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.