Finding the Next Gastar

 | Jan 02, 2014 | 7:05 PM EST  | Comments
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Stock quotes in this article:

gst

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mill

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grh

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mhr

The most successful Portfolio Guru pick in 2013 was Gastar Exploration (GST). At the end of 2012, the common shares were languishing at just over $1 per share and the preferred shares (GST-A) were trading at a mere 70 cents on the dollar.

The company suffered under the overhang from a lawsuit with Chesapeake over a long-ago land deal, and the shares were heavily shorted. Some were clearly betting that Gastar "wouldn't make it," as the contingent liabilities from a full judgment would have overwhelmed Gastar's capital reserves.

Of course, it didn't happen that way (I won't retell the story, but I mentioned it here, here, here) and Gastar was a superlative performer in 2013, closing the year at $6.92.

So, if we use Gastar as the template and we stick with my thesis that emerging energy names will outperform the broad market in 2014, we can look for following criteria for 2014's big winner. The common theme here is that each criterion represents a contrarian angle.

  • Large Short Interest

When the shorts go after small, emerging companies, it's usually what I call "the death short." In this situation short-sellers are betting not on a correction, but on full-on collapse -- bankruptcy, etc. Through careful analysis, I identify companies where the shorts are wrong, and when that happens is doubly beneficial -- the pressure from artificial selling is removed, and buying pressure -- which is very real -- is created as the shorts cover.

  • Ability (and willingness) to raise capital. Often this is what moves the needle for a company, especially one involved in E&P. Gastar's ability to do two high-yield deals, offer more of its Series A preferred and (recently) create a Series B preferred have transformed the company. Some of this capital was issued at very high rates, and it's understandable that the finance guys might want to avoid it.

But that's the key... management has to be so bullish as to be willing to pay higher rates. That tells you that their Internal Rate of Return assumptions are high enough to offset higher interest costs. And that they are bullish enough to risk careers (memories are long among oilpatch investors) by leveraging up.

  • Acreage...with very little current production on it. Land in and of itself isn't a virtuous thing, and I don't favor empire-building. But smart management teams eat up as much acreage as possible before a play becomes a hot play The great thing -- for an investor -- about E&P is that results are quickly announced (by the public players, anyway) and early well results can be a great indicator of the economic viability of a play. That is not necessarily a good thing for the companies, however, as greater interest leads to higher land values which leads to lower IRRS. 

So, it almost seems perverse, but I try to look for companies that aren't exploiting a great deal of their acreage, because the unexploited acreage is rarely full valued by The Street and can be he the hidden upside for the stock.

  • "Bargain" fixed-income securities. Double-digit yields can indicate the market is overestimating the risk in the company's business. That was definitely the case with Gastar, as both of the company's common and preferred shares were depressed. So, identifying undervalued preferred can yield attractive stock picks as well.

Among Portfolio Guru favorites, Miller Energy Resources (MILL) and Magnum Hunter Resources (MHR) fit all four criteria and GreenHunter Resources (GRH ) misses out only on the acreage component... because it is a services company. It's a new year, though, so how about some new names? Well, I am out of column space, so that will have to wait until tomorrow. But the framework has been set, and tomorrow I will fill in my "new" individual stock picks for 2014.

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