As the stock market keeps moving higher an investor has to work harder to find undervalued opportunities. One place to look of course is the area of spin-offs where the spun-off company is often sold quickly and without regard to price by many institutional shareholders.
In my notes I found an old CNBC interview with the master of the spin off investment Joel Greenblatt”
DAVID: Your book says you can be a stock market genius, even if you’re not too smart. What are some of the tricks here that–that–that allow you these kind of astronomical returns?
Mr. GREENBLATT: Well, I think to do it the way everyone else does it every year, 80 percent of the mutual fund managers who do a lot of work, can’t seem to beat the market, you have to take maybe a little different angle. And the way I look at things is if you’re looking in places that other people aren’t, you have a much better chance of beating the market.
DAVID: And these are what you call pockets of opportunity’?
Mr. GREENBLATT: Right. There are some areas of the market where, on average, those areas beat the market just randomly selecting those areas.
DAVID: Let’s talk about spin-off securities, which is one of these pockets. T–tell us about spin-offs–I–the one I talked to you about before we went on the air, that I thought of, was Lucent Technologies–is that an example, wh–when it was spun off by AT&T?
Mr. GREENBLATT: Sure. AT&T actually had two spin-offs last year: One was Lucent Technologies and one was NCR. The one that I purchased was NCR. What happens is, is that–NCR’s a computer company, was a division of AT&T, a telephone company. And to separate itself–this small division from the company–they would distribute shares–AT&T distributed shares to its shareholders in NCR. They weren’t purchased. Just if you owned AT&T shares, you would get a distribution of NCR shares. What happens to these shares is that people who get them sell them off.
DAVID: Mm-hmm.
Mr. GREENBLATT: They bought AT&T–they bought a telephone company. They’re not interested in a computer company that AT&T lost $ 7 billion in in the last six years.
DAVID: Well, they sell them off, though, doesn’t the price go down?
Mr. GREENBLATT: The price–that’s exactly why there’s an opportunity. The people who get the stock don’t want it…
DAVID: Mm-hmm.
Mr. GREENBLATT: …they sell it. You get an initial low price, and w–on average–there was a 30-year study that showed that spin-offs beat the market by 10 percent a year just on average.
DAVID: Got a minute, so we’ll have to split it up. But the other pockets of opportunity–merger securities is another one. Give me an example.
Mr. GREENBLATT: Well, when Viacom purchased Paramount, they purchased it with cash, they purchased it with stock and they purchased it with four other securities–warrants, convertible debentures, things of that nature. If you own stock in Paramount and–and Viacom bought it, you would get stock, you’d get cash and maybe you’d keep those things. But if you get all these securities that you’ve never even heard of, you just sell them off. And there’s an–another opportunity to have extraordinary gains in that area.
DAVID: How do I turn somebody else’s misfortune into my fortune with bankruptcies?
Mr. GREENBLATT: Well, what’s interesting is, in bankruptcies, you don’t really invest in stocks after they go bankrupt, but what you can do is–the way stocks come out of bankruptcy is that they give their creditors, like a bank or a–a–a supplier, stock in the company…
DAVID: Mm-hmm.
Mr. GREENBLATT: …so that they can come out–because they can’t pay off the debt…
DAVID: Right.
Mr. GREENBLATT: …because they don’t have the cash. So these suppliers and banks get stock in a company that they had no interest in getting.
DAVID: Right.
Mr. GREENBLATT: They sell it right off. It’s the same exact opportunity as in spin-offs and merger securities.
DAVID: It’s all in here, “You Can Be a Stock Market Genius, Even If You’re Not So Smart.” Our thanks to Joel Greenblatt, author of “You Can Be a Stock Market Genius.”
A favorite company of many value investors Contango Oil and Gas is about to spin off a tiny, tiny unit called CORE. Contango of course is engaged in natural gas exploration and production in the Gulf of Mexico. CORE is a unit that Contango CEO Ken Peak started up to explore for gold and rare earth minerals in the State of Alaska. I think there are going to be a lot of people who like Contango Oil and Gas but have no interest in a gold and rare earth company that is run by an Oil and Gas man. Contango has a market cap of almost $900 million. CORE is going to have a $3 million in fixed assets and $3.5 million in cash. Yes, under $10 million of book a value.
So with a spin off that is basically a rounding error in size relative to the parent (less than $10 million vs $900 million) AND in a totally different line of work I think there are going to be a lot of shareholders who not only have to sell the spin off because it is so small, but also want to sell it because they don’t like or have any interest in the business.
This looks like a very likely candidate for a reduced price post spin off. But I’m not sure I’m going to be terribly interested in it regardless. Why ? Because I can’t value this business in any way. Yes it has cash and fixed assets, but the cash is going to be consumed by whatever exploration work they do.
What does have my attention though is that fact that CEO Ken Peak thought that this exploration was worth pursuing. Peak is a virtual role model for smart capital allocation decisions so I think you have to pay attention when he risks capital on something.
Here is the detail of Contango/Peak entering the Alaskan prospecting bidness:
MARCH 8, 2010 – HOUSTON, TEXAS – Contango Oil & Gas Company (NYSE Amex: MCF) announced today that its wholly-owned subsidiary, Contango ORE Company (“CORE”), has agreed to invest up to $3.0 million to conduct mineral exploration activities on approximately 580,000 acres of Alaska Native and State of Alaska lands located in interior Alaska (“Mineral Exploration Lands”). CORE purchased a 50% ownership from a private company for $1.0 million, together with our commitment to invest the next $2.0 million of capex to fund the expenses associated with the initial mineral exploration phase on this acreage. CORE and its partner will share expenses on a 50/50 basis thereafter and each will own a 50% working interest burdened by an approximate 5% overriding royalty interest.
Field exploration began in June 2009 and CORE has thus far invested a total of $1.3 million. In our 2009 exploration program, a total of 1,076 rock, soil, pan concentrate and stream silt samples were collected. Of this total, 567 rock and soil samples were taken over a 40-acre area of exploration interest, with 348 samples showing measurable amounts of gold and 30 samples with measured gold of 0.5 grams per tonne or higher. The Mineral Exploration Lands have not been extensively explored for gold and cover several geologic terranes which are prospective for mineral deposits with gold, base metal and platinum group element prospects that are on trend to our Mineral Exploration Lands. Should this summer’s planned trenching, soil samples and mineralization studies indicate that additional exploration is warranted, CORE will have the opportunity to invest significantly more capital in this project.
Kenneth R. Peak, Contango’s Chairman and Chief Executive Officer, said, “This investment does not signal, foreshadow or represent a change in our natural gas and oil exploration business model. We recognize that the risks and challenges inherent in gold exploration are quite different from our natural gas and oil exploration business and were attracted to invest in this project solely by what we perceive to be its reward/risk ratio, where a relatively small amount of initial exploration risk capital ($3 to $5 million is envisioned) could potentially lead to a more extensive gold exploration/development project. Our 2009 exploration program found relatively few samples of commercial grade gold ore – generally considered to be 0.5 grams per tonne or more – but we believe our results merit an expanded exploration program for the summer of 2010.”
Mr. Peak continued, “Our planned 2010 exploration program will be directed toward additional rock sampling, trenching and drilling core holes. Shareholders are reminded that at this early exploration stage our investment should be considered as nothing more than an “interesting speculation” and that the odds of our ultimately being successful in finding gold in a volume sufficient to support a commercial gold mining operation are quite low. To put it in oil and gas parlance, this “play” is the rankest of “wildcats” that is currently only at the “idea” stage and we are hoping, based on our 2010 work program, to learn if we can mature it to the “prospect” stage in order to justify committing additional risk exploration capital. After we have taken our core, rock and pan samples, they will be assayed in an independent lab and then evaluated for prospectivity and commercial development potential. This process will likely take until December 2010.”
You can see that even Peak basically views this as speculation. I’ll likely take a pass on this unless I feel like I can buy at less than the value of the company’s fixed assets which would give us some downside protection and a free lottery ticket on the gold speculation.
