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The Golden Trigger

By Paul Lamont

January 21st, 2015

 

 

Oil Speculators

     As you can see from the chart below from Dec. 5th, small speculators bought oil in droves in mid 2014. They have subsequently reduced their positions (or more likely have been getting wiped out) as the price of crude has fallen.

 

 

Compare this to gold, where in 2012 small speculators moved from being the largest net long in 11 years (they were very, very bullish – stay away!) to not only selling their gold positions - but now they are so confident in the fall of gold that they are shorting it by the largest margin in 15 years. This implies a higher gold price in 2015.

 

The Golden Trigger

     One of the items covered by David Dreman in Contrarian Investment Strategies: The Next Generation is the quarterly earnings announcement surprise. Dreman relates that a negative surprise (defined as disappointing Wall Street expectations) does not do much damage to bargain companies; “investors put these stocks into the lowest category precisely because they expect them to continue to mope.” So if there’s bad news, investors are already expecting it. Ho hum. A negative surprise quarter (Dreman’s results from 1973-1996) show a -0.8% loss for a bargain company’s stock price vs. a -4.8% loss for high priced companies (compared to the rest of the stock market). Basically, “Negative surprises result in major drops in the price of favorites, while having virtually no impact on out-of-favor stocks.” Or put another way, if you make sure you are getting the most for your money, you are a lot less likely to take a big hit should a surprise occur.

 

     Prices act differently when positive surprises occur. There is not an equal tradeoff. “Positive earnings surprises result in major appreciation for out-of-favor stocks while having minimal impact on favorites.” When an out-of-favor stock does better than expected, “investors sit up and take notice.” Dreman shows that this ‘surprise’ lasts longer than a quarter – in fact investors do not realize the mispricing right away, the momentum to rejoin the rest of the market continues for the rest of the following year. For Dreman’s results, bargain companies yielded an 8.1% for the subsequent year vs. 1.2% for the high priced glamour stocks. As Joseph Piotroski describes in “Value Investing: The Use of Historical Financial Statement Information to Separate Winners from Losers”; “the market is systematically ‘surprised’ by the future earnings announcements.”

 

So less on the downside, and more on the upside for bargain stocks. Here is an example of risk and reward not being equal.

 

     What could trigger positive earnings surprises in the near future for a beaten down industry? Perhaps, lower energy prices. According to Accenture: “in the metals industry, energy expenditures represent between 20 and 40 percent of production costs.” As an example, Barrick Gold could save “$25 per ounce on lower diesel expenses” according to Metals Focus. 

 

The Inefficient Spin-off (AND A Possible Opportunity for Patient Investors)

     According to Joel Greenblatt; One study at Penn State, covering a twenty five-year period ending in 1988, found that stocks of spin-off companies outperformed their industry peers and the Standard and Poor’s 500 by about 10 percent per year in their first three years of independence.” Why is this? For many reasons, but particularly;

 

“The spin-off process itself is a fundamentally inefficient system of distributing stock to the wrong people. Generally, the new spin-off stock isn’t sold; it’s given to the shareholders who, for the most part, were investing in the parent company’s business. Therefore, once the spin-off’s shares are distributed to the parent company’s shareholders, they are typically sold immediately without regard to price or fundamental value.” Also “many funds can only own shares of companies in the Standard and Poor’s 500 index, and that index includes only the country’s largest companies. If an S&P500 company spins off a division, you can be pretty sure that right out of the box that division will be the subject of a huge amount of indiscriminate selling. Does this practice seem foolish? Yes. Understandable? Sort of. Is it an opportunity for you to pick up some low priced shares? Definitively.”

 

Greenblatt cites three characteristics to look for in the spin-off:

 

1.                  Institutions don’t want it. (And their reasons don’t involve the investment merits)

2.                  Insiders want it.

3.                  A previously hidden investment opportunity is created or revealed.


Let’s apply this list to the recently announced spin-off of BHP’s assets, South 32. For some background, BHP is the world’s largest mining company.


1. Institutions don’t want it. (And their reasons don’t involve the investment merits)
BHP shareholders wanted a widely expected share buyback instead of a spin-off.  So right off the bat, investors that have stuck with BHP through the mining downturn are disappointed. Now BHP plans to jettison its 'unwanted' assets in the new spin-off company, South 32. Analysts have already given the new company nicknames which include: "’Detritus PLC’ or ‘Rubbish Co’, referencing the fact that the premium assets like iron ore are remaining with BHP Billiton." In addition, news that the spin-off would not be listed in London was widely reported. That has since changed, but did that discourage some in the U.K. to research this spin-off further? Who would want a lower price?


2. Insiders want it.
BHP Chief Financial Officer Graham Kerr is the new CEO of the spin-off. Compensation details (dependent on the initial spin-off share price?) to follow in March.

3. A previously hidden investment opportunity is created or revealed.
The spin-off includes the largest and lowest cost silver mine in world. The new corporate structure will have minimal net debt and target an investment credit rating. As the Wall Street Journal reports;  “Indeed, only its iron ore business and a division comprising aluminum, manganese and nickel assets, ironically among them those it is spinning off into a new company, saw operating profit rise last year." Maybe not so 'rubbish' after all.

You can be assured we will be examining the numbers due out in March on this deal.

 

We are currently researching methods to beat the NYSE ARCA Gold Bugs Index (^HUI). We look forward to reporting the results.

 

At Lamont Trading Advisors, we provide wealth preservation strategies for our clients. For more information, feel free to contact us. Our monthly Investment Analysis Report requires a subscription fee of $40 a month. Current subscribers are allowed to freely distribute this report with proper attribution.

 

***No graph, chart, formula or other device offered can in and of itself be used to make trading decisions. This newsletter should not be construed as personal investment advice. It is for informational purposes only.

 

Copyright ©2015 Lamont Trading Advisors, Inc. Paul J. Lamont is President of Lamont Trading Advisors, Inc., a registered investment advisor in the State of Alabama. Persons in states outside of Alabama should be aware that we are relying on de minimis contact rules within their respective home state. For more information about our firm visit www.LTAdvisors.net, or to receive a copy of our disclosure form ADV, please email us at advrequest@ltadvisors.net, or call (256) 850-4161.