My trading objective: To increase net worth as a function of book value

Yesterday we attended a seminar with Jason Ayers of Optionsource.net on how to create cash flow using options.  He spoke a little about his trading and how his company has taken their holdings to 50% cash before this recent downturn and how they plan to buy back in at reduced rates.  Sometimes I regret not being a better trader and having such superb market timing.  Kudos to Jason!  If you have an opportunity to learn from this guy, it’s really worthwhile, for he’s an excellent speaker and knows his stuff.

I have a different trading strategy.  If you ask me if my portfolio is up or down, I’d have to admit that my “net worth” based on market capitalization is down 7% since February peak.  Ouch!  But what if my goal is not to increase my net worth in market capitalization–but instead to increase it in book value?  Book value is itself not an indicator of the market value of a company, which is really about the profitability of that company in the years to come, but of the total assets (cash, real estate, lands, equipment, inventory) minus liabilities.  Book value is much more stable than market capitalization because it points to the value of the company as a company:  i.e., if another company were to buy out your company you would expect that company to pay book value plus a premium based upon the future profitability of the company:  you will only sell if you think that the premium–i.e., the cash in hand today is more valuable to you, for whatever reason, than your own ability to extract profits from the company in the future.  If the potential buyer offers less than book value then either there is something terribly wrong with your company (Nortel) or you just simply show them the door.  Why would you sell your company at less than book value?  You would only do that if you were insolvent and were forced to sell.

I like junior oil companies and I discovered a means to de-risk them–pay attention to the book value.  This requires looking at the quarterly reports because it changes regularly–as the oil companies use cash to develop their lands.  If the reported book value is higher than the market capitalization, then you are buying the assets of that company at a discount while obtaining its future profits for nothing.

As a strategy, buying junior oil and gas companies at below book value has worked for me with Midway Energy, Crocotta Energy, Prospex (just bought out by Paramount) and Great Plains Exploration (bought out by Avenex).  These were the first junior oil companies that I bought and their share prices are now all well above what I paid despite the recent weakness in junior oils.  Each one was originally purchased below book value.

So while I am down 7% in terms of net worth as a function of market capitalization, as a result of averaging down on junior oil companies, I now own more book value than ever before.  So I consider myself to be doing well despite the current market.

Jeet kune do investing I: the case of Canadian junior oil and gas

I have great admiration for Beating the Index.  The website provides very valuable analysis of the Canadian junior oil and gas sector, the major plays (esp. Bakken and Cardium), and the macro issue of why the price of oil will likely rise in the long term investment horizon.  In addition, Mich, the website’s sole proprietor, reveals to us a part of his self-managed portfolio, what moves he makes as he beats the index.  His style is his own, adapted to suit his particular portfolio.  For example, because he is using leverage, he has to cash in on his winners–sometimes he also drops losers and holdings which remain  static.  In one post, his commentors on his blog praise him for being willing to take losses and move on, saying that this is the mark of great trader.

But then one has to wonder, if an analyst has done his due diligence and decided that a company is a good buy, and then the market decides to dump the stock, whether that stock just became a better deal.  So in my trading, I very rarely dump losers, though I have sometimes done so to realize a tax loss or to implement a change of strategy.  Rather, I’ve averaged down on losers, and most of the time it works, as I shared in a post critiquing Dennis Gartman’s first rule of trading, “Never, under any circumstance add to a losing position…. ever!”  Gartman says to add to winning positions rather than to losing positions.  Generally speaking, I ride the winners, but I don’t often add to my positions.  Gartman’s rigid style seems to be flawed, and his own HAG fund is still going nowhere.

Now Keith Schaeffer, one of the leading independent analysts of the Canadian junior and intermediate oil sector, provides a compelling argument why it is better to add to the companies with momentum:

When it comes to the junior and intermediate North American oil and gas plays, I want to buy expensive stocks. I rarely buy cheap stocks. That sounds counter-intuitive, but it makes sense.

When a company trades at a high valuation it can raise money with less dilution, and can use its stock as currency to take over other companies. They can grow more quickly and more efficiently than companies with low valuations.

“Dilution” is one of the terms that junior oil and gas investors seem to fear.  Indeed, share price usually seems to drop after a public offering.  Crocotta Energy’s recent share offering is a great example:

CTA share price fell on Feb 3 after announcing a $25 million bought deal

One day on an airplane on the way to Barbados, I met A. Zoic, an experienced entrepreneur, who explained “dilution” to me:  He said, “The number of shares are increased, but the size of the company also increases.  So you have smaller percentage of the whole, but the company is much larger.” Zoic’s words came back to me, the inexperienced investor, time and time again as I watched Midway Energy, my largest holding, take on more and more new shares; and Zoic’s advice helped me over the last couple of years to understand that when a junior oil raises money in a public offering that that is a really good thing because it increases the overall size of the company.  This has the added benefit of increasing the average volume of shares traded which in turn makes all shares more liquid.  A great CEO with an established reputation, like Midway Energy’s Scott Ratushny, has been able to raise the investment dollars to create the momentum that makes a good value into a great investment.

In the end, the best strategy for trading junior and intermediate oil and gas is neither the value nor the momentum strategy alone.  Rather, in my view, the two strategies should be implemented together in an artful Jeet Kune Do of  (1) Momentum–buy winners:  I keep adding to my position of CPG; (2) Averaging down seeking value:  I kept buying MEL (when it was still TFL) as it plummeted in price; (3) Buy and hold:  I watched MEL go from 0.39, my lowest price, to $5.19 (and am still holding).   Junior oils are too volatile to cut losses early, and I’ve found for the last four years as a junior oil investor, that my overall gains far outweigh my losses.

What works depends as much on the investor, his liquidity, credit limit, available margin, size of portfolio, as it does on the style of investing.  I rarely cut my losses.  I don’t see that ability as the mark of good investor.  The mark of good investor is perhaps better described as an even keel temperament to do the right thing without allowing the market to determine his next trade for him.  According to the legendary martial artist, Bruce Lee, the best style is no style–consider how these words fit investing:

Too much horsing around with unrealistic stances and classic forms and rituals is just too artificial and mechanical, and doesn’t really prepare the student for actual combat. A guy could get clobbered while getting into this classical mess. Classical methods like these, which I consider a form of paralysis, only solidify and constrain what was once fluid. Their practitioners are merely blindly rehearsing routines and stunts that will lead nowhere.

I believe that the only way to teach anyone proper self-defence is to approach each individual personally. Each one of us is different and each one of us should be taught the correct form. By correct form I mean the most useful techniques the person is inclined toward. Find his ability and then develop these techniques. I don’t think it is important whether a side kick is performed with the heel higher than the toes, as long as the fundamental principle is not violated. Most classical martial arts training is a mere imitative repetition – a product – and individuality is lost.

When one has reached maturity in the art, one will have a formless form. It is like ice dissolving in water. When one has no form, one can be all forms; when one has no style, he can fit in with any style.

Are Canadian junior and intermediate oil stocks in a bubble?

In 2008, those of us who were invested in the junior and intermediate Canadian oil and gas sector, experienced the collapse of a bubble.  I had bought 500 Enerplus, e.g., at $48, and I watched it collapse to $18.20 by March 2009 for $14,900 (62%) loss.  Losses for 100% natural gas Perpetual (pmt) were similar, only it hasn’t recovered much of its lost ground.  Midway Energy Ltd (then Trafalgar Energy) plummetted to a tenth of my original purchase price, but is now back up to $4.33, which is above the highest price that I ever paid for it.

As a result of an aggressive averaging down, oil and gas holdings in my current portfolio are now 65% above book–and that doesn’t take into account profit taking along the way, as I’ve taken the opportunity of the extreme volatility of the last two years to buy low and to sell high.  But with the buy and hold part of the portfolio, diligence is necessary.  Is there any sense in which there is a bubble–that these stocks are just too high and that it is now time to bail, or at very least to reduce?  This is a particular concern to me since my portfolio is 87% weighted towards Canadian junior and intermediate oil and gas companies.

The first consideration is commodity prices.  Natural gas is at a nadir.  Therefore, it is hard to imagine that natural gas weighted companies can go much lower.  These would include Terra Energy, Prospex, and Perptual (TT, PSX, PMT).  Oil is high at $80 but nowhere near where I believe it can go with a rapidly rising demand from emerging markets (esp. China and India) and the constant inflation being forced upon us by our central banks.

A second consideration is low interest rates.  At the moment, most of the intermediate stocks pay dividends far in excess of currents rates in savings accounts, GICs and short term bonds.  Thus, the sector is still attractive as investors seek yield.

A third consideration is fear.  About once a week I read an article indicating that retail investors, if not institutional funds, are still afraid to get back into the stock market, indicating that billions of dollars are still resting on the sidelines.  There won’t be a stock market bubble until more people are all in.

So let’s look at a few of the companies to determine if they are in a bubble.  Statistics are from the TD Waterhouse Market & Research, which I find is often inaccurate, but lets say for now that the numbers are representative of the larger trends.  Market price is as of close yesterday.

Petrobakken (PBN) $18.96 book 17.18 Price/Cash Flow 6.1x

Crocotta Energy (CTA) 1.77 book 2.52 Price/Cash Flow 9.1x

Midway Energy (MEL) 4.33 book $1.44 Price/Cash flow —-

Crescent Point 40.51 book $19 price/cash flow 11.2x

Prospex (PSX) 1.37 book 2.00 P/cash flow 9.4x

Now part of the story is that almost every company in the sector is ramping up its development costs in order to increase production and reserves.  Midway, for example, is on a fast pace of developing its Cardium holdings.  They have 150 drilling sites with an estimated netback of 4 million each (see their corporate presentation), which would provide a potential profit from these holdings alone of $600 million.  That is double its 294.6 million market capital.

Nothing yet indicates to me that there is anything remotely like a bubble in this sector.  Indeed, I am still bullish and think that there are still buying opportunities despite the recent surge in the sector.  In consideration also that the Obama administration has shut down future competition from new offshore drilling in the Gulf of Mexico–putting production behind by at least six months–the Canadian oil and gas sector begins to look extremely attractive.