I Pass on Chesapeake Energy - Here's Why

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Juan Velasco
May 02, 2012
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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, Financial), 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, Financial) around two years ago because it seemed cheap and Prem Watsa was buying into it. Watsa had also bought into USG Corp. (USG, Financial). 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, Financial)(BRK.B, Financial), 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, Financial) 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.



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