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Letter 25: Tax Loss Buying

I am on vacation with limited computer access so this is going to be a short letter.

There was some good news for the oil stocks in my portfolio this week.

News that should help Equal

Equal Energy has not performed very well lately.  I don’t expect much from the stock until something is announced with the companies Mississippian lands in Oklahoma.  While we wait, Sandridge, the biggest landholder in the Mississippian, jv’d 363,000 acres of their land to Repsol this week for $1B.   That works out to $2,754/acre.

SandRidge will sell an approximate 25% non-operated working interest, or 250,000 net acres, in the Extension Mississippian play located in Western Kansas and an approximate 16% non-operated working interest, or 113,636 net acres, in its Original Mississippian play. The 363,636 net acres in total will be sold to Repsol for an aggregate transaction value of $1 Billion. Repsol will pay $250 million in cash at closing and the remainder in the form of a drilling carry. In addition to paying for its working interest share of development costs, Repsol will pay an amount equal to 200% of its working interest to fund a portion of SandRidge’s cost of development until the additional $750 million drilling carry obligation is satisfied.

Admittedly, this is a little on the low side compared to some of the earlier deals.  That is because this deal included 250,000 acres of the second Mississippian play that Sandridge is involved in.  The second play is newer and riskier.

The fact that Sandridge was able to get $2,750 per acre while only including 113,000 acres of the prime land (in Oklahoma the heart of the Mississippian is Grant, Alfalfa and Woods) provides another positive data point for Equal.

Equal has 20,000 acres of land in the heart of the Mississippian.  This is another deal that suggests that the land is worth around $70M.   At $4.50, the stock trades at an enterprise value of $300M and with a market capitalization of $150M.  It is clear that that the Mississippian land is not priced into the stock.

I bought some more Equal on Thursday at $4.50.  I believe the recent decline in the share price is simply tax loss selling.  I believe that the stock would be undervalued at $7/share.  At $4.50, its a little ridiculous.

Coastal Energy News

Coastal Energy has been the best performing stock for me over the last few months.  They have hit on well after well after well.  The string of success continued with the B-09 well news released on Tuesday.

“The Bua Ban North B-09 well encountered the largest pay zone we have seen to date in this field. We are particularly excited that we have encountered oil across five Miocene zones. This confirms the lateral extent of the deeper pay zones below our main producing reservoir. Following this successful result in the deeper zones, we plan to drill further appraisal wells to continue testing the 63.0 mmbbl of prospective resources defined in the RPS report ofNovember 15, 2011, which are incremental to the 67.0 mmbbl of 2P volumes defined in the report.”

What is most important about the result is that it begins to prove up the lower miocene sands.  First Energy noted the following:

The Bua Ban North B-09 well discovered 3-4 mmbbl in deeper Micocene sands which could open a new play for Coastal with an overall prize of 63 mmbbl prospective resources.

The Miocene sands that Coastal is drilling into are actually a number of layered sands as shown in the illustration below.  Up until the B-09 well, Coastal had been focusing on the upper two layers.  The B-09 explored the lower layers.  The RPS report distinguished between reserves and prospective resource in the Miocene.  While the news release did not say so specifically the above snippit implies that most if not all of the prospective resource is in the deeper sands.

There is an excellent summary of the Micoene sands that Coastal is drilling into that was posted by Oiljack on the Investorsvillage Coastal board.

Midway gets us Excited and then…

The moment I noticed that Midway Energy was halted I went out and bought shares in Second Wave.  I thought for sure that the halt was due to a takeover bid and that there would be a subsequent boost to the other Swan Hills players (Arcan and Second Wave).  Unfortunately, while a takeover bid may indeed be in the works, the clarification by Midway left the waters muddied.

Midway Energy Ltd. (“Midway” or the “Company”) announced today that it has become aware that information may have entered the market with respect to certain potential transactions. The Company has not entered into any definitive agreement with respect to these transactions and will issue a press release when and if a successful transaction has been negotiated.

Nothing like clarity.  Nevertheless the stock popped when it opened and Second Wave popped along with it.

I think I will hold onto Second Wave for a while; their latest update was mildly disappointing with a few of the recent wells producing at far less than the earlier more prolific Crescent Point JV wells.  However according to an Acumen Capital report, the lower production rates can be attributed to a failure of the packer equipment during the frac operations, while the 100% WI well drilled to the south (08-23-062-10W5) was limited to 100bbl/d by the surface pumping equipment.  I’m not sure I understand that second one entirely, I mean why would the company install insufficient surface pumping, but nevertheless I hold out some hope that the going forward results for SCS will improve on these numbers.  Meanwhile SCS does not appear to be as encumbered with infrastructure requirements as Arcan is in the short term, so  capital is going to be spent drilling wells.

Unfortunately, as seems to happen from time to time, the practice account I post here had my SCS order rejected because of a lack of margin, something that clearly isn’t the case (I don’t think RBC spends much time updating and debugging the practice accounts functionality).   I am reluctant to try to re-buy the stock now after the pop so for the moment I will not have my SCS position reflected unless it falls back to the $2.45 range that I bought it at in my actual accounts.

Gold Stocks

I am not sure if it was a smart thing to do but I added positions in a couple of gold stocks this week.  These should not be considered long term positions; they are simply me trying to take advantage of what I see as the severe underperformance of the stocks when compared to the bullion.  I added a position in Semafo at $6.40.  Semafo is a mid-tier producer that has generally held up well in the market but that got taken down to new lows of late.  I also added a position in Canaco.  Canaco has had a rather spectacular decline from over $5 a share to a low of a $1.  That is where I bought it.  The company has what looks to be a decent deposit in Tanzania.  Moreover, at $1 they have a market capitalization of $200M and with cash on hand of $115M.

Portfolio

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Letter 24: Risk and Reward, Atna Analysis, More Community Banks

Last week I wrote that I did not understand why  the market was reacting as favourably as it was to the European proposals that came out of the Dec 9th summit.

A tweak here, a tweak there and pretty soon you have… well not a whole lot to be honest.

In a way I felt vindicated  by the market collapse that occurred in the early part of this week.  In another way I felt sick to my stomach, because though I have been creating an evermore conservative weighting to my portfolio, when the shit hits you still feel it.

Kyle Bass was on CNBC this week giving some more detail on his doomsday-like expectations:

The observation that deposits are leaving Greek banks at an annualized rate of almost 50% is somewhat frightening.  Clearly this crisis is going to come to a head soon.

John Mauldin publishes a great conversation between Charles Gave and Anatole Kaletsky.   It is quite provoking, and its hard to walk away after reading it without feeling the impending doom that awaits the Eurozone.  Kaletsky and Gave both make the quite reasonable point that perhaps Germany would prefer a break-up of the Eurozone.  If you watch what Germany is doing, and ignore the platitudes they are saying, you might question their motives.  Kaletsky points out that of the necessary measures to fix the Eurozone, Germany seems to be steadfastly opposed to both Eurobonds and to ECB intervention.  Absent those  measures, what hope does the Eurozone have?  Perhaps that is the plan all along.

Gold Stocks – I should went all out

Gold stocks got CREAMED this week.  I had been lightening up on my gold stocks the week before in anticipation that something might be about to hit.  I didn’t like the way gold was going, I didn’t like the fact that the WSJ was penning articles describing a dearth of Indian demand, and I didn’t like that Draghi talked tough during the EU summit, suggesting that money printing was still some time off.

Nevertheless being that I was not fully out of gold stocks, I got smacked about pretty good over the course of the week.   Atna, Aurizon, and with Lydian all performed quite miserably.

What’s Wrong with Aurizon?

Aurizon is a surprise to me.  I expected the stock to hold up better than it has been.  I might have expected its performance to be closer to that of Alamos.  Both are low cost producers.  Both are single mine operations.  Yet the valuation difference between the two is somewhat staggering.

I can only guess that there is a strong seller of Aurizon out there that wants to be out of the stock by year end.  I can only hope that the new year will bring some sanity to the stock.

While reviewing Aurizon, I began to wonder how much having a AMEX listing hurts the stock.  Anecdotally it appeared to me  that the Canadian stocks with AMEX listings are much more volatile then those without.  I decided to take a closer look.

I grabbed price data since August 1st for 9 stocks, 5 with AMEX listings and 4 without.  From the web I grabbed a visual basic function that calculates volatility based on the following Black-Scholes formula.

For purposes of Black-Scholes calculations, volatility is the standard deviation of the periodic percent change in prices, divided by the square root of time.  Volatility is emphatically NOT the same as “beta”, which measures the correlation of a security’s price movements with those of the overall market.  Neither is volatility simply a measure of the standard deviation of a security’s closing prices over time.

Here is the volatility of each security:

Is there a correlation?  Perhaps, though its not as clear a one as I had suspected.   The distinction is most clear between Aurizon, Alamos and Argonaut Gold.  There is no reason, in my opinion, that Aurizon is so much volatile than these other two stocks.  But apart from that, volatility seems similar between stocks on the two indexes.

I bought back some of the shares of Aurizon at $5.07 that I had sold at over $6 a few weeks ago.

The NPV of Atna

Another stock to get clobbered this week was Atna Resources.  I mentioned a couple weeks ago that I had finished an analyses of the company and would post shortly.  I never did that post, until now.

Below is the after tax NPV10 that I calculated for Atna at various gold prices.

I based my model on the following assumptions:

Briggs:

  • A 11year mine life, at 40,000 t/d
  • Total produced ounces of 476,000 oz over LOM
  • 0.017 oz/t resource over the mine life, strip ratio of 4 and with 80% recoveries
  • Resulting in gold production of  39,700 oz per year
  • Mining costs of $1.30/t mined, milling costs of $4/t milled and G&A costs of $1.7/t mined
  • Cash costs of $898/oz over LOM

Pinson:

  • A 15 year mine life, beginning at 350t/d and ramping to 750t/d by year 4.
  • Total produced ounces of 940,000 oz over LOM
  • 0.4 oz/t resource over the mine life, diluted by 30% with 90% recoveries, resulting in gold production beginning at 50,000 oz and ramping to 75,000 oz.
  • Mining costs of $110/t, milling costs of $50/t and G&A costs of $11/t
  • Cash costs of $687/oz over LOM

Reward:

  • A 8 year mine life, at 24,000 t/d
  • Total produced ounces of 292,000 oz over LOM
  • 0.026 oz/t resource over the mine life, strip ratio of 4 and with 80% recoveries
  • Resulting in gold production of  36,400 oz per year
  • Mining costs of $1.30/t mined, milling costs of $4/t milled and G&A costs of $1.14/t mined
  • Cash costs of $560/oz over LOM

Columbia and Cecil:

  • To the current resource of each I assigned a simple asset value per ounce of $40/oz measured and indicated and $20/oz inferred on the total resource of both properties

Atna is, in my opinion, is one of the best gold stock investments out there.  As demonstrated above, the stock is trading at about 1/3 of its NPV 10 at $1500 gold.  If I wanted to get more aggressive in my evaluation, I would note that many companies are moving to value feasibility on NPV5.  On an NPV 5 basis Atna is worth $3.86 per share at $1500/oz gold.  That number jumps to almost $8 per share at $2100/oz gold.  Clearly there is upside once the momentum begins to build.

I added to my position in Atna on Friday at 78 cents.

Taking Advantage of the Collapse

In addition to Atna and Aurizon, I also added new positions in a few juniors.  Call it the beginnings of a basket; I added a couple of non-producing juniors with deposits to my portfolio this week:

Geologix was recommended by Rick Rule as a takeover candidate on BNN about a year ago.  Since that time the stock has fallen significantly.  The company has a very low grade copper-gold deposit called Tepal in Mexico.  The PEA that was published on Tepal a few months ago put the NPV5 of the project at $412M based on $1000/oz gold and 2.75/lb copper.  Geologix has $14M of cash on hand.  With 145M shares outstanding, the market capitalization of the company was $28M at my entry price of 20 cents.  That puts half the market cap in cash and the other half in a project with an NPV that is nearly 10x the value of the company.  Something has to give here.

Esperanza Resources is another old Rick Rule recommendation.  Rule doesn’t talk much about specific stocks anymore, but there is some evidence that he is still interested in the company.  http://www.investmentu.com/2011/September/why-gold-mining-stocks-will-skyrocket.html .  The company certainly fits the bill of the sort of stock Rule likes.  Esperanza has 1Moz of gold in Mexico.   It’s a heap leach project so it should be able to be brought on production without a massive capital requirement (about $100M).  Like Geologix, the company has almost half its market cap ($100M) in cash on hand ($50M).

I plan to add more to both of these stocks in the coming weeks.

Regional Banks: A  Position in Community Bankers Trust

Community Bankers Trust (BTC) hit my bid when it sold off back down to a dollar this week.  BTC is trading at 27% of tangible book value.  This is, of course, partially because of the large number of non-performing loans on their books.  Non-performing loans make up 8.9% of total loans in the Q3 quarter.  This was down from 10.1% in Q2.  In fact, there are some encouraging signs that the worst of the loan losses are behind us.  The company has shown 3 quarters of lower loan amounts 30-89 days past due.  This trend is beginning to show up in the total non-performing loans, which decreased for the first time in a year in Q3.

Moreover, as I have pointed out previously, insiders continue to buy the stock.  Third quarter purchases by insiders were a little less than $50,000.

And Another Regional Bank Position in Atlantic Coast Financial

To be perfectly honest, I might have made a mistake here.  I’ve only put a very tiny amount of capital at risk, but even that may have been too much.   Atlantic Coast Financial (ACFC) is a lottery ticket.  I bought the stock at $1.70 on Friday.  There is just as much chance that it will go to zero as there is that it will double.

ACFC is a former Mutual Holding company that did their second step bank in February.  The second step added cash to the balance sheet and resulted in a bank trading well below book value.  ACFC trades at a rather crazy 10% of tangible book.  Clearly there is more to the story.

The more to the story is that the bank is centered in Jacksonville Florida.  They primarily make residential real estate loans.  Real estate in Jacksonville has not done particularly well over the last few years (though it appears to be bottoming).

The falling real estate prices have led to skyrocketing non-performing loans.  Those non-performing loans have not shown any sign of peaking yet (thus the possible mistake on my part).

The questions are, how many of these nonperforming loans will eventually be written down, and will there be value left in the equity once the non-performing loans are written down.

What drove me to take a small position in the stock was in part that an improving economy, and stabilizing home prices in Jacksonville, may mitigate further deterioration of the bank assets.  As well, the bank is generating decent earnings before provisions.  Ignoring provisions in Q3, the bank earned $1.16 per share.  In Q2 that number was $0.55.

What is going on at ACFC is something akin to a tug-of-war, whereby on the one hand loan losses strip away value every quarter, while on the other earnings power of the performing loans adds value back.  The share price is so low that it doesn’t take much a a shift in the dynamic between these two forces to change the value equation substantially.  Its easy to see how a stabilization in non-performing loans could quickly allow the earnings power to win the race and shareholder value to go up substantially.

The other factor in my decision to buy was the recent announcement that the company was looking into strategic alternatives.

On November 28, 2011, Atlantic Coast Financial Corporation issued a press release announcing that its Board of Directors has engaged Stifel, Nicolaus & Company, Incorporated to assist the Company in exploring strategic alternatives to enhance stockholder value

Part of the reason that the company is looking for options is that they are not in compliacne with the Individual Minimum Capital Requirement (IMCR) agreed to by the Bank with the Office of Thrift Supervision on May 13, 2011.  Under the IMCR, ACFC agreed to achieve Tier 1 leverage ratio of 7.0% as of September 30, 2011. Tier I capital at the bank is 6.22% right now.

It is a far from perfect scene.  Nevertheless, an improving US economy and stabilizing housing prices could give me a decent return on the stock.  The book value of $19 is unrealistic, a return to $3 is not.

Portfolio Composition

The Coastal Cash Generating Machine

I have perhaps underwritten about Coastal Energy given the size of the position I own in the stock.  That is mainly because the Coastal Energy Investors Village board provides such great information about the company.  It leaves me thinking – what is there left to say?

Nevertheless, sometimes it is worth reevaluating exactly what is fair value for a company, and that is what I want to try to do in this post.  For an oil company, the book fair value can be estimated based on reserves, based on a cash flow multiple or based on a more detailed discounted cash flow analysis.  The problem with all of these methods is that the lifeblood of any oil stock (not the company but the stock) is its potential to find more oil than what the market is currently willing to price in. Keep that in mind when looking at some of the valuation metrics below.  The value the market is willing to assign to Coastal is bound to vary significantly from these book estimates depending on the market expectations of what might be lying in wait to be found.  These days it also seems to depend on what happens to pop out of Sarkozy’s or Merkel’s mouth on any given day, but that’s another story.

Coastal is becoming a cash generating machine.

The chart below illustrates how up to this point Coastal, unlike so many of the domestic oil and gas juniors, is not running on a financing treadmill, but has been able to instead fully fund its operations from cash produced.

Its a little difficult to determine exactly when all the wells were drilled but based on the information provided in the MD&A I would estimate the following number of wells were drilled in the last 3 quarters.  This does not included recompletions.

Now in the first three quarters about $5M in total CAPEX per well drilled was spent, however I am not trying to contend that this is how much it will cost to drill wells going forward.   Some of those costs have been starting up the Bua Ban field (17 wells have been drilled at Bua Ban north in Q2 and Q3).  Vertical wells drilled into the Miocene cost $1.5-$2M.  The recent horizontal well that Coastal drilled (the Bua Ban North A-10) cost $3M.  The point here is that further development of the existing found fields should require capex that is less than it was last quarter ($45M).   Capex requirements in the $30M to $40M range going forward seems reasonable, absent another discovery that requires start-up capex but of course that would be a good thing in its own right.

Because of the significant growth occuring from the wells drilled at Bua Ban North, looking backwards to the historical cash flow of the company is of limited value.  What is required is a forward looking estimate of cash flow based on current and expected production.  Below I have estimated cash flow for 3 scenarios.  Current estimated production at the end of the 3rd quarter, plus two increased production scenarios.  Capex estimates for all of the scenarios are based on Coastal’s own estimate of $250M for 2012 ($62.5M per quarter).

The above assumes fully taxed cash flow for the entire estimate.  This is probably not exactly true.  Coastal is going to have to start paying more taxes at some point in 2012.  But  not right away.  When they do they will pay the following taxes:

  • Royalty that is prorated to the production level.  Coastal has said that at 20,000bbl/d offshore they expect a royalty payment of 10%
  • 50% income tax on profits.  Now this number is a bit misleading because according to Coastal’s explanation, the tax includes the deduction of all capital expenditures as they are incurred.  In their November presentation Coastal presented the following table of the effective tax rate at various oil prices, and 20,000bbl/d of offshore production:

One other thing to note about this table is that offshore EBITDAX of $596M at $100/bbl selling price implies a significant drop in operating costs.  I based my cash flow estimates on $29/bbl operating costs, which is consistent with the first 3 quarters.  For the same scenario (ie. $100/bbl oil and 20,000bbl/d of offshore production) my EBITDAX is significantly lower.  EBITDAX is basically the revenues after royalty, less the production expense and the cash G&A expense (it excludes stock option expense).  There isn’t that much to it.  The only way I can get the same EBITDAX as they have in the above table is if I drop operating expenses to about $10/bbl.

I also cannot get the tax numbers to quite line up the way Coastal has them stated in their presentation.  In the above snippit Coastal stated that the taxes are expressed as a percentage of EBITDAX.  I have to wonder if they didn’t mean revenue or revenue after royalty.

But even with my lower and perhaps more conservative estimate, Coastal is still generating a lot of cash.

Letter 23: Thinking it Through

Let’s Start with Europe (again)

The unfortunate reality of investing at the moment is that you cannot make a decision without first appraising the situation in Europe.  Correlations of most stocks, most asset classes, have gone to one.  The ability of the ECB to buy Italian debt, or the liquidity position of Societe Generale weighs as much on the price of Coastal Energy or Arcan Resources as does the success of their next well.

Its a bizarre new world.

This week Europe had their latest summit installment.  The response of the market to what transpired was confusing.  The market crashed mightily on Thursday, only to rally just as mightily on Friday.  Italian and Spanish bond yields spiked on Thursday but then dropped modestly on Friday.

Given the confusing signal sent by the market, I want to take a few minutes to step through what was agreed to at the ECB and among the EU members.  Hopefully we will be able to draw some useful conclusions as to what it means to the stocks we invest in.

The Fiddling of the ECB

A tweak here, a tweak there and pretty soon you have… well not a whole lot to be honest.  Let’s take a look at what the ECB did:

  • They lowered the rate for banks to borrow money from the ECB
  • They increased the types of collateral that banks can use to get liquidity from the ECB
  • They extended the period for banks to do long term borrowing from the ECB to 3 years and suggested they would facilitate such loans in unlimited amounts.

While these actions are somewhat helpful, what the ECB failed to do (at least directly) was to agree to buy significant quantities of government bonds.    This failure was likely responsible for the collapse in the market on Thursday.

Some have argued that the change in long term borrowing requirements will effectively let banks buy sovereign bonds on behalf of the ECB, effectively skirting the rules.  From the horse’s mouth:

There is no need to be a great specialist to understand that tomorrow, thanks to the central bank’s decision, the Italian state can ask Italian banks to finance part of its debt at rates which are undeniably lower than today’s market rates,” Sarkozy told reporters at a European Union summit on Dec. 9. “I take Italy but I could take the example of Spain. This means that each state can turn to its banks, which will have liquidity at their disposal.”

What Sarkozy is talking about is theoretically possible, however I am skeptical that it is going to be very meaningful in practice.  For one, the EU banks are already in the process of deleveraging.  By all accounts they are already too leveraged.  The process described by Sarkozy just adds more leverage.  For two, you have to think that the last kind of assets that the EU banks want more of are questionable sovereign bonds. Finally for three, if the banks decided to leverage up with even more sovereign debt all you’ve really done is doubled down on eventualy bailout that will be required when that sovereign debt goes bust.  You haven’t actually solved anything.

One of the last gasps of a Ponzi scheme is to use one investment vehicle to start purchasing the assets of another at an inflated price.  In other words, once you run out of outside suckers, you try your best to shuffle around the funds to appear solvent.  Needless to say this typically doesn’t last very long.

In all I don’t think that what the ECB did amounts to much more than a temporary blip of increased demand.  The problem of too much debt remains, liquidity to banks only helps solve the banks liquidity crisis, and the ECB still refuses to get its hands dirty by buying that debt in bulk.  However, if you want another opinion on this, on the bullish side, I think there was an excellent summary written by Savannahboy on Investors Village.

What did the EU do?

Describing what the EU did is trickier.  It is easy to get caught up in the market move upwards on Friday and assume that something significant must have happened at the meetings.  Well, I did a lot of reading and if something significant did happen, nobody told the journalists.  I suppose that the existing “plan of a plan” got tweaked and even pushed forward a couple of steps. Yet it  still remains a long way off from being a clear path to solvency.

A good Globe and Mail article by Eric Reguly reported the following summary of what was accomplished:

At least 23 of the 27 countries in the European Union – soon to be 28 with Croatia’s apparently suicidal desire to climb aboard the listing ship – agreed to a new, long-term fiscal pact designed to ensure that the euro never again gets hit with an existential crisis. (Britain isolated itself by refusing to join the deal, for fear that it would have to sacrifice the safeguards on its banking industry.)… On top of that agreement, the EU is strengthening its roster of financial stabilization tools. The EU will lend about €200-billion ($272-billion) to the International Monetary Fund, co-sponsor of the bailouts of Greece, Portugal and Ireland, to boost its firefighting capabilities. The European Stability Mechanism, the permanent bailout fund, is to launch next summer, a year earlier than originally planned, and its lending capacity is to be increased.

Reguly goes on to make what I think is the very valid point that all of these moves will do nothing to deal with the fact that the peripheral countries are not growing.

Look at Greece. Two years of austerity demanded by the EU and the ECB – read: Germany – with the IMF at their side have pushed the country to the verge of failed state status as economic activity vaporizes. The rest of the EU is slipping into recession.

With no growth, budget deficits everywhere refuse to disappear. Debt is going up. Perversely, the German-inspired response to the persistent deficits is demand for even deeper austerity. This is self-defeating, vicious-circle economics. At its worst, the lack of growth will erode the ability of the weakest countries to service their debts. Once investors figure that out, their sovereign bond yields will soar again, to the point their funding costs become unsustainable. Italy is getting close to that point.

This is key.  Markets are almost exclusively focused on what bandaid can be created to keep the banks from going belly-up next week. Perhaps the summit made some strides in this regard.  We should be able to make it through Christmas without anything catastrophic occuring.  But nothing that is being done about growth.

Jane Jacobs and the Feedback Nature of Currencies

The reality is that the fundamental problem in Europe is what brings it together in the first place: the existence of a single currency.  Italy, Greece, Spain, etc, cannot compete with Germany on a level playing field.  These countries need to have a way of leveling that reality out.  The primary (perhaps the only market based) mechanism for doing so is the relative value of the currency of each region.  If there is only one currency, there is no way to rebalance between the Eurozone countries.

This was the salient point made by Jane Jacobs years ago in her great book “Cities and the Wealth of Nations”.  In that book Jacobs begins with the basic premise that a currency is a feedback mechanism.  She goes on to argue that the problem with a country based currency is that it doesn’t allow for proper feedback of the individual cities that make up that country.   Cities within a country have a wide range of productive capacities.  What needs to occur in order to correct imbalances between cities is a readjustment of each city’s currency.

Jacobs provides a number of examples of how national or imperial currency regions usually results in one or two economically powerful cities, and a number of other dependent cities, usually requiring transfer payments of some sort to survive.

Speaking particularly of Europe she says (remember this was written in the early 1980’s):

In Italy, as time has passed since the unification of the country a century ago, the economics dominance of Milan has grown only more marked, not less so.  Even Rome itself has only a meager cioty region, vanishing a few miles south and east of the city where, immediately, the poor south of Italy begins.  In Germany before its postwar partition, Berlin had become ascendent…In France, only Paris has a significant city region now, unlike the country’s so-called eight great peripheral cities: Marseilles, Lyons, Strasbourg, Lilli, Rouen, Brest, Nantes, Bordeaux.

Outside of Europe she points to the example of Canada (Toronto and central Canada has typically grown briskly and propped up the weaker maritimes provinces), the  US (cities of the northeastern corridor typically being much stronger then those of the south), and Britian (where “the passage of time simply widened the economic gulf between [the rest of Britian] and London”) to name a few.

What Europe has embarked on with the Euro is the exact opposite of what is needed.  Currency regimes need to evolve to produce better feedback, not worse.  The Euro currency feedback mechanism is skewed by the strength of the German economy (actually more exactly the economy of its one or two prime export replacing cities, Berlin and Frankfurt).  Peripheral countries like Italy, Greece, Spain and Portugal are doomed to receive faulty feedback rather than the natural “export subsidy” that would occur if those countries had (lower value) currencies of their own.

US Housing Market

Getting away from Europe, I spent some time this weekend listening to an interesting debate at the AmeriCatalyst Housing conference.  I was introduced to this conference when I discovered some of the videos of Kyle Bass being interviewed at it.  As it turns out there is a lot of interesting stuff at the conference, not the least of which is the discussion below about the state of US housing.  This is a debate / information session put on by experts in the mortgage and housing industry.

Probably the most interesting aspect of the debate was with regard to shadow inventory.  I’ve never been totally clear on just what shadow inventory was, and it seemed to be a number that varied significantly depending on the conclusion the purveyor was trying to draw, so it was interesting to hear the comments of these experts on the concept.

The truth is that the magnitude of shadow inventory depends as much on the definition as anything.  A couple of different estimates of shadow inventory are made by different analysts.  Laurie Goodman (who I first learned of from ftAlphaville fame) pegged shadow inventory at 11M (which is an amazing 20% of housing mortgages outstanding).  Mark Fleming pegs it at 2M.  Both analyts are using the same data.

How is this possible?  Its all in the assumptions.  Shadow inventory is really just houses that are expected to go into default at some point.  There is nothing particularly nefarious about the concept, even though the name suggests it is some sort of inevitable flood of housing supply.  It may be, but it may not.  It depends on what happens.  Laurie, to come up with her 11M number, assumes a fairly large number of prime mortgage defaults, including some that are currently with LTV (loan to value) of less than 100%.   Laurie also looks at 60 day past due as her “bucket” from which to extrapolate current nonperforming loans.  Mark on the other hand, uses 90 day past due, and does not include currently performing prime mortgage defaults.

As Mark Fleming puts it, the true shadow inventory is “behaviorly perception driven”.  In other words, if the housing market begins to be viewed as bottoming, if the economy is perceived as improving, the impetus to default will be less and the shadow inventory will be on the lower end.  If the view is another lengthy recession, then expect a lot more inventory to come out of the shadows.

What it Means to the Portfolio: Lightening up on Gold

I sold out of Newmont Mining earlier this week, and I lightened up on my position in Aurizon Mining. I remain bullish of gold stocks, just not as bullish as I was.

I have been expecting that the European problems would precipitate ECB money printing.  I still believe this is going to happen, At some point that is; as I pointed out the structural flaw in the Euro currency union means that there simply is no way that Italy, Greece, Spain and Portugal (maybe even France) are going to grow themselves out of  their debt.

Nevertheless Draghi’s comments this week suggested that money printing may be a little further off into the future than I had hoped.  Without that, gold remains vulnerable to the headwind of its own price appreciation, and the damage that has done to jewelry sales.

The WSJ  had a good article on this:

India’s wedding-season gold demand has nearly disappeared as the yellow metal’s local prices have climbed to near-record levels because of a fall in the rupee’s value, sparking a rush to sell scrap during the usually peak buying period.

“There is virtually no demand for gold,” said Prithviraj Kothari, president of the Bombay Bullion Association.

I feel reasonably comfortable holding story stocks like Atna Resources and Lydian International (I also started a position in Esperenza Resources this week, though not in my online portfolio).  I feel less comfortable with Newmont, which is basically a play on the price of gold.  The same case can be made to a lessor extent with Aurizon Mines (though the reason to hold onto Aurizon is an eventual consolidation of the gold sector).

Buying the Banks

While I am reducing gold, I am buying back some of the regional bank holdings I sold off after beginning to be concerned about Europe.  The truth is, the regional banks have faired better than I would have expected during the past 6 months.  The recent bottoming of the ECRI weekly leading index, along with decent jobless claims data, suggests to me that the US economy does not have its bottom falling out.  I suspect that a muddle through for the US should be good enough to see decent price appreciation in some of these beaten up regionals.

Bank of Commerce Holdings

A bit of a punt here.

I was listening to BNN last week and I caught Contra The Herd’s Benj Gallander’s top picks.  One of them was Bank of Commerce Holding (BOCH on the Nasdaq).  I did some work this week on the company and it looked cheap (less than 10x earnings, trading at about 50% of tangible book), it had a reasonable level of nonperforming loans (3.3%), and it has the potential for better earnings in the future once it works its way through its loan loss write-downs. So I bought some.

The worry about this regional bank is its region.

The Company conducts general commercial banking business in the counties of El Dorado, Placer, Shasta, Tehama and Sacramento, California.

This is not-exactly-but-close-enough-to the inland empire that didn’t fare so well during the housing bust:

Given the circumstances, the company has done an admirable job of keeping their loan book clean thus far:

  • Nonperforming loans to total loans 3.33 %
  • Nonperforming assets to total assets 2.30%

As well ROE has been decent, particularly if you consider that the number includes the provisions to losses the company has taken:

Return on average assets (ROA) and return on average equity (ROE) for the three months ended September 30, 2011, was 0.91% and 7.45%, respectively, compared with 0.67% and 5.95%, respectively, for the three months ended September 30, 2010. ROA and ROE for the nine months ended September 30, 2011, was 0.75% and 6.45%, respectively, compared with 0.70% and 6.61%, respectively, for the nine months ended September 30, 2010.

I estimate that if you looked at ROE ex-provisions, the number would be very close to 10%.

Bids in for Oneida Financial (ONFC) and Community Bankers Trust (BTC)

While I managed to pick up a position in BOCH quite quickly, I have bids in for, but so far haven’t been able to purchase, too many shares of ONFC and BTC.  Rest assured I will wait patiently until I do.  Both of these banks represent good value, and unlike BOCH they are both in areas with stable economies and housing (Virginia for BTC, Central NY for ONFC).

In the case of Community Bankers Trust, the 3rd quarter brought the first profitable quarter in quite a while.  It also showed a continuation of the trend towards less charge-offs.

BTC trades at less than a third of tangible book value ($3.67) at this point.  Meanwhile, insiders continue to buy shares.

Oneida Financial is a NY based bank with stellar loan performance (well under 1% nonperforming assets to total assets), strong earnings performance (should earn in the neighbourhood of $0.80 this year), and is trading slightly under tangible book value of $9.10.

I am particularly impressed with Oneida’s consistency of earnings throughout this tumultuous period.

Oneida also pays a dividend of 5%.

Portfolio Composition

Week 22: Still Partial to Cash

(see end of post for current portfolio composition)

When you are 57% cash, its difficult to outperform the market to the upside.

That is exactly what happened this week.  The TSX was up 5%, the S&P up 6%, the Venture up 3.3%, and my portfolio was up a lowly 2.9%.  Having as much cash as I do certainly has protected me against the downward trend over the last 4 months, but it will also prevent my portfolio from having outsized gains if we have a significant rally.

I Remain Wary of Europe

I am, however, in no mood to change my tact.  Though I admit that the developments this week were constructive, and they could very well lead to a continuation of the market rally.  In the short term, the dollar liquidity provided by the central banks will allow the European banks to fund themselves for a while longer. Probably more important, Mario Draghi’s statement below, clipped from this WSJ blog post, sets the stage for rate cuts and at least raises the possibility of a QE of sorts out of Europe

Yesterday, Mr. Draghi made a statement that we find tectonic-plating-shifting-like in nature when he said firstly that the “Downside risks to the economic outlook have increased.” They have indeed, and we’ve no problem with what he said for that is indeed the truth. Then, however, the plates shifted when he said, noting that the ECB’s mandate, that price stability is to be maintained “in both directions.” In other words, the ECB’s mandate forces the authorities to be concerned about deflationary risks as well as those inflationary. Did you hear the plates shifting? You should have for they have indeed shifted. Draghi’s warning was that the authorities are just as concerned about deflation as inflation and that monetary expansion is to be considered just as has monetary contraction.

Yet if anything I am less inclined to add to investments.  I am more convinced that the outcome is Europe is close at hand, and the while a positive resolution (assuming there is such a thing) would lead to a continuation in the move to the upside, the risk still remains that the resolution won’t be positive.  I am sure in such a case everything (save the USD and treasuries) will go down.

Bass Talks Again at AmeriCatalyst Conference

Case and point is Kyle Bass, who in my opinion has the clearest explanation of the problems in Europe.  He was again at the AmeriCatalyst conference this year, and a few days ago the segment was postedto youtube.

One of the interesting points that Bass makes is that while Greece bonds are trading at astronomical interest rates, the actual rate of interest the Greeks pay is a little more than 4%.  At thta interest rate, interest payments in Greece are 16% of government revenues.  This was basically the tipping point of no return for the country.

It reminded me of something I wrote in my analysis of Italy a few weeks ago:

According to Italy’s Ministry of Economy and Finance, Italy’s outstanding debt is around E1.85B or USD$2.5t (2010 figure but Italy is close to a balanced budget so its probably nearly the same this year).  Government revenues in 2010 were E729B or  USD$950B.  To do a little simple math then, every increase in the Italian rate of borrowing of 1% results in an eventual increase in borrowing costs for Italy of about $25B, or about 2.5% of government revenues.

In 2010 Italy paid E80B in interest expenditures. So right now the average interest rate that Italy is paying is about 4.3%.  A 1% rise therefore raises the average interest rate to 5.3%…Once the market starts to determine that you are on a road to insolvency, its pretty easy to get pushed on the fast track.  In the case of Italy, 6% is starting to get closer to 7% every day.  If yields rose 3-4%, then Italy would begin to have a problem with the interest that had to pay on their debt.

The problem that I alluded to above is that when you have as much debt as Italy has (or for that matter Greece or Portugal or Japan or even the United States has), your ability to pay that debt is as much determined by the market’s perception of how able you are to pay your debt as it is of anything.

I also noted that “if yields rose 3-4%, then Italy would begin to have a problem with the interest that they had to pay on their debt”.  Well here we are.  Right now Italy has interest payment that are a little under 11% of government revenues.  At 8% interest rates, Italy would eventually soar past Greece’s paltry 16% of revenues on a path that would eventually lead them above 20% of revenues.  Hmmm….

Is the Gold There?

Another very interesting clip from the interview occurs at the 42 minute mark.  If you don’t listen to any other part of the interview, I would beg you to listen to this.   Bass gets asked why he decided to take delivery of the gold futures he held on the Comex.  He explains how he looked into the situation at the Comex.  Turns out they had $80B of open interest and $2.7B of deliverables.   This seemed to him to be slightly underfunded.   He went to the head of delivery’s at the Comex and asks what they would do if suddenly everybody (or at least 4% of contract holders) wanted to take delivery.  The response he gets is A. “Oh Kyle that never happens, we rarely get 1% of contracts taking delivery”, and B. price would fix the problem.

In other words: there is no plan for what to do if everyone wants to take delivery.

This is one of those situations that isn’t  a problem until it is a problem and so far it isn’t a problem.  But when it becomes a problem, and when Comex or whatever clearinghouse that has teh problem has to pony up more gold then it has, well that is the definition of a squeeze.  But maybe this never happens.    If it does happen, price is going to do something, and that is go straight up.

The Best Bargain Among the Gold Stocks

I have been working through an analysis of Atna and while I am not quite ready to post that analysis, I am ready to say that I believe Atna is the best way of playing a bet on sustainable gold prices at $1500/oz or higher.  As I have dug deeper into the company I have been surprised with just how many assets they have.  In addition to a producing mine (Briggs) and a low capital cost, high grade development (Pinson), they have over 1Moz of gold in Montana (Columbia), 300Koz of oxidized resource and based on recent drill results more to come at Reward, and another 150Koz of oxidized resource a few miles away from Briggs at Cecil.   And those are just the properties with a known resource.  In addition they have a score of properties with exploration potential, including a few that are signed off as JV’s to be drilled using other people’s money.

In the analysis I will post later I will get deeper in the net asset value of the company, but for now consider the following table. With Atna, for a price of about $100M enterprise value, you are getting around 5Moz of total resource, of which the majority is either very high grade (Pinson) or has open pit heap leaching potential (Briggs, Reward, Cecil).  All to be had for $20/oz.

I plan to increase my position in Atna even further.  I could forsee a time when it is primary vehicle for investing in gold.

Portfolio Changes

As I posted earlier this week, I’ve reduced down my position in Arcan Resouces substantially.  I now basically have equivalent positions in 3 domestic oil producing juniors, Arcan, Reliable Energy, and Equal Energy.  Consider this to be my oil junior basket.  I own much more of Coastal Energy.  I have no plans to reduce my position there.  Coastal remains the single best oil investment out there in my opinion.  They are self-funding, are increasing their reserves with every well, and trade reasonably at $98,000 per flowing boe, and far below their NAV (the NPV10 as per the 2011 reserve report was $10.42 per share, since that time they have increased proved and probable reserves from 25mmbbl to over 90mmbbl.

Portfolio