Latepost Teach Where It Is Darkest: When Company, Country, Currency In Addition To Commodity Endangerment Collide!

You larn valuation (and notice out how much yous don't know) past times valuing businesses together with companies, non past times talking, reading or ruminating nigh doing valuation. That said, it is natural to desire to value companies amongst profit-making histories together with a well-established job concern models inwards mature markets. You volition receive got an easier fourth dimension edifice valuation models together with yous volition brand it at to a greater extent than precise estimates of value, but non only volition yous larn lilliputian nigh valuation inwards the process, it is too unlikely that yous volition notice immense bargains, because the same qualities that made this companionship like shooting fish in a barrel to value for yous too brand it easier to value for others, together with to a greater extent than importantly, easier to price.

I believe that your biggest wages is inwards valuing companies where at that spot is doubtfulness nigh the future, because that is where people are most probable to abandon valuation offset principles together with croak amongst the herd. So, if yous are a long-term investor interested inwards finding bargains, my advice to yous is to croak where it is darkest, where micro together with macro doubtfulness swirl around every input together with where every gauge seems similar a stab inwards the dark. I volition non claim that this is like shooting fish in a barrel or comes naturally to anyone, but I receive got a few coping mechanisms that piece of work for me, which I depict in this paper.

While I taste valuing companies amongst uncertain futures, at that spot are cases where my silence nigh valuation is disturbed past times the meeting of multiple uncertainties, piling on together with feeding of each other to create a maelstrom. In this post, I desire to focus on 2 companies, 1 Brazilian (Vale) together with 1 Russian (Lukoil), where bad corporate governance, a spike inwards province risk, currency weakness together with plunging commodity prices receive got conspired to devastating result on their stock prices. You could adopt the really unsafe contrarian strategy that Vale together with Lukoil must endure inexpensive only because they receive got dropped so far, but I don't receive got the tummy for that. I do believe, though, that if I tin flaming notice ways to deal amongst this risk, at that spot may endure chance inwards the devastation.

Background, history together with marketplace standing

Vale is 1 of the largest mining companies inwards the world, amongst its largest holdings inwards Fe ore, incorporated together with headquartered inwards Brazil. Vale was founded inwards 1942 together with was solely owned past times the Brazilian authorities until 1997, when it was privatized. In the terminal decade, every bit Brazilian province demand chances receded, Vale expanded its attain both inwards terms of reserves together with markets good beyond Brazil, together with its marketplace capitalization together with operating numbers (revenues, operating income) reflected that expansion.

In U.S.A. dollars

Notwithstanding this long-term tendency trace of growth, the terminal twelvemonth has been an specially hard menses for Vale, every bit Fe ore prices receive got dropped together with Brazilian province demand chances has increased (leading into a presidential election that was concluded inwards Oct 2014). The graph shows Vale's stock cost over the terminal half-dozen months (and contrasts it amongst some other mining giant, BHP Billiton).

While declining commodity prices receive got affected both companies adversely, annotation that Vale’s stock cost has dropped to a greater extent than than twice every bit much every bit BHP’s stock cost has. In fact, Vale has lost closed to $130 billion inwards marketplace capitalization since 2010.

Lukoil is a Russian crude companionship that has seen its profile, marketplace capitalization together with revenues ascension every bit Russia's crude production has surged. While the companionship is non owned past times the Russian government, it does receive got closed ties to the Russian might construction together with that connection, which has served it good during its lifetime, has croak a liability inwards the aftermath of the Russian adventures inwards the Ukraine, compounded past times the collapse of crude prices inwards the terminal few weeks:

In U.S.A. dollars

Though at that spot are cardinal reasons for the stock cost turn down at both Vale together with Lukoil, the fearfulness constituent is clearly too at play, because these companies are exposed to demand chances non only to commodity together with province demand chances but at that spot are too important concerns nigh corporate (or is it political) governance at both companies every bit good every bit currency demand chances factors (as both the Brazilian Real together with the Russian Ruble receive got slid over the terminal few months).

Corporate governance risk

In a postal service on Alibaba, I made the declaration that corporate governance affects value past times making it to a greater extent than hard (if non impossible) to modify management, together with so increasing the demand chances that a companionship that embarks on the incorrect course of teaching may proceed on that path unchecked. With both Vale together with Lukoil, at that spot are both explicit together with implicit reasons to believe that investors inwards these companies volition receive got lilliputian or no say inwards how the companionship is run.

The house to start analyzing corporate governance is the ownership structures of the company. With Vale, the offset sign that corporate governance is weak is the fact that they receive got 2 classes of shares (and yes, I would brand this declaration nigh Google together with Facebook every bit well). In the graph below, I pause downward the top stockholders inwards both classes.

The mutual stockholders, who command the composition of the board of directors together with the voting rights of the company, are held past times Valepar, a trounce entity controlled past times within investor groups. If yous ain Vale shares, every bit I do, it is really probable that yous ain the non-voting preferred shares together with that yous receive got no say inwards who sits on the board of directors together with how the companionship is run. There is too a wild carte inwards this equation inwards the shape of a golden percentage that is owned past times the Brazilian government, giving it veto might over major decisions together with the trace betwixt corporate together with political governance becomes a fuzzy one. While Vale is nominally an independent company, the Brazilian authorities reserves the correct to intrude inwards its management, together with that might tin flaming endure used to practiced together with bad effects. The positive is that it gives Vale a leg-up on contest inwards Brazil, giving it offset dibs on Brazilian reserves of Fe ore, together with the negative is that the companionship tin flaming croak a pawn inwards political games. Much of Vale's success inwards the terminal decade came from a willingness on the part of the Brazilian authorities to give it gratis rein to endure run every bit a profit-making entity, but the machinations leading upward to the terminal election (where the incumbent, Dilma Roussef, was viewed every bit to a greater extent than probable to interfere inwards the company's operations) receive got taken their toll. (The impairment has been fifty-fifty greater at Vale's dysfunctional twin, Petrobras, Brazil's crude company).

Lukoil's ownership construction provides some clues to both why it has been successful together with the potential corporate governance nightmares ahead. The practiced word is that Lukoil has only 1 grade of shares outstanding, amongst equal voting rights, but the bad word is that it is non quite clear whether yous volition ever acquire to vote for meaningful change, making it akin to a Russian political election:

Source: Bloomberg

The atomic number 82 stockholder is Vagit Alekperov, formerly Russian deputy government minister for crude production. It is solely possible that he accumulated substantial knowledge nigh the crude business, piece inwards the ministry, together with brought that knowledge together with entrepreneurial zeal into play inwards founding Lukoil, but it is too probable that he used his connections amongst the might elite to acquire reserves at good below fair-market prices inwards edifice upward the companionship which would brand him obligated to maintaining practiced relations amongst the inner circles of Russian government. In September 2004, ConocoPhilips bought 7.6% of Lukoil's shares to create what it termed a strategic alliance, which it increased to closed to 20%, earlier selling its stake inwards 2011 at an undisclosed price, partly to Lukoil together with partly inwards the opened upward market. It is a wretched commentary on corporate governance inwards Russia, that Lukoil, inwards spite of its flaws, is a paragon of stockholder accountability, relative to most other Russian companies. Notwithstanding this relative standing, if yous are considering buying shares inwards the company, it should endure amongst the recognition that yous volition receive got no role inwards how the companionship is run (no affair what yous read nigh corporate governance on the company's website).

Country risk

While investing is e'er risky, it is riskier inwards some countries than others, partly because of where the countries are inwards terms of its life wheel (with growing emerging markets beingness to a greater extent than volatile than established mature markets), partly because of the overlay of political demand chances inwards the countries together with partly because of the effectiveness or lack thereof of legal protection together with enforcement of holding rights. When valuing companies, yous receive got to constituent inwards where the companionship operates to stair out its exposure to province demand chances together with contain that demand chances into an expected return.

As a commodity company, Vale does sell into a global marketplace together with every bit a producer of Fe ore, it gets a important portion of its revenues from China, which is the largest consumer of Fe ore inwards the world. The province of incorporation inwards Brazil, together with Vale is exposed disproportionately to Brazilian province risk non only because a important proportion of its reserves are inwards Brazil, but too because the authorities has powers to intrude inwards the day-to-day running of the business. Not surprisingly, Vale has been affected by changes inwards perceptions of Brazilian province risk. Using the sovereign CDS spread for Brazil every bit a proxy for province risk, together with looking at the terminal decade, hither is what nosotros get. As Brazilian province demand chances has declined over much of the terminal decade, Vale benefited, but province demand chances is a double-edged sword. As Brazilian province demand chances has risen inwards the terminal few weeks, Vale has felt the hurting inwards the market:

It goes without maxim that Lukoil, which has 90.7% of its reserves inwards Russia, is affected past times Russian province risk. Here again, the terminal decade has been a practiced 1 for both Russian Federation together with for Lukoil, every bit lower province demand chances (measured amongst the CDS spread) for the sometime has gone amongst higher marketplace capitalization for the latter. To investors who were expecting to a greater extent than of the same, this twelvemonth must receive got been a shock, every bit Russian province demand chances surged inwards the aftermath of the events inwards the Ukraine.

In both companies, province demand chances has clearly played a role inwards the drib inwards stock prices. With Vale, at least, it cannot explicate the entire cost drop, since Vale has dropped to a greater extent than than the Bovespa over the terminal few months together with a lot to a greater extent than than the index over the terminal few years. With Lukoil, a greater portion of the blame tin flaming endure attributed to province risk.

Currency risk

When valuing private companies, it is mostly practiced do non to endure a currency forecaster together with to value the companionship based upon prevailing telephone substitution rates (current together with forward, from the market). It is too undeniable that currency movements inwards your favor volition brand a bad investment into a practiced one, just every bit currency movements against yous tin flaming plough a practiced investment into a bad one.

With Vale, the phase was laid inwards a decade where the Brazilian Real strengthened against the U.S.A. dollar, fifty-fifty though inflation inwards Brazil was much higher than inflation inwards the US. As amongst province risk, the currency demand chances dragon has turned on investors together with the terminal few weeks has seen a meltdown inwards the value of the Brazilian currency.

Source: Bloomberg

The story is similar for Lukoil. Influenza A virus subtype H5N1 decade of a strengthening ruble, inwards spite of fundamentals that would propose otherwise, has been followed past times the collapse inwards the terminal few months.

Source: Bloomberg

While the immediate result of a currency turn down is that your investment inwards these companies volition endure worth less inwards U.S.A. dollar terms (simply because of the translation effect), it is debatable what the result of a weakening currency volition endure on both companies over time. To the extent that their reserves are inwards Brazil (at to the lowest degree for Fe ore, for Vale) together with inwards Russian Federation (for Lukoil), the costs are inwards the local currencies but their revenues are inwards global markets, denominated inwards U.S.A. dollars. Thus, a weakening of the currency tin flaming improve earnings margins together with increment value.

Commodity cost risk

Do commodity prices impact the value of commodity companies? Stupid question, right? Of course, they do, but the storey of impact tin flaming vary across companies. Higher commodity prices volition mostly force upward revenues together with to the extent that the cost of developing reserves stays stable, operating margins volition increase. In some cases, though, together with specially so amongst crude companies, the authorities tin flaming usage a heavy manus (see political demand chances inwards the corporate governance section) together with forcefulness the companionship to sell crude at subsidized prices to consumers inwards the country, effectively creating a subsidy cost for the companionship that volition increment amongst crude prices.

Vale's fortunes receive got risen every bit the Chinese economic scheme has grown, primarily because Communist People's Republic of China has croak the largest consumer of Fe ore inwards the world. It is robust Chinese growth that lifted Fe ore prices inwards the terminal decade to hitting highs inwards 2011, but that engine has slowed together with every bit it has, Fe ore prices receive got dropped inwards the terminal 2 years:

This history shows why making a judgment nigh a normal cost for Fe ore is so hard to do. If your historical perspective is restricted to just the terminal few years, the electrical flow cost of Fe ore (about $75/tonne) is depression but extending that perspective to encompass a longer fourth dimension menses (say 20-25 years) may propose otherwise.

Lukoil too benefited from the increment inwards crude prices inwards the terminal decade, driven partly past times geopolitics together with partly past times the explosive surge inwards automobile sales inwards emerging markets. Here again, though, the terminal few months receive got seen a turn down inwards crude prices to less than $80/barrel.

Source: Bloomberg

As amongst Fe ore, the interrogation of whether crude prices receive got dropped below a normal cost is largely a component of perspective, amongst the respond beingness yes, if yous receive got 2 or 3-year perspective but non if yous receive got a ten-year or longer perspective.

While it is like shooting fish in a barrel to brand the declaration that commodity prices displace inwards cycles together with that what goes downward has to croak dorsum upward again, these cycles are unpredictable together with tin flaming stretch over long fourth dimension periods. Thus, yous could receive got spent the entire 1980s waiting for crude prices to croak dorsum up, just every bit yous would receive got waited the entire terminal decade for the drib dorsum inwards prices.

Valuing Vale

The value of Vale is a component of company, country, currency together with commodity risks. To capture the effects, I valued Vale inwards U.S.A. dollar terms together with assumed that Vale was a mature company, growing at 2% a twelvemonth inwards perpetuity. I varied the next inputs:

Operating income: The operating income inwards the trailing 12 months, through Nov 2014, was $12.48 billion, good below the operating income inwards the terminal financial twelvemonth ($17.6 billion) together with the average operating income over the terminal v years ($17.1 billion).
Return on capital: The render on uppercase inwards the terminal 12 months was 11.30%, higher than the cost of uppercase that I estimated of 8.59%, but lower than the render on uppercase inwards the most recent financial twelvemonth (14.90%) together with the average over the terminal v years (18.22%)

To gauge the cost of capital, I built off the U.S.A. 10-year treasury bond charge per unit of measurement every bit the demand chances gratis charge per unit of measurement together with used an equity demand chances premium of 8.25%, reflecting a weighted average of the equity demand chances premiums across the countries where Vale has its reserves (60% are inwards Brazil). You tin flaming cheque out the spreadsheet yourself together with modify the numbers. I receive got summarized the valuation inwards the flick below.

Note that I receive got attempted to contain the result of commodity cost declines together with currency devaluation inwards the base-year operating income, choosing to value the company, using the depressed income from the terminal 12 months. The effects of corporate governance are captured inwards the investment together with financing choices made past times the theatre (with reinvestment together with ROIC mensuration the investment policy together with the debt mix inwards the cost of uppercase reflecting financing policy). Finally, the province demand chances is incorporated into the equity demand chances premium (where I used demand chances premium weighted past times the geographic distribution of Vale’s reserves) together with the default spread inwards the cost of debt. The value per percentage that I acquire amongst this combination of assumptions is $19.40, good higher upward the percentage cost of $8.53 on Nov 18, 2014.

It is solely possible that I am nether estimating how much farther Fe ore prices tin flaming drib together with the impairment that the Brazilian authorities tin flaming (to Vale, the Brazilian existent together with to province risk). I tried varying the numbers to encounter the impact of changes inwards my inputs on the value per share:

I am for certain that I am missing something but at the stock cost of $8.53 on Nov 18, 2014, it looks grossly nether valued. Even inwards my worst illustration scenario, where operating income drops some other 20% from the already depressed LTM seat out together with the companionship earns only its cost of uppercase from this indicate on, my value per percentage is $13.60.

Valuing Lukoil

I followed a similar path for Lukoil. In my base of operations case, I left operating income at 20% below the estimated 2014 together with valued the theatre every bit a stable growth theatre (with a 2% growth rate) together with amongst a cost of uppercase that reflects an updated equity demand chances premium for Russian Federation (9.50%). Even if I assume that crude prices drib past times some other 20% together with that the standoff over Ukraine volition non halt presently (translating into higher equity demand chances premiums), the value per percentage that I acquire is $50.56, higher than the stock cost of $45.30.

At $45.30 a percentage on Nov 18, 2014, I am 1 time to a greater extent than either missing something profound or the stock is massively nether priced. Here again, yous tin flaming download the spreadsheet together with brand your ain choices.

What now?

It is like shooting fish in a barrel to come upward up amongst reasons non to purchase Vale together with Lukoil correct directly together with hold off for things to acquire better. Could things worse? Of course? With Vale, at that spot are 2 Doomsday scenarios. In the first, together with I promise that this does non happen, to a greater extent than for the sake of my Brazilian friends to a greater extent than than because of concerns nigh my investment portfolio, Brazil could croak Argentina, amongst spiking province demand chances together with shaky ownership rights. In the second, Chinese infrastructure investment comes to a standstill together with Fe ore prices drib dorsum to pre-2003 levels. I scream upward that these are low-likelihood events together with that is exactly why I already ain Vale (and I am non inwards the to the lowest degree combat ashamed to acknowledge that I bought my shares at $12/share) together with innovation to add together to my holdings.

With Lukoil, at that spot is the Putin wild card, where the troubles inwards Ukraine expand into Poland, Republic of Hungary together with the residue of the old Soviet empire. That, combined amongst a collapse inwards crude prices, would brand me regret my investment, but I innovation to purchase Lukoil to my portfolio, together with alive amongst the discomfort of having no might to exert change. After all, at the correct price, yous tin flaming alive amongst a lot of discomfort!

If yous are tempted to complain nigh how much uncontrollable demand chances yous human face upward investing inwards Vale together with Lukoil, hold inwards demand heed 2 facts. The offset is that they are bargains exactly because of the uncertainty, every bit global investors flee from he companies, abandoning practiced feel along the way. The minute is that it could endure worse, since yous could endure holding Petrobras (instead of Vale) together with Rosneft (instead of Lukoil) where the concerns are multiplied.

Attachments:
Vale: Financial Summary (Historical)
Lukoil: Financial Summary (Historical)
Valuation of Vale (November 2014)
Valuation of Lukoil (November 2014)