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Income, Investing  | December 31, 2018


In an investment age where passive investing, ETF investing, DGI investing, momentum investing, and trend following investing rule the roost, so to speak, and sentiment is viewed as potentially the most important determining factor for investment decisions, it has become popular to ignore, or even deride fundamentals, which has caused something remarkable to happen.

Specifically, we have the most fundamentally bifurcated market than I have ever seen in my 25 plus years of actively speculating and investing, as there are more simultaneously historically cheap firms, and historically expensive firms, both occurring at the same time, than I can ever remember, creating what should be a dream environment for the few remaining fundamental stock pickers.

Investment Thesis

Underlying cash flows, future discounted cash flows, and the present and future values of balance sheets are what drive business values, and ultimately stocks prices. Since almost all have abandoned this approach, following momentum strategies or various technical strategies, the opportunity is extraordinary for those that practice the traditional lost art of security analysis.

The Expensive Side Of The Market

Like a boat that has a leak, which will eventually sink the ship if it is not dealt with, fundamentals can only be ignored for a certain amount of time, though admittedly this time period can stretch on for years on end.

I have written extensively publicly, and much more privately for my premium research service, on what I believe is cheap today (and there are opportunities today on the long side that rival the best opportunities in late 2008 and early 2009 from my perspective), including in-depth analysis of fundamentally attractive, out-of-favor, non-index favorite equities like Cleveland-Cliffs (CLF), and Chesapeake Energy (CHK), which is currently exhibiting a series of positive technical and price divergences, adding to the valuation case I made in late October of 2018 comparing Chesapeake to Oklahoma City peer Devon Energy (DVN), which I also believe is an undervalued equity today.

For a refresher, here was the elevator pitch valuation comparison for CHK posted in my October 31st article.

What type of multiple could Chesapeake Energy trade at?

I think its fellow Oklahoma City headquartered peer company, Devon Energy (DVN) is a good comparison. Actually, let me restate that. I think DVN is a really good comparison.


CHK in 2020 could look very much like DVN today.

Today, DVN trades for roughly 9 times EV/EBITDA value, which I think is a low valuation for DVN, and an enterprise value of roughly $26 billion.

Applying a similar multiple to CHK for 2020's EBITDA suggests an enterprise value for CHK of roughly $25 billion, minus the net debt of $8 billion, minus roughly $2 billion in preferred equity (rounding up for the debt and preferred equity), which leaves roughly $15 billion for equity holders.

Post-deal, where CHK shareholders are estimated to own 55% of the equity, and WRD shareholders are estimated to own 45% of the equity, with 913 million shares outstanding today, there will be roughly 1.65 billion shares outstanding post-acquisition, implying a $9 per share value on a 9 multiple of 2020 EBITDA.

With a stock price of close of $3.27 today, that is upside potential of roughly 175% for CHK shares over the next 18 months (with the recent declines the value proposition for both CHK and DVN have improved from my perspective).

Now you may, or you may not agree with my analysis, and you may, or you may not agree with my future assumptions. However, there are compelling fundamental reasons why CLF, CHK, and even DVN are cheap equities, and these attractive fundamental characteristics should exhibit an upward gravitational pull on the respective equity prices of the fundamentally undervalued securities.

After all, Warren Buffett has used the famous Benjamin Graham quote often, which was the following:

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."

To quantify these fundamentals, I have been building proprietary valuation tools, including intrinsic values derived from discounted cash flow models, and a quantitative valuation comparative matrix for members of The Contrarian. As part of this analysis, we have analyzed well over 100 companies, including many favorites in today's market environment, and results are eye-opening. The following is a small excerpted sample, with member-only features like the intrinsic value price targets missing.

For the table above, CHK's metrics are adjusted for the upcoming acquisition of WildHorse (WRD), which has not closed yet.

Even with important member only fields missing, the raw valuation metrics illustrate my point that the above mentioned equities are cheap relative to the broader equity market, particularly on a EV/EBITDA basis, and on an Operating Cash Flow to Enterprise Value Yield basis.

Conversely, what are the expensive equities in today's market environment?

Here is a sample of what is expensive from my view of companies I cover in The Contrarian.

The table above of overvalued equities, in my opinion, includes companies that I have covered in-depth as an analyst, and features Diamondback (FANG), JPMorgan Chase (JPM), LTC Properties (LTC), Procter & Gamble (PG), Coca-Cola (KO), W.P. Carey (WPC), American Tower (AMT), American Campus (ACC), Realty Income (O), Store Capital (STOR), McDonald's (MCD), Regency Centers (REG), Simon Property (SPG), Kimco Realty (KIM), Tanger (SKT), Omega Healthcare (OHI), Amazon (AMZN), and Netflix (NFLX). Collectively, these equities are a sub-sector of the very popular equities in the market today, specifically large-cap favorites like McDonald's, Coca-Cola, and Procter & Gamble, growth favorites like Amazon, and Netflix, and a host or REITs.

What is one thing that is a commonality between these equities besides that they are popular (remember the Benjamin Graham quote above), and they have generally been strong equity performers in the current bull market?

Any guesses?

If you said overvaluation, or very high valuations, you got the answer right.

Honing in on a comparison, look at the EV/EBITDA ratios of the above highlighted firms, and the Operating Cash Flow to Enterprise Yields, and compare them to the three undervalued firms I highlighted earlier.

Do you see the valuation difference?

Now, remember the Benjamin Graham quote from earlier.

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."

Closing Thoughts

Fundamentals matter. They do today, even though it does not seem like it, after a roughly decade long bull market that has largely detached from fundamentals, temporarily, in my opinion, like the last decade of growth over value dominance from 1990-2000, and they have mattered historically, as equities have a high correlation to simple fundamental criteria.

Personally, I have been involved as an active speculator and investor for the past 25 years, I have been involved as a professional investor and analyst for over 20 years, and I have studied market history more than almost anyone I know, and I can say that the last time we had such a divergence between fundamentals and securities prices was the late 1990s culminating in late 1999, and early 2000, famously captured by Julian Robertson in his March 2000 letter to Tiger investors, with this quote ringing true today.

And what do I mean by, "there is no quick end in sight?" What is "end" the end of? "End" is the end of the bear market in value stocks. It is the recognition that equities with cash-on-cash returns of 15 to 25 percent, regardless of their short-term market performance, are great investments. "End" in this case means a beginning by investors overall to put aside momentum and potential short-term gain in highly speculative stocks to take the more assured, yet still historically high returns available in out-of-favor equities.

Julian Robertson March 2000

Julian Robertson famously closed his value focused hedge fund in early 2000, right before the historic inflection point where capital finally shifted back to value, with value equities massively outperforming their growth counterparts from 2000 to 2002, and we might be on the cusp of something similar right now, with the apparent capitulation in value equities to close the fourth quarter of 2018, as a number of institutional and retail investors are redeeming shares with no regard to valuation.

Interestingly, while both October of 2018, and December of 2018 have been very difficult months for the broader equity market, leading to one of the worst periods of 4th quarter equity market performance in the stock markets history, I believe the heightened volatility is simply a prelude to a return to normal, as investors are being weaned off of unprecedented central bank generosity the past decade.

Ultimately, fundamentals still do matter, and price discovery will eventually return with a vengeance to a market that has lacked any semblance of price discovery for a majority of the duration of the current equity bull market, as passive and ETF fund flows have combined with momentum and trend following strategies to form a pool of capital that has largely been indiscriminate buyers and indiscriminate sellers.

While we are just embarking on this journey, we are nowhere near being there yet, and we have a long way to go to rediscover price discovery.

To close, even though it has been a very difficult stretch for value-oriented investors, I think we are about to enter a golden age for active value investorswho do the fundamental work, who can find the best value stocks today, and the most out-of-favor sectors, and the most out-of-favor equities will be at the forefront of this opportunity.

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