LONDON – At the London Value Investor conference last week, stock-picker Ben Preston of Orbis – Allan Gray’s global arm – extolled the virtues of Peabody Energy, the world’s largest private sector coal miner, which declared itself bankrupt in April 2016. I caught up with him during the tea break where we caught some of London’s early summer sun outside of the Queen Elizabeth conference centre in Westminster. – Alec Hogg
This is the Rational Perspective. I’m Alec Hogg. And in this edition a coal stock called Peabody, which is getting value-investors really excited.
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The world was first introduced to the term ‘cigar-butt’ shares in, what Warren Buffett regards as the best investment book that was ever written. Published in 1949, Benjamin Graham’s masterpiece is called The Intelligent Investor, and Buffet reckons it provided the skeleton around which all his other investment knowledge was built.
Graham, who changed his surname from Grossbaum in recognition of those anti-Semitic times, likens some shares to a mostly-smoked cigar. These are the stocks in companies whose circumstances have changed significantly for the worse and so, have been shunned by most investors. But often, this neglect can push the unloved orphan’s share price below what is realistic. That provides an opportunity for the smart analyst to see value where the rest of the market doesn’t. Hence, the analogy with the cigar butt that has been discarded, picked up off the street, but still has a couple of good puffs left in it.
At the London Value Investor Conference last week, stock picker, Ben Preston of Orbis – that’s Allan Gray’s global arm – extolled the virtues of Peabody Energy, the world’s largest private sector coal miner. But a company which declared itself bankrupt in April 2016. It was one of many coal operations that hit the wall after the mineral’s price plunge. Shareholders in Peabody were wiped out in 2016, but thanks to an $800m refinancing from banks, let by Citigroup, the company’s coal mines continued producing. So, last April, a year after opting for Chapter-11 bankruptcy protection, a rehabilitated Peabody re-emerged on the New York Stock Exchange.
While it was off the market the company raised fresh capital at $25 a share, and it traded at that level after returning to the market. Those who jumped into the stock, have enjoyed a 64% paper profit since then. Judging by what the Orbis stock-picker has to say, that’s only the start. While it’s track record and coal’s poor long-term prospects will ensure that many will keep looking at it as a cigar-butt, Peabody shareholders may well be smoking away luxuriously for many years to come. But let’s get the story from the man who told 450 other value investors about it, at last week’s conference.
I caught up with Ben Preston outside the Queen Elizabeth Conference Centre in Westminster, London.
Hi, my name is Ben Preston. I’m one of the portfolio managers at Orbis, on the Global Equity Strategy. I joined Orbis in the Summer of 2000, which means I’ve there nearly 18 years. I joined when I was 23 years old, and I’ve really learnt how to invest by working alongside Allan Gray and his son, William.
And of course, you also knew a great SA investment hero, Simon Marais?
Simon was a great friend of mine. It’s very sad to see his passing but the lessons that he taught me stay with me daily.
Preston had one of the more innovative introductions that you’re likely to come across at any investment conference. Let’s have a listen in.
Good morning. A lot of talk so far about how diligent we’re all are and how much hard work we’re doing so, I think I should just start by saying that in January this year I took time away from the British winter to go to Australia, and I found myself soon after down a coalmine. I can’t necessarily recommend it. In fact, after trudging through green sludge in the tunnels down there, it was quite a relief to get back up to the surface and wash the soot off my face. Which I suppose begs the question, why do it at all? And the answer that I have is that nobody else wanted to.
As contrarian investors, we often find that it’s those really messy, misunderstood, ugly situations that present the best opportunities. When everybody else is pessimistic, that’s often when we find the greatest margin of safety, because it’s precisely that pessimism that means the worst has often already past. As I look around the world today, there’s not that much ugliness out there. So, times are good. The economy is strong. The stock market is relatively high and looking for that really undervalued, unappreciated stock feels a bit like looking for a needle in a haystack. But of course, what we’re really trying to do is the other way around. We’re trying to look for a nice piece of hay.
I think one area where there is still a little bit of residual fear is in commodities, after the big downturn over the last few years. And we’ve found some attractive commodity-related shares, including one that I’d like to talk about today, which is Peabody, which is the world’s largest publicly-traded producer of coal.
During the tea break, we both went outside into the sunshine and unfortunately some gusting wind that played havoc with my recorder’s microphone. While we started chatting I began by complimenting Preston on his unusual introduction to Peabody, this New York Stock Exchange listed coalmining company, which describes itself as, ‘the leading pure coal play investment anywhere in the world.’
They way I started was to say that I had actually been down a coalmine in January and had a slightly rough experience.
While on holiday?
While on holiday. And I had a bit of a rough experience down there. It’s actually, quite tough and grimy and I wouldn’t necessarily recommend it. But it was helpful to see the mines with my own eyes. I think that’s an important part of the research we do, is to really try to make sure we understand the companies we’re investing in, and there’s no substitute for actually rolling up your sleeves and going and visiting.
And then looking at the numbers on the mines itself, and in this case, Peabody was offering great value.
Peabody offers a fantastic free-cash-flow yield and that’s not necessarily a surprise, given that they produce coal and the world is a little bit bearish on coal. I think what came as more of a surprise was when we actually visited the mines. They’re producing at full-pelt, and that caused us to ask questions about why that’s actually happening and it led us down a chain of research that ended up in looking at China and understanding what they’re trying to do with their air pollution.
China consumes and produces close to half the world’s coal, and it’s the difference between those two things that the consumption and the production that determines their imports, their inventories and therefore sets the price. And to really understand the coal market, you have to have an eye on what the Chinese authorities are doing in Beijing. What they’ve been, recently in 2016, they’ve tried to improve the quality of the air by putting in place several coal mining reforms, including closing a lot of mines.
That actually had too much of an impact, production dropped too much and there wasn’t enough coal to go around and therefore, they actually revered course quite quickly. So, to keep an eye on those things is critical if you really want to understand what the future might hold for coal.
How did the coal price react to that change by the Chinese authorities?
Well, having being going down for years, in the years of oversupply, coal suddenly doubled when China restricted its mine activity. And so shocked were they by this development that it was only a few months later that they had to relax those controls and the coal price subsequently dropped back again. Which again, it’s an indication of how important their policy is.
That’s value investing 101. You start by finding a share that the rest of the world hates. Then research whether Mr Market has overdone the anger. And then you embrace complexities that others have ignored and exercise patience while practicing Rudyard Kipling’s immortal lines, ‘If you can keep your head, when all about you are losing theirs.’
I think it’s very difficult to know exactly what the rest of the market is thinking, but from what I read, there’s a big perception out there that coal is basically just dead. So, it’s the fuel of the past, it’s not the fuel of the future and therefore, prices must fall, and for the market it’s kind of as simple as that.
So, how is Peabody priced and are you still buying it?
Peabody, by the way, we don’t necessarily agree with that view. We think the transition from coal to newer sources of energy will take decades and will be quite profitable for companies, like Peabody, during those decades. Peabody, as it happens, is offering something like a 15% or 16% free-cash-flow yield today so, you don’t need very many years of those profits to get your money back.
How many years?
Well, at a 15% or 16% free-cash-flow yield, you’ll get your money back in 6 years. If coal prices go up a bit, it’s more like 3 or 4 years. And so it really depends on what the future might hold.
I also like the pictures that you showed of the smog in London, which gives you perhaps some nice parallels with the likely phasing-out of coal in China.
I think whenever you look at things in investing, there’s usually some kind of historical analogy, and that can be very helpful in trying to understand what the future might hold. In this case, it’s quite a clear one. So, if Beijing is trying to control the quality of its air, we went through exactly the same thing in London in the 1950’s, and it’s amazing that here we are, 60-something years later, and we’re still using some coal.
If you take the London example, how long might it be from – and of course nothing is precise – but how long might it be before the Chinese can start having the impact on the coal-demand equation that will justify the negative outlook that Mr Market has?
Well, just controlling the quality of air doesn’t necessarily mean burning less coal. You can burn higher-quality coal, you can put in place environmental measures at the plant. So, what actually happened in the UK was for another 30 years, until the late 1980’s, coal consumption was still growing. So, this thing can take a long time.
Now, the whole idea of the discussion that you had this morning was to show how value investing or contrarian investing works. How do you start spotting opportunities? Do you just look around the markets and find the dogs, and then see whether they are as mangey as they’re made out?
Yes, pretty much, yes. So, it’s a slightly more precise system than that. So, we buy data in from the data providers. There’s something like ten thousand companies out there that we have in our database going back many, many years of historical financial data. And we can use our own proprietary screening methods to screen for ones that look the most promising. Then we go through them, and a lot of them you can screen out fairly quickly. So, you might have some pharmaceutical company and it looks like it’s very attractive on a free-cash-flow yield but then it actually doesn’t take you long to figure out that all of their patents are coming up for expiration in a few years. So, there’s a reason that the market has the share on a discount. We’re looking for those opportunities where you see the discount and then you can’t really figure out, rationally, why it should be that cheap.
Ben, there must be a lot of opportunities now, given the Fourth Industrial Revolution is wiping out industries, whole industries, but not at the rate that Mr Market thinks that it will be done.
Well, disruption risk is huge. As you say, we are really in a period of rapid disruption and we have to be careful about that because some of these shares that offer great, immediate earnings yields do have long-term poor prospects. So, we need to ensure that we’re not on the wrong side of that disruption, but that just comes down to doing our homework.
What sectors in particular can the amateur or private investors be looking at to try to find these types of opportunities?
Well, Simon Marais used to say, if you want to do an investment then do your own homework. Then if you’ve done that, you should go and ask your friends and family if it makes sense, and if everybody agrees then don’t do it. Because the nature of market pricing means that if everybody agrees then it’s typically already in the price. You have to, as an investor, we have to come up with a share where we have a strong belief in the future, but others don’t share that. Some industries are easier to cover than others. But one area where we have found a little bit of value more recently and it’s fairly simple to analyse, is commodities. So, Peabody was an example of that and another one would be Vale, which is the world’s largest producer of iron ore.
Sorry about the wind, which affected the microphone more than I’d expected. I hope it wasn’t too distracting. Next time, I’ll stay indoors.
So, Orbis is now digging around in the commodity sector for investment jewels. Apart from Peabody, Preston reckons that the Brazilian iron-ore giant, Vale, hasn’t reached fair value yet, and that we shouldn’t be put off by that two-year price surge from around $3.50 to over $14 a share. Vale could still double from these levels, and then some, to get back to the peaks of the last commodities boom.
This has been the Rational Perspective. Until the next time, cheerio.
