A Thought-Provoking Post by Aaron Edelheit

It turns out that Aaron Edelheit has a blog ("Investing in a Life of Value"), and a rather eclectic one at that. In addition to investing, Edelheit writes about religion, self-improvement, humor, and healing the world. A gentleman and a scholar, apparently. Here's a thought-provoking post of his about investing from last month, "Thinking of Investing in China?". Excerpts:

4.71%

That is the average annual return from investing in the MCSI China index since March 31 1998. This despite 40% average annual returns in the past five years.

I use this startlingly data point to make a much larger point. Sometimes large economic trends do not make great investments. And obvious top down trends don’t always make good investments.

[snip]

I believe China faces some serious headwinds going forward. Everyone seems to think China can spend anything it wants on commodities such as oil, iron ore, copper, etc., but they don’t. And when you add in the fact that China is about to start importing vast amounts of food as well and that they have a problem with water and one realizes that the country has serious import problems to overcome. And this doesn’t even take into account, the lack of accounting standards, mounting banking problems, a surging gap between between rural and urban Chinese and a lack of clear private property laws.

So before commentators and so-called experts try to convince you to invest in something hot like China consider the longer term record of investing in the country and look deeper into some of the issues affecting the country, you might be surprised by what you learn.

For the record, I have no investments in China or any company listed anywhere that has major operations in China. For reasons I cite above, I believe there are better risk/reward situations elsewhere, especially in North America.

This post reminds me of an article I read several years ago on the trade website 401kwire (bear with me for a moment, and you'll see where I'm going with this.) At the time, I was working in business development for a start-up company in the 401(k) industry. As a web-based, mostly paper-less enterprise, my company could profitably administer retirement plans for small companies. One of the bullet points we mentioned to potential investors was that (I forget the exact numbers) 80% of American small businesses with fewer than 100 employees didn't have a retirement plan, and that represented a huge potential market for us (of course, a significant percentage of these small business had high turnover, or low-paid workforces that could make a 401k impractical, etc.). After a couple of years at this company, 401kwire published an article in which the writer called the small plan market the "China" of the 401(k) industry. The writer dug up a quote from the late 19th Century by an officer of an American company that manufactured matchbooks, in which the American businessman spoke about the potential profits from selling matchbooks to however many Chinese there were back then. His point, of course, was that sometimes markets that look like huge potential opportunities remain potential opportunities (as opposed to actual ones) for a long time.

Edelheit makes some good points about the challenges facing China, and the risks of investing directly in the country, but I think there are ways to profit from the industrialization of China indirectly, by investing in companies based outside of China that are positioned to benefit from this trend (e.g., companies exporting food or raw materials to China, etc.).

A Conversation with the CEO of U.S. Energy Corp. (USEG)

Keith Larsen, the CEO of U.S. Energy Corp. (USEG), was nice enough to spend 40 minutes on the phone with me Friday answering my questions about his company, and sharing his insights about the natural resources industry. Here are a few notes from our conversation.

- Alternative Energy: T. Boone Pickens's plan came up in our conversation, and Keith Larsen mentioned that he had just seen Pickens speak at an event in Denver. Larsen noted that USEG is considering investments in alternative energy, including wind.

- The Gillette, WY project: Currently, it's half built, and the half that is built is 100% occupied and generating $120k in monthly revenue. The other half will be completed by October 1st, and Larsen expects this half to be fully occupied as well, so the completed project should be generating about $240k in monthly revenue for USEG. Gillette has a population of about 50,000, but is growing at about 7% per year and has been benefiting from the secular bull market in commodities -- 40% of America's coal comes from this area (and of course about half of America's electricity is generated by coal-fired power plants).

- Real estate in general: USEG's board has decided not to pursue additional developments, despite the success of the Gillette project, and plans to sell off piecemeal another property it owns -- 25 acres of undeveloped land adjacent to its headquarters. Mr. Larsen expects they will be able to do so at a profit.

- Oil & Gas exploration: The first of three wells being drilled in partnership with Petroquest Energy (NYSE: PQ) is about to be spudded, and the next two are scheduled to be completed this fall. Although Petroquest's website touts an 89% success rate on its wells, Larsen says that figure includes its shale projects, and the more relevant success rate for Petroquest with these sorts of exploratory wells is 70%. If these wells are successful, Larsen estimates they could generate $150k-$250k in monthly revenue per well for USEG. Combined with the revenue from the Gillette, WY development, this could total $1 million in revenue per month, which would be enough to give USEG consistent, positive earnings.

- The Lucky Jack Molybdenum project: Keith Larsen is confident that this project will eventually get completed. He noted that, although our current high energy prices are bad for America unfortunately, they are at least finally increasing public support for natural resource projects such as Lucky Jack (and, of course, oil & gas drilling). Larsen says that despite a small, vocal, minority of environmentalists (who remain unsatisfied by USEG's plans to develop the mine in an environmentally responsible way), the feedback USEG is getting from most locals in the Crested Butte area is that they want the project to go forward, and they are looking forward to the jobs it will create. Larsen also clarified his earlier $10 per pound cost estimate, saying they are working on getting a current engineering cost estimate, and that his $10 figure was a ballpark estimate derived by more than doubling a previous engineering cost estimate. Ten years ago, when molybdenum was trading for about $5 per pound, a previous engineering study estimated that this molybdenum deposit could be mined profitably, at a cost of about $4.50 per pound. Larsen used $10 per pound as a ballpark estimate to take into account the increased cost of mining equipment and labor today.

- Uranium: Larsen explained that the end of our reprocessing treaty with the Russians should put pressure on uranium prices over the next few years. Although Uranium One is not required to give USEG updates on its plans, he estimates that USEG will receive at least $20 million of its $40 million in contingent deferred compensation from Uranium One by 2011. Larsen also noted that USEG also has a 4% interest in any net profits from the Green Mountain uranium deposit, which is estimated to contain 50 million pounds of uranium (uranium currently trades for about $60 per pound). That deposit is currently owned by Rio Tinto which is shopping it around to other mining companies.

- Insider sales: I mentioned the three ~300,000 insider sales listed on Nasdaq in January, and Larsen explained that those were actually shares of a subsidiary that were canceled, and that they are reported as insider sales although they actually aren't. He said that no insider in USEG has sold shares in 10 years.

- Three accounting firms used in the last few years: Larsen said that one of USEG's accounting firms was bought by another, and that also Sarbox required them to change accountants periodically. He noted also that, since they were now actively involved in oil & gas exploration, they might need to switch accountants to a firm more experienced in this area.

U.S. Energy Corp. also recently announced that it has applied for a listing on the Toronto Stock Exchange (TSX), and it expects that application to be approved and that U.S. Energy will start trading on the TSX by the end of October. Since many natural resources companies are listed on the TSX, a listing there should expose U.S. Energy Corp. to a new audience of natural resources investors.

At the current quote ($2.81 per share), USEG trades at less than 60% of its book value. I may add more at these levels.

New Position: Destiny Media Technologies, Inc. (DSNY.OB)

Today I picked up some shares in Destiny Media Technologies, Inc. DSNY.OB at $.40 per share on margin. I plan to pay off the margin loan next month, when I sell the wreckage of some of the stocks I bought from the Magic Formula Investing list last August. Destiny Media is a pick of "issambres839" on the Value Investors Club. Thanks to Daniel Wahl, I've learned that issambress839 is the professional value investor Aaron Edelheit, of Sabre Value Management in Santa Barbara, CA. Edelheit may be one of the best investors I had never heard of up until last month.

In contrast with many value investors who use trailing metrics such as P/S and P/E to screen for stocks (recall rules-based investor Marc Gerstein's frustration with this approach in "What's Wrong with Today's Value Investing?"), Edelheit often researches small stocks without current earnings that are nevertheless trading at a low multiple to his estimates of their future earnings. When he recommended DSNY.OB on the Value Investors Club in January (when it was trading at $.68 cents per share), Edelheit wrote that it was trading at 7x his estimate for fiscal '09 earnings (at the current quote, it's trading at about 4x his estimate; insiders have been buying on the way down). Destiny Media is the second stock I bought based mainly on Edelheit's write up (and subsequent news that confirmed his thesis); the first was the precision agriculture company Hemisphere GPS (HEM.TO), which I bought around $4.34 per share (Edelheit originally recommended it last summer when it was trading at $2.74 per share). Like Hemisphere, Destiny Media is a Canadian company. Edelheit is willing to consider obscure Canadian companies (including those such as DSNY that trade on the OTC Bulletin Board) in search of undiscovered values.

I recommend signing up for guest access to the Value Investors Club so you can read issambress839/Edelheit's write-up for Destiny Media in detail, but here's my summary in a nutshell. Destiny offers a service (its Play MPE network) that enables record labels to digitally (and securely) transfer songs to radio stations. The service includes security features such as a (recently patented) digital watermarking technology to prevent unauthorized redistribution of the songs. The value proposition here is that Destiny Media can save the record labels a lot of money: Destiny's service costs about 90% less than the old method of sending songs in CD format via courier. Destiny had been offering its service to some labels at no charge last year, but has been signing contracts with them to pay to continue the service this year. As Edelheit pointed out in his write-up, since Destiny's stock is obscure, foreign, and has no analyst coverage, few are aware of the paying customers it is lining up for its Play MPE network.

According to Edelheit, Destiny also offers a product called Clipstream, which is similar to Adobe Flash but uses 90% less bandwith. This product could a source of additional future earnings, but his multiple estimate above was based solely on Destiny's Play MPE service.

One note about risk: Destiny has a collection of conventional wisdom red flags for risk -- it's a microcap, it's foreign, and it trades on the OTC Bulletin Board. So it's not exactly a widows & orphans stock. Then again, in the last year we've seen stocks that some would have considered suitable for widows and orphans -- e.g., Citigroup, Fannie Mae, etc. -- suffer stomach-churning drops. This subject is a subject worthy of its own post, but the conventional wisdom about potential risk versus reward with respect to stocks may be worth revisiting.

U.S. Energy Corp. (USEG)

I started a position in U.S. Energy Corp. (USEG) last month at $2.85. Today it closed at $2.81. Below is a write-up of the company I initially posted on GuruFocus.com a few days after I bought the stock. I am re-posting it here now because I spoke with the CEO of USEG today, and before I post my notes on our conversation, I wanted to provide some background on his company, for those who may be unfamiliar with it.

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U.S. Energy Corp. (USEG) is an energy and natural resources exploration and development company currently trading for a third less than its book value (it was trading for .57x book when I bought it a few days ago). The management of USEG has a demonstrated track record of acquiring natural resource assets and selling them at opportune times for significant gains; the most recent example of such a successful sale occurred last year, and was the source of most of the company’s current cash hoard. USEG is a compelling value on its discount to book value alone, but four potential catalysts present opportunities for significant additional appreciation.


Valuation


USEG has a market cap of $75,470,000 and an enterprise value of $10,687,000 (subtracting both the company’s cash and its Treasury securities from the sum of its market cap and interest-bearing debt). It currently trades with P/B ratio of .66 and an EBIT/EV ratio of 82% (using trailing twelve-month data). The reason why the company trades at such a high earnings yield is because up until now it has generated its income through occasional deals rather than through consistent earnings. The company’s strategy going forward is to invest in assets that will produce recurring revenues while still pursuing large deals with windfall potential. The catalysts I describe below include examples of both. Note that the data above do not reflect the results of U.S. Energy’s sale, announced today, June 13th, 2008, of 39,062,072 shares of Sutter Gold Mining Inc. (SGM on the TSX Venture Exchange) for approximately $5,281,200 (in U.S. dollars).



Examples of USEG Management’s Timely Sale of Natural Resources Assets


Last year, U.S. Energy sold uranium properties that it had staked claims on during the 1990s, and had held onto as uranium prices dropped from the $ mid-teens per pound to $6.40 per pound in 2001. With uranium prices at uneconomical levels, U.S. Energy turned its focus to developing prospects for coal bed methane, but held onto its uranium properties. Through a subsidiary, Rocky Mountain Gas, U.S. Energy invested $15 million in the exploration and production of coal bed methane assets. Through a series of transactions, by the end of 2005, U.S. Energy had sold these assets for a total of $27.7 million.


Last April, when uranium prices were about $110 per pound, USEG sold its uranium properties to Uranium One Inc. (which trades under the symbol UUU.TO on the TSX) in exchange for 6.6 million shares in Uranium One, plus additional consideration, which I will expand on below. Uranium prices peaked in the mid-$130s a few months later, in the summer of 2007, and around that time USEG sold all of its shares of Uranium One Inc. for an average price of $13.68. Today, uranium is trading for less than $60 per pound, and shares of Uranium One Inc. are trading at about $4.30. This is an example of near-virtuosic timing and prudence on the part of USEG management, and one that bodes well for its handling of its current and future natural resource projects.


Catalysts


USEG has four potential catalysts to unlock additional value: One in the near-term (most likely this year), two in the medium term (within the next five years), and another in the longer-term (five years from now).


Near-Term Catalyst

· The Completion of a 216 Unit Residential Real Estate Project in Gillette, WY. Demand for housing in this part of Wyoming has been high recently because of the natural resources boom – the Gillette area produces about 40% of America’s coal, and the town’s population is growing by 7%-10% annually. Of the 216 units, 207 have been pre-leased. If USEG holds onto this property, its CEO Keith Larsen estimates it will generate about $250,000 in monthly revenue. Although USEG management sees promise in targeted real estate developments in regions participating in the natural resources boom, they have decided not to pursue any additional real estate projects, to assuage investor demand that they focus exclusively on energy and natural resource projects.

Medium-Term Catalysts

· Oil and Gas Exploration and Production. U.S. Energy has entered into separate partnership agreements with a private Houston-based oil and gas company and with Lafayette, LA-based Petroquest Energy (PQ on the NYSE). Drilling of the first three natural gas wells with Petroquest is expected to begin in June of 2008, and the drilling program with the private company is expected to begin in 2009. According to a presentation by Petroquest management dated June 2nd, 2008, Petroquest’s drilling success rate over the last 9 years has been 89%. U.S. Energy’s CEO has estimated that his company’s interest in these three wells alone could generate $250,000 in monthly revenue (the CEO estimates that USEG may be able to generate a total of approximately $750,000 in monthly revenue between interest income, income from the Gillette real estate development, and the potential revenue from these initial wells). USEG is evaluating other oil and gas investment opportunities to pursue in partnership with exploration & production companies that have proven, successful track records.
· Additional Payments from Uranium One. The largest part of the additional consideration that USEG received from Uranium One last year was $40 million to be paid contingent on the former USEG uranium properties meeting certain production targets; USEG management expects to receive this $40 million in the next few years as these production targets are met. Since USEG is such a small, little-followed stock, these windfall payments may act as catalysts for the share price as market participants see them appear in USEG’s quarterly filings. More importantly, USEG will be able to reinvest these moneys in energy and natural resource projects with promising returns.


Long-Term Catalyst


· Molybdenum Claims in Colorado. USEG’s patented “Lucky Jack” molybdenum claims near Crested Butte, Colorado, represent its most challenging project and also potentially its most lucrative one. USEG management estimates that a mine here could produce 15-20 million lbs of high-grade molybdenum per year, at a cost of about $10 per lb, and that the mine could have a 50-year life. Molybdenum, the demand for which has been driven partly by the global infrastructure boom, currently trades at over $33 per lb, so the potential profits from a Lucky Jack mine at current prices hold would be over $345 million per year. Currently, USEG has commissioned an engineering study of the project, and intends to submit a plan of operation to the U.S. Forestry Service by the end of 2008. If all obstacles are surmounted, and USEG can build a mine here, it would first start producing molybdenum in 2013. USEG may be able to monetize part of its interest in this project before then though, since it plans to sell a stake in its claim to an established mining company and have that company help develop the project.

Two Solutions to America's Energy Crisis

In today's WSJ, Joseph Petrowski, the president of Gulf Oil, offers his solution ("A Bipartisan Fix for the Oil Crisis"). In a nutshell: Democrats need to agree to allow increased domestic exploration and production and Republicans need to agree to higher fuel efficiency standards for cars and trucks. Excerpt:

We can responsibly drill. The technology to find, drill and recover oil has evolved tremendously, and careless drillers will fear tort lawyers more than government regulators. The claim that the oil companies are sitting on leases and not drilling defies all logic. With oil at $135 per barrel and drilling rigs renting at $300,000 per day, there are no idle rigs anywhere.

In The American, Andy Grove, former CEO of Intel, offers his solution ("Our Electric Future"). Somewhat confusingly, he uses the term "dual-fuel" to refer to what most seem to call "plug-in hybrids", i.e., cars that can travel shorter distances on an electric battery but have a back-up gasoline-powered engine. Nevertheless, his general point makes sense: if cars ran primarily on electricity, the country would be less vulnerable to energy shocks because that electricity could be generated by a variety of sources: natural gas, coal, nuclear, etc. Consistent with my point in an earlier post ("Why Oil Prices will likely be Higher in 5 Years -- But not Necessarily in 10 or 15"), Grove notes,

No matter how fast the production of dual-fuel cars is ramped, replacing the bulk of the approximately 250 million cars on the roads in the United States with new cars will take a decade or more.

Something to Munch On: "Recession is not the worst possible outcome"

In his recent column in the Financial Times ("Recession is not the worst possible outcome"), Wolfgang Münchau writes,

If this had been a mere financial crisis, it would be over by now. The fact that we are suffering its fourth wave tells us there might be something at work other than merely financial euphoria and bad regulation.

Münchau goes on to say that the prime cause of our current situation was 15 years of bad economic policies, particularly keeping real interest rates too low for too long. Given that he wonders, "whether the recipes that got us into this mess are also most suited to get us out again."

Worth reading in its entirety, though some of Münchau's prescriptions would seem unlikely to be implemented in the U.S. for political reasons, e.g., gearing monetary policy primarily toward price stability (instead of the Fed's current dual mandate: price stability and full employment), or imposing maximum loan-to-value ratios on mortgages (recall the resistance a few months ago to proposals to raise the down payments on FHA loans to 3.5% from 3%).

The EIA's Latest Short-Term Energy Outlook

The U.S. government's Energy Information Agency released its latest Short-Term Energy Outlook today. Here are a few excerpts:

Demand

World oil consumption continues to grow despite 7 consecutive years of rising prices. Preliminary data indicate that world oil consumption during the first half of 2008 rose by roughly 520,000 bbl/d compared with year-earlier levels. Compared to year-ago levels, this increase reflects a 170,000-bbl/d gain in the first quarter, followed by an 870,000-bbl/d increase in the second quarter. A 760,000-bbl/d decline in consumption in OECD countries during the first half of 2008, mainly concentrated in the United States, was more than offset by a 1.3-million-bbl/d increase in consumption in non-OECD nations led by China and the Middle East (World Oil Consumption). World oil consumption is projected to rise by almost 1.2 million bbl/d during the second half of the year, reflecting the impact of higher expected prices, lower economic growth, and growing pressure in some countries (such as India, Malaysia, Indonesia, and China) to ease price subsidies, which could dampen consumption growth.

Supply


Non-OPEC Supply

Despite higher prices and recent past projections of substantial growth in non-OPEC supplies that matched or exceeded consumption growth, actual non-OPEC production fell far short of both expectations and consumption growth. Faster declines in older fields and delays in expansion projects have limited supply growth. At the beginning of this year, non-OPEC supply growth was projected to rise by 860,000 bbl/d in 2008 and by over 1.5 million bbl/d in 2009. Production is now expected to rise by only 230,000 bbl/d in 2008 and by 830,000 bbl/d in 2009. Lower-than-expected production from Russia and the North Sea, along with lowered expectations for Brazil, are the principal reasons for lower non-OPEC supply levels. Second-half 2008 non-OPEC supply is expected to increase by about 700,000 bbl/d, driven by growth in Brazil and Azerbaijan (Non-OPEC Oil Production Growth).

OPEC Supply

OPEC crude production in the second quarter of 2008 averaged an estimated 32.3 million bbl/d, up only slightly from 32.2 million bbl/d in the first quarter. Higher production in Iraq and Angola more than offset lower production in Nigeria caused by security problems and worker strikes. Assuming that Saudi Arabia’s announcement of raising July output to 9.7 million bbl/d results in a higher sustained rate of production through at least September, OPEC crude production is projected to average 32.7 million bbl/d during the third quarter. At these production levels, available surplus production capacity during the third quarter would be only 1.2 million bbl/d, marking the third consecutive quarter that surplus capacity stood at or below 1.5 million bbl/d. All of this capacity is held by Saudi Arabia (OPEC Surplus Oil Production Capacity). Any industry operating at close to 99 percent of capacity will remain vulnerable to surprises that either boost consumption or disrupt production. Such surprises would place additional upward pressure on prices and contribute to oil price volatility. In this tight global oil market, OPEC countries have also faced delays in adding new production capacity, notably in Algeria and in Saudi Arabia, whose 500,000 bbl/d Khursaniyah project has been pushed back to the end of 2008.