Theres always something.., p.15
There's Always Something to Do, page 15
At this period it was fashionable to denigrate all seismic work on Russia’s hydrocarbon deposits conducted prior to the establishment of the Federation. However, James took the trouble to get hold of the old Soviet data on the two fields. Although not considered admissible by AIM market standards, or indeed GAAP (generally accepted accounting principles)-friendly, James felt that the data was sufficiently professional to enable him to make a very fair estimate of Sibir’s share in the recoverable reserves. It added up to about 1 billion barrels, a significant portion of which could be developed for production quite quickly.
Looking at the sum of the parts from that standpoint James calculated that you were paying a mere 10 cents per barrel in the ground for the Russian reserves, well below the value of any other listed Russian oil company. Quite obviously this represented a considerable margin of safety. Peter, however, remained to be convinced as he believed that nothing in Russia was ever straightforward; this certainly proved to be the case with Sibir.
Nevertheless, he made another trip to Russia in the spring of 1999 at the invitation of Brunswick Capital Management and used the opportunity to visit Khanty-Mansiysk in Siberia – the oil capital of Russia:
K-M is located some 2,000 km north-east of Moscow. It was settled by political prisoners in the ’30s and now boasts a population of some 45,000. Oil was discovered in the ’60s and developed until the early ’90s with production reaching 15 million barrels a day – now down to 6 million due to underinvestment and antiquated technology. We visited KMOC, which has roughly a billion barrels of proven and probable reserves. Drilling is developmental, not exploratory. Relative to its price a billion barrels is interesting, but not compelling. There are others, including Sibir, that have similar interests close by and are cheaper.
We visited a rig by helicopter. I was none the wiser but I was impressed in other ways. The local hotel was spartan but clean. The food was simple and hearty. The people were well dressed. I saw one woman in a fur coat that was well cut and had real style. Modern flats are going up, replacing the old wooden huts. Taxes are being paid here: the region is wealthy. A regional investment fund has been created, similar to Alberta. There is an art collection bought at Sotheby’s. A biathlon range for the 2003 world championships is being built. But where is the opera house!?
On his return Peter told James that he thought Sibir might be worth a “punt” in the Mackenzie Cundill Recovery Fund. James set to work immediately with Cannacord, the brokers who had sponsored Sibir’s AIM listing. Sibir was hungry for investment capital and seemed disposed to accept it on very favourable terms for the investor. What they negotiated was a small private placement in the form of a convertible debenture at a small premium to the market – a negligible price to pay, the shares having fallen from 47p the previous June, prior to the Russian crisis, to 10p. In addition to giving them a preferential position over the common equity there was a 12% coupon. It was a small issue in which, with $5 million, they were the largest player, but it gave them an initial stake for the Recovery Fund at an advantageous price with a built-in margin of safety.
It was, nevertheless, to be a bumpy ride. Everything that could go wrong did. Shell tried to squeeze Sibir out of the Salyn oil field by accelerating the cash requirements to bring it on stream to a level it believed Sibir would be unable to support. Sibir’s largest shareholder, Chalva Tchigirinski, who was in a successful real estate partnership with, among others, the mayor of Moscow’s wife, loaned Sibir enough to plug the gap and Shell was eventually obliged to drop its hard-ball tactics. Sibir still had to sell off its UK and Italian assets to fund its Russian developments.
Next Sibir succeeded in vastly increasing its risk by getting involved in a struggle with the “big boys.” By this time Sibir had acquired an interest in a small chain of petrol stations in Moscow in a joint venture with BP and it had a claim to a controlling interest in the Moscow Oil and Gas Refinery, the strategic refiner for the Moscow region with no other competition within a 150 mile radius of the city. The strength of the legal title to this refinery appeared to rest on a personal relationship between Tchigirinski and the mayor of Moscow, or, perhaps more pertinently, the mayor’s wife. Its adversaries were LukOil and Sibneft, then owned by Roman Abramovich, whose angelic face belies a steely determination to achieve his ends, as well as a robustly Russian approach to doing so. In alliance with Tchigirinski and the mayor, Sibir fought the battle in and out of court and emerged successful. It was an important strategic victory because control of the refinery enabled Sibir to sell its production domestically at a significant premium. At the time pipeline capacity for the export of Russian oil was considerably less than the ability of the fields to pump the barrels and the domestic market was not sufficiently developed to be able to absorb the balance except at very low prices. The Urals discount on the world price was at times as high as 50%. The realized net price for the refined product from oil sold to the Moscow refinery was much closer to the international price, so that the value of the quota for processing oil through the refinery was much greater than Sibir’s asset value. But in achieving this control Sibir had put some powerful noses out of joint and the retaliation was swift and ruthless.
Through the mechanism of a series of very extraordinary Extraordinary General Meetings of the partnership group, about which they had not been informed, Sibir’s management woke up one day to discover that their 50% interest in the Siberian joint venture with Sibneft had been unaccountably diluted down to 1%. At the same time certain elements within ministries in Moscow began a series of attempts to confiscate the Salyn oil licence on a variety of spurious grounds, although it ultimately failed. Possibly suspecting that Sibir was an unhelpful associate for a company wishing to do business with the Russian state, BP tried to back out of its retail deal.
All of this turmoil created huge volatility in the Sibir share price, which James Morton exploited to advantage, running and rerunning the “sum of the parts” calculations to reassure himself and Peter that the margin of safety was still intact. It always was. In fact even at the peaks Sibir’s shares never traded at above 40% of the “sum of the parts.” By 2006 the capital gain was five times the investment and in addition James had traded it extremely deftly, enhancing the return to 40% per annum from 30%. Once it became clear that Sibir was not going to be forced into bankruptcy Shell turned into an exemplary partner in the Salyn field, which began to provide substantial cash flow, enabling Sibir to accumulate a considerable cash pile.
But the drama still had one more act. By 2008 Tchigirinski’s real estate operations in Moscow were in serious trouble and he was running out of cash. He invited Henry Cameron, Sibir’s well-respected CEO, to a meeting at his villa in the South of France. It must be supposed that Tchigirinski intimated to Cameron that it was now pay-back time. This time it was he who required a lifeline. No doubt he represented it as being a very short-term emergency and he may have believed that was the case. Cameron was no fool and must have weighed up the situation as a pragmatist with a Russian hat on. The upshot was that the better part of $500 million left Sibir’s bank accounts for Tchigirinski’s, ostensibly as consideration for his Moscow real estate assets. This would have transformed Sibir from an oil and gas production company into a quasi property company. When the news of the proposed transaction was eventually broken to the rest of Sibir’s board, they refused to authorize it. Unfortunately the cash never reappeared and, when this became known, Sibir was suspended from the AIM market and Cameron was summarily fired. Tchigirinski simply disappeared, but bailiffs seized his villa in the South of France, impounded his boats and aircraft, and his Eaton Square home in London was sold for £33 million.
The value of Sibir was impaired but far from destroyed. A case could still be made for a break-up value well in excess of £10 per share and oil prices were reaching ever dizzier heights. It was, nevertheless, Sibir’s weakest moment. Its jugular was exposed and the wolf pack was circling. Renaissance, the Russian investment bank, moved very swiftly, no doubt anticipating that Sibir’s shareholders would be running scared and hoping to secure a kill before anyone else could react. They launched a tender offer at a derisory £2.00 per share and might have succeeded but for Richard Fennels, a lawyer by training, and ex-chief executive of Ansbacher, a City of London merchant bank, now with his own corporate finance boutique and a string of excellent Russian connections. He went straight to the top people at Gazprom Neft, the fifth largest oil producing and refining company in Russia, whom he knew well, and with great skill persuaded them that a knock-out offer to pre-empt anyone else was required. To the immense surprise of many of Sibir’s shareholders, and the relief of nearly all of them, what followed was a clincher bid at £5.00 per share.
Neither Peter nor James was inclined to wait around to pick up the 20p premium available to the “risk arbitrageurs” and the entire position was sold into the “grey market” at £4.80. The Sibir investment had finally turned into a “ten bagger.” If ever there was an illustration of the efficacy of a solid margin of safety, it had to be this. But the rising oil price had done no harm either. The whole saga had been an enormously valuable learning curve whose worth probably far outweighed the, albeit handsome, investment return. It had prepared the ground for a number of other successful investments, particularly by the Recovery Fund, in the more outlandish extremities of the old republics of the Soviet Union. It had given them real insights into how it was possible to generate very substantial profits in post-Soviet transitional economies without being exposed to unacceptable levels of risk. What was required was an asset-based margin of safety significantly greater than would be considered adequate in the more developed markets. It was also fairly obvious that in these less developed markets tangible fixed assets were superior to cash, which had a nasty habit of evaporating.
19
The Canadian Buffett
PETER FIRST MET PREM WATSA back in the 1980s when Prem was an executive at the Confederation Life Insurance Company in Toronto. As they got to know each other they discovered that they had a great deal in common. Like Peter, Prem is a convinced and practising disciple of Benjamin Graham, an admirer of Warren Buffett, and counted Sir John Templeton as a friend, counsellor on many levels, and business mentor. Also in common with Peter, Prem regularly visited Sir John in Nassau and enjoyed his confidence. Sir John was a shareholder of Fairfax Financial, Prem’s company, as well as a unit holder of the Cundill Value Fund.
Peter had been a firm admirer of Prem’s for many years and the respect was mutual. However, on strict value principles he had never found it possible to buy shares in Fairfax since it had never sold below book value; that is, not until 2000. By 1995, after ten years in business under Prem’s stewardship, Fairfax consisted of six insurance companies, an investment management firm, a claims adjusting company, and a Bermuda-based reinsurer. The holding company was extremely profitable and Prem had acquired a reputation for buying up good companies with short term problems that he knew he could fix – and paying a low price to book value. The Fairfax share price had risen over the period from $3.75 to $80.
Between 1995 and 1998 Fairfax went on the acquisition trail as never before, adding Swedish-owned Skandia American Insurance, which doubled its assets. This was followed by Compagnie Transcontinentale de Réassurance, financed by a private placement at a premium to the Fairfax share price. In 1998 there were two more purchases, this time financed with debt to the tune of three times Fairfax’s shareholders’ equity: Crum and Forster Holdings, a Xerox subsidiary that had been on the block for some time so it came at a good price, although with the usual set of problems, and TIG Holdings, both of them serving the US commercial market with TIG specialized in New York.
Investors were enthused about this series of acquisitions and the integration appeared to be proceeding well and according to plan. However 1999 ushered in a season of abnormally severe storms in Europe, resulting in very high catastrophe losses at the same time that investment returns started to falter in the wake of the Russian debt crisis and the failure of the hedge fund Long-Term Capital Management. Underwriting performance was severely hurt and Fairfax’s return on equity fell below 20% for the second year running. The share price suffered, falling from $228 to $164, below book value for the first time in the company’s history and into Peter’s sights. In the spring of 2000 Peter bought $122 million of Fairfax at an average price of $171. It was the biggest single position that any Mackenzie equity fund had ever had.
In the soul-searching that had followed the Cable & Wireless loss, Peter had suggested that with respect to any investment where the CIR group were unanimously favourable, there was a strong case for appointing a devil’s advocate to argue a contrary view. In the Fairfax case that would have been quite unnecessary: CIR had recently acquired a bright new analyst who was anxious to make his mark. He was given the responsibility of following the Fairfax investment on a day to day basis and he set about doing so with a vengeance, concluding that there was a very high probability Fairfax could run into difficulty. Neither Peter, nor Tim McElvaine, who ran the Mackenzie Cundill Canadian Security Fund, nor Wade Burton, who oversaw the Canadian investments of the main Value Fund, was greatly bothered. They were convinced that there was a very adequate margin of safety within the assemblage of Fairfax’s assets, without which it would not have been bought. However, the young man was both persistent and voluble on the subject and so, when the stock spiked up again nine months later, Peter cut the position in half at an average of $217.
It was a fortuitous decision, although not for the reasons advanced by his young colleague. 9/11 intervened, hitting TIG, with its New York bias, especially hard and tipping Fairfax into loss for the first time ever. Despite Fairfax being more than adequately capitalized, particularly as a result of the IPO of Odyssey RE, its main reinsurance vehicle, which had netted the parent company over $400 million, the share price plummeted. Peter stayed with the position, relying on his estimate of Prem’s ability to steer Fairfax out of troubled waters and on the detailed asset analysis put together and continuously updated by Wade Burton.
Peter’s confidence was fully justified as Prem did an about-face on Fairfax’s strategy of growth through acquisition to focus on internal growth and a drive for new business to pull in the premiums. The change of tack was very quickly rewarded. Not only did Fairfax return to profitability in 2002, it made the largest profit in its history – $415 million, attributed by Prem to a combination of positive response to the sales push in the form of an influx of premiums as well as above average investment returns. Initially the shares bounced back sharply to over $200.
However, as with all myths of invincibility, it takes just a single reverse to shatter the illusion. Investors had not really regained their confidence and negative rumours about Fairfax abounded, most of them with scant foundation or riddled with inaccuracies. The problem, however, was that at this juncture investors were prepared to listen and the bears were out in force. The stock price began to drift downward again.
Fairfax pipped up to another peak in earnings in 2003 but this was followed by two years of losses. These were industry-wide, as a result of the worst hurricane seasons in US history, but for Fairfax no excuses were acceptable. Ordinary bears had metamorphosed into a pack of aggressive short sellers intent on destroying the company if they could. Within CIR Wade Burton remained Fairfax’s staunchest ally, supported by Peter, whose confidence in Prem was still amply reinforced by his conviction that the sum of the parts calculation provided a more than adequate margin of safety. When he was approached to lend out his stock in Fairfax, clearly in order to facilitate the short sellers, he refused emphatically and, as the shares fell back from $200 to just above $100 in 2005 and 2006, the investment was more than doubled. It was added to again in early 2007.
By this time there was an additional reason for the holding. In his letter to shareholders accompanying the Fairfax annual report in 2004 Prem had enunciated his doubts about securitized products.
We have been concerned for some time about the risks in asset backed bonds, particularly those backed by home equity loans (we own no asset backed bonds). It seems to us that the creation of these asset backed bonds eliminates the incentive for the originator of the loan to be credit sensitive … With securitization, the dealer [almost] does not care as these loans can be laid off through securitization. Thus, the loss experienced on these loans after securitization will no longer be comparable to that experienced prior to securitization. This is not a small problem. There is $1 trillion in asset backed bonds outstanding. Who is buying these bonds? Insurance companies, money managers, and banks – in the main – all reaching for the yield given the excellent ratings for these bonds. What happens if we hit an air pocket?
At that time the reassurance that Fairfax was clean of such instruments gave Peter additional comfort with respect to the solidity of his margin of safety in the company. However by 2006, as the banks’ leverage ratcheted up from 10:1 to 50:1, Peter was as deeply concerned about the time bomb in the financial system as Prem.
During the early 1990s a new instrument had emerged, known as a Credit Default Swap: in effect an instrument that allowed the purchaser to protect himself against the default of any traded instrument in exchange for the payment of a fairly small “premium,” or spread, over the relevant Treasury Bill rate. By purchasing “naked” CDS’s, that is without actually owning the instrument against whose default one was purchasing protection, one could speculate against any credit. Prem was by then supremely pessimistic about the likelihood of a major financial catastrophe caused by a collapse in the securitized bond market and had begun to buy “naked” CDS’s on this class of paper very aggressively. Although equally pessimistic, Peter was not permitted to do this in a mutual fund, so that the most effective way in which he could back his judgement was to participate by proxy through owning shares in Fairfax.
