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I Pass on Chesapeake Energy - Here's Why

May 02, 2012 | About:
Value investors are attracted to low prices, which is a perfectly fine and even desirable instinct; it makes them buy companies that are unloved and sold by the masses and over time they sometimes do quite well — provided that they check some things. Good decisions not to buy can be profitable in the long run. Most know that if you unfortunately get caught on a single bad investment it could be a drag on your performance. I believe that quality management with integrity is one of the things that needs to be checked in order to avoid that risk.

I know little about Chesapeake Energy (CHK), but enough to realize that I should not spend an effort trying to understand it and concentrate my limited time on other things. I did evaluate Sandridge Energy (SD) around two years ago because it seemed cheap and Prem Watsa was buying into it. Watsa had also bought into USG Corp. (USG). USG's stock was severely hit by the construction market, but I never doubted about its management and it was one of my most successful investments.

SD was a different story. After trying to understand a bit about the gas business and land reserves I passed on SD partly because I had serious doubts about its management integrity, specifically over its CEO, Tom Ward. My doubt was that Ward seemed to have sold a big bunch of his company stocks in a very timely fashion: Just before announcing major merging news that impacted negatively the stock price. What he did may not have been illegal but it made me doubt his honesty.

I read a bit about Prem Watsa's fund at the time via its shareholder letters. Being trained by reading Warren Buffett's letters I found Watsa's fund much less attractive compared to Berkshire Hathaway (BRK.A)(BRK.B), it seemed to me that he was less focused on management integrity and company quality than on price, which is okay, but not my style. More sympathetic to Buffett: I prefer a fair price in a good company than a cheap price on a mediocre one. I also read that SD's CEO had been a close partner and friend of CHK's CEO, Aubrey McClendon. There were dubious stories about their business ventures, so I thought then that by being friends they both probably had similar moral standards. That, in addition to the complexities of the gas business made me decide to pass on SD at the time. So now that I hear that the bad stories about CHK are confirmed I have even more reasons to pass on CHK.

SD's CEO, Tom Ward, was also a co-founder of CHK and he is also a co-founder of the hedge fund involved in the current scandal. Today's news confirmed that my suspicions were correct and I would have lost money if I had invested in his company without selling by now.

Regarding CHK, I would personally never invest in a company used as a vehicle to enrich its CEO using a hedge fund on the side that trades the same commodity that the company sells, even if it's legal. If that's not a conflict of interest, like McClendon and Ward maintain, then what is? It is enough of a proof that the CEO is immoral, does not disclose important information and cares disproportionately more about his personal enrichment than about that of his shareholders. The least thing I would require before investing there, regardless of the price, is making sure that it is not run by him nor anyone directly under him.

The problem is that if CHK's CEO goes then the company will maybe not be as profitable, considering that lots of the gains it made in the last six years were precisely via his CEO's directed hedging operations: "The bottom line is that Chesapeake has delivered $8.4 billion in realized hedging gains to shareholders since 2006," said Kehs, the company spokesman. "That's extraordinary shareholder value added through innovation and by far the best record in the oil and gas industry." So what will happen with those trading profits if McClendon goes? And what will happen if he stays given the huge doubts over its management's integrity ? I do not know, but I do recognize that it has the ingredients of a no-win situation.

To understand this in a broader context I mention here the four rules used to invest based on the financial integrity approach:

1) The company ought to have a strong financial position that is measured not so much by the presence of assets as by the absence of significant encumbrances, whether a part of a balance sheet, disclosed in financial statement footnotes, or an element that is not disclosed at all in any part of financial statements.

2) The company ought to be run by reasonably honest management and control groups, especially in terms of how cognizant the insiders are of the interests of outside security holders.

3) There ought to be available to the investor a reasonable amount of relevant information that is akin to full disclosure, though this will always be something that falls somewhat short of the mark.

4) The price at which the equity security can be bought ought to be below the investor’s reasonable estimate of net asset value.

Those are the rules used in the financial integrity investing approach as defined by Martin Whitman in "The Aggressive Conservative Investor (2005)", an excellent book recommended by Seth Klarman. It's a book that impacted me maybe even more in a sense than the classics written by Benjamin Graham or Philip Fisher. It is up to date, practical and down to earth, with very flexible and broad concepts. It goes beyond the rigidness of other investing philosophies associated to growth or value, yet is very reasonable and specific on what to look for and avoid to have a safe investment experience. For more about investing wisdom you can find my favorite list of books here.

Since CHK does not qualify for rule number 2) I tend to stay out of it. The fact that a gas hedge fund, operated on the sidelines by the executive officer was not disclosed is enough to doubt if rule 3) is OK. Also many of the companies traded in other countries, including Japan, do not qualify for 3). I have found what seem to be very cheap stocks in Japan, but at least in English, the disclosed information is too poor, and my Japanese knowledge, limited to a handful of words, is extremely limited to make up for it. That's why I do not usually invest directly in Japan or China — I could simply not find good enough disclosures and company data over there.

Management integrity questions aside, the other barrier to invest in Chesapeake Energy (CHK) is that I do not understand the gas business. That's why I sold, fortunately at the right time, my NRG Energy stocks. I had been trying to better comprehend NRG's business but even though I read and read I just couldn't get deep enough into understanding it. It led me to the conclusion that there are enormous amounts of new gas reserves due to new horizontal drilling techniques that give access to multiple times more gas now than just a few years ago. So there might also be a new level of gas prices here to stay. Therefore rule 1) is also unclear since low gas prices could be a significant financial encumbrance. Leaving only rule 4), an apparently low price, OK. It could also be the case that natural gas prices shoot up, but that possibility, combined with a dubious management, does not seem high enough in order to make a safe investment, therefore I let this one pass and stay on the sidelines.

Cheers!

Juan

Disclosure: I do not own CHK nor plan to own it ever.

About the author:

Jose Vasquez
I was born in Spain and lived in France, Chile, USA and Belgium. I used to work in IT and Banking. I am a family man, I have a lovely wife, 3 sons and one step daughter. I have humble tastes, I like to stay home and read about companies. I started investing before the internet bubble. I knew little and liked technical analysis so my results were bad. Fortunately I did not have much to lose. Some years later in 2006, bored of doing real state investments, I opened an interactive brokers account and restarted. This time, not wanting to make mistakes, I decided to follow a model: Warren Buffett, he was at good making money via stocks. So I started reading about him, his shareholders letters, the books that he recommended, etc... I started applying his principles, reading 10K's digesting all sources of information. I started buying good and cheap companies to hold forever unless something changed fundamentally. When the housing crisis started I was 75% cash. By then I had identified good companies at very cheap prices so I invested most of my savings in stocks. It doubled fast. By the second semester of 2009 I turned my software company into an investment vehicle and dedicated myself full time to it. I changed lifestyle and moved from Belgium to the beach, Brazil, north east coast (www.kuchita.com). The goal was to keep fixed costs low in order to be able to live with a minimum 6-8% yearly return, to move away from the inhuman life of civilization and to have some peace and sunny weather. Now I can think and study about companies 60 hours/week. I can finally do what I want full time and can say that I have never been so happy, specially also with my just born 4th son, my other great kids and my sweet wife who supports me fully while I study most of the day and patiently wait for the opportunity to make a swing ! My portfolio is disclosed here: http://www.kuchita.com/view/sumo.php For more:

Visit Jose Vasquez's Website


Rating: 4.3/5 (55 votes)

Comments

Cornelius Chan
Cornelius Chan - 2 years ago
"Disclosure: I do not own CHK nor plan to own it ever."

LOL[i][/i]
Cornelius Chan
Cornelius Chan - 2 years ago
"I prefer a fair price in a good company than a cheap price on a mediocre one."Amen[i][/i]
BEL-AIR
BEL-AIR - 2 years ago
Good article...

I have to agree with you Juan on the fact that you must have honest and competent management running a company.

I made that mistake once and will never knowingly do it again by investing in Chinese companies when they were falling a year back, what a lesson that was.

Another reason not to like CHK is the fact that it's short term current liabilities is twice it's net short term current assets. furthermore it's long term debt is larger than it book value and about 10 times it's yearly earnings...

Add in the fact of low natural gas prices and it might have trouble servicing it's huge debt in the future.., I throw it in the to hard pile.

Good choice you made to avoid this one.

I will pass on it as well for many reasons including the ones you mentioned.

Jose Vasquez
Jose Vasquez - 2 years ago
Hi Bel-Air,

uy uy... Chinese companies ! I had BYD (Chinese battery, cal maker, solar panels), bought at 10 along with Buffett it went up to 80 in a year, and 2 years later back to 14 ...

I could get out at 20 later on (Buffett still holds that one).

I got annoyed by several things, like that they always delayed their product announcements and that it depends on government subsidies (which were reduced) but the main reason is that the company information you can get is very superfluous. Definitely not compared to what you get in SEC fillings in the USA.

PD: CHK's balance sheet has lots of red flags, current liabilities/current assets ratio has by far exceeded the safe zone.

Cheers!

Juan
mcwillia
Mcwillia - 2 years ago
In an oil and gas company, each oil well is a tiny business unto itself. It has a market, an amount of capital expenditure, a market, an inventory, etc. To analyze a business like CHK, one must analyze each well, to the extent possible. And that's really it. And its really hard.

Petroleum engineers and professional landmen are required to evaluate an upstream E&P company. These are quintessentially asset plays, so only those who understand the assets should be investing here. And a securities lawyer is needed to assess what portion of liability will hit the company as opposed to the directors and CEO.

Aubrey will get dumped. The board will be replaced. The assets will likely get taken over or be run by new management. The only question is the value of the assets here. If you know the specific acreage and the pressures, porosity, formations, drilling costs, production rates and depletions, well log data, etc. then you can estimate the value and the advisability of borrowing 8 billion to develop them. As Buffett says, circle of competence. Petroleum engineers, landman, securities lawyer. Those three skills give one the circle-of-competence to know CHK and what its worth. Aside from someone who marshalls those skills, reliable analysis of CHK is not really possible.

batbeer2
Batbeer2 premium member - 2 years ago
>> If you know the specific acreage and the pressures, porosity, formations, drilling costs, production rates and depletions, well log data, etc. then you can estimate the value and the advisability of borrowing 8 billion to develop them.

You can know all that and still not have a clue about the advisability of borrowing 8 billion to develop them.

On the other hand,

  • Is it in any way relevant that Chesapeake, in April, sold less than 5% of their assets fo $ 2.6B?

  • Does the pending IPO of the services business with $ 1.3B of revenue matter?

  • jbobfleming
    Jbobfleming - 2 years ago
    Hi....Thx for the post, character definitely means something, even these days. I owned a few hhundred shares the day this latest story broke. Made me want to puke, got stopped out. Its funny, I was starting to leg into the name because of the large stake held by Longleaf (Southeastern). Assumed those guys did the due diligence. Smells totally of Enron, the guy's personal finances are totally out of control. Wouldn't be surprised by anything at this point...Cheers
    Jose Vasquez
    Jose Vasquez - 2 years ago
    Another bright investor fell into this: Lou Simpson, who used to manage Geico's portfolio at Berkshire Hathaway for decades, is one of CHKs directors and has millions invested there.
    batbeer2
    Batbeer2 premium member - 2 years ago
    Yesterday, Mason Hawkins commented on this issue.

    1) He's not thinking about selling.

    2) He thinks it's cheap.

    3) He thinks it's a takeover target.


    So.... yet another bright investor making a mistake ?
    buynhold
    Buynhold - 2 years ago
    >> Another bright investor fell into this: Lou Simpson

    @juan:

    It's ok to not invest in CHK because McClendon seems reckless, and though he has created enormous value so far, he could easily destroy it as well (like he did with his personal finances). It's a personal choice.

    It's doesn't mean Lou Simpson has made a mistake - he may have invested in CHK simply for the value of the assets.

    @batbeer:

    Mason doesn't seem all that happy with the management's plans and McClendon's ways, based on the two recent comments made by Southeastern. I think they have realized he is a bit reckless.

    Jose Vasquez
    Jose Vasquez - 2 years ago
    Hi Buynhold,

    Maybe you can help me with this questions, I like a lot Lou Simpson and followed what he did so I am quite surprised he lost millions, at least of paper profits, of his personal money with CHK.

    Do you think that Lou Simpson, being a director, did not realize that the CEO was of dubious integrity?

    Maybe the CEO was good at hiding his dubious integrity, which I doubt given the recent headlines. Lou Simpson could have trusted the CEO, it's a possibility, though trusting him, specially his integrity, proved to be a real pity for him and an expensive one,

    Or maybe Lou Simpson, being very smart, did indeed realize how amoral the CEO was but thought it was of minor importance. He though that was a minor problem, of little importance and compensated by the company valuation. In such case he cared more about a good valuation than about the CEOs integrity ?

    Cheers!

    Juan
    Jose Vasquez
    Jose Vasquez - 2 years ago
    Hi Batbeer2,

    Personally as long as the CEO is not out I wouldn't put a dime into it, but that's a personal opinion: I do not feel comfortable putting my money to be managed by a CEO I cannot trust.

    I understand though that a big shareholder does not want to disclose publicly that the company is overvalued :).

    I also believe that given the signs of how management behaved it was a bad idea to invest in the first place in the past.

    Cheers!

    Juan
    batbeer2
    Batbeer2 premium member - 2 years ago
    Hi Juan,

    >> I understand though that a big shareholder does not want to disclose publicly that the company is overvalued :).

    LOL

    FWIW, I think you are seeking answers while it's the questions you have wrong. Eg: >> Do you think that Lou Simpson, being a director, did not realize that the CEO was of dubious integrity?

    You (possibly erroneously) assume Lou now believes the integrity of the McClendon is dubious.

    I think it's better to ask, "Does Lou Simpson trust McClendon ?".

    - Assuming the answer is "no", what is likely to happen next ?

    - Assuming the answer is "yes", what is likely to happen next ?

    - Either way, if Lou turns out to be wrong on that call, what happens next ?

    This discussion reminds me of a similar discussion I had in 2009 about WCG with that stock at $ 15. Bears argued that the bull case was speculative. IMHO it was the bears that were dreaming up unthinkable liabilities. I'm not saying the same thing is going to happen to CHK. I don't know that. I'm just saying I've been here before.

    Another question I think is worth asking: If I'm wrong about McClendon, is it likely the problem is going to be worth $ 20B ? For reference:

    - BP settled in the gulf for $ 20 B.

    - Bernie Madoff took some $ 18B from his clients.
    Jose Vasquez
    Jose Vasquez - 2 years ago
    Hi Batbeer2,

    I understand if some are attracted by what seems to be a low valuation or why big investors are not selling. Buffet also did not sell after Salomon Brothers scandal, but to safe his reputation and investment he reallocated to New York in order to personally take over Salomon's management and acted successfully in order to fire the CEO.

    Buffett said something like: "Do not do something you will regret if it appears on the news". I think CHK's CEO should have asked that to himself before, but judging from his media comments he did not care about it, he saw "no conflict of interest" :).

    If you have invested here I hope you recover your money, but a stock recovery doesn't change the fact that I would have liked more disclosures, not having received them made me definitely lose CHK's CEO trust, and by what I read lots of investors aren't happy either, it's obvious to me why and it's funny to see people closed to that, as if nothing was wrong :).

    I personally prefer to pass on investing in a company whose CEO did not disclose a hedge fund trading the same commodity that its company sells. As a shareholder I would have liked to know that and would have pushed to fire him if I had to discover it by reading the newspaper. I hope Lou Simpson is busy doing that.

    Cheers!

    Juan

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