Joel Greenblatt wrote about it in his 1997 book You Can Be a Stock Market Genius. Greenblatt, at that time, was a relative unknown. But his Gotham Capital had put up 50% average annual returns for 10 years. The book had a big impact on how I think about investing.

What are we talking about? Spinoffs…

A spinoff is simply when one company takes a part of its business and makes a formal separation with the parent company by creating a new, free-standing company.

You don’t have to own the parent to the get spinoff. It’s just that the shareholders of the parent get the shares automatically. You can pick up shares after a spinoff.

Spinoffs as a group have a tendency to beat the market. There have been a number of studies on this point. The most famous might be a Penn State study that showed spinoffs outperformed the market by about 10% per year in the first three years of independence.

That’s a huge edge!

Why does this happen? I think the best explanation is simply rooted in the nature of business. When a smaller group is freed from the parent, there are creative and entrepreneurial energies released as well. There is a management team that can now focus on the spun-out assets alone, without worrying about what the parent thinks or needs. There is some benefit from this focus and freedom.

So spinoffs are one of those pools of investing ideas I routinely fish in for new ideas. The amazing thing is that despite all the publicity and studies, the anomaly persists! Why? Well, as Greenblatt says, it’s practically built into the system. “The spinoff process is a fundamentally inefficient method of distributing stock to the wrong people.”

After all, people didn’t ask to invest in the spinoff. They didn’t choose to buy the shares. They bought shares of the parent, not the spinoff, which were given to them. So they tend to sell the spinoff. This is what usually happens. And all that selling pressure drives down the shares.

The spinoff, too, is usually a small piece of the parent — maybe 10%, often less. So if you have $10,000 in a stock, you get maybe $500 of this other stock. Rather than bother with it, you just sell it. Institutions do this, too. Instead of spending resources trying to figure out this new thing, they just get rid of it.

As Greenblatt writes: “Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low-priced shares? Definitely.”

Why do a spinoff at all then? Each case is different. Sometimes it is a way to get rid of a business that is tough to sell on its own. Tax reasons might enter into it. Or it might solve some other strategic objective. The most-common reason is to create shareholder value with greater transparency. The hope is that the market might appreciate the separate businesses more fully.

One example is General Growth Properties. Spinning out Howard Hughes was a way to package all of its development assets into one company so it could focus purely on running malls. Howard Hughes owns a hodgepodge of planned communities and things unrelated to malls. As a separate company, Howard Hughes can devote its full attention to its development assets. It’s a win-win.

Greenblatt offers a simple three-point checklist to search for winners. Howard Hughes met all three:

• “Institutions don’t want it.” I can tell you there was no interest in Howard Hughes from institutions. Even now, there is little interest in the company. It still has no Wall Street coverage, for instance. It doesn’t fit it any of Wall Street’s boxes. It’s a hodgepodge of real estate with uncertain cash flows, neither fish nor fowl.

• “Insiders want it.” By contrast, insiders loved Howard Hughes. They bought shares. Brookfield was among the big investors here and still owns 6% of the stock today.

• “A previously hidden investment opportunity is created or revealed.” Buried in GGP, Howard Hughes assets could easily be ignored and overlooked. But on its own, with attention and capital, Howard Hughes can advance projects and unleash their potential.

Howard Hughes traded independently on Nov. 10, 2010. It went down after the first week of trading. But by April 2011, it had nearly doubled. Even if you had held the shares from the spinoff to now, you’d be up 25%, versus 5% for the market as a whole.

That’s why you should always pay attention to spinoffs…

Sincerely,

Chris Mayer
for The Penny Sleuth

3 Easy Steps to an Unusual Investment “Guarantee” was originally featured in the Penny Sleuth.

It’s fascinating to see how people cope with the volatility. Their choices and behavior lead to some very odd market price constellations.

A money manager friend of mine sent me a note from Noah Blackstein, the manager of the Dynamic Alpha Performance Fund. He notes that the market is seeking yield and low-beta securities. In English, this means that people are looking for income and for stocks that don’t move as much as the market.

Beta is the common measure of volatility. If a stock has a beta of 1, it means it has moved in step with the overall market. A beta of 1.5 means it’s moved 50% more than the market. So if the market went up 10%, this stock went up 20%. A low beta of 0.50 means the stock moved 50% as much as the market. It’s this last fish that is the choice catch in today’s market.

Because of that, stocks with the desired attributes have become expensive. Blackstein offers up a pair to show his point: Microsoft versus Southern Com… “Microsoft trades at 9 times EPS, has a five-year EPS growth of 13% and yields 3.1% and sits with a balance sheet full of cash. Southern Co. trades for 17.5 times earnings per share, has a five-year growth rate of 3% and yields 4.4% with a ton of debt.”

It’s worse if you look at Canadian companies compared with U.S. companies. He offered up Enbridge, a pipeline company, with a 2.7% yield and a price-earnings ratio of 24 times. It has lots of debt. The stock is up 30% this year. Microsoft, by comparison, yields more (3.1%), offers a lower price-earnings ratio (9) and is stuffed with cash. The stock is down 9%.

Why?

Now, here is the key. Microsoft has a beta of 0.78, versus Southern’s 0.38 and Enbridge’s 0.15. Market participants are willing to pay up for a stock that won’t have them reaching for a bottle of Maalox on days like today. Low beta has won out. “How can this be anything other than a low-beta bubble?” Blackstein writes.

Here’s the thing, though: Though short-term market prices have all kinds of burps that make no sense, the market does sort things out rationally over the long haul. Stocks of bankrupt companies eventually hit zero. Undervalued stocks eventually become fully valued.

The fundamentals may not mean much in the day-to-day and week-to-week trading, but they get sifted out over the course of a few years. This is the basis of all intelligent investing.

I’ve written about Doug Barnett, who runs the Thai Focused Equity Fund, to my Mayer’s Special Situations readers before. His fund had phenomenal performance in a market that is very volatile. Stocks soar and dive on rumor and take emotional roller coasters that test the resolve of its shareholders. But over the long haul, the market does discriminate. Barnett’s 18% annually proves it does. As Doug said, “You get compensated for having a more-volatile path to achieve your goals.”

The second pillar on which to build is the insight that you often make money taking the other side of popular trades. Or more specifically, you get very good prices to take the opposite of a popular trade. This is the bedrock of contrarian investing, which seeks out a hardened consensus and bets against it.

Therefore, if the market wants yield and low volatility, then it follows that you will get more value for your money by taking stocks with no or little yield and high volatility.

So… you would want to avoid utility stocks. Even though they look attractive based on the 10-year Treasury yield (which, frankly, is a Fed-manipulated number), they are the classic low-beta-yielding securities the market loves right now. They suffer in comparison to what else you might buy (see again the Microsoft versus Southern Co. comparison).

You would, instead, look at smaller-cap stocks, which are traditionally high beta. By the way, you can find betas easily. You’ll see it, for example, on Yahoo! Finance under the “Key Statistics” section.

Junior mining stocks and small-cap oil and gas producers are stocks that have been whacked hard of late. These are areas where pricing is good. For most of these, the betas are around 2. Most small-cap stocks have high betas, and hence, the market is shunning them.

I would also say you can still get good yield in high-beta stocks.

Of course, you have to wait it out. If you are going to fret short-term swings, you are going to fray your nerves, sell near bottoms and pretty much make yourself miserable and poorer. You have to decide whether you can play the game or not, and if you do, you have to be willing to suck it up and hold on…

Sincerely,

Chris Mayer
for The Penny Sleuth

One Indicator That Will Help You Beat Volatile Markets… was originally featured in the Penny Sleuth.

It frees up massive amounts of crude oil from deposits on dry land once thought to be inaccessible. While most investors don’t know anything about this extraordinary phenomenon, it’s filling the coffers of some little-known American oil companies with tons of cash.

It’s a big breakthrough for the nation’s oil industry.

As the Natural Resources Defense Council points out, it, “would give America access to large, domestic oil resources — potentially more than four times the proven U.S. reserves, or up to 10 full years of our total national consumption.” That’s a quadrupling of U.S. oil reserves.

Now here’s where the action is the hottest: The Bakken trend. This U.S. region lies in the giant Williston Basin and stretches across parts of the Dakotas, Montana, Manitoba and Saskatchewan…

In the 1990s, geochemist L.C. Price, working for the U.S. Geological Survey (USGS), compiled a stunning report on the Bakken trend. He concluded that it contained 200–500 billion barrels of oil. In 1999, he turned in his report to the USGS, but nothing happened. In 2000, Price died, but the USGS still had the report. The USGS refused to release it. Price’s story of Bakken was the province of oilmen telling stories in bars… until today.

It took the force of a North Dakota senator to press the USGS to take up where Price left off. But finally, the Bakken has the world’s attention. New work on the area confirms the essence of Price’s research, if not his 200–500 billion barrel estimate. Some 2006 estimates place 300 billion in North Dakota and Montana alone.

Also, geologist Julie LeFever, who worked with L.C. Price on his initial report, published a paper adding that additional barrels lie in various layers of the Bakken.

What does this mean for the smart oil and gas investor? Prospects of returns far better than anything you’ve ever heard of from the Canadian oil sands or Colorado’s shale.

“The Bakken formation estimate is larger than all other current USGS oil assessments of the lower 48 states,” the report says “and is the largest ‘continuous’ oil accumulation ever assessed by the USGS.”

Who knows exactly how much oil lies beneath the Bakken? On April 10, 2008, the USGS issued a shot heard round the Bakken. Its newest estimation reveals a 25-fold increase in the amount of oil that can be recovered from the Bakken formation. North Dakota and Montana’s Bakken alone have an estimated 3–4.3 billion barrels of oil that could be recoverable with today’s “magic drug” technology. The Bakken has suddenly become one of the hottest crude oil plays in North America. Already, investors from Norway, the United Kingdom, France and Italy are in on the game. Private equity predicts Asian investors will be next…

Bakken, you see, is just that big. Predictions for peak daily production range from a healthy 300,000 barrels per day (bpd) to a whopping 700,000 bpd. That kind of production could last 10–15 years. Meanwhile, the Gulf of Mexico produces half what it did 10 years ago. The Bakken is the future of U.S. energy.

And there’s even bigger news… a new formation under the Bakken shale. Three Forks-Sanish could prove just as good as the Bakken. This is just what geologist Julie LeFever suggested back in ‘06. Three Forks’ sand and porous rock could offer up 1.9 billion barrels of oil using current technology. At least that’s the latest number I have from North Dakota’s Industrial Commission. But Harold Hamm, CEO of Continental Resources (a key player in the Three Forks) claims there could be as much as 8 billion barrels.

Getting oil and gas out of the Bakken has never been easier. Since just 2008, Bakken’s experienced drill teams have whittled down the time it takes to drill over two miles down into the shale. What once took 45 days now takes only 19.

Right now, the Bakken has put a record number of rigs to work. Things haven’t been this busy since 1981. About 6,000 wells produce in just the North Dakota Bakken alone. The region added over 1,000 new wells since 2008, when I first started covering this resource bonanza.

Early investors in shale oil and gas have made fortunes.

Take Range Resources, for instance, a company that locked down a lot of shale acreage early in the other big shale finds — the Barnett and Marcellus. It’s up 2,294% in the last 10 years.

Specifically in the Bakken formation, my readers cashed out on shale player Kodiak Oil & Gas for 113% gains.

So there is a ton of money to be made from this new technique. And if you take advantage of this tidal wave, it could make you wealthier than you’ve ever thought possible…

Sincerely,

Chris Mayer
for The Penny Sleuth

You Could Make You 3,800% Gains from This Technology Breakthrough was originally featured in the Penny Sleuth.

Some of the long-standing bulls have thrown in the towel.

Jim Grant, for example, was a general partner in Nippon Partners from 1998-2010. The idea was to invest in undervalued Japanese securities, of which there were many. Nippon Partners closed up shop in December 2010 because it wasn’t making any money.

Why?

“Japanese corporate managers, by and large, don’t own equity,” Grant said. “They have a platonic interest in the stock price.” In Japan, there is not much of a market for corporate takeovers, activist investors and the like. Management teams are entrenched. Shareholders are unimportant.

“You get tired,” Grant writes. “The last straw was when one of our companies was selling at a huge discount to everything and announced that it would undertake a capital investment larger than its stock capitalization.”

Maybe this will be the catalyst that sparks some life in Japanese equities. After all, there is precedence for the creation of great wealth during a time of lessening government involvement. Even in Japan.

At the Agora Financial Safety and Survival Summit, I talked about the Japan. As I said earlier, the great appeal of Japanese stocks is how cheap they are…

This table below, from Symphony Financial Partners, which runs a Japan-focused fund, shows you the percentage of Japanese stocks that meet three tough valuation criteria:

However, as the Symphony guys point out, “low valuations and cash-rich balance sheets are all chants we have heard before.” The common lament of an investor in Japanese stocks is that they are cheap and stay cheap, that the management teams do nothing to unlock the value in their companies, that they just sit on the cash or blow it on dumb projects.

What’s different this time? “The real change,” they continue, “is the discernible increase in high premium M&A/MBO activity.” (MBO stands for “management buyout” and is when a management team buys out a company, taking it private.)

For the first nine months of 2011, there were more MBOs than in all of 2010. It looks like it will be a record year for MBOs in Japan. What’s interesting is the fat premiums they are paying to make those deals. On average, buyers are paying 50% above the stock market price!

In a September note, the Asian research firm CLSA gave six reasons for the increase in mergers and acquisitions in Japan:

• Japan is dirt-cheap.
• The rules have been changed, with the specified aim of spurring M&A.
• Companies have so much money it is burning holes in their pockets.
• Even if companies don’t have the money themselves, banks are falling over themselves to lend them the money.
• Corporate governance just overtook the U.S. (40% of U.S. companies have poison pills, 45% have staggered boards — which means it takes many years to fire the board — and 70% have golden parachutes. These are not problems Japanese investors have to handle.)
• Rules on what constitutes a monopoly just got wildly more liberal — from the old, parochial domestic market view to taking a worldview of market share: Nippon Steel/SMI may have had a combined 40% share in Japan, but it had less than 3% global share.

Maybe, just maybe, a fire has been lit under Japanese shares… this is a market you should not ignore.

Sincerely,

Chris Mayer
for The Penny Sleuth

Why You Shouldn’t Ignore This Beaten Down Market… was originally featured in the Penny Sleuth.

The oil-rich inlet is named for Captain Cook. He stumbled on this 180-mile inlet on his search for the Northwest Passage. It stretches from the Gulf of Alaska to Anchorage. Too bad for Cook, he never realized the true value of his discovery.

However, investors today are in the best position to reap the gains. Right now, the value of Cook’s oil “jackpot” is over $23 billion, but it wasn’t always like this…

You see, after the Russians’ discovery, a variety of fortune-seekers — lone prospectors, private wildcatters and big oil companies — took shots looking for commercial oil here. While there was some success, there were mostly setbacks and a trail of abandoned wells.

It wasn’t until 1961 (two years after Alaska became a state) that Swanson River — a joint venture between Richfield and Standard Oil — became a commercially successful oil field.

The rest, as they say, is history.

More than a billion barrels of oil, along with 5 trillion cubic feet of natural gas, has been pumped out of the Cook Inlet area. Oil and gas development in Alaska as a whole has been huge.

About one-fifth of the domestically produced oil in the U.S., for instance, comes from Alaska.

But these assets have been in long decline. Production of crude oil is down more 70% from its high in the 1980s.

Cook Inlet is now an old horse with oilmen trying to coax whatever they can get out of it.

But here’s where things get interesting…

Chevron, one of the largest Cook Inlet producers, recently said it would sell all of its assets here. This includes offshore and land-based oil and gas fields, 10 offshore rigs and two gas tank farms. Chevron will also part with its interests in two regional pipelines.

“The decision comes as production from Cook Inlet oil and gas fields is declining,” Anchorage Daily News reports, “typically, a period when big energy companies lose interest in their investments and smaller operators jump in.”

Here, then, is the opportunity. There is still a lot of oil and gas left in Cook Inlet. It’s just too small for big guys like Chevron to spend time and money on. For a smaller outfit, it could mean a fortune.

Remarkably, despite the fact that the Cook Inlet is the oldest producing basin in Alaska, much of it is still untapped, as Petroleum News points out:

Nearly all of the operating oil and gas fields in Cook Inlet derive from exploration done in the 1950s and 1960s, before the discovery of the giant Prudhoe Bay field caused the attention of explorers to switch to the North Slope. As a consequence, only limited exploration of Cook Inlet has taken place in more recent decades.

The state of Alaska, too, is bending over backward to keep investment in oil and gas flowing.

The state leans greatly on this industry. Some 80% of state revenues depend on oil and gas extraction.

It employs thousands of people. Those people in turn support shops, restaurants and the whole wheel that is a community.
So the government created some sweetheart deals for oil and gas companies to spend money here. Among these goodies is a 40% state refund on money spent for drilling and exploration costs — paid in cash to the operator. There are other laws in place that could refund as much as 20% of other costs and 25% of net losses incurred.

Again, for a small operator looking to get a sweet return on a moderate-sized pot of money, Alaska is golden. The economics of Alaskan oil and gas are as good as anywhere in the world.

Location is very important. As with real estate, where you are makes all the difference. I like to find “pockets” where natural gas goes for a big premium. For example, in Turkey, prices are more than double what they are in the U.S. And here we find another pocket in Alaska. Plus, the state gives you all kinds of goodies besides.

I see Alaska’s oil and gas fields becoming a very profitable region for smaller companies.

Cook Inlet may well enjoy a revival.

In fact, the seeds are already starting to germinate. One group is bringing the first new drilling jack-up rig to come to Alaska in 16 years. Another group is bringing back shut-in wells. There is actually a fairly long list of companies squeezing life from old assets and/or exploring new prospects, spurred on by generous state incentives.

It’s the beginning of a good old-fashioned Alaskan oil and gas boom. In a world where foreign sources of oil are more frowned upon and uncertain than ever, my guess is that investors will look warmly on the efforts of those in “the last frontier.”

[The Sleuth's Note: Doing a quick search using Yahoo! Finance, we came across a few Alaskan drilling companies. You can start out by taking a closer look at these: Parker Drilling Company (NYSE:PKD), Tesoro Corporation (NYSE:TSO), and Linc Energy LTD (ASX:LNC). But, before buying anything, we suggest doing your homework.]

Sincerely,
Chris Mayer
Penny Sleuth

How to Become the Next Alaskan Millionaire was originally featured in the Penny Sleuth.

You know how high oil prices tend to create boomlets in certain businesses?

Alternative energy, small car manufacturers and the like get a boost. Aircraft suppliers may also see a boost.

Fuel is the largest expense for the airline industry – at 30% of operating costs. And the airline industry faces pressures to cut costs. Recently, the Air Transport Association forecast that the airline industry would make $4 billion this year, down 78% from last year. So there is pressure (again) to cut costs.

Airlines have already cut staffing costs. You can see this in labor costs as a percentage of operating costs. They now stand at about a quarter of costs compared to 35% in 2001. Airlines have also been smarter about pricing and routes, as airfare rates have stayed up.

The big opportunity for the airline industry, though, is to cut into that fuel cost number. The way to do that is with more fuel-efficient aircraft. A new A320, for instance, saves more than 25% on fuel costs compared with the older MD-80.

The old workhorses of the fleet, such as the 737s an 757s, also are lacking in fuel-efficiency.

What’s also interesting here is that the airline industry also has scrimped on investing in new planes. In fact, the world’s 50 largest airlines spent only 8% of sales on new aircrafts. That is the lowest total in a decade. I’d bet that number climbs in the next few years.

But there is an even more compelling reason to like aircraft suppliers. Actually, there are 33,500 reasons…

Boeing recently put out its long-term forecast for aircraft for the next two decades. This is a much-watched and commented-on forecast, as Boeing has as good an insight into the backlog of the industry as anyone.

They project that passenger traffic will triple by 2030 and the number of commercial aircraft will double. They estimate this will create a market need for 33,500 new planes.

The tab: $4 trillion.

Where is the growth coming from? I’m sure you could guess, and it fits well into our World Right Side Up thesis.

The idea behind the World Right Side Up is that the very large gap between emerging markets and developed markets is closing and will continue to close. We’re seeing this gap shrink now in aerospace.

Twenty years ago, 72% of all air traffic was on carriers from North America or Europe. Today, only 55% is. Boeing forecasts that figure will fall to 40% by 2030. It’s a different world than the one we knew in the 20th century. It will also create new and different opportunity sets for investors.

Boeing’s forecast is still a forecast and it could be wrong, as all such forecasts can be. But if it is wrong in the particulars, I think it will prove directionally accurate. Meaning, we’re going to need a lot more planes, and that creates a nice tail wind for a certain flock of businesses.

I tend to favor the suppliers over the manufacturers, as some of suppliers have better growth prospects and upside potential.

I continue to follow a group of aerospace-related stocks. I think it’s an attractive lot… and if the projections pans out, investors that take action could see large profits in the future.

[The Sleuth’s Note: You can start researching this sector too. Google Finance has some coverage of companies in this sector here. If the aerospace-related companies take off, you could add some real wealth to your portfolio.]

Sincerely,

Chris Mayer
Penny Sleuth

33,500 Reasons to Like Aircraft Suppliers was originally featured in the Penny Sleuth.

The speaker was Joshua Friedman, the co-chief at Canyon Partners, which manages $20 billion. He was speaking at Grant’s Spring Investment Conference, which I attended in early April.

Friedman used the imagery of the old bell curves. There is the normal bell curve and the “new normal” curve with fatter tails. In plain terms, it means more crazy things will happen. It means outliers will become more common. It means the unexpected will happen more frequently. Wildness lies in wait, as Chesterton had it.

In many ways, markets have always been this way, as the late Benoit Mandelbrot observed. For instance, financial theory – based on the old bell curve – predicts that a market move of 7% or more in a single day will happen once every 300,000 years. Yet the 20th century alone had 48 such days. “Truly, a calamitous era,” Mandelbrot writes, “that insists on flaunting all predictions.”

What to do?

Michael Harkins, a respected investor at the firm of Levy, Harkins & Co., said to avoid “cash sinkholes.” Exhibit A was Alcoa, a “capitalist catastrophe,” as he put it. Every dime the company earns and more is consumed in costly, capital-intensive projects that generate no free cash.

Harkins likes blue chippy names – Tupperware (NYSE:TUP) (“a cash machine with 85% of sales outside of the U.S.”), McDonald’s (NYSE:MCD) (“a cash machine… competitors are leveraged up”) and American Express (NYSE:AXP) (“a cash machine with pricing power”).

He also pointed out that investors have short memories and that the market is constantly wiping the slate clean, ensuring that cash sinkholes and “capitalist catastrophes” continue to capture the affection of new investors.

The aforementioned Friedman had an idea as well. “Go long optionality,” he said. Invest “not only in cheap assets, but assets where you get optionality cheaply.”

What is optionality?

One way a stock has optionality is if it can deliver big results when certain seemingly unlikely things occur. I think of it as the payoff if that fat part of the tail happens. Think of a publishing company that publishes the next Harry Potter. Or a movie studio that makes the next Avatar.

My best idea on cheap optionality in today’s market is low-cost, pure-play natural gas stocks in North America. Natural gas prices are low, drifting around $4 for last two years. If you buy a natural gas stock that makes sense assuming natural gas prices stay at $4, then you ought to do OK even if natgas continues to drift along at $4.

But the optionality you get is if natural gas prices get to $6, which they must do someday. When is anybody’s guess. But when they do, then the stock doubles. Or if natural gas prices get to $8, then the stock doubles again. You have a stock with a giant free call option on higher natural gas prices.

These are the kinds of stocks you want to buy in this market: Low downside, but huge upside if what seems unlikely or unexpected happens. (Nobody is predicting $6 gas anytime soon.) The promise of small steady gains is not worth the risk in a market with fat tails and that can roll back years of small gains in a few bad months.

Bet on the unexpected, as long as your downside is covered.

Sincerely,

Chris Mayer
Penny Sleuth

Get Big Results with “Optionality” was originally featured in the Penny Sleuth.

Peter Cundill is his name. His investment approach is the subject of a new book by Christopher Risso-Gill, who was a director at Cundill Value Fund for 10 years. Titled There’s Always Something to Do, it is a summary of the Cundill approach. The book takes its name from a line from Irving Kahn, a doyen of investing (born in 1905) and still chairman of Kahn Bros., which manages $450 million. Kahn said, “There is always something to do. You just need to look harder, be creative and a little flexible.” So true.

In these pages, we have made the study of great investors part of the regular diet, every bit as valuable (and perhaps more so) than winning stock ideas. So let’s continue that tradition and take a look at what kind of thinking peeled off 33 years of 15%.

Cundill was, like so many great investors, a devoted follower of the ideas laid out by Ben Graham back in the 1930s. Graham has a long list of followers and admirers, including Warren Buffett, the aforementioned Kahn, Cundill and many others besides (including yours truly).

While there is much to Graham’s thinking, a cornerstone of the approach is the idea of a margin of safety. You buy only what is cheap and well supported by some estimate of intrinsic value. It is a persnickety, unfashionable, patient approach that demands a great deal of discipline. It is one that takes more interest in what is happening in the folds of balance sheets and in the crevices of footnotes than in predicting what the market is going to do next. “I’m agnostic about where the market will go,” Cundill often wrote. “I don’t have a view.” His goal was to find undervalued securities. Period.

The book has lots of “war stories” to show how Cundill applied these ideas in his career. But the book also has plenty of pithy how-to investing wisdom drawn from Cundill’s speeches, shareholder letters and personal diaries.

I enjoyed Cundill’s thinking on when to sell, as he used an idea I’ve endorsed in these pages: “When a stock doubles, sell half — then what you have is a free position.” Selling is the most difficult thing in all of investing. No one is good at it. But this seems a reasonable approach that protects hard-earned profits and helps buttress mistakes. We’ve sold half positions often after doubling our money, but now we can give it a name in honor of this great investor. We’ll call it a “Cundill sell.”

There are also many good insights into the investing process. Cundill notes that “99% of investment effort is routine, unspectacular inquiry, checking and double-checking, laboriously building up a web of information with single threads until it constitutes a complete tableau.” I agree completely. And I think back on all the time spent doing routine stuff like listening in on quarterly conference calls, perusing 10-Ks, 10-Qs, proxy statements and the like.

Unglamorous, perhaps, but necessary work. Cundill, too, did his own work. “All I really need is a company’s published reports and records; that plus a sharp pencil, a pocket calculator and patience.”

There are other aspects of Cundill’s ideas that are good to highlight. One: He had a catholic appetite when it came to investing. “If it’s cheap enough,” he wrote, “we don’t care what it is.” This is an important part of my investment philosophy as well. I go where the value is without loyalty to commodities, market caps or any of the other silos that specialists often use to carve up the market.

Cundill was also international in his approach. “I’ve traveled pretty extensively,” he noted. “So I don’t really see much more risk investing in foreign countries than I do investing in North America.”

Where did Cundill look for ideas? “You find bargains among the unpopular things, the things that everybody hates. The key is that you must have patience.” He liked to look at stocks making new lows. He liked to read the news to see what was troubled. He also liked checking in to see what other great investors were doing. “You know good poets borrow and great poets steal. So see what you can find out.”

He was also not afraid to hold cash. Cundill often held large cash positions, sometimes as much as 40%. Many investors would do well to take a page from Cundill’s playbook here.

His idea that investing is a game of generals, not committees, is also one that resonates with me. “To my knowledge, there are no good records that have been built by institutions run by committees… In reality, outstanding records are made by dictators.” Most of the best investors are solitary eagles, though there are, of course, some famous partnerships that work well, too. (Think Warren Buffett and Charlie Munger.)

Cundill liked to concentrate his ideas, rather than spread his money out thin. “My father was a very good birdshot and he always said, ‘Never shoot into the brown.’ In other words, never shoot into a flock of birds without first choosing a single bird.”

Cundill also had the habit of traveling to the world’s worst stock market. He started this while he was living in Vancouver and it was rainy in November. He would travel to the world’s worst stock market to that point in the year. Sounds like a good idea that I may have to try.

There was a stock screening idea in the book that I thought was interesting. It’s called “The Magic Sixes.” Basically, you screen for stocks trading for 60% of book value, at 6 times earnings and paying a 6% dividend yield. (This is a strategy that could be worth checking out right now…)

To Cundill, investing is not a matter of smarts alone. “Just as many smart people fail in the investment business as stupid ones. Intellectually active people are particularly attracted to elegant concepts, which can have the effect of distracting them from the simpler, more fundamental truths.” Well said.

Another idea: “Sooner or later, the market will do what it has to do to prove the majority wrong.” This is a good thought. It’s important to think about what unexamined assumptions you hold. What do you take as a given? Perhaps you shouldn’t.

I smiled when I read Cundill write: “I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch. I have no idea whether I’m working or whether I’m playing.” I feel much the same way.

Cundill died earlier this year at the age of 72. This book ensures that future investors will not lose his hard-earned wisdom. A nice addition to the investment library – and plenty of actionable advice as we try to tame these wild markets…

Sincerely,

Chris Mayer
for Penny Sleuth

How This Investor Turned $10,000 into $1 Million was originally featured in the Penny Sleuth.

Over the next hundred years, a variety of fortune-seekers — lone prospectors, private wildcatters and big oil companies — took shots looking for commercial oil here. While there was some success, there were mostly setbacks and a trail of abandoned wells.

It wasn’t until 1961 (two years after Alaska became a state) that Swanson River — a joint venture between Richfield and Standard Oil — became a commercially successful oil field.

The rest, as they say, is history.

More than a billion barrels of oil, along with 5 trillion cubic feet of natural gas, has been pumped out of the Cook Inlet area. Oil and gas development in Alaska as a whole has been huge. About one-fifth of the domestically produced oil in the U.S. comes from Alaska.

But these assets have been in long decline. Production of crude oil is down more 70% from its high in the 1980s:

Annual Alaska Field Production of Crude Oil

Cook Inlet is now an old horse with oilmen trying to coax whatever they can get out of it. But here’s where things get interesting.

Chevron, one of the largest Cook Inlet producers, decided recently to sell all of its assets here. This includes offshore and land-based oil and gas fields, 10 offshore rigs and two gas tank farms. Chevron will also part with its interests in two regional pipelines.

“The decision comes as production from Cook Inlet oil and gas fields is declining,” Anchorage Daily News reports, “typically, a period when big energy companies lose interest in their investments and smaller operators jump in.”

Here, then, is the opportunity. There is still a lot of oil and gas left in Cook Inlet. It’s just too small for big guys like Chevron to spend time and money on. For a smaller outfit, it could mean a fortune.

The state of Alaska is bending over backward to keep investment in oil and gas flowing. The state leans greatly on this industry. Some 80% of state revenues depend on oil and gas extraction. It employs thousands of people. Those people in turn support shops, restaurants and the whole wheel that is a community.

So the government created some sweetheart deals for oil and gas companies to spend money here. Among these goodies is a 40% state refund on money spent for drilling and exploration costs — paid in cash to the operator. There are other laws in place that could refund as much as 20% of other costs and 25% of net losses incurred.

Again, for a small operator looking to get a sweet return on a moderate-sized pot of money, Alaska is like the El Dorado of oil and gas.

And there is actually a natural gas shortage in the region. Current proved reserves may well fall behind demand by 2012. Yet the inlet has an estimated 13–15 trillion cubic feet of gas, as well as more 200 million barrels of oil — mostly overlooked by the big majors.

As a result of the shortage, prices for natural gas here are about $3 more per million cubic feet (mcf) than they are in the lower 48. While gas wallows around $4, Alaskan natural gas goes for $6.50 and as much as $10 per mcf in the winter.

This is the fascinating thing about natural gas that many investors don’t understand. Location is very important. As with real estate, where you are makes all the difference.

I could see a kind of echo boom to Alaska’s oil and gas, where it becomes a very profitable region for smaller companies. Cook Inlet may well enjoy a revival.

In fact, the seeds are already starting to germinate. One group is bringing the first new drilling jack-up rig to come to Alaska in 16 years. Another group is bringing back shut-in wells. There is actually a fairly long list of companies squeezing life from old assets and/or exploring new prospects, spurred on by generous state incentives.

It’s the beginning of a good old-fashioned Alaskan oil and gas boom. In a world where foreign sources of oil are more frowned upon and uncertain than ever, my guess is that investors will look warmly on the efforts of those in “the last frontier.”

Sincerely,
Chris Mayer
Penny Sleuth

May 16, 2011

Hidden Profits from These Forgotten Treasures was originally featured in the Penny Sleuth.

But what is more important for stock prices is not the profit margin itself, but the direction they move. Rising profit margins goose stock prices in wonderful ways, but declining profit margins are a tough anchor to overcome.

The problem today is the most of the big blue chips report record profit margins, as Horizon Management pointed out in a recent research note.

Here is a list of the profit margins of the top 10 technology stocks of the NASDAQ 100 by market cap. They represent more than 40% of the NASDAQ 100.

“The average net profit margin is roughly 25%,” Horizon observes, “which is without any historical precedent whatsoever.”

This, then, is the Achilles’ heel of the market as far as the fundamentals go. Profit margins are extremely high and unlikely to stay there, which ought to lead to earnings disappointments down the road. It was no surprise that Cisco Systems fell 16% in a day after the market fretted over weakening profit margins at the tech giant.

This phenomenon extends well beyond just the tech set. As Horizon points out, the same thing is in evidence in the S&P 500, which is a broad measure of the overall market. Let’s look at the top 50 market caps in the index. This includes a mix of companies such as Chevron, GE and DuPont.

What do we find?

Horizon notes:

“There are quite a few companies with very high absolute profit margins. For example, Apple, Coca-Cola, Oracle, Schlumberger, McDonald’s, Occidental Petroleum and Freeport-McMoRan Copper & Gold all have the common feature of after-tax net profit margins well in excess of 20%… In general, a 20% profit margin for any company is a historical rarity.”

This is important because many investors seem to be banking on the idea that such companies will enjoy fat margins in perpetuity.

In some ways, the surge in profit margins is what you would expect to see in the early phases of a recovery. Companies cut costs going in a downturn. Then, as sales rise, there is a big boost to the bottom line, as costs have yet to catch up.

Today, though, I doubt many of these firms have much more to cut. Instead, the focus is now growing sales and taking business from competitors or defending an existing business. The focus, too, is how to deal with rising raw material costs. All of these put enormous pressure on margins. We should expect to see them fall.

So perhaps the valuations of many of these stocks — often with price-to-earnings ratios between 12-16 — are more spot on than they appear if you assume falling profit margins, falling returns on equity and the like.

As an investor, I think it is better to focus less on what profit margins are today and more on where they will go in the future.

The stock market overall has gone up quite a bit, lifting all boats to some extent. It is hard to isolate any single factor. Nonetheless, I think the point is that where profit margins are headed is more important than where they are. It’s like hockey great Wayne Gretzky’s advice: “Go where the puck is going to be, not where it is.”

For the market overall, profit margins are likely headed south. Those that can maintain or increase their profit margins will be the exceptions. Finding them, though, could mean the difference between a winning investment and a losing one.

Sincerely,
Chris Mayer
Penny Sleuth

May 9, 2011

How You Can Hit Peak Profits was originally featured in the Penny Sleuth.