Inflation “a Hydra-Headed Monster”

With inflation surprisingly low, the Federal Reserve still raised interest rate this week. It has been almost a decade since the last rate hike. They must be confident that the U.S. economy is stronger than it looks. While on the topic of inflation, below are two graphs of interest.

Source: HULTON ARCHIVE/GETTY IMAGES
Source: HULTON ARCHIVE/GETTY IMAGES

In 1974, the economist Herbert Stein, then a top adviser to President Richard Nixon, called inflation “a Hydra-headed monster” that “came in various forms—sometimes led by wages, sometimes by prices, by foods, by oil; sometimes it was domestic and sometimes imported.”

Below is a chart of U.S. inflation since 1775. You will notice that we haven’t suffered a period of deflation since the Federal Reserve was created in 1913. The violent drop and rise in inflation and deflation is also gone.

Source: WSJ
Source: WSJ
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Oil – It’s The 1860s All Over Again

This is my latest article published on Seeking Alpha. I tried to put the current oil crash in historical context. I found some very striking resemble with the problems of today’s oil industry and the ones in the late 19th century.

I also want to take the occasion to wish everyone a Merry Christmas and Happy Holidays. May 2016 bring good health, prosperity, success and peace.


I’m currently reading Titan by Ron Chernow. This is an excellent book about the life of John D. Rockefeller Sr. (July 8, 1839 – May 23, 1937, Obituary from the New-York Times). Mr. Rockefeller was known as the co-founder of theStandard Oil Company and was the world’s richest person. Adjusted for inflation, his fortune upon his death in 1937 stood at $336 billion according to Fortune (in 2008 U.S. dollars). Chernow does a great job shining a light on the secretive mysterious John D. Rockefeller. The biography is fair. Unlike other works about Rockefeller, Chernow doesn’t demonize or canonize Rockefeller in his book.

I’m writing this article because of the striking resemblance with today’s oil industry and the one in the book. I’m referring to the late 19th century. I want to share with you some insights between back then and today. You will get the feeling that you were reading today’s oil news. I believe that history repeats itself and there are lessons to be learned. And since this boom and bust cycle are not new, it might also provide some understanding on where we are heading. I hope you enjoy.

Let’s Go Back In Time

To understand where this is going, it’s important to understand how we got here.

Source: Public Domain. A Pennsylvanian oil field in 1862.

In the 1850s the whale fisheries had failed to keep pace with the mounting need for illuminating oil, forcing the price of whale oil higher and making illumination costly for ordinary Americans. Only the affluent could afford to light their parlors every evening. There were many other lighting options such as lard oil among others but no cheap illuminant that burned in a bright, clean, safe manner. George Bissell, considered as the father of the American oil industry, had the intuition that oil that was plentiful in western Pennsylvania could be a first rate illuminant. The slimy liquid was so ubiquitous that it tainted well water and plagued local contractors drilling for salt. In 1855,Professor Benjamin Silliman from Yale produced a report that vindicated Bissell’s hunch that oil could be distilled to produce a fine illuminant (like kerosene), plus a host of other useful products. As a result, Bissel and his company, Seneca Oil Company (formerly the Pennsylvania Rock Oil Company) needed to dispatch someone to Pennsylvania to look for large pools of oil. That man was Colonel Edwin Drake, known as the first to successfully drill for oil. Drake arrived in Titusville, Oil Creek Valley. Oil was known to exist here, but there was no practical way to extract it. Its main use at that time had been as a medicine for both animals and humans. Natives used it for war paint and for soothing skin liniment. It took a couple years but Drake struck oil in 1859. This was the beginning of a pandemonium. Bands of fortune seekers and speculators streamed into Titusville and other oil-related businesses quickly exploded on the scene. I guess you can call this the Klondike of oil.

Boomtowns appeared briefly, witnessed frantic activity, and then vanished as abruptly as they had appeared. In a short-time after oil is struck, a sleep frontier settlement is transformed into a hectic town filled with hotels and saloons. Pithole, Pennsylvania is an example of that boom to ghost town phenomenon. In 1865, after oil was discovered Pithole became a boomtown with thousands of people rushing in. Then after the oil was gone, Pithole was left with just six voters. The book talks about a $60,000 hotel, the fancy Bonta House hotel, that was sold for $600 for the lumber and doors. Back then nobody knew how much oil there was and it looked as if the oil would be more than a transient phenomenon. The worries that the Pennsylvania oil wells would dry up consumed a lot of energy. In the late 1860s there were stern prophecies about the industry’s impending demise. Today we know that we are not running out of oil anytime soon but how many times are we reminded of the Peak Oil Theory?

To a much lesser extreme, this reminds me of North Dakota and Fort McMurray in Alberta. Fort McMurray has a lot of oil left for a few decades but the recent oil crash has brought a lot of pain including a housing bust. Just like western Pennsylvania at the time the potential money to be made in Fort McMurray and North Dakota was irresistible, whether in drilling or in auxiliary services; people could charge many times the asking rate.

The oil industry was unruly and turbulent. From its first days, the industry tended to oscillate between extremes: gluts so dire that prices plummeted below production costs or shortages that sent prices skyward but raised the even more specter of oil running dry. Prices back then were volatile with the supply-demand equation shifting radically each time a new gusher came in. It was never clear where prices would settle or what constituted a normal price. When this expanded supply led to lower prices and deflationary bust, it set the pattern for the rest of the 19th century, which experienced huge economic advances, punctuated by treacherous slumps. Lured by easy profits, legions of investors rushed into a promising new field and when big gluts developed from overproduction, they found it impossible to recoup their investment. In 1861 a barrel of oil fluctuated between $10 and 10¢ a barrel! And that’s not a typo. In 1864 a barrel fluctuated between $4 and $12, and then fell to $2.40 a barrel after the Civil War. Does this remind you of today’s boom and bust environment? Below is a chart of the history of crude oil prices.

(click to enlarge)Source: Goldman Sachs. Data up to 2014.

By the late 1860s, there was a slump in the oil industry, keeping it depressed for the next five years. Low kerosene prices, a boon to consumers, were catastrophic for refiners, who saw the profit margin between crude and refined oil prices shrink to a vanishing point. In 1870 total refining capacity tripled the amount of crude oil being pumped and most refineries were in the red. Now the downstream businesses will feel the pain of a slump in refining margins. Refining margins are starting to slump. Barclays’s benchmark puts average margins in the fourth quarter about 45% lower than the prior quarter.

Worse, the oil market wasn’t correcting itself according to the self-regulating mechanism described by neoclassical economists. Producers and refiners didn’t shut down operations in the expected numbers. John D. Rockefeller said “So many wells were flowing that the price of oil kept falling, yet they went right on drilling.” Rockefeller tirelessly mocked those “academic enthusiasts” and “sentimentalists” who expected business to conform to their tidy competitive models. According to the standard model of competition, as oil prices fell below production costs, refiners and producers should have shutdown. But the oil market didn’t correct itself in this manner because refiners and producers carried heavy bank debt and other fixed costs and by operating at a loss they could still service some debt. Each refiner, pursuing his own self-interest, generated collective misery. Does it sound like today’s news? The U.S. drilling activity didn’t slow down as much as expected and a lot of producers are still pumping oil to avoid defaulting on their loans.

The Oil Regions of Pennsylvania created many millionaires and left many more paupers. Many who had made easy fortunes in oil found themselves bankrupt. Now how many people have lost their shirt in the latest oil crash? People are losing their jobs, loans are defaulting, fortunes have melted, income going to retirees is gone, oil dependent countries are falling apart, and the carnage continues. People who succeeded believed in the long-term prospect of the business and never treated it as a mirage that would soon fade. That’s what John D. Rockefeller and Standard Oil did.

The violent price swing created an urgent need for certainty, stability, order, and predictability. The solution back then was forming a cartel with the leading producers. In 1869 and 1870 are the years cited by Rockefeller as the start of his campaign to replace competition with cooperation. On February 1, 1869, the Petroleum Producers’ Association was created to curtail production and lift prices. According to Rockefeller the industry needed to be tamed and disciplined since it was struggling with excess capacity and suicidal price wars. That’s almost hundred years before the Organization of the Petroleum Exporting Countries (OPEC) that was formed in 1960. Standard Oil ran “running arrangements” with its rivals in which Standard Oil guaranteed them a certain level of profits if they accepted a ceiling on their output. This caused the problem all the cartels face: How do you prevent cheaters. Whenever refiners with running arrangements exceeded their assignment allotment, Standard Oil, as the swing producer, curtailed its own output to maintain prices. This is exactly the situation Saudi Arabia has been facing since the 1970s. Cheaters are not the only problem for the cartel, it also had to grapple with the “free rider” problem. That is opportunistic refiners outside the cartel who enjoyed the higher prices it produced without being bound by its production limits. In the end the agreement crumbled because producers couldn’t enforce discipline in their ranks. High prices lead to producers to pump more leading to another major glut in the market. In today’s world, the biggest free riders are Russia, the U.S., and Canada among others. They benefit from OPEC’s output restrictions and counted on the organization to curb output to support price. Well that mutual belief fell apart and so did the floor that the oil price was standing on.

A year ago OPEC, influenced by Saudi Arabia, decided to defend market share instead of cutting output, ultimately hoping to drive high-cost producers such as U.S. shale firms out of the market. OPEC’s decision last Friday in Vienna is escalation of that policy. OPEC will not limit oil production. OPEC says it shouldn’t have to cut output alone and there’s really no appetite to cut, especially from Iran. OPEC historically functioned for so long because they were able to coordinately restrict supply and therefore influence oil prices. Now they have dropped their founding mission to operate in a free-for-all ceilingless production environment in an already oversupplied market.

“Everyone does whatever they want” – Iranian Oil Minister Bijan Namdar Zanganeh

As a side note, most of the stuff refineries produced back then was kerosene. This was years before the introduction of the automobile. Nobody knew what do to do with the light fraction of crude oil known as gasoline and many refiners let this waste product run into the river. Rockefeller said “we used to burn for fuel in distilling oil and thousands and hundreds of thousands of barrels of it floated down the creeks and rivers, and the ground was saturated with it, in the constant effort to get rid of it.” And because the industry was so out of control and that voluntary association didn’t work, John D. Rockefeller wanted to bring the industry to heel under Standard Oil control. As for Pennsylvania, oil production peaked in 1891, when the state produced 31 million barrels of oil, 58 percent of the nation’s oil that year. Standard Oil became a monopoly and the world’s first and largest multinational corporations. The Federal Government dismembered Standard Oil in 1911 into dozens of constituent companies.

Summary

The oil market is disconnected from fundamentals. The oil industry is a victim of over production at any cost. Producers are focusing on protecting market share even if that means selling barrels below cost. Others are still filling up inventory space just because they need to pay interest on their loans. The market, instead of acting on fundamentals, is trading on momentum. Low prices are the excuses for lower prices. We are never at the center, or in equilibrium. We are always to the left or to the right of the pendulum. And when the market corrects itself it shoots past equilibrium and goes straight the other way.

The latest oil boom is responsible for the recent bust as it happened in the late 19th century in Pennsylvania after discovering a new big gusher. With high prices and sky-high profits, the field had soon grown overcrowded. Supply didn’t follow demand. When oil prices were high, capital expenditure exploded and producers drilled everywhere. The feeling was that oil prices were only going to go up. Oil booms and busts happened frequently in the past, except today we though that “time is different”. The thesis was the age of cheap oil was over because of the ever growing oil thirst of China and the rising demand in emerging markets. Well the thesis is still more or less relevant, it addressed the demand side of the equation. The issues are on the supply side of the market and latest developments set up for more price wars in an already heavily oversupplied market.

We might be in 2015 and we might think of ourselves as smart and sophisticated. Our society doesn’t look anything like the wild one described in the 1800s. However, even if our society is more advance, our behavior didn’t evolve and as a result we repeat the same mistakes of the past. When you think things couldn’t get uglier, they do. As for me, I will try to finish that 774 page oil brick.

Clarke Inc. – Canada’s Activist Value Investor

Latest article on Seeking Alpha. Below is a sample since Seeking Alpha has the rights. The article is free for for a month before the paywall us up. Enjoy!


 

Reposted from Seeking Alpha
By Brian Langis

TSX: CKI

U.S.: CLKFF

Clarke Inc. is primarily traded on the Toronto Stock Exchange under the sticker CKI. Last thirty day trade value is approximately $93k per day.

Note: Dollar amounts are in Canadian $ unless mentioned otherwise. USD-CAD 1.3371 Price of 1 USD in CAD as of November 29, 2015.

Part of my writings is to shine the light on companies that deserve more attention. My most successful investments are usually found in places where nobody is looking since this is where you get the best deals. I believe that Clarke Inc. (OTC:CLKFF) is a company that deserves to be on your investment radar. CKI is a company that people will talk about one day after making a huge successful deal and they will wonder why they haven’t heard of it in the past (CKI is too small for analysts and institutional investors).

Clarke Inc. is an investment holding company based out of Halifax, Nova Scotia. Don’t let the Halifax part fool you. After all, isn’t Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) run from Omaha. For the skeptics, CKI has an office in Toronto; it’s where the deals flow in Canada. CKI is company with a ~$155m market cap, trading at ~0.8x book value and provides a 4% dividend yield. Clarke Inc.’s Chairman is George Armoyan, a colorful activist value investor in Canada. CKI describes itself as an activist catalyst investment company with a diversified portfolio of strategic and opportunistic investments. More often, Clarke seeks active involvement in the governance and management of the company which it invests with the goal of improving the underlying company’s performance and maximize the company’s value. For this research, I have not spoken to George Armoyan, but I spoke to Michael Rapps, the CEO.

This is a brief rundown on how Clarke Inc. usually operates. CKI starts accumulating shares of a target company, mostly mid-size companies so far, those with a stock market value of around $50m to $150m. Then when it crosses the 10% threshold that requires CKI to publicly disclose its holding, the company demands seats on the target’s board of directors and input into management. The goal is to gain control and then engineer a turnaround and generate a profit.

A quick look at Clarke Inc.’s investment portfolio is not pretty. It’s not supposed to be. That’s the key to its superior returns. I looked at past Clarke investments and none of it was sexy. Every investment Clarke Inc. made money on in the past didn’t have a sign pointing that’s going to be the next big money maker. It’s still the case today with its current portfolio; it’s not composed of stocks everybody likes to buy. Following the trends that are popular isn’t a formula for success and CKI definitely knows that. If you want a real bargain, you have to look where nobody is looking, where there are problems, and where there’s blood on the street. Most people simply don’t know how to find it and or they simply don’t have the spine to go through with the investment.

Like most stocks, Clarke Inc. took a beating during the recent downturn and now provides an interesting entry point to build a position. CKI was trading at a peak of $12.30 in July to fall where it’s currently trading at now, around $9.90. The slump represents a 20% fall from its peak. The table below is five-year chart of CKI’s stock price. You will notice the stock was mostly flat until late 2013 and had a run-up that more than doubled the share price. There’s a reason for the run-up which is explained below.

(click to enlarge)

Source: Google Finance. CKI 5-Year Chart. CKI is up 136.8% vs. 3.85% for the S&P TSX.

Regarding holding companies, aside Berkshire Hathaway and Power Financial Corp. (OTCPK:POFNF), I don’t own any other investment holding companies even when they trade at a significant discount to book value. I have seen the compelling investment thesis; the sum-of-the-parts are much higher than market value, you get this part of the business for free, it trades for less than cash etc…and despite all the great reasons to own the “cheap” stock, the price barely moves. I find that most holdings companies are asleep and there’s a lack of action to unlock value. There are exceptions and I’m generalizing the sentiment. I have been following many investment holding for years out of curiosity, and most of the time nothing happens, like Power Financial Corp., where the stock price hasn’t gone anywhere in a decade (but at least it distributes a dividend).

Clarke Inc. is a different investment holding. The company is pro-active and cares about its stock price. In the last two years, Clarke has demonstrated that it wants to close the discrepancy between quoted value and intrinsic value, as demonstrated by the run-up in the stock price for that period (see previous chart above). To achieve those superior returns, the team running Clarke have divested the company of some of its private holdings. Turning these assets into cash has helped close the gap between market price and book value. Then the company modestly raised its dividend from $0.06 per share to $0.08, and now $0.10 per share. The current dividend yield of ~4% certainly attracts more investors, such as your income-oriented class. CKI has also been very aggressive at buying back its share, with $40m in repurchase in the first half of 2015 alone. Clarke has fully redeemed its debentures and has eliminated its debt. The company also decided to regularly put out presentations to make the case for investing in its stock. These are some of the different initiatives the company has put together to raise its profile among the investor community. The combination of actions shows that the CKI cares about its stock price.

Here’s Clarke’s mission and business operation:

Clarke is an investment company. Our objective is to maximize shareholder value. While not the perfect metric, we believe that Clarke’s book value per share, together with the dividends paid to shareholders, is an appropriate measure of our success in maximizing shareholder value over time.

We attempt to maximize shareholder value by allocating capital to investments that we believe will generate high returns and reallocating capital over time as needed. In doing this, Clarke’s goal is to identify investments that are either undervalued or are underperforming and may be in need of positive change. These investments may be companies, securities or other assets such as real estate, and they may be public entities or private entities. We do not believe in limiting ourselves to specific types of investments. From time to time, Clarke will invest passively in a security where it believes the security is undervalued and there is no need for change or where it believes the security is undervalued but that the management team in place at the underlying company is doing an appropriate job to reduce the undervaluation.”

I don’t usually buy into these nice scripted mission statements and you shouldn’t either. It’s a given that every company says their objective is tomaximize shareholder value. However, Clarke Inc.’s actions lead me to believe that it stands by what it wrote. The first part of the statement is generic boilerplate statement. It’s the second part that’s retained my attention. In the second part, the key statement is “allocating capital to investments that we believe will generate high returns and reallocating capital over time as needed.” This statement reminded me right away of the excellent investment book by William Thorndike, The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. The book demonstrates CEOs who created exceptional long-term value because they excelled at capital allocation. For CKI, as an example, excellent capital allocation decision is buying back shares when it’s trading below book value.

At the moment, being an activist investor is the approach du jour on Wall-Street but not in Canada. Activism is more looked down upon in Canada than the US. The approach of ruffling feathers when things go bad is heavily criticized which fuel the negative perception of activist investing. It seems that all activist investors are being lumped together, good and bad. However, I believed there are two kinds of activist investors, the ones with a long-term approach like ValueAct and Nelson Peltz, which have proven to create shareholder value over time and the ones with a short-term approach, which are usually value destructive because they focus on short-term gain at the expense of the long-run performance. George Armoyan and Clarke Inc. were activist investors before it was a cool word. Mr. Armoyan’s track record has proven that he can work positively with the management team, make changes that are beneficial to shareholders, and have a positive impact on rational capital allocation over time. My point is that he’s not another guy getting on the activist bandwagon. Mr. Armoyan is not a trend.

You can copycat Clarke Inc. by investing in the stocks that the company holds. However, you would enter your position at a higher price than Clarke Inc. did because once it obligated to reveal a position, the herd jumps in and the target company’s stock price shoots upward. The better option is ignore the herd and to buy shares of CKI. At a discount, you will have the same exposure than buying the stocks on your own, benefit from an excellent owner-operator, receive a dividend, and benefit from Clarke Inc. buying back its shares. In the last five years, the latter seemed like a good strategy. I am convinced that Clarke’s underlying businesses have value that far exceeds where the public market values them.

About Clarke Inc.

Clarke Inc. was a family business founded in 1921 and its IPO was in 1998. Today’s Clarke Inc. has nothing in common with the original company. Clarke Inc. used to be in the transportation industry and there’s no more link to the original founding family. Clarke Inc. was an underperforming trucking company that George Armoyan took over in 2003 through his private investment vehicle, GeoSam Investments (named after his two kids, George and Sam). He changed management and redirected cash flow through different investments. Clarke Inc. sold its transportation and logistics service to TransForce in 2013. Clarke Inc. used convertible debentures to fund it buying spree and has since redeemed all the convertible debentures. Below is a graph of the brief corporate history since Armoyan got involved.

(click to enlarge)

Clarke Inc. is patient. The company doesn’t mind sitting on cash until it finds the right target. CKI only deploy capital when it has real conviction that it has found a solid idea. When it doesn’t find interesting ideas, it holds cash.

When I spoke to Michael Rapps, he told that Clarke Inc. will not limit itself to any sectors and it will go anywhere opportunities are. Its mandate is to make money. However, Mr. Rapps told me that they have a “no” list. They don’t invest in mining, tech companies, and pharma among other things. They have a penchant for real assets, such as real estate, things that can be monetized and provide downside protection.

The full article is accessible on Seeking Alpha here.