Many investors wouldn’t have touched Whitehaven Coal with a hazmat suit on. It was January 2016 and thermal coal had just hit US$47/ton. Under the weight of $925m of net debt, Whitehaven’s market capitalisation had fallen by almost 90%. Forager’s investment case at the time made the downside clear – there was a “chance of low prices forcing the company into liquidation”. So why buy into a company that had a chance of going bankrupt?
It wasn’t hubris. The team didn’t know when, or even if, the coal price would turn. But there was an opportunity: Whitehaven’s prospects were asymmetric.
And asymmetric payoffs can make for good investments. Even when the most likely scenario is losing 100% of your money.
Low coal prices for extended periods, anything close to the $55 per ton cost of production, would have left Whitehaven in the hands of the bankers. That would be a zero for equity holders – a complete writeoff.
If a couple of things went right, though, the stock could rise ten-fold. The low coal price of the time meant that few producers were making money. A realised coal price of $100 or more per ton, not unheard of for the business, would generate enough earnings to pay the debt back quickly, leaving plenty of value for shareholders.
We call these situations equity stubs: businesses that clearly have value but where the equity is dwarfed by an overwhelming debt burden. For Whitehaven debt was $925m, while the market value of its equity was only $400m.
The asymmetric payoff profile – minus 100% on the downside but plus 1,000% on the upside in the case of Whitehaven – makes these situations more akin to buying an option than buying an ordinary share. And it’s to option pricing theory that we turn when thinking about how to value them.
Pricing an option
We won’t get too deeply into Black Scholes option pricing here. Like most complicated theories, common sense will do. There are three important inputs to the value of an option: strike price, expiry and volatility. Here’s how we apply them to equity stubs.
Firstly, the strike price. For an equity stub this is the point at which the value of the business is enough to cover the debt and the equity starts becoming worth something. For Whitehaven this was a coal price of about $65 per ton. Anything above that and the equity should be worth something, although not necessarily the $400m of market capitalisation at the time.
The second factor is time, or how long you have until your option expires. The more time you have to exercise an option, the more time there is for something to go right, and the more it should be worth. When it comes to the pricing of an equity stub, time usually relates to the terms and flexibility on the debt: how soon can the lenders force you into bankruptcy? Luckily, Whitehaven had struck a new debt facility with its banks in March 2015. The debt facility would last until July 2019, giving the business three and a half years before debt needed to be renegotiated.
And finally, the volatility or variability of potential outcomes is important. Volatility is synonymous with risk in the financial world, but when it comes to equity stubs, more volatility is better. Think of it as wanting the widest possible range of potential outcomes. Your downside is capped at 100% while the upside is unlimited. With thermal coal prices moving from over US$120 per ton in 2011 to below US$50 in late 2015, volatility was high.
It wasn’t as easy as plugging numbers into a spreadsheet, but our rough valuation of this option at the time exceeded Whitehaven’s market capitalisation by some magnitude. Despite the heightened risk of complete ruin, the business made for a good risk-adjusted investment.
Position sizing is crucial, of course, and even more so for stocks with asymmetric outcomes. As the risk of a severe loss was high, our weighting was low. We were risking 1.5% of the portfolio, with full knowledge that the downside involved losing it all.
So, what happened?
The Fund bought a small position at $0.38. In three weeks the stock price had doubled, doubling the price of our option and bringing it closer to what we thought that option was worth. Nothing had changed in the business or in the coal market. We wrote it down to luck and banked profits.
And then, frustratingly, the real upside arrived. Coal prices did end up doubling to US$100 per ton. And with the upside being realised, Whitehaven now trades at $4.25 per share. Having missed some big gains on this one, we are still debating the best way to manage equity stubs that work out. Perhaps reducing rather than selling the position after a doubling in price let’s you stay in the game for the big winners.
Opportunities like this will come up for the Australian Fund from time to time. Portfolio weightings will be small, but we are always on the lookout for stocks where a small loss is risked in exchange for a potential big win.
Hi Alex,
Great article, I did the same. Brought at $0.40, Sold at $0.96.
In the future I would likely just reduce as even a revised holding at $4.25 would be great.
Thanks for sharing this insight.
Great article and completely agree. The opportunity is accentuated in markets these days by the insistence on most value managers on running concentrated portfolios with ‘high conviction names’ only. It results in deep value high risk but asymmetric stocks like this having no natural buyers at all. ASL was another stock in this bucked that is up 15x from its lows. I missed most of the WHC ride, but owned ASL all the way up (I’m now out). The option thesis was the same. The same can be said of the Greek banks at the moment, which I own (all in small size, of course).
In terms of how to manage share price rises/intermediate term option ‘repricing’, this is indeed a difficult question, because it is worth bearing in mind that stocks seldom rally this strongly off the lows for no reason. It might be a good or a bad reason, but there will be a reason, and you might not yet be privy to it (e.g. people got onto the China supply side reforms story early before it became widely apparent). Instead of reacting to the price itself as if nothing has changed, the solution is probably to dig around frantically for the reason why the price is going up. Failing any discovery of the reasons in the meantime, taking some profit but holding on to more for longer than you might be instinctively inclined to do might pay. Options are priced off probability, so avoiding binary portfolio adjustments is usually advisable.
That said, there are no easy rules of thumb here – every situation is at least somewhat unique. Like playing chess, many positions are similar but subtly different. I’ve found with experience though that it is very very easy to sell cyclicals too soon, so if in doubt, in the early-mid stages of a recovery, holding on often pays.
Cheers,
LT
PS the other lesson here is also the importance of overcoming the psychological bias against looking at a stock again you’ve already sold at lower prices. It’s hard, but there is no point compounding one error with another.
I missed WHC from 30c (although made a tonne of money on the Indonesian coal stocks, which were even cheaper, as they were still profitable at coal price lows with strong balance sheets, yet traded at mid single digit PEs) but took a fresh look at it at $3.00 and felt it was still cheap, and so bought some. Believe it or not, it still seems cheap at $4.30 and I still own it (although in small size).
At $95 coal, it is trading at 7x sustainable free cash flow or a 14% FCF yield, and with minimal debt, most of that cash will come back to shareholders as fully franked dividends. They have plans to expand production some 50% over the next 5yrs or so. AUD depreciation will be a partial hedge against coal price weakness.
WHC is well placed as they produce high quality coal which is less polluting than Indonesian lower rank coal. We have seen in iron ore a huge price gap emerge between higher quality 65pc pellets and 62pc and (especially) 58pc fines, as China focuses on reducing pollution. There has been a very low level of investment in new coal mines over the past 5yrs & Chinese supply side reform seems real, and so it is quite possible prices stay ‘stronger for longer’. The stock also trades at only a modest premium to book for world class assets.
Hi Alex,
Agreed with Dylan J – great article.
Glad to hear the pro’s also struggle with timing. Also glad you’ve got the guts to share it with us, keep it up.
If it doubles, why not sell half, so your downside is then zero? I have no idea how to figure out the sale of remaining stake though, but I guess that’s why you’re on the big bucks!
Just trying to get my head around this.
It seems the shares were sold because they were close to the ‘option’ value at an unchanged coal price. If the coal price had risen, I assume the shares would have been retained because they would be worth less than the ‘option’ value recalculated with the higher coal price. If they would have been sold regardless, then the investment effectively was not asymmetric to start with.
Going the other way, if the coal price had instead dropped and the share price not declined, would the shares have been sold because they again were close to the ‘option’ value recalculated with the lower coal price?
With St Barbara it went from 8.9c to 25c and I halved and then the remainder at 50c…. it ran all the way up past $3.
With Resapp we bought at 1.7c. Sold half at 25c and half the remainder at 50c. It then fell back to single digits on a trial failure..
I can think of scenarios like this (albeit smaller gains) and they play out regularly in both directions.
You never go broke taking a profit.
Hi Alex
Thanks for sharing. Always a challenge on selling out vs selling down but holding a reasonable percentage to make a difference if value continues to rise.
Cheers
Any reason why the blog post regarding Technicolor has disappeared?
https://foragerfunds.com/bristlemouth/tag/digital-technology/
I remember this call, and well done Forager. Also love stub investments. In 2009, i bought ABY – a large WA based copper mine, which was net cash, and had a large well funded majority shareholder at the time, Hindalco. Shares were trading at 10c, well below NTA, and close to cash NTA (from memory they had no debt either), which assumed the copper concentrator, and mine was valued at zero (Despite a book value of $400m). Sold for $1.60+ 12 months later after copper price recovered back above $2/ib.
Good analysis of the set up, but I think, respectfully, that it was a poor trade as the assymetrical nature of the payoff was negated by selling once it had doubled. Essentially the risk reward was 100% downside and 100% upside. The trade should have been left to run to achieve multiples of the downside as per the initial analysis. This is why the saying “you never go broke taking a profit” is false. Next time an investment of this nature is made and you lose the capital you are essentially break even across the two trades.
Great insight Pat. I think the whole team is in agreement with you. That’s why we rub our noses in this old speculation from time to time.
Following on from my previous post, the trade should have been left to run ONLY if the parameters involved in the initial analysis did not deteriorate to the point when an updated analysis would indicate that the trade is no longer (positively) assymetrical.