The marvellous Wall Street capitalization machine: Northern Oil edition

Northern Oil has its defenders and the defenders tend to point to one thing only – the value of Northern Oil's acreage.  After all you would never buy Northern Oil based on its current revenue or its current profit.  Here are the quarterly numbers (you will need to click for full detail):

(The company notes the 3c per share loss in the fourth quarter was after oil hedging losses.  The loss was also after an extra depletion charge.)

Anyway its pretty hard to justify Northern Oils $1.6 billion market cap based on these quarterly numbers.  We are talking approximately 35 times revenue – and well over 100 times earnings (on their numbers – numbers which I believe are inflated).

To justify the market cap you need to assume that soon-to-be-developed acreage is worth a fortune.  And the defenders do just that.  For example Canacord Genuity (a major promoter) in its daily note (23 March 2011) led with this:

Investment recommendation 

We are reiterating our BUY rating and thesis based on Northern Oil’s acreage quality and relative growth potential. The company's core competency is lease acquisition, and we remain encouraged by its ability to accelerate acreage acquisition and development activities. In our view, the recent bearish sentiment and associated sell-off are overdone. We remain very comfortable with our assessment of the Bakken, oil and gas accounting and Northern Oil’s valuation. We view this weakness as a buying opportunity given precedent transactions and the company’s proven ability to organically acquire acreage at accretive levels.

Investment highlights

 From our constructive stance, we believe the bulls would argue that Northern Oil trades at a ~17% discount (EV/EBITDAX) to its closest peers (BEXP and OAS) and that the recent Linn Energy transaction (CXO/LINE valued at +$12,700 per acre, NOG valued at ~$8,600 per acre) more than underpins its fundamental valuation. The LINE and NOG metrics are adjusted for production at $100,000 per boepd. The bears point to depletion accounting and corporate governance concerns.  While oil and gas accounting is complex, we are very comfortable with our assessment of Northern’s business model, reserve accounting and oversight controls and balances.

The key here – which I highlighted – is that the company is only valued at $8,600 per acre compared to some recent transactions at $12.600 per acre.

That would be good if we were comparing apples with apples (or acres of identical quality).  We can however find a good scatter of acreage prices.  The Feburary 25 edition of Rocky Mountain Oil Journal gives a Bakken state of play.  This is what they said about North Dakota auctions by the State in 2011:

Aside from the oil and gas numbers, North Dakota also set numerous lease records for 2010. The state held four land sales during the year, selling 164,848.38 acres for a total of $311,238,786.60. This translates into an eye-popping per-acre average of $1,888.03. The Mar. 10, 2010 sale was particularly memorable, with 53,274.97 acres being sold for $158,099,211.75, representing an unbelievable per-acre average of $2,967.60.

Note that a $1,888 average is “eye popping” in a trade magazine.  The March auction was “ unbelievable” at $2,967.

I run out of adjectives for Northern Oil's market cap at $8,600 an acre.  But that is Wall Street – buy it at sub $3000 an acre, put it in a company and have pension funds buy it from you (when you sell your stock) at $8,600 an acre.  Everyone is happy!

But hey – why use average auctions when we have Northern's own numbers?  When you read these numbers remember that well spacing is typically about 1 per 600 acres to 1 per thousand acres with the lesser spacing being more common.  Quoted from the 10K:

The following describes some of our larger acquisitions during the fourth quarter of 2010: 

Williams and McKenzie Acreage Acquisition 

In December of 2010 we acquired approximately 1,748 net acres for $2,500 per net acre in Williams and McKenzie Counties of North Dakota. All of the acreage consists of non-operated tracts that are not subject to specific exploration or development agreements. Several operators have been permitting and drilling wells in close proximity to the acreage, and we expect development of our acreage will commence in 2011. 

Slawson Exploration Lambert Prospect 

In December of 2010 we acquired a 50% working interest in approximately 14,538 net acres for total consideration of $1,737,483 in Richland County, Montana. Slawson will be operating the prospect and all drilling and future acquisition costs will be shared pro-rata with Slawson based upon our proportionate working interest in the prospect. This prospect is in close vicinity of Elm Coulee, and considered an extension of the Southwest Big Sky project, which is also operated by Slawson. 

BLM Sale

In December of 2010 we purchased 720 net acres from the Bureau of Land Management for $875 per net acre in Richland County, Montana. The acreage lies within a selected township that recently experienced a successful test well targeting the Bakken formation, but is not subject to specific exploration or development agreements. 

Miscellaneous Acreage Acquisitions 

In November 2010 we purchased 506 net acres for $2,000 per net acre in a single spacing unit in McKenzie County, North Dakota. In December 2010 we purchased 506 net acres for $1,500 per net acre in a separate spacing unit in Richland County, Montana. As of December 31, 2010, the McKenzie County, North Dakota well was awaiting completion and the Richland County, Montana well was spud. In December of 2010 we purchased 322 net acres for $1,775 per net acre in Mountrail County, North Dakota, of which 235 net acres is estimated to spud during the first quarter of 2011.

Now the first acquisition (William McKenzie) is 1748 acres (two or three wells at standard spacing) at $2500 per acre.  These will be drilled this year - and they were purchased at about the mid-price for Bureau of Lands sales in 2010.  You would expect them to be ordinary acres. It is a bit adventurous the the stock market to value this at $8600 per acre but it is at least in line with industry norms.

But the second acquisition (Slawson Exploration Lambert Prospect) was very different.  It was a 50 percent interest in net 14,538 acres (call it 7269 acres net for Northern) for $1,737,483.  That is $239 an acre.  And they did not buy it from a dupe part - they bought it from Slawson who operates and will continue to operate those acres.  The operator was willing to sell these acres for $237.  It looks awful rich to value them at $8,600 per acre for these acres.

The BLM sale was at about a third the cost of the average BLM sale during the year - and that was at a competitive auction.  $875 per acre in a competitive auction is not chump-change but it is about 10 percent of the market-cap per acre the company trades at.

Wall Street - the capitalization machine

Wall Street capitalizes future earnings.  The price of a stock now is the market estimate of what cash it can generate for investors in the future.  Sometimes Wall Street is really dismal and the price of stocks is much lower than the value of the same businesses would sell for in a private transaction.  (That is when Warren Buffett likes to buy stocks.)  Sometimes Wall Street values stocks far more than independent industry transactions.  At that time businesses wanting to sell rush go to public.

Boone Pickens when he purchased oil stocks famously said that it was cheaper then to "drill for oil on the floor of the New York Stock Exchange" than it was to drill out in the field.

Northern Oil stock is the anti-Boone-Pickens transaction.  The company buys acreage at as low as $237 an acre and have the AMEX value it it at $8600 and have lots of Wall Street's Finest Analysts tell you that is cheap compared to comparable transactions.

Thanks - but I am still short.



John

Northern Oil and Gas – the source of the strange auditor

There are lots of things that I do not know about Northern Oil and Gas.  The thing I would most like to know are the flow rates on their wells at initial, six month, twelve months, eighteen months and twenty four months.  The decline rates of the wells are the key to the economics of the Bakken and will tell you whether any or all the stocks are buys or even shorts.  The decline data I have suggests a decline rate of over 2 percent per day but only includes the front-end of the decline curve.

My first post had one question that left me pondering.  The question was how did Northern Oil and later Voyager Oil choose an auditor that nobody has ever heard of in Salt Lake City over twelve hundred miles from their office?

Moreover it wasn't any ordinary auditor – it was Mantyla McReynolds, an auditor with an almost unblemished record of auditing penny stocks that later collapsed.

Well I have the answer – at least in the case of Northern Oil.  The auditor came with the initial shell company into which Northern Oil was merged.  Mantyla McReynolds was the auditor both before and after the reverse take over.

The initial shell company was called Kentex Petroleum and it was controlled by Duane S Jensen.  The initial shareholders received 6 percent of Northern Oil for just a listing.

Duane (and his children) have a long record with penny-stocks using the same Salt Lake City auditor.  Indeed a few Jensen (sometimes Jenson) specials were mentioned in the first Northern Oil blog post.  However Bikini Team International Inc stands out.  This is their business description:

Our initial operations consisted of a "bikini team" comprised of women clad in bikinis who were engaged through us to appear for a fee. Some of the events that the bikini team appeared at were: an NFL super bowl party at the Roadhouse Grill in Evanston, Wyoming; as "ring" girls from May 2001 to September 2002 for the Wendover Boxing Series; the 24th of July Rodeo at the Delta Center Salt Lake City, Utah in 2001 and 2002; and the 2002 Winter Olympics, which were held in Salt Lake City, Utah, where they worked for Budweiser as the snow angels and hosted several pre-Olympic parties with Budweiser. They also appeared at several charity events, primarily in held in the State of Utah, like the X-Mas box foundation, the Cancer foundation, Christmas toy drive, Ron Boone golf classic at Thanksgiving Point, Downs Charity, Make a Wish foundation and the Ride for Hope With Harley Davidson in May 2001 and 2002. They also hosted bands at concerts, such as Lifehouse and 3 Doors Down and appeared on the Salt Lake City Fox 13 television morning show and sports segment "Rungee Time" for 15 months.

I really wanted to find photos of the Swedish Bikini Team – but all I found is Duane's (sometime Dwayne's)  more colourful record going back to the 1970s including SEC sanction and rougher...

If readers want to dig they will find plenty that is amusing.  I still chortling at a listed superbowl party.



John

The Street Sweeper on Northern and Voyager: Part 2

The Street Sweeper has published Part II on Northern Oil and Voyager Oil.

Linked without comment.

Northern Oil and Gas: It's only a Northern Song

I have been sitting on this post for while pending the publication of an article by Mellisa Davis (of The Street Sweeper).  She has now gone public quoting me - so here is something I have been working on.

High growth subprime companies - a brief stylized history

Until the crisis one of the staples of my life was financial institutions which under provided for inevitable losses and grew really fast.  Examples include Metris and Americredit - both of which collapsed, partially recovered and were eventually taken over.

Before the collapse they had less-than-prime lending businesses in credit cards and auto loans respectively.  Metris was the more pure example.  Another example was the credit card business of Circuit City.

These companies understated losses.  That made them seem profitable.  That profitability is only temporary because eventually it becomes obvious to even the most stubborn and blinkered management that the loans are not going to pay.  When that happens a charge is inevitable - and future profitability winds up at a lower level (more akin to economic reality).

However the companies in question deferred the day of reckoning.  They did this a couple of ways.  First when someone could not pay their loan they tended to extend them more credit.  Metris’s average balance outstanding went above $4000 (or more than double average balances at similar companies).  That meant that when the losses (inevitably) came they were bigger.

The second way that they deferred the day of reckoning was just to grow really really fast.  After all, if you don’t recognize any losses on new loans, then filling your portfolio with new loans meant your aggregate credit looked OK, even if the old loans were toxic.  The denial solution de jour was hypergrowth.  The hypergrowth hid problems and also (incidentally) drove stocks to the moon giving management ample opportunity to cash out.  In other words the path that made management rich was to make the problem bigger and bigger.

Sometimes before they blew up (and they inevitably blew up) you would get a signal: a quarter with an unexpected “reserve adjustment”.  Reserve adjustment being a (belated) admission that the reserves were not adequate.  Sometimes there was no signal except insider selling.  Mostly even the insider selling was not a good signal because the insiders were always selling.

Lesson from this

There is a lesson I drew from this.  Be very wary of fast-growing hyper profitable companies (especially companies in competitive industries) where the earnings are critically dependent on a reserve or variable that has to be estimated and on which the estimate is really a guess.  This could be lending or insurance or large contract construction with contract warranties or in this case an oil company.  The company in question is Northern Oil and Gas (Northern): a member of the S&P mid-cap index.

The Bakken shale oil plays

Northern Oil and Gas (and its little sister company Voyager Oil) own acreage and part shares in oil wells in the Bakken Shale.  The Bakken Shale is one of the hotter properties in North America and is the subject of much promotion including several (sometimes anonymous) stock promotion blogs dedicated entirely to investing in the Bakken (see here, and here).  Some have go-go names like “Million Dollar Way” appealing to relatively unsophisticated investors.

That said - the Bakken is a real oil field and it has real players and is producing a lot of oil.

The Bakken is a large (200 thousand square miles) mid depth (typically about 10 thousand feet) and not very wide (typically about 40 feet wide) oil bearing shale deposit.  The area overlaps two American States (North Dakota and Montana) and one Canadian Province (Saskatchewan).

The field has been known about for many years because traditional oil fields underlie the Bakken and as the wells have been drilled, small quantities of light sweet crude have been logged.  However the technology to extract oil in quantity from the Bakken is relatively recent and involves drilling down 10 thousand feet, kicking a horizontal well down 5-8 thousand feet, putting explosives down the well to crack the rock and then chemicals and water at very high pressure to extensively fracture the rock.  And then the oil flows.

This has driven North Dakota oil production extremely well:

If you extrapolate graphs of production (something I don’t think you should do) then North Dakota overtakes Alaska in 2017 to be the major US oil producing state.

The problem with Bakken shale oil

The problem with Bakken shale oil is that the pores in the rock are tight and the rock needs to be fractured to extract it.  It is a stylized fact of oil production that the tighter the rock the faster the oil well declines to a trickle - especially after the reservoir has been forcedly fractured.

This makes sense.  If the rock is homogenous, quite porous and extends over a large area you would expect an oil well to flow for a very long time (multiple decades).  However if the rock flows only a small amount of oil without fracturing (the small amount being the amount near the well bore) then when you fracture it it will flow many small amounts (the small amounts being amounts near the fracture system).  And when you have exhausted the oil that happens to be near the fracture system then the flow should flow to a trickle as the rock is not very conducive to flow.

The risk with the Bakken is that the wells decline much faster than anticipated when the well is drilled and faster than anticipated in the accounts.

If this happens the company will have to take a “depletion adjustment” - the analog of my subprime company taking a “reserve adjustment”.

Now, also as an analog of the subprime company if the company, is drilling a whole lot of wells that are declining faster than anticipated, it can hide this through growth.  After all, new wells don’t just stop flowing: they need to be old wells before that happens.  And you can hide an aggregate decline problem by drilling like crazy.  It just winds up being a bigger decline problem when you stop drilling.

And now you see my subprime oil company: it is Northern Oil and Gas and it is a doozy.  Market cap is over $1.7 billion and the stock is up from 3 and a bit dollars to almost $30 since the beginning of 2009.  It is - through partners - drilling like crazy.

It is a strange company, despite the large market cap it only has 11 staff.  It takes minority shares in other companies oil wells.  It does not drill anything itself.  Every well seems to strike oil (that is what it is like in the Bakken) but because they do not operate the wells they only have limited insight into the decline rates.  Shareholders have even less insight into the decline rates.

Searching for a benchmark for Bakken decline rates

I spent a lot of time trying to find a benchmark for oil-well decline rates in the Bakken.  It's hard because people tend to keep this information confidential especially if they are bidding for local acreage.  Also the technology to fracture Bakken wells is relatively new and so to some extent decline rates (especially over the out years) are just unknown.  Still, I have heard good stories about individual wells that are flowing well after three years.  I have heard horror stories about wells that are flowing at less than a barrel per day after one year.  The average almost certainly lies in this range.

I was getting hung up on a benchmark when one of my favorite bloggers Peter Sacha stepped in with a really useful post.  In it he picked apart the accounts of Petrobakken.  Petrobakken is the major player in the Saskatchewan Bakken.  What is more he had a decline curve.

Its only a decline curve for the first year - of production - and it is for a particularly big well (a seven stage frac).  However, the initial flow rate was almost 250 barrels of oil per day and after 12 months this had declined to 75 barrels per day.    It is a steep decline.

And it shows in Petrobakken’s accounts.  Peter Sacha deadpans that the company likes to report “cash flow” which does not include the depletion allowance for wells.  He then notes the company spent $812 million in capex most of which was to replace depleting wells.  The cash flows are enormous - but the capital expenditure needed to maintain those cash flows are enormous - and that is because the depletion is rapid.

The key analytical assumption of this blog post is that we can compare decline rates for Petrobakken and Northern Oil.  Both Petrobakken and Northern Oil are Bakken shale producers.  Petrobakken is just much bigger and a little older and a little more experienced with decline rates.  But both companies have a large spread of wells in similar areas so the average decline rate (relative to current production) should be similar.

Here are the accounts for the first nine months.  (I don’t give the annual accounts because Northern Oil had an irregular depletion charge in the last quarter.)

For Petrobakken (and sorry you will need to click)

Note that over 9 months Petrobakken had 750 million in oil and gas sales before royalties and 654 million in net revenue.  The depletion charge was 391 million.  Depletion is 52 percent of gross revenue and almost 60 percent of net revenue.  These wells deplete badly and the depletion charges are large.

Here is Northern Oil for the first nine months (and sorry again you will need to click).

Note that for Northern the gross revenue for the first nine months is 35.6 million (a very small fraction of Petrobakken).  The depletion charge plus amortisation is 8.36 million.

Depletion and depreciation is only 23.5 percent of gross revenue.

Same field.  Same geology.  Less than half the depletion rate.

Same geology, same field suggests that the right approach to compare these companies is to assume the same depletion rate for both companies.  Of course which depletion rate - Northern or Petrobakken?

We could assume that Northern is right and these fields could actually last a lot longer than Petrobakken thinks.  In which case however you should buy Petrobakken as it will generate cash flow for years and will have already expensed the associated costs.  If Northern is right don’t buy Northern - buy the company which is really earning far more than it says.

Altenatively Petrobakken is right and the right depletion rate is 52 percent of gross revenue.  In that case for nine months the depletion plus depreciation at Northern should not equal 8.36 million it should equal that times 52/23.5 or 18.5 million.  Instead of having income from operations of 14.4 million for the nine months as per stated you have income from operations of only 4.3 million.  Income after tax is just over 3 million.  That is for nine months - but hey - annualize it!

Oh, the market cap is over $1.7 billion.

If I do the depreciation as per Petrobakken (and I see no reason why I should not) then this stock is around 400 times earnings.

Obviously enough we are short.

It all swings on accounting for depletion - so who certifies the accounts?

All of this swings on accounting for depletion.  If you use Northern’s accounting then this is a high growth high PE stock.

If you use Petrobakken’s accounting this is a lower growth stock with much higher PE and less prospects.

At that point I ask who is certifying the accounts?

Well the auditor is Mantyla McReynolds.  Have you never heard of them?  Nor had I and I am a connoisseur of obscure audit firms.

First I checked whether they were a local firm.  No such luck.  They are based in Salt Lake City and Northern Oil is based in Wayzata Minnesota.  That is 1254 miles away according to Google maps.  They went out of their way to find this auditor.

So who does Mantyla McReynolds audit?  I went through the SEC database to see who else is audited by them and this is what I found:

• Northern Oil and its sister company Voyager Oil.  (Voyager is run by family members of the executive of Northern and there are some related party transactions.)
• Pacific Gold Corp - stock price 3c.
• GeNOsys Inc - stock price 4c.
• Guide Holdings Inc - which has finally gone to meet its maker (price rounds to zero).
• Northsight Capital Inc - 45c.
• Studio One Media Inc - $1.28.
• TC X Calibur Inc - 51c.
• Other penny stocks...

You get the idea.  We are critically dependent on an estimated accounting expense (depletion) that is low compared to the competition (the far more established Petrobakken) .  Further, these estimates are certified by an auditor most associated with penny stocks.  Moreover, that auditor was chosen despite being over a thousand miles away and having no obvious expertise in oil and gas.

And despite all this advantage the company took a small reserve adjustment in the fourth quarter.  (Isn't a depletion charge the first warning?  My guess - some well actually ran dry!)

You can imagine that all this made me uncomfortable with the stock.

Alas Melissa Davis (at the Street Sweeper) has found far more about the stock than me.  And none of it raises my comfort level.

What the Street Sweeper found

Remember my issue here is the accounting for depletion.  The whole valuation, indeed the whole story swings on the depletion numbers, and Petrobakken gives you a good reason to doubt the depletion numbers.

I recommend you read the Street Sweeper piece.  However, given that I am obsessed by the accounting, I thought you should focus on the CFO.  Here is what the Street Sweeper says:

NOG appointed a new CFO early last year, records show, promoting former Vice President of Operations Chad Winter to that important post despite his apparent lack of credentials for the job. Winter has never registered as a certified public accountant in NOG’s home state of Minnesota, records indicate, and (unlike the company’s other leaders) has in fact never even reported that he holds a college degree. Even so, filings show, Winter fills three key positions at NOG – CFO, principal financial officer and principal accounting officer – that are regularly assumed by CPAs, with established records of experience and training, at other companies.

This guy looks like the least experienced guy ever to be appointed to all the finance positions at a nearly $2 billion oil and gas company.

I think I can stay worried about the depletion numbers.  Short seems a reasonable bet to me.

John

PS.  The Street Sweeper suggests there is a Part II.  I look forward with anticipation as they found plenty of stuff I did not know about this stock.  

Starr Asia sues CCME and others

Presented without comment (antecedent post here):


Starr Asia sues CCME et al

China Agritech: How should I reply to Kevin Theiss re China Agritech?

Forgive me a brief gloat about a successful short.

China Agritech has fired its auditor after the auditor threatened to resign.  NASDAQ has suspended the stock and there is no indication of when it will trade again.

The Carlyle representative on the board (Anne Wang) has resigned and never answered any email I sent her or any questions on this blog.

The auditor firing 8K is a gem.  Ernst & Young has recommended the "initiation of an independent investigation, in order to verify certain transactions and balances recorded on the Company’s financial statements and records for the year ended December 31, 2010."

E&Y also "orally advised the Audit Committee that it may not be able to rely on management’s representations based on the issues identified."

In other words they thought management may be lying and they thought an "independent investigation" (meaning independent of the board) was warranted.

None of this should be a surprise to any reader of this blog.

I also annoyed China Agritech's management especially because of my repeated (and unsuccessful) attempts to talk to Carlyle.

This is a letter I got from their PR flack on 24 February.  How should I respond?  Note that the flack (Kevin Theiss) says we (meaning Grayling - not China Agritech) have collected evidence that my allegations were groundless.

Dear Mr. Hempton,

We are aware that you have published a series of blog articles to negatively comment on China Agritech's business operations and attack the Company's credibility. It is becoming more alarming that you have repeatedly reached out to our largest outside shareholder. Your intention and ongoing efforts to derail our well-established, long-term relationship with our largest shareholder has come to our full attention. If you have any questions, concerns or comments, we welcome you to contact China Agritech’s management directly. We will provide you with our timely answers. Lastly, we have collected evidence that your allegations are groundless. If you continue to harass our shareholder, we will take further legal action against you.

Sincerely,

Kevin Theiss
-----------------------------Kevin TheissAccount DirectorGrayling USA825 Third Avenue, 18^th FloorNew York, New York 10022
Tel       +1 (646) 284-9400Direct   +1 (646) 284-9409Fax      +1 (646) 284-9494
E-mail  kevin.theiss@grayling.comE-mail  kevin.theiss@grayling.comFollow Grayling NY:On Facebook at Grayling NYOn Twitter at www.twitter.com/GraylingNYGrayling is a global Investor Relations, Public Relations, Public Affairs and Events consultancy.  We have offices in 70 locations, in 40 countries across Europe, the US, the Middle East and Asia Pacific.  We are the second largest independent PR firm in the world.  Grayling is part of Huntsworth plc.

John

PS.  Huntsworth PLC - the company that ultimately threatened to sue me on behalf of China Agritech - is publicly listed.  Their CEO states on their website that Huntsworth "have developed a culture of rigorous focus on margin improvement throughout the Group". Is there any business not worth doing for a high margin?  Does this letter represent the quality of their work?

Weekend edition: Spoof of Brian Cox's Wonders of the Solar System

Brian Cox leaves me gob smacked.  He is blisteringly smart but wears it with an easy rock-star charm.  (Before he was a top-flight Physics Professor he was literally a pop star with chart topping hits.) His Einstein for beginners book is fabulous and even comprehensible (at least I think I get it).  His (less demanding) BBC series Wonders of the Solar System is one of the best bits of popular science I have seen.

If you have never seen Brian Cox you will need a little guide - otherwise jump to the second video - a fabulous spoof.




And now the spoof (complete with a language warning reflecting that Brian is from the English North and they can cuss like Australians):




John

Hat-tip: Brian Cox's Facebook feed.

Danger danger: The Wall Street Journal has no idea on how to do hedge fund due diligence

About 30 percent of Bronte's portfolio is shorting frauds.  We are very good at identifying frauds: we are experienced and diligent.

Alas some members of the fourth estate – often those with high profile mastheads – have no idea what they are doing.  This article: “Danger danger, thinking of investing in a hedge fund.  Here are some tips for sniffing out potential fraud” is so misguided as to be comical.

Lets state it up front.  There is a single tip that will allow you to avoid almost all the frauds – just one.  The tip is this:

Do not invest in a fund where the fund manager has access to your assets.

Ok – that needs a little explaining but its not complicated.  If – as an American -  you invest in Bronte Capital you don't give us the money.  We are not even legally allowed to take it.  You send the money to Citco.  Citco is the world's largest hedge fund outsource company – but there are alternatives.  David Einhorn's Greenlight Capital uses one of the bigger banks.  There are smaller players such as Spectrum, Conifer and others.

When you send the money to Citco they hold the assets.  We just trade them by issuing instructions to brokers.  However if we asked Citco to send the money to our personal bank account they would (rightly) refuse.  Moreover Citco value our assets every month and they – not us – send the statements to the clients.  We don't do the valuation so we can't fake it.  We don't hold the assets so we can't steal them.

Private clients surprisingly don't get this.  One of my friends runs a successful (albeit small) fund from his home.  People regularly make out checks out to him.  (If you send us money we will say thank you and send it back...)  The core due diligence test is simply not understood by retail clients – and alas the Wall Street Journal perpetuates their ignorance.

And guess who was the custodian for the assets invested in Bernie Madoff's fund.  BMIS – and that stood for Bernie Madoff Investment Securities.  And Bayou- another large fraud.  Well Bayou of course.  How about Astarra – the fraud I exposed in Australia.  Well their custodian was Trio Capital – a small custodian in the rural Australian town of Albury.  And guess what – Trio and Astarra had the same owners!  What about New World Capital Management – a fraud I wrote up but which was never prosecuted: well the perpetrator himself of course.  I could go on and on and on.  It is really easy to spot frauds and the fact they keep reappearing is testament to people not having a clue how to look for one.

If there is a single due diligence lesson then it is this: ensure that your money mangers have an independent custodian and preferably one of the majors.  And the first step in due diligence is this: don't do your due diligence on the fund manager – do it on the custodian.  Ring the custodian through their switch (not on a phone number provided by the fund manager) and confirm statements of the fund manager with the custodian.*

If you do this you are unlikely to get fleeced.  Simple as that.

Rob Curran misguidedly – and in the interest of the financial establishment tells you what his first red-flag in assessing managers is.  I quote:

The Fund Came to You: The Fund Came to You:  While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy. While it's not unheard of for a hedge fund to approach a wealthy individual, reputable funds usually concentrate their prospecting on institutional investors, says Randy Shain, executive vice president of First Advantage Litigation Consulting, who has been looking into hedge funds for 20 years. Always ask for the names of a fund's institutional investors, then contact them to verify that they are investors and have no qualms about the fund's legitimacy.

Well politely – garbage.  I have written before on how institutional investors are right people to contact when you want to move the fund from $500 million under management to $1.5 billion under management.  They are absolutely useless at finding the hot fund manager with $5 million under management on their way to five years of 30 plus percent returns.  If you used this rule you would never have invested with Warren Buffett when he ran Buffett partnership.  All of the Buffett biographies make clear he approached well-to-do people like local medical specialists.

But its worse.  If you invest in managers that come to you through funds of funds or institutions you will probably wind up paying double-layer fees to get something like the average of all hedge fund managers.  Our initial client sent us the multi-fund manager record for a major (and successful) fund of fund.

(Click to expand).

He thought this these returns were BS.  I was kinder – these returns ok relative to equities over the same period – and more stable and probably ex-ante lower risk – so I believe this fund of funds has added value.  But the returns are not what you get from a couple of clever guys doing smart stuff.  Moreover there is a real danger in going through the institutional managers – which is that you get something that averages near the financial consensus.  And being in a crowd on Wall Street feels safe but it is actually shockingly dangerous.

Anyway my summary is that the number one method of choosing a fund given by Rob Curran (that is avoid one that comes to you) is counterproductive.  And the number one method of proving you are not defrauded rates a very thin method in the Rob Curran article.

And the Rob Curran article annoys me too – because at Bronte we are careful about trying to construct portfolios without regard to the consensus.  We don't look like institutional managers (no suits).  We don't sound like institutional managers (those accents).  And we we don't think like institutional managers (we don't like style boxes and we will happily change styles if market conditions change).  Rob Curran is telling all the WSJ readers to avoid funds like Bronte or Kerrisdale or any of the other thoughtful start-ups out there.**  And if this criticism sounds a little strident then it should be.  He is defending the financial consensus and the big institutions and frankly I don't think the big institutions covered themselves with glory over the last five years.

Secondary steps to chose the individual hedge fund

You know my view – the really good fund managers are outside the consensus.  Ratbags if you will – but ratbags with risk control.  Danny Loeb was a tearaway when he was younger.  [The rumor is that he posted more than 100 thousand messages on chatboards under the moniker of Mr Pink.]  David Einhorn might look like he is 18 (he is preternaturally young) but listen to what he says and he throws grenades.  (Who can forget the stoushes with Allied Capital and Lehman Brothers?)  And these guys are really smart.  And I guess if you want to chose a hedge fund and you don't want to work too hard you could ring them up.  In the mutual fund space my old boss at Platinum in Australia is far less out-there than those two but he is super-smart and he is not afraid to have people disagree with him.

But you would have missed Einhorn and Loeb when they were young and their best returns were mostly when they managed relatively small amounts of money.  Being an initial year investor in either of these funds was frightfully good.  [Incidentally Buffett's best returns were also when he was younger and smaller.  Buffett partnerships returns were substantially better than Berkshire Hathaway.]

So how do you chose a smaller manager?

Well first remember my test: do they hold the assets themselves of give them to a reputable third party to hold.  Don't forget this rule – it solves almost everything.

Then ask how they get the returns.  Leverage levels matter (they should be low – but 120 long 40 short is probably less risky than just 100 long).  Position size matters.  Short positions should generally be small (or using other mechanisms that limit risk like shorting debt rather than equity).  Long positions can be (much) larger.

Then ask them questions.  Pick an industry that you know really well and they profess to know.  If you can't do that work out some other mechanism to check out that they are not talking through their posterior.  (Clever and well thought through shareholder letters are a good start.  A blog is not bad either!)

Finally there is a test which I do (and which has enabled me to see many frauds) but that is seldom done elsewhere.  Match the stated returns to the ex-ante stated positioning.  For example I have disclosed several times on this blog that I am interested in shorting fraudulent Chinese stocks.  It should then come as no surprise that we are doing (very) well this month.

Likewise alas it was well known that Bank of America was our biggest position as it fell back from the 19s to the 11s.  Bank of America was above 19 in March 2010.  Here are our returns:

(These returns are for a separately managed account for our foundation client.)

The Bank of America position wasn't the only reason for the dud-period in the middle.  We are a global fund and measure ourself in US dollars.  The US dollar appreciated sharply through that period (devaluing our largish Euro denominated positions).  We quite explicitly generally do not hedge currency so you would expect to see currency volatility in our returns.  We also had a position in Maguire Preferred (now MPG Preferred) which gave us a wild though profitable ride.

More to the point – this was done primarily with big cap long positions (and small profitable positions in some defaulted preferred securities) and highly diversified and usually small cap shorts.  The positioning is as explained in my lament post.

Finally I have some strong views about prime brokers.  You should use only funds with US domiciled prime brokers for the reasons outlined in this post.

In other words it is pretty easy to do due diligence on us.

Incidentally the question we are asked almost all the time is "how much money do you manage?"  The implication that you need to be large to be good.  I assure you in almost every case returns are negatively correlated to funds under management.  You want the answer to be low - another inversion of the normal presumption.  Large however is the comfort of crowds - a comfort misplaced in markets.

Here are the steps generalized for any small gun hedge fund manager you might want.

Step 1:  Check the independence of the asset custodian.  This is a black-and-white test.  Any gray in the answer then the fund fails.  Period. Actually if it fails email enforcement@sec.gov and see if you can get bounties for spotting it.

Step 2:  Are they smart?  Test them on some industry. Bring an expert if you have one. Otherwise carefully read their material.

Step 3: Do they keep the position size and the leverage low enough to be safe?  Shorts must be smaller than longs.

Step 4: Do their returns correlate with what they say?  Focus on the particularly good months and the flat months.

Step 5: Is their brokerage arrangement sound (especially do they use US domiciled prime brokers).

And if you are a rich guy and they ring you out of the blue.  They are either trying to steal from you or they are being entrepreneurial.  Entrepreneurial is good – sometimes very good.

Follow the above steps and you will sort the wheat from chaff.

Is it too much to ask the Wall Street Journal to do the article properly next time?


John


*If you ring the custodian at a phone number provided by the money manager you could find yourself talking to a Potemkin custodian – just as people who rang advertising agencies at phone numbers provided by CCME would up talking to Potemkin advertising agencies. No kidding.  When someone gives you a reference do not ring the number they give you – ring the switchboard of the company they work at.  Always.

**Kerrisdale is far more aggressive than Bronte.  Their returns are better too.  But I have wondered openly whether aggression and risk are actually that well correlated - and I would use them as a case example.  I have conducted none of the tests described here on Kerrisdale.

What the demise of China Media Express says about the demise of Hank Greenberg and AIG

I met Hank Greenberg in late 2000.  He was chatting mostly to Ajit Jain – the Berkshire Hathaway reinsurance impresario and I was a spare wheel.  But Hank was I thought the most impressive person I had ever met.  He name-dropped shamelessly (he had had just flown back to New York on a private jet after “chatting” with Li Peng).  But he was so far ahead of me on so many issues it made me feel dumb.  He even looked – at least in the brief conversation – as if he were considerably smarter than Ajit Jain – and Ajit is no intellectual slouch.

I was just out of my league...

Anyway there is a view around AIG – a view that I shared – that AIG was built in the mold of Hank  and it required Hank – a certified genius and an unbelievable workaholic – to keep it all together.  AIG you see had a single risk control mechanism: Hank.

In this view Elliot Spitzer by causing the demise of Hank Greenberg caused the demise of AIG – and by extension the demise of the entire financial system.

I thought that might be going a bit far – but it is hard to argue against the proposition that AIG got much more risky without Hank around.

And the stories were legion too.  I know someone who was on a trading floor for AIG in Taiwan.  There was a big error and it potentially exposed AIG to hundreds of millions in losses.  Everyone was kept silent because if it leaked then people would front-run AIG closing their position and thus increasing their losses.  People slept at their desks.

But the next morning – fresh off the private jet from New York – there was Hank.  He had come to take control of the situation – and he stood behind traders as they solved the problems for minimum losses.

Hank was the man.

Now Hank is only a couple of percent the man he used to be.  His multi-billion dollar holding of AIG has been reduced to its last few hundred million.  His main asset is Starr Asia – a holding company for a variety of Asian investments (and some old AIG stock).  It was through Starr that Hank made his investment in China Media Express (CCME).

At peak Starr's investment in CCME was worth over $60 million.  This is nothing to the Hank of old – but the new diminished Hank probably thinks that $60 million is a lot of money.  It might even be a reasonable proportion of Hank's fortune.  As recently as January 2010 Starr dropped another $30 million into CCME.  And by that time CCME was a controversial company.

The demise of CCME

I wrote that China Media Express was either  (a) one of the best businesses in the history of capitalism or (b) one of the most brazen frauds in the history of capitalism.

Given the auditor has resigned and is suggesting fraud, the company is suspended and well – all sorts of other ugliness – we know which now.  It was one of the most brazen frauds in the history of capitalism.

And we know who was the biggest victim: Hank Greenberg.

And given Hank's much diminished status this was not chump change.  It was a meaningful hit.

If your one-man-risk-control unit can be fooled by something so obvious then why couldn't it also be fooled by someone offering 25 bps extra carry by double-levering life insurance statutory funds into the AAA strips of subprime securitizations?

China Media Express – apart from being a really fun story – punctures the last Hank Greenberg myth – a myth that I personally believed.


John

PS.  I think we can conclude that Ajit Jain really was the most impressive person at that table.  I sure as hell wasn't.

Banking and supercatastrophe

The second substantive post on this blog was about 77 Bank - a bank in Sendai - the capital of Miyagi Prefecture.  This is the epicenter of the Tsunami/Earthquake damage.

The original post - like this blog at the time - probably had less than 20 readers.

I have repeat the post below.

Warren Buffett once said that Fannie Mae had more supercatastrophe risk in it than Berkshire Hathaway.  He figured the really really big hurricane or earthquake could do more damage to Fannie than Berkshire even though Berkshire is the largest supercat insurer in the world.

Buffett was - I suspect - right.

We now unfortunately have a gruesome test of Buffett statement on finance and supercatastrophe.  There is probably more uninsured damage in the destruction of North East Japan than in any other event in history - and uninsured damage falls sharply on banks.

77 Bank - deeply concentrated in the disaster zone - is the test.  It is not a test I would want to repeat.  But I think we will - at the end of this - be able to confirm Buffett's observation that banks don't like supercats.

-------------

The original post - which was titled Japanese Regional Banks - a mirror on America

77 Bank is a regional bank in Sendai (the capital of Miyagi prefecture). The Japanese guys I know think of Sendai as a backwater – a place where the “cool guys” hang out on motorcycles wearing purple clothes. Economically it is just another rapidly aging backwater where the young (other than those that hang out on motor cycles wearing purple clothes) are moving to Tokyo.

The name 77 Bank harks to tradition. During the Meiji restoration the Emperor gave out numbered bank charters. Traditional regional banks still label themselves by the number. www.77.co.jp and many other numbered sites belong to banks.

77 Bank has a very large market share (near 50%) in Sendai. The market is more concentrated that the great oligopoly banking markets of Canada, Australia, Sweden etc. It should be profitable – but isn’t.

Here is its balance sheet:

(click for a more detailed view).

Note that it has USD42.6 billion in deposits. This compares to $35.8 billion for Zions Bancorp – as close to an American equivalent as I can find.

77 only has USD26.4 billion in loans though. If you take out the low margin quasi-government loans it probably has only USD20 billion in loans.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much.

It’s a big bank. It has next to no loan losses because it has no lending.

Here is an income statement:

(click for a more detailed view)

Profits were USD87 million on shareholder equity of 3251 million. You don’t need a calculator – that is a lousy return on equity for a bank without credit losses.

You might think that given that they have no profitability and no lending potential they might be returning cash to shareholders. Obviously you are new to Japan. Profits are 27 yen per share and the dividend is 7 (which they thoughtfully increased from 6).

In a world where banks everywhere are short of capital 77 bank is swimming in it. Here is the graph of capital ratios over time:

This bank has an embarrassment of riches – and nothing to do with them.

Welcome to regional Japan.

An American Mirror

The title of this post was “An American Mirror”. And so far I have not mentioned America.

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

There are also mirror image lands – 77 is our mirror image.

Macroeconomic investing calls

We live in a world with considerable excess (mostly Asian) savings. Banks with access to borrowers made good margins because the borrowers were in short supply. Savers (or banks with access to savers) were willing to fund aggressive Western lenders on low spreads.

77 Bank has been the recipient of those low spreads. It has not been a fun place for shareholders as the sub 3% return on equity attests.

The economics of 77 Bank (and many like it) will change if the world becomes short on savings. There is NO evidence that that is happening now – and so 77 Bank will probably remain a lousy place for shareholders.

The market produces what the market wants

This is an aside really. We live in a world with an excess of savings. This is equivalent to saying that we live in a world with a shortage of (credit) worthy borrowers. So we started lending to unworthy borrowers – what Charlie Munger described as the “unworthy poor [whoever they might be] and the overstretched rich”. We know how that ended.

Unfortunately the financial system cannot make worthy borrowers. It can only lend to them when it can identify them.

This Subprime meltdown heralds the death (for now) of lending to the unworthy. The shortage of the worthy however is as acute as ever – and money for the worthy is still very cheap.

The subprime meltdown does not solve 77’s problems.