Positions Revisited

I want to revisit some of my stock decisions and see what was the outcome and analyze if there is anything I should have done better. I will try to be intellectually honest with my assessments and recognize my errors. Also i want to look back and see if there are any mental traps that affected my decisions and recognize when i fall for these psychological biases.

Below is all the positions that I have talked about on this blog for over a year or so. All are businesses that I looked to own but did not or I bought and sold.

General Growth (GGPWQ): I have dismissed the value in this name when it was trading at $.35. now the stock is over $4.5 an impressive 600%+ return. Was I wrong? Off course I was. Would I do the same decision again? Probably yes. There is nothing inherently wrong in how I analysed the situation. I came to the conclusion that there is a probability of permanent loss of capital; this probability excluded the equity of GGP right away.

I honestly can live with the consequences of such decisions. I prefer to err on the side of preserving capital than take a speculative position like General Growth.

Coach (COH): I liked the business and its management but I decided I will only buy at $18 or below to give me enough margin of safety. Coach is trading at $33; some 80% return if I have gone ahead and bough at my buy decision.

My inaction cost me here. This one hurts more than General Growth because there was no reason not to buy. I scummed to the fear and paralysis during the market tumble earlier this year. My bias for the status-quo and regret avoidance have cost me.

Hawk Drilling (HAWK): I did not like this spin-off for various reasons. However, the stock has gone from $22 to $35 in the span of several weeks. The business has a lot of ugly factors in it, which is what you want to buy in a spin-off. But again this one I can live with. The price has gone up not to the specifics of the company but because of movement in natural gas as evident of a similar move by its competitor Hero Drilling as seen in the chart; Natural Gas has also moved from $2.7 mcf to $3.7 during the same period. I concluded that this was a leveraged play on Natural Gas and I did not want to call its direction.

Switch of Bank of America to American Express: After BofA bought Merill Lynch I decided to get out and switch to AMEX. My analysis were right that BofA would have tough time with Merill and I am better with a company that have a great brand name and much more easily understood and analysed than a bank. AMEX return 65% from the switch to BofA -14%.

In this instance I did not have any status-quo bias I acted and I did not have a loss aversion bias. I hope I can have the same capacity to perform the same decision in similar situations.

Preferreds (Brookfield and Bombardier) and Senior Loans Positions: I have bought several positions with the credit theme to be a better proposition than equity. All worked very well with most of them 70% gains plus their yield.

However, equity performed very well since its March lows. All my buying from late 2008 to early 2009 has been tilted toward credit instruments rather than equities. There were several companies that I liked that could have provided me with handsome returns over the last six months. Again, some paralysis on my part to pull the trigger on stocks with attractive prices, similar to Coach above.

Teck Resources (TCK): This position has worked as I expected. The assets were too valuable. When it was trading at $4, I did not think there was any chance of loss of capital. Now that the stock is trading at $30 it still has some room to high 30s.

However I made a silly mental error. I sold too early and left a lot of profit on the table by halving my position. The business did not hit my value estimate and I reacted to the price run and I fell to regret avoidance mode. I should have asked what is the value?

FirstService (FSV): I sold at 8% loss when I realized I made several errors in valuation and business model assessment. My mistake here is that those assessment should have been made before hand not afterwards. I rushed to take advantage of price decline before the opportunity escapes me. Little I know the price declined further. Here it was a process violation; the position should have never been established and because of the error I am 8% poorer.

NorthStar Realty (NRF): I am down some 50% on this one. I can be wrong on this one but I followed my process and my thesis still good. I am willing to hang onto it until I see another opportunity with better return profile.

Sears Holding (SHLD): I am down 30% on this position. Again so far I am wrong and the intrinsic value has declined with the name as its real estate assets have went down in value. Moreover, I realize now that valuation discount alone is not enough it has to be coupled with good business model and economics.

Cardinal Health, Peyto Energy, and Burlington Northern: All of these positions are recent and any analysis is not worth its trouble.

I just wonder how this post would have been different if the market have not rallied. I come to remember the quote " rising tide lifts all boats". So I am thankful that I did well but I always think that there is an element of luck in my decisions.

Value idea: Peyto Energy Trust

Natural gas is at extreme lows as it should; there is tremendous supply in the system. Storage is almost full. There will be no where to put extra production. The reason is the vast discoveries of shale gas. North America is abundant with natural gas contrary to what was believed of North America peak gas. Even with a harsh winter I do not think the supply picture will improve.

However I believe that goods or assets can't sustain prices below its average production cost over the long term. Sure there will be some divergence in some periods but it should return to equilibrium eventually. The question is when. I am not going to speculate on that as it is going to be a crap chute at best.

However a good position if I can find a way to participate in the price recovery of natural gas, while I get some downside protection and a margin of safety. I think Peyto Energy Trust (Pey.un) gives me this proposition. Peyto is :

Canada-based energy trust. The Trust’s principal business activity is the exploration for, development and production of petroleum and natural gas in Western Canada. As of December 31, 2008, the total proved plus probable reserves were 998.3 billion cubic feet equivalent (166.4 million barrels of oil equivalent) with a reserve life of 23 years. Production is weighted approximately 85% natural gas and 15% natural gas liquids and oil.

I like Peyto for the following:

• hedge book for half of their production of the next 12 months at an average price of $7.5 per mcf
• low debt to capitalization and good coverage of debt service and dividends
• low cost producer of natural gas. currently their operating costs per BOE is $2.56 as of their latest quarter
• long life reserves
• the cost structure for the most part is variable and gets reduced with lower revenues.
• cheap valuation where its Entp. Value to NPV is .57, a measure to value the company to its discounted cash flow from reserves in the ground.
• The current dividend yield is Distribution is 15.5%. The coverage of the distribution is good but if gas prices continue its decline it will be halved.
• I get good odds betting on natural gas plays. The upside is potentially large while the downside is limited. We are already at a decade low of natural gas price. Most Natural gas producer did not participate fully in the recent rally and lag the indices by a wide margin.
• And a very good management, extremely good management.
• My catalyst will be the revision to mean in natural gas prices as most likely it can't keep going down. We are in a period of supply and demand imbalance and there should be an equilibrium found in the next 12 months.

What can go wrong:

• Payout ratio is trending higher, which is understandable given the weak revenue figure. Peyto has already cut its distribution and it could a further cut is probable.
• Natural gas is the "widow maker" and can be very volatile. There is no reason it can't go to low $2s per mcf.
• Their operating lines can be shut or reduced if credit environment deteriorates further. Producers rely on operating lines to fund operations and exploration.
• Royalties are influx in the government of Alberta and can be very fickle to factor in analysing operations. Couple years ago royalties has been hiked on gas producers but once the bust has set in it was reconsidered.
• The conversion to corporate entity issue. Trusts will be subject to regular corporate taxes in 2011 so this is issue is hanging on Peyto and all trusts alike.

A note: This is a Canadian trust equivalent to master limited partnership in the US so it will have personal tax consequences that will have to be taken into consideration when purchasing

Changes to portfolio

Reducing EEM stake by more than half. I have been holder of Emerging Market index for a while in an effort to diversify internationally. The call was to hold the index for the long term but as my style of investing changes, more focus on event driven investing, I find my emotions rule how I view this position. I get swayed by economic analysis from various sources. I do not have any insight or edge.

Also, I have bought in the EEM when all were selling in Sep of last year. Valuation then made sense. Now emerging market funds are loaded with capital as money flow into them like crazy. Valuation has increased from 10 x earning to 20 time earnings now. People have high expectation of emerging market due to growth potential. I think it is a likely scenario that economic dominance will shift to some emerging economies like China and India but the odds that the market gives me for returns are not favorable. So I am taking my profits here and I will set tight.

I am also selling out of FirstService(FSV). I am existing this position with a small loss of 7%. I have made this call based on valuation alone. the value of the sum of the parts were higher than the market cap of the company. However as I started to look at the business details, a step I should have done before buying, I started to change my mind and cheap valuation does not cut it alone. I sold because:

• high compensation to CEO and management compared to peers and level of earnings growth.
• rollup strategy that is empirically destroys value
• ROIC is on par with the cost of capital
• bulk of the growth is attributed to acquisitions. what will happen if they can't acquire anymore?

Another sell decision TSX index: too much concentration in Natural resources and financials. Actually between the two sectors it makes up to 75% of the index. And those two areas where I do not have a lot of insight. Another small loss of 4%.

Spin-off Idea: Cardinal Health

By end of business today Cardinal health, CAH, will spin-off its medical care division, Carefusion, CFN, and it will focus on drug distribution. The spin off is very interesting midst all the talk of health-care reform because whenever there is uncertainty it pays to go long.

The market is very hot for the CFN spin off. Although CFN accounts for only a small portion of CAH's revenue, maybe less than 7%, it makes third of its profit. The business is very high margin and its potential for growth is solid. The independent company will be able to focus on new products and free to allocate capital to R&D. But it is fully valued when the when issued shares trade at $19. I figure its value is around $20-$23.

What is interesting is the parent company. The market is betting against it. Short volume has increased significantly over the last month or so. Wagers against health-care shares rose more than 7 percent, the most of 10 groups, to 890.3 million as President Barack Obama proposed an industry overhaul. Shorts thesis is earnings will come be under pressure due to health-care reforms. May be it is true. But CAH margins will stay intact and it will be part of the solution.

Once the spin off is complete, CAH is no more than a logistics provider to drug makers. It provides supply chain services to them and have no R&D commitments. Drugs like goods funnel in and through its distribution network reaches customers. So if health-care reforms lead to reduced costs of drugs, CAH's input costs and revenue will come down in tandem. Its margins will not be affected. Sure the absolute level of revenue and earnings will decline but the company value will be still intact.

I am liking going long CAH rather than CFN, it gives better odds.

Value Idea: Pride's Spin off

Forced Sellers:

I think this will be dumped by investors because they will want Pride high margin business in the deep water drilling and not the shallow-water low margin and limited growth business. But the $64,000 question is are they forced sellers due to non economic reasons or are they justified in their actions?

Industry Fundamentals:

lower utilization rates and pressure on daily rates. Oil finds moving to deeper waters, which seahawk fleet is not capable of operating under. Their biggest customer are requiring more depth capable rigs, which prices them out of more business.

The disparity between the US Gulf of Mexico Shelf and deepwater rig markets continues to widen. Earlier this year, the jackup market reached its lowest level in 33 years, according to ODS-Petrodata figures, and slid downward from that point. Drilling contractors continued their exodus from the Gulf whenever possible, moving jackups to more lucrative areas. Despite a slowdown in some jackup markets, eight rigs will have mobilized from the Gulf by the end of July. As far as the deepwater Gulf, most people consider it a growth market. As many as 17 new-build deepwater rigs are scheduled to enter the region by the end of 2010. More deepwater rigs could mobilize there for a few wells, then mobilize back to other markets during this period. As a result the utilization rates have been coming down steadily over the last few quarters.

Rig Type	Current		Month Ago		6 Months Ago		1 Year Ago
Drill Barge	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)	90.0%	(9/10)
Drillship	90.5%	(38/42)	92.7%	(38/41)	79.5%	(31/39)	78.4%	(29/37)
Jackup	74.9%	(275/367)	74.9%	(274/366)	82.5%	(296/359)	91.0%	(312/343)
Semisub	80.2%	(134/167)	82.5%	(137/166)	82.7%	(134/162)	83.9%	(130/155)
Submersible	50.0%	(1/2)	50.0%	(1/2)	100.0%	(2/2)	100.0%	(2/2)
Tender	80.8%	(21/26)	76.9%	(20/26)	92.3%	(24/26)	88.5%	(23/26)

Natural gas prices are weak and depressed. There is plenty of supply and surplus inventory to keep the pressure on prices for awhile. I do not want to try to forecast or predict the direction of natural gas because what if my baseline forecast did not materialize. Natural Gas prices are called the "widow maker" for a reason, they are very hard to call.

Overcapacity in the sector. There are several deliveries to take place for shallow water rigs. During the past several years, the supply of available jackup and semisubmersible rigs has been unable to meet the increasing demand of oil and gas companies on a global basis. As a result of this global supply and demand imbalance, various industry participants ordered the construction of over 180 new jackup and semisubmersible rigs, over 60 of which were delivered during the last three years. Approximately 60 additional jackup and semisubmersible rigs are scheduled for delivery in 2009.

The new rig deliveries scheduled for 2009 include over 30 jackup rigs, the majority of which are not contracted for work upon delivery from the shipyard. These new drilling rigs will increase supply and likely reduce utilization and day rates as rigs are absorbed into the active fleet, especially in light of the recent decline in oil and natural gas prices and jackup rig demand. However, the current supply of jackup rigs is limited and it is time consuming to move offshore rigs between markets. Accordingly, as demand changes in a particular market, the supply of rigs may not adjust quickly. Utilization and day rates in specific markets could fluctuate significantly while utilization and day rates in other markets may be relatively unaffected. Additionally, several rig construction cancellations have been recently announced and the tightening credit market has created substantial uncertainty as to whether construction of other rigs will be completed.

Ok, you would say that weak industry fundamentals are cyclical and should adjust. Then seahawk would give you great risk/ reward proposition, assuming its price will fall to below liquidation value of its assets, which more likely it will. In this case company fundamentals has to be flawless to get me interested.

Company Fundamentals:

• Potential of fines regarding bribery charges and accounting irregularities, however there is limit to the fines paid to $1 million, any excess pride will take care of it.
• Mexico Oil company account for 60% of SeaHawk gross revenue. One customer dominate their business. This was not a problem when the company was a division of Pride but on a stand alone basis is very risky.
• accounting is a bit aggressive:
• changes to depreciation expenses by extending the useful lives of rigs, which means a boost to their earnings as depreciation expense get smaller. This annoys me to no end when companies change their depreciation policies or assumptions. It makes comparisons difficult and obviously management motives to boost earnings by hook or trick.
• already there is investigation for accounting irregularities by pride into Seahawk division.

• no debt and clean balance sheet, which a very good in this environment.

• SeaHawk Jackup rigs are shallow in the 200-250 feet range which does not work in the current industry dynamics. Their biggest customer are requesting deeper and deeper rigs, which prices Seahawk out.
• very capital intensive business. in order to expand more capex need to spent to buy new rigs. most free cash flow will go to acquisition of new PPE.
• most of its rigs are idle they have 40% utilization rate.
• most rigs are old so it may require some capex going further
• no unique competitive advantage that is very apparent that will distinguish their operations from others.

Management

SeaHawk's president and CEO was CEO of Hercules offshore, similar business to seahawk. He left the company in June 2008 and the company took a big impairment expenses due to large acquisition done on his watch, $2.3 Billion in cash and stock. As a result of the acquisition, Hero balance sheet is over leveraged and impairment charges mounted when the turn in the economy came.

Investment returns over his tenure were not overly outstanding.

	2004	2005	2006	2007	2008
ROE	11.35%	19.13%	38.98%	11.35%	(73.37%)

He spent $660.1 million in capex, not including the merger deal, cumulative over the 2004-2008, and generated $618.9 millions in cash from operations during the same period. During the same period cumulative earning were partly at $291.2 million, and if you include 2008 results it would be a significant loss.

Management Compensation Plan

This is a bright spot, somewhat, as the good chunk of compensation is in form of equity. I say somewhat because not all long term incentive compensation is equity. The better alternative is to have 100% of their long term compensation in restricted stock. From their filing:

The beginning value of the initial equity award is $4,800,000 for Mr. Stilley, $1,000,000 for Mr. Manz, $690,000 for Mr. Cestero and $575,000 for Mr. German. ....50% of the equity compensation will be in the form of restricted stock.

Competitive Position

The company is second lowest cost operators in the GOM region. Hero operates better cost structure than Seahawk. According to my analysis the operating the costs per available day is

Business	Notes	OE per avail Day
Seahawk	only GOM locations	$49,634
Hercules Off shore	very similar business to Hawk but diversified geographically	~$28,000
Ensco International Incorporated	shallow water but more specialized assets/ fleet. their GOM fleet water depth is 250-400 ft	$50,175
Rowan Companies	shallow water but more specialized assets/ fleet water depth 250-500
DO	deep water rigs- not very applicable
Nobel	deep water rigs- not very applicable	~$63,000
RIG	deep water rigs- not very applicable (55 standard jackups with depth from 250-400)

Conclusion:

There are so many strikes against the spin off and not too many positives even if valuation are ridiculously cheap, which I did not need to perform. This is a leveraged play on the prices of natural gas, which is very hard to call: will it stay depressed or take off? Weak sector fundamentals and potential liability and fines all are external to the company and can be manageable by good management team. However, I have my doubts about the new CEO hi track record in Hero is not encouraging. If there is any contrarian play on this name, I do not see it. I will pass on this spin off.

Spin-off Idea: Pride International

Not a lot of spin offs came to the market lately. But I think that is about to change as companies will reorganize themselves and cut businesses that no one want to buy. There is two opportunities right now: Pride International Spin off of Seahawk Drilling and CableVision spin off of the Madison Square Garden business. I will introduce the Pride spin off and talk some other time about Cablevision.

Pride International (PDE) is spinning off its Gulf of Mexico operations to shareholders. Pride International is an offshore drilling company that leases rigs and vessels to producers. The company recently made strategic effort to focus on deep water and other high-specification drilling solutions. As a result the decision to spin-off its shallow water business. Jack-up revenues has been declining in over the last few quarters. Management thinks this GOM drilling is slow growth business and that's why they want to divest out of it.

The shallow water business or the leasing of jack-up rigs is concentrated in the Gulf of Mexico (GOM) only with no other international operations. The shallow waters of the GOM is a mature region that oil production has peaked some time ago. companies are moving deeper and deeper for new finds. Pride management is justified in dumping this low growth business to focus on the deep water. However, the questions is can an independent Seahawk make earnings grow on their own without the constraints of Pride management of investing in deep water segment?

The offshore and land drillers have been trading at very low valuation. The sector PE is around 10. some notable high margin and specialized businesses like DO, RIG and NE are selling at PE between 5-9. These businesses have very specialized field and very much have solid backlogs, unlike Seahawk, for years to come so the valuation seems puzzling?

The service companies are leveraged play on the price of oil and gas, particularly natural gas in the Gulf of Mexico. Currently Natural gas is at very low pricing levels that make some field uneconomical to operate. Most will making a call on the price of gas to invest in these GOM drillers. I want to avoid making such a call. I am not in the forecasting business but in the investing business.

This is an interesting proposition. The spin off will be completely debt free with management that is properly incentivized with restricted equity and options but the company operate in poor sector until Natural gas increase in value. The price of the commodity does not concern me a lot at the moment and will play a secondary factor in the decision making. I will look for more important things on the company level:

• management compensation plan
• management track record and prior accomplishments
• accounting practices and policies
• valuation once it is traded
• competitive position in the industry
• what are my risks
• Will there be forced sellers?

Not every spin off is an automatic investment; the economics of the company must make sense as well. I will work on my analysis to see if this is worth establishing a position in.