Successful Investors

"Successful investors tend to be unemotional, allowing the greed and fear of others to play into their hands. By having confidence in their own analysis and judgment, they respond to market forces not with blind emotion but with calculated reason. Successful investors, for example, demonstrate caution in frothy markets and steadfast conviction in panicky ones. Indeed, the very way an investor views the market and its price fluctuations is a key factor in his or her ultimate investment success or failure"

Seth A. Klarman, Margin of Safety

Having cursed myself with last weeks post regarding the inability to find any value:
1). I can’t find any value in the marketplace. Businesses are selling at a price that does not meet my required margin of safety.

This week was an answer to my call and for that reason alone I made a few purchases. However, they were not purchases in any conventional sectors or industries in the marketplace, but rather in commodities. It was an easy purchase for the most part and I look for continued weakness to purchase more. The commodity in question is U3O8 (uranium) and the purchases of businesses were Uranium One (sxr.to) and Denison Mines (dml.to or dnn).

I believe both businesses allow for a high margin of safety, growth in profitability, a solid underlying commodity, and one even has a moat! When I scan for value, I don't try to anchor myself to the "likely" candidates of Sir Buffett or some of the other famed value investors, I stick to what I know. In fact, some would agree that Sir Buffett is one of the greatest commodity investors of all time based on his description of the insurance business. Insurance is unlike a Hershey chocolate bar where a customer tells his (in)significant other "I want to purchase Mercury insurance as opposed to White Mountains" because insurance is purchased based on price. So... Sir Buffett's insurance operation is a perfect example of a commodity business.

Furthermore, Sir Buffett's recent purchases have a commodity theme , think Posco, Burlington Northern, Conoco Phillips, PetroChina. One of my pet-peeves is when I hear or read that he doesn't invest in commodities. I would be remiss if I didn't mention his purchase and subsequent selling of 129.7 ounces of Silver in 1998. Meaning, any value investor can invest in a business with a solid underlying commodity provided it allows for a high margin of safety.

Next week will be dedicated to gold, but this week Uranium is the order of the day. Uranium the commodity has increased from $7 in 2002 to $133 in June, and now at $110, a decrease of around 17%. Uranium businesses have fallen by an average of 40-45%. Uranium has two prices, the short-term (spot) and the long-term, while the short term has fallen, the long-term has stayed at $95. One other note, at the beginning of the year, Uranium spot was at $70.

This is an industry that has had little to no investment in assets or people (skills) for over 25 years. Most of the reserves are in very politically safe, stable countries, they include Canada and Australia. Moreover, there are 435 reactors in over 30 countries with a demand of 173 million pounds of uranium. There are also 28 nuclear reactors under construction that will be operable while another 64 reactors are planned for future generation of electricity. Because nuclear reactors are very environmentally friendly and offer a very low cost alternative for many undeveloped parts of the world there will be demand. So, we know the demand side of the equation, unfortunately the supply side is a little tricky.

Uranium production has been lower than demand and much of the additional supply to reach an equilibrium has included recycled uranium and surplus inventories. Highly Enriched Uranium ("HEU"), the source for weapons has been another major source (Russia, Component 1). Additionally, Cigar Lake, the prized asset of Cameco has been beleaguered by excess flooding, to the point where the mine was originally set to come online at the back-half of this decade ('08) has been delayed to ('09) and now ('11, Component 2)

Component 1, I believe that Putin, once his position as the president of Russia is over will set up a position as Energy Minister for himself to take advantage of great assets. Russia has made their intentions clear that post 2013, they will use remaining stockpiles for their own use (read: strategic source for China). Naming Russia as one of your main suppliers is the equivalent of picking a homeless guy off the street and asking him to help you out to pay your debt. The debt being your demand for uranium.

"How do we know this is not Palladium?" -asks a Ford stockholder

About two years ago I successfully invested in a palladium company because of their supply/demand issues. Coincidentally, at one time the commodity was trading at very cheap prices and then there was a run-up because Russia (50% of supply) decided to delay and disrupt production. Palladium is used in catalytic converters to reduce smog. The commodity goes crazy, rising from a low of $150 to $1,100 in a '79 like supply shock oil manner. Because all the major car companies used the metal for smog devices, Ford Motor Company in an act of desperation purchased future contracts at $1,100 and subsequently lost over 1 Billion dollars (B with 9 Zero's). Uranium is not palladium because demand has been rising with new nuclear reactors in construction. But most importantly, because Russia doesn't control the majority of production, Canada and Australia do. Here is the list of the top Suppliers:

Canada (27.9% of world production)
Australia (22.8%) being the largest producers
Kazakhstan (10.5%)
Russia (8.0%)
Namibia (7.5%)
Niger (7.4%)
Uzbekistan (5.5%)
United States (2.5%)
Ukraine (1.9%)
China (1.7%)

(Notice how the top to main producers represent a little over 50% of production)

France produces around 80% of their energy source from Nuclear energy, but they are not a producer, and neither is India who has embraced this source of energy. Meaning, demand is there!

Component 2, Cigar Lake has been a disaster and for good reason, mother nature. This disaster will delay production and if it is worse, we may be without a huge source of supply. Wouldn't that mean that Cameco's pain is another companies pleasure? The reduced supply would encourage more producers to increase production to realize higher prices, basic law of supply and demand. I will quote a little from the July, 30 Cameco conference call:

"Cameco operates in an industry that requires a long-term perspective, built from a position of strength...while the uranium spot market is showing weakness during a thinly traded summer, the long-term market fundamentals remain solid, driven by an industry with increasingly bright prospects...last week's decline was aggravated by the down draft of the general market, the strengthening Canadian dollar, and the drop in the uranium spot price...the industry average spot price at quarter end was 135.5, which was up more than 40% from the $95 at the end of the first quarter, and almost triple from a year ago, at which time it was just under $46. This dramatic increase was driven by relatively small spot volumes often sold by auction...we are into the summer months, which is typically a period of weaker demand...there is presently more supply than demand in the spot market...it is not expected that 2007 spot volumes will be more in the 20 million pound range, considerably less than the 33 million pounds transacted in the spot market last year...longer term, nothing has changed in respect to the underlying fundamentals of the uranium market...It is also important to keep in mind that the market continues to be heavily reliant on several large sources of supply and if things do not unfold as presently forecast, then we could see some very large swings in price!"

Spot vs. Long Term

The long term price is at $95, an increase of 12% from the first quarter and double the price from last year. Cameco stated "Historically, long-term prices have been at a $1 to $2 premium over the spot price...largely due in large part to the buyer's willingness to pay a slightly higher price in order to lock in a future price at a time where there was no concern about future supplies. The future supplies were assumed to be a given. The rapid increase in the spot price fueled by auctions resulted in the spot price exceeding the term price by about $40."

The increase of spot over long term was unrealistic and somewhat of an anomaly. Most producers have a choice of selling a spot or long term. Usually, if you sell uranium at long-term price, you sell at 95% of the long term price. However, spot prices could come down and because I don't predict market direction if it comes down, producers will simply sell at long-term price. In which case, they would still realize amazing profits. The worlds operating reactors demand 173 million pounds per year, this figure does not include the 28 under construction or the 64 planned.

Production figures:
2004- 104.6 pounds
2005- 108.1 pounds
2006- 104 pounds
average (105.5, a deficit of over 60 million pounds)

The top two main country suppliers represent over 50% of production, but according to the Denison annual report, "Seven companies accounted for over 78% of primary production, while the six largest uranium mines produced over 58% of the aggregate global production." This is a mini-OPEC with a deficit of supply/demand, short-term gyration in spot prices don't/shouldn't represent a scare.

Denison expanded in their annual report on the spot vs. long-term price:
"The spot market is the market for uranium purchased for delivery within one year. Over the period from 1996 through 2004, annual spot demand averaged just under 20 million pounds UsO8 or about 12% of the annual world consumption, but has jumped to about 35 million pounds over the last two years as utility inventories commence to be rebuilt and investors and hedge funds have entered the market as significant buyers. The remaining component of the supply is the term market where uranium is bought and sold under multi-year agreements between nuclear utilities and uranium producers/suppliers. By way of definition, the long-term uranium price reflects the initial base price under a newly-negotiated multi-year uranium agreement with deliveries commencing 12-24 months in the future and extending for 3-4 years thereafter."

"The sale of Denison's uranium has traditionally been through long-term contracts and not on the spot market, [because] prices in the long-term market have normally been higher than those in the spot market at the time the contracts are entered into and are normally less volatile. However, when market prices are increasing rapidly, as has been the case over the last several years, prices received under the legacy contracts cannot match such increase. As a consequence, prices are being renogotiated based on market related pricing formulas, or the legacy contracts are being allowed to expire in accordance with their terms so that uranium can be sold on the spot market or at prices related to the spot price."

I didn't intend to write this much on the fundamentals of uranium, instead I wanted to focus on the two companies I have been purchasing the past two weeks. However, it serves a purpose, tomorrow there will be part two, expanding on the fundamentals and diversification of the two companies.

Conclusion for today: for businesses with the underlying commodity of uranium as their core source of revenue, it doesn't make sense to lose an average of 40% value when the spot price of uranium is only down 17%, but most importantly when Long-term pricing of uranium is your selling point (price). Long-term pricing has not moved lower; in fact, I wouldn't be surprised if spot prices move lower than long term pricing by a difference of $1 or $2 based on historical pricing. The parabolic move in spot could be as Denison pointed out, hedge-fund buying. Knowing that hedge-funds are momentum players and that energy companies would have been Ford-like to purchase all of their need future supplies on the spot is more proof that there is value in this area. One other reason to believe that hedge funds would be sellers now as opposed to buyers are the enormous holding cost of uranium compounded by no leverage in holding uranium (the commodity). That is why, some uranium businesses are down by an average of 40%, commodities as a whole are still treated as an asset-class for the purpose of diversification. When the market falls, portfolio strategist from the majors and TV pundits pound the table and demand that you "sell your risky assets."

While there is selling, and it may continue for weeks to come, I will be a buyer, opportunistic and aggressive. These purchases offer a high margin of safety and I have great confidence in my analysis and judgment. For the same illiquid reasons that I purchased deep out-of-the-money puts on the XLF expiring in '09, this is a sensible move for me.

Thank you,

S.K.

Financial Engineering

‘Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.’ Buffett '91

A rare occurrence indeed, posting two consecutive weeks in a row and hopefully more to come if time permits. This week the subject will be the unproductive and ineffective type of engineering: financial engineering. The engineering field is very respectable and is efficient in that there is a purpose and a finished product. Often there are issues with the finished product, but most importantly, they come with time. For example, this past week’s tragic collapse of a bridge in Minnesota was a long time in the making. However, because it happened, bridges all over the country will be inspected and engineers will make adjustments to ensure more durable bridges.

Business is about profitable growth, not growth in size (market cap) and the eventual creation of value (for shareholders). Do not be fooled by the voices in the media that tout the record earnings growth because they are a little mythical. First, much of the business world believes that earnings per share (“EPS”) are the most important number to judge a company by. Moreover, Wall Street wants predictable earnings from the many companies that report on a quarterly basis. Thus, the creation of value is given 3 months to blossom! Furthermore, most of the upper management of companies manage earnings as opposed to managing the company.

Second, the fall of the Dollar has allowed many multinational companies that do most of their business outside of the States to record amazing growth in profit. It has certainly been a great currency arbitrage for multinational companies, but it is not their fault, rather it is another smoking sign. A basic example would include a company reporting a 7% increase in net profits for the year, but if the dollar has fallen 8%, profits actually contracted.

So what happened is that most CEO's, CFO's turned to a new field by becoming financial engineers. The end result was to grow EPS at reasonable rate (determined by analysts) to make sure that their stocks didn't plummet. Every quarter, all the analysts estimate of EPS for the next quarter are averaged and that is the "number" that management has to make. Creative accounting is only one of the many tools used. An example includes the case of Cisco, a BW article in 2002 (here) talked about the hype. Here is an excerpt:

"That night, at the company's main San Jose warehouse, employees scrambled to load as many boxed-up machines onto trucks as possible, thus enabling them to be counted as "sold" for accounting purposes before the quarter ran out at midnight. "We had guys running with parts, trying to run them up to the trucks," recalls Larry R. Carter, chief financial officer, who monitored the action from a computer terminal in the warehouse that tallied shipments in real time. One harried staffer, in his haste, fell headlong to the concrete floor in front of Carter. Ten minutes before midnight, Chambers called Carter's cell phone from Davos, Switzerland, where he was speaking at an economic summit. "Did we make it?" Chambers asked. After a few more minutes of watching the numbers come in, Carter had to pass along the bad news: Cisco would undershoot expectations by a penny per share, its first Wall Street miss in 11 years."

"Did we make it?" And so it goes, but make no mistake, every 4 or 5 years a new way of "making it" comes around and exposes the destruction of value. I personally believe that for the past three years the way to "make it" was buybacks. Simply put, net earnings rose at a slower pace than earnings per share and it was an act that was rewarded by Wall Street analysts and media. The upper management figured that by buying shares of their own stock (put in treasury) earnings would increase; it was not organic growth by any means. In fact, the popular saying was that companies were participating in equity arbitrage, the act of dividing the E (earnings) by the P (price) and if the rate was higher than the 10 year treasury, to borrow (debt) and buyback shares of their own stock. Because you can right off the interest of the debt payments, you were rewarded for adding leverage.

"I’ve seen more people fail because of liquor and leverage- leverage being borrowed money. Donald Trump failed because of leverage. He simply got infatuated with how much money he could borrow, and he did not give enough thought to how much money he could pay back." Buffett

The innocent companies were penalized, if they had a solid balance sheet with little to no debt, a corporate raider would buy a small percentage of your company and order you to take on more debt and to use the proceeds by purchasing stock. Furthermore, because corporations are driven by net returns on capital after taxes, the tax write off of interest payments masked the EPS growth. That my friend is how and where the majority of earnings growth was made over the past few years.

Jeremy Grantham of GMO stated, “Corporate tax has always been a tax on efficiency- be less efficient, make less money, and you’ll pay less tax. The more reckless you are, the more you borrow, and the more interest you deduct, the less tax you pay.” It is the equivalent of driving with your seatbelt on and a cop stops you because you are too careful. So you get a ticket and because you obey the law you refuse to put your seatbelt on. The next time you are driving (w/o a seatbelt) the same cop stops you and asks why you have your open while you are driving, so he gives you an eye-patch to cover one of your eyes. This is not an exaggeration by any means, it was the rule in Wall Street until recently when Credit Spreads widened making buybacks too expensive because of a higher cost of capital (“COC”).

Now, I don't want to be misunderstood, there were and are many companies that purchased back their own stock at a discount, and that will create enormous shareholder value. Wally Weitz, fund manager of the Weitz fund in his latest quarterly letter stated, “Generally good ideas are taken too far.” True, he was talking about the idea of mortgage backed securities, but the statement has value.

Earlier this week, Procter and Gamble (“PG”) stated their plan to buy back up to $30 billion of its shares. For a company as safe and sound as PG, I think this will benefit shareholders a great deal. The company is always evolving and has great management that actually manages the company as opposed to managing the earnings.

Today’s post is more of a value-investing type of message than the previous one(s). This will be the order of the day for a while for three reasons:

1). I can’t find any value in the marketplace. Businesses are selling at a price that does not meet my required margin of safety.

2). I want this blog to have some value based on personal ideas/beliefs in order to create a personality towards businesses that we look at in the future. For example, most readers automatically know my views on the economic numbers because of this post.

3). I am still learning, although my un-audited returns for the past three years are above market returns, I want to learn as much as possible. The early posts are the foundation of a young investor’s beliefs and education.

Thank you,

S.K.