Last week, I confessed my penchant for finding companies that appear one way, but look another way after intense digging. This is where I find companies that are misperceived, and can possibly unfold great value. And that’s where I found First Marblehead Corporation (FMD), a private student loan underwriter that’s going through a transition period for its business model after the securitization market froze in 2007

Valuation

Currently, the stock trades at about $1.60 and they have $2.48 a share in liquidation value based on three factors:

• • Net cash
• • A company they just purchased
• • A tax liability that’s likely to be extinguished

The cash alone is $1.60/share, and they burn about $0.10/share per quarter right now.

The private student loan market is coming back.  It’s clearly supply constrained now, as illustrated by high FICO borrowers being required to pay 10% interest rates, compared to 5% for a mortgage. The fat spreads will attract more lenders, and FMD can help them enter the business. This contrasts to most of the rest of the credit market, which is more demand constrained. (See my article on Koo Koo Economics.)

First Marblehead is rebuilding itself as an outsourced student loan underwriter. This is not normally a core competency for a bank, as there is no collateral or income to lend against. If they assist banks in making loans at 8%, they’ll probably get to keep about 3% of the loan, i.e., the student borrows $100 at 8% interest, the bank gets 5%, and FMD gets 3%. The market is about $10B per year – although it used to be $20B in 2007 — and if they again had the 20% of the market that they’re used to, that would be about $300M in revenue per year on an NPV basis — 14M NPV10 for every $100M in loans made.

They will need to put up some first loss capital, but it should still be a high margin business — it used to be 40% net margins. There’s no way they earn over $100M in net profits next year, but it’s not impossible to see that number a few years down the road.

Did I mention that the CEO’s primary compensation when he returned was set as options at $6, $12, and $16/share?

It will be interesting to see how the market responds to the company’s first revenue in four years when they report this fall. If the stock increases by more than 50%, it will be above liquidation value and more risky, because then you have to start valuing the business. When you get something free, there’s much less risk.  Because the business doesn’t appear to be free, due to GAAP rules with the unrelated debt, it’s mispriced.

Disclosure: I have a position in First Marblehead.

Follow us on Twitter @CompleteGrowth.com.

If reality was perfectly transparent, and people were rational calculating machines, then all the academic theories would be correct, and we’d have an efficient market where risk and return are perfectly correlated. When one or both of these factors breaks down, the potential exists for higher returns with lower risks.

There’s a recurring example of this that I seek out. This occurs when first appearances look one way, but deeper investigation reveals a different reality. These misperceived companies are all but certain to be inefficiently priced — sometimes, dramatically so.

First Marblehead Corporation (FMD) is a private student loan underwriter that’s going through a transition period for its business model after the securitization market froze in 2007. The stock looked pretty interesting, and the downside well protected at around 90% of liquidation value at the start of the year. After an apparently significant accounting restatement that was actually meaningless, and after what seems to be an arbitrary forced seller in the market, the stock plunged by over a third. During this time, a portfolio manager in New York, who owned the stock, called me to ask what was going on with the company, because the stock was falling.

He told me that, because of his company’s internal risk controls, he was essentially forced to sell out of his position. The risk reduction instruction of this “risk control” was to sell net liquid assets at 65 cents on the dollar, with a free business thrown in – because someone out there didn’t like owning it and was selling.

Having followed the company for several years, I felt I had a good understanding of its long-term value, and understood the downside protection from the economic accounting numbers. In this case, the generally accepted accounting principles (GAAP) rules made no sense. So, while vigorously double-checking all my research, I bought a lot more shares as the stock went down.

If I didn’t have a partnership structure like I do with only long-term, thoughtful investors, then I may have been forced to act against all that I know to be sensible, and sell, as well. Fortunately, for individual investors who may be reading this, you don’t have to blame Gladys in the Risk Department, or someone — anyone — else for forcing you out of an incredibly cheap position!

The superficial view of First Marblehead is that:

(1) They are a company that has had no revenue and massive losses since 2007.

(2) Their industry is dead.

(3) They have a hugely negative net worth because their loans performed poorly.

The reality is that the strict rules-based GAAP accounting forced them to consolidate securitizations that they underwrote years ago, but that have no economic ties. They have over 50% more than the current stock price in net cash. They also have revamped their business model, and this summer will be the first time that they have revenue since 2007. How much revenue is impossible to know, but when you get the business for free, it doesn’t much matter.

The founder came back two years ago to rebuild the business after turning down an offer to start a “Second Marblehead,” where he would have actually owned more of that company. But he decided to come back because the repayment data that they had would have been too difficult to replicate. By the way, that’s also thrown in for free, and not on the balance sheet.

Student loans are a special type of loan because there’s no collateral to repossess, and no employment income to go against, so other metrics must be used. First Marblehead is a specialist at this and, when the securitization market shut down in 2007, it killed off all their smaller competitors while they survived.

Next week, I’ll have a look at the stock’s valuation.

Disclaimer: I have a position in First Marblehead.

Follow us on Twitter @CompleteGrowth.com.

Last week, I began my discussion of macroeconomics and the work of Richard Koo. We’ll continue from where I left off.

The solution to this scenario is either widespread default of debts, or for the government to act as the “borrower of last resort” and spend the money with which the private sector is paying back its debt. Under normal circumstances, the government will normally do a far worse job than the private sector at allocating resources. However, when everyone is paying off debt — essentially the same as hoarding — the opportunity cost of resources is practically zero, because nobody wants to use them, as they’re all too busy healing their wounds.

The market signals this fact with very low long-term interest rates like the U.S. had during the Depression, or Japan still has now.  If the Fed sets short-term rates at 0%, then private sector banks could either lend to the Fed, where excess reserves are held at 0%, or could lend to the government by buying Treasuries at 0.1%, or anything above 0, since there would be no net private borrowers.

This is all very interesting to think about, but there are a few implications to keep in mind that could affect you, even if you’re trying to look only at small companies and “hide from” the macro concerns in the world like I do.

1. (1) Interest rates can stay low for a very long time.  As long as the private sector is repairing its balance sheet, there is essentially no new demand for loans, so rates will stay low.  This is especially important to consider if you’re looking at apparently cheap banks.
3. (2) The worries about interest rates jumping up are mostly misguided, and it’s far less likely than you might think.  Most of these arguments are simple mean-reversion arguments, or because the Chinese or Japanese will stop buying our bonds. The U.S. situation is complicated by the trade deficit but, in general, the huge deficit can be financed internally from excess bank reserves, because the alternative option for the bank is keeping it at the Fed at 0%.
5. (3) While the overall economy may still take a few more years to recover, as balance sheets repair, there can be a lot of “mini-bubbles” created due to 0% interest rates. This seems especially true during Quantitative Easing, which is counter-intuitively intended to force people into more risky investments – like getting them out of the cave, even though it’s still raining, to go meet women!
7. (4) Corporate profit margins are temporarily higher than normal during this period because of unusually low labor costs. It’s much harder to find a new job when you have an underwater mortgage, because moving and selling would realize the loss. In addition, high unemployment reduces labor pricing power. Build in an extra margin of safety for proportionally rising labor costs in the future.

Overall, Koo says it better than I ever could — plus he has graphs. Hopefully, my unusually low-level fundamental view – my passion before investing was particle physics – can help make sense of it.  Inverting your assumptions and taking an evolutionary perspective have been two of the most useful thinking techniques I have come across, so I would highly recommend them.

One final thought to all those who are criticizing the government and Bernanke.  While I’m not going to defend them here, their job is much more complicated than most people realize.  Take, for example, the criticism that retirees are being ripped off because interest rates are so artificially low that they’re being forced to speculate in stocks.

The implication is that, if the economy was not being manipulated, a huge percentage of the population could just sit back on autopilot and get 8% real returns.  This is simply wrong. These historical returns have existed because of increased specialization and interdependency in the economy that has come from intelligently solving problems, not avoiding them.

We can’t go back to the bubble days; the only way out of the current mess is to go “through” it.

Follow us on Twitter @CompleteGrowth!

I normally don’t spend much energy on the macro picture. You can often count on one hand the factors that will ultimately lead to the investment success or failure of a small company. These include good management, market position, and valuation.

In contrast, predicting the macro picture is often extremely complex. When people get it right twice in a row, it’s far more likely to be from luck rather than from a true understanding of the thousands of potentially important variables in simultaneous motion. That said, it’s an interesting set of puzzles, and I have a problem with just letting things go by that I don’t understand without trying to answer some questions.

Most macro books I have read are either vastly oversimplified, or were written by a “man-with-a-hammer-syndrome” economist who spent five years working on the pricing inelasticity of dry cleaning in an economy, or some other narrow factor. The most synthesizing economist I have ever read — by a very long stretch — is Richard Koo.  His book, The Holy Grail of Macroeconomics, ties together explanations for most macro forces in a balanced and consistent way, without taking extreme viewpoints that are often required to stand apart, and sell books in a crowded field.

Here’s a 20-minute video summary of his key idea. Enjoy the clip, but I still highly recommend the book.

Koo’s key insight is that, when a nationwide debt-financed asset bubble collapses, human behavior fundamentally changes. The normal “infinite wants” pattern of profit-maximization that underlies all of economic theory is replaced by a “deal-with-the-current-storm-until-it-passes” mentality of debt minimization.

Inverting your assumptions can be both insightful and fun, and this has historically been an effective thinking tool. There were a few somewhat useful conclusions gleaned, for example, when a young German thought about the consequences of a world in which the speed of light was fixed, and the other variables left to change, rather than the more immediately intuitive idea of fixing the frame of reference and assuming speed would change.

The key inversion here is to flip economics itself on its head, which is defined as the study of limited supply trying to satisfy the unlimited wants of man.  What would happen in a situation where the wants were, instead, the limiting factor?  Other than the world turning austere like the Amish, what situations would lead to the normal assumption of infinite wants being broken?

Thinking with an evolutionary perspective can help. Most species, including our own, have the long-term underlying goal of proliferation – or, as stated by Scarface’s Tony Montana, “First you get the money, then you get the power, then you get the women.” However, when there is a more acute need, like hunger or danger, you tend to have to deal with that before you can think about breeding.

In caveman days — when evolution created our current brain structures – when there was a bad storm outside, the humans who survived were the ones who stayed put in their cave instead of going out to meet women. If you fast forward away from this prehistoric example to our highly interdependent, specialization-driven economy in today’s world, you start seeing an interesting unnatural “storm” — the more people hide in their caves to wait out the storm, the worse the storm gets!

When a very widespread debt-financed asset bubble pops, assets decline in value, but the debt remains. Those who are underwater on their loans – but still alive and working – have this psychological overhang that they need to get their cave in order. They want to get their debt paid off to manageable levels before they can metaphorically go out and proliferate, i.e., grow their businesses.

Now, I won’t get too technical here – although I’d be happy to write another, more technical, article if requested in the comments section — but when everyone tries to pay off debt at once, even though it is absolutely the right thing for each individual player at the time, it’s not pretty for the society. This causes the money supply to shrink, which decreases the underwater asset values further, which leads to a deflationary spiral like the U.S. saw in 1929 to 1932.

To understand this phenomenon at a very fundamental level, consider Adam Smith’s observation that it was increased specialization of the needle maker that was the core force leading to increased productivity. Increased specialization is synonymous with increased interdependency with other people. When people are focusing inwards and trying to deal with their own short-term debt issues, it runs the economic miracle of increased specialization and interdependency in reverse.

To be continued next week…

Last week, I began the saga of HearUSA (EAR), a company we purchased after engaging in great reasoning and logical input. But we forgot to take one thing into account: “meteor” risk.

As I wrote last week, HearUSA’s largest supplier, shareholder, and creditor — global conglomerate Siemens AG – tried to force them into default on their credit line.  They did this, not because the company ran out of cash to pay their bills, or because of a recently tripped covenant, which all were on our list of things that might go wrong – but, rather, because of an undisclosed dispute about a partial pre-payment from an asset sale two years prior.

When HearUSA sold their Canadian subsidiary, they were required to use a certain fraction of the proceeds to pay down their credit line with Siemens.  Unbeknownst to the public, there had been a dispute about this amount, and Siemens wanted slightly more — the unit was sold for $23.7M or 1.6X revenues, and the disputed amount is about $2M.  According to the language in the credit line, if the company did not make this payment, they would technically be considered in default, allowing Siemens to foreclose and “steal” the company out from under the shareholders.

Having just dealt with two situations like this last year — see 2010 year end letter How to Steal a Company — and assessing the situation as much as I could with public information, I sold about 75% of our position with the stock, which plummeted a quick 40% — 65% as of today.  I realized an approximate total loss of 3% to the Partnership.  The reason for selling down to a 1% position was that the position had essentially converted itself from what seemed like a solid core undervalued holding into a mispriced option-type holding where a total loss was conceivable, but the upside is asymmetric to the loss. In this case, it would probably be 7X or so if the credit arrangement would be restored to the previous terms, and business improves as expected, due to the AARP deal.

I could, maybe, understand this situation happening if the creditor was a vulture hedge fund that used this tactic to pull the company out from shareholders.  But the idea that a respected global conglomerate could use these tactics, when they have dozens or hundreds of other customers and suppliers to deal with on an ongoing basis, just seemed totally nonsensical.  I had specifically focused on the credit arrangement while doing research. I always want to know who stands in front of you in the capital structure, and on what terms. I was encouraged by the fact that Siemens had acted very favorably in the past, renegotiating terms when a company needed more cash.

Overall, their historical relationship seemed far more favorable to HearUSA than if the creditor was a traditional bank.  Siemens has a profitable relationship, and supplies over 90% of HearUSA’s product.  Surely that’s enough. But then, the CEO of the hearing aid division left the company shortly after the February events, and the soap opera continues in the courts.

While this story goes on, and there will be more to learn as time goes by, my preliminary guess would be that there must have been some kind of significant personal disagreement between HearUSA’s management and Siemens for the situation to devolve from a mere disagreement over a relatively small principal prepayment to a total foreclosure.

Perhaps this point could have been uncovered by more in-depth personal research, where I could have tried to understand the personalities. That will definitely be a factor that I look into going forward.

I was scheduled to meet with HearUSA’s management in early January while in Florida visiting another company in the same area, but they cancelled, supposedly because of travel requirements.  At smaller companies, such as HearUSA, individual personalities seem to be able to have a far more significant effect than at a much larger company.

Going forward, I have learned the angles that I need to research better. I will not dwell on this mistake or blame anyone but myself. (We are too small currently to officially blame/sue anyone yet, anyway.)  Feeling like a victim is the first step to doing something evil, but feeling dumb is the first step to self-improvement.

Disclosure: I have a position in HearUSA.

As I mentioned in my last article, I’m a big fan of postmortems and learning from mistakes — particularly if the outcome is so unusual, that it’s tempting to explain it as an anomaly.  Even if these outcomes seemed impossible, they did happen and, ultimately, reality makes sense, even if not initially.  From a scientific perspective, the more unique the perspective when compared to the norm, the more new information is provided.

The biggest mistake of our first quarter was a company called HearUSA (EAR).  It was one of our larger positions, at about 8% of the Partnership. It seemed remarkably cheap and right at the threshold of a turnaround, so it was very clear why the market was mispricing it.

HearUSA operates hearing aid centers around the country and, while it is a relatively small company at just under $100M revenues, it is a relatively significant specialist in what is a highly fragmented market.  It had long struggled to be profitable, with slight losses for the last decade or so. For the last four years, it held out the promise of a turnaround through an exclusive partnership with the American Association of Retired Persons (AARP).

Last year, the market had basically given up on the stock out of fatigue when the AARP deal, which seemed to be an excellent targeted marketing channel, took far longer than anticipated to implement.

After researching the company for a while, and watching the stock decline, I decided that the AARP deal was still going to happen, but was just taking longer than anticipated. I probably don’t need to explain in too much detail how it’s conceivable that a large bureaucracy composed entirely of senior citizens might happen to take longer than expected to complete a complex deal.

Ultimately, in the summer of 2010, this partnership was finally made official nationwide, and the AARP agreed to endorse and support HearUSA through their channels.  If anything, the fact that the deal was completed and took longer was a good sign that the AARP was very protective of their channels, and it would be that much more difficult for a competitor to get that kind of advantage.

When the deal was formally finalized, the stock did… nothing.  I am continually amazed by the detachment between stock prices and real events.

We acquired our position after the risk in this deal was already behind the company and things seemed substantially safer.  The deal had a lot of operating leverage, because the centers are not especially busy. HearUSA enjoys few large transactions — as opposed to many small transactions where operating efficiency is a key driver of profitability such as at McDonalds. If sales increased by just 40% from the new partnership — which seemed reasonable — profits would increase far more, and the stock would be at, perhaps, 3X earnings in a couple of years.

Things seemed all lined up: the deal was done, business would start picking up over the next six to 12 months – they have about a six-month sales cycle — and the company reported modestly increased store traffic for the next quarter.

But even with all our great reasoning and logical input, there was one thing we forgot to take into account: “meteor” risk.

In February, HearUSA’s largest supplier, shareholder, and creditor — global conglomerate Siemens AG – tried to force them into default on their credit line.  They did this, not because the company ran out of cash to pay their bills, or because of a recently tripped covenant, which all were on our list of things that might go wrong – but, rather, because of an undisclosed dispute about a partial pre-payment from an asset sale two years prior.

Next week, Part Two.

Disclosure: I have a position in HearUSA.

Investing in common stocks involves risks – though apparently not according to people buying Chinese Internet stocks at 100X revenues: See “Is Youku the worst stock in the world?”

Sometimes, those risks can seem understandable but, sometimes, you end up getting hit by something you never thought was conceivable at the outset. Those risks are why it’s called investing and not just “winning,” not to take a low blow at any former sitcom star or his remaining 2-½ fans.

While some like to stick to the more easily definable risks and patterns and write off the strange one-time events, I am a big fan of studying these so-called anomalies.  Even if they seemed impossible, they did happen and, ultimately, reality always make sense, even if not initially.

There are two examples that I want to discuss: the historical case of Penn Traffic, and the recent example of HearUSA (EAR).

Penn Traffic was a grocery store turnaround story that, in late 2009, seemed to have made it through the storm, and then filed for Chapter 33 — a rare Chapter 11 hat trick, since it had previously filed Chapter 11 in both 1999 and 2003.

HearUSA is a currently evolving story. In January, right at the point when business should have been improving due to a transformative exclusive deal with AARP, their largest shareholder, creditor, and vendor, Siemens, put them into default over an undisclosed disputed payment from a transaction from two years before!

I was somewhat familiar with Penn Traffic stores, having visited their P&C grocery stores occasionally during my time in Ithaca. I read more about the situation after someone on a message board for an apparently very safe and cheap oil stock, pointed out how relentlessly bullish the prospects were for Penn Traffic — right before the oil stock collapsed, as well. This was not a crazy Yahoo board frequented by momentum lemmings who are happiest right before a cliff, but Joel Greenblatt’s valueinvestorsclub.com, a site that requires very well-written analyses, and is exclusive — only 250 members are allowed to post at any given time.

Penn Traffic was not a great business by any measure, but even a poor quality business is worth more than zero.  Sales had deteriorated along with the economy and a weak competitive position through 2008 and 2009, but some experienced activist investors, who had bought in at much higher prices, controlled the stock.  The board, which was controlled by these activists, had brought in experienced new management, particularly the CFO, who had an excellent track record at larger firms and seemed to be solving many of the problems that pushed it into Chapter 11 in 2003.

The company gained a windfall by selling their distribution business in early 2009, which paid down their debt. With net cash, the stock actually had a negative enterprise value at one point.  From the most distressed low point, the stock actually appreciated more than five times, which was still incredibly cheap by any metric at that point.  Things looked to be recovering when, in August 2009, the CFO left to pursue another apparently interesting opportunity. There was no huge red flag – he didn’t resign because of disagreements, or because of the always-nebulous “personal reasons.”

Then came the big bombshell. On October 30, 2009, their lenders called them in default on their debt, based on an “alleged overstatement of the value of certain machinery.”  Despite their most recent 10Q showing net cash, they caved and filed for bankruptcy shortly after, selling their assets to Tops Markets, and wiping out the equity.

So what happened? I still don’t know precisely what pushed things over the edge, especially when they seemed to have net cash, and the bleeding from the previous two years seemed to have stopped.  Looking back, I do have some observations.

I have looked at a number of distressed cases where companies go through a near-death experience. One pattern that has occurred where equity has survived has been the case where management – particularly founders — had significant long-term equity holdings.

ATP Oil and Gas (ATPG) is a good example. Through early 2009, when oil plummeted to near $30/bbl and their debt mounted, they managed to use creative financing to minimize equity dilution to a mere 20% or so. They were far more leveraged than Penn Traffic, but their managers had most of their net worth in the stock. As a result, they had the energy and motivation to negotiate through the night with creditors.

Another example is Frank Stonach’s Magna (MGA) in Canada. Stonach looked his creditors in the eyes and said – paraphrasing — “This is my baby and I’m going to do everything I can to get out of this if you give me a bit of extra slack.”  That is a very different human dynamic than some turnaround specialists flown in by an activist, even if his upside may be similar on paper through stock options.

Another observation is that there seems to be a certain momentum to turnarounds. If previously good news starts to turn, bad news can be a harbinger for more bad news — a variation on the idea that there is never just one cockroach in the kitchen.  I can’t think of many “double dip” turnarounds though, often, things do get worse before they get better, or take longer than expected.

The ultimate lesson though is that, while it pays to dig as deeply as you can, there will always be some things that can’t be foreseen. Fortunately, we can choose to weight our portfolios appropriately. Even in a very high conviction idea, there is a big difference between losing 20% of your portfolio to a freak event, and losing 100%!

Next time, more on the current saga of HearUSA.

Disclosure: I have a position in HearUSA.

Investing in natural resources is a different universe than investing in regular businesses that operate in manufacturing, retail, or services. The latter accrue value based on human systems that deal with customers, sales, and suppliers. In natural resources companies, the composition of the dirt under their feet is what can matter most.

I’ve spent quite a bit of time over the last year trying to learn more about natural resources companies, with a major focus on oil and gas. I have a bit of a background in energy – I was intrigued about nuclear fusion since I was 11 years old — so I understand the utility of energy, and how difficult the alternatives to fossil fuels are to create economically. To be honest, I really don’t understand something like gold where its value is based on what the next guy is willing to pay. In other words, who’s more afraid of B^4 — Big Bad Ben Bernanke — with his money printing presses than you are?

While Devon Shire, a fellow Canadian, is no doubt the resident expert here on oil and gas, and we substantially agree and think similarly on most oil names, I will do my best to share some small insights that I can on why I like some companies out there.

Petrobank Energy (PBG) is an interesting Canadian company that Devon Shire has written about before.  It’s run by some great managers who took over the company 10 years ago, and transformed it from a $50M gas company into a $4B+ group of oil companies — Petrobank, Petrobakken, and Petrominerales, which was a spin out.

The key value in Petrobank is its Toe to Heel Air Injection (THAI) technology, and its heavy oil properties to apply it to. They have acquired a large amount of property with bitumen (very heavy oil) reserves that are similar to the oil sands, but with too much top-cover to be economical to extract via traditional mining methods.  They could be extracted using Steam Assisted Gravity Drainage (SAGD), but THAI will be much more efficient.

THAI is to SAGD as an airplane is to a space-bound rocket.  An airplane will always be vastly more efficient than a rocket, because it only has to carry half its fuel and gets to suck the oxygen out of the air it travels through. A rocket, on the other hand, needs to carry its fuel and oxidizer along with it, and the oxygen actually weighs significantly more than the fuel itself.  In a rocket, for example, the exhaust product is H2O, which has eight times more oxygen by mass than hydrogen fuel. It would be about three times more if rockets burned jet fuel.

While SAGD simply injects steam to heat up the bitumen to allow it to flow to the well, THAI takes advantage of an additional physical property of bitumen: it burns.  By pumping air through the bitumen, it acts like bellows on embers of a spent fire and heats the bitumen so it can flow to the well.  Additionally, this combustion has the effect of partially upgrading the oil by breaking apart the longer hydrocarbon chains, which saves money on refining later. Petrobank gets 10% more $/bbl for its partially upgraded bitumen than traditional oil sands.

Currently Petrobank’s heavy oil is mostly booked as “contingent resources.” These are similar to reserves, but haven’t as yet been deemed officially economically recoverable with specific development plans. These are with assumptions using commercially proven SAGD, because they have not scaled up the THAI process yet. They booked their first official THAI reserves last month, which is a huge step towards large-scale commercialization.  Using the conservative SAGD economics, the resources have a PV-10 of $2 billion. Using enhanced THAI could be much higher than this, but how much does this cost?

Petrobank is actually available in the market for approximately free, give or take a hundred million depending on the day.  In other words, if you buy Petrobank, you’re basically buying a holding company for Petrobakken stock and Petrobank’s heavy oil and THAI assets for basically free.

Petrobank owns 59% of Petrobakken, which accounts for virtually its entire market capitalization, since they have no debt.  Now, if only for margin requirements, it would be really interesting to be able to buy Petrobank stock and short an equal amount of Petrobakken, “creating” the parent with its heavy oil assets for free.  Sadly, the actual margin requirements for doing so require you to tie up quite a bit more capital to carry this position — unless you have negotiating skills with banks like “Zero Haircut Financial Management,” formerly Long-Term Capital Management (LTCM).

Also, why short Petrobakken, which independently seems to be pretty cheap based on its reserves and land position? I’m generally not a fan of shorting things, unless you feel like the world would be a better place if they didn’t exist … which brings us to my pair trade idea.

I propose to buy Petrobank and short Northern Oil and Gas (NOG), which ironically operates to the south of Petrobakken in the same Bakken oilfields – consistent with their backwards financial statements.  Simply put, assuming NOG’s land is of a similar geology to Petrobakken, they are understating their depletion at least by half, which understates expenses and thus overstates net income.  Because they are financed by stock sales and growing fast, this can be hard to see in the aggregate cash flow numbers, because oil wells have a natural production decline curve, while cash costs are mostly up front.  You can find more details in an excellent report by The Street Sweeper.

Even if all the accounting is accurate, NOG trades at over 100X earnings, and over $8,000/acre of land, or roughly four times higher than Petrobakken. NOG has no business except tying up land leases and taking minority interests when operators come to the area.  Daniel Plainview would call them “speculators, that’s men trying to get between you and the oilmen.”  Rather than buying an oil E&P company like Petrobakken, you’re buying an entity more like a Bakken oil private equity fund, with no outside investors to earn fees off of, at four times NAV.

Here’s an analogy to this pair trade: Say you meet a nice looking girl with a really clingy boyfriend – everywhere you see her, he’s always just there.  You could find some way to lure him away directly, but that would cost you too much in margin requirements, and maybe he’s actually an okay guy on his own. (I may be pushing it a bit to try to connect this to the stocks – the girl is Petrobank.)

But let’s say that the boyfriend has a brother, who’s an alcoholic, and can’t keep correct track of his depletion of liver enzymes. You find out one day, when the alcoholic brother has been drinking, and schedule to meet the nice girl for dinner that night.  By dinnertime, the clingy boyfriend is at the police station bailing out his brother all night, so all you’re left with is the girl. The boyfriend — who’s not a bad guy after all — doesn’t suspect you of anything.  The moral of the story: never be afraid to apply your lessons from the rest of your life to investing.

Last week, I began the saga of a Chinese truck-cab manufacturer, which has been the most convoluted, strange, and frustrating situation that I have ever encountered as an investor. Here is the story’s conclusion.

Early in 2010, after nearly two years and with the locals excited to take control of their board, things started to fall apart for Tongxin International Ltd. (TXIC). First, the local management wanted to sell off some of their stock to take advantage of the price, which had increased since they went public. Unfortunately, because of legal restrictions on insiders, they were told they couldn’t sell much while they were still working for the company.

Second, the issue of the warrants was raised and the locals wanted their shares, but the agreement was that they would receive their extra shares only if all of the warrants were exercised. But only half had been so far. Our founder was looking forward to the day — near at hand — when the two years would be up. At that point, he would regain control of the board and rid himself of these Americans who promised him more capital, and then insulted him by bringing in college students to tell him how to run his business, which was as old as the students themselves!

Because they still hadn’t implemented the proper accounting control systems, the two-year succession of control agreement became invalid. This enraged the founder. Now disenchanted with the value of his public company, he staged a coup, using shareholder money to hire hiring expensive lawyers to try to take control by force. After all, they still had a majority of the shares. It turned out that, because of the warrant exercises, they were down to slightly below 50%, and therefore didn’t have the legal power to take control of their company on their own.

This would, therefore, require something more creative. Perhaps if he could drive the stock price down to pennies, he could just buy it back in the market and take back his baby.

Around this time, the American management uncovered some accounting issues. They had hired a top tier auditor to verify the books, in order to gain more credibility with the U.S. markets, and the auditor was stuck. Up until September 2009, the company was still trading with the small spun-out division that had to be specially accounted for because it was, technically, a related party. This was bad for appearances, and the company agreed, back in September, to cease these related party transactions.

Curiously, after they agreed to stop, a newly-formed company, controlled by friends of the founder, sold a large piece of land to the company for what seemed like a steep price. Then, it purchased a majority stake in the spun-off division, using the money from the purchase. This new company also seemed to be providing shipping services for steep prices. Shortly after, the founder was quoted in the local press about how business was booming at this newly-formed company, which was having record revenue, and was anticipated to grow to $35M in 2010 from zero prior to September 2009. He also stated that he had no official ties to the company, lest that make it a related party and render its transactions of dubious legitimacy.

Towards the end of 2010, the U.S. management still had not signed off on the financial statements, refusing to attest to the validity of the transactions that they believed to be of a dubious nature. Appearing to be holding up progress, the board — all in the same Greek Tragedy of the Month Club — voted to remove management and install a new American CEO, a former friend of the previous one. The new CEO then announces that revenues are going to fall short of projections by some $35M this year because of a downturn in the industry. Thus ends our parable.

The situation remains complicated. The business appears to be fundamentally solid, though whether that actually benefits shareholders — as the law requires — or is siphoned out the side door, is to be determined. One serious positive is that there are still U.S. citizens on the board. They and the American CEO are legally liable if things were to fall off a cliff into the worst-case scenario. They have a serious incentive to avoid that situation, which could very likely end in jail time for them if it can be proven they were complicit, or assisting in theft.

Recently, a CFO who defrauded foreign investors was sentenced to be executed. As far as I know, this is a first – such punishment is normally reserved for Chinese who defraud their own.

Back to TXIC. This is certainly the only situation I can think of where every new piece of information I learned turned out to be worse than the worst-case scenario I could have imagined. I had heard extreme stories of this kind of thing back in the early 1990’s for the very first foreign investors, and had understood that things were much improved and developed, but that appears not to be the case here.

The lesson from all of this is that you must do more investigation into management’s backgrounds. There are too many unknowable factors with emerging markets. Just as Ben Graham in the 1930s and 40s insisted on wider diversification in his portfolio because of the lack of investor protections, an investor in emerging markets today must practice the same policy.

Last week, I discussed how misunderstanding a company is a key factor in finding attractive investment opportunities, and looked at a domestic example. Today, I’ll look at one from China.

The case of Tongxin International Ltd. (TXIC), a Chinese truck-cab manufacturer, has been the most convoluted, strange, and frustrating situation that I have ever encountered as an investor. It was the primary cause of my poor performance this year. Because the situation has yet to be concluded, though, it could still work out well. Nonetheless, this investment has really hammered home the lesson of doing more of an investigative check on the individuals to whom you are entrusting your capital, and how essential they are or aren’t to the desired outcome.

In some cases, the influence of management can be less significant, such as when your valuation is based on hard assets in a region with strong legal protections. In other cases, particularly in service businesses where the people and culture constitute nearly the entire value of the company, competent and trustworthy management is a prerequisite.

I visited TXIC on my trip to China in September and met the founder and local CEO. My impression, which I still believe to be true now, is that he is a sharp-minded engineer and entrepreneur at heart whom I would trust to defeat his competitors by legitimate and hard work. He’s generally someone you’d want on your side.

The current situation, however, suggests otherwise. Even though the business is legitimate and performing well, the upside is not going to shareholders but, instead, to highly sophisticated, self-dealing by locals.

Normally, when buying a business that has a lot of hard assets at three to four times earnings, there’s a lot of room for error in your analysis to still come out well. However, in the second half of 2010, this stock has been the single worst performing Chinese stock that I’m aware of, despite the fact that nobody is even doubting the legitimacy of the operating business. This is unlike China Media Express Holdings (CCME), which was just reported on by Muddy Waters and Citron.

Remarkably, a basket of Chinese companies that were exposed in 2010 as fairly obvious hoaxes performed significantly better than this stock. This occurred despite the fact that they will almost certainly turn out to be worthless. It’s amazing to observe how rapidly sentiment can deteriorate in some cases; yet, in others, it can stay relatively cheery, even in the face of contrary evidence.

Perhaps when the truth is exposed to be so bad, the mind simply cannot accept it, and gravitates to a rosier, though less likely, reality. Message boards are an interesting case study in this. One company, RINO Int’l Corp. (RINO.PK), which was the subject of much message board activity, was exposed as a near total fraud, and the CEO even admitted to making up a number of customers. Despite this, there were countless message board posters coming up with creative explanations to justify their initial purchases: Statements included “there are still some customers” and “an oral contract is still binding.”

Parable of a disgruntled Chinese entrepreneur

A parable might be the best way to describe what appears to have led up to recent events. Twenty-five years ago, a young entrepreneur set out to make something for himself under the oppressive regime. Anyone incapable of being a fighter, or with a good wit, would certainly not last long, and be put out of business by unscrupulous officials or larger state-run enterprises. But he managed to start with a few thousand dollars, with a small group of friends, and get off the ground.

He became a well-respected entrepreneur in the community and grew wealthy by dominating his niche, growing to nearly $150M in revenues by reinvesting the profits they generated. Several years ago, a banker proposed to him that he could raise capital from U.S. investors and grow faster, becoming an even larger pillar in the community. He had also been seeing other companies in the automotive industry receiving foreign capital and growing rapidly, and worried that the baby that he’d built during the past 25 years might not be able to compete without this foreign rocket fuel.

For an unusually long eight months of deal making, they prepared to go public in the U.S. through a reverse merger into a shell with a cash balance. When the deal neared its deadline in April 2008, our founder claimed he had already earned 60% of the profits he projected for the year, and wanted to get that profit back as a cash payment before the deal closed. The managers of the shell refused, because this was in stark contrast to the deal they had agreed to. Unfortunately, due to the structure of the deal when it closed, the founder – who thought he was going to receive some $35M to grow the business — only received half the amount, because some of the holders of the shell opted to get their cash back rather than participate in the deal.

The founder and his partners still owned most of the stock, and all of the stock of a small division they had to spin out prior to going public. There were also some warrants that would potentially bring in cash at the expense of dilution, but the founder made sure that he could receive more shares to maintain his ownership stake if the company performed well and the warrants were exercised.

The managers of the American shell received control of the board. Their plan was to implement proper governance systems for a public company within two years, and then turn control over to the locals. The American managers tried to do what they could to be helpful and modernize the production, bringing industrial engineering students from the local American college to analyze and offer advice.

Tune in next week to Part 2 of the saga.