There were several good performers in the quarter. Among the best were Cabot Oil & Gas (COG) +25.2%, Foot Locker (FL) +20.5%, Rosetta Resources (ROSE) +8.4% and Patterson-UTI Energy (PTEN) +7.6%.
Cabot Oil & Gas has continued to perform well due to its exposure in the Marcellus shale. The company‟s results in this prolific natural gas area have been exceptional. It is becoming clear that Cabot has one of the better positions in the Marcellus. The flow rates from Cabot‟s wells in this region are among the very best in this field.
Foot Locker has also performed well. It has a clean balance sheet and management continues to operate as we expected. This has now gotten the attention from Wall Street and the stock has moved up. As a result, we trimmed our position during the quarter.
Rosetta had another good quarter. Its crown jewel, the Gates Ranch in the Eagle Ford located in Texas, continues to perform well. The 26,500 acres contain more than 12 TCF of oil and natural gas, with production increasing from 7mcfe/day to 90 mcfe/day in one year, and is now 60% of the company‟s total production. More importantly, the economics of these wells are extraordinary. The company estimates that each well, on average, should recover 7.2 bcf per resource of oil and natural gas. This translates to a per well PV-10 (before tax present value using a 10% discount rate) of over $13 million, using commodity prices around $80/barrel for oil and $5/mcfe for natural gas.
Using the current development pace, well spacing, and type curve in the Gates Ranch area alone, Rosetta looks to have continued development through 2016, while recovering less than 20% of the resource in place. The company is already testing down spacing to 50 acres instead of the existing 100 acres spacing. Should this turn out to be economical, then Rosetta could have another 250 wells to drill in this highly economic area.
Rosetta has another 23,500 net acres in liquid rich areas in the Eagle Ford that it will continue to assess. Several areas show promise based on wells already drilled by Rosetta and by surrounding competitors. In addition, the company has 300,000 net acres in the Southern Alberta Basin. It has drilled 11 delineation wells across the entire acreage. It is planning 3 horizontal wells to assess the commerciality of this play. Should it be commercial and the economics favorable, the Southern Alberta Basin could be highly additive to Rosetta's intrinsic value.
The balance sheet has improved significantly with debt coming down from $350 million to $250 million. With cash of $80 million and an undrawn revolver of $300 million, Rosetta has the balance sheet to develop the highly profitable Gates Ranch area and use the cash flows from this to support the development of other promising areas. The stock price has moved up significantly since we invested in Rosetta, but the economics of the Gates Ranch area, the potential in other areas in the Eagle Ford and the Southern Alberta Basin, leave room for further upside. With that said, we continued to trim the stock during the quarter in response to the share appreciation.
Patterson-UTI Energy, the leading land rig company in the U.S., continued to benefit from increased drilling. The company has performed well by adding new rigs to its fleet, taking advantage of demand for the higher-end equipment that is needed and preferred in the more demanding shale developments. Patterson-UTI has also added significant frac capacity over the last few years. This is now paying off since this equipment is being used in shale developments.
During the quarter, we trimmed more than one fifth of our stocks as they approached or reached their fair values. This discipline is a key part of our process, selling stocks as they get close to or exceed their fair values, and buying stocks that sell at substantial discounts to their intrinsic values.
The worst performers for the quarter were Cimarex Energy -22.0%, Reliance Steel -14.1%, Rowan Companies -12.1%, and Newfield Exploration -10.5%. These stocks gave up some of their large gains they had previously experienced. We began trimming three of these stocks as their share prices were running up during the quarter. Cimarex was acquired during the financial crisis when its stock was trading in the teens. We have sold 60% of our position in the company as the stock price has run up. The stock closed the quarter at $90, down from $115 at the beginning of the quarter. We are comfortable holding the remainder of our position since the company is well managed, has a strong balance sheet, has a high liquids content in its production and reserves and it has the ability to grow production going forward. The same can be said for Newfield Exploration, also acquired during the financial crisis. We have sold more than half of this position and are holding the remainder due to Newfield's high liquids content in production and reserves, good balance sheet and management team with a focus on returns on capital and the processes in place to execute.
We started accumulating shares in Oshkosh Corporation (OSK) during the second quarter. Oshkosh is a specialty vehicle manufacturer. Its products include off-road armored army trucks, fire trucks, aerial work platforms, telehandlers, ambulances, snow removal vehicles, concrete mixers, and refuse collection vehicles. The Company was founded in 1917 and is based in Oshkosh, WI. What attracted us to Oshkosh was its long history and strong leadership positions in the markets it serves. The Company has great reach and invests heavily to provide superior products and services. An investment in OSK is about anticipation of future industrial recovery and a continued belief that our military is a logistics business, and therefore, the Department of Defense will at least maintain its vehicle fleet. The current strength in Oshkosh‟s defense business should protect shareholders until there is a recovery in industrial and commercial markets. The company's valuation during the second quarter met our parameters which resulted in initiating the position.
InterDigital, Inc. (IDCC) is another new company we added during the second quarter. It is a non-practicing entity that monetizes intellectual property in the wireless technology space. Although it does not manufacture any products, the company is not a basic patent portfolio manager or a patent troll but, rather, is an inventor of patents (they have invented 98% of their patents). It spends significant sums on R&D and files patents on technology considered essential for the wireless device industry. In turn, it demands licensing revenues. It is our belief that mobile communication will continue to grow in a rapid fashion. IDCC is well-represented in this growing wireless market due to the technology they provide to different vendors and should benefit from the proliferation of wireless voice, data, and internet service regardless of the eventual winners in the space. The company has a pristine balance sheet and a valuation that supports an initial position.
When we were children growing up, the kids at school use to play “Uncle”. That is the childish game where one kid grabs and twists the arm of another child behind his back and asks the kid who is in excruciating pain to give up by crying “Uncle”. We were never good at that game because we did not like a lot of pain, but the Greeks must be the world champs. They are clearly getting their collective arms twisted into a pretzel by the other EU countries and the International Monetary Fund (IMF), but simply refuse to cry “Uncle” and default on their sovereign debt.
We do not profess to be international macro-economic experts, yet it is very apparent to us that the Greeks will not directly receive 100% of the aid the EU or IMF have offered. No, billions in Euros pledged to “support” Greece are likely going to European banks in the form of guarantees for those banks that hold Greek bonds, or to fund some other EU entity to buy Greek debt at a steep discount. On the other hand, the Greeks are handed a pile of austerity prescriptions that will further erode their economic prospects.
At more than 150% of debt/GDP, Greece is one of the most highly levered countries in the world. This leverage only increases with the passage of time. Frankly, we do not see how Greece can avoid defaulting on its debt. Adding more debt to a shrinking or no growth economy does not make sense when the country cannot even pay off what is maturing this year or next. In our opinion, the EU is going to have to make a very difficult decision: either they support Greece, and possibly Portugal, Spain, Italy, and Ireland, at a great cost to the German, French, Dutch, and Finnish taxpayers, or they let Greece default and hope the contagion effects can be contained. We believe the risks to the global economy are high in both cases.
In the meantime, Greece needs to sell government-owned assets and raise capital to reduce the country's leverage or the prospective periodic payments from the EU and IMF will not be forthcoming. We agree that Greece needs to sell government assets and reduce the size of the government's hand in the country's economy. However, Greece, which is already one of the highest taxed countries in the world, has raised or will soon be raising taxes even higher. For instance, the Value-added Tax (VAT) was recently increased two percentage points. Income taxes on the wealthy are expected to increase, and this is after the wealthy already pay over 60% of their income in the form of income and social security taxes, assuming they report their income accurately. These higher taxes will likely drive more of Greece‟s economy to the “underground,” where the shadow economy now represents 25% of the official level.
We feel that higher tax rates on the Greeks at this point are a formula for more financial distress. Tax compliance in Greece is quite low compared to other European countries. As an example, the country has an extra tax for homes with swimming pools, but only 2% of the roughly 18,000 homes in northern Athens are paying the tax. With the official unemployment rate at 16%, tax compliance low, a contracting economy and high marginal taxes, the last thing the Greeks need is more taxes.
We fundamentally disagree with the EU and IMF prescriptions to cure the ailing Greeks. Rather, Greece should lower marginal tax rates, sell government owned assets to the private sector, restructure their legal system and cut burdensome regulations to incentivize capital investment in the country.
Following our recommendations, we believe Greece would experience more job opportunities, faster economic growth, and higher tax-revenue collections. As the economy grows and tax collections increase, the country‟s debt burden would start to decline and become more manageable. Instead, Greece is seeing capital flight, bank deposits that are shrinking (4 billion Euros in the month of May alone) and civil unrest as people lose their jobs.
We think what is happening in Greece is important for U.S. investors to understand because of the direct and indirect effects on our economy and country. First, most investors are familiar with the fact the Federal Reserve Bank announced its Quantitative Easing (QE2) program last summer and has enlarged its balance sheet by roughly $600 billion to $2.8 trillion. But does anyone know where the money went? Most knowledgeable people assume the Fed injected the money into the U.S. banking system in the form of additional bank reserves. There is clear evidence that since the Fed embarked on QE2 that the U.S. banking system did indeed experience an increase in excess reserves of roughly $600 billion. No mystery there. However, on closer inspection, it appears, according to Stone & McCarthy, nearly all $600 billion went into U.S. domestic bank branches of international banks; Deutsche Bank, BNP Paribas, Lloyds, etc.
The question arises as to why would the Fed inject money into these banks or why would these banks take on the additional credit from the Fed? As far as we are aware, these banks do not have a large deposit base in the U.S. These banks have small branch networks from which to make loans, for example, to the local plumber looking to expand his business. Is it possible that the Fed injected this money into these banks to forestall the looming European bank crisis and avoid a domino effect on our banks that have swap agreements with the aforementioned European banks? If Greece and Portugal, and for that matter Ireland, Spain and Italy, default on their sovereign debt might the U.S. economy directly suffer another debilitating blow as our banks and other financial institutions potentially suffer large losses due to their exposure to European bank agreements?
Of course, the Fed and the European banks are not going to announce why these banks in effect absorbed 100% of QE2. The appearance that these European banks received the vast majority of QE2‟s funding also partially explains why our domestic economy has exhibited sluggish growth over the past year. Had QE2's money been injected into either large or small U.S. banks, some of the Fed's largesse could have been used to finance our economy. There are many unanswered questions, and the answers could be more benign than what we pose as possible explanations for where the money went and why.
Interestingly, the entire Greece issue may be resolved by the German Constitutional Court. Several groups in Germany are arguing that the bailout of Greece, Portugal and others violate German Basic Law. German Basic Law provides that the Bundestag (Germany‟s Lower House of Parliament) has veto power over any bailout Germany's Chancellor agrees to with any other party. If the Constitutional Court affirms this right and the Bundestag fails to pass the bailout plan, look for market volatility to exert itself once again.
The situation in Greece and other highly-levered countries also indirectly affects U.S. investors. This is because Greece's financial pain could also befall on the U.S. if we do not reduce our Federal deficits and debt levels. What is happening in Europe today clearly exposes the risks to investors if unsustainable budget deficits and debt go unchecked for too long. While the current U.S. situation is not as dire as Greece's is today, our country is on the same harmful path as Greece and other profligate countries. The U.S. still has viable options at its disposal, without negatively impacting the long-term growth potential of our economy. However, the longer we wait to address these problems, the greater the odds our economy will suffer real damage. We do not need to cry uncle right now because we are not desperate, but it behooves Congress and the President to fix our structural spending issues with respect to entitlement programs and other Federal spending plans now, before it is too late.
Speaking of being desperate, the International Energy Agency (IEA) in late June announced the U.S. and 27 other countries would release 60 million barrels of oil into the market over the next few months. The reason why the IEA made this decision, according to its press release, was that the war in Libya had caused over a million barrels of oil per day to be pulled from the market. However, at the time of the IEA‟s announcement, WTI (West Texas Intermediate) oil prices had already declined nearly 17% from their spring 2011 high of $114 and there were no significant complaints or civil unrest due to the price of oil. While consumers embrace lower fuel prices, very few want their governments to manipulate prices for short-term, expedient purposes. Nonetheless, the price of WTI is now above the price on the day on which the IEA made its announcement. All the IEA did was confirm what we have been writing about for the last several years. That is, the supply of cheap oil is very tight and, as the non-OECD countries continue to develop and grow, the inexorable demand for oil will continue to put upward price pressure on this valuable commodity.
Turning to our crystal ball, we see continued choppy real economic growth for the rest of the year. However, we do not expect either Q3 or Q4 2011 to experience negative GDP results. That said, if the sovereign debt rescue plan in Europe unravels, all bets are off and we would expect our fragile economy to stall –and likely go into a recession. When an economy is growing only 1.5-2%, it does not take much to switch from positive to negative territory.
The credit markets have not fully healed, despite a substantial narrowing in credit spreads over the last couple of years. The residential housing market is still fraught with many foreclosures and nearly 25% of homes with a mortgage have negative equity. Recently, the Federal Housing Administration (FHA) announced that it will extend the period for unemployed homeowners to miss mortgage payments to a full year from the current three or four months. This will allow qualified homeowners to go without making a monthly payment for 12 months before the foreclosure process begins on FHA loans. Nettlesome government housing policies, such as the current FHA plan and other loan modification programs, do not help the credit markets.
The credit markets can only return to health once the financial institutions that own the bad loans either foreclose on the borrowers or sell these loans and get the bad credit off their books. The extend and pretend strategy only exacerbates the economic malaise in which we currently find ourselves.
The unemployment rate still hovers above the 9% level, and the U6 rate is over 16%. Clearly, the government‟s $600 billion stimulus plan, which was forecasted to help the unemployment rate decline to 6% by now, is not working. The higher costs and more rigid mandates to hiring workers imposed by the current administration are hampering job growth. Many small businesses, which have produced the majority of new jobs over the last two decades, do not have confidence in the economy or have the sales and profits that would encourage them to expand their workforce. The following two statements are from the June 2011 survey by the National Federation of Independent Business (NFIB):
“NFIB's monthly Small-Business Optimism Index dropped one tenth of a point (0.1) in June, settling at 90.8, an unsurprising reading, basically unchanged from the previous month and solidly in recession territory. While some indicators rose slightly – including expected capital outlays – pessimism about future business conditions and expected real sales gains tugged the Index down, causing a small but disappointing drop in the Index for the fourth consecutive month.”
“Small-business owners are registering a vote of 'no confidence' in the federal government,” said NFIB Chief Economist Bill Dunkelberg. “Between the deluge of new regulations and a Washington policy agenda that is largely ignorant of Main Street needs, stubbornly low consumer spending, and grave concern among small firms about the federal budget, there is not much to be optimistic about as a small-business owner.”
If the credit markets are weak and the job numbers bleak, why is stock market registering positive gains? The answer is two-fold: international profits are growing and domestic margins have held up better than many expected. A weak dollar, exhibited by the euro trading above 1.30 for most of the year, is allowing U.S. firms to translate their overseas profits into more dollars. The mirror image of a weak jobs market is lower corporate expenditures for labor. Thus, corporate profit margins continue to remain elevated and near post WWII highs.
We believe corporate profit margins will trend back down toward long-term averages. With the domestic economy experiencing sluggish growth, the European economies in a seemingly perpetual neutral gear, and China rapidly raising interest rates because of accelerating inflation, it will be more difficult for U.S. companies to show continuing good sales and profit growth. Moreover, corporate management has cut many expenses, including labor, about as far as is reasonably possible without suffering quality or customer service degradations. Thus, as margins and profits peak, stocks will find it harder to post continued earnings growth.
We outlined this scenario last year, and it looks like our warning of substantially lower stock returns versus the prior couple of years is playing out as expected. We recognize our expectations could be wrong and that the stock market may produce strong double-digit returns or better this year. However, our fishing hole is in the small-to-mid cap range of publicly traded companies. And, according to BNY Mellon, the Russell 2000 and 2500 P/E multiples at the end of June stood at 28.3x and 23.8x, respectively. These P/E ratios are not on depressed earnings; rather they are placed on earnings generated by profit margins at the very high end of the post WWII era. We are hard pressed to find a better way to destroy capital than to pay extremely rich multiples on potentially peak profits.
The bottom line for us is that we believe normalized profits are being ignored by other investors, and the stock market is willing to accept current earnings expectations as sustainable profits for the vast majority of companies. We see too many risks that could negatively impact profits and premium valuations investors are willing to pay today. The odds just are not in our favor to aggressively deploy capital.
We all have heard the term “cash is trash”, particularly with an effectively zero-interest rate policy by the Fed. However, the value of cash and liquidity has all too often rapidly appeared when investors lose confidence in the future. We feel comforted by our liquidity position and expect to diligently deploy this capital when reward-to-risk ratios meet our criteria for long term value creation. In closing, we thank you for your continued confidence and trust.