Friday, May 25, 2012

Was the Chesapeake Annual Report a Warning Sign?

"That which hath made them drunk hath made me bold."

- Shakespeare
Armies of accountants and analysts pour over the financial reporting sections of the annual reports of large companies like Chesapeake. The executive commentary at the beginning of these reports is largely dismissed by analysts as company sales propaganda. In this case, however, an intuitive read of the tone of this section would probably have proven insightful.

From an investing perspective, the excessive emphasis on the word bold is troubling. It appeared that management felt that boldness was the central objective of the company. Although only a few pages long, we see reference after reference to this idea:

"...we had a bold idea..."

"...we followed with the equally bold idea..."

"...other bold moves..."

"...bold acquisition growth..."

" the bold moves of acquiring as many natural gas assets as we could..."

"...we made increasingly bold investments..."

"...bold shift to shale gas..."

"...Chesapeake made the bold move..."

"...we made the bold move..."

"...bold investments in technology..."

"...bold vertical integration strategies..."

"...we made the bold decision to expand..."

"...bold shift from natural gas to liquids..."

"...we responded with the bold move..."

"...we accelerated the next bold move of our company's history..."

" our bold strategy has become the industry standard..."

"...our bold 25/25 plan..."

"...this is clearly a bold plan..."

"...the best will be those few bold companies..."

"...Chesapeake has made bold moves..."

"...make the bold move..."

"...that have guided our bold moves..."

My hubris-o-meter was flashing red the whole time I was reading the report back in February.  There is a place for boldness.  But there is also a place for prudence.  In retrospect, it does not appear that these two qualities were in balance.

Wednesday, May 23, 2012

Investment Jargon

"Jargon is a very convenient shield for people not entirely sure of what they are saying."

- Louis Rukeyser
A great example of this jargon shield is a recent Seeking Alpha article purporting to assess the value of Chevron.  The valuation thesis was clearly stated as follows:

"Chevron has a market capitalization of $201 billion, and the enterprise value is roughly $192 billion. This means it is very overvalued."

The article then provided a comparison of various metrics between Chevron and its peers before concluding with the valuation reprise:

"Overall, I would not recommend this company's stock, even though it does have good profit margins and low debt levels. The problem is that the market capitalization is roughly $9 billion above the enterprise value, which means the firm is overvalued."

This is pure folly on many levels.  If a company has little or no preferred stock or minority interests, then the enterprise value calculation is really simple:

Enterprise Value = Market Value - (Cash - Debt)


(Market Value > Enterprise Value) ---implies--- (Cash > Debt)

So removing the jargon about enterprise value, we're left with the statement that since cash is greater than debt, the company is overvalued.  This is the strangest statement about value I've ever read.  In fact, the difference between market value and enterprise value has nothing to do with valuation.

One reason we know this concept has nothing to do with valuation is the fact that it's unaffected by changes in the stock price!  If Chevron stock went to $20 or $200 tomorrow, the difference between market value and enterprise value would still be the same!

The fact that cash exceeds debt doesn't tell you whether the company is making or losing money.  It tells you nothing about value.  It does, however, tell you something positive about liquidity and risk.  You will notice that any company with a conservative cash position will have an enterprise value less than its market value.  Companies in this position include Johnson & Johnson, Intel, Microsoft, Exxon, Google, Apple, Ebay, Qualcomm, Cisco, Biogen, etc.

Louis Rukeyser is right.  The only reason such nonsense can be published is because it hides behind jargon.  The average person walking down the street does not know what "enterprise value" means, so the article sounds credible.  But here's what the analysis would sound like if it were written in plain English:

Chevron has more cash than debt, so it is very overvalued.  Even if the stock dropped 50% in price, the company would still have more cash than debt, so it would still be overvalued.  Avoid companies with more cash than debt.  Instead, seek out companies with a lot more debt than cash, as they are undervalued.  Buy those companies at any price level as that is irrelevant.
It sounds ridiculous written this way.  However, this is exactly what is being said in the original article.  It's just cloaked in jargon.  The fact that the author has 900 followers and is ranked as a Top 5 contributor also leads to the aura that wisdom is being passed down from high to the masses.

The moral of the story?  Don't be swayed by impressive sounding jargon that you don't completely understand.  In some cases, it's very possible the author has no more understanding of it than you do.

Tuesday, May 22, 2012

Gifts and Fairness

"Live so that when your children think of fairness and integrity, they think of you."

- H. Jackson Brown, Jr.
While browsing the Wall Street Journal today, I read an article about a couple that disagreed on giving small gifts to their children.  The focus of the story was about how to talk about your financial differences and learn to compromise.  While I commend the couple for working on their communication, I was really taken back by the inconsistency of the original concerns.

For the wife in the story talked about how she loves to receive small surprise gifts from her husband - a bouquet of flowers, a music CD, a box of candy.  His generosity and spontaneity with these gifts was one of the characteristics that endeared him to her when they met, and she still loves receiving these occasional gifts today.

However, for reasons that escape me, this appreciation for gifts does not extend to situations where she is not the recipient.  After the couple had children, the husband considered it a natural extension of his personality to be excited to purchase occasional gifts for their children - a soccer ball, a hot wheels car, a slice of cake from the local bakery.

The wife completely disapproved of this behavior and grew exasperated the longer it continued.  They had arguments and fights over the gifts to the children.  She insisted that they stop, but this was difficult for the him because he loved giving gifts to the kids.  She claimed that she does not want her children to be spoiled by receiving things they did not earn.

In my world, it does not seem extravagant to buy your child a ball or a slice of cake, but I suppose everyone has their own threshold for what level of giving constitutes spoiling.  What is more troublesome to me is the inconsistency of the argument, as the gifts for the wife and children appeared to be roughly equal in cost and frequency.  The gifts to the children were not welcome, yet the gifts to the wife were loved.  Ultimately the husband agreed to buy gifts for the children less frequently and the wife agreed to look the other way and try not to complain when he did. 

I am not trying to be the fairness police here, but I was quite surprised that neither the author nor any of the reader comments even alluded to the idea that the disagreement itself seems to involve a very unhealthy level of egocentrism.  I wonder how the children ultimately feel after growing up in such an environment.  When daddy surprises mommy with a CD or a box of chocolates, mommy is very happy!  But when daddy surprises Johnny with a soccer ball or a slice of cake, mommy is very angry!

Does anyone else find the backdrop of this article to be really odd?

Tuesday, May 15, 2012

Financial Weeds

"Even the richest soil, if left uncultivated will produce the rankest weeds."

- Leonardo da Vinci

Five years ago my lawn was a disaster.  It was about one third grass, one third weeds, and one third bare spots.  Since then it has slowly progressed each year, as I was determined to improve it.  I tried a lot of different things, and I still don't really know what I'm doing, so I'm not going to pontificate about lawn care on this blog.  But I will note one thing in retrospect: I wish I'd spent less time worrying about the weeds and more time worrying about the grass.  Why?  If you have healthy grass, it does 80% of the weeding for you by choking out the weeds.

I see a financial analogy here.  We tend to focus on the weeds in our personal finances.  We agonize over the ATM fees, the mortgage debt, the investment losses, the budget imbalances.  Sometimes this is necessary, but many times we would be better served to focus on the positives.  A better approach would probably be to focus on the positive aspects of our career and our investments and actively seek to expand those areas, thereby choking out the financial weeds.

Saturday, May 5, 2012


"We are, all of us, water beings on a water planet. Water is life. Without it, all living things die. Our dependence on water is absolute; our psyches know this and signal us in myriad ways of water's elemental importance and significance. That is why we love the water and remember experiences associated with it."

- J. B. Mannion

I'm in summer vacation planning mode right now, and I've noticed that every vacation I've ever experienced had water as a centerpiece.  There were many beach vacations spent looking out at the Atlantic.  But even when I was not at the shore, there was always water.  Invariably there was a lake or a river or a stream nearby.  The only times I do not remember bodies of water were the ski vacations, and of course, there would be no snow without water.

Almost everyone knows a water molecule is made up of two hydrogen atoms and one oxygen atom.  But most people don't know the shape of the molecule.  It is not symmetric with a hydrogen atom stuck to opposing sides of the oxygen atom.  Instead, the smaller hydrogen atoms are bunched toward one end, looking a lot like ears on the head of a mouse.  As it turns out, this shape is the magic that drives nearly everything on our planet.

The asymmetric shape of the water molecule means that it is polarized, with a positive and negative end.  More precisely, there are two positive and two negative points on the molecule.  This polarity allows an individual water molecule to bond with up to four other water molecules, an unusually high number for such a simple molecule.  This extensive bonding gives water its super powers.

Water molecules like to stick to each other and to a lot of other things.  This cohesion and adhesion triggers capillary action in narrow tubes.  This is how plants and trees suck up water against gravity.  Where water meets air, cohesion manifests itself as surface tension.  Among other things, this allows rain drops to form and fall.

The simplicity, shape, and polarity of these molecules allow water to act as a near universal solvent, easily dissolving salts, sugars, proteins, and DNA, as well as many gases like oxygen and carbon dioxide.  This allows one simple substance to do everything from oxygenating the oceans to enabling delicate metabolic processes in our bodies.

The hydrogen bonding also gives water an enormous heat capacity.  This allows water to stabilize the temperature of our bodies and buffer the climate of our plant.  And it's also responsible for one of nature's more spectacular surprises: water is less dense as a solid than a liquid.  In other words, ice floats on water.  Water also strongly absorbs most of the electromagnetic spectrum, yet it allows visible light to pass through.

Look all around you.  Almost everything you see would be impossible without the unique geometry of the water molecule, the miracle substance of our world.  We instinctively love the water without any further explanation, but I do find that a greater understanding of it enriches my experience.  I will be near the water this summer and enjoying every minute of it with my head and my heart.