Go where it is darkest: When company, country, currency and commodity
risk collide
I believe that you learn valuation by doing,
not talking, reading or ruminating about it. It is natural to want to value companies
where there is a profit-making history and a well-established business model in
a mature market. You will have an easy time building a valuation model and you
will arrive at a more precise estimate, but not only will you learn little
about valuation but it is unlikely that you will find immense bargains, because
the same qualities that made this company easy to value for you also make it
easier to value for others, and more importantly, easier to price. I believe
that your biggest payoff to valuation is in valuing companies where there is
uncertainty about the future, because that is where people are most likely to
abandon valuation first principles and go with the herd. So, if you are a long-term
investor interested in finding bargains, my advice to you is to go where it is
darkest, where micro and macro uncertainty swirl around every input and where
every estimate seems like a stab in the dark. I will not claim that this is
easy or comes naturally to me, but I have a few coping mechanisms that work for
me, which I describe in this paper.
While I enjoy valuing companies with
uncertain futures but there are cases where my serenity about valuation is
disturbed by the coming together of multiple uncertainties, piling on &
feeding of each other to create a terrifying maelstrom. In this post, I
want to focus on two companies, one Brazilian (Vale) and one Russian (Lukoil), where the confluence of bad corporate governance,
a spike in country risk, currency weakness and plunging commodity prices have
conspired to devastating effect. You could adopt the lazy & very dangerous
contrarian strategy that Vale and Lukoil must be
cheap simply because they have dropped so far but I don't have the stomach for
that. I do believe, though, that if I can find ways to grapple with this risk,
there may be opportunity in the devastation.
Background, history and
market standing
Vale is one of the largest
mining companies in the world, with its largest holdings in iron ore,
incorporated and headquartered in Brazil. Vale was founded in 1942 and was
entirely owned by the Brazilian government until 1997, when it was privatized.
In the last decade, as Brazilian country risk receded, Vale expanded its
reach both in terms of reserves and markets well beyond Brazil, and its market
capitalization and operating numbers (revenues, operating income) reflected
that expansion.
Notwithstanding this long-term
trend line of growth, the last two years have been a difficult period for Vale,
as iron ore prices have dropped and Brazilian country risk has increased
(leading into a presidential election that was concluded in October 2014). The
graph shows Vale's stock price over the last 6 months (and contrasts it with
another mining giant, BHP Billiton).
Lukoil
is a Russian oil company that has seen its profile, market capitalization and
revenues rise as Russia's oil production has surged. While the company is not owned by the
Russian government, it does have close ties to the Russian power structure and
that connection, which has served it well during its lifetime, has become a
liability in the aftermath of the Russian adventure in the Ukraine, compounded
by the collapse of oil prices in the last few weeks:
Though there are
fundamental reasons for the stock price decline at both Vale and Lukoil, the fear factor is clearly also at play, because
these companies are exposed to risk not only to commodity and country risk but
there are also significant concerns about corporate (or is it political)
governance at both companies as well as currency risk factors (as both the
Brazilian Real and the Russian Ruble have slid over the last few months).
Corporate governance risk
In a post on Alibaba, I made the argument that corporate governance
affects value by making it more difficult (if not impossible) to change
management, and thus increasing the risk that a company that embarks on the
wrong course may continue on that path unchecked. With both Vale and Lukoil, there are both explicit and implicit reasons to
believe that investors in these companies will have little or no say in how the
company is run.
The place to start
analyzing corporate governance is the ownership structures of the company. With
Vale, the first sign that corporate governance is weak is the fact that they
have two classes of shares (and yes, I would make this argument about Google
and Facebook as well). In the graph below, I break down the top stockholders in
both classes.
Vale is effectively run by Valepar, which is a shell entity controlled by seven
investor groups. If you own Vale shares, as I do, it is very likely that you
own the non-voting preferred shares and that you have no say in who sits on the
board of directors and how the company is run. There is also a wild card
in this equation in the form of a golden share that is owned by the Brazilian
government, giving it veto power over major decisions and the line between
corporate and political governance becomes a fuzzy one. While Vale is nominally
an independent company, the Brazilian government reserves the right to intrude
on its management, and that power can be used to good and bad effects. The
positive is that it gives Vale a leg-up on competition in Brazil, giving it
first dibs on Brazilian reserves of iron ore, and the negative is that the
company can become a pawn in political games. Much of Vale's success in the last
decade came from a willingness on the part of the Brazilian government to give
it free rein to be run as a profit-making entity, but the machinations leading
up to the last election (where the incumbent, Dilma Roussef, was viewed as more likely to interfere in the
company's operations) have taken their toll. (The damage has been even greater
at Vale's dysfunctional twin, Petrobras, Brazil's
other large natural resource giant).
Lukoil's
ownership structure provides some clues to both why it has been successful and
the potential corporate governance nightmares ahead. The good news is that Lukoil has only one class of shares outstanding, with equal
voting rights, but the bad news is that it is not quite clear whether you will
ever get to vote for meaningful change (making it akin to a Russian political
election):
The lead stockholder is Vagit
Alekperov, formerly Russian deputy minister for oil
production. It is entirely possible that he accumulated substantial knowledge
about the oil business, while in the ministry, and brought that knowledge and
entrepreneurial zeal into play in founding Lukoil,
but it is also likely that he used his connections with the power elite to get
reserves at well below fair-market prices in building up the company which
would make him obligated to maintaining good relations with the inner circles
of Russian government. In September 2004, ConocoPhilips
bought 7.6% of Lukoil's shares to create what it
termed a strategic alliance, which it increased to close to 20%, before selling
its stake in 2011 at an undisclosed price, partly to Lukoil
and partly in the open market. As with Vale, the line between corporate and
political governance is a gray one at Lukoil, and if
you are considering buying shares in the company, it should be with the
recognition that you will have no role in how the company is run (no matter
what you read about corporate governance on the company's website).
Country risk
While investing is
always risky, it is riskier in some countries than others, partly because of
where the country is in terms of its life cycle (with growing emerging markets
being more volatile than established mature markets), partly because of the
overlay of political risk in the country and partly because of the
effectiveness or lack thereof of legal protection and enforcement of property
rights. Consequently, when valuing companies, you have to factor in where the
company operates to measure its exposure to country risk.
As a commodity
company, Vale does sell into a global market and as a producer of iron ore, it gets a significant portion of its revenues from
China (the largest consumer of iron ore in the world). The country of
incorporation in Brazil, and Vale is exposed not only because a significant of
the proportion of its reserves are in Brazil, but also because the government
has significant powers in the day-to-day running of the business. Not
surprisingly, Vale has been impacted by changes in perceptions of Brazilian
country risk. Using the sovereign CDS spread for Brazil as a proxy for country
risk, and looking at the last decade:
As Brazilian
country risk has declined over the last decade, Vale benefited, but country
risk is a double-edged sword. As Brazilian country risk has risen in the last
few weeks, Vale has felt the pain in the market:
It goes without
saying that Lukoil, which has 90.7% of its reserves
in Russia, is affected by Russian country risk. Here again, the last decade has
been a good one for both Russia and for Lukoil, as
lower country risk (measured with the CDS spread) for the former has gone with
higher market capitalization for the latter.
To investors who
were expecting more of the same, this year must have been a shock, as Russian
country risk surged in the aftermath of the events in the Ukraine.
Currency risk
When
valuing individual companies, it is generally good practice not to be a
currency forecaster and to value the company based upon prevailing exchange
rates (current and forward, from the market). It is also undeniable that
currency movements in your favor will make a bad investment into a good one,
just as currency movements against you can turn a good investment into a bad
one.
With
Vale, the stage was set in a decade where the Brazilian Real strengthened
against the US dollar, even though inflation in Brazil was much higher than
inflation in the US. As with country risk, the currency risk dragon has turned
on investors and the last few weeks has seen a meltdown in the value of the
Brazilian currency.
The story is similar for Lukoil. A decade of a strengthening ruble, in spite of
fundamentals that would suggest otherwise, has been followed by the collapse in
the last few months.
It is not clear what the
effect of a weakening currency will be on both companies. To the extent that
their reserves are in Brazil (at least for iron ore, for Vale) and in Russia
(for Lukoil), the costs are in the local currency but
their revenues are in global markets, denominated in US dollars. Thus, a
weakening of the currency can improve profit margins.
Commodity risk
Do
commodity prices affect the value of commodity companies? Stupid
question, right? Of course, they do, but the degree of impact can vary
across companies. Higher commodity prices will generally push up revenues and
to the extent that the cost of developing reserves stays stable, operating
margins will increase. In some cases, though, and especially so with oil
companies, the government can use a heavy hand (see political risk in the
corporate governance section) and force the company to sell oil at subsidized
prices to consumers in the country, effectively creating a subsidy cost for the
company that will increase with oil prices. (That is a problem at Petrobras, for instance).
Vale's
fortunes have risen as the Chinese economy has grown, primarily because China
has become the largest consumer of iron ore in the world. It is robust Chinese
growth that lifted iron ore prices in the last decade to hit highs in 2011, but
that engine has slowed and as it has, iron ore prices have dropped in the last
two years:
Lukoil
also benefited from the increase in oil prices in the last decade, driven
partly by geopolitics and partly by the explosive surge in automobile sales in
emerging markets.
Here
again, though, the last few months have seen a decline in oil prices to less
than $80/barrel.
While
it is easy to make the argument that commodity prices move in cycles and what
goes down has to go back up again, these cycles are unpredictable and have very
long lead times. Thus, you could have spent the entire 1980s waiting for oil
prices to go back up, just as you would have waited the entire last decade for
the drop back in prices.
Valuing Vale
The value of Vale is
affected by all of the above: its value is a function of company, country,
currency and commodity risks. To capture the effects, I valued Vale in US
dollar terms and assumed that Vale was a mature company, growing at 2% a year
in perpetuity. I varied the following inputs:
1. Operating
income: The operating income in the trailing 12 months,
through November 2014, was $12.48 billion, well below the operating income in
the last fiscal year ($17.6 billion) and the average operating income over the
last five years ($17.1 billion).
2. Return
on capital: The return on capital in the last 12 months was
11.30%, higher than the cost of capital that I estimated of 8.59%, but lower
than the return on capital in the most recent fiscal year (14.90%) and the
average over the last five years (18.22%)
To estimate the cost of
capital, I built off the US 10-year treasury bond rate as the risk free rate
and used an equity risk premium of 8.25%, reflecting a weighted average of the
equity risk premiums across the countries where Vale has its reserves (60% are
in Brazil). You can check out the spreadsheet yourself and change the numbers.
Varying the numbers, I get
the following estimates of value per share for Vale.
|
Last 12 months (11.30%) |
Last fiscal year (14.90%) |
Average of last 5 years (18.22%) |
Equal to cost of capital |
|
|
Last 12 months
($12,475) |
$20.55 |
$21.83 |
$22.57 |
$18.87 |
|
Last fiscal year
($17,596) |
$30.69 |
$32.50 |
$33.53 |
$28.32 |
|
Average of the last
5 years ($17,119) |
$34.12 |
$36.11 |
$37.25 |
$31.52 |
I am sure that I am
missing something but at the stock price of $8.53 on November 18, 2014, it seems like it is grossly
under valued.
Valuing Lukoil
I
followed a similar path for Lukoil, varying operating
income and return on capital, while valuing the firm as a stable growth firm
(with a 2% growth rate) and with a cost of capital that reflects an updated
equity risk premium for Russia (9.50%).
|
|
Last 12 months
(11.71%) |
Last fiscal year
(12.04%) |
Average of last 5
years (14.32%) |
Equal to cost of
capital |
|
Last 12 months
($11,803) |
$80.81 |
$81.32 |
$84.24 |
$80.45 |
|
Last fiscal year
($12,808) |
$88.60 |
$89.16 |
$92.32 |
$88.21 |
|
Average of the last
5 years ($12,744) |
$88.10 |
$88.66 |
$91.81 |
$87.72 |
At $45.30 a share on November 18, 2014, I am again
either missing something profound or the stock is massively under priced.
What now?
It is easy to come up with reasons not to buy Vale
and Lukoil right now and wait for things to get
better. That is precisely why I already own Vale (and I am not in the least bit
ashamed to admit that I bought my shares at $12/share) and plan to add to my
holdings. I plan to buy Lukoil to my portfolio, and
live with the discomfort of having no power to exert change. After all, at the
right price, you can live with a lot of discomfort.