." I agree that this is a 5/5 book.

There are two types of technological innovations: sustaining and disruptive. Sustaining innovations appeal to an existing customer base by improving existing products on those products' traditional measures of value: performance, capacity, reliability, price per unit, etc. They are the gradual improvement of dominant technologies with a focus on selling higher margin products to the biggest customers, because these customers are willing to pay for incremental performance.

Disruptive innovations produce products that, while technologically inferior from the perspective of the existing customer base, include improvements that hold potential for new markets. These technological shifts are so profound that previous technologies go out of business: sailing ships, wagons, telegraphs, vacuum tubes etc.

The puzzle, or dilemma, that this book seeks to solve is why established companies almost never introduce or survive these disruptive innovations. The dearth of examples of big firms surviving radically new technologies demands an explanation. His theory is that established firms miss the chance to capitalize on disruptive technologies because in their early stages the technologies are not good enough for their most profitable customers.

The book focuses primarily on the hard disk industry because it went through multiple disruptive innovations in a period of a couple decades. Smaller personal computer hard drives with lower capacity and higher price per unit of data were initially inferior to minicomputer hard drives, and notebook computer hard drives were initially inferior to PC drives in the same way.

Similarly, steamships could not initially compete with clippers and started out transporting only in inland waterways. Hydraulic excavators likewise were inferior to cable-driven shovels.

Established firms selling sustaining technologies do not feel threatened by the inferior disruptive technologies, even as those disruptive technologies are clawing up the learning curve, because the attributes offered by the disruptive technologies are valued only in markets that are remote from and unimportant to the established firms. Eventually, the disruptive technologies improve to the point of competing with and then overtaking the existing technologies.

The notion of products competing on the basis of some attributes and choosing not to or failing to compete on others reminds me of the book Blue Ocean Strategy (3/5). One of the things it argues is that companies should occasionally shift focus from customers to non-customers and consider whether some attribues of products (what Christensen calls "dimensions") should be eliminated, reduced, or perhaps raised or created.

One interesting question that both books raise is whether products been over-designed; that is, optimized along one dimension beyond the point of marginal utility to customers, since managers will blindly continue to pursue sustaining progress in the dimensions that an industry traditionally competes on. For example, both mention the insulin industry, which had traditionally competed on the purity of the product. By the 1980s, one competitor had created at great cost a perfect replica of human insulin while Novo found a "blue ocean" by creating an automated "Novopen" for injections that changed basis of competition from product purity to convenience of injecting.

Dimensions of value and the blue ocean concepts may be helpful in shedding light on a puzzle from last year about business models, where we were trying to figure out how an average business can be a great investment. A commenter on Nate Tobik's blog recently pointed out that,

"Rational entrepreneurs seek out gaps and niches in the market which means that businesses which are already operating are left undisturbed for no other reason than that they were already there. It's only when entrepreneurs behave irrationally that they enter a market and cause industry wide returns to fall below the cost of capital. From a business school perspective this behavior is random because it does not follow rational principles. From observation it tends to happen in industries that people think are exciting or that people get into for no other reason than that everybody else is doing it. A business being in a boring, obscure and uneventful industry can therefore be a lasting source of excess returns on capital."

An education in economics can cripple businessmen by teaching that perfect competition drives profits to zero. The truth is that most products have some degree of differentiation and price is rarely the primary consideration in purchasing (especially for B2B).

Recently, hedge fund manager Andy Redleaf inverted the disruptive innovation concept to make an interesting prediction:

"Christensen’s concern was with why great incumbent frms fail to develop the technologies that will eventually send them to their graves. Flip the argument around, however, and we get a pretty clear picture of eras in which small firms can be the driving force of the economy, eras in which disruptive innovation dominates sustaining innovation. The invention of the integrated circuit created such an era. Tiny new microelectronics firms became great microelectronics firms because those tiny firms invented microelectronics; tiny new software firms became great firms because they invented the software firm model. [...]

We have entered an era of incumbency. [T]he biggest changes are behind us — at least until the next technology with the disruptive power of the integrated circuit comes along. For now and the foreseeable future, innovation will sustain the incumbents of the microelectronic economy, not disrupt them. The question for investors and for us is which of the nation’s great operating firms will excel as the investment bankers of sustaining innovation and which will prove unequal to the task."

There's a grain of truth to this. Christensen himself points out that,

 "[S]tart ups which propose to commercialize a technology that is essentially sustaining in character have a far lower likelihood of success than start-ups whose vision is to use proven technology to disrupt an established industry with something that is simpler, more reliable, and more convenient."

Because the startups competing with sustaining technologies will be competing against incumbents. To say that the era of disruptive innovation is over seems off. First, we obviously have no idea when the next technology with broadly disruptive power will be invented. It could be thorium power. It could be better batteries allowing for widespread adoption of electric vehicles.

But even if "everything that can be invented has been invented," and there are to be no inventions akin to the integrated circuit, it hardly seems true that there is no more room for disruptive startups. In fact, the disruptive innovations that Christensen covers are pretty micro in nature.

I should mention a competing explanation for failures to switch to distuptive technologies when they arrive: the failure of companies to know what business they are truly in. For example, Studebaker was smart enough to understand that he was in the transportation business, not the wagon business, and he made the transition. Meanwhile, big box stores like Borders and Circuit City did not realize that their customers ultimately wanted products, not stores to visit, and have gotten crushed by Amazon.

Actually, it is a bit difficult to understand why the in-store bookseller vs Amazon fits with the framework of Christensen's theory. Did Amazon start out inferior to the brick and mortar booksellers? I suppose that it did in several respects: ability to preview, and immediacy of order and receipt. It is hard to remember, but Amazon was much less impressive before "search inside this book", before you could order books on your iphone, and receive them via free two-day shipping.

Amazon is a data point in support of Redleaf's thesis on incumbency, because it is a giant with a $120 billion market cap yet it is disrupting and upending other industries.

"More than any other corporation of the Internet age, Amazon embodies the emerging culture of business strategy. It is the General Electric of our times, and Bezos is the Jack Welch. When the definitive book on corporate strategy for the early Internet era is written, Amazon will be the main example, not Google, Apple, Microsoft or Facebook. Those are great companies too, but their greatness lies in other departments. As far as corporate strategy goes, they are mediocre players, not grandmasters."

And it is true that Amazon will probably be the disruptor and not the disruptee for a while. But back to the competing explanation: why wouldn't managers know what business they are in? Wouldn't competition select for firms that understood this, and wouldn't some firms get it right, even by accident?

Yes, and this makes me think that Christensen is right for a reason that he touched on but did not delve into thoroughly: the principal-agent problem [also 1,2].  He notes that because of the severe career blemish of being associated with a product that fails because of lack of demand, managers back projects for which demand seems most assured. They are risk averse, just like bureaucrats in a bureaucracy.

The disruptive technologies seem uncertain because they would have to be marketed to unfamiliar and possibly nonexistent customers. If the disruptive technology did work, in the end it would cannibalize the existing technology. What is Bob down the hall at HQ, who has been working with the existing technology for 20 years, going to say about that? Political ick factor!

So the managers bury their heads in the sand because it's the shareholders' money anyway. They are focused on maximizing the present value of their salaries, which means making sure Bob's division doesn't try to get you fired. Barnes & Noble sued Amazon in 1997 for claiming to be the "world's largest bookstore", aruing that Amazon "isn't a bookstore at all... It is a book broker making use of the Internet exclusively to generate sales to the public." OK!!

This would predict that owner/operator firms, and firms with fewer layers of management, would be less likely to get pushed aside by distuptive innovations that manager/agent firms. Score another notch for reasons that owner operators outperform.

Trinity Industries Discusses Q4 2012 Results ($TRN $CNRD)

We have mentioned Trinity before on the blog. Here is the Q4 transcript.

"Our Barge business set a new record for annual revenues in 2012 and came close to surpassing the previous record for profits.

The fourth quarter profits increased year-over-year by 38% after adjusting for flood-related insurance settlements in the previous year. The sequential improvement in quarterly profits of 16% was a result of favorable pricing and the mix of barge types delivered.

During the quarter, we secured $193 million in new barge orders which brings our barge backlog to $564 million at the end of December. The movement of petroleum and chemical products continues to create a robust market for tank barges. We now have visibility into 2014 for our tank barge facilities. Demand for our hopper barges continues to show weakness as a result of the reduction in domestic coal usage and the poor grain harvest last season.

In our Inland Barge Group, we expect revenues of between $550 million and $580 million in 2013 with an operating margin in the range of 14% to 16% resulting in operating profit of between $77 million and $93 million for the year. While we expect to report solid results in 2013, at this time our guidance were Inland Barge represents a noticeable step down from the strong performance reported by the group in 2012. The backlog for this business provides good visibility in the tank barge business with the long production runs into 2014. However, as Bill mentioned, weaker demand persists on the dry cargo side leaving some open capacity for hopper barges in 2013."

Paper: "The Information Content of Option Demand"

Link:

"This paper investigates the relation of stock returns and option demand imbalances due to an excessive option demand of investors with information on the underlying. Furthermore, we address the impact of informed option demand on price pressure in option markets. We derive a measure that captures the excess option demand of informed traders and empirically verify its predictive power for stock returns. We find economically significant returns for option market strategies that trade on the informed demand in options (e.g., 25% or 39% for out-of-the-money long calls or puts with 1-month time to maturity). Additionally, informed option demand is associated with an increase in option bid-ask spreads and put-call parity violations, implying that informed trading reduces liquidity in the option market and increases deviations from the arbitrage equilibrium."

Paper: "Mathematical Models for Stock Pinning Near Option Expiration Dates"

Another paper, "Mathematical Models for Stock Pinning Near Option Expiration Dates" [pdf] by Marco Avellaneda , Gennady Kasyan and Michael D. Lipkinz,

"We consider the phenomenon of 'pinning' of stock prices at option strikes around expiration dates. Pinning at the strike refers to the likelihood that the price of a stock coincides with the strike price of an option written on it immediately before the expiration date of the latter."

Yes, pinning does happen but more because of marketmaker hedging than conspiracy.

"Kirby Corporation To Present At The BB&T Transportation Services Conference" ($CNRD $KEX)

Highlights from the presentation [pdf]:

• The inland tank barge fleet is 3,100 barges, of which 956 (31%) are more than 30 years old. 
• Only 724 tank barges were built in the last five years.
• Kirby and American Commercial Lines are the largest tank barge operators (about a third of the total).
• There are about 6 dry bulk barges for every tank barge.
• Approximately 8% of industry’s [coastal tank barge] fleet is single hull and required to be removed from service by end of 2014.
• Continued strong inland petrochemical and black oil products demand with utilization in the 90% to 95% level, leading to favorable term and spot contract pricing.
• Higher demand in coastal markets, leading to higher utilization and favorable term and spot contract pricing.

New Paper: "Short interest, returns, and fundamentals"

A new paper (February 2013), "Short interest, returns, and fundamentals", by Ferhat Akbas, Ekkehart Boehmer, Bilal Erturk, and Sorin Sorescu. Findings:

• "If short sellers are detectives who uncover future bad news, bad news should follow periods of heavy shorting. [...] In a given month, the most heavily shorted stocks have the most negative public news the following month. At the other extreme, the least shorted stocks have the most positive public news the following month. The relation between short interest and future news is almost monotonically decreasing..."
• "[R]esidual institutional ownership ... measures the deviation of a firm’s institutional ownership from the average institutional ownership within its size decile, in any given quarter. [T]his result [short interest predicts negative news] is stronger when residual institutional ownership is low.
• We show that short sellers correctly anticipate negative earnings surprises, bad public news, and downgrades in analyst earnings forecasts several months ahead. Their ability to predict future fundamental news events appears to be the dominant driver of their ability to predict future returns. Shorts seem to be particularly well informed about stocks with low levels of institutional ownership, which are presumably harder to short.

I think you could measure the smartness of investor groups and look at whether they are long or short a particular equity. Smartest groups: insiders, shortsellers, competent asset managers for whom the position is a big position. Dumb groups: retail, index funds, most long-only funds.

We know that institutional investors sell down their equity position as the bankruptcy date approaches, and the dumping is amplified once the bankruptcy petition is actually filed. During the pendency of the bankruptcy, retail investors own an average of 90% of the firms' common stock.

Another variable would be the rate of change of the constituent groups' holdings. Shortsellers adding, insiders doing nothing, retail buying? That's a classic implosion pattern.

Something else you never hear about: whether insiders own their companies' debt securities. Do the GMXR execs own the 2015 paper yielding 40%?

Latest Hussman

Link.

"The problem today is that the recent half-cycle has taken valuations back to historically rich levels. Presently, the Shiller P/E is 22.7, with a dividend yield of 2.2%. Do the math. A plausible, and historically reliable estimate of 10-year nominal total returns here works out to only 1.06*(15/22.7)^(.10)-1+.022 = 3.9% annually, which is roughly the same estimate that we obtain from a much more robust set of fundamental measures and methods.

Simply put, secular bull markets begin at valuations that are associated with subsequent 10-year market returns near 20% annually. By contrast, secular bear markets begin at valuations like we observe at present. It may seem implausible that stocks could have gone this long with near-zero returns, and yet still be at valuations where other secular bear markets have started – but that is the unfortunate result of the extreme valuations that stocks achieved in 2000. It is lunacy to view those extreme valuations as some benchmark that should be recovered before investors need to worry."

Conrad Industries Hits New All-Time High ($CNRD)

Up 8% today!

GMX Resources Hits All Time Low, Warns of "Potential Restructuring" ($GMXR)

This morning, GMX put out a press release with its 2012 reserve estimates. The PV-10 of the Bakken proved developed producing reserves (i.e. producing wells) is $38.7 million. That is astonishing, because the company spent close to $100 million on capital expenditures last year alone, mostly drilling wells in the Bakken. It supports the hypothesis that the company's Bakken wells have negative rates of return.

The company also said that, "using SEC pricing, Haynesville/Bossier PUD wells reflect a negative PV-10 value of -$48 million, and the PV-10 value for the Company’s proved reserves without the H/B PUD wells is $128.4 million compared to the total proved reserved reported of $80.1 million." One reason for the share price collapse is that it's seeming clearer now that the equity is an out of the money option.

However, the other major reason was this paragraph in today's press release,

The Company has recently sought indications of interest for certain debt and equity liquidity alternatives, but not received sufficient support for all of its liquidity needs or plans. The Company is continuing to explore and evaluate options for its capital needs, as well as continuing to evaluate and finalize its 2013 budget for capital expenditures based on its available liquidity. In connection with its evaluation, the Company plans to retain a financial advisor to assist the Board and senior management in its ongoing exploration of a variety of financing alternatives, including a potential restructuring of the Company’s balance sheet in light of its current liquidity and cash needs.

Yikes! Amazing that restructuring needs to be considered even though the next debt maturity is not until 2015. The working capital situation (still haven't seen a YE 2012 balance sheet) must be really dire.

Bearish Apple

Looks like $700 in September was the peak. The new CEO is too dumb to understand a simple balance sheet arbitrage.

Suntech Bonds Trade at 35 ($STP)

Bonds are tanking on heavy volume today, including a million at 34.5, which was a YTM of >2100%!

You can buy a Jun $2 put for $1 which will double if the stock recovers zero in a liquidation.

Another GMXR Press Release

Today after hours, after the 17 percent decline.

"The Heiser 11-2-1H well, located in Sections 2 & 11, Township 145N Range 99W in McKenzie County is currently producing with a peak 24 hour flow rate of 3,268 BOEPD. The Company has a 66% working interest in the well which targeted the Middle Bakken with a lateral length of 9,620'."

I discovered last year that initial production numbers for GMXR wells are basically irrelevant. Using initial production as a metric is predicated on the assumption that if one well has an IP of X bbl/day and another has an IP of 10X bbl/day, then in six months the better well will still be producing 10 times as much per day, that the better one will produce 10 times as much over its lifetime, and that it is therefore worth 10 times as much.

While GMXR wells with higher IPs do have higher production after four months, the production numbers after four months are compressed into a tight band. Meaning: a 10x difference in initial production implies a month four production difference of less than 2x.

This well is still on confidential status with the state, so we have no actual information that would lead us to conclude that this is a good well. The number that GMXR quoted is "barrels of oil equivalent", which treats an MCF of natural gas as 1/6th of a barrel of oil, even though the actual price ratio is about an order of magnitude less favorable than that.

Personally, if I was running a company with secured debt yielding ~20 percent and unsecured, earlier maturing debt yielding 40 percent, I would be much more forthright with investors in press releases, lest people think I was cherry picking good news in a manipulative way to stem share price declines.

Petroquest Preferred

The Petroquest preferred stock, yielding 10.4% and convertible.

Enterprise value through the preferred is $184mm and the year-end PV-10 is $240mm.

So you are essentially doing a 75% LTV loan against the PV-10 with a 10% coupon and a conversion option.

GMXR Tanks ($GMXR)

Well, the Friday afternoon GMXR announcement was not subtle enough for the market to ignore, so the stock is tanking to a new all-time low of 0.45 (pre-split).

I had another afterthought: the company told us the cash situation but not the working capital situation. That is, we don't know to what extent payables have been stretched and how quickly cash is going to flow out the door.

J.S. Bach - Crab Canon on a Möbius Strip

Sunday Night

Hussman:

"Gordon Chang appeared on CNBC on Friday, noting the troubling difference between exports reported by China to other countries and imports reported by other countries from China, as well as the gap between low cargo numbers and high reported export numbers. In response, the CNBC anchor said – and I am not making this up – 'You know Gordon, I agree with you, but let me take a different tac[k] on this, alright? Let’s say you believe that China is making up the numbers. But if the stock market there keeps going up because of it, and you believe the government will keep priming the numbers, isn’t that sort of a reason to bet on the Chinese stock market?'"

Falky:

"One could say that Al Gore adds dubious value on his various boards and venture investments, as his main value consists of knowing the right regulators and big government contractors, crony capitalism, which is much more destructive than those dreaded limit orders that are often cancelled."

Krugman Piece to File Away

This guy just can't resist:

"Realistically, we’re not going to resolve our long-run fiscal issues any time soon, which is O.K. — not ideal, but nothing terrible will happen if we don’t fix everything this year. Meanwhile, we face the imminent threat of severe economic damage from short-term spending cuts.

So we should avoid that damage by kicking the can down the road. It’s the responsible thing to do."

That is going to sound as brilliant as when he said that "Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble" in 2002.

Be sure to watch the 1931 short film that anticipates Krugman.

"GMX RESOURCES INC. Provides Company Update" ($GMXR)

Wow, this is a bad update:

• The Company's production for the fourth quarter of 2012 was approximately 310,000 BOE, which included approximately 55,100 Bbls of oil, 1.4 Bcf of natural gas and 23,800 Bbls of NGLs. The 55,100 Bbls of oil was virtually all Bakken generated and resulted in an average of ~600 Bbls/day
• Production for the year-end 2012 was approximately 1.9 MMBOE, which included approximately 203,500 Bbls of oil, 8.9 Bcf of natural gas and 237,500 Bbls of NGLs. 
• Estimated Bakken oil production for 2012 was 148,500 Bbls
• The Company's available cash at year-end 2012 was $46.0 million and includes $16.8 million reserved for the maturity of the Company's 5% Convertible Senior Notes due 2013.
• The Company has recently sought indications of interest for certain debt and equity liquidity alternatives, but not yet received sufficient support for all of its liquidity needs or plans.

Production for Q4 was initially "guided" to be 75,000 bbl. Then it was lowered to 60,000 on Dec 4. Turned out to be 55,100. (This is why we created the Chart of Truth for GMX.)

A good high estimate of producting well valuation might be about $100,000 per daily barrel of production. So their Bakken production is worth ballpark $60 million. That is a fraction of the secured debt.

So, the company ended the year with $29.2 million in cash. It was probably cash flow negative in Q1 so far and will continue to be. No wonder they are trying to raise more capital. And it is obviously why they made an interest payment on the Senior Secured Second-Priority Notes due 2018 in stock in lieu of cash.

The problem is that the nearest debt maturity (2015) yields 40 percent. They had to roll the 2013s over (partially) with secured debt. It's just not clear how they could borrow more money or who would be willing to lend them more money.

If I am running that company, I feel like I need to batten down the hatches on cash right away. No more preferred dividends (maybe let the preferreds swap for equity) and try to do something about the cash interest expense on the 2015s (swap those for equity too). No more capex. (Why are they participating in wells?)

"A123 says unsecured creditors to get 65 pct of claims"

"Unsecured creditors of A123 Systems Inc, a bankrupt maker of batteries for electric cars that had U.S. government backing, will likely collect around 65 cents for each dollar they are owed"

Comments from Hornbeck Offshore Earnings Call Q4 2012

From the transcript,

"We’ve resisted natural temptation to overly subscribed long-term charters in a low-rate environment and elected to keep a number of our vessels available in the spot market. This was based on our positive view of the Gulf of Mexico’s resiliency as a core region and its expected turnaround. The same view that propelled the November 2011 launch of our most recent newbuild program.[...]

In the Post-Macondo Gulf of Mexico we see this Jones Act preference as a long term trend not only for construction vessels but for vessels of all types working offshore. Part of this preference may stem from the comfort that our customers in the Gulf of Mexico drive from the high operating standards of the US vessel owners and crews who are regulated by the US Coastguard one of the most exacting marine regulators in the world. [...]

The month of December was a month most active, we can remember in terms of customers’ enquiries and tender activity for upcoming drilling programs in and outside of the US Gulf of Mexico."

Review of The 12 Million Stuffed Shark: The Curious Economics of Contemporary Art

I've written in the past about hideous contemporary "art" like that of Damien Hirst or Andrew Warhola. You might not think that contemporary art (or The 12 Million Stuffed Shark: The Curious Economics of Contemporary Art) has any relevance to investing, but consider some puzzling aspects: Why are masterpieces so expensive? Why is bad art now so expensive, too?

Art shows how quickly most men grow tired of compounding wealth and what little imagination most men have at finding a use for vast wealth. Planes and boats are classic rich man's toys and credit bubble assets, because you can get them as big as your heart desires. There is a long lead time to build them, making the price swings extra-volatile. But nothing compares to the perfectly inelastic supply of artworks where the artist is dead, because the supply has zero elasticity so the prices can theoretically get bid to infinity, and relative to the value of the materials, they do.

Stuffed Shark author Thompson mentions Tatar vodka billionaire Roustam Tariko, who supposedly paid over $100 million for the hideous Dora Maar au Chat by Picasso, although Tariko has denied it. This is notable because Tariko is working to wrestle control of U.S./Polish vodka maker Central European Distribution Corp, which has the wonderful distinction of having the highest yielding corporate bond that is not in default (over 1,000 percent YTM).

The masterpieces become staggeringly expensive because the number of museums grows while the number of masterpieces is constant. Meanwhile, estate taxes and reversion to the mean make it difficult for these paintings to remain in private hands. If your heirs were lucky enough to inherit your Vermeer, could they afford to pay the $40 million dollar estate tax on it?

Once the paintings are owned by museums they rarely trade again. This means that new museums have a difficult time finding a respectable complement of works, and have to bid against each other for whatever comes on the market. Hence the high prices.

The junk art is expensive due largely to corruption but also stupidity. Corrupt for several reasons. First, museums are either explicitly or implicitly buying it with our money, since the donor of the work gets a tax deduction. This is true even though a donation increases the value of an artist's other works still owned by the donor. According to Thompson, not only do recent or pending museum shows for an artist increase the value of that artist's work, but a single artist show at a major museum can increase value by "50-100%".

That means if you are in a position of power at a museum (curator, board, donor), you can have the museum buy or borrow works that you have a financial interest in and increase the value by showing them - pumping their own portfolios. Apparently this goes on all the time. 

A Business Week article claims that ghastly Damien Hirst pieces "acquired during his commercial peak, between 2005 and 2008, have since resold at an average loss of 30 percent." Amusingly, Alberto Mugrabi thinks that people will still be talking about Hirst in 2,000 years.

Apparently, the contemporary art virus is now infecting China too. I'm surprised that they are falling for junk like this, but it goes with my China skepticism thesis.

Overall, I give this a 3/5.

Hornbeck Offshore Announces Fourth Quarter 2012 Results ($HOS)

Just released:

• The sequential increase in dayrates was primarily driven by improved market conditions in the GoM and Puerto Rico.  Utilization for the double-hulled tank barge fleet was 99.3% for the fourth quarter of 2012 compared to 87.3% for the year-ago quarter and 93.4% for the sequential quarter.  The increase in utilization over the prior-year quarter is primarily due to increased demand for the Company’s tugs and tank barges driven by the activity in the Eagle Ford Shale and a tight market for clean petroleum product capacity in the Northeast U.S.
• After adjusting for 71 days of fourth quarter downtime for regulatory drydockings, the Company’s commercially available high-spec OSV fleet achieved an effective utilization of 98.8%.    
• Fourth quarter 2012 revenues increased 8.6% to $133.2 million compared to $122.7 million for the fourth quarter of 2011
• 4Q2012 utilization for the Downstream fleet was 99% up from 87% in 4Q2011 and 93% in 3Q2012
• Improved market conditions have allowed the Company to recently increase leading-edge spot dayrates for its 240/265 class DP-2 OSVs to the $38,000 to $42,000 range, up from $30,000 to $36,000 range last quarter.
• The Company announced today the expansion of its fifth OSV newbuild program by four vessels, as well as its intentions to ultimately build up to eight Jones Act-qualified MPSVs as a subset of its growing OSV newbuild program to service the subsea construction and IRM market that is expected to expand significantly in the GoM beginning in 2015.

Bullish for Conrad - high barge utilization and more activity coming to the GOM. The moronic drilling ban has probably created a gigantic pent up demand for projects that will last years regardless of what oil does.

It's funny because a surge of activity is better for suppliers / vendors than steady constant activity would be. It should mean that capacity is constrained and so they get more of the rents as opposed to the producers. Shipping product is obviously costing more now that barge fleets are fully utilized.

I've written up the GOM market color before, but here are highlights:

• [Sep 2012]"The Gulf of Mexico, which saw deepwater backlog fall 10% in 2011 following the Macondo moratorium, is back at record backlog and we expect further supply commitments in the coming months."
• [Oct 2012] "Hercules Offshore backlog per rig is at a 5 year high. Slide 6 shows shallow GOM lease block sales back to early 2008 levels."
• [Oct 2012] "Both Schlumberger and Baker Hughes had good things to say of the Gulf of Mexico. Calling it 'the fastest growing deepwater market in the world...'"
• [Oct 2012] "Gulf of Mexico is still one of the best places in the world to invest [...] This is clearly another bright spot in the U.S. for future activity"
• [Oct 2012] "in the U.S. Gulf of Mexico, we are expecting 2013 demand for our service and product lines that support deepwater drilling to surpass the level we experienced before the Macondo incident in April of 2010. [...] subsea tree installations in the Gulf are not expected to reach the prior peak level of 2008 until 2016.""
• [Nov 2012] "A resurgence in the Gulf of Mexico offshore markets, spurring both newbuild and conversion projects, and augmented by substantial U.S. government spending, has resulted in shipyard backlogs that are as good as they have been in some time; carrying well into 2014 and beyond"

Historically, oil and gas related work was a big component of Conrad's business. However, the oil price crash and then the post-DWH moratorium resulted in a string of bad years for this segment. Luckily they were able to replace this business with other types of projects. But if both inland barges and energy related business are booming at the same time, revenue and profit margins should both increase substantially.

"Suntech Power (STP) Could Decline 50% in Next 50 Days - Raymond James" ($STP)

An article quoting Raymond James analyst Pavel Molchanov's analysis of Suntech:

Molchanov said if the company was a non-Chinese PV manufacturer it would already be bankrupt. [...P]ossible outcomes that he sees. Outcome #1 (50% probability): Heavily dilutive equity issuance; Outcome #2 (35% probability): Bankruptcy; Outcome #3 (15% probability): Non-dilutive outcome.

So 85% chance of the stock price getting crushed. That is similar to what I think, but I would argue that the probability of bankruptcy is much higher than the probability of equity issuance. We have just about run out of time to restructure the notes outside of bankruptcy.

Citi has started coverage of Suntech with a sell rating and $1.50 price target. I've seen the report and it's more focused on picking winners in solar than predicting what is going to happen with the STP debt maturity (which it hardly mentions). Still, it may just be their polite way of saying the stock is going to zero.

Suntech Power Bonds Yield Over 1100%! ($STP)

Just some tiny bond trades today, but yields were over 1,100 percent! With a maturity in 37 days, it's a bad sign to see price declining, low volume, and rising yields on the bonds.

What would make anyone think the equity is worth anything?

No One Believes in Plans: The R&D Anomaly

From "Does the Stock Market Underreact to R&D Increases?" by Allan Eberhart, William Maxwell, and Akhtar Siddique,

"We examine a sample of 8,313 cases, between 1951 and 2001, where firms unexpectedly increase their research and development expenditures (R&D) by a significant amount. We find consistent evidence that our sample firms are undervalued following their R&D increases as manifested in the significantly positive long-term stock returns that our sample firms' shareholders experience. We also find consistent evidence that our sample firms have significantly positive long-term abnormal operating performance following their R&D increases. Our findings suggest that R&D increases are beneficial investments, and that the market is slow to recognize the extent of this benefit (consistent with investor underreaction)."

It could be investor underreaction, the phenomenon whereby investors are "anchored by salient past events". There is plenty of research showing that investors underreact to all sorts of news: good earnings, bad earnings, share repurchases, financial distress, dividend initiations, stock splits and reverse splits, and so forth.

But there's another hypothesis for an underreaction to research and development expenses, a theory we touched on last week: no one believes in plans. We have people like William Bernstein arguing that the long-run real rate of return on capital is one percent, if you're lucky. This is the indeterminate world idea that Peter Thiel talks about,

"In a determinate world, there are lots of things that people can do. There are thus many things to invest in. You get a high investment rate. In an indeterminate world, the investment rate is much lower. It’s not clear where people should put their money, so they don’t invest. [...] Indeterminacy has reoriented people’s ideas about investing. Whereas before investors actually had ideas, today they focus on managing risk. [...] In an indefinite world, investors will value secret plans at zero. But in a determinate world, robustness of the secret plan is one of the most important metrics. Any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans. The ability to execute against long-term secret plan is thus incredibly powerful and important."

Underreaction to research and development is perfectly consistent with Thiel's idea. And public markets currently put a huge premium on predictable, non-divertable cash flows and more attractive (lower) multiples on cash flows that are seemingly uncertain.

Two New Investing Anomalies

First is "Institutional Investors’ Investment Durations and Stock Return Anomalies: Momentum, Reversal, Accruals, Share Issuance and R&D Increases" by Martijn Cremers and Ankur Pareek. They created a measure of institutional investor investment horizons based on quarterly institutional investor portfolio holdings, which is the 'average stock duration:' the weighted average of the duration the stock has been in the institutional portfolios. They find that

"the stock returns momentum anomaly only occurs for stocks that are generally held by short-term institutional investors. Similarly, the accruals and share issuance anomalies are much stronger for stocks with shorter investment horizons. Finally, short-term investors also under-react more to increases in R&D investment."

Second is "A Tale of Two Anomalies: The Implications of Investor Attention for Price and Earnings Momentum" by Kewei Hou, Lin Peng and Wei Xiong. They find that

"earnings momentum profit decreases with turnover [and] that the long-run returns of the earnings momentum portfolios for months 13-36 after portfolio formation show no sign of reversal. These results support our hypothesis that investors' underreaction to earnings news drives the earnings momentum effect and that the degree of underreaction weakens with investor attention."

The presence of short term investors is associated with stock mispricings. The accrual anomaly consists of investors focusing on headline earnings and failing to distinguish between accrual and cash flow components of earnings. Short term investors seem to be fixated on headline earnings, indicating that they are not reading financial statements very carefully. Or, alternatively, they buy stocks for trading and not for owning. Similarly, the benefits of research and development are long term and so short term investors ignore them.

Someone on Twitter was asking: why does every trade need a catalyst? Well, if the S&P 500 paid a 7 percent dividend yield, would anyone care about catalysts? What if companies with great moats like Google or railroads paid 7 percent dividends? Obviously no one would care about catalysts, they would just clip coupons.

I wonder whether the focus on catalysts is because the market is overpriced, in the sense that no one can live off of the coupons on a portfolio, and so staying ahead requires painstaking and original investment research looking for catalysts?

How does this relate to the short term investing anomalies? Well, by definition, a catalyst is a value-unlocking event that you hope happens soon. Focus on imminent catalytic events may be what causes short-term investing.

GMX Resources Elects to Make Interest Payment in Stock in Lieu of Cash ($GMXR)

Today's filing:

"GMXR's Senior Secured Second-Priority Notes due 2018 have a quarterly interest payment due the second day of March, June, September and December. Interest on the notes accrues at 9.0% per annum. GMXR has an option to pay the interest in cash or in shares of our common stock. GMXR has elected to pay the interest payment due March 2, 2013 in shares of our common stock provided, the number of shares of our common stock issuable shall not exceed 604,216 shares. If the number of shares of common stock issuable as interest would exceed 604,216 shares, we will pay any additional interest amount payable in cash. The record date for this interest payment is February 16, 2013. The number of shares of common stock to be issued will be calculated as the quotient of (a) the difference between the total amount of such interest payment and the amount of such interest payment paid in cash, divided by (b) the product of (x) 0.75 times (y) the per share volume-weighted average price of the common stock for each of the 10 consecutive trading days ending on, and including, the trading day immediately preceding the relevant interest payment date. If we were to pay this interest payment entirely in cash, the aggregate amount of cash would be approximately $2.1 million. If we were to pay this interest payment entirely in shares of common stock, the aggregate fair market value of the shares would be approximately $2.8 million."

That's a huge amount of stock - equal to about twelve days' volume. It's also equal to about 5 percent dilution of the common! Just from one quarterly interest payment!