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.

Using the Wrong Framework - Again and Again

Yesterday I did not have enough time to blog on my Biggest Mistake of the Day (BMD) due to some personal issues.  But I have made a commitment to make this a daily process - so this is my make up assignment from yesterday's personal leave.

For ten years, I have been studying American Tower (AMT).  For years I have been interested in this cellphone tower operator.  As cellphone usage increased, cell towers become a "bottleneck" in the business.  It has always had the characteristics of a "toll bridge" but I have not been able to get my pricing correct. 

Initially, I was concerned about "high debt".  My first concern exhibits that I was, again, using the wrong framework from inception.  In the case of an "income statement" based company, debt is definitely a four letter word.  In the world of an "income statement," debt is a way of bringing future earnings into the present.  In our world of fixed costs, a little downturn in revenues has an outsized impact on the bottom line.  Since cyclicality is inherent to capitalism, debt sets up a potential total loss to the equity shareholders.  One way to analyze debt is to ask how many years of earnings it will take to pay it back.  If it's more than seven, look out.

In the case of AMT, my first company review had a number of 100 years to pay it back!  To adjust, I added back depreciation which brought the range back to nearly seven.  That high level of debt made me apprehensive to start with. 

Next I was concerned about the high multiple of earnings.  My first P/E analysis was in excess of 100.  Again, I adjusted by adding back depreciation which gave me a "cash flow" to earnings multiple in excess of 20.  This had all the appearance of a "nose bleed" territory.  I noted, at the time, that valuations were more appropriately focused on revenues, set my prices and waited for the stock price to drop to more attractive levels.

The stock price went up.  Basically straight up.

Finally, I sat down to study where I got it wrong.  It is clear that, once again, I was looking at a "balance sheet" company.  This was not hidden.  In fact, AMT leads its financial statements with its "balance sheet."  AMT was basically borrowing to fund the purchase of assets as a "cellphone" REIT (to which it later converted for tax advantages). 

By viewing AMT as a "balance sheet" company, I would have started with the assets of $8.5 bln, compared it to the debt of $4 bln which would give a "leverage ratio" of 2 or 200%.  From that, I could have estimated the return on assets (adj for depreciation and capital expenditures) and compared that to the cost of liabilities for a net yield on assets.  By studying AMT from that perspective, the extraordinarily high roa assets becomes evident - driving for a higher and more appropriate valuation.

Like PSA, AMT has roughly doubled over the past ten years while the S&P is up 50%.

Using the Wrong Framework - Again

This process of reviewing my Biggest Mistake of the Day (BMD) is going to make for a painful and humiliating 2016.  I'm hoping that I will have less to write about in 2017 as a result.

Today I was reviewing the financial information of Public Storage (PSA) which is the largest owner and operator of self-storage space in the U.S.  PSA operates as a Real Estate Investment Trust (REIT) which means that it does not have to pay taxes at the corporate level as long as it pays all of its earnings to the shareholders. 

(As an aside on this favorable tax treatment, misconceptions have abounded. REIT operators have claimed that they do not benefit from favorable treatment because the dividends are taxed at ordinary income rates that top out at nearly 40% while normally dividends are taxed at 20%.  This logic is faulty because it ignores that the REIT, unlike a corporation, avoids taxes.  A quick comparison.  Company A is a REIT and earns $10 million and pays out all earnings to its shareholders.  Company A pays $0 in taxes and its shareholders (assuming taxable) pay roughly $4 million.  Company B, in the same business, earns $10 million and pays out all earnings to its shareholders.  Company B has a tax bracket of roughly 35%, so it pays $3.5 million in taxes with the remaining $6.5 million in earnings going to shareholders.  These shareholders (again assuming taxable) pay at roughly 20% and so pay $1.3 million.  Company A earnings end up with tax of $4 million and Company B earnings end up with tax of $4.8 million.  REIT operators do have tax advantages.)

Back to my BMD.  I started closely studying PSA in 2005.  I analyzed it with the wrong framework because I focused on traditional income statement measures such as earnings, cash flow and revenues.  I even looked more closely and used a widely- used real estate measure called "funds from operations" (FFO) which is a measure that takes earnings and adds back depreciation and amortization costs.  Using this measure, I estimated that I would pay $36 per share for PSA.  During 2005, the stock's price ranged from $51 to $72.  I thought, "Wow. This stock is pricey!"

Two times a year, every year since then, I have studied the FFO and revised my pricing as the FFO steadily rose.  The only time PSA's stock price went beneath my buy price was briefly in 2009 as the world moved into fire sale mode.  I blamed the pricing disconnect between my pricing and the stock market's pricing on the huge operating margin of 60%+, in a world where I am happy with margins in excess of 12%.  But, as I discussed in my BMD of 1/1/2016, operating margins are not a relevant metric (despite wide usage - even on the quarterly discussions of the company) on a "balance sheet" company.

PSA is definitely a balance sheet company because its service is its balance sheet of a collection of self-storage units.  Once it is clear that a valuation metric needs to use the balance sheet, it is necessary to find the most useful metric.  In the case of PSA, that is not easy.  The balance sheet is primarily made up of real estate whose value is understated due to a combination of historical values and depreciation.  For this reason, book value and equity are misleading. However, with enough digging and without the wrong framework (again), there are sensible ways to get to a valuation.  This is something I should have done earlier. 

Since 2005, PSA stock has risen over 250% in contrast to the stock market, which on average, has risen about 100%.  That's a big penalty for using the wrong framework.

Using the Wrong Framework

I am starting 2016 with a new resolve. This year I will articulate mistakes that I have made and, more importantly, that I am prone to. Warren Buffett, my standing hero, talked about needing to write reports more frequently if he were to start confessing his mistakes. I figure if I just start to blog about the Biggest Mistake of the Day, I'll be on a good start to a book.

Mistakes is a big category - as they say, errors of omission and commission. I am focusing first on errors of commission, although I am not going to give a financial impact tally. All mistakes are costly, unless they lead to greater insights. So here goes - making stepping stones out of all these stumbling blocks.

In financial analysis, the starting point is gathering a tremendous amount of data. Most of this is already gathered for us in the form of quarterly and annual financial statements that are filed with the SEC. This accounted for data becomes the information that we rely on to get to actionable ideas. As financial statements get longer, as information gets more complicated and as life gets busier, we begin to rely on shortcuts or simple frameworks to save time and energy or simply out of sheer laziness.

I don't think my latest Biggest Mistake of the Day was out of sheer laziness, but it was out of a lack of thoughtfulness. In the analysis of financial statements, it is usual for the company and for me to start with a study of the income statement that details the revenues, expenses and net profits of the company. After familiarizing myself with its content, I start to study ratios, such as "operating margin." This is a measure of how much profit (before "external costs" like taxes) is in every revenue dollar. The higher the operating margin, the more likelihood that the company can withstand the brutal forces of capitalism.

Normally the balance sheet follows the income statement. The balance sheet details what the company owns and what it owes and what the difference is - equity. The reason the balance sheet follows the income statement is that the balance sheet is the means of providing the services of the business. However, there are companies in which the balance sheet is not the means of the service, but is the service itself. I believe that companies whose business is the balance sheet should provide that statement first - and sometimes that does happen (although oddly some companies whose balance sheet is the means of the service puts it first; I don't get that).

When a company provides its balance sheet as the service, ratios like "operating margin" do not matter. For example, the margin of profit between a bank's interest income from borrowers and its interest cost for depositors is not really important. If a bank receives $1 million of income and $ .5 million of cost, the $ .5 million does not really tell us anything. Instead, this information must start with the balance sheet by setting the income and expenses as a % of assets. In banks this is regularly done.

However, in the case of insurance companies, which are also balance sheet service providers, the investment community spends a disproportionate time on "operating margin" issues(aka, "combined ratios") which are not really useful. Instead, as in the case of banks, insurance companies should have revenues analyzed as a percentage of assets. In this way, the truly leveraged nature of insurance companies can be grasped and the sensitivity to small changes can be understood.

I personally fell into this trap as I used "debt" measures, "operating margin" ratios Price to Earnings ratios and "combined ratios" to understand and assess the value of many insurance companies. Instead, it is more important to dissect the Return on Assets and connect it to Return on Equity and, finally, to understand its connection to Price to Book ratios. By using the right framework, the sources of an insurance company's strengths and weaknesses should become more apparent.

Assessing Net Profits

After learning what a business does, the first financial measure I try to understand is the history of the company's net profits. The term "net profits" is often used interchangeably with "earnings." (This use of one or more terms to describe the same thing happens frequently in finance and confirms its reputation for imprecision. I would prefer "earnings" connote "taxable income," but that would not fit well with "earnings per share" in which the usage is identical to "net profits.") Both are often used to describe what's left over for the owners after all other bills have been paid. This seemingly straightforward task is complicated by the regularity of one-time exceptions, such as merger fees or tax adjustments or lawsuit costs. In addition, companies put into the "one-time exception" category regular restructuring costs. These patterns are most noticeable in the consumer staples group of companies, marring otherwise consistent earnings. What's an analyst to do? I think that including these charge-offs as a likely occurrence in the future based on past history is the best course of action, even though that often prevents one from "paying up" for the stock.