Ravi
Nagarajan
submits:
"An investment operation is one which, upon thorough
analysis promises safety of principal and an adequate return.
Operations not meeting these requirements are speculative." -
Benjamin Graham
When Benjamin Graham described the distinction between investing
and speculation, he did not do so in order to make a moral
statement condemning speculative behavior. Instead, he was
attempting to make a very important point with the goal of ensuring
that individuals understand when they are engaged in an investment
operation versus indulging in an outright speculation. The
individual who makes a financial commitment based on speculative
motives but thinks that he is actually investing is almost sure to
realize unsatisfactory results over time. In contrast, there are
some disciplined investors who are able to speculate "on the side"
in a manner that does not jeopardize their investment
portfolio.
The majority of value investors most likely avoid all types of
speculative activity as a matter of temperament or habit. This is
because success in
speculation
can tend to erode the mental discipline required to properly manage
investments
particularly when speculative and investment funds are commingled.
Success in speculation can encourage further speculative activity
as anyone who has been to Las Vegas can clearly understand. This is
why Benjamin Graham advised us to "never mingle your speculative
and investment operations in the same account, nor in any part of
your thinking."
Contango ORE - An Intelligent Speculation?
Despite our best efforts as value investors to avoid anything that
may resemble speculation, sometimes unique circumstances can arise
that force us to replace passive avoidance of speculative behavior
with an active choice. Such a scenario will soon face shareholders
of Contango Oil & Gas (
MCF
) who will receive one share of Contango ORE ((
CORE
)) for each ten shares of Contango in a spin-off scheduled for
December. Contango has attracted a following among value investors
and has been capably managed by Chairman and CEO Kenneth Peak since
the company's founding in 1999.
From an initial investment of his entire $400,000 life savings,
Mr. Peak has built a company that today has a $880 million market
capitalization and is one of the lowest cost producers of natural
gas operating primarily in the shallow Gulf of Mexico. The company
has an exemplary record of success in exploration and intelligent
deployment of capital. Management has provided a short document
describing the
history of the company
(pdf).
In 2009, Contango set up a wholly owned subsidiary to engage in
exploration of gold and rare earth minerals in Alaska. While this
initiative is tiny in comparison to Contango's main business in oil
and natural gas, by management's own admission, minerals
exploration is highly speculative and management has no particular
expertise in the area. Company filings over the past year have made
it clear that Contango's primary business strategy remains in oil
and gas. Contango is now planning to spin off CORE to shareholders.
CORE is clearly speculative, and Contango shareholders are forced
to make an assessment: Is this an intelligent speculation or should
the shares be sold?
Terms of Spin-Off
The spin-off will result in Contango shareholders receiving one
share of CORE for each ten shares of Contango owned as of the
October 15, 2010 record date. Based on Contango's latest
10-Q
filed today, the company will provide CORE with an additional $3.5
million in cash immediately prior to the spin off and the aggregate
value of the distributed assets will be approximately $0.45 per
Contango share. For more information on CORE, please refer to the
Form 10
registration with the SEC (
Note: Contango management has indicated that an updated Form 10
will be filed this week.
)
CORE's Business Plan
Management has candidly stated that they do not have any
experience mining for gold or rare earth minerals. The company has
no revenue or any prospect for revenue generation in the near
future. The $3.5 million cash infusion that CORE will receive at
the spin-off will probably cover substantially less than two years
of operations given that CORE plans to spend $2 million on
exploratory drilling activities over the next twelve months, to say
nothing of ongoing operating costs. There are no credit
arrangements in place to provide funding if revenues do not
materialize before the cash is depleted.
On the positive side, the operation will be run on a shoe string
budget and will share management with Contango Oil & Gas. CORE
will have three part time employees including Mr. Peak and none of
the employees will receive cash compensation for the foreseeable
future. CORE will distribute restricted stock to directors and
officers immediately prior to the distribution equal to
approximately 4.5 percent of the common stock that will be
outstanding following the distribution. CORE has an agreement with
Avalon Development Corporation to provide consulting and
exploration services and will be compensated with restricted shares
equal to approximately 1.5 percent of the common stock outstanding
after the spin-off.
CORE has secured leasehold interests of approximately 659,000
acres for the exploration of gold deposits along with an additional
97,280 acres of mining claims for exploration of rare earth
elements. Initial rock and soil samples have indicated that there
are measurable amounts of gold, but the company indicates that
there are no proven reserves at this time. The 2011 exploration
plan is to "fly airborne magnetic, electromagnetic, and
radiometrics early next summer."
Gold and Rare Earths - Castles in the Air?
Putting on our speculative hats, it is obvious that both gold
and rare earth minerals have been attracting increasing attention
in recent months. Gold is currently at a record high in nominal
dollar terms and ominous stories about Chinese restrictions on rare
earth production and export appear on a daily basis in the
newspapers. With China responsible for over 90 percent of rare
earths production, there is a clear need for domestic sources of
these minerals and investor interest is high.
Spin off situations often result in a temporary price decline of
the spun off shares as holders of the parent company dispose of
small stakes in what may be a peripheral business that does not fit
their investment objective. In a situation where the spin off
represents an
investment
opportunity, the initial decline in share price has often been a
way for value investors to profit as a more natural constituency
emerges for the newly independent company.
In this particular case, we have a situation where the spin off
represents clearly speculative assets. Many of the value investors
who own Contango shares could very well decide to dump CORE shares
given the speculative nature of the business. However, the
countervailing force might be speculators who have bought into the
gold and rare earths story and wish to gain exposure. In other
words, speculators may build "castles in the air" and assume that
CORE will be successful in its endeavors and bid up the stock. The
very limited float could result in an interesting supply/demand
dynamic. However, the likely $6 to $7 million market cap may put
the company under the radar and it could be ignored.
Peak May Be Worth Betting On …
As we stated at the outset, CORE is a speculative company and it
is obvious that the shares could end up being worthless. In fact,
it is probably more likely than not that the shares will have
little value in the long run. Nevertheless, Ken Peak has a history
of success in extraction of minerals from the earth and he could
very well surprise us with a major discovery. In addition,
speculators may build "castles in the air" and bid up CORE shares
in an irrational way due to the fact that it has gold and rare
earths exposure. We are inclined to retain the spun off shares as a
"lottery ticket", although we are under absolutely no illusions
that it represents an "investment operation" as defined by Benjamin
Graham.
Important Note: The record date for the distribution was
October 15, 2010. Current buyers of Contango Oil & Gas will
not receive CORE shares at the spin off. Although we have a
disclaimer section linked to each article, we must stress that
CORE is speculative in nature and this article is NOT investment
advice or a suggestion to buy shares.
Disclosure:
The author of this article owns shares of Contango Oil &
Gas.
See also
Goldcorp's Superhero Tradition: Keep an Eye on the
Juniors
on seekingalpha.com