A fun piece came into my email box about analyst coverage of BP after the Deepwater Horizon. The article, by The Reformed Broker, is a rant about fundamental analysts. It is a good fun read for those who enjoy some schadenfreude (a guilty pleasure at viewing other’s misfortune). Yes, the analysts did spend too much time with their DCF (Discounted Cash Flow) models and not enough time studying up on how Exxon became part of Exxon Mobile (XOM). If you listened to the analysts, you might have lost close to 50% of your investment in very short order. Let’s try to learn something by looking at this strange disconnect between the analysts and the events playing out in the Gulf of Mexico, Washington DC and London.

First, Ask What Went Wrong?

Start with the obvious: How could almost all the key institutional analysts have gotten the call on BP so wrong?

There are two reasons:

  1. Analyzing what is visible; overlooking what is invisible
    Each call was based on extrapolations of existing accounting information and models of potential liabilities based on the Exxon Valdez oil spill in 1989. The analysts were focusing on the visible data: historic financial data and an accident that happened on the surface of the water near the coast of Alaska. All good and well but the market decided to focus on two problems that are invisible (or at least very opaque).
    First, the blowout is located 5,000 feet below the surface of the Gulf of Mexico. It is literally invisible. The most modern US nuclear submarine would not be able to get to half of that depth before being crushed by the pressure and almost all light cuts out below 650ft. In the case of the Exxon Valdez, both the US Government and the management of Exxon were clear about how much oil was being carried on the ship. This time, no one has a clue about how much oil will eventually spill into the water.
    Second, no one can say for sure how much new regulation will be imposed on the offshore drilling industry as a result of this disaster. These two invisibles have been driving the stock price, not DCF values.
  2. If you liked it at that price, you are gonna love it now!
    OK, that may be a bit of exaggeration. We are not talking about kitchen appliances (or gold coins) on late night TV. But the hyperbole highlights the frame of reference problem. The analysts who liked BP at $60 were in the wrong frame of mind when it was marked down to $50 then $45, $40 and so on. If they thought fair value was north of $60 before, how could they not get excited about a clearance sale? But it wasn’t a sale. The frame of reference changed because the market was in the process of digesting the steadily worsening picture in the Gulf. Sometimes, the market is trying to tell you something. It might be a 20% off sale but at the very least, you should be willing to challenge your assumptions.

Next, ask if you should even be here?

For this frame of reference, we should question where the energy sector belongs in the greater scheme. It is fascinating to follow the reports and learn about how oil companies drill for oil a mile under water. But what does that have to do with your investment portfolio today? How much should one be investing in energy companies today with the global economy just barely out of the Great Recession? The answer is not difficult or complex. Taking IXC as a proxy (IYE if you would like to limit yourself to US only), you have not missed much by ignoring the sector over the last 6 months (both before and after the blowout). If you look at the medium term prospects of IXC (click here), the System is telling you that your money is better off elsewhere. Does that make sense? Before the blowout, low industrial capacity utilization and the prospect of a cooling Europe and possibly China signaled caution. After the blowout, the case for underweighting energy is even stronger when you think about how much more it will cost to drill for oil once the US Congress finishes passing new laws and President Obama finishes issuing executive orders. The time to look at this sector is when all the bad news is public and the economy looks ready to demand fresh sources of oil. We have reached neither of those conditions at present.

What can we conclude?

Bottom up research can be risky business. The conclusions can be undone by factors that are hard to fathom (or in this case, are invisible) and the analysts themselves are often too close to their subjects to offer good perspective. The next time you see a hot tip like BP at $48 on your favorite blog, ask yourself if all the bad news is really in the market and what would happen if another shoe were to drop. BP’s management may have been able to deal with a blowout leaking 1,000 barrels of oil a day but at 60k a day, the company’s prospects look very different.

By having a top down framework, which has been telling you that energy is at best a lagging sector right now, you can avoid investing in these “hot opportunities”. Picking a good sector in a broader index or a solid stock in a promising sector is a far easier way to make money in the long term.

Where are we this week?

The System shows us in much the same place as last week. Although the markets did perk up a little, most risk assets are still sporting low or negative scores. One issue looming over the equity markets is the huge number of large equity issues crowding the gates in Hong Kong and Shanghai as Chinese corporates clamor over one another to issue new shares. The expected valuations look rich compared to what investors seem willing to pay, the potential cash call is significant and any hiccups might generate bad news that could reverberate around the world. Perhaps the G-20 meeting isn’t the only reason China has announced a further revaluation of the RMB.

Try our new tool

Check out your favorite stock, ETF, index or Mutual Fund on our “Steam Gauge“. If you click this link or the picture below, it will take you to a page with the S&P500 ETF loaded into the ticker window. You can hit the “Try Me” button or enter your own ticker. After you get the result, the reset button will give you a blank window to try other tickers. We will be rolling out a more advanced tool for our Gold Members that will allow you to put in multiple tickers and see how they compare to each other.

IRP Steam Gauge

Filed under: Market CommentMarket Psychology

Like this post? Subscribe to my RSS feed and get loads more!

Possibly related posts