Monday, April 20, 2015

The Search for Investment Serenity: The Look Back Test!

Late last year, in a post titled “Go where it is darkest”, I argued that the best investment opportunities are likely to be found in the midst of fear and uncertainty. I looked at two companies, Vale and Lukoil, that were caught up in perfect storms, where commodity prices had moved against them, the countries (Brazil and Russia) that they were located in were in turmoil, the local currencies were in retreat and the companies themselves faced corporate governance questions. I concluded that post with the statement that I was investing in Vale and Lukoil, notwithstanding the high risk in each one and the uncertainty that I felt about valuing them, because the risk/return trade off seemed to be tilted in my favor. A few months later, with my investment in Vale down substantially and the investment in Lukoil treading water, I decided to revisit the valuations.

Looking Back: Testing your investment serenity!
Satchel Paige is rumored to have once said “Don’t look back. Something might be gaining on you” and most of us take his advice to heart, especially when it comes to investments that have gone bad. We spend almost all of their time thinking about investments that we can add to their portfolios, we repeatedly check on our "winners", crediting ourselves for our foresight in picking them, and we studiously avoid looking at the "losers". Studies of investor behavior find substantial evidence that investors hold on to losers too long and that they are quick to blame outside sources or bad luck for these losers, while attributing winners to their stock picking skills.  

I believe that the biggest mistakes in investing are made not in what or when you buy, but in what or why you choose not to buy and what and when you sell (what you have already bought). I know that I need to look at my past investments, not to lament mistakes I have made or to wallow in regret, but because each investment in my portfolio has to meet the same test to remain in my portfolio, as it did when I first bought it. As an intrinsic value investor, that test is a simple one. I should buy when a stock trades at a price below its value and should not if it trades above value. Consequently, when I look at my portfolio this morning, I should apply the same rule to every investment in it, asking whether at today’s price and today's estimated value, I should buy more of that stock (if it has become even more under valued), hold on to it (it is remains under valued or has become fairly valued) or sell the stock (if it has become over valued).

Simple, right? Yes, if are a serene investor who can be dispassionate about past mistakes and rational in your judgments. I am anything but serene, when it comes to assessing past investments and I know that what I choose to do will often be guided by the worst of my emotions, rather than good sense. I will double up (or down) on my losing investments, not because they have become more under valued, but because of hubris, will hold on to my losers, because denial is so much easier than admitting to a mistake, and sell because of panic and fear. While I cannot will myself to rationality, there are things that I try to do to counter my all-too-human emotions. 
  1. Due Process: Left to my own devices, I know that I will selectively revalue only those investments that I like, and only at the times of my choosing, and ignore revaluations that will deliver bad news. It is for this reason that I force myself to revalue each investment in my portfolio at pre-specified intervals (at least once a year and around significant news stories). 
  2. Spread my bets: I have found that I am far more likely to both panic and be defensive about investments that are a large portion of my portfolio than for investments that are small, one reason I stay diversified across many stocks (each of which passes my investment test) rather than a few. 
  3. Be explicit in my valuation judgments: I have found that is far easier to be delusional when you buy and sell based upon secretive, complex and closed processes. It is one reason that I not only try to keep my valuation assumptions explicit but also share my valuations. I know that someone will call me out on my delusions, if I try to tweak them to deliver the results that I want.
  4. Admit publicly to being wrong: I have tried to be public about admitting mistakes, when I make them, because I have found that it frees me to clear the slate. I must admit that it does not come easily to me, but each time I do it, I find it a little easier than the last time.
  5. Have faith but don't make it doctrine: I have faith (misplaced though it might be) that I can estimate intrinsic value and that the price will eventually converge on the value and that faith is strong enough to withstand both contrary market movements and investor views. At the same time, I know that I have to be willing to modify that faith if the facts consistently contradict it. 
I can hope that one day my investment decisions will not be driven by need to defend, deny or flee from past mistakes, but I am still a work in progress in my quest for investment serenity.

Vale and Lukoil: The Original Rationale
I invested in both Vale and Lukoil at the time of my original post (November 19, 2014) and justified my decisions on two fronts:
  1. The Macro Argument: I argued that since both companies were being weighed down by a combination of commodity price, country, currency and company risk, a lifting of any one of these weights would work in favor of my investment. I did confess that I had no market timing skills on any of these fronts and that I was drawing on statistical likelihood that one or another of these weights would lift.
  2. The Micro Story: I picked these companies in particular, rather than others in these markets that faced the same risks, because I felt that they were better positioned both in term of surviving continued market troubles and that they were under valued. In November 2014, I felt that Vale was a better bet than Petrobras, partly because it carried less debt and partly because the Brazilian government had not been as active in directing how the firm was run. At that time, Lukoil carried less debt, was less entangled with the Russian government and had better corporate governance (everything is relative) than Gazprom or Rosneft, two other Russian commodity companies. 
My valuation of Vale at the time of the post is summarized below:
At $8.53/share, it looked under valued to me, even with significant drops built into its operating income.

With Lukoil, the valuation at the time of the post is summarized below:
It was not as under valued as Vale was, but under valued enough that I was comfortable buying the stock. With both investments, it was the micro bet (that the stock was under valued) that drove my investment but I held out hope that one or more of the macro variables would move in my favor.

Vale: The Petrobras Blowback?
Almost five months after my initial foray, I took at look at Vale, fully aware that I would see numbers that I did not like:

The stock stands as testimonial to one of the dangers of investing on the dark side. Just as you think things are very dark, they can get even darker. In the five months, iron ore prices have dropped 31.07% and Vale, as the largest iron ore producer in the world, has felt the pain. The pain is accentuated by Brazil’s slide in international markets, as its currency has lost almost 15% of its value, relative to the US dollar. The news story that has dominated the news is the ongoing corruption scandals at Petrobras and Vale, in my view, has been caught int he under currents. Vale, after all, shares many characteristics with Petrobras, with the Brazilian government controlling management through a golden share and control of voting shares, a captive board of directors and a dividend policy on auto pilot. 

With the benefit of hindsight, you could argue that I should have waited but lacking the skills to make that timing judgment, the question I face now is whether I should continue to hold the stock. To answer that question, though, I should be asking whether I would buy the stock today at $6.19, given what the company looks like now. Updating the financials to reflect one more quarter of data and  a continued drop in iron ore prices, I revalued the company:
At the value that I obtain, $10.71 per share, the stock is under valued by about 42% at its stock price of  $6.19 on April 15, but that value is down dramatically from the $19.40/share that I estimated last November. Part of the reason lies in the fundamentals (with commodity prices dropping and country risk expanding) but part of it reflects my valuation mistakes (a failure to adjust operating income adequately for the drop in iron ore prices). Notwithstanding my failures at forecasting, at today's price and value, I would have no qualms about buying the stock.

I know that I may be letting my desire to be right override my good sense and setting myself for more pain in the future, and I am aware that there are three big dangers that await me. First, the reported earnings for 2014 reflect some, but not all, of the damage from lower iron ore prices,  and it is almost certain that there will be more bad news on earnings this year. Second, the decline in iron ore prices shows no sign of letting up and it is possible that there will be no bounce back in iron ore prices for a while. Third, now that the Petrobras goose has stopped laying golden eggs, the Brazilian government may turn its attention and interest to Vale and that would be deadly for investors. 

Lukoil: The Russian Adventure continues
The last five months have been interesting ones in the oil market, as oil prices have continued to slide. In the graph below, I look at Lukoil from the date of my original purchase through April 15.

In a period where oil prices dropped 17.75%  and the global oil index declined by 4.66%, Lukoil held up remarkably well, increasing 4.23%. Much as I would like to claim credit for my stock picking skills, it is worth noting that  the MICEX was up 10.39% in local currency terms and about 5% in US dollar terms over the same period. 

As with Vale, I revisited my valuation of Lukoil, updating the numbers to reflect an earnings report from the company and updated market numbers.
The value has dipped slightly to $48.49/share, largely as a consequence of lower oil prices, and the price has risen slightly to $51.69/share, leaving me with the end result that the stock is slightly over valued today. If I were making a decision on whether to buy the stock today, I would be not buy the stock, but since I have it in my portfolio already, I am inclined to hold on to it, since it is close to fairly valued.

The Closing
As you can sense from my ramblings during this post, what started as an assessment of whether Vale and Lukoil should continue to be part of my portfolio has become a rumination on the much bigger question of investing faith and  philosophy. In investing, I think it is dangerous to have both too little faith and too much. If you have too little faith,  you will abandon your investments too quickly, if the market moves against you or if others seem to be doing much better than you are. If you have too much faith, you can cross the line into fanaticism, where you are so convinced of your rightness that you ignore facts to the contrary. I hope that my faith in my intrinsic value is both strong enough to withstand short terms set backs and to adapt to changing market circumstances and that I can find some measure of investment serenity.

Vale: Annual Financials for 2014 (20F)
Lukoil: Annual Report for 2014 
Vale Valuations: November 2014 and April 2015 
Lukoil Valuations: November 2014 and April 2015


derMensch said...

I think it is dangerous to value Vale without detailed forecasting of Iron Ore prices and factors. Since ~50% of iron ore is consumed by China even a slight decline in consumption in that one country will have major feedback into Ore prices. China iron ore consumption appears to be falling off a cliff and with real estate developers (biggest steel consumers) starting to default on debt I just don't see how Iron Ore will recover in the near future. There also appears to be a minor civil war happening between AU miners that are actually increasing production from over investments during the Iron Ore boom to squeeze out more producers. Net-net Iron Ore prices could take years perhaps decades to work out.

Anonymous said...

Dear Professor,

"If I were making a decision on whether to buy the stock today, I would be not buy the stock, but since I have it in my portfolio already, I am inclined to hold on to it, since it is close to fairly valued." Some might say that, since it's fairly valued, it doesn't make much sense to hold on to this investment, as you might be better of then holding onto an index and hence avoid idiosyncratic risk. Some other might also point that holding onto this stock is an example of endowment cognitive bias, which in the end caters for subpar portfolio returns. I wonder if you could comment on that. Thank you

Anonymous said...

How about the opportunity cost, lost when you hold on to an investment that nowadays you would not buy again?

Anonymous said...

Thank you Professor for the updated valuation for vale and lukoil. Just curious about your criteria for selling a stock? For example how much of a premium does Lukoil have to "trade on" to intiate a sell order.


Shailesh Naik said...

In respect to valuation of pure commodity firms , there are two risk . How big is leverage ( financial and operating ) and second how is it cost structure changing vis a vis competition . If cost structure is uncompetitive and leverage is high the firm can go to bankruptcy, whereas if cost structure is competitive and even if leverage is high it can survive the cycle . Pure normailised may not work like it may for consumer companies

Aswath Damodaran said...

If I follow your reasoning, you should invest in commodity companies only if you can do a deep dive into what drives commodity prices. If I had any evidence that those who do this deep research into commodity markets are better at forecasting commodity prices than the rest of us, I would go along with this, but there is no evidence that commodity experts are any better than the rest of us. So, forecasting commodity prices is not for me. I will leave it to others to do.

Aswath Damodaran said...

You are right. My holding on to Lukoil may be more an indication of my biases than a rational decision. That bias, though, will show up as a higher estimate of value than i should get. If my estimate is reasonable (and I concede it might not), I would rather hold Lukoil than a commodity fund or index, because the entire oil sector seems to be priced on the assumption that oil prices will recover to about $70/$75 a barrel. For the moment, at least, I do need oil company exposure in my portfolio and Lukoil looks like my cheapest-priced option.

Anonymous said...

Thank you profesSor!

Interesting analysis on company valuation, but focusing on Vale and Petrobras scandal, i was wondering if such valuation today should not reflect in some way how corruption shall afect capital markets. On one hand, equity markets such the US will apply restrictions for a company that broke compliance regulations, and debt markets shall as well apply aditional risk premiums.

One prove of this is how China developmet bank came to rescue Petrobras and its liquidity problems, as financial market is quite closed to them.

Anonymous said...

Given the dividend policies are pretty much the same between the VALE common and preferred, and taking into consideration you get a bit more of a voting right with the common, I wonder if the preferred may be the better option. The common seems to trade at a premium; it seems undeserved.

The price you used from 4/15 appears to be from the common.

UniverseofRisks said...

in your vale valuation, the D/E ratio changes significantly between the two valuation spreadsheets. simply due to the price drop in vale stock. Since that's mostly due to the drop in iron ore prices (diversifiable risk). Wouldn't a long run historical beta be a better bet especially with a moving average. Or a bottom up beta using a historic average debt to equity ratio?

Anonymous said...

Thank you Prof Damodaran for the clarification about Lukoil and sorry for pestering for a update valuation for lukoil and vale over the past few months.

Anonymous said...

Dear Professer,

as always, a great article!

What is your long term view (5 years) about Vale S.A.? The current preferred stock price at USD 4,94 looks very depressed. The big mining companies (Rio, BHP, Vale) further increase their supply (Vale big project S11D will start 2018) and therefore the cash cost for iron will decrease further and in the same time the Fe-content of iron ore Vale will increase. 2017/2018 will therefore decrease the Vale-capex. At the current iron ore cost USD 50 there should be in my opinion a adjustment at high cost suppliers?!

Ok, the Ebit for 2015/2016 will be depressed, but dont you think vale can not increase the ebit to over 10 Bill. USD?

Your valuation is on all 5 bill.stocks. What about the premium/discount for the preferred shares?
You mentioned the dividend-policy. Do you think it is not sustaining policy?!

For me looks Vale (preferred) still very cheap. But i am only a amateuer...


Anonymous said...

Hello Professor!

thank you for your analysis. I bought Vale S.A. (preferred) for a price higer than 12 USD and my portfolio contains a great share of Vale-Shares. Also a lot of idiosyncratic risk. I would not do it again but now i have to wait. I hope it will be a happy end. Under current circumstances I am inclined to hold the stock. I think it is a great company (cash-generator) in an interesting environment. I think it is a oligopoly and the entrance barrier for new competitors are very high (through scaling-effects).
I hope the supply/demand situation will clarify in the next 2-3 years (see Worldbank-Prediction).

The USD 10,70-value is it more a best/worst case scenario? What do you thin? Can it become more worse for Vale?

Thank you in advance!

Anonymous said...

Hello Mr. Damodaran,

your analysis about Vale and Lukoil are very interesting.
Could you please update (maybe in the summer time) yur analysis about these commodity-Companies?

What do you think about the ratings of Vale? SP holds on investment grade. Do you think the company could be downgraded?
Is the dividend sustainable or does it make sense?

Thank you!

rajiv130 said...

Isnt this trading well below liquidation value? Then again they are a major so who would buy individual parts.

Aswath Damodaran said...

What liquidation value? Do you mean the reserves? They are worth money but definitely not even close to the $135 billion they owe in debt. If you mean that they are trading at less than book value, book value measures nothing at this point.

Carlos Douat said...


I could check you used the number of outstanding shares of 850,563 (as reported in the financial statatements). 95,697 shares are held as treasury stock, which accounts for the difference found in Capital IQ (754,866 shares) under the MICEX:LKOH ticker.

Is there a reason for the treasury stocks to be considered on the share price calculation?

derMensch said...

Professor -

How should political factors be incorporated into valuation or risk modeling (e.g. corruption, elections, nationalization, subsidy policies, etc.)?


Aswath Damodaran said...

Treasury shares are still shares outstanding. They are just held by the company. In contrast, in a stock buyback, the number of shares actually drops by the shares bought back, since they are taken out of circulation.

Erico said...

Great article! Remark: When I look at the details of the normalization for Lukoil, the numbers for debt don't match the balance sheet and it seems that the cash balances were flipped between 2013 and 2014

Fabrizio Valerii said...

Thanks for the update Professor.

In the November valuation of VALE you took the conservative approach of assuming the last 12 months as base year for the return on capital (lowest value of the variable in the time series but higher than the cost of capital at the time). In the sensitivity analysis back then you considered a worst case scenario with a ROIC equal to cost of capital.
Now that the ROIC, 2014 value, is lower than the cost of capital, your approach of assuming a higher base value (equal to cost of capital) strikes me as being less conservative.
Could you please provide an explanation for the different approach.

Jeremy Yang said...

In a few news report from China, the biggest consumer of iron ore, almost 90% of Chinese iron ore miners have cost structure of iron ore per ton above $60. And the civil war of Australia miners also shows the current level of iron ore price makes miners other than the big 3 unable to survive. I think it's only a matter of time for high-cost miners to surrender and leave. In this scenario, prediction of iron ore price is not necessary in valuing VALE. We as investors should focus on how long and how well can VALE perform under current iron ore price.

SJK GANESH said...

Hello Professor,
From US's standpoint, is the below inference correct?
Cheaper oil---increased consumption----higher growth----higher inflation----higher interest rates? I mean, is the savings through cheaper oil big enough to achieve higher growth and higher interest rates? pls advise.

Anonymous said...

Dear Professor,

Shouldn't you substract the total amount of liabilities from your value of operating assets? (USD 59k instead of USD 29253) For instance "other non current liabilities" and "pensions" have a claim before equity holders.

Thanks and best regards,