The Danger of Stock Screeners (Linn Energy LLP)
A stock screener is a useful toy for an investor. In most markets bargains cannot be found by checking stocks at random, and a good screen is a good way to narrow the field. However, a screen is only a first step; a poster at a forum I visit (the same one who referred me to Linn Energy, actually) complained that the first thing new investors do once they finish a copy of Graham’s The Intelligent Investor is run a screen for stocks with a PE ratio under 10, pick out a few names they recognize, and that is their portfolio. There is a certain logic in this plan, since the annual return from the market indexes is said to have been between 9 and 11% depending on who you ask, and without projecting growth a PE ratio of 10 at least gets you what you pay for. And a PE ratio significantly less than 10 looks very appetizing.
However, the trouble with screeners is that they can produce some perfectly ridiculous results. For example, Linn Energy LLP (LINE) has a PE ratio of 1.39 right now. Obviously, this means that you can buy it and get your money back within a year and a half, and still own the stock, right? Well, although the value investor acts under the theory that the market occasionally gets things wrong, rare is the occasion indeed when it gets things crazy (although it does happen). It’s much more likely that the “real” P/E ratio is different. And yet, with a yield of over 11%, LINE is worth a second look. Just because the data make no sense doesn’t mean that the market can’t still be wrong.
LINE is an oil and gas producer, and the bizarre PE ratio comes from the fact that, like many producers, they use derivatives to hedge their exposure to the price of oil and natural gas. However, accounting rules require them to record the changes in value of their derivatives during each earnings period, but they are not permitted to record the counterbalancing change in the oil and gas they hold. Since LINE holds three to five years’ worth of production of these derivatives, any hiccup in the price of oil or natural gas will affect those derivatives by several times what their current results will be affected by. So, ironically, the derivatives that are supposed to make their operations more stable make their reported earnings quite unstable.
In 2008, if you remove the unrealized portion of the derivative gains from their results, their income from operations drops from $825 million to $141 million (much of this income appeared in the most recent two quarters, hence the bizarre PE ratio). This is an issue considering they paid out $287 million in distributions in that year. YTD 2009, removing the unrealized losses moves their results from a $147 million loss to a $138 million income from continuing operations, and they distributed $145 million to date. The terms of the partnership require them to distribute all excess cash, hence the high payout ratio. At least for the last six months depreciation has equalled cash spent on investing activities, and before then they were still in the capital-raising phase, which clouds the picture.
I don’t know that I see much capacity for near-term growth; virtually all of their projected production is hedged at prices well above current prices; about $7.50-8.50 for natural gas when the current price is less than $5. For oil, half of it is locked in at $90/barrel, or higher. Because of the collars and locked in prices, they don’t benefit if prices go up, just as they’ve avoided suffering as prices have come down. And if they develop a new field, they’d have to lock in the current prices, not the historical ones they had when prices were higher.
What concerns me, though, is stability of operations. WIN, our other high yield candidate, has a long history of producing enough cash flow to cover their distributions, while LINE doesn’t have a long history at all. Even adjusting for derivatives, I’m not sure that its earnings will be stable at this level; utilities have a reputation for stable operations and LINE claims to develop long-lived fields, but that doesn’t tell us how they will do once they have to reset their hedges. If they do keep their earnings stable, for 2008 earnings as adjusted by me they’d have a PE ratio of 18.23, and for doubling 2009 YTD earnings, 9.31, which is not bad. It’s an earnings yield of 10.74% which would almost cover their dividend, and if their depreciation and amortization are not commensurate with future capital costs the dividend may well be covered. Normally one would want to see higher dividend coverage so the company doesn’t have to sell debt or equity to keep up the dividend, and indeed LINE has been raising additional capital by selling new partnership units, which would be unnecessary if they would drop the policy of distributing all available cash. So, if you think they’re going to be stable at this level, they probably would be worth considering for investment. But their PE ratio is certainly not 1.39.