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)





Last fiscal year ($17,596)





Average of the last 5 years ($17,119)






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%). You can download this spreadsheet and play with the numbers.


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)





Last fiscal year ($12,808)





Average of the last 5 years ($12,744)





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.