My earlier blog with this title has grown like Topsy. It's very long. Throughout, my answer to the question of cheap was ... Transocean! Its stock, its bonds, everything. Now I know that opinions differ. For two years now, a solid majority of stock (and bond) analysts have clawed away at the company. A solid majority recommend sale of the stock, and consider the bonds to be dead money. Moody's bond downgrade to Caa1 is the exclamation point. Yet, quarter after quarter, Transocean rolls along, beating consensus earnings projections, retiring debt, husbanding money and managing future cash flows with finesse.
[3/13/17. Why Transocean in particular? Aren't there dozens (hundreds) of other companies equally mis-priced, with equal, or superior, prospects for recovery? YES. Yes indeed. So why haven't I dug in, investigated, analyzed, probed deeply, and come up with a comprehensive list? The answer is not complicated. I'm just one guy with just so much time to spend on this obsession. It would be safer to have a long list, but the task grows geometrically as you expand that list. I don't need thirty outliers, as long as I'm right about THIS one.]
In the last year, the company has retired about $1.2 billion in near-term debt and issued $2.4 billion in longer-term debt (maturities in 2023 and 2024). While the terms of one issue were onerous (9%), the most subsequent issues, backed by recently delivered drilling rigs, are a more modest 7.75% and 6.5%. Note the positive trend in financing costs.
Moody's will undoubtedly squeal even louder than before, pointing out that all the new issues are senior to older, longer-term debt. That's true. That seniority thing, though, is a liquidation issue. IF the company defaults, then the newest debt will be paid first, to the disadvantage of the older debt. To me, the vital point is that the new money pretty much insures that Transocean won't default at all. It solves the company's cash flow issues well past the critical year of 2020. That year's $2.5 billion of capex and debt maturity threatened the company's fragile cash hoard. The additional cash cushion provided by new debt floats the company over the next five years of financial rocks.
Once I became convinced that Transocean's near-term challenges had been addressed, I bought quite a lot of debt maturing in 2018 and 2020. All of it has floated to and above par. Even more interesting is the recent action in later maturities, like my go-to Global Marine bonds (7% of 2027). After bottoming to a sick-making 42, they are now flirting with 80! Now that's still a depressed price, with a present yield of 8.75% and a potential total return of 42%, assuming a two-year return to par. So, the bargain is intact. It's just not as spectacular as before. Add a bit of margin, though, and the two-year return could easily rise to 80%.
The company is still at the mercy of oil's murky cycle. With it now floating near $50 a barrel, there will be little money to be made for awhile. But still, some. Transocean has a fairly robust backlog (about $12 billion), so will undoubtedly pull in between $2 and $3 billion in gross revenues for awhile. Lean and mean, with a good cash cushion, it will be ready for the upturn. As a bond investor, I really don't care if Transocean thrives in the long run. Mere survival is very much OK with me. In the meantime, I'm being paid, very handsomely, to wait.
February, 2017. I probably should wait until Transocean posts its 2016 full-year results before commenting further. But, I'd like to be a bit out front, and take a pot shot or two at the ratings agencies. Recent price action in Transocean bonds has been very strong. Since my last update, the Global Marine bonds have topped 90. That's a very large move, and directly contrary to the drastic ratings downgrades issued both by Moodys (Caa1) and S&P (B-). I've stated before that Moody's is in the midst of a hissy-fit. S&P's B- for Global Marine, contrasting with its B+ for all the other Transocean issues, is also just weird.
These guys seems to miss every boat. Back when the bond was trading near 40, their ratings were far higher. Then, just as the bond began a huge recovery, they decided to issue punitive downgrades. The very actions Transocean took to shore up its balance sheet were treated as disasters by Moodys and S&P. Investors, though, seem a bit shrewder. Global Marine price improvements have matched the supposedly "stronger" Transocean action point for point. Buyers of all issues seem to understand that improving the balance sheet for the company as a whole makes each and every individual bond stronger, not weaker. As to the supposed difference between Global Marine (a wholly owned Transocean entity) and Transocean itself ... well, there really is no meaningful difference. S&P is splitting hairs, assuming they even understand that Global Marine is just another Transocean obligation.
February 26, 2017. Year-end results for 2016 are in, and confirm exactly what I've been predicting. Most striking is that the company's cash position is now about $3.1, up over $700 million from a year ago. Mark Mey, at the company's earnings call for 2016 summed it up:
"We are certainly washing cash right now. We have over $3 billion of cash. I’d like to take you back 12 months so the last year this time when oil was trading at $26 a barrel, capital markets were firmly struck for off-shore drillers, that’s what the change. So, we have a full capital market option available to us whether it's secured, unsecure or any other type of instrument that we’re going to put in the balance sheet. So, I don’t feel that we’re under pressure at the moment to enhance liquidity. We will take opportunities as they provide themselves to us."
For a bond investor, this near-incoherent utterance is nevertheless music to the ears. Even though the company is still experiencing falling revenue, the capital markets are no longer concerned about the company's ability to pay its debts. So, they are increasingly willing to lend Transocean money. The company's ability to obtain increasingly favorable credit terms during 2016 bodes very well for 2017 and beyond.
The first order of business will (I suspect) be to renew and extend its $3 billion line of credit. Much like a HELOC (home owner's line of credit), the money can be drawn, paid back, and drawn again at the company's discretion. The flexibility this provides cannot be overstated.
The effect on Transocean's debt pricing is steadily clearer: everything is rising, even the most far-dated issues. I expect that nearly one will hit (and exceed) par in 2017. At that time, the game will be over for me (and you) as buyers of Transocean debt, but most certainly not as holders. Just as my Goldman Sachs purchases of 2008 and 2009 are still nestled in my portfolio, spitting out predictable bi-yearly payments, so will the Global Marine bonds and their longer-dated sisters.
March 9, 2017. And Now the Missing 10K! After the very soothing conference call announcing excellent financial resuls for 2016, Transocean then muddied the waters by delaying the release of its 10K form, the "official" statement of earnings. The company cited unspecific issues with controls relating to tax accounting. This delay was received badly; the stock and bonds all dipped, wiping out the nice bumps following the news conference. Uncertainty scares people, particularly bond investors. Many sell first, then decide what it all means.
Now, ten days later, the 10K is on file. The delay certainly didn't mean they had to start from scratch. So, what's going on, and how serious is it? There are sections in the 2016 10K that shed a little light. It's about income tax accounting:
"Specifically, the execution
of the controls over the application of the accounting literature to the measurement of deferred taxes did not operate effectively in relation to: (1) the
remeasurement of certain nonmonetary assets in Norway, (2) the analysis of our U.S. defined benefit pension plans liability and associated other
comprehensive income and (3) the realizability of our deferred tax assets and the need for a valuation allowance."
Transocean pays very little in income taxes right now, $107 million, down from the 2015 $200 million figure. I think that's important. A sharp movement up or down would still be small, relative to the company's cash flow and balance sheet. And that's ultimately, exactly what the 10K eventually says.
Attached are two letters from Transocean's auditors, Ernst and Young. They are both dated March 6, 2017.
The first is harsh: "In our opinion, because of the effect of the material weakness described above on the achievement of the objectives of the control criteria,
Transocean Ltd. and subsidiaries has not maintained effective internal control over financial reporting as of December 31, 2016, based on the
COSO criteria."
The second, though, is a plain-vanilla endorsement of the company's publicly released results for 2014, 2015 AND 2016:
"In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of
Transocean Ltd. and subsidiaries at December 31, 2016 and 2015, and the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the
related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein."
Bottom line: the company is getting a sharp rebuke for sloppy accounting practices, the impact of which are "immaterial". I suspect Mark Mey's head is on the chopping block for professional sloppiness (just look at the vapid way he talks), but Transocean's recent stellar results are the real deal.
I suspect the two letters explain the 10K delay: Ernst & Young needed to complain about financial controls, Transocean needed the auditors to validate the bottom line. It took ten days to iron it all out.
Is the recent price weakness a buying opportunity? Probably, but I'm kind of stuffed right now.
Thursday, December 1, 2016
Friday, November 4, 2016
Why am I so darn smart?
All right, all right. I'm not that darn smart at all. But I still can lay claim to investing results that match, or exceed, those of some awfully smart people (yup, Warren, Bill, Will, etc). How can that be?
If there's one truism for the past fifty years, it's that it is VERY hard to beat the averages in the stock market. Active investors, whether individuals or fund managers, consistently fall short of the indexes they attempt to best. Frankly, the contest is so uneven that most rational investors have long since given up. They have fled to index funds, or ETFs in droves. That's a good thing. Very few active fund managers beat the averages over time. Most underperform drastically. Are the ones who succeed really that good? Well, a dart board will probably answer that question. If enough people toss darts, a few will hit the center. Are they geniuses, or just lucky?
Still, I have had great results, for quite a long time, with my bond investing. I've only tracked my results in detail since 2008, but over the years, I've had additional home runs (RJR Nabisco, AT&T and AT&T Wireless bonds). One issue, one only, defaulted: a stupid, fortunately tiny, purchase of CCC rated Southeast Bank in 1991. I have, upon occasion, sold a position for a loss (Clear Channel springs to mind), once my comfort level was breached. However, through thick and thin, the overwhelming majority of my bond positions have flourished. Time and again, an issue bought at a substantial discount has recovered to (and frequently above) par. (Update Feb 2017: And this is not just due to past good luck. My bond-investing results for the year just completed are very solid: 15%. This in a time of historically low bond yields! What about 2017? Well, too soon to say, but the year has started out well, and that 15% doesn't look unobtainable at all.)
One possibility is that I'm a bond-picking genius. Pause for applause. But far more likely is the fact that most bonds find a way to avoid default. They may experience violent up- and downdrafts, but ultimately, the great majority limp through. Bond owners, on the other hand, are a frantically skittish bunch. The slightest whiff of trouble sends them heading to the exits. In their rush to sell, bond prices are disproportionately depressed. Suddenly, an investment-grade company will trade, temporarily, with yields far above its cohorts. Here is a partial list of such companies (all of them presently in my portfolio): 21st Century Fox, Abbey PLC, AXA, Bed Bath and Beyond, First Union, GTE, Goldman Sachs, Hartford, HP, Lombardy, Morgan Stanley, Protective Life, Southern Copper, Telecom Italia, Telefonica Europe, Time Warner, Transatlantic, Union Carbide, Validus, Vale, Viacom and Xerox. Folks, that's a long list. Most of the companies are at the lower end of investment grade, but every single one has recovered from its swoon, and made every interest payment along the way.
So, in a nutshell: the stock market is so frantically efficient that it's really really hard to beat the averages. And the bond market is so wildly inefficient that a doofus like me can tiptoe through it and harvest the low-hanging fruit.
How is this possible? Well, the very things that make me unable to compete on the stock battlefield seem to favor me in bond-land. I'm tiny, I can only buy small driblets of things, and my activity has no effect whatsoever on the prices of what I buy and sell. That idiot who dumped his Time Warner bonds because a merger fell through passed them to me. A bond manager won't waste his time on a five or ten-bond position. I'm happy to. I keep nibbling until the opportunity passes. What's astonishing is that the opportunities keep cropping up. Right now it's energy. To be sure, the most outrageous bargains have disappeared (25% yields for distressed Transocean), but 12% is still available.
Now, why will YOU be unable to make this work for YOU? Because, my dear reader, you are probably human. Your fear will make you wait until the best opportunity has passed, your greed will make you grab for things that are overpriced. Really. How do I know? Because my own fear and greed have snared me time and again. It takes real stones to buy when others are bailing. It takes Spartan discipline to hold back when the market has just hit an all-time high. I think I'm best at the low points. A solid record of success in troubled times makes me willing to dip my toes in. I'm no longer taking huge chances: just bite-size ones. But enough morsels make a very good meal, eventually.
I've been writing this blog for over six years now. To date, a grand total of perhaps ten people have looked briefly, and walked away (metaphorically) forever. Yet I persevere. Why? Well, the pain is quite low, and I remain optimistic that, at some point, more than one person will take it seriously. Then there might be a geometric increase in interest. Why this optimism? Because I am convinced that I'm on to something, something valid, actionable, and potentially life-changing. I has been so for me, and could be for many other folks as well. How many? An excellent question I just asked myself. Clearly not millions. A flood of folks pursuing the same approach would quickly overwhelm the limited array of opportunities. It would be just like the demise of the January effect. But dozens, hundreds, thousands? Yes indeed. My approach to bond investing has been hiding in plain sight for generations. I doubt intensely that I'm unique in seeing it all. Scattered around the country are undoubtedly dozens, perhaps thousands of fellow travelers. Perhaps they're looking at my blog in secret, cursing me in secret for giving it all away. Perhaps.
If there's one truism for the past fifty years, it's that it is VERY hard to beat the averages in the stock market. Active investors, whether individuals or fund managers, consistently fall short of the indexes they attempt to best. Frankly, the contest is so uneven that most rational investors have long since given up. They have fled to index funds, or ETFs in droves. That's a good thing. Very few active fund managers beat the averages over time. Most underperform drastically. Are the ones who succeed really that good? Well, a dart board will probably answer that question. If enough people toss darts, a few will hit the center. Are they geniuses, or just lucky?
Still, I have had great results, for quite a long time, with my bond investing. I've only tracked my results in detail since 2008, but over the years, I've had additional home runs (RJR Nabisco, AT&T and AT&T Wireless bonds). One issue, one only, defaulted: a stupid, fortunately tiny, purchase of CCC rated Southeast Bank in 1991. I have, upon occasion, sold a position for a loss (Clear Channel springs to mind), once my comfort level was breached. However, through thick and thin, the overwhelming majority of my bond positions have flourished. Time and again, an issue bought at a substantial discount has recovered to (and frequently above) par. (Update Feb 2017: And this is not just due to past good luck. My bond-investing results for the year just completed are very solid: 15%. This in a time of historically low bond yields! What about 2017? Well, too soon to say, but the year has started out well, and that 15% doesn't look unobtainable at all.)
One possibility is that I'm a bond-picking genius. Pause for applause. But far more likely is the fact that most bonds find a way to avoid default. They may experience violent up- and downdrafts, but ultimately, the great majority limp through. Bond owners, on the other hand, are a frantically skittish bunch. The slightest whiff of trouble sends them heading to the exits. In their rush to sell, bond prices are disproportionately depressed. Suddenly, an investment-grade company will trade, temporarily, with yields far above its cohorts. Here is a partial list of such companies (all of them presently in my portfolio): 21st Century Fox, Abbey PLC, AXA, Bed Bath and Beyond, First Union, GTE, Goldman Sachs, Hartford, HP, Lombardy, Morgan Stanley, Protective Life, Southern Copper, Telecom Italia, Telefonica Europe, Time Warner, Transatlantic, Union Carbide, Validus, Vale, Viacom and Xerox. Folks, that's a long list. Most of the companies are at the lower end of investment grade, but every single one has recovered from its swoon, and made every interest payment along the way.
So, in a nutshell: the stock market is so frantically efficient that it's really really hard to beat the averages. And the bond market is so wildly inefficient that a doofus like me can tiptoe through it and harvest the low-hanging fruit.
How is this possible? Well, the very things that make me unable to compete on the stock battlefield seem to favor me in bond-land. I'm tiny, I can only buy small driblets of things, and my activity has no effect whatsoever on the prices of what I buy and sell. That idiot who dumped his Time Warner bonds because a merger fell through passed them to me. A bond manager won't waste his time on a five or ten-bond position. I'm happy to. I keep nibbling until the opportunity passes. What's astonishing is that the opportunities keep cropping up. Right now it's energy. To be sure, the most outrageous bargains have disappeared (25% yields for distressed Transocean), but 12% is still available.
Now, why will YOU be unable to make this work for YOU? Because, my dear reader, you are probably human. Your fear will make you wait until the best opportunity has passed, your greed will make you grab for things that are overpriced. Really. How do I know? Because my own fear and greed have snared me time and again. It takes real stones to buy when others are bailing. It takes Spartan discipline to hold back when the market has just hit an all-time high. I think I'm best at the low points. A solid record of success in troubled times makes me willing to dip my toes in. I'm no longer taking huge chances: just bite-size ones. But enough morsels make a very good meal, eventually.
I've been writing this blog for over six years now. To date, a grand total of perhaps ten people have looked briefly, and walked away (metaphorically) forever. Yet I persevere. Why? Well, the pain is quite low, and I remain optimistic that, at some point, more than one person will take it seriously. Then there might be a geometric increase in interest. Why this optimism? Because I am convinced that I'm on to something, something valid, actionable, and potentially life-changing. I has been so for me, and could be for many other folks as well. How many? An excellent question I just asked myself. Clearly not millions. A flood of folks pursuing the same approach would quickly overwhelm the limited array of opportunities. It would be just like the demise of the January effect. But dozens, hundreds, thousands? Yes indeed. My approach to bond investing has been hiding in plain sight for generations. I doubt intensely that I'm unique in seeing it all. Scattered around the country are undoubtedly dozens, perhaps thousands of fellow travelers. Perhaps they're looking at my blog in secret, cursing me in secret for giving it all away. Perhaps.
Wednesday, July 13, 2016
Leaps and Leverage: A Lab Experiment
Yeah, once again the old guy skates out onto thin ice! After telling the world that the only good game in town is bonds, here I am talking about the near polar opposite, a security DERIVED from a stock. And I don't like stocks in the first place. So, why even go there?
Well, I'm retired, and have a good deal of time on my hands. And my bond game is slow. Now that's actually a good thing. The whole idea behind them is to take a carefully risk-adjusted position and wait for time to make it all good. It's an excellent game, and has worked through a variety of market conditions. Even in today's ultra-low yield environment, I have consistently found situations where the risk-reward ratios seem very favorable.
Well, options present a whole new world of scenarios, where risk-reward is magnified. The risk is ever-present, but the rewards are occasionally so tempting that I get ... tempted. Here's the kind of thing I'm talking about. A volatile stock (like Transocean, RIG) has an entire world of even more volatile derivatives: calls and puts. I'm not going to give a basic lesson in these right here. Suffice it to say that a call is the right to buy 100 shares of a given stock for a given price and period of time; a put is the right to sell 100 shares for a given price and period of time. As a stock fluctuates, these things swoop! Call prices rise faster (percentage-wise) than the stock does, and fall faster. Same thing in reverse for puts.
I'll only be writing about calls here. Buying one has limited risk, but that risk can involve the entire amount you've invested. Say you buy a call maturing in January of 2018 (this is a LEAP, or long-term option), strike price of 13. Today, with the stock trading around $12.50, that call would cost somewhere around $3. Since the call cannot be exercised profitably at present (the strike price is higher than today's stock price), the call is "out of the money" and the $3 is entirely time value, or opportunity cost. If the stock rises to $16 by 2018, you could exercise it, but make nothing at all. At $19, though, you double your money by selling for a $6 return, netting $3 on an investment of $3). That's a 100% profit. Every $3 additional adds 100% to the profit.
Is buying this option a good idea? Well, I'd call it pretty bad. The stock has to rise 23% before you can break even. You need to be very confident to justify the risk of losing your entire investment.
Selling a call is intrinsically even riskier. You pocket a premium (in this case, perhaps $2.50, since the bid is always lower than the asking price), but accept unlimited risk. If the stock shoots from today's $12.50 to $30 (hey, it traded over $50 a couple of years ago, with a historical high of $171!), you'd lose $18.50 for each $2.50 you took in. Is that a good idea?
You get a completely different concoction when you blend the two, though. Establishing a spread, where you buy one kind of call and sell another, can be vastly less dangerous, but still profitable. For example, you could buy a 2018 call with a strike price of 8 and sell a 2018 call with a strike price of 13 for a net cash outlay of $3. The long call costs more than the short call, but the money coming in from the short call reduces the total cost. They key to a spread is that the long call lets you supply the shares being demanded by the owner of the call you sold. In this example, you could receive up to the difference between the strike prices, or $5 per option pair. Such a spread has a potential maximum profit of $2 (the difference between the two strikes ($5) and the cost to establish the position ($3)).
Is this a good idea? Well, the potential profit is 66%, for a spread that expires in 1.5 years, or 44% annualized. Sounds pretty good, right? BUT, you can still lose it all. How? If the stock closes below 13 in January of 2018, you start making less and less. At $12, you now make $1 on the $3 invested (sell at $12, buy at $8). Still OK. At $11, it's break-even. That's not OK, since you've tied your money up for no gain at all. At $10 it's a 33% loss (-$1 on $3 invested), at $9 it's a 66% loss and at 8 or below, you've lost it all, 100%.
To me, this is still unattractive: a maximum potential gain of 66% versus a potential loss of 100%. To be sure, I think the odds are in favor of the gain, rather than the loss. But who knows?
There is a wrinkle here, though. IF the stock's upside potential looks favorable versus its downside ("if" is a very big word here), then it can pay to establish the long call (lower strike price) first. It too has a potential loss of 100%, but if your hope of upward movement is realized, then all calls will rise in tandem with the stock. For a call out of the money, the rise won't be 1 to 1. For the $13 Transocean call, for example, the stock would probably have to rise nearly $2 for the option to go up $1. But assuming that movement does occur, then the option can be sold for a higher price than today, thus lowering the cost of the newly established spread to $2, down from the $3 it would cost now.
What does this relatively small change mean for the investment? Well, now the potential profit is $3 on a reduced investment of $2. That's 150% upside. That's enormous. Since you're considering this step because you are optimistic about Transocean's price prospects moving forward, suddenly this risk-reward scenario looks pretty good.
Bottom line: I decided to run a sort of lab experiment, based upon the fundamental analysis above. I've been doing this approach (buying long calls, then writing short calls AFTER the stock has risen) for a few weeks. Transocean stock as risen sharply (from $9.50 to $12.50) during this time, a busy engine providing forward momentum. So far I have written 15 spreads, all with this potential for a 150% gain versus possible 100% loss. I still have 20 long calls (bought more recently) with no corresponding short position. Transocean will need to rise about one more point for the next leg to work similarly.
How will this all turn out? I'll keep you posted (and no, I won't delete the post if it all turns to mud).
December 1, 2016. The worm turns! OPEC just announced an agreement to stabilize/reduce output. The entire industry boomed. Transocean stock jumped from under 11 to nearly 14. Prior to the jump, I had bought a total of 35 calls January 2018 with a strike of 5 (average cost $5.83), 10 calls with a strike of 3 (cost of 8.5) and sold 15 calls January 2018 with a strike of 10 ($3.8). So, that original spread was set to yield nearly $3 on a $2 investment, or 150%. My kind of deal. Subsequently, the stock dropped severely, bringing my net option position to flat, and even (briefly) negative territory. As stated repeatedly, this is no game for those with palpitations.
With Tuesday's news, though, the situation reversed drastically. Now the overall position shows a paper gain of $10,000 on a cash investment to date of $17,000. The rise in the value of the 10 calls (to $4.25) enabled me to sell another 15 calls. Since they can be matched with the long 5 calls purchased at $5.83, the net cost for the 15 spreads is $1.58. Assuming Transocean closes at or above 10 in January 2018, the profit will be 215%. I still have 15 unspread long calls. If the stock keeps rising ...
December 5, 2016. Another rise in the stock has enabled me to cover my final 15 long calls with a paired short call. The final sales were priced at $5.10. Now, I can just wait. If Transocean closes at or above $10 a share in January 2018, then I will achieve a maximum return of $24,500 on a net initial investment of 9,323, or 250%. Not bad on a total move upward of roughly 30% in the underlying stock. At this point, the maximum profit looks highly probable, as Transocean is priced nearly 40% above the $10 strike price on the short calls. The position already shows a paper profit of $11,100. I'd be tempted to grab that, rather than wait for the additional $4000 to materialize in a year or so. The problem is that unwinding the position, paying asking prices for the short calls and receiving bid prices for the long calls, would eat up most of the difference. Unwinding in January 2018 will be automatic, and cost-free. So, I'll be patient.
It all sounds so simple; just a hugely leveraged version on the buy low-sell high scenario. Note, though, that I spent several weeks looking at a sizeable paper loss At one point, it was down about 33%. If I had thrown $100,000 or $1,000,000 at the bet, my sleep cycle would have suffered. As it is, the sharp drop seemed small enough to ignore. My reading of the basics (oil supply/production cycle, company internals (revenue vs debt vs capex) made the trade look very promising; so I didn't sweat the highly visible risk.
From here on out, I'll concentrate on the bonds. That's my long-term strength, and I still see signficant opportunities for the company's longer-maturing debt.
January 8, 2017. It should be clear from my blog over the years that I believe getting rich slowly is a better long-term strategy than its opposite. However, if you are determined to play the stock game, looking for companies that are undervalued, and relying upon the market to recognize and eventually reward your insight, then this particular options spread game seems very promising to me. Working with leaps give you up to two years of breathing space. The risks are very clear (shame on me if I haven't put them front and center), but the rewards can be breath-taking.
My own results are far too spotty to suggest a comprehensive investment strategy (like the Bodacious Bond Portfolio). And a year like 2008 could (and, for me, did) ruin your day, week, and year. Still, a disciplined, laddered series of spreads, diversified over industries, might be very powerful. A few winners could overwhelm quite a few losers.
The big question here is whether is it even possible to outguess the market. By that I mean, a stock (or bond), at any given point, represents the best combined judgement of hundreds, perhaps thousands of pretty shrewd people about a company and its prospects. It's fairly arrogant to disagree. Yet, hind-sight lets us see how often, and dramatically, this shrewd consensus misses the mark. Prices leap up beyond reason, and plunge equally beyond reason. The consensus-makers are constantly looking sideways at each other, and betting on what those peers are going to do. Kind of a circle-jerk, if you want to be crude (I do). Pros generally prefer to stumble with the herd than stumble conspicuously alone. The fact that they get graded, four times a year, and in full public view, makes them skittish and a bit stupid.
This gives an individual investor a huge advantage. Nobody cares what you, a boob in the sticks, is doing. So, they won't make fun of you, because you're invisible! That's a very good thing; you can, in theory, be brave without fear of public humiliation.
I'd love to talk to others about this approach, and I might even try to continue my lab experiment past 2018. I suspect that it will, in time, turn into another get rich slow scheme, due to layers of diversification.
Well, I'm retired, and have a good deal of time on my hands. And my bond game is slow. Now that's actually a good thing. The whole idea behind them is to take a carefully risk-adjusted position and wait for time to make it all good. It's an excellent game, and has worked through a variety of market conditions. Even in today's ultra-low yield environment, I have consistently found situations where the risk-reward ratios seem very favorable.
Well, options present a whole new world of scenarios, where risk-reward is magnified. The risk is ever-present, but the rewards are occasionally so tempting that I get ... tempted. Here's the kind of thing I'm talking about. A volatile stock (like Transocean, RIG) has an entire world of even more volatile derivatives: calls and puts. I'm not going to give a basic lesson in these right here. Suffice it to say that a call is the right to buy 100 shares of a given stock for a given price and period of time; a put is the right to sell 100 shares for a given price and period of time. As a stock fluctuates, these things swoop! Call prices rise faster (percentage-wise) than the stock does, and fall faster. Same thing in reverse for puts.
I'll only be writing about calls here. Buying one has limited risk, but that risk can involve the entire amount you've invested. Say you buy a call maturing in January of 2018 (this is a LEAP, or long-term option), strike price of 13. Today, with the stock trading around $12.50, that call would cost somewhere around $3. Since the call cannot be exercised profitably at present (the strike price is higher than today's stock price), the call is "out of the money" and the $3 is entirely time value, or opportunity cost. If the stock rises to $16 by 2018, you could exercise it, but make nothing at all. At $19, though, you double your money by selling for a $6 return, netting $3 on an investment of $3). That's a 100% profit. Every $3 additional adds 100% to the profit.
Is buying this option a good idea? Well, I'd call it pretty bad. The stock has to rise 23% before you can break even. You need to be very confident to justify the risk of losing your entire investment.
Selling a call is intrinsically even riskier. You pocket a premium (in this case, perhaps $2.50, since the bid is always lower than the asking price), but accept unlimited risk. If the stock shoots from today's $12.50 to $30 (hey, it traded over $50 a couple of years ago, with a historical high of $171!), you'd lose $18.50 for each $2.50 you took in. Is that a good idea?
You get a completely different concoction when you blend the two, though. Establishing a spread, where you buy one kind of call and sell another, can be vastly less dangerous, but still profitable. For example, you could buy a 2018 call with a strike price of 8 and sell a 2018 call with a strike price of 13 for a net cash outlay of $3. The long call costs more than the short call, but the money coming in from the short call reduces the total cost. They key to a spread is that the long call lets you supply the shares being demanded by the owner of the call you sold. In this example, you could receive up to the difference between the strike prices, or $5 per option pair. Such a spread has a potential maximum profit of $2 (the difference between the two strikes ($5) and the cost to establish the position ($3)).
Is this a good idea? Well, the potential profit is 66%, for a spread that expires in 1.5 years, or 44% annualized. Sounds pretty good, right? BUT, you can still lose it all. How? If the stock closes below 13 in January of 2018, you start making less and less. At $12, you now make $1 on the $3 invested (sell at $12, buy at $8). Still OK. At $11, it's break-even. That's not OK, since you've tied your money up for no gain at all. At $10 it's a 33% loss (-$1 on $3 invested), at $9 it's a 66% loss and at 8 or below, you've lost it all, 100%.
To me, this is still unattractive: a maximum potential gain of 66% versus a potential loss of 100%. To be sure, I think the odds are in favor of the gain, rather than the loss. But who knows?
There is a wrinkle here, though. IF the stock's upside potential looks favorable versus its downside ("if" is a very big word here), then it can pay to establish the long call (lower strike price) first. It too has a potential loss of 100%, but if your hope of upward movement is realized, then all calls will rise in tandem with the stock. For a call out of the money, the rise won't be 1 to 1. For the $13 Transocean call, for example, the stock would probably have to rise nearly $2 for the option to go up $1. But assuming that movement does occur, then the option can be sold for a higher price than today, thus lowering the cost of the newly established spread to $2, down from the $3 it would cost now.
What does this relatively small change mean for the investment? Well, now the potential profit is $3 on a reduced investment of $2. That's 150% upside. That's enormous. Since you're considering this step because you are optimistic about Transocean's price prospects moving forward, suddenly this risk-reward scenario looks pretty good.
Bottom line: I decided to run a sort of lab experiment, based upon the fundamental analysis above. I've been doing this approach (buying long calls, then writing short calls AFTER the stock has risen) for a few weeks. Transocean stock as risen sharply (from $9.50 to $12.50) during this time, a busy engine providing forward momentum. So far I have written 15 spreads, all with this potential for a 150% gain versus possible 100% loss. I still have 20 long calls (bought more recently) with no corresponding short position. Transocean will need to rise about one more point for the next leg to work similarly.
How will this all turn out? I'll keep you posted (and no, I won't delete the post if it all turns to mud).
December 1, 2016. The worm turns! OPEC just announced an agreement to stabilize/reduce output. The entire industry boomed. Transocean stock jumped from under 11 to nearly 14. Prior to the jump, I had bought a total of 35 calls January 2018 with a strike of 5 (average cost $5.83), 10 calls with a strike of 3 (cost of 8.5) and sold 15 calls January 2018 with a strike of 10 ($3.8). So, that original spread was set to yield nearly $3 on a $2 investment, or 150%. My kind of deal. Subsequently, the stock dropped severely, bringing my net option position to flat, and even (briefly) negative territory. As stated repeatedly, this is no game for those with palpitations.
With Tuesday's news, though, the situation reversed drastically. Now the overall position shows a paper gain of $10,000 on a cash investment to date of $17,000. The rise in the value of the 10 calls (to $4.25) enabled me to sell another 15 calls. Since they can be matched with the long 5 calls purchased at $5.83, the net cost for the 15 spreads is $1.58. Assuming Transocean closes at or above 10 in January 2018, the profit will be 215%. I still have 15 unspread long calls. If the stock keeps rising ...
December 5, 2016. Another rise in the stock has enabled me to cover my final 15 long calls with a paired short call. The final sales were priced at $5.10. Now, I can just wait. If Transocean closes at or above $10 a share in January 2018, then I will achieve a maximum return of $24,500 on a net initial investment of 9,323, or 250%. Not bad on a total move upward of roughly 30% in the underlying stock. At this point, the maximum profit looks highly probable, as Transocean is priced nearly 40% above the $10 strike price on the short calls. The position already shows a paper profit of $11,100. I'd be tempted to grab that, rather than wait for the additional $4000 to materialize in a year or so. The problem is that unwinding the position, paying asking prices for the short calls and receiving bid prices for the long calls, would eat up most of the difference. Unwinding in January 2018 will be automatic, and cost-free. So, I'll be patient.
It all sounds so simple; just a hugely leveraged version on the buy low-sell high scenario. Note, though, that I spent several weeks looking at a sizeable paper loss At one point, it was down about 33%. If I had thrown $100,000 or $1,000,000 at the bet, my sleep cycle would have suffered. As it is, the sharp drop seemed small enough to ignore. My reading of the basics (oil supply/production cycle, company internals (revenue vs debt vs capex) made the trade look very promising; so I didn't sweat the highly visible risk.
From here on out, I'll concentrate on the bonds. That's my long-term strength, and I still see signficant opportunities for the company's longer-maturing debt.
January 8, 2017. It should be clear from my blog over the years that I believe getting rich slowly is a better long-term strategy than its opposite. However, if you are determined to play the stock game, looking for companies that are undervalued, and relying upon the market to recognize and eventually reward your insight, then this particular options spread game seems very promising to me. Working with leaps give you up to two years of breathing space. The risks are very clear (shame on me if I haven't put them front and center), but the rewards can be breath-taking.
My own results are far too spotty to suggest a comprehensive investment strategy (like the Bodacious Bond Portfolio). And a year like 2008 could (and, for me, did) ruin your day, week, and year. Still, a disciplined, laddered series of spreads, diversified over industries, might be very powerful. A few winners could overwhelm quite a few losers.
The big question here is whether is it even possible to outguess the market. By that I mean, a stock (or bond), at any given point, represents the best combined judgement of hundreds, perhaps thousands of pretty shrewd people about a company and its prospects. It's fairly arrogant to disagree. Yet, hind-sight lets us see how often, and dramatically, this shrewd consensus misses the mark. Prices leap up beyond reason, and plunge equally beyond reason. The consensus-makers are constantly looking sideways at each other, and betting on what those peers are going to do. Kind of a circle-jerk, if you want to be crude (I do). Pros generally prefer to stumble with the herd than stumble conspicuously alone. The fact that they get graded, four times a year, and in full public view, makes them skittish and a bit stupid.
This gives an individual investor a huge advantage. Nobody cares what you, a boob in the sticks, is doing. So, they won't make fun of you, because you're invisible! That's a very good thing; you can, in theory, be brave without fear of public humiliation.
I'd love to talk to others about this approach, and I might even try to continue my lab experiment past 2018. I suspect that it will, in time, turn into another get rich slow scheme, due to layers of diversification.
Saturday, June 25, 2016
Annuities Revisited, With a Vengeance!
My wife recently retired, and we faced, once again, a deluge of tempting things to do with her 401K and other retirement funds. Coincidentally, a friend asked me about a juicy annuity: he could cash in a company 401K plan worth $200,000 and get something like $1000 monthly, "forever!" "That's 6%!", he exclaimed. In fact, the world is beating a path to senior doors, all making similar pitches. For example, Barron's Magazine just listed the 100 "BEST" annuities in America. Leading the list of plain vanilla annuities are offerings from American National (5.8%, $966 monthly) and Guardian (5.79%, $964 monthly). There are endless variations, with survivor benefits, inflation adjustment, foot massage, etc. The moral? Be afraid, very afraid.
My first question to anyone interested in an annuity is whether he gets the difference between "return on principal" and "return of principal." At this, most people's eyes glaze over. They should reach for the Visine instead. In my friend's example, the 6% is a return ON principal, but there would never be a return OF principal. As Mark Twain learned to his great regret, the difference is crucial. The company is going to keep the original $200,000, no matter how long you live. If you live a VERY long time, the payments might make up for loss of principal, but like your virginity, the pristine annuity investment is gone forever.
There is a very simple way to test whether an annuity is a good idea. Pretend you're a bank yourself, "Sybaritic Seniors?". Assume some home-buyers come to you, hoping to borrow that self-same $200,000. Like any standard borrower, they expect to pay a fixed amount per month. After the final payment, in say 20 years (the average life expectancy of a 65 year old buying an annuity), they want to own the home free and clear, owing Sybaritic Seniors nothing at all. They ask you to set the monthly payment at $965. Doesn't this sound a whole lot like an annuity company seeking to borrow your $200,000 with a $965 monthly return?
Pull up any basic mortgage calculator. You will find that a $200,000 loan with a monthly payment of $965 over twenty years implies an interest rate of 1.5%! Would you, in your wildest dreams, ever lend that kind of money for that length of time for that tiny return? Wouldn't that just be ... stupid? All an annuity company (your bank's customer) would need to do to get rich is find an investment that would yield over 1.5% yearly, and pocket the difference. Gosh, where would they ever find that? Well, there are THOUSANDS of investment-rated bonds that yield over twice that 1.5%! Some would yield three times as much.
There's more bad news here. If your 401K or IRA was funded with pre-tax dollars (most are), then the annuity payout is taxable! At 25% (pretty common for average folks), your post-tax return plunges to $724, or 1.125%. Ouch. But wait, as in an infomercial, THERE'S MORE! Over the last 16 years, the average rate of inflation in the US has been 2.24%. That means, as in the above example, you are losing over two dollars to inflation for every post-tax dollar you receive. This is how an annuity can put you on a Friskies diet in a few years. Yum!
If I were in the annuity business, I would just find a few (thousand) anxious seniors, wave that tempting "6%" in their faces, actually pay off at the rate of 1.5%, and slurp the cream for the next couple of decades. With any luck, those lenders will do you the extra favor of dying early. In that case, you still have their money, but no longer owe a dime!
Now, let's pause a moment. The annuity is not, of course, actually a mortgage. The example above assumes a fixed-rate, fixed term mortgage (1.5%, 20 years). In real life, an annuitant might live much much longer. If she lives to 100, then total payments of $521,100 might look pretty good. But, remember that $200,000 of it was her money to start with. Even under this extreme scenario, the compounded rate of return over that 35 years is still a mere 2.77%! And don't forget the terrible news about income taxes and inflation.
Now do you understand why everybody and his brother is trying, frantically, to sell you an annuity? Taking the above example, it would make sense for the seller to hire a bunch of aggressive salesmen (call them financial advisors, if you like), and pay them 5 or 10 percent off the top. He's locked the suckers in for decades, so what's a little baksheesh among friends? He'll still get rich on the carry, they on the bribe.
In one of my very first posts (October 2010), I suggested the common-sense alternative to an annuity: a few carefully chosen BBB-rated bonds, coming due about the time you think you will ... come due (or later, of course). You can still find some of these yielding north of 6%, particularly energy issues. Yeah, they're considered risky and volatile, but in the bond world, that still means the great majority will pay off, in time and on time. Diversification would handle most of the risk. $200,000 invested in such bonds would return $1000 a month for twenty (or thirty, or forty) years. Then, when the bonds mature, you will still have the $200,000 you started with. Great for you, or your grateful heirs. And if you really need extra money in the meantime, you can always sell off some of the bonds. They trade on the open market, after all. Try asking your annuity provider for the same consideration!
My first question to anyone interested in an annuity is whether he gets the difference between "return on principal" and "return of principal." At this, most people's eyes glaze over. They should reach for the Visine instead. In my friend's example, the 6% is a return ON principal, but there would never be a return OF principal. As Mark Twain learned to his great regret, the difference is crucial. The company is going to keep the original $200,000, no matter how long you live. If you live a VERY long time, the payments might make up for loss of principal, but like your virginity, the pristine annuity investment is gone forever.
There is a very simple way to test whether an annuity is a good idea. Pretend you're a bank yourself, "Sybaritic Seniors?". Assume some home-buyers come to you, hoping to borrow that self-same $200,000. Like any standard borrower, they expect to pay a fixed amount per month. After the final payment, in say 20 years (the average life expectancy of a 65 year old buying an annuity), they want to own the home free and clear, owing Sybaritic Seniors nothing at all. They ask you to set the monthly payment at $965. Doesn't this sound a whole lot like an annuity company seeking to borrow your $200,000 with a $965 monthly return?
Pull up any basic mortgage calculator. You will find that a $200,000 loan with a monthly payment of $965 over twenty years implies an interest rate of 1.5%! Would you, in your wildest dreams, ever lend that kind of money for that length of time for that tiny return? Wouldn't that just be ... stupid? All an annuity company (your bank's customer) would need to do to get rich is find an investment that would yield over 1.5% yearly, and pocket the difference. Gosh, where would they ever find that? Well, there are THOUSANDS of investment-rated bonds that yield over twice that 1.5%! Some would yield three times as much.
There's more bad news here. If your 401K or IRA was funded with pre-tax dollars (most are), then the annuity payout is taxable! At 25% (pretty common for average folks), your post-tax return plunges to $724, or 1.125%. Ouch. But wait, as in an infomercial, THERE'S MORE! Over the last 16 years, the average rate of inflation in the US has been 2.24%. That means, as in the above example, you are losing over two dollars to inflation for every post-tax dollar you receive. This is how an annuity can put you on a Friskies diet in a few years. Yum!
If I were in the annuity business, I would just find a few (thousand) anxious seniors, wave that tempting "6%" in their faces, actually pay off at the rate of 1.5%, and slurp the cream for the next couple of decades. With any luck, those lenders will do you the extra favor of dying early. In that case, you still have their money, but no longer owe a dime!
Now, let's pause a moment. The annuity is not, of course, actually a mortgage. The example above assumes a fixed-rate, fixed term mortgage (1.5%, 20 years). In real life, an annuitant might live much much longer. If she lives to 100, then total payments of $521,100 might look pretty good. But, remember that $200,000 of it was her money to start with. Even under this extreme scenario, the compounded rate of return over that 35 years is still a mere 2.77%! And don't forget the terrible news about income taxes and inflation.
Now do you understand why everybody and his brother is trying, frantically, to sell you an annuity? Taking the above example, it would make sense for the seller to hire a bunch of aggressive salesmen (call them financial advisors, if you like), and pay them 5 or 10 percent off the top. He's locked the suckers in for decades, so what's a little baksheesh among friends? He'll still get rich on the carry, they on the bribe.
In one of my very first posts (October 2010), I suggested the common-sense alternative to an annuity: a few carefully chosen BBB-rated bonds, coming due about the time you think you will ... come due (or later, of course). You can still find some of these yielding north of 6%, particularly energy issues. Yeah, they're considered risky and volatile, but in the bond world, that still means the great majority will pay off, in time and on time. Diversification would handle most of the risk. $200,000 invested in such bonds would return $1000 a month for twenty (or thirty, or forty) years. Then, when the bonds mature, you will still have the $200,000 you started with. Great for you, or your grateful heirs. And if you really need extra money in the meantime, you can always sell off some of the bonds. They trade on the open market, after all. Try asking your annuity provider for the same consideration!
Saturday, May 30, 2015
Warren, Charlie, George, Bill(s), Move Over!
After 7.5 highly adventurous years of bond investing, I decided it's time to take stock, or rather "bond". So, I went back to the beginning (2008), when I switched from my (frankly) disastrous stock / options style of investing to bonds: bonds, nothing but bonds, bonds all the time. I prepared a trade-by-trade listing of each purchase and redemption from May, 2008 until the present. My first purchase, Clear Channel 7.25% of 2027 was the very worst. I bailed out in September of 2011, with a nasty loss of $3100 on an original investment of $6800. Things soon got better though, a whole lot better.
From that start date to now, I bought a face amount of bonds to the tune of $2.88 million. The actual cost was $2.4 million. Since nearly all the bond positions have since risen well above par, that gain alone looks rich. In the meantime, I sold off positions worth $1.28 million, for a pre-tax profit of $176,000. The remaining positions are worth $1.35 million, with an unrealized profit of $304,000. On the taxable side, I used margin along the way, generally paying about 1.25% annually from Interactive Brokers. Starting with an initial total dollar outlay of $277,000 as of March 1, 2009, this portfolio is now worth $652,000. Adding back in $477,000 withdrawn over this period for living expenses, the adjusted value is $1.13 million, a return of 307%, or a compounded return of 20.5%! People praise Soros and Buffet for gains in the 18-20% annual range. Their calculations don't account for ANY withdrawals over the years; mine were nearly half a million! Had I reinvested those funds over the years, my results would have been substantially richer and I'd be looking down my nose at those amateurs.
So, where are MY acolytes, slavering for scraps from MY yearly press conference?
Of course, my IRA returns are far more modest: only 115% on an original outlay of $274,000. That's merely 12.5% annually over five years (my IRA bond investments were complete by July, 2010). Still, what bond maven wouldn't have killed for such returns (I'm talking to you, Bill Gross)?
Looking back, I am very inclined to fret. If I had only doubled, tripled, quadrupled down! Knowing what I knew, believing what I believed, why didn't I swing for the cheap seats? Well, to put it bluntly, I did, to the extent of my abilities. While it would have been technically feasible to be far more aggressive, I actually went to the farthest limits of my psyche. The risks I took (and they were considerable) were all I could handle. More and I might have exploded, imploded, or simply melted. Only the retrospective glow of success makes additional risk-taking look plausible. So, I simply have to pound the drum I have, not that bigger better one.
My disadvantages vis a vis Warren and his crowd are many: they have lots of insider information, they have huge sources of very cheap funds; they can command seriously favorable terms in buying and selling; they can influence management to do their will; and the pilot fish trailing in their shadow bid up the stuff they buy after the fact. I, however, am not without certain modest advantages as well: I can buy and sell without moving the market; I can overweight to my heart's content; I have no one riding my ass about last quarter's results and ... well, that's about it. But perhaps there is one additional advantage: it's MY money; I care a lot about it; and I watch it very carefully.
When I started this blog, I was sure I had useful advice, and this latest analysis bears me out. Folks, listen up! You'll thank me later!
From that start date to now, I bought a face amount of bonds to the tune of $2.88 million. The actual cost was $2.4 million. Since nearly all the bond positions have since risen well above par, that gain alone looks rich. In the meantime, I sold off positions worth $1.28 million, for a pre-tax profit of $176,000. The remaining positions are worth $1.35 million, with an unrealized profit of $304,000. On the taxable side, I used margin along the way, generally paying about 1.25% annually from Interactive Brokers. Starting with an initial total dollar outlay of $277,000 as of March 1, 2009, this portfolio is now worth $652,000. Adding back in $477,000 withdrawn over this period for living expenses, the adjusted value is $1.13 million, a return of 307%, or a compounded return of 20.5%! People praise Soros and Buffet for gains in the 18-20% annual range. Their calculations don't account for ANY withdrawals over the years; mine were nearly half a million! Had I reinvested those funds over the years, my results would have been substantially richer and I'd be looking down my nose at those amateurs.
So, where are MY acolytes, slavering for scraps from MY yearly press conference?
Of course, my IRA returns are far more modest: only 115% on an original outlay of $274,000. That's merely 12.5% annually over five years (my IRA bond investments were complete by July, 2010). Still, what bond maven wouldn't have killed for such returns (I'm talking to you, Bill Gross)?
Looking back, I am very inclined to fret. If I had only doubled, tripled, quadrupled down! Knowing what I knew, believing what I believed, why didn't I swing for the cheap seats? Well, to put it bluntly, I did, to the extent of my abilities. While it would have been technically feasible to be far more aggressive, I actually went to the farthest limits of my psyche. The risks I took (and they were considerable) were all I could handle. More and I might have exploded, imploded, or simply melted. Only the retrospective glow of success makes additional risk-taking look plausible. So, I simply have to pound the drum I have, not that bigger better one.
My disadvantages vis a vis Warren and his crowd are many: they have lots of insider information, they have huge sources of very cheap funds; they can command seriously favorable terms in buying and selling; they can influence management to do their will; and the pilot fish trailing in their shadow bid up the stuff they buy after the fact. I, however, am not without certain modest advantages as well: I can buy and sell without moving the market; I can overweight to my heart's content; I have no one riding my ass about last quarter's results and ... well, that's about it. But perhaps there is one additional advantage: it's MY money; I care a lot about it; and I watch it very carefully.
When I started this blog, I was sure I had useful advice, and this latest analysis bears me out. Folks, listen up! You'll thank me later!
Saturday, February 7, 2015
What is cheap?
When you're thinking about investing in almost anything, you will, I guarantee, be plagued by the question of whether you're buying at the right price. Right price? Well, really, you need a cheap price. Essential to the investing dynamic is to buy low and sell high.
Well, I have bad news for you. Today's "bargain" price is tomorrow's "falling knife." The brutal truth is that there is no correct price for anything. There's only a price that is a compromise between a buyer (who is greedily looking for the lowest springboard to appreciation), and a seller (who is either afraid or is in turn seeking greener pastures for the same ultimate reason). Nobody buys because they truly think their purchase is overpriced, and few sell because they are convinced the item is extremely cheap. Notice, though, I said "few" in the prior sentence. And that's really important. People do, on occasion, sell things for tremendously low prices because they think they have little choice. They sell in despair ("I give up, this damn thing is headed for the toilet"), or they sell to raise cash to meet desperate needs (say the dreaded margin call).
In the broad flow of events, markets swing irregularly from euphoric highs to irritably dreary years of minor ups and downs, to occasional moments of sheer terror. When the market has risen inexorably for six years (hmm, remind you of any recent period?), people start thinking the abnormal is normal, and grasp for things that have already risen to the stratosphere. You hear variations of the greater fool theory underlying the purchase recommendations of market professionals ("yes, it's relatively high for the moment, but long-term dynamics will make today's price look trivial" - think of the endless flow of Amazon hype).
It is the moments of terror, though, that really interest me. While they seem like extreme outliers, I find them popping up fairly frequently: 2001-2, 2008-9, the euro crisis of 2010-11, and today's oil price collapse. If the crisis is severe enough, truly irrational behavior results. I've documented the extreme opportunities that occurred in the great recession and the euro kerfluffle. Now, lo and behold, they're on full display in the oil sector.
After trumpeting the "Case for $35 Oil", Barron's recently raised the ante ("The Case for $20 Oil"). If it hits that $20, what do you think Barron's next prediction will be? Of course, NOBODY (well, maybe a Saudi or two) makes money at $20/barrel, and very few at $35. So, those lows will disappear in the blink of an eye. In the last oil collapse (2008), oil plunged from $145 to $32 a barrel. So, it's pretty safe to say that $32/barrel is a VERY low price, as is the recent $44. The bulk of the world's producers have break-even somewhere around $50, so that too is a pretty low price. At $60, most folks start making money, but few make a whole lot. So, $60 is also a pretty low price. Fracked oil has a median break-even around $65. So, even $65 looks reasonably low.
The tug of war in the next few years will be between the low-cost producers who can make a buck below $60 and those who need to see $80 or more. Political winds will, at times, distort this struggle to the upside, while prolonged dips below $60 will dampen production. Frackers, after all, have no ideology; they'll postpone or halt drilling when they see no way to make a good buck. And, they'll jump right back in when they do see a way.
The quick response capabilities of frackers and other alternative producers (plus steady growth of wind and solar energy) pretty much guarantee that we won't see historical oil highs ($145 in 2008, $124 in 2010) any time soon. So, you can safely say that prices north of $100/barrel are high, just as $32 or $44 is low. So, that's what cheap and expensive are in the world of oil, at least for now. IMHO.
In writing about this sector absolutely flattened by recent oil price drops, one company in particular interests me: the maritime driller Transocean. It recently bottomed (maybe) at around $15, and is now hovering around $18. Are these low prices? Well, there's a fair amount of ink arguing that it's too high. A Motley Fool investor just threw in the towel (after a 62% drop in his holdings of Transocean), and hints that others should too (even though he admits the company will probably trade sharply higher in the near future). As with the price of oil itself, though, I think it's fairly obvious that the company's price is cheap. The blood in the water helps me see this.
So, forget the bottom, just focus on the essentials: will the company survive the present crisis, and will it ever have a future in the future? I've think Transocean (symbol RIG) will survive short-term (adequate cash, fairly modest demands on that cash). Long term, the question relates to whether oil drillers, as a group, will be needed. Well, much as people are focused on fracking as a direct threat to ocean drilling, it's also quite clear that frackers represent incremental production. Their costs are relatively high (probably break-even north of $65), and relatively short well-life requires constant (and probably ever more expensive) replacement of supply.
Ocean drilling is targeted to the largest and relatively least exploited sources of big-time supply. Roughly half of world production comes from offshore drilling at various depths. While exploration and development is expensive, lifting costs (simply pumping the stuff) are quite low, on average $10/barrel, with total upstream costs around between $41 for offshore shelf, $51 for deepwater and $56 for ultra deepwater oil. Even the expensive rigs therefore compare favorably to highly-hyped fracking. So ... is there a future for the sector? Of course there is. When oil returns to $60, new business will start trickling in, while there will probably be a rush once $80 is reached.
Right now, the balance of fear and greed is overwhelmingly on the side of fear. Taking action is hard, things might get even cheaper. True enough, but do you seriously think oil will STAY at $20, or $30, or $40? So, I think doing SOMETHING makes sense. I'm buying Transocean calls (10 of January, 2017) for astonishingly small time premiums (around $.50 per share for a two-year leap). I've already locked in some spreads (selling calls 18 of 2017), with a maximum profit to expiration of 140%. That profit will be realized if the stock closes at or above $18 in January 2017. Will it? Heck if I know. But I think the odds are heavily in my favor, as the stock closed at $18.51 yesterday.
I'm also nibbling at the bonds, particularly an issue of Global Marine (7%, 6/1/28) now yielding over 10% to maturity. This issue is actually an obligation of Transocean, but apparently the folks considering buying it don't know. The bonds yield a full point higher than similar Transocean bonds, even though the two are actually the same entity, with the same credit rating (Baa- Moody's, subject to possible downgrade). I wrote about the math of buying such bonds in my last post: a four to five year doubling of the investment is entirely feasible.
Update: one week later, 2/9/15. Busy week. The stock has moved from about $18.50 to $20.44. I have bought, in total, 65 call options, most 10's of 2017, at prices varying from $7.37 to $9.80. As RIG rose, I began selling call options, first at 18, then at 20 (all of 2017). All but 10 options are now spread-paired, with a maximum profit potential of $29,000 if the stock stays at or above $20 by January of 2017. Today's close of $20.44 makes the prognosis highly favorable.
My sense is that RIG is will approach some version of "normal" valuation around $30, so I intend to keep the process up until it approaches that level. As during the past week, I'll try to buy call options with the minimum possible time premium (perhaps $.50 or so), and pair then pair them with a short call at the money, as the stock rises. Each two point rise allows for a 150% profit on the spread, so I might get five more chances to ride this wave. The reason I'm selling calls at the money is, I hope, obvious: to limit risk while still allowing for fairly huge gains over a two-year period.
Update: February 18. Transocean has cut the dividend by 80%, and fired the idiot who let Carl Icahn bully the company into an unsustainable $3.00 rate in the first place. This is good news. A new sense of urgency and common sense will lead the company to cut back on buying hugely expensive new drilling rigs, and thus conserve enough cash to maintain the company's investment grade credit rating. So, the bonds, will, I am fairly sure, start rising sharply. As will the company's stock. At today's $19/share, my call positions are in the money, but only slightly. Any number of things could cause crude to rise sharply from today's levels, and the stock will float with that tide. Is this the sure thing of 2008-9? No, but it's not a whole lot removed from it.
There is a huge range of opinions about Transocean, with one Chicken Little predicting a bottom of $6/share, and other folks projecting $25-30. So, this is the exact moment when predicting things can, or should, establish soothsaying credibility. I'm doing frequent updates to document, here and now, what I am expecting to see down the road. By the way, when I edit older posts (and I do so, frequently), it is always to correct word choice and thought flow. I don't believe in modifying predictions based upon subsequent events. So, if future events make my Transocean thread look witless, then so be it.
Update: February 26. Another adventurous week, this time to the downside. Transocean has sagged to just under $16/share. While my overall options position is showing a small loss, I am comforted by the observation that the position would, ultimately, result in a decent profit by January, 2017, assuming the stock stayed right where it is now. That is due to the fact that the short options (18 and 20) are both out of the money, and would expire worthless in 2017 at today's price. The long calls, however, are still solidly in the money, and would be worth the final 2017 price less $10. The upside I outlined above continues unchanged: roughly 150% if the stock closes at or above $20 in January of 2017. By the way, Moody's just downgraded the debt to Ba1, just into junk territory. S&P and Fitch are still rating it investment grade. While all three might fall into line, I wouldn't be surprised if the split rating continued awhile. Such tag-teaming is not unusual, as it often influences a company to fall into line financially. So, let's see what transpires next.
Update: 5/14. Even more action, now on the upside. After tottering just below 16 (which brought out a wave of sell-side advice, with the above-cited Chicken Little now predicting a bottom of 3!), the stock has since shot up to 21. Yesterday's pundit? "Transocean is 20% undervalued." My spreads are in the pink, needing no further up movement to achieve their maximum profit in January 2107. Upon reflection, I decided to stop establishing spreads and sold back a few unpaired calls for a $2000 profit. Instead, I intend to focus on the bonds. I've repositioned my IRA, selling some mature (and richly priced) positions to make room for the Global Marine 7% bonds of 28, average purchase price around 77. I have also used margin to buy a fairly substantial number of bonds in my taxable accounts. The margin ratio is roughly 50%, so the yearly return with IB's 1.25% margin rate is roughly 16%.
My shift in emphasis is based on the consideration that I have little idea of what the "correct" price is for Transocean (yeah, 15 is very low, 60 is very high). I do, however, have a very clear idea of what is sensible for the bonds: par, or better yet, 110% of par. That's based on a simple comparison of their present yields with a broad spectrum of high level junk bonds. Even considering the risk, they are wildly underpriced. Now trading around 83 (up from the very low 70's), the bonds still have a long way to go. If they regain their investment status (very very likely, as the company seems to be weathering the oil crisis quite well), the bonds will probably go up to 120 or so. I intend to be along for the ride.
Update: 11/9/15. Movement in both the stock and bonds has been very negative, although both are now slightly above their lows. Moody's rating has ticked down one notch further, to Ba2. I took the the opportunity, following a spurt in the stock price to the mid 16 level to close out my option positions, with an overall profit of $7500. Not great considering the risk, but I won't complain. The bonds continue to sag, with my Transocean 7% of 28 positions hovering around 60. So that bargain price of 77 mentioned above now feels more like a falling knife. Global Marine's implied yield of 13.5% to maturity is a full 2% higher than its Transocean sisters, a persistent and illogical disparity. It stands out like a sore thumb, as other companies with similar yields are well down the junk ladder from Transocean. It is also, of course, a temptation for the brave. I have, however, temporarily reached my limit for bravery. I won't sell, but would rather wait for the bandwagon to roll forwards before jumping back on.
Still, there is plenty of reason for good cheer. Of paramount importance is the way Transocean has responded to the turn-down. They've cut the dividend entirely, delayed the delivery of multiple rigs and cold-stacked a bunch of other units. Better yet, though, from the point of view of a bond investor, they have attacked debt with a vengeance. In the last three quarters alone, they have retired $.9 billion of current debt, as well as $.4 billion of longer term debt, a 13% reduction of total debt. Since 2011, Transocean's liabilities have shrunk from $19.4 billion to $11.8 billion. That's a 39% reduction and bodes very well for the company's survival down the road. To sum up: from a cash management point of view, Transocean does not look like a junk-rated company at all.
Will this strict attention to finances be good for the company in the long run? That's hard to tell. Those delayed next generation drilling rigs might be sorely missed in a couple of years, hurting long-term growth. But, one of the great things about being a bond investor is that we don't need to worry so much about long-term growth. The stock-holders can gnaw on that. Our concern is more basic: will Transocean honor its debts long enough for us to cash them in at par? Ask the holders of Transocean's 4.95% of November 2015 what they think!
11/16/15. One additional note: a Motley Fool article "Transocean's Recent Earnings Show a Company on Track to Survive" dated 11/14/15 reads the figures far more positively than I did. The article states that Transocean has reduced its total liabilities by $2.6 billion in the last year. Its net debt / EBIDTA ratio of 2.03 and current ration of 2.68 compare very favorably to fellow driller Ensco. But Ensco has a Moody's investment grade rating of Baa2, three levels higher than Transocean! Ensco's debt trades at a maximum yield to maturity of 9%, compared to Transocean's present 14% for Global Marine bonds. As I said above, something is seriously out of whack here. Transocean doesn't look at all like a junk-rated company.
12/14/2015. WHEEEEEE! The roller coaster (I hope that's what this is) hurtles down! My Transocean bonds (7% of 2028) have cracked 50 on the downside! That's a yield to maturity of nearly 18%! Why, in light of the fairly benign third quarter results cited above, is this happening? I think I know, or at least, I hope I know. The ratings cut into junk-land has put pressure on funds of various kinds to offload the Transocean/Global Marine bonds. It's now December, and I think the year-end deadline is causing a sharp imbalance in the supply/demand ratio. So, even though I'm fairly terrified, I've started buying ... again! Transocean's mere survival will make these bonds soar, and I suspect the ascent will start in January. I promise an update then, even though my chin might be smeared with egg. You can take a picture to scare your kids.
2/26/16 UURRRPP! Still down! Most recent trades for the Global Marine bonds are just below 40! And yet ... full year results are in for 2015. Despite retiring $1.5 billion in debt, and buying new ships to the tune of $2 billion, the company's cash is actually up for the quarter, to $2.3 billion. With the line of credit, that's $5.3 billion, cash in hand, to cover future expenditures of $3 billion in debt maturities and $2.4 billion in new builds between now and 2020. So, the company just has to earn $100 million in the next three years to keep afloat. With a backlog of $16 billion, that's a no-brainer.
About the backlog: a lot of commentary goes into cancellations, treating them as a disaster for the company. From a cash-flow point of view, that's simply wrong. What really happens is that Transocean gets a hefty payment, right now, to compensate for the loss it suffers for not doing future work. These contracts were written back in the days when deep drilling rigs were in peak demand, and so the penalties are severe. In effect, Transocean books an immediate profit, gets an immediate infusion of cash, and is still perfectly free to hire the rigs out at any price they can get. Sure, it will be a pitiful day rate, but even that represents additional cash flow.
So, allow me a moment of sheer speculation, as I have no knowledge of the contracts Transocean has made with its many clients. The company's gross margins are somewhere in the 50% range: ie, $1 in earnings for every $2 in billings. At present, I think it's better than that. So, a penalty clause for early cancellation will certainly be designed to compensate the company for a substantial percentage of that profit. I'm gonna guess $25% of the contracted amount. If that's right, then cancelling the entire backlog would still bring in $4 billion, for which the company would perform zero work.
So, the 2016, 2017 and 2018 bonds look totally safe, even though some are trading to yield 20% to maturity. This is the surest bet I've seen since the US government basically guaranteed the banks' debt in 2008. The bonds with maturities past 2018 are another story, but still a good one, I think.
So, let's look at 2019. Assuming the company has tapped its line of credit to pay off bonds maturing in 2018, Transocean would need to come up with $3 billion to pay off that line. Since I am hypothesizing a minimum of $4 billion in backlog revenue going forward, that would result in $1 billion in positive cash. With capex complete, the company would have a year of breathing space, with no debt due. Then, between 2020 and 2022, there will be an additional $2.7 billion of debt to repay, say a little over $3 billion with debt interest. Over that four years, therefore, the company needs to come up with roughly $2 billion of cash to stay afloat. Transocean could sell stuff, at a loss probably, but $2 billion is entirely possible. OR, the company could resume selling its product, deep and mid-water drilling, once demand recovers. Will that recovery occur?
While things look bleak right now, is it reasonable to assume they will be equally (extremely) bleak in 2020, 2021, 2022? With the world gulping 35 billion barrels of oil a year, while replacing a modest fraction of that in exploration, will the demand for drillers never recover? While the demise of oil is touted frequently, how will the hundreds of millions of new Chinese, Indian and Brazilian middle class entrants fuel their new automobiles? With hydrogen or electricity? Ha! Oil demand will rise, inexorably, while supply will be challenged, inexorably.
Update: March 23, 2016. There are signs the worst is over. Crude oil prices have soared from about $26/barrel to a present $41. That's a fat 57% rise! Of course, who would have been wise enough to start buying at $26? Not I. However ... Those 7.375% Transocean bonds of April 2018 sold down briefly to below 75, an annual yield to maturity of nearly 25%. While one might have legitimate concerns about bonds maturing past 2019, it appeared absolutely obvious to me that Transocean's cash hoard of $2.3 billion and line of credit of $3 billion made the redemption of the 2018 bonds nearly certain. So, I started buying. Just a day or two later, the idea seemed to percolate widely. The price jumped quickly from 74 to 90, and is now hovering between 92 and 95. At 95, the yield to maturity is still juicy (11% or so), so I've continued loading up along the way. With one-to- one margin, the two-year return will still be 40%! To make the story even sweeter, Transocean just announced a delay of up to four years in the delivery of five new drilling rigs. This means the company will have an additional $500 million cash in hand (in addition to its present $2.3 billion cash hoard and $3 billion line of credit). So, that's $5.8 billion available to pay off $2.7 billion of debt and $1.3 billion of capex between now and the end of 2018. Even if the company didn't earn a dime in 2016, 2017 and 2018, there would still be a cash cushion of $1.8 billion. But a considerable amount of revenue (as discussed above) is nearly certain. A mere $1 billion yearly would enhance the cushion by 50%
Update: July 2016. The uptrend continues, with bumps. Oil is now hovering around $45 per barrel, having peaked recently at $50. Transocean's stock has been on a roller-coaster. It plunged to $8.50, only to soar to today's $12.14, a rise of 42%! Across the board, the bonds have risen sharply from drastic lows. The action has been particularly robust in the near maturities: 2018 and 2020. The 7.375% 2018 bonds are now trading above par. The 6.5% bonds of 2020 are now at 94.
Two things account for this sharp improvement. One is the delay Transocean negotiated in delivery of new-builds into 2020-21. A second step was just announced: the company will issue new bonds in the amount of $1.25 billion, maturing in 2023. At the same time, they announced a tender offer of $1 billion to redeem bonds maturing in 2020, 2021 and 2022. Since the 6.5% bonds of 2020 represent $910 million by themselves, it is reasonable to assume that they will absorb most of the buybacks. The bonds now trade at roughly 94 because the tender offer is at 94.5. The discounts on the other two issues are sharper, so they will probably not be tendered in bulk.
So, why target 2020? Well, there is a large challenge then. In addition to approximately $.9 billion of bonds coming due, the company also needs to pay out $1.9 billion for new ships. If the company's core business continues to languish over the next four years, it would be challenged to come up with that nearly $3 billion in cash. The new bond issue is precisely targeted to address this cash flow problem. It gives the company an additional three years to handle its debt concerns. Make no mistake: the tender means that Transocean is expressing high confidence in its ability to weather the period from 2016-2019.
What does the tender plus new bond issue portend for later issues (2021, 2022, 2027, 2028, 2029, 2031, 2038, 2041)? Well, according to Moody's, it's a near-catastrophe. Their rating was promptly cut to Caa1, a stomach-churning two notches below their prior rating of B2. Their reasoning is that the new bonds will have provisions ensuring they are favored over the company's other senior debt. Fair enough, but ... really? On the narrowest front, the net increase in debt is only $250 million, quite modest in comparison to total outstanding debt of over $7 billion. And, let's be clear, delaying the grim reaper might mean he doesn't visit at all. Companies, unlike people, don't necessarily die at all.
Particularly curious is that the downgrade applies equally to the specific issue that is most likely to be retired: the 6.5% bonds of 2020. Even if a holder doesn't tender, it seems nearly guaranteed that the remaining scraps will be paid off upon maturity in 2020. These bonds aren't weaker than before; they are virtually as safe as the equally dismally-rated 2018 bonds.
I regard Moody's downgrade as a hissy-fit, addressing a real, but narrow risk. Sure, in default, the post 2023 bonds would suffer. But guys, the likelihood of a default is substantially lower now than it was before the new issue. The company's near-term cash crunch has been alleviated, while the cushion increases by $.25 billion.
A Caa1 rating shrieks doom, and doom soon. That's simply wrong for a company responding to a threat four years down the road. Sure, bad things might happen after 2020, but even then, Transocean has a variety of alternatives. It could issue more debt, issue more stock, further delay delivery of new ships (with penalties, to be sure) and/or sell off the very new-builds that created the cash crunch in the first place. At a fire-sale of fifty cents on the dollar, Transocean would pull in up to $3 billion to toss to circling p(c)reditors. None of these steps merits rave reviews, but each could keep the wolf from the door.
Caa1 also proclaims that today's abysmal environment is unlikely to change within the next four years. Well, that might be true, but linear projections of short-term trends are usually stupid. The path of oil prices has been repeatedly marked by sharp declines followed by equally sharp up-turns. Most experts point out that total oil consumption is destined to rise steadily, regardless of Western conservation efforts. At the same time, replacement of existing oil reserves continues to lag drastically. Bottom line, I think a supply crunch is far likelier for 2020 than continued slump.
As long as the 2020 bonds trade below par, I think they're a screaming bargain. Don't tender them; instead collect the income till maturity, along with that extra five point gain to par. Without leverage, that's a 36% gain. With 50% leverage, it jumps to 65%. Better yet, wait until the tender premium of 3 points passes (July 18). The bond price will probably fall to 91, or less, once the tender period has ended. That will represent a huge buying opportunity: a $900 gain to par on ten bonds plus $2925 in interest makes for an unleveraged 42% return to maturity (77% with 50% margin). That's the kind of highly favorable risk/reward you can find only rarely in bonds.
Once the 2020 bonds approach maturity, it will be time for the new 9% bonds of 2023. Since they will have status senior to later Transocean bonds, they too have very nice potential. Of course, pricing will be critical: it would be nice to pick them up at or below par. Considering that the later bonds now yield in the 13% range, that should be distinctly do-able. (Update 3/13/17. Or not. Looks like these bonds are not - yet - available for public trading. Dunno why.)
To prepare for this pivot, I've been selling off part of my large position in the 7% Global Marine bonds of 2028. Since I bought a large slice of them at prices as low as 41 (yes, 41!), these trades have been cash-neutral. At 66, I can pair the sales against bonds bought at at higher prices to establish tax losses, but mentally match them against my rock-bottom purchases. As long as prices hold up for the Global Marine bonds, I can continue the pivot with only nominal losses, while substantially enhancing the safety of my overall Transocean exposure.
As to the 6.375% notes of 2021 and the 3.8% notes of 2022, well they'll require more fortitude. Their potential returns are large, though, and the risk is significantly lower today than it was before Transocean issued the new bonds. Absent an early default, they will be long-gone before the post-2023 holders are possibly savaged by their drop in priority in bankruptcy court. Even so, I think these longer bonds are a better bet than they were a week ago.
Moody's, perversely, has in general started being super cautious after its criminally negligent treatment of mortgage securities leading up to 2008. Over-reacting now, Moody's, won't make up for those catastrophic errors eight years ago. I'm just itching to revisit this issue in a couple of years. I'll bet Moody's present stance will look just as stupid then as it clearly was in 2008.
Well, I have bad news for you. Today's "bargain" price is tomorrow's "falling knife." The brutal truth is that there is no correct price for anything. There's only a price that is a compromise between a buyer (who is greedily looking for the lowest springboard to appreciation), and a seller (who is either afraid or is in turn seeking greener pastures for the same ultimate reason). Nobody buys because they truly think their purchase is overpriced, and few sell because they are convinced the item is extremely cheap. Notice, though, I said "few" in the prior sentence. And that's really important. People do, on occasion, sell things for tremendously low prices because they think they have little choice. They sell in despair ("I give up, this damn thing is headed for the toilet"), or they sell to raise cash to meet desperate needs (say the dreaded margin call).
In the broad flow of events, markets swing irregularly from euphoric highs to irritably dreary years of minor ups and downs, to occasional moments of sheer terror. When the market has risen inexorably for six years (hmm, remind you of any recent period?), people start thinking the abnormal is normal, and grasp for things that have already risen to the stratosphere. You hear variations of the greater fool theory underlying the purchase recommendations of market professionals ("yes, it's relatively high for the moment, but long-term dynamics will make today's price look trivial" - think of the endless flow of Amazon hype).
It is the moments of terror, though, that really interest me. While they seem like extreme outliers, I find them popping up fairly frequently: 2001-2, 2008-9, the euro crisis of 2010-11, and today's oil price collapse. If the crisis is severe enough, truly irrational behavior results. I've documented the extreme opportunities that occurred in the great recession and the euro kerfluffle. Now, lo and behold, they're on full display in the oil sector.
After trumpeting the "Case for $35 Oil", Barron's recently raised the ante ("The Case for $20 Oil"). If it hits that $20, what do you think Barron's next prediction will be? Of course, NOBODY (well, maybe a Saudi or two) makes money at $20/barrel, and very few at $35. So, those lows will disappear in the blink of an eye. In the last oil collapse (2008), oil plunged from $145 to $32 a barrel. So, it's pretty safe to say that $32/barrel is a VERY low price, as is the recent $44. The bulk of the world's producers have break-even somewhere around $50, so that too is a pretty low price. At $60, most folks start making money, but few make a whole lot. So, $60 is also a pretty low price. Fracked oil has a median break-even around $65. So, even $65 looks reasonably low.
The tug of war in the next few years will be between the low-cost producers who can make a buck below $60 and those who need to see $80 or more. Political winds will, at times, distort this struggle to the upside, while prolonged dips below $60 will dampen production. Frackers, after all, have no ideology; they'll postpone or halt drilling when they see no way to make a good buck. And, they'll jump right back in when they do see a way.
The quick response capabilities of frackers and other alternative producers (plus steady growth of wind and solar energy) pretty much guarantee that we won't see historical oil highs ($145 in 2008, $124 in 2010) any time soon. So, you can safely say that prices north of $100/barrel are high, just as $32 or $44 is low. So, that's what cheap and expensive are in the world of oil, at least for now. IMHO.
In writing about this sector absolutely flattened by recent oil price drops, one company in particular interests me: the maritime driller Transocean. It recently bottomed (maybe) at around $15, and is now hovering around $18. Are these low prices? Well, there's a fair amount of ink arguing that it's too high. A Motley Fool investor just threw in the towel (after a 62% drop in his holdings of Transocean), and hints that others should too (even though he admits the company will probably trade sharply higher in the near future). As with the price of oil itself, though, I think it's fairly obvious that the company's price is cheap. The blood in the water helps me see this.
So, forget the bottom, just focus on the essentials: will the company survive the present crisis, and will it ever have a future in the future? I've think Transocean (symbol RIG) will survive short-term (adequate cash, fairly modest demands on that cash). Long term, the question relates to whether oil drillers, as a group, will be needed. Well, much as people are focused on fracking as a direct threat to ocean drilling, it's also quite clear that frackers represent incremental production. Their costs are relatively high (probably break-even north of $65), and relatively short well-life requires constant (and probably ever more expensive) replacement of supply.
Ocean drilling is targeted to the largest and relatively least exploited sources of big-time supply. Roughly half of world production comes from offshore drilling at various depths. While exploration and development is expensive, lifting costs (simply pumping the stuff) are quite low, on average $10/barrel, with total upstream costs around between $41 for offshore shelf, $51 for deepwater and $56 for ultra deepwater oil. Even the expensive rigs therefore compare favorably to highly-hyped fracking. So ... is there a future for the sector? Of course there is. When oil returns to $60, new business will start trickling in, while there will probably be a rush once $80 is reached.
Right now, the balance of fear and greed is overwhelmingly on the side of fear. Taking action is hard, things might get even cheaper. True enough, but do you seriously think oil will STAY at $20, or $30, or $40? So, I think doing SOMETHING makes sense. I'm buying Transocean calls (10 of January, 2017) for astonishingly small time premiums (around $.50 per share for a two-year leap). I've already locked in some spreads (selling calls 18 of 2017), with a maximum profit to expiration of 140%. That profit will be realized if the stock closes at or above $18 in January 2017. Will it? Heck if I know. But I think the odds are heavily in my favor, as the stock closed at $18.51 yesterday.
I'm also nibbling at the bonds, particularly an issue of Global Marine (7%, 6/1/28) now yielding over 10% to maturity. This issue is actually an obligation of Transocean, but apparently the folks considering buying it don't know. The bonds yield a full point higher than similar Transocean bonds, even though the two are actually the same entity, with the same credit rating (Baa- Moody's, subject to possible downgrade). I wrote about the math of buying such bonds in my last post: a four to five year doubling of the investment is entirely feasible.
Update: one week later, 2/9/15. Busy week. The stock has moved from about $18.50 to $20.44. I have bought, in total, 65 call options, most 10's of 2017, at prices varying from $7.37 to $9.80. As RIG rose, I began selling call options, first at 18, then at 20 (all of 2017). All but 10 options are now spread-paired, with a maximum profit potential of $29,000 if the stock stays at or above $20 by January of 2017. Today's close of $20.44 makes the prognosis highly favorable.
My sense is that RIG is will approach some version of "normal" valuation around $30, so I intend to keep the process up until it approaches that level. As during the past week, I'll try to buy call options with the minimum possible time premium (perhaps $.50 or so), and pair then pair them with a short call at the money, as the stock rises. Each two point rise allows for a 150% profit on the spread, so I might get five more chances to ride this wave. The reason I'm selling calls at the money is, I hope, obvious: to limit risk while still allowing for fairly huge gains over a two-year period.
Update: February 18. Transocean has cut the dividend by 80%, and fired the idiot who let Carl Icahn bully the company into an unsustainable $3.00 rate in the first place. This is good news. A new sense of urgency and common sense will lead the company to cut back on buying hugely expensive new drilling rigs, and thus conserve enough cash to maintain the company's investment grade credit rating. So, the bonds, will, I am fairly sure, start rising sharply. As will the company's stock. At today's $19/share, my call positions are in the money, but only slightly. Any number of things could cause crude to rise sharply from today's levels, and the stock will float with that tide. Is this the sure thing of 2008-9? No, but it's not a whole lot removed from it.
There is a huge range of opinions about Transocean, with one Chicken Little predicting a bottom of $6/share, and other folks projecting $25-30. So, this is the exact moment when predicting things can, or should, establish soothsaying credibility. I'm doing frequent updates to document, here and now, what I am expecting to see down the road. By the way, when I edit older posts (and I do so, frequently), it is always to correct word choice and thought flow. I don't believe in modifying predictions based upon subsequent events. So, if future events make my Transocean thread look witless, then so be it.
Update: February 26. Another adventurous week, this time to the downside. Transocean has sagged to just under $16/share. While my overall options position is showing a small loss, I am comforted by the observation that the position would, ultimately, result in a decent profit by January, 2017, assuming the stock stayed right where it is now. That is due to the fact that the short options (18 and 20) are both out of the money, and would expire worthless in 2017 at today's price. The long calls, however, are still solidly in the money, and would be worth the final 2017 price less $10. The upside I outlined above continues unchanged: roughly 150% if the stock closes at or above $20 in January of 2017. By the way, Moody's just downgraded the debt to Ba1, just into junk territory. S&P and Fitch are still rating it investment grade. While all three might fall into line, I wouldn't be surprised if the split rating continued awhile. Such tag-teaming is not unusual, as it often influences a company to fall into line financially. So, let's see what transpires next.
Update: 5/14. Even more action, now on the upside. After tottering just below 16 (which brought out a wave of sell-side advice, with the above-cited Chicken Little now predicting a bottom of 3!), the stock has since shot up to 21. Yesterday's pundit? "Transocean is 20% undervalued." My spreads are in the pink, needing no further up movement to achieve their maximum profit in January 2107. Upon reflection, I decided to stop establishing spreads and sold back a few unpaired calls for a $2000 profit. Instead, I intend to focus on the bonds. I've repositioned my IRA, selling some mature (and richly priced) positions to make room for the Global Marine 7% bonds of 28, average purchase price around 77. I have also used margin to buy a fairly substantial number of bonds in my taxable accounts. The margin ratio is roughly 50%, so the yearly return with IB's 1.25% margin rate is roughly 16%.
My shift in emphasis is based on the consideration that I have little idea of what the "correct" price is for Transocean (yeah, 15 is very low, 60 is very high). I do, however, have a very clear idea of what is sensible for the bonds: par, or better yet, 110% of par. That's based on a simple comparison of their present yields with a broad spectrum of high level junk bonds. Even considering the risk, they are wildly underpriced. Now trading around 83 (up from the very low 70's), the bonds still have a long way to go. If they regain their investment status (very very likely, as the company seems to be weathering the oil crisis quite well), the bonds will probably go up to 120 or so. I intend to be along for the ride.
Update: 11/9/15. Movement in both the stock and bonds has been very negative, although both are now slightly above their lows. Moody's rating has ticked down one notch further, to Ba2. I took the the opportunity, following a spurt in the stock price to the mid 16 level to close out my option positions, with an overall profit of $7500. Not great considering the risk, but I won't complain. The bonds continue to sag, with my Transocean 7% of 28 positions hovering around 60. So that bargain price of 77 mentioned above now feels more like a falling knife. Global Marine's implied yield of 13.5% to maturity is a full 2% higher than its Transocean sisters, a persistent and illogical disparity. It stands out like a sore thumb, as other companies with similar yields are well down the junk ladder from Transocean. It is also, of course, a temptation for the brave. I have, however, temporarily reached my limit for bravery. I won't sell, but would rather wait for the bandwagon to roll forwards before jumping back on.
Still, there is plenty of reason for good cheer. Of paramount importance is the way Transocean has responded to the turn-down. They've cut the dividend entirely, delayed the delivery of multiple rigs and cold-stacked a bunch of other units. Better yet, though, from the point of view of a bond investor, they have attacked debt with a vengeance. In the last three quarters alone, they have retired $.9 billion of current debt, as well as $.4 billion of longer term debt, a 13% reduction of total debt. Since 2011, Transocean's liabilities have shrunk from $19.4 billion to $11.8 billion. That's a 39% reduction and bodes very well for the company's survival down the road. To sum up: from a cash management point of view, Transocean does not look like a junk-rated company at all.
Will this strict attention to finances be good for the company in the long run? That's hard to tell. Those delayed next generation drilling rigs might be sorely missed in a couple of years, hurting long-term growth. But, one of the great things about being a bond investor is that we don't need to worry so much about long-term growth. The stock-holders can gnaw on that. Our concern is more basic: will Transocean honor its debts long enough for us to cash them in at par? Ask the holders of Transocean's 4.95% of November 2015 what they think!
11/16/15. One additional note: a Motley Fool article "Transocean's Recent Earnings Show a Company on Track to Survive" dated 11/14/15 reads the figures far more positively than I did. The article states that Transocean has reduced its total liabilities by $2.6 billion in the last year. Its net debt / EBIDTA ratio of 2.03 and current ration of 2.68 compare very favorably to fellow driller Ensco. But Ensco has a Moody's investment grade rating of Baa2, three levels higher than Transocean! Ensco's debt trades at a maximum yield to maturity of 9%, compared to Transocean's present 14% for Global Marine bonds. As I said above, something is seriously out of whack here. Transocean doesn't look at all like a junk-rated company.
12/14/2015. WHEEEEEE! The roller coaster (I hope that's what this is) hurtles down! My Transocean bonds (7% of 2028) have cracked 50 on the downside! That's a yield to maturity of nearly 18%! Why, in light of the fairly benign third quarter results cited above, is this happening? I think I know, or at least, I hope I know. The ratings cut into junk-land has put pressure on funds of various kinds to offload the Transocean/Global Marine bonds. It's now December, and I think the year-end deadline is causing a sharp imbalance in the supply/demand ratio. So, even though I'm fairly terrified, I've started buying ... again! Transocean's mere survival will make these bonds soar, and I suspect the ascent will start in January. I promise an update then, even though my chin might be smeared with egg. You can take a picture to scare your kids.
2/26/16 UURRRPP! Still down! Most recent trades for the Global Marine bonds are just below 40! And yet ... full year results are in for 2015. Despite retiring $1.5 billion in debt, and buying new ships to the tune of $2 billion, the company's cash is actually up for the quarter, to $2.3 billion. With the line of credit, that's $5.3 billion, cash in hand, to cover future expenditures of $3 billion in debt maturities and $2.4 billion in new builds between now and 2020. So, the company just has to earn $100 million in the next three years to keep afloat. With a backlog of $16 billion, that's a no-brainer.
About the backlog: a lot of commentary goes into cancellations, treating them as a disaster for the company. From a cash-flow point of view, that's simply wrong. What really happens is that Transocean gets a hefty payment, right now, to compensate for the loss it suffers for not doing future work. These contracts were written back in the days when deep drilling rigs were in peak demand, and so the penalties are severe. In effect, Transocean books an immediate profit, gets an immediate infusion of cash, and is still perfectly free to hire the rigs out at any price they can get. Sure, it will be a pitiful day rate, but even that represents additional cash flow.
So, allow me a moment of sheer speculation, as I have no knowledge of the contracts Transocean has made with its many clients. The company's gross margins are somewhere in the 50% range: ie, $1 in earnings for every $2 in billings. At present, I think it's better than that. So, a penalty clause for early cancellation will certainly be designed to compensate the company for a substantial percentage of that profit. I'm gonna guess $25% of the contracted amount. If that's right, then cancelling the entire backlog would still bring in $4 billion, for which the company would perform zero work.
So, the 2016, 2017 and 2018 bonds look totally safe, even though some are trading to yield 20% to maturity. This is the surest bet I've seen since the US government basically guaranteed the banks' debt in 2008. The bonds with maturities past 2018 are another story, but still a good one, I think.
So, let's look at 2019. Assuming the company has tapped its line of credit to pay off bonds maturing in 2018, Transocean would need to come up with $3 billion to pay off that line. Since I am hypothesizing a minimum of $4 billion in backlog revenue going forward, that would result in $1 billion in positive cash. With capex complete, the company would have a year of breathing space, with no debt due. Then, between 2020 and 2022, there will be an additional $2.7 billion of debt to repay, say a little over $3 billion with debt interest. Over that four years, therefore, the company needs to come up with roughly $2 billion of cash to stay afloat. Transocean could sell stuff, at a loss probably, but $2 billion is entirely possible. OR, the company could resume selling its product, deep and mid-water drilling, once demand recovers. Will that recovery occur?
While things look bleak right now, is it reasonable to assume they will be equally (extremely) bleak in 2020, 2021, 2022? With the world gulping 35 billion barrels of oil a year, while replacing a modest fraction of that in exploration, will the demand for drillers never recover? While the demise of oil is touted frequently, how will the hundreds of millions of new Chinese, Indian and Brazilian middle class entrants fuel their new automobiles? With hydrogen or electricity? Ha! Oil demand will rise, inexorably, while supply will be challenged, inexorably.
Update: March 23, 2016. There are signs the worst is over. Crude oil prices have soared from about $26/barrel to a present $41. That's a fat 57% rise! Of course, who would have been wise enough to start buying at $26? Not I. However ... Those 7.375% Transocean bonds of April 2018 sold down briefly to below 75, an annual yield to maturity of nearly 25%. While one might have legitimate concerns about bonds maturing past 2019, it appeared absolutely obvious to me that Transocean's cash hoard of $2.3 billion and line of credit of $3 billion made the redemption of the 2018 bonds nearly certain. So, I started buying. Just a day or two later, the idea seemed to percolate widely. The price jumped quickly from 74 to 90, and is now hovering between 92 and 95. At 95, the yield to maturity is still juicy (11% or so), so I've continued loading up along the way. With one-to- one margin, the two-year return will still be 40%! To make the story even sweeter, Transocean just announced a delay of up to four years in the delivery of five new drilling rigs. This means the company will have an additional $500 million cash in hand (in addition to its present $2.3 billion cash hoard and $3 billion line of credit). So, that's $5.8 billion available to pay off $2.7 billion of debt and $1.3 billion of capex between now and the end of 2018. Even if the company didn't earn a dime in 2016, 2017 and 2018, there would still be a cash cushion of $1.8 billion. But a considerable amount of revenue (as discussed above) is nearly certain. A mere $1 billion yearly would enhance the cushion by 50%
Update: July 2016. The uptrend continues, with bumps. Oil is now hovering around $45 per barrel, having peaked recently at $50. Transocean's stock has been on a roller-coaster. It plunged to $8.50, only to soar to today's $12.14, a rise of 42%! Across the board, the bonds have risen sharply from drastic lows. The action has been particularly robust in the near maturities: 2018 and 2020. The 7.375% 2018 bonds are now trading above par. The 6.5% bonds of 2020 are now at 94.
Two things account for this sharp improvement. One is the delay Transocean negotiated in delivery of new-builds into 2020-21. A second step was just announced: the company will issue new bonds in the amount of $1.25 billion, maturing in 2023. At the same time, they announced a tender offer of $1 billion to redeem bonds maturing in 2020, 2021 and 2022. Since the 6.5% bonds of 2020 represent $910 million by themselves, it is reasonable to assume that they will absorb most of the buybacks. The bonds now trade at roughly 94 because the tender offer is at 94.5. The discounts on the other two issues are sharper, so they will probably not be tendered in bulk.
So, why target 2020? Well, there is a large challenge then. In addition to approximately $.9 billion of bonds coming due, the company also needs to pay out $1.9 billion for new ships. If the company's core business continues to languish over the next four years, it would be challenged to come up with that nearly $3 billion in cash. The new bond issue is precisely targeted to address this cash flow problem. It gives the company an additional three years to handle its debt concerns. Make no mistake: the tender means that Transocean is expressing high confidence in its ability to weather the period from 2016-2019.
What does the tender plus new bond issue portend for later issues (2021, 2022, 2027, 2028, 2029, 2031, 2038, 2041)? Well, according to Moody's, it's a near-catastrophe. Their rating was promptly cut to Caa1, a stomach-churning two notches below their prior rating of B2. Their reasoning is that the new bonds will have provisions ensuring they are favored over the company's other senior debt. Fair enough, but ... really? On the narrowest front, the net increase in debt is only $250 million, quite modest in comparison to total outstanding debt of over $7 billion. And, let's be clear, delaying the grim reaper might mean he doesn't visit at all. Companies, unlike people, don't necessarily die at all.
Particularly curious is that the downgrade applies equally to the specific issue that is most likely to be retired: the 6.5% bonds of 2020. Even if a holder doesn't tender, it seems nearly guaranteed that the remaining scraps will be paid off upon maturity in 2020. These bonds aren't weaker than before; they are virtually as safe as the equally dismally-rated 2018 bonds.
I regard Moody's downgrade as a hissy-fit, addressing a real, but narrow risk. Sure, in default, the post 2023 bonds would suffer. But guys, the likelihood of a default is substantially lower now than it was before the new issue. The company's near-term cash crunch has been alleviated, while the cushion increases by $.25 billion.
A Caa1 rating shrieks doom, and doom soon. That's simply wrong for a company responding to a threat four years down the road. Sure, bad things might happen after 2020, but even then, Transocean has a variety of alternatives. It could issue more debt, issue more stock, further delay delivery of new ships (with penalties, to be sure) and/or sell off the very new-builds that created the cash crunch in the first place. At a fire-sale of fifty cents on the dollar, Transocean would pull in up to $3 billion to toss to circling p(c)reditors. None of these steps merits rave reviews, but each could keep the wolf from the door.
Caa1 also proclaims that today's abysmal environment is unlikely to change within the next four years. Well, that might be true, but linear projections of short-term trends are usually stupid. The path of oil prices has been repeatedly marked by sharp declines followed by equally sharp up-turns. Most experts point out that total oil consumption is destined to rise steadily, regardless of Western conservation efforts. At the same time, replacement of existing oil reserves continues to lag drastically. Bottom line, I think a supply crunch is far likelier for 2020 than continued slump.
As long as the 2020 bonds trade below par, I think they're a screaming bargain. Don't tender them; instead collect the income till maturity, along with that extra five point gain to par. Without leverage, that's a 36% gain. With 50% leverage, it jumps to 65%. Better yet, wait until the tender premium of 3 points passes (July 18). The bond price will probably fall to 91, or less, once the tender period has ended. That will represent a huge buying opportunity: a $900 gain to par on ten bonds plus $2925 in interest makes for an unleveraged 42% return to maturity (77% with 50% margin). That's the kind of highly favorable risk/reward you can find only rarely in bonds.
Once the 2020 bonds approach maturity, it will be time for the new 9% bonds of 2023. Since they will have status senior to later Transocean bonds, they too have very nice potential. Of course, pricing will be critical: it would be nice to pick them up at or below par. Considering that the later bonds now yield in the 13% range, that should be distinctly do-able. (Update 3/13/17. Or not. Looks like these bonds are not - yet - available for public trading. Dunno why.)
To prepare for this pivot, I've been selling off part of my large position in the 7% Global Marine bonds of 2028. Since I bought a large slice of them at prices as low as 41 (yes, 41!), these trades have been cash-neutral. At 66, I can pair the sales against bonds bought at at higher prices to establish tax losses, but mentally match them against my rock-bottom purchases. As long as prices hold up for the Global Marine bonds, I can continue the pivot with only nominal losses, while substantially enhancing the safety of my overall Transocean exposure.
As to the 6.375% notes of 2021 and the 3.8% notes of 2022, well they'll require more fortitude. Their potential returns are large, though, and the risk is significantly lower today than it was before Transocean issued the new bonds. Absent an early default, they will be long-gone before the post-2023 holders are possibly savaged by their drop in priority in bankruptcy court. Even so, I think these longer bonds are a better bet than they were a week ago.
Moody's, perversely, has in general started being super cautious after its criminally negligent treatment of mortgage securities leading up to 2008. Over-reacting now, Moody's, won't make up for those catastrophic errors eight years ago. I'm just itching to revisit this issue in a couple of years. I'll bet Moody's present stance will look just as stupid then as it clearly was in 2008.
Sunday, January 11, 2015
Back to Bonds, Finally?
I've strayed from my bailiwick recently. With little to say about bonds, and little to recommend them, I've focused on other themes, particularly stock buybacks and the silly optimism that accompanies them. Well, I'm not backing away from this line of discussion at all, and have full confidence that time will validate my profound skepticism about the entire concept. So, I'll be commenting further as time passes, as my keen analysis bears fruit (!).
Twice before, I've kind of thrown in the towel, metaphorically, when it comes to bonds. Two once-in-a-lifetime opportunities (2008-9 mortgage crisis, 2010-11 Euro crisis) receded, and low-yield high ennui situations prevailed. And yet ... once again ... the relentless flow of current events brings me sharply back to new, inviting, and perilous opportunities in the wonderful world of bonds.
Not surprisingly, it all relates to oil, and the shocking collapse in prices that is revolutionizing world markets. Where to begin, where to end? Well, first and foremost, ignore the folks who argue that it's all a massive head fake. No, it's not that Obama (or Saudi Arabia) has a secret plan to crush Putin and Iran. It's actually simple: oil and gas prices are down, way way down, because the iron law of supply and demand is finally kicking in. Huge sources of new production have been coming online for several years (due to fracking in the US and Canada, and the slow recovery of production in other critical regions), while persistent political unrest has kept prices artificially high. The turning point is opaque (why now, why not a year ago?), but that very delay has magnified the downward price shock.
Huge movements like this (oil below $50/barrel!) cause turmoil, and turmoil, in turn, breeds confusion and fear. FEAR (think of it as negative GREED) is one of the most reliable and powerful forces in the market. And yes, dear ones, GREED is in fact the other. When it comes to bonds, fear is particularly powerful. Bond investors scare easily, and perceived threats to the stability of bonds make them bleat toward the exits.
So, what is getting stampeded right now? Of course, oil companies, and the companies that service them. Not surprisingly, many pundits are predicting catastrophe.
But, this whole tempest needs perspective. Is this a near-death event like the 2009 mortgage meltdown and the 2011 Euro crisis? Highly unlikely, I think. Russia will be on the ropes (oh, TOO BAD!), as will Venezuela and various other petro states. Yes, there's also a nasty round of currency devaluation going on, which could trigger recessions. On the other hand, consumers world-wide have just been gifted a huge cash infusion, via lower gas prices. That should cushion the shocks to what is, after all, a limited portion of the world economy. Common sense suggests that the solution to low gas prices will be ... low gas prices! New exploration and development will be postponed, consumption will pick up, and oil will start rising again. Political instability in any one of a dozen places could send prices soaring. How far, and when? Heck if I know. But we've been down this road many times, and I doubt it ends at Mt. Doom.
Let's get specific about this latest tempest. Transocean (RIG) is the biggest oil drilling company in the world. But, over the past two years it has dropped from $58 to $16 a share, a 72% pummeling. The dividend is now a stratospheric 18%.
Here's a helpful hint: that dividend is toast (not right away, but zwieback nevertheless). To buy the stock hoping to feast on that dividend would be stupid (really stupid). However, does this mean that the stock is dead? Or better asked, is Transocean dead? I think the answer is very clear: no. While both Moody's and S&P are threatening to downgrade Transocean's debt to junk level, I think there's a reasonable chance that one or both will hold back. Transocean has a well-diversified array of drilling units, many stable long-term contracts, and a pretty good stash of cash (over $3 billion, with current liabilities of $.9 billion). If it eliminates that dividend (it will, it will), another $1 billion is added to the company's cash. It has assets to sell, if needed, and can mothball other units to minimize the cash drain they represent. I suspect the company will find a way to fend off the downgraders.
However, the mere possibility of a downgrade has the faint of heart fainting heartily. Take a look at Transocean debt: One example, the 6.8% bonds of 2038, now trading around 80, for a yield to maturity of 8.8%. Those are yields associated with B- rated junk, perhaps six rating levels below the present (shaky BBB-). So, ask yourself, is Transocean really that close to the abyss?
Absent a default, what would a purchase of this issue offer? Well, a present yield of 8.8%, for 23 years! At maturity, a guaranteed 25% return on the initial investment, as the issue returns to par. This is the plain vanilla scenario. Add in a soupcon of leverage (say borrowing one dollar for each dollar invested), and the present yield sky-rockets to 15.75% (assuming that beautiful Interactive Broker margin rate of 1.25%). Imagine a return to par in five years, and the $5150 net profit (on $4000 invested and $4000 borrowed on a ten bond position) would be a gorgeous 128% of the initial investment, or 18% compounded. This is the stuff I dream of, and, to toot my own horn, that dream has been realized over and over in the past six years.
What if the future is less rosy for Transocean? What if, gulp, it actually crashes and burns? Well, here again, the beauties of bond investing come to the fore. As legal obligations of the company, the bonds must be repaid, if liquidation yields enough to do so. As the company presently has roughly $32 billion of assets, and roughly $12 billion of long and short-term bond obligations, it certainly looks like repayment (of principal AND interest) would be a pretty safe bet.
I am sure it comes as no surprise to my loyal readers (of course, since there are none at present, they are not easily surprised, or loyal, for that matter) that I have started buying these bonds, small nibbles of $5 and $10k at a time. So far, I have modest paper losses, which is keeping me cautious. If the bonds start a sustained recovery, I intend to get greedy, shades of 2009!
How about investing in the stock itself? Ordinarily, I'd say no, citing the almost endless list of things that can go wrong with stocks as a class. But here? As I've mentioned many times before, opportunity knocks when blood is in the water, things are ridiculously cheap, and fear holds you in absolute paralysis. Does Transocean (and the entire energy sector) meet these criteria? Hell yes. A recent seekingalpha column concludes the stock has 100% upside, even if oil remains at present levels, and earnings slump $1 billion in 2015. So, I intend to nibble on a few deep-in-the-money Transocean calls maturing in 2017. These babies could go to zero, or soar tenfold in the next two years. I'm obviously betting on the latter, but in no case betting a lot. I'll save most of my greed and aggression for the bonds instead.
How long will this particular once-in-a-lifetime situation last? Three to six months is my guess. Then oil prices will stabilize (probably at relatively low historical levels), oil-related companies will stagger slowly back to reasonable valuations, and their bonds will resume life as boring and low-yield creatures of the field. So, the opportunity lies between now and then. Be brave now, or curse the wasted opportunity later.
Update: Tax day, 2105. It's been about three months, so half-way through the window of opportunity described above. It's been mostly downhill, until just this week. Suddenly, the stock has jumped sharply from below $16 to nearly 19, most of the move today. My long calls have risen from a fairly substantial loss to an equally substantial paper gain. My bonds are still down a bit, following the ratings downgrades, but now only a little bit. So, the window is still open; but three more months might, as hypothesized, spell the end of this particular opportunity. I've been nibbling today; and may start gulping soon.
Twice before, I've kind of thrown in the towel, metaphorically, when it comes to bonds. Two once-in-a-lifetime opportunities (2008-9 mortgage crisis, 2010-11 Euro crisis) receded, and low-yield high ennui situations prevailed. And yet ... once again ... the relentless flow of current events brings me sharply back to new, inviting, and perilous opportunities in the wonderful world of bonds.
Not surprisingly, it all relates to oil, and the shocking collapse in prices that is revolutionizing world markets. Where to begin, where to end? Well, first and foremost, ignore the folks who argue that it's all a massive head fake. No, it's not that Obama (or Saudi Arabia) has a secret plan to crush Putin and Iran. It's actually simple: oil and gas prices are down, way way down, because the iron law of supply and demand is finally kicking in. Huge sources of new production have been coming online for several years (due to fracking in the US and Canada, and the slow recovery of production in other critical regions), while persistent political unrest has kept prices artificially high. The turning point is opaque (why now, why not a year ago?), but that very delay has magnified the downward price shock.
Huge movements like this (oil below $50/barrel!) cause turmoil, and turmoil, in turn, breeds confusion and fear. FEAR (think of it as negative GREED) is one of the most reliable and powerful forces in the market. And yes, dear ones, GREED is in fact the other. When it comes to bonds, fear is particularly powerful. Bond investors scare easily, and perceived threats to the stability of bonds make them bleat toward the exits.
So, what is getting stampeded right now? Of course, oil companies, and the companies that service them. Not surprisingly, many pundits are predicting catastrophe.
But, this whole tempest needs perspective. Is this a near-death event like the 2009 mortgage meltdown and the 2011 Euro crisis? Highly unlikely, I think. Russia will be on the ropes (oh, TOO BAD!), as will Venezuela and various other petro states. Yes, there's also a nasty round of currency devaluation going on, which could trigger recessions. On the other hand, consumers world-wide have just been gifted a huge cash infusion, via lower gas prices. That should cushion the shocks to what is, after all, a limited portion of the world economy. Common sense suggests that the solution to low gas prices will be ... low gas prices! New exploration and development will be postponed, consumption will pick up, and oil will start rising again. Political instability in any one of a dozen places could send prices soaring. How far, and when? Heck if I know. But we've been down this road many times, and I doubt it ends at Mt. Doom.
Let's get specific about this latest tempest. Transocean (RIG) is the biggest oil drilling company in the world. But, over the past two years it has dropped from $58 to $16 a share, a 72% pummeling. The dividend is now a stratospheric 18%.
Here's a helpful hint: that dividend is toast (not right away, but zwieback nevertheless). To buy the stock hoping to feast on that dividend would be stupid (really stupid). However, does this mean that the stock is dead? Or better asked, is Transocean dead? I think the answer is very clear: no. While both Moody's and S&P are threatening to downgrade Transocean's debt to junk level, I think there's a reasonable chance that one or both will hold back. Transocean has a well-diversified array of drilling units, many stable long-term contracts, and a pretty good stash of cash (over $3 billion, with current liabilities of $.9 billion). If it eliminates that dividend (it will, it will), another $1 billion is added to the company's cash. It has assets to sell, if needed, and can mothball other units to minimize the cash drain they represent. I suspect the company will find a way to fend off the downgraders.
However, the mere possibility of a downgrade has the faint of heart fainting heartily. Take a look at Transocean debt: One example, the 6.8% bonds of 2038, now trading around 80, for a yield to maturity of 8.8%. Those are yields associated with B- rated junk, perhaps six rating levels below the present (shaky BBB-). So, ask yourself, is Transocean really that close to the abyss?
Absent a default, what would a purchase of this issue offer? Well, a present yield of 8.8%, for 23 years! At maturity, a guaranteed 25% return on the initial investment, as the issue returns to par. This is the plain vanilla scenario. Add in a soupcon of leverage (say borrowing one dollar for each dollar invested), and the present yield sky-rockets to 15.75% (assuming that beautiful Interactive Broker margin rate of 1.25%). Imagine a return to par in five years, and the $5150 net profit (on $4000 invested and $4000 borrowed on a ten bond position) would be a gorgeous 128% of the initial investment, or 18% compounded. This is the stuff I dream of, and, to toot my own horn, that dream has been realized over and over in the past six years.
What if the future is less rosy for Transocean? What if, gulp, it actually crashes and burns? Well, here again, the beauties of bond investing come to the fore. As legal obligations of the company, the bonds must be repaid, if liquidation yields enough to do so. As the company presently has roughly $32 billion of assets, and roughly $12 billion of long and short-term bond obligations, it certainly looks like repayment (of principal AND interest) would be a pretty safe bet.
I am sure it comes as no surprise to my loyal readers (of course, since there are none at present, they are not easily surprised, or loyal, for that matter) that I have started buying these bonds, small nibbles of $5 and $10k at a time. So far, I have modest paper losses, which is keeping me cautious. If the bonds start a sustained recovery, I intend to get greedy, shades of 2009!
How about investing in the stock itself? Ordinarily, I'd say no, citing the almost endless list of things that can go wrong with stocks as a class. But here? As I've mentioned many times before, opportunity knocks when blood is in the water, things are ridiculously cheap, and fear holds you in absolute paralysis. Does Transocean (and the entire energy sector) meet these criteria? Hell yes. A recent seekingalpha column concludes the stock has 100% upside, even if oil remains at present levels, and earnings slump $1 billion in 2015. So, I intend to nibble on a few deep-in-the-money Transocean calls maturing in 2017. These babies could go to zero, or soar tenfold in the next two years. I'm obviously betting on the latter, but in no case betting a lot. I'll save most of my greed and aggression for the bonds instead.
How long will this particular once-in-a-lifetime situation last? Three to six months is my guess. Then oil prices will stabilize (probably at relatively low historical levels), oil-related companies will stagger slowly back to reasonable valuations, and their bonds will resume life as boring and low-yield creatures of the field. So, the opportunity lies between now and then. Be brave now, or curse the wasted opportunity later.
Update: Tax day, 2105. It's been about three months, so half-way through the window of opportunity described above. It's been mostly downhill, until just this week. Suddenly, the stock has jumped sharply from below $16 to nearly 19, most of the move today. My long calls have risen from a fairly substantial loss to an equally substantial paper gain. My bonds are still down a bit, following the ratings downgrades, but now only a little bit. So, the window is still open; but three more months might, as hypothesized, spell the end of this particular opportunity. I've been nibbling today; and may start gulping soon.
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