Go where it is darkest: When company, country, currency and commodity risk collide!

You learn valuation (and find out how much you don't know) by valuing businesses and companies, not by talking, reading or ruminating about doing valuation. That said, it is natural to want to value companies with profit-making histories and a well-established business models in mature markets. You will have an easier time building valuation models and you will arrive at more precise estimates of value, but not only will you learn little about valuation in the process, it is also unlikely that you will find immense bargains, because the same qualities that made this company easy to value for you also make it easier to value for others, and more importantly, easier to price.

I believe that your biggest payoff is in valuing companies where there is uncertainty about the future, because that is where people are most likely to abandon valuation first principles and go with the herd. So, if you are a long-term investor interested in finding bargains, my advice to you is to go where it is darkest, where micro and macro uncertainty swirl around every input and where every estimate seems like a stab in the dark. I will not claim that this is easy or comes naturally to anyone, but I have a few coping mechanisms that work for me, which I describe in this paper. 

While I enjoy valuing companies with uncertain futures, there are cases where my serenity about valuation is disturbed by the coming together of multiple uncertainties, piling on and feeding of each other to create a maelstrom. In this post, I want to focus on two companies, one Brazilian (Vale) and one Russian (Lukoil), where bad corporate governance, a spike in country risk, currency weakness and plunging commodity prices have conspired to devastating effect on their stock prices. You could adopt the very dangerous contrarian strategy that Vale and Lukoil must be cheap simply because they have dropped so far, but I don't have the stomach for that. I do believe, though, that if I can find ways to grapple with this risk, there may be opportunity in the devastation.

Background, history and market standing

Vale is one of the largest mining companies in the world, with its largest holdings in iron ore, incorporated and headquartered in Brazil. Vale was founded in 1942 and was entirely owned by the Brazilian government until 1997, when it was privatized. In the last decade, as Brazilian country risk receded, Vale expanded its reach both in terms of reserves and markets well beyond Brazil, and its market capitalization and operating numbers (revenues, operating income) reflected that expansion. 

In US dollars

Notwithstanding this long-term trend line of growth, the last year has been an especially difficult period for Vale, as iron ore prices have dropped and Brazilian country risk has increased (leading into a presidential election that was concluded in October 2014). The graph shows Vale's stock price over the last 6 months (and contrasts it with another mining giant, BHP Billiton).

While declining commodity prices have affected both companies adversely, note that Vale’s stock price has dropped more than twice as much as BHP’s stock price has. In fact, Vale has lost approximately $130 billion in market capitalization since 2010.

Lukoil is a Russian oil company that has seen its profile, market capitalization and revenues rise as Russia's oil production has surged. While the company is not owned by the Russian government, it does have close ties to the Russian power structure and that connection, which has served it well during its lifetime, has become a liability in the aftermath of the Russian adventures in the Ukraine, compounded by the collapse of oil prices in the last few weeks: 

In US dollars

Though there are fundamental reasons for the stock price decline at both Vale and Lukoil, the fear factor is clearly also at play, because these companies are exposed to risk not only to commodity and country risk but there are also significant concerns about corporate (or is it political) governance at both companies as well as currency risk factors (as both the Brazilian Real and the Russian Ruble have slid over the last few months).

Corporate governance risk

In a post on Alibaba, I made the argument that corporate governance affects value by making it more difficult (if not impossible) to change management, and thus increasing the risk that a company that embarks on the wrong course may continue on that path unchecked. With both Vale and Lukoil, there are both explicit and implicit reasons to believe that investors in these companies will have little or no say in how the company is run. 

The place to start analyzing corporate governance is the ownership structures of the company. With Vale, the first sign that corporate governance is weak is the fact that they have two classes of shares (and yes, I would make this argument about Google and Facebook as well). In the graph below, I break down the top stockholders in both classes.

The common stockholders, who control the composition of the board of directors and the voting rights of the company, are held by Valepar, a shell entity controlled by inside investor groups. If you own Vale shares, as I do, it is very likely that you own the non-voting preferred shares and that you have no say in who sits on the board of directors and how the company is run. There is also a wild card in this equation in the form of a golden share that is owned by the Brazilian government, giving it veto power over major decisions and the line between corporate and political governance becomes a fuzzy one. While Vale is nominally an independent company, the Brazilian government reserves the right to intrude in its management, and that power can be used to good and bad effects. The positive is that it gives Vale a leg-up on competition in Brazil, giving it first dibs on Brazilian reserves of iron ore, and the negative is that the company can become a pawn in political games. Much of Vale's success in the last decade came from a willingness on the part of the Brazilian government to give it free rein to be run as a profit-making entity, but the machinations leading up to the last election (where the incumbent, Dilma Roussef, was viewed as more likely to interfere in the company's operations) have taken their toll. (The damage has been even greater at Vale's dysfunctional twin, Petrobras, Brazil's oil company). 

Lukoil's ownership structure provides some clues to both why it has been successful and the potential corporate governance nightmares ahead. The good news is that Lukoil has only one class of shares outstanding, with equal voting rights, but the bad news is that it is not quite clear whether you will ever get to vote for meaningful change, making it akin to a Russian political election:

Source: Bloomberg

The lead stockholder is Vagit Alekperov, formerly Russian deputy minister for oil production. It is entirely possible that he accumulated substantial knowledge about the oil business, while in the ministry, and brought that knowledge and entrepreneurial zeal into play in founding Lukoil, but it is also likely that he used his connections with the power elite to get reserves at well below fair-market prices in building up the company which would make him obligated to maintaining good relations with the inner circles of Russian government. In September 2004, ConocoPhilips bought 7.6% of Lukoil's shares to create what it termed a strategic alliance, which it increased to close to 20%, before selling its stake in 2011 at an undisclosed price, partly to Lukoil and partly in the open market. It is a sad commentary on corporate governance in Russia, that Lukoil, in spite of its flaws, is a paragon of stockholder accountability, relative to most other Russian companies. Notwithstanding this relative standing, if you are considering buying shares in the company, it should be with the recognition that you will have no role in how the company is run (no matter what you read about corporate governance on the company's website). 

Country risk

While investing is always risky, it is riskier in some countries than others, partly because of where the countries are in terms of its life cycle (with growing emerging markets being more volatile than established mature markets), partly because of the overlay of political risk in the countries and partly because of the effectiveness or lack thereof of legal protection and enforcement of property rights. When valuing companies, you have to factor in where the company operates to measure its exposure to country risk and incorporate that risk into an expected return.

As a commodity company, Vale does sell into a global market and as a producer of iron ore, it gets a significant portion of its revenues from China, which is the largest consumer of iron ore in the world. The country of incorporation in Brazil, and Vale is exposed disproportionately to Brazilian country risk not only because a significant proportion of its reserves are in Brazil, but also because the government has powers to intrude in the day-to-day running of the business. Not surprisingly, Vale has been affected  by changes in perceptions of Brazilian country risk. Using the sovereign CDS spread for Brazil as a proxy for country risk, and looking at the last decade, here is what we get. As Brazilian country risk has declined over much of the last decade, Vale benefited, but country risk is a double-edged sword. As Brazilian country risk has risen in the last few weeks, Vale has felt the pain in the market:

It goes without saying that Lukoil, which has 90.7% of its reserves in Russia, is affected by Russian country risk. Here again, the last decade has been a good one for both Russia and for Lukoil, as lower country risk (measured with the CDS spread) for the former has gone with higher market capitalization for the latter. To investors who were expecting more of the same, this year must have been a shock, as Russian country risk surged in the aftermath of the events in the Ukraine.

In both companies, country risk has clearly played a role in the drop in stock prices. With Vale, at least, it cannot explain the entire price drop, since Vale has dropped more than the Bovespa over the last few months and a lot more than the index over the last few years. With Lukoil, a greater portion of the blame can be attributed to country risk.

Currency risk

When valuing individual companies, it is generally good practice not to be a currency forecaster and to value the company based upon prevailing exchange rates (current and forward, from the market). It is also undeniable that currency movements in your favor will make a bad investment into a good one, just as currency movements against you can turn a good investment into a bad one. 

With Vale, the stage was set in a decade where the Brazilian Real strengthened against the US dollar, even though inflation in Brazil was much higher than inflation in the US. As with country risk, the currency risk dragon has turned on investors and the last few weeks has seen a meltdown in the value of the Brazilian currency.

Source: Bloomberg

The story is similar for Lukoil. A decade of a strengthening ruble, in spite of fundamentals that would suggest otherwise, has been followed by the collapse in the last few months.

Source: Bloomberg

While the immediate effect of a currency decline is that your investment in these companies will be worth less in US dollar terms (simply because of the translation effect), it is debatable what the effect of a weakening currency will be on both companies over time. To the extent that their reserves are in Brazil (at least for iron ore, for Vale) and in Russia (for Lukoil), the costs are in the local currencies but their revenues are in global markets, denominated in US dollars. Thus, a weakening of the currency can improve profit margins and increase value.

Commodity price risk

Do commodity prices affect the value of commodity companies? Stupid question, right? Of course, they do, but the degree of impact can vary across companies. Higher commodity prices will generally push up revenues and to the extent that the cost of developing reserves stays stable, operating margins will increase. In some cases, though, and especially so with oil companies, the government can use a heavy hand (see political risk in the corporate governance section) and force the company to sell oil at subsidized prices to consumers in the country, effectively creating a subsidy cost for the company that will increase with oil prices. 

Vale's fortunes have risen as the Chinese economy has grown, primarily because China has become the largest consumer of iron ore in the world. It is robust Chinese growth that lifted iron ore prices in the last decade to hit highs in 2011, but that engine has slowed and as it has, iron ore prices have dropped in the last two years: 

This history shows why making a judgment about a normal price for iron ore is so difficult to do. If your historical perspective is restricted to just the last few years, the current price of iron ore (about $75/tonne) is low but extending that perspective to cover a longer time period (say 20-25 years) may suggest otherwise.

Lukoil also benefited from the increase in oil prices in the last decade, driven partly by geopolitics and partly by the explosive surge in automobile sales in emerging markets. Here again, though, the last few months have seen a decline in oil prices to less than $80/barrel. 

Source: Bloomberg

As with iron ore, the question of whether oil prices have dropped below a normal price is largely a function of perspective, with the answer being yes, if you have 2 or 3-year perspective but not if you have a ten-year or longer perspective. 

While it is easy to make the argument that commodity prices move in cycles and that what goes down has to go back up again, these cycles are unpredictable and can stretch over long time periods. Thus, you could have spent the entire 1980s waiting for oil prices to go back up, just as you would have waited the entire last decade for the drop back in prices.

Valuing Vale 

The value of Vale is a function of company, country, currency and commodity risks. To capture the effects, I valued Vale in US dollar terms and assumed that Vale was a mature company, growing at 2% a year in perpetuity. I varied the following inputs:

1. Operating income: The operating income in the trailing 12 months, through November 2014, was $12.48 billion, well below the operating income in the last fiscal year ($17.6 billion) and the average operating income over the last five years ($17.1 billion).
2. Return on capital: The return on capital in the last 12 months was 11.30%, higher than the cost of capital that I estimated of 8.59%, but lower than the return on capital in the most recent fiscal year (14.90%) and the average over the last five years (18.22%)

To estimate the cost of capital, I built off the US 10-year treasury bond rate as the risk free rate and used an equity risk premium of 8.25%, reflecting a weighted average of the equity risk premiums across the countries where Vale has its reserves (60% are in Brazil). You can check out the spreadsheet yourself and change the numbers. I have summarized the valuation in the picture below.

Note that I have attempted to incorporate the effect of commodity price declines and currency devaluation in the base-year operating income, choosing to value the company, using the depressed income from the last 12 months. The effects of corporate governance are captured in the investment and financing choices made by the firm (with reinvestment and ROIC measuring the investment policy and the debt mix in the cost of capital reflecting financing policy). Finally, the country risk is incorporated into the equity risk premium (where I used risk premium weighted by the geographic distribution of Vale’s reserves) and the default spread in the cost of debt. The value per share that I get with this combination of assumptions is $19.40, well above the share price of $8.53 on November 18, 2014.

It is entirely possible that I am under estimating how much further iron ore prices can drop and the damage that the Brazilian government can (to Vale, the Brazilian real and to country risk). I tried varying the numbers to see the impact of changes in my inputs on the value per share:

I am sure that I am missing something but at the stock price of $8.53 on November 18, 2014, it looks grossly under valued. Even in my worst case scenario, where operating income drops another 20% from the already depressed LTM number and the company earns only its cost of capital from this point on, my value per share is $13.60.

Valuing Lukoil

I followed a similar path for Lukoil. In my base case, I left operating income at 20% below the estimated 2014 and valued the firm as a stable growth firm (with a 2% growth rate) and with a cost of capital that reflects an updated equity risk premium for Russia (9.50%). Even if I assume that oil prices drop by another 20% and that the standoff over Ukraine will not end soon (translating into higher equity risk premiums), the value per share that I get is $50.56, higher than the stock price of $45.30.

At $45.30 a share on November 18, 2014, I am again either missing something profound or the stock is massively under priced. Here again, you can download the spreadsheet and make your own choices.

What now?

It is easy to come up with reasons not to buy Vale and Lukoil right now and wait for things to get better. Could things worse? Of course? With Vale, there are two Doomsday scenarios. In the first, and I hope that this does not happen, more for the sake of my Brazilian friends more than because of concerns about my investment portfolio, Brazil could become Argentina, with spiking country risk and shaky ownership rights. In the second, Chinese infrastructure investment comes to a standstill and iron ore prices drop back to pre-2003 levels. I think that these are low-likelihood events and that is precisely why I already own Vale (and I am not in the least bit ashamed to admit that I bought my shares at $12/share) and plan to add to my holdings.

With Lukoil, there is the Putin wild card, where the troubles in Ukraine expand into Poland, Hungary and the rest of the old Soviet empire. That, combined with a collapse in oil prices, would make me regret my investment, but I plan to buy Lukoil to my portfolio, and live with the discomfort of having no power to exert change. After all, at the right price, you can live with a lot of discomfort!

If you are tempted to complain about how much uncontrollable risk you face investing in Vale and Lukoil, keep in mind two facts. The first is that they are bargains precisely because of the uncertainty, as global investors flee from he companies, abandoning good sense along the way. The second is that it could be worse, since you could be holding Petrobras (instead of Vale) and Rosneft (instead of Lukoil) where the concerns are multiplied.

Attachments:
Vale: Financial Summary (Historical)
Lukoil: Financial Summary (Historical)
Valuation of Vale (November 2014)
Valuation of Lukoil (November 2014)