A hedge fund manager that I enjoy following is the very well known Whitney Tilson of T2 Partners. Tilson is an investor focused solely on buying shares of companies trading at material discounts to intrinsic business value and shorting shares of companies trading at significant premiums to intrinsic business value.
Tilson speaks very openly about the positions that his fund holds and more importantly why his fund owns shares of specific companies.
So I read with interest the following excerpt from T2 Partners March letter to investors:
Panicked Headline Investing
As value investors, we often invest in companies and industries that are deeply out of favor because that's where bargains - babies thrown out with the bathwater - often lie. At the extreme end of this spectrum is what we call "panic headline investing." The opportunity arises when something goes terribly wrong at a well-known company, resulting in very negative headlines that lead to the widespread view that the company is so toxic that its stock is uninvestable at any price - and thus panic selling. We love buying from sellers who don't care about price.
Sometimes panicked headlines affect an entire sector such as financial stocks during the credit crisis and, to a much lesser extent, last August and September at the peak of the European sovereign debt crisis (we took advantage in 2008/09 with Berkshire Hathaway, Wells Fargo and American Express, and last fall with Citigroup and Goldman Sachs, among others). But during normal times, it's usually something company-specific. A classic example is BP during the oil spill in mid-2010 (another one we profited immensely from). Over the past year, other examples we'd cite are News Corp last August (phone hacking), Hewlett Packard last August and September (management shakeup), Netflix last October (Qwikster debacle), Jeffries Group last October (MF Global bankruptcy), Sears Holdings last December (bankruptcy fears), and Diamond Foods in February (accounting scandal).
We look closely at all of these situations and occasionally invest in one. For example, of the six recent ones noted above, we invested in two: Netflix, which has been very profitable and which we continue to own, and Jeffries Group, which we have nearly entirely exited after almost doubling our money. Why did we invest in these two and take a pass on the other four? It's hard to say - to some extent, after all of our analysis, it comes down to gut-level comfort. Given the success we've had doing this type of investing, perhaps we should try harder to get comfortable with these situations more often…
I thought this topic was a perfect for the daily headlines we are now seeing for a company that I own, that company being Chesapeake Energy (CHK).
Of course you likely already know the details of the Reuters special report on Chesapeake CEO Aubrey McClendon's Founders Well Participation program and how McClendon has financed this participation with a massive amount of debt borrowed from a company that Chesapeake also deals with.
Over the past several years I have written several times about the mental tug of war I've had over whether or not to invest in Chesapeake. My interest in investing in Chesapeake related to the massive portfolio of unconventional resource acreage the company had compiled. My hesitation related solely to whether I wanted to entrust my investment dollars to the stewardship of CEO McClendon and Chesapeake's Board of Directors.
My concern about management and the Board of Directors related to 3 items:
1) Aubrey's massive margin calls in 2008 that were triggered by the collapse in the shares of Chesapeake and resulted in him losing a huge chunk of his net worth. Seeing someone so reckless with his personal finances gave me pause as to how careful he would be with Chesapeake's financial health.
2) The giant bonus that Chesapeake's Board of Directors granted McClendon in 2008 subsequent to the margin calls that took McClendon's compensation for the year to almost $100 million. With the world in utter financial chaos I thought it most alarming that a company would grant this kind of bonus.
3) Near the same time in 2008 with the world falling apart Chesapeake paid McClendon $12 million for an antique map that hung in the Chesapeake office. That is obviously ridiculous, not just considering when this payment occurred but also because there is no possible justification for an oil and gas company buying a $12 million map collection with shareholder money.
There is no doubt that these three items are more than enough reason to stay away from Chesapeake. But despite the stink from these items I could not resist temptation and last fall at around $25 took a decent sized position in Chesapeake.
Why? Because the implied value of Chesapeake's portfolio of unconventional resource plays proven by a series of arm's length asset sales suggested that Chesapeake's shares had multi-bagger upside potential.
These asset sales were with different parties and involved several different resource plays. My belief was (and still is) that these sales provided very compelling evidence of asset value far in excess of what the stock market was implying.
Here is a recap of those transactions:
Here are the joint ventures to date:
1. Haynesville joint venture with Plains Exploration (PXP) - The timing on this one was extremely fortunate occurring as natural gas prices were over $10 immediately before the world fell apart in June 2008. Chesapeake sold 20% of its Haynesville acreage to Plains for $3.16 billion. That implied that the acreage retained by Chesapeake was worth $13.2 billion.
2. Marcellus joint venture with Statoil (STO) - At a time when deals couldn't get done Chesapeake got a deal done. In November 2008, Statoil paid $2.1 billion for a 32.5% interest in Chesapeake's Marcellus shale acreage. The implied value of the retained acreage for Chesapeake was $7 billion. The price received certainly reflected the market conditions of November 2008, but at the time Chesapeake needed to strengthen its financial position.
3. Barnett Shale joint venture with Total - It is almost like Chesapeake is trying to learn new languages, this time teaming up with a French company. For $2.25 billion Total got a 25% interest in Chesapeake's Barnett shale properties, which implied that the retained value was $6.8 billion.
4. Eagle Ford joint venture with CNOOC (CEO) - Chesapeake put its Eagle Ford acreage position together with blinding speed in 2010. In November 2010 CNOOC bought a 33% interest in the land for $2.2 billion implying that Chesapeake retained a land position worth $4.4 billion.
5. Niobrara joint venture with CNOOC - Same partner, different property. This time the Niobrara where CNOOC purchased a 33% interest for $1.3 billion implying that the retained value is $2.6 billion to Chesapeake.
6. Utica Shale joint venture with Total - The French Oil company Total, which already completed a joint venture with Chesapeake on the Barnett shale, is back for more. Total will acquire a 25% interest in 542,000 of Chesapeake's Utica shale acres for $2.03 billion. $610 million of this is in cash at closing and $1.42 billion will be paid in the form of drilling and completion cost carry.
Now in addition to the above reasons which I originally considered both for and against taking a position in Chesapeake I now have to consider this Founders Well Participation Program and the controversial debt used by McClendon to finance it.
My take on these issues would be as follows:
1) The Founders Well Participation Program - This is a non-event for me. Those of us who have followed Chesapeake for years have long known about this program and have long wished it didn't exist. Why a guy earnings tens of millions of dollars also needs this program to keep him incentivized is beyond me. No, strike that it isn't beyond me. Greed is the reason that this program exists.
But I knew about this program when I invested in Chesapeake, so that is my problem.
2) The billion dollars in debt financed by a company that does business with Chesapeake - This is not a non-event for me. Unfortunately though I wouldn't call it a surprise either.
It isn't a surprise because of the history of this company and its CEO. The map collection purchase, the margin calls and the ridiculous 2008 bonus. This billion dollars in debt that may or may not be a conflict of interest is just more of the same.
And more of the same is a Board of Directors and CEO who either do not understand what it means to be stewards of shareholder interests or simply do not care.
Technically a case could be made that everything is fine with respect to the financing arrangements McClendon has for the Founders Well Program. However, no case can be made that everything is fine with the judgement displayed by a Board of Directors who thinks this is ok.
There is a line in almost everything you do in life where right and wrong meet. If you are married and want to stay married, your actions should be such that you don't come close to that line. Similarly your job as a member of a Board of Directors is to make sure that the company you are directing comes nowhere near that line.
It doesn't take someone with the business ethics of Warren Buffett to figure out that Chesapeake has been spending a lot of time close to (maybe over, maybe not) that line that separates right and wrong.
As a small shareholder of Chesapeake I'd like to send a message to the Board of Directors.
I admire the company that McClendon has built. I think the collection of assets that he has assembled is incredible and are worth multiples of the current share price. But you (Board of Directors and CEO) have lost my (as a shareholder) trust and I'm not sure I want you running this company for me anymore. No matter how great a job a CEO has done, a publicly traded company is owned by its shareholders. It is not wealth creation vehicle for its CEO even if that CEO founded the company.
It seems pretty clear to me that in the minds of this Board of Directors the interests of the CEO are put well in front of the interests of the people who actually own the company. And those people are the shareholders like me.
On behalf of myself and the shares I represent, I would like to request that we have a change in both the Board of Directors and CEO so that we can be certain shareholder interests become priority number one.
Because that is what the job of the Board of Directors was supposed to be.