A few disclosures – This is a borrowed idea. I will not use the word steal, as I got it from a friend 🙂

This idea was published by Ayush on his blog (see here) and then he mentioned it to me via an email. I was intrigued by the extremely low valuation (which is not obvious) and some medium to long term triggers.

I started looking at the company in the month of December, and before I could create a full position, the stock price ran up. Inspite of the run up, the company is an interesting, though speculative opportunity.

Another disclaimer – I hold a small position in my personal portfolio, but as it is a speculative idea, I have not added it to my family or the model portfolio.

The company
The name of the Company is Selan exploration and it is an E&P (exploration and production) company. The company has five oilfields – Bakrol, Indrora, Lohar, Ognaj and Karjisan

As part of the NELP policy, the company has the rights to explore and develop these oil fields. The company was among the first private sector players to get the rights to do so and if successful in finding oil and gas reserves, they have to pay a certain level of royalty to the government. In addition, the entire production of the company is taken up by the government or PSU under the production sharing contracts

The E&P business

The basics of exploration and production are actually quite simple to understand – The government grants the license to explore and exploit a specific area which may be rich in hydrocarbons, under a specific contract. The company winning the contract then undertakes exploration of the area using various advanced technologies such as 3D seismic surveys and exploratory drilling to identify the size of the reserves and the best location to drill wells to exploit these reserves.

Once the reserves are delineated (identified), the company applies for the various clearances (such as environmental) which once approved, allows the company to drill production wells. Although the technology is quite advanced and allows a company to identify deposits accurately, it is not a precise science and hence a certain percentage of the wells may turn out to be dry wells (not enough oil in that particular location). These dry wells have to be abandoned and the cost has to be written off (similar to a product which fails in the market).

The productive wells, once online produce oil and gas which is transported via pipelines or other means to oil refineries.

The problems
Let’s start with the problems which have caused the stock price to stagnate over the last few years. That will also give us an idea of the medium and long term triggers for the company.

The company was granted the exploration rights in the 90s and has been able to increase the production from 62000 BOE in 2004 (barrel of oil equivalent) to roughly 2.82 Lac BOE in 2009. I described the process of license, survey, clearances and approvals to get to the final production stage of drilling the production wells and pumping out the oil.

As you see from the process, we have government involvement at each step and anything where the government is involved means lack of clarity and uncertain timelines.

As has happened for multiple sectors in the economy, the clearances for drilling production wells came to a halt in the last four years. Due to the nature of oil exploration and production, the current wells start getting exhausted in time and if you are not drilling new wells, the overall production starts dropping.

In case of Selan exploration, production dropped from 2.8Lac BOE in 2009 to 1.64 Lac BOE in 2013. The revenue dropped from 99 Crs to around 97 Crs in 2013 and the net profit was roughly the same (at around 45Crs)

A mumbo jumbo of terms
Before I get into what is the opportunity here, let’s talk about a few terms for the Oil and gas industry. For starters, barring Selan and Cairn (I), I don’t think the PSUs in this sector are worth considering as investments. These companies are run as piggybanks by the government to subsidize fuel in the country. It is debatable on how good that is for me as a citizen, but I am clear that it is a disaster for a shareholder.

If you want to understand how the industry works (without the chaos of government interventions), you may want to look at US and Canada based companies such as Chesapeake, Devon energy or Exxon Mobil. If you are looking at a pure play E&P Company, there are several small companies such as Novus energy or Jones energy.

Why bring up these non Indian companies? Any US or Canada based company has to declare several key parameters which help an investor to analyze an exploration company. Some of those parameters are

2P reserves (proved and probable reserves)

Operating netback per BOE : revenue minus cost

NPV10: DCF valuation of the reserves (revenue based)

EV/BOED: Enterprise value/ Barrel of oil equivalent in reserves (valuation measure)

Cost curves, EUR, Exploration cost and well IRR (for each field)

Current oil flow rate (BOED) to understand the current revenue levels

You can find the definitions easily by doing a Google search for these terms.

So which of this data is provided by Selan exploration? None!

Are they doing anything illegal? No, because I don’t think there are clear disclosure norms on the above for Oil and gas companies in India (none that I could find). In comparison, Cairn (I) has more disclosures and communication.

The thesis
In absence of this disclosure, why even bother and move on to something else? That is a valid point and hence I have called it a speculative bet as I am making it with minimal information.

What do we know here?

For starters, it seems that the company has 79.2 Million (7.9 Crore) BOE of reserves in two fields alone (Bakrol and Lohar). The company sells at around 1.2 dollar/ BOE (EV/2P) versus 5.5 for cairn (I). Comparable companies in the US/Canada sell at around 8-12 dollar/BOE. Of course the foreign companies are not comparable, due to a very different regulatory environment.

In addition to this valuation gap, we are not even considering the potential reserves in the other fields (which seem to be bigger than the ones in production). So we are talking of a situation where the market is valuing the company based on the current production rate (Which is suppressed due to lack of approvals) and is not giving any credit for its reserves.

The company is able to generate a pre-tax profit of around 70 dollars / BOE versus 10-25 Dollars for the US/ Canada companies. The huge difference is due to the fact that Selan produces mostly oil compared to oil and gas in case of other companies.

So the company is very cheap based on known reserves and is also quite profitable. In addition the company has spent close to 65 Crs in the last three years on exploration expense (remember the surveys to find the oil and gas reserves?). Once it starts getting the approvals, it can start drilling the wells and start pumping out money …sorry oil.

So why is this still speculative or contingent? It is contingent on the company receiving approvals – Which is seems to be getting recently based on the update in the latest quarterly report. These approvals are based on the whims and fancy of our government and one can never be sure what will the scenario be next year.

Why is it speculative – because there is so little disclosure and we are using the reserve numbers from a past annual report? We do not have any clear updates in the latest reports and so it is like driving with a foggy windshield window.

I have taken a small bet on the company to track the company and may buy or sell in the future based on new developments. As always, please do your homework and make your own decisions.

 
 

I wrote earlier about a Darwinian approach to portfolio construction. This approach involves the ranking all the stocks in a descending order and replacing the last position with a better stock/ idea. The key concept behind this idea is to replace the weakest position with a stronger one and thus improve the portfolio quality.

I did not discuss about how to rank the various stocks in the portfolio. I will discuss the business aspect of the ranking in a future post. Let me share some thoughts on how to consider valuation when doing this exercise.

A 2X in 3 years

As the title suggests, I have now started asking a question for each position (at the time of quarterly and annual results) – Does this position have the potential to double in 3 years ?

Note the use of the word  – potential. One can never be sure if the stock would double.

How does one look at the potential ? There are two variable driving the stock price – earnings growth and valuation. Lets say the stock is selling at intrinsic value and the earnings are growing at around 24% per annum. At the risk of over simplifying (and not stating some additional factors), we can expect the stock to increase at roughly the same rate and thus double in 2 years.

If however the stock is selling below fair value, then we may get an additional bump from an increase in the PE ratio. However I would prefer to place a higher wieghtage on the earnings growth than the valuation – which depends more on the whims of the market.

Not a scientific exercise

One can easily find a lot of flaws in the above thought process. You can argue that, no one knows the market situation three years from now. In addition, the company performance may turn out to be much lower than expected, thus negating the entire exercise.

All the above points are true and I could add more. However the point of the entire exercise is to look at the potential of each stock (atleast annually) and assess its attractiveness based on new information. It is easy to fall in love with a position (especially in my case) and hang on to an old thesis, whereas the world around the company has changed completely.

What do to with such cases

Lets say you identify a stock where the potential return is unlikely to be 2X in 3 years. What now ? do you sell and buy another stock ? What if you don’t have another idea ?

Lets bring in the concept of opportunity cost. Lets say you dont have a better idea. Then the alternative is to sell and invest it in a fixed income instrument. Is the opportunity cost around 9% then? .

I don’t think so. I would say the opportunity cost is the average returns you have made over the long term. Lets assume that your portfolio has returned  15% per annum on average in the last 10 years. I would say that this is your opportunity cost and the existing position has to be above this threshold to remain in the portfolio

Why is this your opportunity cost ? The reason is simple – you have been able to make this return in the past on average and if you sell the existing position and hold cash, something will surely come up in time to deliver this kind of return. You may not make this return the next month or next quarter, but can expect to make it over the next few years.

So the question to ask is – does this position meet my opportunity cost threshold? If yes, hold on to it till you can find a better idea – preferably a 2X or 3X in the next few years.

 
 

I ran a few ‘experiments’ during the year, some of which I wrote about on the blog. As the year draws to a close, I am preparing the report card and as always it’s a mixed one – Lots of D and F and not a single A 🙂

One point to keep in mind is that I run these experiments with miniscule amounts of money. The emotional pain is no less if the experiment fails, but the damage to the wallet is minimal (as my wife puts it, everyone needs their vices :)).

Let’s look at some of these experiments, learnings and plans for next year.

Buying dirt cheap stocks

The main ‘idea’ behind these positions was that the stock was dirt cheap and hence once the pessimism cleared, the price would bounce back

Let’s look at two cases under this category

Business cycle related

The capital goods sector has been hit very hard in the last few years and the news worsened during the year. As I wrote in this post – ‘How I think about macro’, I personally thought the pessimism around this sector was overdone and one could look for some quality firms in the industry to take a position at rock bottom valuations.

My pick was BHEL as it was selling at a 10 year low in terms of valuation (you can download my calculations from here) and I personally thought that if the company could be profitable even under such trying circumstances, then it was worth a bet.

You can see the price action below

Capture

As you can make out, my timing was hardly perfect. I was early and averaged down as the price kept dropping. My average cost worked out to around 120 and my sale price was around 160, resulting in around 35% gain during the period

So what’s the grade ? It’s a B at best for the following reasons

Learnings

–          I don’t have timing skills and this episode proved it again. I care about buying at the right price rather than at the right time. However in the above example, it is important to get the timing right too, otherwise one will have to wait for a long time. A number of fellow investors I know are experts at this – but I am not. As a result, this type of investing has rarely worked for me.

–          Due to the lack of timing skills (and being aware of it), I have been hesitant to create a large position in such opportunities. The result of a small position is that a 33% return, does not move the needle on the portfolio. As a result, buying such kind of stocks, which I do not plan to hold for the long term are just a waste of time (for me)

–          These kinds of timing opportunities in the end may just be good to keep me entertained, but will not add to my returns in the long run.

Management issue

I wrote about zylog here. I  laid out the argument for this position in the post and the reason for the eventual exit.

What was the net result ? A 70% loss and an F grade.

It is easy to look at this episode with hindsight bias (management was suspect and hence one should not touch the stock).  Around the same time last year, I was looking at some high profile cases of failure (read here) and wanted to test the following hypothesis – is it possible to figure out management fraud from publicly available documents such as annual reports (market grapevine does not count).

I looked at zylog and saw that the stock had dropped to around 20% of its peak price. As I could not find anything suspicious in the documents, I decided to create a tiny position in the company.

The above trade turned out to be a disaster as it soon became known that the management was indulging in insider trading.

Learnings

–          The above action by a management would land it in jail in most countries. In India, they are just prohibited from trading in the market. Should we still wonder, why the small investor does not trust the stock market ?. I learnt a powerful lesson from this episode  – if there is some smoke, there is usually a fire.

–          As a small investor, I am a sitting duck and can be taken for a ride by a management if they wish to do so, without any consequences. The best bet for me is to have zero tolerance for management ethics. If something is fishy, don’t touch the stock, no matter how attractive the idea.

Value trade

I wrote about this short term opportunity here. As I noted in the post, this is a stock which had become cheap for  short term reasons (quarterly earnings miss), though there was no long term issue or any management concerns.

The idea was to buy the stock dirt cheap and sell once the short term pessimism wears off. The price action of this trade is given below

Capture2

So what was the net result – around 40% gain and I would give myself a B+.

This type of investing is more suited to my personal temperament. I am able to analyze that the market is being too pessimistic due to short term factors. If the business is doing fine and there are no management issues, I am able to take a mid size position and make reasonable returns over a one year time frame.

These kinds of opportunities are not risk free (infinite computers has its own issues) and there is always an element of luck in it. However, some of these opportunities can act as placeholders for cash, if I cannot find something better to do.

Not all trading

If you have started reading my blog recently, you may feel that I am into short term trading. That is miles from the actual reality. The above cases, are just experiments on the side, representing not more than 1% of my personal portfolio.

Why do it ? I will put it down to curiosity. I just like to explore different approaches and see how they work out. In the end, most of them turn out to be unsuitable to my temperament. I am not saying that these are not valid approaches (others may do it well), but just that they don’t suit my temperament,

The long term changes

The key change I have been focusing on my core portfolio, is moving towards higher focus or concentration. I have kept a fairly diversified portfolio in the past with majority of positions under 10% of the total portfolio. I have now started increasing the size of some positions where I have a higher level of confidence in them.

Chicken that I am, the move is likely to be very slow and measured.

—————-
Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.