My mom believes I was born worried. I believe I'm just cautious, and life made me so. Whether nature or nurture, I'm worried, as usual.
Professionally, I worry most about large downside risks and potentially high stock and bond prices. I believe there remain more things to worry about than normal, while viewing the prices of stocks as at least a bit high and the prices of many bonds as sky high.
Below I will discuss what worries us most; compare the levels of worry in government bonds, the “VIX”, Germany, and Oklahoma City; and offer means by which current worries can be mitigated.
Worries – Six Big Ones
Our six biggest worries today are the following:
1) Europe still carries tremendous risks, even in supposed havens such as Germany;
2) Japan's current lack of growth, miserable demographic profile, and massive debt load creates huge interest-rate risk and/or currency risk;
3) China's 2012 (government-stated) GDP growth is decelerating and will even fall short of the rate experienced in the 2008-2009 crisis period;
4) China's economic allies – particularly commodity-driven partners like Australia, Canada, and Brazil – are likely to see their economic growth correlate with the near-term Chinese slowdown;
5) Iran's nuclear program might be dealt with at anytime, creating huge tension in the Middle East and risking an energy-price spike; and
6) Here in the U.S., we have historically high income inequality; an over-leveraged (i.e., overly indebted) and under-saved consumer; an over-leveraged federal government; over-leveraged state and local governments; frighteningly under-funded Social Security, Medicare, Medicaid, and pension programs; record-high corporate profit margins (this is more bad than good, in my opinion); forthcoming tax-rate increases; and forthcoming government-spending decreases.
In my opinion, the six points are real concerns, even for investors not overly prone to worrying.
Worries – Reflected in Government Bond Yields, Not Fully Reflected in Potential Hedges
Of course, investors less worrisome than me are concerned. For example, five-year government bond yields hover just above zero in much of the developed world: 0.56% in the U.S., 0.48% in the U.K., 0.29% in Germany, 0.01% in Switzerland, and 0.19% in Japan. Investors have flocked to these bonds and bid up their prices, in search of safety. Even more stunningly, both Germany and Switzerland have seen their two-year bonds reach negative yields in recent months. That is, you pay them for lending them money. It would be like paying a historically trustworthy friend to live in a rental apartment you own, because a lesser-known but rent-paying guest might just wreck the place. These low and negative rates indicate the extreme degree of fear present in the markets. People are buying "high-quality" government bonds with little to no yield, despite warnings about debt levels even in these "safer" countries.
Strangely, and on the other hand, one particular metric indicates an absence of worry. The VIX (graph below), often called "The Fear Index", measures the expected volatility (i.e., the magnitude and frequency of ups and downs) of the S&P 500 over the next month. The VIX now sits at 16 – its lowest level since the beginning of the crisis in 2007, and even below its 22-year average of over 20. It is also far off its all-time high of over 80 in 2009, and well below the 52-week high of 43, which was reached twice last year when concerns spiked about the European situation and the U.S. debt-ceiling. But isn't it strange that the VIX indicates low levels of expected volatility, given our six big worries and given the safety-driven low bond yields in the highest-quality countries in the world?
Maybe the low level of the VIX indicates that investors are beginning to view large, high-quality corporations as even safer than the safest of countries. It could be that investors believe the above-average profit margins of large corporations are sustainably high. It could be that investors are comforted by the strong balance sheets of most large corporations. It could be that investors, like me, prefer stocks to bonds because of their relative prices. I suspect each of these things is true, or partly true.
But even if one argues that, over the long term, stocks are less risky than bonds from current prices, stocks as a group are nearly always more volatile than bonds. (Note that we do not equate risk and volatility.) When the general level of market worry rises substantially, stocks will nearly always decrease more than bonds. And with our six big risks lingering, the market, quite simply, seems to be underpricing stock-market volatility (via the VIX). Given that expected stock-market volatility is a key input in the cost of hedging against a stock-market decrease, with less expected volatility creating less expensive hedging, we have moved much closer to hedging a portion of your stock-market exposure.
We continuously monitor three variables that determine our inclination to hedge your stock portfolio: 1) the degree of stock market overvaluation, 2) the probability and magnitude of big risks, and 3) the cost to hedge. We believe the market is somewhat overvalued. We believe there are a number of big risks, and, in aggregate, their probabilities are well above normal. And at current volatility levels, the hedging costs are nearly acceptable. Assuming no change in our outlook, if volatility slips a bit further, and if the market creeps a bit higher, we expect to hedge to some degree. Stay tuned.
Worries – In Germany and OKC
Turning from the general to the specific, I will briefly compare two securities: 1) the 10-year German government bond and 2) the shares of Chesapeake Energy, based in Oklahoma City. The former is generally considered ultra-safe, while the latter is generally considered ultra-controversial. In preview, your worry-prone portfolio manager has purchased for you the more controversial of the two.
German bonds are considered safe, evidenced by a 10-year bond yield of just 1.24%, even more of a knuckle-scraper than the U.S. level of 1.45%. Some view these yield differentials as appropriate. After all, Germany's debt to GDP is just over 80%, compared with over 100% in the U.S. Germany's unemployment level is just 6.8%, compared with our 8.2% level. And Germany’s budget deficit is just 1% of GDP, compared with our 10% mark. More generally, Germany's fiscal tendencies are very adult. Not only does much of world now think of Germany as the responsible parent of irresponsible delinquents, but also its historical commitment to anti-inflationary policies – ever since its painful hyper-inflationary period of the 1920s – is more than financial stereotype. In summary, Germany seems (relatively) healthy, and safe.
Naturally, then, a petrified Greek or Spanish saver (i.e., with deposits in Greek or Spanish banks) is comforted, or maybe even excited, by thoughts of 1.24% German bond returns. After all, if Greece or Spain were to withdraw from the eurozone, even the value of bank savings accounts in Greece or Spain would decrease significantly, as those savings, newly denominated in a newly formed Greek drachma or Spanish peso, would be worth much less than the previous euro-denominated value.
However, incredibly low yields and great demand from Greeks, Spaniards, and others does not safety make. According to the World Trade Organization, 60% of German exports went to other European countries in 2010, and exports run over half of German GDP. If Europe slows or stalls, or worse, the German economy will obviously be exposed.
Possibly worse yet, according to the Bank of International Settlements (BIS), at the end of 2011, German banks held claims of $13 billion on Greece, $95 billion on Ireland, $134 billion on Italy, $30 billion on Portugal, and $146 billion on Spain – $418 billion in all, or 12% of German GDP.
And then there are commitments, some not yet drawn upon, to help defend the euro. According to Christian Schwarz and Matthias Klein of Credit Suisse, Germany could be on the hook for the following: $33 billion for the first Greek bailout, $256 billion or the European Financial Stability Facility (EFSF), $230 billion for the European Stability Mechanism (ESM), $15 billion for the European Financial Stabilization Mechanism (EFSM), $69 billion for the Securities Markets Program (SMP), and $217 billion for Target II. This all totals many acronyms, and $814 billion, or 23% of German GDP!
Even if Germany is not ultimately responsible for all of the items above, it is subject to an incredible irony: As nervous Europeans continue to shift bank deposits to Germany, German risks rise, because if the central banks of other European countries cannot pay their shares, Germany's share would climb significantly – a huge and hard-to-handicap risk. You too can have all this safety, for the low, low yield of 1.24%!
Turning to Oklahoma City, Chesapeake Energy Corporation (CHK) explores for and produces natural gas and, to a lesser extent, oil. The shares trade for $17, after a 52-week high of $36 and all-time high in 2008 of $67. Given its recent share-price action, and its controversial founder and CEO, the shares are thought to be risky. No one seems to question the quality of the assets that the company owns. Instead, most of the controversy surrounds its founder, Aubrey McClendon. Some think he's brilliant, and some think he's wild and out of control; thus far, the latter group seems to be winning the vote.
The business growth has been exceptional for a long time, and we believe the results are evidence of McClendon's significant skill. In 1994, CHK's first year as a public company, it generated $4 million in cash from operations. In 2013, it is expected to generate well over $4 billion in the same metric. The precise figures come to 43% per year growth for over nearly two decades (and 20% per year on a per-share basis). It could be argued that the 2013 figure is somewhat understated relative to 1994 as well, since CHK owns lots of assets that are not producing cash flow yet.
Many experts and locals have long recognized McClendon's seemingly insatiable desire to grow. At several points, he has promised to slow the growth and distribute the cash flow to investors, only to change course and resume his aggressive acquisition tendencies. Some have come to believe that he is simply an empire-builder, he cannot stop himself, and he will never actually distribute the cash flow. Additionally, in a very high-profile story, McClendon nearly went bankrupt, due to large purchases CHK shares with margin loans, which suffered as the stock dropped during the financial crisis. He thereafter sold his art collection to the company and its way-too-forgiving Board of Directors to dig out of his personal debts. More recently, it was discovered that McClendon previously managed a $200 million oil and gas hedge fund while Chairman and CEO of CHK, a disturbing conflict of interests. It was also discovered that the company, and its McClendon-loyal board, was allowing McClendon to personally invest alongside CHK in all of the wells it was drilling, through loans – totaling over $800 million – from CHK to McClendon. In short, the corporate governance has been a resounding mess.
However, while McClendon’s governance has been lousy, and while CHK has near-term issues, we believe the company’s assets have great value. Detailed, sum-of-the-parts analyses put the value of the company at $45 per share to $60 per share (net of all debt). These valuations assume oil prices of roughly $75 per barrel and gas prices of roughly $3 Mcf (million cubic feet) to $4 Mcf. Today, oil prices are nearly $90 per barrel and gas prices are over $3 per Mcf. I think the valuation assumption for future oil prices is a reasonable, and maybe conservative, long-term projection, sitting within the range of the marginal cost of production. But I think the gas-price assumption is very low.
In the news for much of the last few years, natural gas itself is a big story, and, we believe, a value. There has been a boom in shale gas production in the U.S., driven by newly available drilling techniques. This boom, exacerbated by last year's warm winter, has driven the gas supply high, and the gas price low (which hurts CHK). In fact, natural gas is the only commodity world that has decreased in price over the last decade (see graph further below).
The typical commodity cycle proceeds as follows: When the price drops, production slows, reducing supply and increasing prices, causing production increases, dropping prices again. However, one of the recent natural-gas boom's features was a tendency for production companies like CHK to lease the mineral rights (including natural gas) in areas with shale gas – from Pennsylvania to Texas to North Dakota. In order to avoid relinquishing the rights to the leases, the contracts often require lessees to initiate drilling, regardless of price. As a result, there is an excess of gas drilling at the moment, despite generally uneconomic prices well below the cost of marginal production.
While there are near-term supply impediments to gas-price increases, we believe it will normalize – eventually. Additionally, the long-term demand looks quite bright, especially when one considers the following: 1) it's clean burning, 2) it's domestically produced, 3) it's abundant, 4) it's being considered for use in truck and bus fleets around the country, 5) it's planned for use in every new electrical generation plant in the U.S., and 6) it's driving huge capital investment to prepare for the export of gas to Europe and Asia, where gas prices are two to three times as much as in the U.S. So, if any or all of these factors drive gas prices toward their longer-term average of $5Mcf-$6 Mcf, this would imply a significantly higher valuation still for CHK shares.
We've liked CHK's assets for some time, and we've liked the natural gas story for a while as well. But we, too, had concerns about McClendon's questionable governance. Improvements began a year ago, when, at the insistence of the company's largest shareholder, Southeastern Asset Management (which we respect immensely), Lou Simpson, the long-time portfolio manager for GEICO/Berkshire Hathaway, joined the CHK Board of Directors. We thought this was a tremendous step in the right direction, and it intensified our focus on CHK.
But the real turning point, in our opinion, occurred in early June, when CHK announced it was making changes to its corporate governance in a degree I have never seen. The chairman and CEO roles were split (a big positive). McClendon would no longer personally invest in the company's drilling wells. Compensation for board members was reduced. Four board members were replaced, with three nominees from Southeastern and a fourth from Carl Icahn, a well-respected shareholder activist and a new shareholder this spring. A fifth board member was replaced with a new chairman – the former ConocoPhillips chairman. Both Southeastern and Icahn vetted the new chairman before his appointment. CHK agreed to replace another director soon. In total, the nine board members will consist of seven nominees pre-approved and/or submitted by Southeastern, giving us great comfort. Finally, most of the new board members have personally purchased a substantial number of CHK shares since their appointments.
In summary, the market thinks German bonds are safe. We think it's near crazy to lock in 1% yields for 10 years for even a near-perfect credit, which Germany clearly is not. And with unprecedented money printing still pervasive, a German bond buyer takes yet another significant risk – the possibility that significant inflation is the only solution for the eurozone.
Alternatively, the market thinks Chesapeake is controversial. We think the controversy is over. We don't think the near-term challenges are over, but we think the share price has dramatically over-weighted those challenges. As always, we could be wrong on CHK. But we feel highly confident that with a proper time horizon, a portfolio of controversial CHK's will trounce a portfolio of German bonds.
Worries – Mitigations, and Warren’s Perspective
As an investor, it is prudent to be a worrier. And when the market environment is shaky, as it is today, it is easy to become worried. But…as an investor…
· One cannot wait for a moment with an absence of worry; and
· One cannot search for a security with an absence of worry.
Even if there were such a moment or security, the corresponding return would likely be low – lower than 1.24%, apparently. Returns as low as 1.24% carry another worry – the worry that 1.24% is not enough to meet long-term goals, and needs.
Today, instead of simply seeking to avoid worry, and risk, we believe one must mitigate her worries through four tactics:
1) Consider stock-market hedges, but only when all three of our criteria (above) are met;
2) Limit exposure to supposedly safe government securities yielding near nothing;
3) Identify high-quality businesses trading at attractive valuations; and
4) Commit to the only time horizon that is known to produce results – the long term.
To close, I have included an excerpt below from a CNBC interview with Warren Buffett last year (11.14.11). It clearly highlights our current preference for stocks over bonds. As always, Warren's perspective is right on.