Gulfport Energy and Wexford Capital: Part 2

The very long set of transactions entered into by Gulfport Energy with Wexford Capital was surprising to me as well as to a couple of readers.

One question though was (and I am paraphrasing): are these transactions large with respect to Gulfport Energy? Is that the reason you are short?

I can answer the first question simply: yes - related party transactions are important in Gulfport. That is easily seen by looking at their assets as mapped on their home page:

The company has interests in the Canadian Oil Sands, the Niobrara Shale, Thailand, the Permian Basin, Southern Louisiana and the Utica Shale.

Lets go through them individually.

The Canadian Oil Sands operations are held through Grizzly Oil Sands. The proxy tells us that Gulfport own a "24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford."

The Niobrara Shale is "effective April 1, 2010 ... an area of mutual interest agreement with Windsor Niobrara LLC, which we refer to as Windsor Niobrara, to jointly acquire oil and gas leases on certain lands located in Northwest Colorado for the purpose of exploring, exploiting and producing oil and gas from the Niobrara Formation." That agreement provides that each party must offer the other party the right to participate in such acquisitions on a 50/50 basis. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement." Gulfport is "the operator" of the Nobrara acreage - but the partner - Windson Niobrara is controlled by Wexford.

The Thailand assets are in two parts - Tatex Thailand II and Tatex Thailand III.

Gulfport have a 23.5% ownership interest in Tatex Thailand II, LLC. The remaining interests in Tatex II are owned by other entities controlled by Wexford.

Gulfport have a 17.9% ownership interest in Tatex III. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford.

Windsor, an entity controlled by Wexford, is the operator of all Gulfport's assets in the Permian Basin.

The Permian Basin Assets were (at year end) subject to an agreement with Windsor which provides that each party must offer the other party the right to participate in 50% of each such acquisition. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement.

In other words Windsor owned 50 percent of these and operated them. There is an interesting post-year end transaction which may be the subject of another blog post.

The Southern Louisiana assets (known as West Cote and Hackberry) are not owned by Wexford but Wexford entities provide barging, drilling and pressure control services.

The Utica Shale assets are operated by Gulfport but like the Niobrara and Permian assets they are subject to a 50-50 sharing agreement with a Wexford controlled entity.

In other words Wexford is integral to the running or ownership or both of every asset controlled by Gulfport. The Chairman of Gulfport (Mike Lidell) cements this link. He is the operating member and in some cases an officer of many of the Wexford entities.

Wexford knows more than anyone else about this company

As we have shown Wexford is either a major owner or operator or supplier to every Gulfport Asset. The Chairman of Gulfport is also (at least in part) a Wexford man.

Wexford is a big fund - according to its website it has $5.6 billion under management.

It is worth knowing what Wexford is doing with their stake. The answer is selling. And selling. And selling some more:

Trade Date	Symbol	Company Name (Issuer)	Trade Type	Shares	Price ($)	Value ($)
2012-03-13	GPOR	Gulfport Energy Corp	Sale	245,000	32.80	8,035,020
2012-03-08	GPOR	Gulfport Energy Corp	Sale	329,670	32.53	10,723,835
2012-03-09	GPOR	Gulfport Energy Corp	Sale	370,422	33.17	12,285,416
2012-03-12	GPOR	Gulfport Energy Corp	Sale	150,000	32.43	4,864,200
2012-03-07	GPOR	Gulfport Energy Corp	Sale	381,968	32.32	12,347,115
2012-03-06	GPOR	Gulfport Energy Corp	Sale	50,000	31.23	1,561,700
2012-03-05	GPOR	Gulfport Energy Corp	Sale	59,000	32.18	1,898,797
2012-02-29	GPOR	Gulfport Energy Corp	Sale	17,000	34.50	586,585
2012-03-02	GPOR	Gulfport Energy Corp	Sale	17,200	33.75	580,534
2012-03-01	GPOR	Gulfport Energy Corp	Sale	459,000	34.11	15,657,408
2011-12-05	GPOR	Gulfport Energy Corp	Sale	1,150,000	27.84	32,016,000
2011-03-30	GPOR	Gulfport Energy Corp	Sale	2,760,000	30.56	84,345,600
2010-12-17	GPOR	Gulfport Energy Corp	Sale	3,910,000	19.40	75,854,000

Still they have 5.3 million shares left - and these have a not-inconsiderable value. Moreover almost all the sales have been at prices far above the current price. Their ownership position (including capital raises) has far more than halved.

I take a highly knowledgeable and very rich seller selling aggressively at prices around $30 as a good sell signal at prices around $30.

It is less good a sell signal where we are currently trading (at prices around $20). The reasons I am still short will need to wait for another post.




John

Wexford Capital and Gulfport Energy

Gulfport Energy is a reputable Oklahoma based oil and gas company with widespread interests including in Canadian oil sands (via Grizzly Oil Sands) and in the Utica shale. It trades on the NASDAQ and has a market cap of a little over 1.2 billion dollars. The ticker is GPOR.


Wexford Capital is a reputable hedge fund and investment group based in Greenwich Connecticut with (according to the website) $5.6 billion in assets under management. That is more than 100 times what we manage.


The principal of Wexford is Charles E Davidson. He has a fine CV which I have cribbed from the website:

Charles E. Davidson, 59, co-founded Wexford in 1994 and serves as its Chairman and Chief Investment Officer.  Mr. Davidson has primary responsibility for the overall strategic direction of Wexford’s investment activities and serves as the senior portfolio manager for the Wexford Spectrum Funds and the Wexford Catalyst Funds.  From 1984-94, Mr. Davidson was a General Partner of Steinhardt Partners, L.P. where he was responsible for all fixed income arbitrage, risk arbitrage, private equity, distressed/bankruptcy and special situation investments of the multi-billion dollar hedge fund.  From 1977-84, Mr. Davidson was employed by Goldman Sachs & Co. where he was the head of domestic corporate bond trading and proprietary trading.  Mr. Davidson holds an MBA and a BA in economics from the University of California – Los Angeles.

Last week I read the proxy for Gulfport Energy which goes through the relationship with Wexford. There, properly disclosed, are many related party transactions.


The hedge fund I run is (apart from the management contract) involved in no related party statements so I find complex related party transactions surprising. However, as I said, they are properly disclosed. Here are a list of related party transactions from the last proxy:

... Based solely on Form 4 filed with the SEC on March 13, 2012 by Charles E. Davidson. Represents 5,336,526 shares of common stock held by CD Holding Company, LLC. Mr. Davidson is the manager and a member of CD Holding Company, LLC and the Chairman and Chief Investment Officer of Wexford Capital LP...

... We are a party to administrative service agreements with Stampede Farms LLC, which we refer to as Stampede Farms, Everest Operations Management LLC, which we refer to as Everest, and Tatex Thailand III, LLC, which we refer to as Tatex III. Under these agreements, our services include professional and technical support and the fees for such services can be amended by mutual agreement of the parties. Each of these administrative service agreements may be cancelled (1) by us with at least 60 days prior written notice and, (2) by the counterparty at any time with at least 30 days prior written notice to us and (3) by either party if the other party is in material breach and such breach has not been cured within 30 days of receipt of written notice of such breach. We did not provide services under any of these agreements in 2011 and received no reimbursements thereunder. Each of Stampede Farms, Everest and Tatex III is controlled by Wexford Capital LP, or Wexford...

... We contract with Athena Construction, L.L.C., which we refer to as Athena, to provide barge services in our West Cote Blanche Bay, or WCBB, and Hackberry fields located along the Louisiana Gulf Coast. For the year ended December 31, 2011, we paid Athena $3,389,000 and owed an additional $676,000 for such services at that date. Athena is controlled by Wexford...

... Effective March 1, 2008, Everest provides tax planning, preparation of supporting tax schedules and consultation services to us based on an agreed fee structure. The scope of such services can be modified with the mutual agreement of the parties. Everest is controlled by Wexford. We paid Everest $5,000 for these services in 2011. 

Caliber Development Company, LLC, or Caliber, provides building maintenance services for our headquarters in Oklahoma City, Oklahoma. For the year ended December 31, 2011, we paid Caliber $20,000 and owed an additional $2,000 at that date. Caliber is an entity controlled by Wexford. 

Great White Directional Services LLC, which we refer to as Directional, performs directional drilling services for us at our WCBB and Hackberry fields. Directional was an entity controlled by Wexford until August 24, 2011 when it was sold to an unrelated third party. Directional is no longer a related party. While still a related party, we paid Directional approximately $2,625,000 and owed an additional $1,133,000 for such services at that date. 

Great White Pressure Control, which we refer as Pressure Control, performs services for us at our WCBB field. Pressure Control was an entity controlled by Wexford until August 24, 2011 when it was sold to an unrelated third party. Pressure Control is no longer a related party. While still a related party, we paid Pressure Control approximately $80,000. No amounts were owed to Pressure Control as of August 24, 2011. 

Black Fin P&A, LLC, which we refer to as Black Fin, performs plugging and abandonment services for us at our WCBB field. For the year ended December 31, 2011, we did not pay any amounts to Black Fin and owed $436,000 to for such services at that date. Black Fin is an entity controlled by Wexford.

... We have a 23.5% ownership interest in Tatex Thailand II, LLC, or Tatex II. The remaining interests in Tatex II are owned by other entities controlled by Wexford. Tatex II holds 85,122 of the 1,000,000 outstanding shares of APICO, LLC, or APICO, an international oil and gas exploration company. APICO has a reserve base located in Southeast Asia through its ownership of concessions covering two million acres which includes the Phu Horm Field. During 2011, we received $870,000 in distributions from Tatex II. 

We have a 17.9% ownership interest in Tatex III. Tatex III owns a concession covering approximately one million acres in Thailand. Approximately 68.7% of the remaining interests in Tatex III are owned by other entities and individuals affiliated with Wexford. During the year ended December 31, 2011, we paid $3,794,000 in cash calls to Tatex III. 

We own a 24.9999% interest in Grizzly, a Canadian unlimited liability company, through our wholly owned subsidiary Grizzly Holdings, Inc. The remaining interests in Grizzly are owned by other entities controlled by Wexford. As of December 31, 2011, Grizzly had approximately 754,000 acres under lease in the Athabasca region located in the Alberta Province near Fort McMurray. Grizzly Holdings Inc. entered into a loan agreement with Grizzly effective January 1, 2008, under which Grizzly borrowed funds from us. Borrowed funds initially bore interest at LIBOR plus 4% and had an original maturity date of December 31, 2012. Effective April 1, 2010, the loan agreement was amended to modify the interest rate to 0.69% and change the maturity date to December 31, 2011. Effective October 15, 2010, the loan agreement was further amended to change the maturity date to December 31, 2012. Interest was paid on a paid-in-kind basis by increasing the outstanding balance of the loan. During the year ended December 31, 2011, we loaned Grizzly approximately $3,182,000 and recognized interest income of approximately $147,000. Effective December 7, 2011, Grizzly Holdings Inc. entered into a debt settlement agreement with Grizzly under which Grizzly agreed to satisfy the entire outstanding debt and accrued interest of $22,325,000 by issuing additional common shares of Grizzly with no effect to the ownership structure of Grizzly. 

During the third quarter of 2011, we purchased a 25% ownership interest in Bison Drilling and Field Services LLC, or Bison, at a cost of $6,009,000, subject to adjustment. In April 2012, we increased our ownership interest in Bison to 40% for an additional payment of $6,152,000. The remaining interests in Bison are owned by entities controlled by Wexford, including Windsor Permian LLC, or Windsor. Bison owns and operates drilling rigs. 

During the fourth quarter of 2011, we purchased a 25% ownership interest in Muskie Holdings LLC, or Muskie, at a cost of $2,142,000, subject to adjustment. The remaining interests in Muskie are owned by entities controlled by Wexford, including Windsor. Muskie holds certain assets, real estate and rights in a lease covering land in Wisconsin that is prospective for mining oil and natural gas fracture grade sand...

... Effective as of November 1, 2007, we and Windsor entered into an area of mutual interest agreement to jointly acquire oil and gas leases in the Permian Basin. The agreement provides that each party must offer the other party the right to participate in 50% of each such acquisition. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement. During 2011, we acquired approximately 604 net acres from Windsor under the terms of this agreement for an aggregate of $1,102,000. Windsor is controlled by Wexford. 

Windsor is the operator of all of our acreage in the Permian Basin. As operator of these properties, Windsor is responsible for the daily operations, monthly operation billings and monthly revenue disbursements for the properties in which we hold an interest. For the year ended December 31, 2011, Windsor billed us approximately $56,103,000 and at December 31, 2011, we owed $5,593,000 for these services. 

Effective April 1, 2010, we entered into an area of mutual interest agreement with Windsor Niobrara LLC, which we refer to as Windsor Niobrara, to jointly acquire oil and gas leases on certain lands located in Northwest Colorado for the purpose of exploring, exploiting and producing oil and gas from the Niobrara Formation. The agreement provides that each party must offer the other party the right to participate in such acquisitions on a 50/50 basis. The parties also agreed, subject to certain exceptions, to share third-party costs and expenses in proportion to their respective participating interests and pay certain other fees as provided in the agreement. We are the operator of this acreage in the Niobrara Formation. As operator, we are responsible for daily operations, monthly operation billings and monthly revenue disbursements for these properties. For the year ended December 31, 2011, we billed Windsor Niobrara $6,642,000 and, at December 31, 2011, Windsor Niobrara owed us $3,557,000 for these services. Windsor Niobrara is controlled by Wexford. 

In February 2011, we entered into an agreement with an unrelated third party to acquire certain leasehold interests in acreage located in the Utica Shale in Ohio. The agreement also granted us an exclusive right of first refusal for a period of six months on certain additional tracts leased by the seller. As of December 31, 2011, we had acquired leasehold interests in approximately 98,000 gross (49,000 net) acres in the Utica Shale in Eastern Ohio under these and other agreements for approximately $118,421,000. As of February 20, 2012, we had closed on additional acquisitions bringing our leasehold interests to approximately 107,000 gross (53,500 net) acres. We have commitments with various future closing dates that could increase our acreage position in the Utica Shale to an aggregate of approximately 125,000 gross (62,500 net) leasehold acres. Entities affiliated with Wexford, primarily Windsor Ohio LLC, or Windsor Ohio, participated with us on a 50/50 basis in the acquisition of the leases described above and, at December 31, 2011, held leasehold interests in approximately 49,000 net acres for which they paid approximately $118,413,000, excluding fees and expenses of $1,184,000 billed under the acquisition team agreement described below. We are the operator on this acreage in the Utica Shale. 

Effective July 1, 2008, we entered into an acquisition team agreement with Everest to identify and evaluate potential oil and gas properties in which we and Everest or its affiliates may wish to invest. Pursuant to this agreement, Gulfport and Everest each agreed to form an acquisition team. Upon a successful closing of an acquisition or divestiture, the party whose acquisition team identified the acquisition or divestiture is entitled to receive a fee from the other party and its affiliates, if applicable, participating in such closing. The fee is equal to 1% of the party’s proportionate share of the acquisition or divestiture consideration. The agreement has a one-year term unless earlier terminated by either party upon 30 days notice. 

From time to time, certain of our petroleum engineers provide services relating to evaluation of potential investments to Wexford and geological evaluations, seismic review and similar services to Tatex II and Tatex III. Wexford, Tatex II and Tatex III, respectively, have agreed to reimburse us based on the amount, scope and nature of services provided by our petroleum engineers to such entities. We did not provide any services under these arrangements in 2011.

As you can see there are considerable (properly disclosed) related party transactions with Wexford. Helpfully they include a summary:

Our Relationships with Wexford and its Affiliates 

Charles E. Davidson is the Chairman and Chief Investment Officer of Wexford and he beneficially owned approximately 16.8% of our outstanding common stock as of December 31, 2011. Wexford is the manager of the Wexford-controlled entities described above. As manager, Wexford has the exclusive authority to, among other things, purchase, hold and dispose of the assets of each such entity. Mr. Liddell, our Chairman of the Board, is the operating member and, in some cases, an officer, of certain of these entities. All distributions made by these entities are first paid to the Wexford members in accordance with their respective ownership interests until they have received amounts equal to their respective capital contributions. Thereafter, distributions are to be made 90% to the Wexford members in accordance with their respective ownership interests and 10% to Mr. Liddell. Mr. Liddell is not currently entitled to, and has not received, distributions from any of these entities. All transactions between us and these entities are reviewed and approved by our independent directors.

All for thought and consideration of my readers.

John

Disclosure: We are short Gulfport Energy and have been for some time. We recently increased the position.

A stock called Comedy: the joke is on someone or other

China Medical Technologies – a Chinese diagnostic, medical testing and genetic tools company which I am short – is possibly the strangest story in our portfolio. Here is the official “business description”:

China Medical Technologies, Inc., a medical device company, develops, manufactures, and markets immunodiagnostic and molecular diagnostic products. It uses molecular diagnostic technologies, including fluorescent in situ hybridization (FISH) and surface plasmon resonance (SPR), and enhanced chemiluminescence immunoassay (ECLIA), an immunodiagnostic technology in the development, manufacturing, and distribution of diagnostic products for the detection of various cancers, diseases, and disorders, as well as companion diagnostic tests for targeted cancer drugs. The company offers immunodiagnostic products, such as ECLIA analyzers and reagent kits for various clinical applications, including anemia, cardiac diseases, food safety, growth disorders, hepatitis, HIV, infertility, liver fibrosis, metabolic function, reproductive endocrinology, SARS, thyroid disorders, and tumors tests. It also provides FISH probes, a molecular diagnostic IVD reagent for the prenatal diagnosis of various genetic diseases; detection and prognosis of various cancers; and identification of cancer patients. In addition, the company offers HPV(human papillomavirus)-DNA chips, a molecular diagnostic biosensor chip, and SPR analyzers for the diagnosis of HPV infection and genotyping of HPV. It sells FISH probes and SPR chips to large hospitals through its direct sales force; and ECLIA reagent kits to small and mid-size hospitals through distributors. The company was founded in 1999 and is based in Beijing, the People's Republic of China.

The old ticker for the company was CMED but the company has been delisted, trades on the pink-sheets and has gone completely silent. They issue no SEC filings, pay coupons on none of their debt and do not answer questions from investors or regulators. The ticker is now CMEDY.PK.

According to their last published accounts they had roughly 100 million US dollars in cash, 20 million US dollars (118 million RMB) in quarterly pre-tax profits and were under absolutely no financial stress. They did however have $396 million US dollars in convertibles outstanding. At a high stock price those converts would convert. At a low price they would pay in cash so if the stock price was low enough the company might have had to refinance. However with 20 million per quarter in profitability it was hardly going to a problem.

Well it looked like it was not going to be a problem.

Some shortsellers thought that the company was using its cash to purchase assets from undisclosed related parties. More florid allegations went around but I have verified none of them.

Still the stock went down.

It went below the conversion price for the convertible which meant the above-mentioned covert would be due in cash. And then – strangely – the company put out a press release stating they intended to restructure this debt. Here is the key release:

BEIJING, Dec. 13, 2011 /PRNewswire-Asia-FirstCall/ -- China Medical Technologies, Inc. (the "Company") (Nasdaq: CMED), a leading China-based advanced in-vitro diagnostic ("IVD") company, today announced that the Company intends to implement a debt restructuring plan to improve its balance sheet. The plan may include, without limitation, a debt-for-debt exchange with existing holders of the Company's convertible notes maturing in August 2013 and December 2016, which may potentially involve holders receiving new debts with different interest rates, maturities and principal amounts compared to the existing debts or other alternatives to be agreed. Holders of the Company's convertible notes are requested to contact the Company's Cayman legal representative, Thorp Alberga at cmednoteholders@thorpalberga.com, which will collect contact information from such holders to facilitate their communication with each other to form a noteholders' committee to liaise with the Company. 

This was truly remarkable. The company – at least on the stated balance sheet – had enough money to pay the debt (at least for a while). It certainly did not need to default on trivial coupons – but it defaulted.

Worse – it did not even tell anyone it defaulted. The bond trustee notified holders and that is all. And since then the company has been completely silent. It does not answer any questions from investors or regulators. It has just disappeared.

So what happened?

There are two hypotheses: (a) this really is a fraud or (b) this is a real company and the management are playing “silly buggers” to restructure the balance sheet to their liking (or even to steal the company).

A lot of people believe the second thesis. In this a solvent company simply stopped paying its debts and are hoping the convertibles covert (at $10 a share) and sell the stock in market (at $2 a share) to recover what money they can. And the insiders (who are talking to nobody) are buying the stock at $2 a share (perhaps with cash from the company) and in the end they will really own it.

There are other theses – including that the company is being taken private surreptitiously through a shadowy arrangement with a small American mutual fund group. This furthered the spike in the stock.


Read the Yahoo! chat board and you can have another twenty theses some implying honest management and lying short-sellers and some implying awful things about the management. There is very little way of telling them apart. Management answer no questions so all speculation is in a knowledge vacuum.


We were short but we were worried that this might be the good Chinese company thrown out by a fraud allegation - we are always wary of being wrong. And the stock was going up which is never comfortable for a short seller.

So whilst the stock hung in the air much the same way bricks don't we hired someone with genuine expertise in diagnostic tests to look at the technical specifications of the medical tests they had on their website. (Our expert can read Chinese.)

Here was their response:

They have three product lines: ECLIA, FISH, and SPR. I am a bit busy doing other stuff, so I will do this in three parts, one product line per part. Here is the first part on ECLIA: 

ECLIA instrument and assays are proprietaryECLIA Product brochures have no product specification Sensitivity of instrument is stated as 10^-19, but no units givenCan’t find any patents that belonged to the company 

ECLIA is what they call Enhanced chemiluminescence immunoassay. The company said it is a closed system, i.e. proprietary instruments and diagnostic assays. The assays cannot be used in 3rd party instruments, and the instruments cannot be used for 3rd party assays. This is very strange because cost is important in diagnostics based on chemiluminescense technology. A closed system means higher cost, smaller volume, but you hope to make up for it on price, i.e., differentiate products based on quality. Indeed, they claim that their instrument is very sensitive, 10^-19. But 10^-19 of what? They don’t specify the unit. Regardless, whether it’s molar or ng/ml, 10^-19 sounds very impressive. However, I am used to nano or pico scale, and 10^-19 is one million times more sensitive than pico scale. This seems impossible. Not only impossible technically, but also business wise –  what diagnostic applications would need this kinds of sensitivity? I can’t think of any. Also, I don’t think sensitivity matters for the type of assays they sell. 

Chemiluminescence immunoassay is the technology found in pregnancy tests sold in drug stores. This is an old and cheap technology. In general, you use this technology to get yes or no answers quickly and cheaply. The sensitivity of  chemiluminescence immunoassay is usually below 0.5ng/ml, i.e., already very sensitive. Regardless, for in vitro diagnostics, most of the technology should be in the assays, not in the instruments. And here is where I found strange - the company does not have product specification for its assays on the web. On the other hand, lots of Chinese instrumentation and diagnostic assays products sold on Alibaba show no product specification at all.  The only immunoassay technology that is known for its sensitivity is radioimmunoassay, but it is a niche product specific for detecting allergen for allergy diagnostic. If CMEDY’s technology is real, then it's ECLIA products have a very small niche and it probably has no sales - the company has only one test for allergy – total IgE.

We remain short this stock. CMEDY is a good ticker – add an 0 (which is where I think the stock will wind up) and you get COMEDY. That is good for a laugh.


John

The question I wanted to ask at the Berkshire meeting

I never got to ask a question at the Berkshire meeting. I was a little awed and did not even ask until about 2pm (which was silly). There was a lottery ticket system to determine who got to ask a question anyway.

So here goes (and for the most part I genuinely do not know the answer).

Insurance companies sell promises to make good real goods and services some time in the future for cash now. For example they promise to pay someone's medical expenses or a nursing home bill say 10 years after a premium has been collected. 

They mostly hold the cash receipts in cash and bonds. Berkshire also use some real assets (eg railways) and many banking stocks. 

Because insurance companies are short real goods and services and long cash and other nominal assets they negatively affected by inflation. Long tail insurance companies are obviously worse hit with inflation than short tail companies. 

Can you run through the major Berkshire insurance businesses (GEICO, Gen Re, Ajit Jain's business and others) and tell us what damage inflation will do and why?

Answers are gratefully accepted - especially from Uncles Charlie and Warren (who I somehow doubt read this blog).




John

PS. I should disclose because people are doubting it - that Bronte Capital is LONG Berkshire stock.

J

Thoughts on the Berkshire meeting and a comment on long term care reinsurnace

I am in Omaha and have just been to the Warren and Charlie show. It has been on my "to do" list for my whole adult life and I am strangely disappointed.

It is of course blasphemous to be disappointed in Charlie and Warren. These octogenarians could teach me plenty - they just did not. It was annoying to be in the presence of people so smart and to learn so little.

I have read various notes from the meeting for almost twenty years so I had a fair idea what to expect. I could expect - questions on politics and economics, questions from young people wondering what to do with their life and questions from hedge-fund managers using 25 thousand rich people in a room as an opportunity for self promotion.

I got all this - and for the most part I got the usual homily answers. (The same questions were asked last year and the year before and the year before that. Answers can be got from meeting notes.)

This year we got multiple questions from hedge fund managers who were concerned about the stock price. Charlie Munger in frustration tartly observed that if one (nameless but well known) hedge fund manager was that concerned about short term matters he wasn't really welcome in this room. This got general applause but could (like many of Charlie's answers) be a little more diplomatic.

But with the above exceptions the questions were better than I expected. Much better. We had serious questions from competent Wall Street analysts who mostly asked about insurance, underwriting and regulatory issues - issues that cut to core of what Berkshire is and Berkshire's ability to route money to the parent company (where it can be used unencumbered) and to pay insurance claims. The detailed answers to these questions were largely squibbed.

One analyst for instance made the obvious observation that the organizational structure is "challenging" and wondered why the railway (BNSF) was owned by a regulated insurance subsidiary. Charlie and Warren squibbed it - arguing that BNSF provided more resources for paying claims - noting roughly $5 billion in pre-tax profits. But throughout the meeting Warren argued that one advantage of BNSF was that it was going to be allowed to invest vast sums (far in excess of depreciation) at acceptable regulated returns. In other words BNSF is going to absorb cash. How does this mean the insurance sub is going to have more cash to pay claims? Can claims be paid in steel rails or railway bridges?


This wasn't an atypical squibbed answer. Warren (correctly) argued that General Re was a good asset now but that previously it lost its way. Charlie wasn't going to let Warren get away with this - it was thoroughly lost when Berkshire purchased it (and paid a huge price). However the details of how General Re was brought back into order were simply glossed over. Warren observed that Gen Re had a very nice life reinsurance business. That surprised me. Swiss Re has a sort-of-OK life reinsurance business but life reinsurance is a business that has produced a few disasters one of which I followed closely*. I was struggling to understand what made the life reinsurance business a good business.

Warren also noted - as a throwaway - that they had a long term care reinsurance business that he wished they had less of. Again there was no explanation as to why. But this time it is inside my field of competence so I am going to explain myself.

The disaster of long term care insurance

Long term care insurance has bankrupted almost everyone that ever touched it. It is the insurance against the need to go into a nursing home and it has mostly been sold by insurance agents on commission.

Here is what a commissioned agent does.

They make friends with people who run nursing homes.

When the kids (now middle aged) visit a nursing home they might put their (elderly) parents into the insurance broker is notified. The insurance broker then sells them a policy for their parents.

Of course the policy is going to be used. The people who buy long term care insurance are precisely the people who are going to claim. It is a disaster.

Eventually the policies become so expensive (to cover the losses) that people who won't claim never buy a policy. Adverse selection becomes total.

Long term care insurance is the worst business I have ever seen.

Warren of course never told us that - but somehow he wound up re-insuring it.

I guess he did not want to explain his stupidity.

But then long term care doesn't need to be that awful. Indeed there is (at least) one company that does it well.

That doesn't make long term care a good business - but it might make it an acceptable business.

That company is (and this will be a surprise to many of my readers) Genworth. The same Genworth that was a spin-out of crappy long-tailed insurance businesses from GE Capital. It includes a mortgage insurance company (with what is probably a toxic Australian exposure) and a long term care business.

Here is what they do to make the long term care business acceptable.

They employ a sales force of 60-65 year old people on salary not commission. Because they are on salary not commission they have no incentive to write bad risks. They do not troll for business in nursing homes.

This sales force visits the home of leads and has a cup of tea or coffee and a social chat. They might spend twenty minutes having a chat.

They will find out what the lead's husband or wife is doing.

They will find out whether the lead is doing the New York Times crossword or reading sophisticated books.

And whether they play golf or do some exercise.

They will look for pictures of the grandchildren and ask questions about them.

They will observe and ask about the pile of toys and children's games in the corner.

And only then will they ask anything that looks like an underwriting question but they will have already decided whether to underwrite the business.

Here is what is going on.

People who have stable relationships into old age tend not to wind up in nursing homes. They look after each other. Singles are the biggest risk and asking about a spouse is the critical question.

Doing the New York Times crossword or reading sophisticated books indicates no Alzheimer's disease. That removes another major insurance risk.

Golf suggests some physical fitness - and removes more risk.

The children's toys however are - after a solid marriage - the next largest risk mitigating factor. If the grandparents look after the grandchildren that creates a reciprocal obligation. The children are far less likely to put granny in a nursing home if granny is a part of their own kid's lives.

Warren knows all this. He knows why some insurance businesses are better than others. He knows why their life reinsurance business is good (I have no idea). He knows why their long-term care reinsurance business is bad (and after this post so do you).

But Warren told us surprisingly little. And for that I am disappointed.




John


*I was once obsessed by the collapse of Annuity and Life Re.

Post script: in all except a very bad year or a very high cap-ex year the depreciation plus profits of BNSF will probably be less than cap-ex so there are likely to be distributable funds. One exception may be if a catastrophe removes many of the bridges or damages the rails or closes the line for an extended period. That however may well be a big claims year for the insurance company so the situation can still be problematic.

Huabao Suspends Trading After Falling on Short-Seller Report

Huabao - a Chinese flavours and fragrances company in Hong Kong - has suspended trading after falling on a short-seller report. To quote a Business Week article:

Huabao International Holdings Ltd. (336), a maker of flavors and fragrances used in cigarettes, suspended trading in Hong Kong after the stock plunged on a short-seller report that questioned its finances. 

Huabao fell 8.1 percent to HK$3.98 at the close in Hong Kong yesterday after short seller Anonymous Analytics said the company “reports absurdly high margins, which industry sources say should not be possible.” 

The company didn’t give a reason for the suspension. In a Hong Kong stock exchange filing late on April 24, Huabao said it wasn’t aware of any reasons for the changes in its share price and trading volume.

Readers of this blog should be familiar with the stock as I blogged about it here. I also blogged about the (now in excess of a) billion US dollars the CEO had cashed out and the derivative transactions that she had used to do so.

The suggestions in my blog post - and a few other things - were covered in the short-seller report.




John Hempton


Disclosure: We remain short this company - albeit in modest quantity.

Do I have any blog readers in Istanbul?

Just asking. I am visiting.

Send me an email through the blog.

Daddy you are more evil than I thought

It is the holiday part of the trip and I was strolling through the back-lot footpaths of Venice with my twelve year old son. We were doing out best to get lost (surprisingly easy) and I had given up worrying that my wife had (dangerously) gone shopping.

It was four hours chatting to the boy about business and history and life without the interruptions of computers, phones or video games.

We talked about the trading history of Venice, the closure of the Venetian constitutional system (La Serrata of 1286 to 1297) and the subsequent relative decline. We talked about the expenses of the nearly endless series of wars against the Ottoman empire.

We even mentioned the rise of double-entry accounting. We got as far as the collapse of the Venetian State at the hands of Napoleon.

We also talked at length for the first time about our business. We run a hedge fund. Our job is simple: make rich people richer through investing, trading in financial markets.

Half of that is relatively easy to explain: we buy shares in good companies. My son wanted to know why I was not interested in buying Facebook (he thought the shares are going up). I told him that it had 4 billion in revenue, 1 billion in profits and a market cap that was likely to edge 100 billion. The numbers are from memory (I am on holidays). That seemed expensive. However it was only about $200 per regular user which does not seem so expensive. I did not think I could analyse it well. This was the beginning of a discussion about price.

But then the area our fund is best known for came up. I am a short seller.

I went through the mechanics of short-selling. I borrow a share from a broker. I sell it in the market. If the stock goes down I get to buy it back for less than I sold it. I repay the loan by returning the share and I keep the profit. I explained it does not work so well when the stock goes up.

Then I got to the nub of the issue: I am a short-seller of frauds and stock promotes. I look for people in the stock market who have fake accounts and who are stealing from gullible shareholders (also known as marks, dupes, fools, day traders or mutual fund managers). There is a torrent of money being ripped off (many billions of dollars for instance in the case of the Chinese frauds a surprising amount of which came from Fidelity). Through short-selling I stick up my sail on my little boat in the hurricane of theft and some of that loot drops into the cabin.

He asked me how I find all these fake accounts and fake companies and I told him a few of our methods (we have many).

He asked if I ever dobbed the scammers in to regulators and I said I did sometimes but it was mostly not a satisfactory experience. To be a good short-seller I only need to be right about 90 percent of the time. If most the companies I short-sell have fake accounts I will do fine. However if I dob them into regulators I need to be absolutely right in that it does not bode well to dob an honest person into the authorities. So mostly I keep my gob shut and express my opinion (and it is an opinion) in a bet in the financial market.

Moreover talking about which stocks you think are frauds is a dangerous thing. Regulators sometimes (even foolishly) have been known to investigate short-sellers for telling the truth. (Being  short Lehman Brothers and vocal about it was a good way of getting an SEC investigation for talking truth to power.) Also crooks sue short-sellers giving you nasty and expensive legal bills.

Silence is altogether a better strategy.

But then he came to the nub of the issue. The easiest scammer to find is a repeat offender. We actively seek out people who promote dodgy stocks and who who are repeatedly involved in dodgy companies. The slogan is “once a scumbag, always a scumbag”. That slogan is probably not strictly accurate -  but we only need to be right 90 percent of the time to be fantastic at this business – and the recidivism amongst scammers is surprisingly high.

In that sense long sentences for people like Bernie Ebbers are not in my interest. I would prefer slime-bags to be back-in-business rather than in prison. More opportunities for me.

So, perceptively my son asked whether it was in my interest to dob scammers into regulators – he asked whether the reason we did not do it much was because of the reasons stated above or because we liked the scammers to be free and profitable. Alas – and I had to confess it – at least part of it was that being a successful short-seller required that regulators were inadequate to the task of policing fraud.

I did not talk about this with him – but it is becoming harder under Mary Schapiro. The SEC is getting better at their job – and that is not good for me. It would be better if regulators stayed hopeless. Alas they are getting better.

So, says my son asks you like nasty people to steal from poor investors, mutual funds (and he did not say pension funds for school teachers) so that you can join them in taking the loot by being a short-seller – and you don't want the regulators to do anything about it because there are more opportunities for you?

Sheepishly I confess yes.

And he says with a mixture of admiration and horror: “daddy you are more evil than I thought”.





John

PS. A long time ago I promised Felix Salmon an economic defence of short-selling. I did not deliver – but it is sort of written in my head. I think I owe it to my son too.

Lessons in my laundry: Italian edition

On my travels I found myself in a fine hotel in Central Milan. I came in about Midnight the previous night from London (courtesy the atrocious service of Easy-Jet*).

At 6.15AM I was up for my morning meeting - via a fast-train to Bologna. My shirt was clean courtesy the expensive London laundry. I just wanted an ironing board to press out the wrinkles.

There was not one in the room - so I rang reception. I asked them to bring one up. They said "impossible" which I found peculiar. An ironing board is a pretty standard service in a 4 star business hotel.

Then they explained that they could not get one before 7.30 (which was just before my train left). I said this was a bad fail for a business hotel.

Then they said something that was so stereotypical Italian it left me breathless. They told me it would be against the law to bring an ironing board to my room before 7.30 am.

I told this to my Bologna business contact and he scoffed. Of course somewhere in the 10 million lines of Italian code there is - of course - something that talks about ironing boards. Dysfunctional government (at least by the standards of OECD countries) is an iconic feature of Italy - but this was not government as a problem - it was government as an excuse.

At least Easy-Jet don't blame the government for their bad - even rude - service.



John


*If anyone knows why European discount carriers are so horrible but Southwest (surely a similar model) is so pleasant (at least in a relative sense) let me know. In the USA I will fly Southwest in preference to any other airline. In Europe I am learning to avoid the discount airlines.

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A post script is warranted: Part of my dislike of Easy-Jet had to do with a ridiculous overcharge of GBP12. Trivial really. However when I complained at the counter the discussion had the tone of "I can see you are right but our computer won't let me refund the money so sorry". Silly stuff that indicated process over service. And I had 90 minutes at an airport and was frazzled. Not a good combination. I did not raise my voice - just walked away frustrated.

In frustration I wrote a (nasty) letter to them. I do not think they linked me to this blog - but they refunded the 12 pounds. I think that marks them as several steps better than Ryan Air. I have not quite forgiven but I think I am prepared to give them another go.

Lessons in my laundry: Hong Kong edition

I do irregular (but extended) business travel. (It comes from living in Australia – when you travel it is usually more than a week.)

And so I find myself needing to wash and iron business shirts and press a suit. Nothing complicated – but strangely the price and procedure changes by country. In New York I usually stay in Brooklyn and my walk to the subway takes me past a Chinese laundry which is breathtakingly cheap – my bag usually costs under $12. That is about a quarter what I would pay in Sydney (which is an expensive city for almost everything) and a third London. Brooklyn seems cheaper than other US cities.

This low-cost laundry (clearly a benefit to me) is made possible by a near-sweatshop centralised Chinese laundry where (immigrant) workers work hard for what may or may not be minimum wage.

When I wrote a post about that I was criticised for daring to state the obvious about income inequality in the United States. It is a taboo topic. In my defence several readers noted that investment bankers regularly press their own shirts in London. I certainly do in Sydney.

When I stayed in a friend's house in Chicago I discovered much to my surprise they did not have an ironing board. I thought it worth a blog post. And whilst the underlying tone was that income inequality was not the finest attribute of a society I have to say it is not entirely a bad thing. The couple I stay with in Chicago are a monstrously successful husband and wife team with children. Very few married women with children pull that off in Sydney – and the reason was obvious. The wife's work life (high profile but only moderately remunerative) relied more than a little on the two nannies and the implied low-wage workers (such as the staff at the local laundry) who relieved her of the mundane house-work that fills many (mostly female) lives in Australia.

This was feminist achievement made possible by income inequality. But it was achievement at a very high level and the USA is better for it.

This trip I stayed at a friend's apartment in Hong Kong. Nice place – not huge – but half-way up the Mountain on Hong Kong Island with an expansive view of skyline (when you can see through the pollution).

I asked to borrow an ironing board. My friend said he could do better. He knocked at a small door past the closet next to the kitchen and out popped a Filipino house-keeper maybe 20 years his senior. She cheerfully laundered my clothes and left them neatly pressed. She also made me breakfast, cleaned up my dishes and made my bed when I went to work.

I made a point of trying to work out her story. She had been a migrant worker throughout her life – mostly in Hong Kong but also in Dubai (which she found harder). She was thinly educated but thought her children (who she had spent years away from) were better prepared than her. The reason for migrant work was to educate her children (though I know nothing about their prospects – the Philippines are not a highly functional place). Unlike Harry Potter she did not show any unhappiness in living in the “cupboard under the stairs”. Instead it was a step-up for her and (especially) for her family. And it was better than Dubai.

But it made me deeply uncomfortable. Migrant workers are a profoundly anti-democratic institution – they provide a class of very-low income people who don't vote. The ethos of democracy is something burnt into my consciousness. In this ethos we are “created” equal (and thus have an equal vote) and dint of luck and hard work (or coming from the right womb) produce inequalities (some deserved, some otherwise). But the vote (hopefully a secret ballot) is one of the great equalisers – and acts to create a more harmonious society (albeit one that will interfere with income distribution to some extent). The woman who cheerfully lived in the cupboard under the stairs challenged what I thought was right in the world.

But then I was in Hong Kong (that is China) and another low-wage worker who does not vote in China seems – well – somewhat irrelevant. And my world view was out of place. Moreover the woman's children were clearly better off for her migrant work. And the Philippines would be a true basket case without remittances.

And low-income workers are a gift to those who get to employ them. They make the Feminist achievements of my above-mentioned Chicago friends possible. They can free productive people to work on things that were productive.

And that was clearly the case for my friend – consciously trying to pick up additional commercial languages (think India), improve his computer processing skills (python) and read a book per week. His ambition to build himself into as fine a thinker (and with as many diversified mental models) as Charlie Munger. Human capital development made possible by the profoundly undemocratic institution of migrant work.

But that was not the only thing people do with their wealth in Hong Kong. Hong Kong Island has become a pastiche of office towers for financial businesses and shopping malls selling the global standard set of luxury goods. Interspersed amongst that are stylish but ultimately vacuous bars where you can get wasted in the time you would have otherwise spent ironing your clothes and doing the dishes. It is not far (just a subway) from Kowloon where you can experience the smells and sounds of Asia – but they joke on Hong Kong Island that you need your passport to go there.

This is a world very different to mine – with some amazingly productive people – their productivity made possible by the institutions of China. Interspersed amongst that the most dilettante hedonistic lifestyle of an elite who can think of nothing better to spend their loot on than Swiss watches and French Brandy.

Whatever: I am going to make a confession. I liked having someone launder my clothes and the stylish bars are very cool. Freeing up all that time to read an extra book per week – that would be very cool too.




John