Korea’s Frozen Assets: How to Always Make Money in Stocks
By Dan Ferris
November 25, 2006
On February 13, 1806, a Massachusetts businessman named Frederic Tudor loaded curious cargo into a ship docked in Boston Harbor. Tudor then accompanied the ship on a 1,500–mile journey to the Caribbean island of Martinique.
The ship's sole cargo consisted of huge blocks of ice cut from a Massachusetts lake.
Tudor had watched local men make fortunes importing and exporting various commodities from New England. The year Tudor was born, Boston merchants made a fortune selling an entire shipload of ginseng in Canton, China. In 1805, over seven million tons of peppercorns were exported from Salem Harbor.
Tudor thought that the ice frozen in Massachusetts lakes and ponds was a valuable commodity, one that could be shipped far and wide for a profit. He viewed it as a frozen asset that was wasted each spring as it melted away. People ridiculed Tudor's idea, including his father, who lectured him every morning on his "miserable prospect for success," urging his youngest son to abandon the voyage.
Tudor persisted. His enterprise succeeded. In the process of building his ice–exporting business, Frederic Tudor founded an entire industry, employing thousands of men and horses to harvest millions of tons of ice each winter. Gavin Weightman tells Frederic Tudor's story in detail in his excellent book, The Frozen Water Trade.
Frozen assets are an unpopular idea. It made me think: Tudor saw value where no one else did.
And he spent time doing something he loved, something no one else thought he should bother with. In time, his idea became downright popular, making him a wealthy man. This chain of events is familiar to readers of my monthly advisory, Extreme Value. In fact, Tudor's saga represents the life cycle of an Extreme Value investment.
Two years ago, Korea Electric Power Corp. (NYSE: KEP), also known as KEPCO, was in its own frozen asset stage. The South Korean government owns most of this company. Despite promises to privatize portions of it, the company's valuable assets sat on its balance sheet, figuratively frozen like a prehistoric behemoth. That, among other reasons, is why KEPCO traded at a steep discount to utility stocks around the world… And why, in 2004, it traded close to the post-Asian-crisis levels of 1998. Yet KEPCO's earnings had nearly doubled since then, and its dividend was three times more than it was at that time.
The other reasons for KEPCO’s dirt-cheap valuation? Operating margins dependent on oil and gas prices… a nutcase neighbor in Kim Jong Il… and government-controlled electricity pricing. One other thing bothered investors… KEPCO’s business wasn’t highly leveraged with debt.
Believe it or not, Wall Street doesn't like it when a company doesn't have "enough debt" on its balance sheet. I know, I know. It's hard to fathom, but the people who never apologized for telling you to buy Enron two weeks before it declared bankruptcy are constantly on the prowl for assets they can turn into banking deals. They don’t care for excess assets.
Which brings us to KEPCO. With some global utilities carrying debts amounting to several times their shareholders equity, you'd think one with less debt than equity might be a sight for sore eyes. With just 0.6 times as much debt as equity, KEPCO's balance sheet looked like a safer bet than say, CenterPoint Energy, with nearly six times as much debt as equity, or AES Corp, with about 15 times debt to equity. It's hard to feel like an owner of such indebted companies, when you know there are many bondholders and banks with copious claims all senior to yours.
Optimal capital structure be damned – I just don't like borrowed money. Less debt is always better than more debt, no matter what Wall Street says, and no matter how much interest I can write off on my taxes. You can find better write–offs, I promise. In that light, KEPCO has managed its obligations well. KEPCO's debt–to–equity ratio has improved steadily and dramatically since 1998. Back then, debt was 175% of equity. Today, there's more equity than debt.
No matter what Wall Street’s reasons were, when I recommended KEPCO to my Extreme Value readers a few years ago, the company was trading for four times earnings and less than two times cash flow. KEPCO also traded for less than half book value, providing us with a large margin of safety... and leaving plenty of room for the share price to rise.
And rise it did. We’re up over 100% on KEPCO in just over two years – all by owning one of the world’s cheapest, safest stocks. Making big returns on your money doesn’t have to involve taking big risks. It simply involves buying assets for less than what they’re worth.
If you know nothing other than this, you’ll always make plenty of money in stocks.
Good investing,
Dan Ferris
