A Modern-Day Buffett Is Jumping On This 'Hated' Company

Friday, January 31, 2014 - 1:00pm

by Jody Chudley

I think Warren Buffett is the greatest equity investor the world has ever known. I'm not alone in my opinion.

His investing style is rooted in the value investing teachings of his mentor Benjamin Graham.  As Buffett would explain it, he just sits around and waits for fat pitches where a company is clearly worth a lot more than its stock price implies.

When something is obviously mispriced (read: undervalued), Buffett buys -- and he buys with conviction. It sounds simple, but it isn't.  

What Buffett fails to mention is that when something is obviously cheap to him, it often looks cheap for good reason to the rest of us. In fact, Buffett's most successful investments have often been stocks that the rest of us are afraid to buy.

A perfect example: One of Buffett's greatest investments was American Express (NYSE: AXP). In retrospect, his investment in this world-class company may look like a no-brainer. But at the time, it was a complicated and nerve-racking prospect. 

In 1964, American Express shares dropped by 50% as the result of fears over potential liability the company had in relation to the infamous salad oil scandal. Buffett did his homework, concluded the fears over the eventual liability for American Express were overblown -- and made a big concentrated investment in the company. 

In fact, Buffett actually changed his investment rules inside the Buffett Partnership Ltd., increasing the amount he was allowed to put into one position to 40% in order to fully exploit the opportunity. He had previously promised investors that no single investment would make up more than 25% of the Buffett Partnership Ltd.

Within two years, with 40% invested in the company, Buffett has more than doubled his money on American Express. Over the next 10 years, American Express increased tenfold.

While Buffett was buying shares of American Express, almost everyone else was selling. To most investors, it appeared that the potential liability facing the company could bankrupt.

Buffett, on the other hand, saw opportunity and used the stock sell-off to his advantage.

A Different Kind Of Oil Scandal
Anadarko Petroleum (NYSE: APC)
is a global oil and gas exploration and production company.

Anadarko has a portfolio of very high-quality upstream (producing) assets onshore in the United States, in the deepwater Gulf of Mexico and in various other high-impact basins around the world.

Source: Anadarko Petroleum

Last month, APC tanked on news of a legal issue that revealed Anadarko could have to pay damages of $5 billion to $14 billion.  

This legal issue relates to a company called Tronox that was spun out of Kerr-McGee in 2005. In 2006, Anadarko acquired Kerr-McGee -- thereby assuming all of its liabilities.

Tronox was a paint materials division that used titanium dioxide in its paints. This division was spun out of Kerr-McGee in 2005 in an effort to make Kerr-McGee a more attractive takeover target.

In 2009, Tronox went bankrupt because of environmental cleanup costs stemming from pollution caused by titanium dioxide at its sites. Tronox sued Anadarko and Kerr-McGee that same year, arguing that the 2005 spin-off that created Tronox was fraudulent because it saddled Tronox with environmental liabilities that caused it to become insolvent.

In December, a judge ruled that the case had merit and that Anadarko could be on the hook for damages in that $5 billion to $14 billion range.

To be sure, this is bad news -- but a modern-day Warren Buffett thinks the price decline in Anadarko shares is considerably overdone.

Hedge fund manager David Einhorn of Greenlight Capital purchased shares of Anadarko following the December sell-off. Einhorn believes that Anadarko shares are undervalued, even assuming a worst-case legal outcome and a $14 billion loss.

According to Einhorn, if you factor in Anadarko's 91% stake in Western Gas Equity Partners (NYSE: WGP) and its non-producing Mozambique prospect, then, assuming the worst-case outcome from Tronox, Anadarko shares are trading for less than 4 times earnings before interest, taxes and amortization (EBITA).

That is excessively cheap in relation to Anadarko's peers that have inferior assets but trade at considerably higher multiples.

Note that Einhorn isn't suggesting that the Tronox liability isn't a valid concern. He is suggesting that shares of Anadarko are cheap even with the worst-case Tronox outcome factored in.

But that worst-case outcome is not a given, of course. According to the expert legal advice Einhorn sought, Anadarko is not likely to be liable for the full $14 billion, and in any case, the ultimate payment will be at least partially tax-deductible.

So the Anadarko investment case is attractive with the worst-case Tronox outcome assumed -- and even more attractive if the ultimate liability is less than that.

Risks to Consider: Anadarko shares are likely to be in the penalty box for a while until investors realize that the lawsuit isn't the end of the world. A successful investment here is going to require some patience until the lawsuit is resolved.

Action to Take --> Follow Einhorn's example and buy APC. The market was correct to drop the shares of Anadarko on the Tronox news, but the sell-off was overdone. Over time, Anadarko shares should rebound to a more appropriate valuation.

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Jody Chudley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.