Don’t Let Your Portfolio Get Manti Te’oed

As investors, we are constantly searching for companies with compelling stories. But we must be wary of letting a compelling story stop us from asking key questions. Don’t fall prey to confirmation bias, the tendency to favor information that supports prior beliefs. Take extra care with a hypothesis you hold dear.

See below for a portfolio update on Linn Energy

Recall the Manti Te’o story, about the linebacker for the University of Notre Dame with an inspirational story about a late girfriend who proved to be a fake. The story of a football star winning the big game after an unfathomable tragedy proved so beguiling no one checked it out.

For me, this story is not about a naive young man who fell victim to a hoax. It is about journalists who report without conducting due diligence. It is about people’s willingness to believe what they want to be true.

Te’o’s story mirrors many stories that are told about publicly traded companies. Occasionally fraud is involved, but more often than not a company’s value is inflated simply because investors only allowed themselves to believe the good parts of the story. This was the cause of the dot-com bubble, and more recently it was the cause of the rise and fall of numerous advanced biofuel companies. With oil production peaking globally and governments strongly supporting advanced biofuels, it was a no-brainer that this sector would be on fire. But proponents made a few incorrect assumptions when they told their story, and investors in the sector have lost a lot of money.

Or consider the case of GasFrac. Hydraulic fracturing, or “fracking,” has been used for decades on oil and gas wells to break open channels in the reservoir rock, increasing the flow of oil and gas to the well bore. Fracking was first commercially introduced in 1949, and application of the technique grew rapidly in the oil and gas fields of Oklahoma and Texas. Fracking increases the amount of oil and gas that can be recovered from a field, and is credited with boosting recoverable US oil reserves by 30 percent and natural gas reserves by 90 percent.

In recent years, fracking has been used alongside horizontal drilling to extract oil and natural gas from shale deposits that can’t be economically tapped by conventional methods. As fracking spread, concerns were raised about the potential for fracking fluids — water mixed with a cocktail of chemicals, some of which may be carcinogens — to migrate into the groundwater.

What was needed was a way to frack these formations without fracking fluid. A company that invented such a process would have a very large market. Enter Gasfrac Energy Services (TSX: GFS).

Gasfrac invented a way to do the fracturing without the dirty water. Instead of water and fracking fluids, the company uses gelled propane under pressure to create the fractures. Gasfrac claimed that the technology produces more oil and gas than hydraulic fracturing because propane can migrate further into the formation. And because propane mixes well with oil and gas it is recovered. This justified the higher cost of gas fracking versus hydraulic fracking. Further — and most importantly to many who are opposed to fracking because of concerns about water contamination — no harmful fracking fluids could migrate into the water table.

This is definitely a great story, and it is entirely plausible. Some stock newsletters gushed over the potential. One called it “The Google of Natural Gas, with a Game-Changing Innovation That Could Hand You a 157% Gain!”

The teaser for the stock read in part:

  • This company is growing almost as fast as Google did in its early years, outpacing the leaders in an industry that’s growing like wildfire. And like Google, they are literally rewriting the way their industry works.
  • As you may already know, there’s been some backlash against fracking by environmental groups. And a good deal of this backlash is based on the massive amounts of water pollution that fracking currently creates.
  • But this company has created a new kind of fracking technology — one that doesn’t result in a single drop of waste water!
  • And this company has a lock on their new process. With ten patents issued and seven outstanding, this process can’t simply be copied or stolen away by a competitor. 
  • So you can see why this company represents one of the greatest opportunities in natural gas today.
  • I think its stock could rise 157 percent from current levels!

That certainly sounds like a no-brainer. That teaser was sent out by a newsletter that covers natural resources on or around Feb 27, 2012. Here is the Gasfrac stock chart since that time:

Gasfrac stock chart

Since the publication of that gushing stock teaser in which the author thought the share price could climb by 157 percent, the share price of Gasfrac has declined by more than 82 percent. How could the market have so overvalued this company just a bit over a year ago? Confirmation bias. Management oversold their story, and investors lapped it up — because it just made so much sense.

Here was a game-changing technology in a hot field, and revenues were in fact growing rapidly. However, the company’s business is capital intensive, and despite the rapid growth in revenues it took on debt to support capital expenditures. But the biggest reason for the freefall in the share price is that there really wasn’t a compelling economic advantage to using Gasfrac’s technology over hydraulic fracturing. The company simply wasn’t signing up enough customers, and the customers it did have weren’t rapidly ramping up  use of the technology.

This story isn’t intended as an indictment of Gasfrac. Despite the plunge, its story isn’t over. In fact, like Manti Te’o, the company still has plenty of fans and there are signs it is turning a corner. Further, there are specific situations in which hydraulic fracturing may be exceptionally challenging (e.g., in a desert), and Gasfrac may offer a solution.

This story is rather a cautionary tale reminding investors of the danger of confirmation bias. If anything, we need to apply anti-confirmation bias and look for information that contradicts an otherwise compelling story. That won’t prevent us from sometimes taking a loss, but it can prevent us from experiencing the kind of devastating plunge suffered by Gasfrac shareholders.

Around the Portfolios

Linn Energy
(Nasdaq: LINE)

Another month, another bad review for Linn Energy from Barron’s, which has just published an update on allegations of accounting derring-do that thoroughly failed to impress the market in February. The thrust now as then was that Linn’s overvalued, its rollup strategy doomed and its performance disappointing. The distributions under underwritten in part by hedges that will eventually come off the books, which is the part that’s credible.

As for comparing Linn’s valuation with that of ExxonMobil (NYSE: XOM), Chevron (NYSE: CVX) and other C corps, the article ignores overall MLP valuations, investors’ growing preference for regular income, as well as the common temptation to defer taxes on that income for many years, and possibly forever.

It also ignores some important numbers. Like 34 percent, which was the effective tax rate Linn Energy takeover target Berry Petroleum (NYSE: BRY) paid on its earnings last year. Institutions and mutual funds make up 93 percent of Berry’s shareholder base. Those that wish to keep shares of Linn affiliate Linn Co (Nasdaq: LNCO) after the merger due to be concluded by June 30 get to retain an income stream from the old Berry assets, now shielded from the corporate income tax. Or they can sell and keep the 20 percent deal premium.

Keep in mind that Berry shares are now trading roughly at Linn’s original offer price, while many comparable stocks have sagged in the interim. And also of course that Linn can pay that premium and still increase make a deal immediately accretive to its cash fow and distributions, thanks to its premium valuation.

That premium may be a byproduct of the units’ spectacular run since the IPO, or it could be just down to plain old tax arbitrage. Say you’re the controlling shareholder of an oil company. Would you rather pay a third of earnings out in corporate income tax or sell to a master limited partnership in exchange for units which will defer most of the tax bill for many years and possibly permanently upon death? The Berry deal confers a first-mover advantage on Linn in the race to shield the most energy profits from the corporate income tax. The fact that Linn has a bad quarter or that it’s got a lot of room for error is going to be overshadowed soon enough by Berry’s added heft and other deals, now that the company has secured $1 billion in extra bank credit.

That was the point Wells Fargo made today in response to the Barron’s piece. “We continue to believe LINE’s distribution is secure and poised to grow at a mid-single-digit annual growth rate over the next five years,” the Wells Fargo analyst wrote. Also, “we continue to believe the LNCO financing vehicle provides the company with a competitive advantage and could help both support distribution growth and improve Linn’s leverage ratios over the coming years.”

The timing of the Barron’s piece is curious, coming as it did the weekend before an ex-dividend date and ahead of the expected merger consummation. The only “new news” was the update on Linn’s disappointing quarter and the fact that there were now names attached to what had previously been anonymous sources.

These are not names patient Linn investors need to sweat. The proprietor of the bearishly disposed hedge fund cited started this shop only in November, reportedly with just $50 million in assets. Among those on the other end of this trade is the investing legend Leon Cooperman, whose Omega Advisors fund held $150 million worth of Linn at year-end. Reputation and size aren’t everything in the investing game, of course, But they can provide important clues. We’re sticking with our call to buy LINE below $40.    

    – Igor Greenwald

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