Crosstex Energy

I have placed this grid describing the stock price returns of Crosstex for a 10 year period of time.  It illustrates a couple of points.  The first is that numbers compound geometrically, not arithmetically. Here is a real life example of gains totaling about 440% and loss was about 90%.  Added together would create a value of 350% over ten years.  Instead, it was a nearly 130% gain.  The lesson?  There are several, but probably the most important is that volatility is only good when you understand what you are investing in.  If you did, 2008's downturn would have been a huge buying opportunity. If you did not, you might have sold at the wrong time.

I bring this grid up partially because I still don't understand the company. Crosstex was a midstream pipeline company that was merged with Devon Energy's pipeline assets to form Enlink in 2014. Pipeline companies have again gotten headline attention as their prices have dropped precipitously.  In 2008, I started analyzing the company when the stock price was at $33.  There were two reasons that I decided to study it.  First of all, a well-known investor named Glenn Greenberg had taken a large position in the stock.  Second, the company's headquarters were within a couple blocks of my home; I could walk to a meeting with management.

BMD - Underappreciating Currencies

For years, I have put the topic of currency movements in the "don't understand, won't understand" pile of information.  But I have changed that.  I have officially set up a folder on my computer labelled "currencies."  It is still empty, but it's my first step in moving to at least "don't understand, can't understand."

For a long time, currencies have been fairly routine.  After World War II, leaders got together and created the Bretton Woods accord.  Part of the plan was to encourage world trade as a way of healing from the horrendous war that just occurred by encouraging world trade.  World trade is extremely difficult when currencies are disruptive.  By setting up mechanisms to smooth currency movements, world trade is encouraged.  It seems to have worked fairly well, until recently.

Suddenly, dramatic declines in the Brazilian real (pronounced "hey - ow"), the Russian ruble and the Japanese yen have made investment analysis difficult.  My Biggest Mistake of the Day (BMD) is that I lack any method for getting a general sense of the appropriate relationship between their currencies and my own.  While it was clear to me that lowering interest rates and implementing Quantitative Easing (QE) policies weakened the US Dollar, I did not pay sufficient attention to the amount of weakening.  At some extreme, the US Dollar is too "strong," meaning that distortions are too significant to be sustainable.  The opposite is also true.

While precision is impossible, a general sense can be developed by looking at historical relationship and factors - something I have not done.  Given that I have some investments with exposure to the aforementioned currencies, it seems important to start to fill up the "currencies" folder.

Back At It - Wrong Framework Again!

My commitment to publish my Biggest Mistake of the Day (BMD) has fallen under the weight of a volatile month.  Whether or not the Chinese said it, it certainly might be a curse to "live in interesting times"  - at least in terms of keeping a blogging promise.

I have been reviewing my analysis of British Petroleum (BP).  BP is a major vertically integrated oil and gas company.  Several different functions of the oil and gas business, such as "upstream" exploration and production, "midstream" transportation and "downstream" refining and marketing are consolidated under one roof. Each of these functions has characteristics that are so different that many companies, such as ConocoPhillips (COP), have split them into separate businesses.

Typically the most valuable part of a vertically integrated oil and gas company are the reserves.  The nature of reserves is to discover them, develop them and extract them.  The end result is no asset.  This is an unusual structure.  Most of the time, companies have non-depleting assets that are designed to generate recurring revenues.  Here is where the challenge is to use the correct framework.

It is tempting, in the case of an exploration and production (E&P) business, to study its revenues, its expense structure and its cash flows and attempt some type of valuation based on those metrics.  Many Wall Street analysts resort to this - or even just use the dividend yield to value it.  Value Line, an investment service, uses a multiple of "cash flow" by which it means net profits (stated variously) added to depreciation. This is certainly an easy way to come to a conclusion, but it is hardly "fundamental" analysis. 

Even the accounting profession struggles with an approach. Accounting has to use a framework which is designed for a conventional business - one whose assets generate recurring revenues. As a result, the balance sheet and income statement presentation provides little insight into the understanding and valuation of an E&P business.

However, over time, accounting has created supplemental reports that provide useful information.  The critical starting point is to gain a sense of the value of the "proved developed reserves."  These are the reserves which are basically ready to produce oil and gas because all of the "get ready" expenses have been spent.  By studying the "proved developed reserves" and the changes in them from year to year, an analysis can arrive at the value of the reserves and gain insight into the value-adding or value-destroying nature of the activities that create them.