market folly

Grey Owl Capital Management is out with its second quarter letter and the focus of the commentary is devoted to opportunity in the markets. While as a whole they feel markets are overvalued, they highlight that near-term uncertainties have yielded potential opportunities in Transocean (RIG) and Apollo Group (APOL).

Firstly with Transocean (RIG), the thesis largely lies in a long-term play on rising oil demand (and prices). Grey Owl had previously owned shares of RIG but sold them back when oil prices neared sky-high prices of $120 per barrel. Late this February, they re-initiated a small position partially as an inflation hedge. Then, opportunity came-a-knocking: an oil spill emerged in the Gulf of Mexico under BP's watch and Transocean was the owner of the rig. The unfortunate environmental incident caused both stocks to tumble.

Yet from an investing standpoint, many investors are able to look beyond the near-term and focus on the long-term picture. Whitney Tilson's hedge fund T2 Partners has presented the bullish case for BP. Additionally, while not directly related to the oil spill, David Einhorn's Greenlight Capital has bought Ensco (ESV) as a result of the depressed stock prices in the oil drilling sector. And today we're presenting Grey Owl Capital's bullish case for RIG. The main concern for Transocean is the liability associated with the oil spill. Grey Owl quickly points out that it is a standard industry practice for the operator (BP) to indemnify the owner (RIG) from risks associated with blowouts, with the exception of gross negligence. As such, unless Transocean is proven grossly negligent, they are in much better shape than BP from a liability standpoint.

Overall, Grey Owl points to Transocean's huge contract backlog of almost $30 billion (a free cashflow backlog estimated just under $15 billion) as a means to weather this storm. Additionally, they highlight that any concerns over the Gulf of Mexico drilling moratorium should only have a modest impact as 75% of RIG's contract backlog resides in non-Gulf of Mexico waters. Grey Owl feels that this single event will not have a lasting effect on Transocean's business and that at $50 per share, RIG is trading just under 6.5x 2010 consensus EPS estimates. They fully expect the stock to be under pressure in the near term, but they're focused on the long-term and expect the stock to trade back to pre-spill levels in a year's time.

Secondly, Grey Owl outlines an opportunity derived from uncertainty in Apollo Group (APOL). This has been the definition of a battleground stock and Grey Owl have staked their claim. As we've detailed before, Steve Eisman of FrontPoint Partners laid out the short thesis on APOL in a presentation he called 'Subprime Goes to College.' This then caused the President of the Career College Association to pen a response to Eisman's thesis. Grey Owl points out that the for-profit education sector is subject to extreme headline risk. However, the biggest risk is the potential new regulations designed to limited student debt burdens. Grey Owl feels that even if these are implemented, Apollo Group trades around fair value. They write,

"APOL trades at a free cash flow yield of 11% and a P/E of 12.5 on a trailing twelve-month (TTM) earnings. This is for a business that has 28% operating margins, has grown revenue an average of 17% over the last three years with very little marginal capital required, and has zero debt. In this case, the extreme uncertainty around the regulatory changes has caused the market to over-discount."

In fact, APOL has appeared numerous times on valuation screens found in the Value Edge newsletter (15% discount here). So, the stock is obviously cheap. But the question then becomes, is it rightly so? Other investors believe that there will be long-term ramifications in the industry. After all, why else would hedge fund Conatus Capital sell out of APOL and then Andreas Halvorsen's Viking Global sell APOL as well after holding it as one of their larger positions.

We've detailed the progression as many prominent hedge funds took bullish positions in the for-profit education space last year. Yet somewhere along the line, something changed and that 'something' was increased uncertainty. Grey Owl viewed this uncertainty as an opportunity and dove right in. This dichotomy of viewpoint is what makes a market.

Embedded below is Grey Owl Capital Management's second quarter letter:



You can download a .pdf copy here.

One year from now we'll have to look back and see whether or not uncertainty yielded opportunity. We've posted a ton of hedge fund market commentary and recommend also checking out the latest thoughts from Perry Capital, David Gerstenhaber's macro outlook at Argonaut Capital, Corsair Capital's latest investment ideas, as well as David Einhorn's latest Greenlight Capital letter.