Activity during the first quarter was relatively muted with no new purchases or sales. The current market environment – characterized as drifting slowly higher and lacking much volatility – affords limited investment opportunity for opportunistic, value-oriented investors. As we will discuss in more detail below, the ability to deploy large amounts of capital today at reasonable prices is few and far between.
One area of the market which continues to offer significant value, due to overwhelmingly negative sentiment, is energy. We discussed our investment thesis at length in last quarter’s letter: reiterating our belief that $50 oil is uneconomic for most drillers and will result in significant production declines, particularly in the U.S. We wanted to share with you several recent data points which are extremely noteworthy and support our thesis, yet are mostly ignored by the mainstream business press (i.e. you won’t read about it in the Wall Street Journal).
First, monthly production in two of the most prolific tight-oil shale plays in the U.S. – the Bakken Shale in North Dakota and the Eagle Ford Shale in South Texas – experienced declines in production over the past two months. These two regions alone represent 30% of total current U.S. oil production and accounted for over 50% of the increase in U.S. production during the past two years. And second, it’s only a matter of months before the largest shale play in the U.S., the Permian Basin in South Texas, also starts to decline (it’s projected to register a meager ½% increase in production in April).
The rate of decline is occurring faster than even we anticipated, a result of precipitous reductions in active drilling rigs coupled with unprecedented decline curves from existing wells. While we expect the recovery to be uneven and somewhat volatile, we are encouraged to see the necessary fundamental changes required for higher prices starting to take hold. We continue to own three core energy investments – Chesapeake, Denbury, and Transocean – which are significantly undervalued and collectively represent 15% of the portfolio’s weighting.
Investing in a Zero-Bound World
If long-term investment success requires some context of valuation, then the single greatest challenge facing investors today is navigating the world of zero-bound interest rates. While predicting rates in the short-term is impossible and mostly irrelevant, the same cannot be said for rates over the long-term. Almost every single long-term investment decision implies some expectation for the risk-free rate in the future and, consequently, the price you are willing to pay for an asset.
In the past, we dedicated little energy in our research process to interest rates. As bottom-up, fundamentally driven value investors we assumed that the long-term risk free rate would approximate its historic average – around 5%. This seemed reasonable and worked well for the past 13 years. Now, with the 10-year U.S. treasury below 2% and many developed economies in Europe witnessing negative long-term rates, it’s sensible to step back and re-assess what was once a relatively simple concept.
More troublesome, is that the current rate environment is the product of artificial central bank policy – there is little doubt that rates would be higher if left to market forces alone. This is causing distortions that are troubling at best, and utterly contrary to human logic at worst. Several data points stand out as glaring examples and should be viewed with deep concern and skepticism.
According to an article published in the Wall Street Journal on April 19th, the average multiple buyers are paying to acquire firms in the U.S. so far in 2015 is 16.5x EBITDA (earnings before interest, taxes, depreciation and amortization). This compares to 13.3x in 2014 and represents the highest level since the figure was first tracked in 1995. Keeping in mind that interest, taxes and depreciation are real costs implies buyers are willing to pay well north of 20x free cash flow. While it’s impossible to verify, the only reasonable explanation CEOs and Boards can justify such a rich price is based on incredibly low financing rates and a belief that rates will stay low for a long period of time.
Even stranger is the case of Spanish bank, Bankinter, which has recently been forced to rebate homeowners with variable-rate mortgages tied to the Swiss franc Libor. As this rate recently turned negative, the bank was forced to reduce outstanding principal balances owed by borrowers. Imagine purchasing a home with a mortgage and the bank pays you for this privilege – these types of illogical distortions are taking place in a negative interest rate world. The famous Greek philosopher Aesop must be turning in his grave, because it now appears that two birds in the hand are worth one in the bush, and not the other way around.
Finally, we recently received a call from one of our brokers, Goldman Sachs, informing us that any future cash balances held at Goldman will be charged 50 basis points (perhaps we shouldn’t complain about 0% interest rates). In the great upside-down world of Alice in Wonderland we now inhabit, it’s more financially lucrative to stuff money under the mattress.
The reaction to the silliness described above requires a heavy dose of investor caution and reminds us of the following astute observation made by Warren Buffett: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.”
The long-term unintended consequences of zero-bound interest rate policy are unknowable and vast; yet, we can venture a few educated guesses: potential asset inflation (especially for income-yielding products), excessive leverage which is manageable only in a low-rate structure, and misallocation of capital based on a future that will look exactly like it does today.
Disciplined value investors are confronted with a fork in the road: assume that zero-bound rates are the new normal and “pay-up” for investments, or assume that at some point rates rise to a level in-line with historical averages and remain disciplined.
Nothing is more critical today than deciding which road to take. The same company, producing the same profits, will be valued at two vastly different prices depending on whether the long-term risk-free interest rate is 2% or 5%. Based on the elevated valuations currently bestowed on almost all asset classes (including private companies and real estate), investors are increasingly willing to assume zero-bound interest rates are here to stay, whether or not they are conscious of this decision.
For those of you familiar with our investment philosophy and often-contrarian viewpoint, it will come as no surprise that we are reluctant to follow the crowd. Our first duty in managing your capital is to preserve your capital, even if the result is foregone profits in the short-term. Instead, we choose to take the road that is less risky; which, in this instance, assumes that long-term interest rates will once again rise to a more normal level (and, perhaps, the possibility that future rates could be significantly above normal).
The practical implication is that we continue to value existing and potential investments with a discount rate that is similar to the one we have always used, with an average of 9-10%. It also means that for companies that utilize debt on their balance sheet we assume that their current cost of capital will inevitably rise over time. Both of these assumptions limit the price we are willing to pay and, in many cases, compel us to pass on new purchases. Nevertheless, we continue our pursuit of investments that qualify on both fundamental and valuation criteria, and wait patiently to deploy our capital when the price is right.