I have really come to appreciate Efficient Market Theory; it’s eloquent, clever, and logical. For the uninitiated, EMT basically states that all information about a security is reflected in the price. Thus, every stock, and therefore the market as a whole, MUST be fairly valued. The conclusion of all this is picking stocks is a loser’s game, and you’re better off in an index fund.
However, the one BIG assumption made by EMT is that all market participants are rational and emotionless allocators of capital, which of course isn’t the case. The Market is a “system,” and just like any other system, the Market reflects EVERY input. As EMT suggests, the “inputs” into the Market include all public information, but the inputs ALSO include every ounce of fear and every iota of greed. It’s these “soft” inputs that by definition make the market inefficient. Additionally, these “soft” inputs are unique because, unlike information, they build upon themselves (after all, it’s a second derivative world). In other words, fear begets fear and greed begets greed (this concept has been coined “reflexivity” by George Soros).
Now, I could wax philosophical about this kind of thing, but I’d much rather focus on using the above framework to uncover undervalued stocks (called “ick” investing by Michael Burry). Because emotions have a compounding effect on stocks (i.e. reflexivity, i.e. fear makes the stock go down, which in turn creates more fear, which in turn makes the stock go down further, etc.), an overabundance of fear can create a significant gap between price and value. To put it simply, if you go searching for negative headlines, earnings shortfalls, and lawsuits, you could find yourself in the land of opportunity!
If you bought stocks in the first few months of 2009, you were probably “ick” investing… and btw well done! But those screaming opportunities are long gone (and at the time they weren’t obvious, they’re only “screaming” in hindsight). So let’s focus on where ick investing takes us today. What makes the investing public cringe? The answer, of course, is lots of things.
But for the purposes of this article I’m going to focus on an area where I’ve recently invested: natural gas exploration and production companies with leveraged balance sheets. I recently purchased GMXR and one of the top 3 stocks on my watch list is SD.
So, what has made this particular group “icky”? Natural gas inventories are the highest they’ve been in 5 years and at the same time more and more wells are being drilled. We’re also in the midst of the Great Recession, so the demand for natural gas is well below historical levels. This supply/demand reality has driven the price of natural gas EXTREMELY low. Secondly, as a result of the shenanigans over the past several years, just about every investor is weary of highly leveraged companies. This fear isn’t completely unfounded either, with an uncertain interest rate picture some of these firms could really take it on the chin if rates go up. However, it’s my guess that the prices for this group of stocks not only reflect the current reality, but also reflect an overabundance of fear.
Now I’ll briefly discuss some of the reasons I like SD. First let’s talk about management. Tom Ward is the CEO of SandRidge, and is also the co-founder and former president/COO of CHK (he served in this role from 1989 to 2006). With an ownership stake in the mid-teens, his interests appear to be closely aligned with those of shareholders. Equally as important, he knows HOW to build a company and he understands that a company is a vehicle/means for creating wealth.
Recently SD has been shifting its focus to oil with its purchase of oil assets from FST and its pending merger with ARD. I think this shift in strategy will mitigate natural gas specific risks, AND I also think this shift in strategy has yet to be recognized and priced into the stock.
Lastly, at the peak of the commodities boom SD traded at over $65 a share and today it trades around $7.50. I personally think SD is worth somewhere between $10 and $20 a share, so let’s split the difference and assume it has an intrinsic/fair value of $15. If we then assume it takes 2 years for the stock price to converge with its fair value, you get a 40% annual return, not bad…
As a final note, it looks like some gurus and insiders agree with me – Prem Watsa and T. Boone Pickens have been buying shares along with Board members and senior leadership.
-MEvsEMT
The author uses a value investing philosophy to run a highly concentrated portfolio, which represents the majority of his net worth. The author first began investing in 2005, and over the last 4+ years he has generated an annual return of 19.4% vs. 2.3% for the S&P. Any time he buys or sells a stock he posts about it on his blog, www.mevsemt.blogspot.com
However, the one BIG assumption made by EMT is that all market participants are rational and emotionless allocators of capital, which of course isn’t the case. The Market is a “system,” and just like any other system, the Market reflects EVERY input. As EMT suggests, the “inputs” into the Market include all public information, but the inputs ALSO include every ounce of fear and every iota of greed. It’s these “soft” inputs that by definition make the market inefficient. Additionally, these “soft” inputs are unique because, unlike information, they build upon themselves (after all, it’s a second derivative world). In other words, fear begets fear and greed begets greed (this concept has been coined “reflexivity” by George Soros).
Now, I could wax philosophical about this kind of thing, but I’d much rather focus on using the above framework to uncover undervalued stocks (called “ick” investing by Michael Burry). Because emotions have a compounding effect on stocks (i.e. reflexivity, i.e. fear makes the stock go down, which in turn creates more fear, which in turn makes the stock go down further, etc.), an overabundance of fear can create a significant gap between price and value. To put it simply, if you go searching for negative headlines, earnings shortfalls, and lawsuits, you could find yourself in the land of opportunity!
If you bought stocks in the first few months of 2009, you were probably “ick” investing… and btw well done! But those screaming opportunities are long gone (and at the time they weren’t obvious, they’re only “screaming” in hindsight). So let’s focus on where ick investing takes us today. What makes the investing public cringe? The answer, of course, is lots of things.
But for the purposes of this article I’m going to focus on an area where I’ve recently invested: natural gas exploration and production companies with leveraged balance sheets. I recently purchased GMXR and one of the top 3 stocks on my watch list is SD.
So, what has made this particular group “icky”? Natural gas inventories are the highest they’ve been in 5 years and at the same time more and more wells are being drilled. We’re also in the midst of the Great Recession, so the demand for natural gas is well below historical levels. This supply/demand reality has driven the price of natural gas EXTREMELY low. Secondly, as a result of the shenanigans over the past several years, just about every investor is weary of highly leveraged companies. This fear isn’t completely unfounded either, with an uncertain interest rate picture some of these firms could really take it on the chin if rates go up. However, it’s my guess that the prices for this group of stocks not only reflect the current reality, but also reflect an overabundance of fear.
Now I’ll briefly discuss some of the reasons I like SD. First let’s talk about management. Tom Ward is the CEO of SandRidge, and is also the co-founder and former president/COO of CHK (he served in this role from 1989 to 2006). With an ownership stake in the mid-teens, his interests appear to be closely aligned with those of shareholders. Equally as important, he knows HOW to build a company and he understands that a company is a vehicle/means for creating wealth.
Recently SD has been shifting its focus to oil with its purchase of oil assets from FST and its pending merger with ARD. I think this shift in strategy will mitigate natural gas specific risks, AND I also think this shift in strategy has yet to be recognized and priced into the stock.
Lastly, at the peak of the commodities boom SD traded at over $65 a share and today it trades around $7.50. I personally think SD is worth somewhere between $10 and $20 a share, so let’s split the difference and assume it has an intrinsic/fair value of $15. If we then assume it takes 2 years for the stock price to converge with its fair value, you get a 40% annual return, not bad…
As a final note, it looks like some gurus and insiders agree with me – Prem Watsa and T. Boone Pickens have been buying shares along with Board members and senior leadership.
-MEvsEMT
The author uses a value investing philosophy to run a highly concentrated portfolio, which represents the majority of his net worth. The author first began investing in 2005, and over the last 4+ years he has generated an annual return of 19.4% vs. 2.3% for the S&P. Any time he buys or sells a stock he posts about it on his blog, www.mevsemt.blogspot.com
