Warrants, Sprott, Markel and some Personal Trades — a Friday File Hodgepodge

by Travis Johnson, Stock Gumshoe | June 7, 2013 4:39 pm

I have a few thoughts to share with my favorite Irregulars today for our Friday File (we also shared a new article from Doc Gumshoe earlier today [1]if you’re interested). Today we’re looking at a few trades I’ve made this week (four buys and one sell), updating thoughts on a couple companies I’ve covered before, and also noting the investment I didn’t make this week.

First, the transactions I’ve made with my personal account this week — as I mentioned I might do I sold my shares of Canyon Services (FRC.TO CYSVF) at around $11.50, following some optimism that drove the shares back up a bit and close to the top of its recent range (Canyon is up about 20% in the last three months and is not particularly expensive, but I think expectations are too high going forward). This means I’m closing out at a loss, personally, of about 10% on these shares, including dividends. You can see more of my thoughts on this one in last week’s Friday File[2], I am considering putting some of that money into C&J Energy Services (CJES) or perhaps another competitor (CJES and Canyon are both up roughly 2% over the last week), as I also mentioned last week, but with what I expect will continue to be pretty weak operational results from most of these North American land-based oil services companies for a while I’m not in a rush to get more exposure to that segment at the moment. There may be more disappointments and bargain prices ahead, particularly if the overall markets or natural gas prices suffer.

And I also made a small purchase just today, I bought my first position in Rosetta Stone (RST), the language learnings software company I wrote about as our “Idea of the Month”[3] following the Value Investing Congress a few weeks ago.

Rosetta Stone is a growth story, not really a value story (yet, at least) based on cash flow or earnings, but there is a strong value argument to be made about the strength of their brand and their ability, following the ongoing turnaround and rationalization of marketing, to build that brand into a much larger company over time. This is a company that has very high name recognition and brand value thanks to their huge marketing spend over the years — and while that marketing spend didn’t translate into earnings in the way they were hoping (particularly internationally), it did build brand value that they should be able to really milk more efficiently now that they’re focused on cost-effectiveness. It’s rare to find a strong brand value in a huge potential (if largely untapped) global market hiding inside a company with an enterprise value of not much more than $200 million, there are risks but there is also great potential.

The share price took an abrupt tumble this week because they announced a secondary offering at $16 a share — secondary offerings pretty much always drive down share prices, at least in the short term, but this one is not dilutive in any way — the company isn’t being chopped into yet smaller pieces as with most secondaries. The shares being sold already exist and are owned by some of the large private equity holders who helped take them to an IPO a few years ago. The secondary offering does add to the supply of shares available for trading (the free floating shares), which can depress share prices in the short term if demand doesn’t rise to take up those shares, and investors always worry at least a little bit about insider selling, but on a fundamental basis the company is the same as it was when I wrote about them and therefore it’s cheaper and looks slightly more appealing and I’ve opened a position.

I did mention the possible selling by those insiders in that “Idea of the Month” article as a likely cause of a future dip that might create a buying opportunity, but I didn’t think, frankly, that it would happen quite this soon. So I’m now on board with this stock personally with a small initial position and will be watching to see if the turnaround continues to go well and what new products they’re able to come out with (or temporary speed bumps to bring more dips in the stock price) in the months to come.

And I also wanted to update you, in case you missed my earlier brief note this week[4], on my warrant holdings — I added to my positions this week in both the Boston Private Financial Holdings warrants (BPFHW) and the PNC Financial warrants (PNC-WT or PNCWS, among other possible tickers). Both are now substantial holdings in my portfolio, BPFHW would be in my top ten stocks if it were a stock and PNC-WT, which is probably substantially less risky, isn’t far behind.

Both of those warrants obviously carry more risk than an equity investment — they don’t pay dividends (though they should adjust for future dividend increases from the underlying stocks), and they are derivative speculations that are worth nothing if the share price of the underlying stock is below the strike price at expiration (BPFH strike price is at $8, PNC at $67 and change). These were featured in the “Idea of the Month” article for April, so you can see more detail on these warrants and how they work in that article here.[5]

I think the fact that we get five-plus years for the story to play out makes these hugely attractive bets, but they are bets nonetheless — we need look no further than the Retail Opportunity Investments Corp (ROIC) Warrants (warrant ticker ROICW) that did so well for us to see what happens with relatively small moves in the underlying stock, particularly as we near expiration. The interest-rate-driven recent 10% drop in the share price of ROIC led to a 40% drop in the value of ROICW. So that’s the cautionary tale, but if PNC and BPFH are able to rise in price by an average of just a few percent per year these warrants will break even, and if they can rise 5-10% a year the warrants will be hugely profitable. Both are illiquid and prone to overreaction, so if you’re interested I’d look for weak days for financial stocks to bring sharp dips in the warrants.

And quite a few readers called to my attention the sharp drop in shares of Sprott Resource Corp (SCP.TO, SCPZF) earlier in the week — and a little birdie also told me that this came from Dan Ferris at Extreme Value[6] recommending a sale of the shares.

Why would he do that? Well, he was the person who called Sprott Resource Corp. to my attention in the first place with some teaser pitches about the stock several years ago, and I’ve heard secondhand comments about him being not-so-pleased with their new cash strategy — rather than hoarding cash and gold until they can make a big contrarian investment when commodity prices are low, often cobbling together companies from undervalued assets as has been their successful strategy so far with their few big wins, they’ve been (since January) paying out a very large monthly dividend and using up some of that cash.

That means, presumably, that they’re either using the dividend to support the share price, and would use that higher share price as currency in future deals, possibly diluting shareholders if the deals aren’t accretive … or that they are convinced they’ll have substantial cash-generating exits from some investments before they have the need for cash for new acquisitions. Add that to the fact that the most recent dividend declared and paid was about 8% lower than the dividend paid for the first several months of this year, and you can see why the shares have been a bit flaccid. The sharp drop on Tuesday and Wednesday was almost certainly from Ferris recommending a sale, but the stock has recently been weak without that as well.

Well, the lowering of the dividend is almost mechanical at this point, since they’ve made no improvements in the value of their assets lately — the dividend is based on an annualized 10% of trailing book value, so if book value drops (as it would if asset values drop and you’re paying out your cash in dividends, all else being equal) the dividend in the future will be lower. This is clearly a hurdle for the investment managers at Sprott Resource to jump over — the question, really, is whether or not you think they’ll do so.

The big holdings of Sprott Resource are still contrarian, and mostly out of favor with the markets at the moment … it’s just that they haven’t made any new big successful trades or exits lately to boost book value.

Their largest asset is about $124 million worth of shares in Long Run Exploration (LRE.TO) shares, and that’s a gas-focused Canadian energy company so that’s clearly a contrarian bet at the moment (and one they’ve lost money on so far as they created the company through acquisitions, they’ve invested about $157 million into it so far, over many years).

Other big assets are in agriculture and include Union Agriculture, a Uruguay farm operator, and One Earth Farms, which operates massive farms on First Nations lands in Canada and also raises and now distributes meat products, both of those have occasionally been “hot” investments as agriculture rises in investors attention, but don’t get a lot of love right now. Both are often rumored as potential IPOs whenever agriculture gets hot on the market, and Union Agriculture actually came close to an IPO before pulling back, presumably because of a lack of interest or weak pricing.

They also own 30%+ of a drilling startup called Independence Contract Drilling in Houston that designs, builds and operates their own “ShaleDriller” rigs, and that’s likely less valuable right now with all the competition and low utilization in the US rig business thanks to low nat gas prices, and they have large positions in some smaller juniors like Potash Ridge and Virginia Energy that are clearly speculative (Virginia Energy has an uphill battle getting permission to explore and build a uranium mine in rural Virginia, Potash Ridge is a tiny junior mine startup in Utah so the stock is beaten down).

And, of course, they hold a substantial portion of their balance sheet in gold bullion — they own 73,971 ounces of gold, so that’s worth just over $100 million now, a substantial drop from the $125 million or so it would have been worth before this current gold swoon. They say that, overall as of April 30, they calculate the value of their investments at $480 million — a large part of that is hard to substantiate because of the assets that aren’t liquid or publicly traded, but that’s certainly far more than the current market cap.

The company is running low on unencumbered and unneeded cash, since the dividend spits out more than $3 million per month to shareholders, so I expect they’ll have to extract some value from their holdings in the near future. Part of the reason they cited for starting the dividend late last year is that they believed the “value extraction” from their investments would be more reliable and predictable in the future, supporting their cash flow to pay dividends, so we’ll see how that plays out.

Personally, I still like the decisions the management team is making for the long term, I’m still willing to let them keep managing these funds for me — particularly since they’ve had enough confidence in the prospects to payout a dividend and therefore forego their management fees on those funds (management also owns shares). it’s still at a discount to book value, and the shares still make sense to me as a contrarian bet on (mostly) agriculture and natural gas.

I am NOT reinvesting my dividends in Sprott Resource, to be clear — the dividend may represent much of the gain now, and if the asset value isn’t rising in the near future than dividend reinvestment may be wasted. But I am holding my shares and would even consider buying again if it gets beaten down to a more substantial discount to underlying value or they become more active in making deals. They haven’t had a big “win” of a deal exit in a while and their natural resources focus certainly means most of their investments have lost value this year, especially compared to the overall market. I will be curious to see what they do over the next few months as their cash balance winds down with the dividend payments — will we see an IPO from One Earth Farms or Union Agriculture? Good or bad news from one of the other holdings? Don’t know, but at this valuation I’m OK with waiting.

And the trade I didn’t make this week? I did not end up buying more Markel (MKL), despite my strong temptation to do so as the shares dipped a bit to $520 or so.

I think the combined Markel/Alterra should have a book value of roughly $440 per share based on their last quarterly filings before the merger completed last Month, though that’s a rough calculation (adding together their shareholder equity, and subtracting the $1 billion in cash that went to Alterra shareholders), and I think buying at 1.1X book should be very safe for long-term investors — that would be $480.

Buying at 1.2X book, which is where Markel has typically bottomed out in the past, would mean a price of $528 … but Alterra has typically carried the much lower price/book valuation accorded to reinsurers, so I’m not confident enough that 1.2X book will be a floor to buy more immediately, given the risks of integration and the likely stumbles or costs that may emerge. I am watching it very closely and I’m excited to see what Tom Gayner and the Markel guys can do over time with Alterra’s huge and conservative bond portfolio. If it drops further, I may well buy more — Markel is a large position in my portfolio already, but it’s also a high-conviction long-term position for me, and I like buying more of such positions whenever the price gets appealing.

That’s all I have to share with you this week — have a wonderful weekend!

  1. shared a new article from Doc Gumshoe earlier today : http://stockgumshoe.com/2013/06/microblog-whats-happening-in-cancer-treatment-are-we-making-progress-or-are-we-stuck/
  2. see more of my thoughts on this one in last week’s Friday File: http://stockgumshoe.com/2013/05/drillers-and-pumpers/
  3. wrote about as our “Idea of the Month”: http://stockgumshoe.com/2013/05/may-idea-of-the-month-busted-growth-revival-story/
  4. my earlier brief note this week: http://stockgumshoe.com/2013/06/add-on-to-my-2018-bet/
  5. more detail on these warrants and how they work in that article here.: http://stockgumshoe.com/2013/04/april-idea-of-the-month-betting-on-2018/
  6. Extreme Value: http://stockgumshoe.com/reviews/extreme-value/

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