BP: Classic value or major trap?

Back in February 23^rd 2010, in a post titled “Skin in the game” I somewhat publicly, committed to “walk the talk” and initiate the composition of a stock portfolio. Some 4 months have passed and I feel the appropriate time has now come to at least take the first steps.

In short, I have placed a buy order for US-traded ADR shares of the much-maligned British Petroleum (ticker: BP). For full transparency I will let it be known that it’s a 25 $ market-type order and as such the position is not open as of the date of this post. Furthermore, in the spirit of relative concentration this single bet will represent a substantial 4% of my current equity portfolio.

First and foremost let it be said that I realise that there’s much wrong with BP as a corporation, not least its obviously poor safety record and its ill-handled reaction to the April 20^th spill and subsequent human and environmental disaster. In this respect, the abysmal performance of its common stock over the last 8 weeks seems fairly logical. Adding insult to injury for most holders is the suspension of its once mighty dividend payout, thus depriving several million savers on both sides of the Atlantic of a key source of financial security.

Furthermore, the creation of an independently managed (not BP’s) $ 20 Billion escrow account as a form of financial guarantee to cover potential liabilities poses additional challenges. This approach is a first after an environmental disaster and effectively removes BP’s ability to manage the timing of some of the eventual payouts. Just as critically it serves to quantify the magnitude of this tragic event.

And yet, in spite of the remarkable level of uncertainty surrounding the spill (remember the oil is still gushing out, and as of yesterday, June 24^th, now reaching the shores of the Florida “pan-handle”), my analysis tells me there’s considerable value in BP at its current market price. Allow me to elaborate:

1. Although the size of potential liabilities (the total sum of fines, compensation, lost production, repair fees and lawsuits) remains unknown, a conservative estimate can be made on the basis of both historical precedent and “back-of-the envelope calculations). My calculations point to a worst-case scenario of around $35 B which represents about 18 months of BP’s normalised free cash flow.

2. The previous estimate of liabilities is extremely conservative as it assumes that all responsibility rests with BP, which is unclear as its drilling and exploration partners will surely assume (or be forced to bear) some of the financial pain

3. BP’s balance sheet is equally healthy (as its Income Statement), no significant debt repayments as scheduled for the next few quarters. Moreover, BP has already began the process of further capitalising its balance sheet with the unpopular but wise suspension of the dividend and the publicly announced intention to reduce CAPEX to the tune of $ 2 Billion per year. Adding further non-core asset sales will bring some further $ 10 B into play.

4. From a Price-to-Earnings multiple, the risk/reward trade off seems to come with a hefty margin of safety. 10 year EPS (including periods with oil at $ 28 a barrel) is $ 4.6. Plugging in a conservative 9x multiple (v. a 10 year trailing average of 14x) would suggest that today’s 4x PE ratio is a steal.

5. Assuming an almost disproportionately conservative earnings shortfall of 30% to $4.41 per share points to an intrinsic value of $40 in the low range of the PE ratio and a more attractive $61 once “normal” multiples resume. In any case from its current price, the potential upside is at minimum 42%.

6. Supplementary reasons such as diversified revenue sources, both geographically and sector wise (it is the largest natural gas producer in the USA…), together with deep pockets and little leverage will act as a back-stopper to any fears of bankruptcy.

In short, odds favour the patient investor and never more so than in this case. I am ready for a fun but bumpy ride. Are you?

Active vs. Passive (Index) Investing

These are testing times, with no clear direction in the markets, having just come off a horrendous 5 weeks in most western stock markets, which put a halt to a 14 month bullish spree since originating in March 2009. The so-called “perma-bears” such as Nouriel Roubini and Marc Faber are back in vogue once again, continuing their warnings. But it’s not just the usual suspects that are showing concern.

Even investors that have done remarkably well in the recent past by venturing into oversold assets as of early 2009 are swelling their cash balances in the absence of opportunity. Recent interviews suggest that cash balances, a.k.a. “dry powder among value funds stands as high as 20 to 25% of assets.

Is it hence the time to heed the advice of index investing advocates?

There’s much to be said for it, indeed recent reading of Charles Ellis’s “Wining the Loser’s Game- Timeless Strategies for Successful Investing pointed me in these direction… On the same note, a recent talk by my former MBA Professor of Finance, Javier Estrada, provided a wealth of data to support the virtues of an equity-weighted, index-wide, geographically diversified, long-term, buy & hold strategy.

Admittedly, obtaining the returns of a market-wide benchmark over a long period of time, say 15-20 years is an attractive proposition under any scenario.

And yet despite all of these sound arguments and substantiated research I can’t bring myself to just track the market. Why does this happen? Haven’t we learnt our lesson? Is it not yet clear that we as investors are the market and as such any sustained out performance requires sustained under performance by equally informed and trained counterparties? What is it that makes us (or at least me, in this case) think that we can do better than the rest?

Call it what you will, but for me it comes down to a competitive nature and the remarkable and defining impact of human emotion.

Personally I have over time, though not always, increasingly relished in acting in a way that is contrary to conventional thinking in matters economic. From renting real residential estate in a market where said action is deemed almost a social failure, to investing in equities throughout 2008 and 2009 when the world “stood on the brink”, to borrow for the Economist.

Throughout this period and to this day, I can’t lay claim to performing deeper research than full time professional investors or to have access to more complete data than other investors. My sources of information are not only free and non-proprietary but more importantly, widely available to any potential investors. As such the opportunities I review and act upon are readily available to any interested party.

Where I think the difference lies however, between myself and other stock market players, both active and index investors is in our emotional interpretation of the context surrounding securities pricing. Let’s take an example that has been front-pager news for some 6 weeks now:

British Petroleum’s (BP) massive Gulf Cost spill.

How do we react to BP? When is the price drop large enough to discount even the worst-case scenario? (Dividend removal included!). When do we allow the numbers to take the front seat as opposed to the Congressional grilling of BP execs or worse still, the underwater web cam and its relentless images of a real-time environmental tragedy?

I say about now!

By consciously opting to:

1. Remove the noise. i.e. turn off the TV and just gather the facts

2. Ignore the crowd. i.e. see above

3. Look into the few key numbers (e.g. long-term trailing average cash-flow generation) and compare this to both potential downside and long-term value of the enterprise.

All effort should be aimed at determining if there is a substantial gap between BP's current price and its cycle-resisting intrinsic value. Should the answer be positive, this surely represents the triumph of overcoming emotions and actively exploiting other's errores over conceding to a passive index strategy.

Time, as always, will tell.