I didn't pay my money and take my chances ; well not on Bri-Chem.
June 2,2020
Robert Tattersall in Globe and Mail
Baron Rothschild, the 19th-century investment banker, suggested that investors should “buy when there’s blood in the streets – even if the blood is your own.” As I look at the small-cap portion of my portfolio, the red ink is deepest in the oil-services sector. Although the overall market has enjoyed a robust recovery in the past few weeks, this has not extended to the energy sector, especially the small-cap service companies. They continue to trade close to their recent low points.
Investors are correctly warned against averaging down on stocks that have fallen sharply and where the original buy thesis is no longer valid. My original thesis for buying these stocks is clearly now out the window, hit by a triple threat: failure to approve pipelines to transport Canadian oil to export markets, a price war between Russia and Saudi Arabia and, of course, the collapse in demand for fuel caused by the COVID-19 pandemic.
Even so, as a long-time value investor, I am irresistibly drawn to a group of stocks that trade as low as 7 per cent of book value, with market capitalizations as low as $2-million and with modest exposure to the Canadian oil sector. This is what I discovered as I updated the numbers for the eight portfolio holdings shown in the accompanying table. Four of them are contract drillers, while the other four are suppliers to the sector ranging from drilling motors to gauges used in mobile storage tanks. All of them trade below a dollar – cheaper than a lottery ticket.
| Company | Ticker | Recent price $ | Price/Book | Financial leverage |
| Akita Drilling Ltd Cl. A | AKT.A-T | 0.36 | 0.07 | 1.84 |
| Bri-Chem Corp. | BRY-T | 0.07 | 0.1 | 2.78 |
| Cathedral Energy Services Ltd. | CET-T | 0.12 | 0.09 | 1.56 |
| Ensign Energy Services Inc. | ESI-T | 0.72 | 0.08 | 2.41 |
| Essential Energy Services Ltd. | ESN-T | 0.15 | 0.15 | 1.27 |
| McCoy Global Inc. | MCB-T | 0.44 | 0.3 | 1.58 |
| Precision Drilling Corp. | PD-T | 0.76 | 0.13 | 2.17 |
| Titan Logix Corp. | TLA-T | 0.35 | 0.61 | 1.07 |
To be realistic, the first quarter included only one month of the COVID pandemic for six of them (Bri-Chem Corp. and Cathedral Energy Services Ltd. have yet to report), so the pain has only just begun for these companies, but the market has already delivered a verdict; as measured by the price-to-book value ratio, investors think that the net assets on the balance sheet are worth as little as 7 cents on the dollar. This is in spite of the fact that Akita Drilling Ltd. already took a $60-million impairment charge in the quarter, while Ensign Energy Services Inc., McCoy Global Inc. and Precision Drilling Corp. reviewed their asset values and determined that no impairment charge was necessary. It is certain that writedowns will occur as the year progresses, but the market has already factored in a large margin of error.
The ability of a company to survive the coming months will often be decided by the strength of the balance sheet and the forbearance of creditors. The financial leverage column in the table shows the ratio of total assets divided by common shareholder equity, so a lower number is stronger. Bri-Chem has the highest financial leverage, at 2.78, and has a “going concern” qualification in the financial statements, so the $2-million market cap comes as no surprise. The other more-leveraged companies, Ensign and Precision, also have larger market capitalizations. They are not too big to fail, but lenders may be inclined to cut them a little slack because of the damage they could do to the lenders’ loan book. Titan Logix Corp. has remarkably low financial leverage, although it unfortunately made a $4-million loan to Bri-Chem. If this defaults, the ratio would increase to 1.09.
Based on the market capitalization, any of these companies, except for Ensign and Precision Drilling, could be acquired for pocket change by a larger player in the industry. They could merge with comparable companies. Or they could go out of business.
Perhaps the greatest surprise of the update was the discovery that these companies may be Alberta-based, but their exposure to the Canadian oil patch is, in most cases, quite modest. In fact, all but one of them derive less than 50 per cent of their revenue from Canada, so their future is not entirely dependent on domestic prices and policies. This may not be a permanent advantage as the U.S. shale oil industry is in grim shape, but international diversification is usually a positive.
At this point, a prudent investor would embark on additional research to sort out the winners and losers, cull the herd and focus on the presumed survivors. In this case, I suspect that additional research would be redundant. We are dealing here with unknown unknowns ranging from the price of oil to the patience of creditors and the duration of the pandemic-related disruptions.
So, I am going to ignore the advice of sensible and cautious people and invest a small amount of portfolio cash to a cross-section of all eight stocks on days when the market is gloomy. Some of them will file for creditor protection under the Companies’ Creditors Arrangement Act and I will lose all of the investment, while others may increase their value 10 times over. It is impossible to know who will be the winners, so this is why I think of them as lottery tickets. One big difference, though, is that my losers will be tax write-offs, so I share my losses with the government. Unlike a losing lottery ticket.
I am not endorsing any of the stocks in my sad grouping, but if you have a collection of dead companies walking in a corner of your portfolio, I suggest you create a similar spreadsheet. Then, invest the money normally devoted to lottery tickets in the entire group. A few years from now, you will be boasting about the 10-baggers and mentally erase the losers.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Macke