Why Prem Watsa Of Fairfax Financial Put 15% Of His Portfolio Into SandRidge Energy

Mar.12.14 | About: SandRidge Energy, (SD)

Summary

Production from horizontal drilling techniques might be underestimated.

Strong insider ownership of the company.

CEO has a history as an investor/capital allocator in a private equity energy fund.

Prem Watsa (born 1950 in Hyderabad, India) is the founder, chairman and CEO of Fairfax Financial Holdings, based in Toronto, Canada.

Fairfax Financial is a financial holding company based in Toronto, which is engaged in insurance and investment management. Book value has compounded at an astounding rate and its share price outperformed the S&P 500 by a wide margin.

FFH Total Return Price Chart

FFH Total Return Price data by YCharts

Sometimes Watsa is referred to as the Canadian Warren Buffett. Prem Watsa strongly believes in the principle of allocating a high percentage of resources to your best idea. This is immediately apparent once you review the Fairfax Financial stock Portfolio:

Company % Recent activity
RFP - Resolute Forest Products 35.95
BBRY - BlackBerry Ltd. 29.81
SD - SandRidge Energy Inc. 15.21
OSTK - Overstock.com Inc. 7.58
XCO - EXCO Resources Inc. 4.44
BWINB - Baldwin & Lyons Inc. CL B 2.04
BCE - BCE Inc. 0.90
KW - Kennedy Wilson Holdings Inc. 0.69
JNJ - Johnson & Johnson 0.60 Decrease 97.12%
CRESY - Cresud Inc. 0.56
PFE - Pfizer Inc. 0.56
WFC - Wells Fargo 0.24
BRK.B - Berkshire Hathaway CL B 0.19
USB - U.S. Bancorp 0.09
USG - USG Corp. 0.09
NYT - New York Times Cl. A 0.09
BRK.A - Berkshire Hathaway CL A 0.08
DXM - Dex Media Inc. 0.08
C - Citigroup Inc. 0.08
LRN - K12 Inc. 0.06
ORI - Old Republic International 0.06
NYCB - New York Community Bancorp 0.05
MRK - Merck & Co. 0.05
UPL - Ultra Petroleum Corp. 0.05 Add 142.54%
EVAC - Edwards Group Ltd. 0.04 Buy
VPHM - ViroPharma Inc. 0.04 Buy
PTEN - Patterson UTI-Energy 0.04
CTB - Cooper Tire & Rubber Co. 0.04 Decrease 67.63%
SLM - SLM Corp. 0.03
EDU - New Oriental Education & Technology 0.03
MBI - MBIA Inc. 0.03
HOLX - Hologic Inc. 0.03
BP - BP plc 0.03 Add 40.00%
STL - Sterling Bancorp 0.03 Buy
CSX - CSX Corp. 0.02 Buy
NEU - NewMarket Corp. 0.02
GD - General Dynamics 0.02 Buy
IBM - International Bus. Machines 0.02
HPQ - Hewlett-Packard 0.02 Buy
NTE - Nam Tai Electronics Inc. 0.02
PWE - Penn West Petroleum Ltd. 0.01 Buy
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Resolute Forest Products (NYSE:RFP), BlackBerry Ltd. (NASDAQ:BBRY) and SandRidge Energy Inc. (NYSE:SD) together make up 80% of Fairfax long holdings. Prem Watsa's involvement in BlackBerry is a hot topic and gets a lot of press.

According to Yahoo Finance Resolute Forest Product manufactures and sells newsprint, specialty papers, market pulp and wood products. It operates through four segments: Newsprint, Specialty Papers, Market Pulp and Wood Products.

Most likely this is a typical value investment in a stock that is battered down as its sector is widely considered to be close to extinction. In addition the stock has had a good run recently.

The most interesting of these three top holdings to me is SandRidge Energy. Knowledge of Prem Watsa's investment style and research into SandRidge has lead me to believe there are a few key reasons why Watsa put 15% into the company:

1. Mississippian drilling

Morningstar analyst Mark Hansen reported: "SandRidge will be 'connecting' the hundreds of vertical wells that have been drilled on its Mississippian acreage over the past 30 years using existing wellbore data to target the thick blanket depositions that emanate from source rock in the Woodford Shale. SandRidge believes horizontal drilling can dramatically increase per-well estimated ultimate recovery and reduce the uncertainty associated with drilling vertically into carbonate reservoirs. Early results appear to confirm this thesis."

Unfortunately I'm not an expert on drilling techniques but according to Oilindependents.org and the Kansas Independent Oil and Gas Association, traditional, vertical wells in the Mississippian Lime have recovered an average of 86,000 barrels of oil equivalent (BOE) per well. The association estimates horizontal wells may recover from 250,000 to 450,000 boe per well, just one measure of the dramatic changes brought about by horizontal drilling techniques. While I was writing this article fellow Seeking Alpha contributor Richard Zeits published an article with SandRidge's latest drilling results.

It is possible that SandRidge's future cash flows are underestimated by the market because this technology is relatively new and there is uncertainty regarding the yield of the Sandridge acreage.

2. CEO Capital Allocator

SandRidge is headed by president and CEO James Bennett. Bennett has served as president and CFO since March 2013 and executive vice president and CFO since January 2011. From 2010 until he joined SandRidge, he was managing director for White Deer Energy.

White Deer Energy profiles itself as a strategic value investor. It manages $2.2 billion in two private equity funds targeting investments in oil and gas exploration and production, oilfield service and equipment manufacturing and the midstream sectors of the energy business. White Deer's investment strategy is to partner with talented management teams and build successful companies.

At the very least James Bennett, with his background as an investor, is highly mindful of the importance of capital allocation. He is more likely than the regular CEO to make ROIC a priority. CEOs that think like investors are less likely to be empire builders. James Bennett's background might very well play a role in Watsa's betting so much on the company.

3. Insider Ownership

Buffett likes to invest in companies with decent insider ownership and Prem Watsa isn't called the Canadian Warren Buffett for no reason. Strong insider ownership aligns their interest better with that of minority shareholders. Consequently it is more likely they will act in your interest as an investor at all times, which increases the likelihood the stock will outperform the market.

According to the Morningstar report, SandRidge's directors and officers own about 10% of the outstanding common shares of the company. This strongly aligns their interests with those of minority shareholders. Their primary goal will be achieve the highest ROIC possible with the least risk. This strong insider investment is preferable to insiders who are solely motivated by option or bonus reward schemes.

Conclusion

I Identify three reasons that may have influenced Prem Watsa to invest heavily into SandRidge Energy. The market may be underestimating production volume of the horizontal drilling in Mississippi. The new CEO of SandRidge is an experienced capital allocator and likely to be very mindful of shareholder interest. In addition directors and officers own 10% of the company's common stock, further increasing the odds that management will work towards one goal only: creating shareholder value.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.