Crisis investing: oil edition

Crisis, what crisis?

One of the prosaic, but educational features of the Barel Karsan blog, is chapter-by-chapter reviews of classic investment books. At the moment it’s reviewing David Dreman‘s Contrarian Investment Strategies: The Next Generation.

Dreman’s quantitative approach inspired a generation of stock screeners and, considering how towards the end of his life Benjamin Graham embraced simple quantitative screens over the intensive analysis he had previously espoused, I think Dreman is closer to where Graham was going than, say, Graham’s protégé Warren Buffett is.

Chapter 12 describes crisis investing, and Karsan’s précis made me reach for Dreman’s book. As a fund manager, he’d invested through the banking and pharmaceutical crises of the nineties, so maybe we can apply his crisis strategy as oil from BP‘s uncapped well laps up against the American shoreline.

"A market crisis," he says in the book:

… presents an outstanding opportunity to profit, because it lets loose overreaction at its wildest. In a crisis or panic, the normal guidelines of value disappear, People no longer examine what a stock is worth; instead they are fixated by prices cascading ever lower. The falling prices are reinforced by expert and peer opinion that things must get worse.

Under these circumstances, Dreman says, the normal guidelines of value are even more important than usual, they’re the investors “armour”.

Dreman favours companies financially strong enough to endure a crisis. They should be at least 40% self-funded, financed by equity as opposed to liabilities. (Graham favoured 50%, a limit that would knock both BP and Shell out of my crisis screen, below).

He also uses the basic valuation ratios, price earnings, price to book and dividend yield to determine whether a company is cheap, favouring the PE above all:

Even if a company is a tower of financial strength, that doesn’t mean I haven’t paid too much for its stock. This is particularly true in a panic. As we have seen, in a crisis you can demand even lower price-to-value ratios than in more normal times. What’s more you will get them! So don’t be overanxious as stocks free-fall. What looks dirt cheap can often drop another 20% or 30%.

Finally, he urges diversification:

No matter how cheap a company or industry appears, things can still go wrong. That’s why in the bank crisis we only took small positions in any single bank.

There’s no shortage of UK listed companies in the oil and gas sector. The trouble is, once you weed out all the companies that are unprofitable and statistically weak or speculatively priced, you’re left with just five:

Crisis screen (Oil & Gas sector)
Name	Cap £m	F_Score	Eq:Ass	10yPE	1yPE
BP	60,493	6	43	7	6
DRAGON OIL	2,067	6	79	26	11
FORTUNE OIL	129	6	21	36	11
JKX OIL AND GAS	406	5	84	14	6
ROYAL DUTCH SHELL	42,493	5	46	10	10

Exclusions:
Market capitalisation < 10m, F_Score < 5, equity:assets < 40%, PE < 10.
Source: Sharelockholmes.com, Date: 30 June 2010

I’ve augmented Dreman’s measures with the F_Score, which had yet to be invented when he wrote Contrarian Investment Strategies. Any company with more negative signals, than positive (a score of less than five out of nine) is excluded from my crisis screen, because the company was already weak before the crisis hit.

And because oil company profits vary enormously with the oil price, I’ve included the the price to ten year average earnings ratio as a  more realistic estimation of an oil company’s earning power. To qualify a company as a bargain both PEs should be 10 or lower. Only BP (BP-)  and Shell (RDSB) do.

The paucity of obvious value makes me wonder whether BP’s woes have provoked a crisis in confidence in the industry, as opposed to the few companies responsible this time.

While a "vortex of fear" may have pushed BP’s price lower and lower since April 20 when an explosion on the Deepwater Horizon rig introduced us to the crisis, it doesn’t seem to have been particularly contagious.

BP shares have fallen 49% since April, but Shell’s have only fallen 17%, and Exxon, a US oil major, is down 18%. Bearing in mind the FTSE is down 16% in the same period, these falls don’t smell of panic to me. Dragon Oil and Fortune Oil have fallen 14% and 11%, small kinks in their price lines, which have appreciated enormously in the last decade.

You know you’re in a crisis when it’s headline news, says Dreman. Crises sell newspapers and this oil slick has certainly sold a few. But it fails another crisis test. Dreman says:

One of the most important characteristics of a crisis – at least to the contrarian investor – is the abundance of opportunities.

He’s buying though. According to his latest column:

Oil and gas exploration and development companies, as well as oil service companies, have been whacked hard since the BP spill started. The stocks have also been knocked down by the temporary ban on deep-sea drilling enacted by President Obama. Don’t obsess over the jockeying going on in the courts over this issue. The public’s distaste for importing oil from bad regimes, and the anguish of unemployed roughnecks, will cause either the President or the courts to end the moratorium.

He recommends two oil and gas ETF’s that are 14% and 27% below their highs.

I’m surprised. This doesn’t look like crisis investing to me. According to Dreman’s descriptions of the banking crisis valuations almost halved and prices plummeted 50% or more. The huge returns from investing in them were a function of how they had fallen.

Oil shares may be cheapish, but despite my co-columnists Peter Temple’s and John Mulligan’s enthusiasm for BP, I won’t be adding a posse of oil companies to the Thrifty 30 portfolio unless we see widespread crisis valuations.

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Valuing Exxon

Geoff Gannon reckons Exxon is worth $80 a share, the shares cost $57.

BP’s funding options appear limited, until it plugs the well.

Tim du Toit has put together a James Montier resource page that leaves no resource unturned.

Contrarian Partners, which trades against the research put out by investment banks, reports a strong six months.

Professors Rogoff and Reinhart say:

The mainstream of academic research in macroeconomics puts theoretical coherence and elegance first, and investigating the data second.

They didn’t.

Another data-head, Robert Shiller, utters the ‘D’ words: depression, deflation, double, and dip, all in one interview.