Invest More Like a Shark

Those of us who watch the hit TV show Shark Tank are very familiar with the panel of potential investors who consider offers from aspiring entrepreneurs seeking capital for their ideas. As investors, we are actually all “sharks” who make capital decisions on where to invest our money. Some investors hire wealth managers to make decisions for them and others prefer to make the decisions themselves. We believe the ultimate sharks are famed investors Warren Buffett and Charles Munger but the current panel of “sharks” are all well connected and great capital allocators. The sharks are never afraid of losing money as long as they believe the odds are tipped in their favor. We believe that thinking with the same mindset as the “sharks” will help you take some of the emotions out of these volatile markets.

We are all fortunate enough to live in country that offers some of the best investment opportunities in the world. However, some investors continuously monitor the markets for economic signs that might indirectly impact their investments. These questions usually apply to current events or headlines that capture readers attention. A few questions below seem to be the ones currently being debated.

  • After the enormous relief rally, has the current correction ended?
  • How low will the price of energy fall?
  • How will falling energy prices impact the economy in 2015?
  • Will the global contagion from the slowdown occurring in the rest of the world spillover into the US?
  • Is it possible that Russia will default on its debt and will Putin lose power?
  • Can the deflation/recession in Europe move to the US?
  • If the Federal Reserve starts to raise rates at some point, will my investments lose value?

We can state with a large degree of confidence that very few investors can accurately predict the answers to these questions. However, most of the responses you hear will make for entertaining commentary on TV. As value investors, we think it’s best to have a mindset of a “shark”. The successful investors on the Shark Tank have an entirely different set of questions they try to answer before taking ownership in the business.

  • How long will it take me to get my cash back and how much can this investment return?
  • What is my potential downside risk in this investment?
  • How much money can I possibly lose vs. the potential for upside?
  • Do I understand how this investment works and what are the potential risks?
  • Is this a scalable opportunity that can be leveraged?
  • Are there high recurring capital expenditures to fund this investment?
  • Can competitors easily replicate this idea and take market share?
  • Will I be able to work with this management team/entrepreneur seeking capital?

We believe that the second set of questions is how you should be evaluating your investments. The first set of questions are all irrelevant to long-term investors who are properly diversified to their risk tolerances and goals. The second set of questions are much more relevant to making ongoing capital allocation decisions. If you think of yourself as a “shark”, your investment process will be much more decisive and your long-term investment results may improve.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

2015 Portfolio Positioning: Beware the “Black Swan” in Oil

As we prepare for our year-end reviews with our clients, we are highlighting how the rout in energy prices has impacted their portfolios as they save for retirement or other financial goals. In our view, we continue to see major downside risks within certain industries and countries that rely on high oil prices. We believe that prudent sector rotation, where some industries do better than others, will be critical to adding some downside protection to your portfolio. One of my favorite quotes from Warren Buffett applies well to today’s market environment, “Risk comes from not knowing what you’re doing.” As we head into 2015, the market environment has become unpredictable as investors struggle with the uncertainty created from the drop in energy prices. With stocks falling off all-time highs and bond yields at all-time lows, we believe wary investors should seek a second opinion on their investments if they are uncertain of the likely outcomes from this difficult market environment. If your advisor is not providing you with timely market updates, they might be struggling with how to reposition your portfolio from this “Black Swan” event in oil prices, which has caused such capital loss in the energy sector.

Over the past few months, we have recommended a zero weighting in energy companies and we continue to believe that there are more attractive sectors within the U.S. stock market to invest. We are advising that our risk-averse clients continue to underweight much of the energy sector but remain invested in other industries that are benefiting from the drop in energy prices. Lower unemployment and lower energy bills should underpin the economy as we begin 2015. Economic data has shown that the drop in energy is positively impacting the consumer and many consumer discretionary and industrial companies stand to benefit. However, we now becoming more cautious on many of these companies as they have seen substantial gains in their stock prices. As we read press coverage about how consumers should benefit from lower fuel costs, we believe that investors have already priced in much the future cash flow gains from the drop in energy.

The greatest opportunity now might be uncovering potential opportunities in the energy sector but we remain cautious. We believe that low oil prices may continue to make markets volatile and this could create many interesting opportunities for investors as we head into 2015. Below are a few things that we are watching closely.

  • After the substantial drop in many Energy stocks the sector looks relatively cheap based on price-to-earnings (P/E) and price-to-free-cash flow (P/FCF) relative to the S&P 500 Index but this could be a classic “value trap” if the price per barrel of oil does not rebound.
  • If oil prices do not rebound there could be a number of bankruptcies and this time the government will not step in bail out the over-leveraged oil producers much like they did the banks in 2008. We expect continued volatility in the high yield credit markets, where energy issues makes up a significant portion of the overall asset class.
  • The bottoming process for oil companies will be marked by extreme volatility. A number of U.S. exploration and production (E&P) companies that have key strategic advantages might be acquisition targets for larger oil producers who have cash to spend and are not leveraged themselves. These companies we believe are becoming very attractive buying opportunities and we hope they become even cheaper.
  • We anticipate dividend cuts and/or capital write-downs if prices do not rebound. We are closely following comments made by the managements of major energy companies on the stability of their dividends. If energy companies cut their dividends many investors may be forced to sell their positions. This could create a potential buying opportunity.
  • There is a chance that many energy producers suffer the same fate that gold miners have experienced in the past few years. Many of these gold stocks have seen huge rallies followed by ensuing reversals. We believe that active traders might target many E&P companies in the Permian Basin, Bakken, and Eagle Ford shale areas as very good tradable opportunities.
  • A recent blue print that was created from the market crisis of 2008 might play-out for energy companies in 2015. The companies that were the most leveraged and experienced the closest near death experience were actually some of the best investments to make when the crisis ended.
  • If oil remains low, we believe that many U.S producers might be forced out of the market, but this could cause the price of oil to rise as fast as it has fallen when supply tightens.
  • As the tide goes out on many of the managements in the energy sector, we could be in store for a few more major surprises.
  • If prices continue to drop, we believe that larger investors such as Warren Buffett might step in and buy infrastructure companies that transport energy. These companies offer very good long-term investment opportunities when the dust settles.
  • Foreign governments that depend on high oil prices to sustain their government may experience political upheaval.
  • The falling price of oil might help many struggling European countries at the expense of Emerging Market countries that rely on higher oil to fund their governments.
  • The result from substantially lower deflation may result in a further drop in U.S. interest rates. A subsequent drop in mortgage rates could result in another refinancing boom, as young investors might look to this market as an opportunity to lock-in low fixed rates and take advantage of a stable housing market.
  • We are very wary of margin calls due to the highly leveraged market. The drop in oil prices might cause an unwinding of entire positions, which may result in a full market correction. Many tax sensitive investors might sell their 2015 winners to offset losses in their energy positions. This tax harvesting might add to market volatility as we close out 2015.

Overall, we believe risks remain and it is prudent to remain overly cautious. We will gladly sacrifice any potential upside off the bottom in exchange for not risking the permanent impairment of capital. We believe dividend cuts and potential bankruptcies could be around the corner for highly leveraged explorers with higher marginal costs if oil remains at these levels.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.

Falling Price of Oil – What Does It Mean For Your Portfolio?

Institutional Thinking for Individual Investors™

By Mitch Zides, CFA, CFP®, AIF®, NSSA® November 28, 2014

“Rule No.1 is never lose money. Rule No.2 is never forget rule number one.” – Warren Buffett.

As the price of oil has fallen sharply from nearly $110+ a barrel back in June 2014, to approximately $70 a barrel today, we reflect on Buffett’s famous quote. We all know that entails investing through uncertainty with the possibility of loss but keeping Buffett’s rule in mind can potentially keep you from avoiding major catastrophic losses. One of these losses is actually taking place in the energy sector.  This nasty reversal of over 38% is most likely having negative implications on your investments if you haven’t been correctly positioned for this this swift and unexpected drop in energy prices. Investors who have been properly diversified probably haven’t even noticed this complete meltdown in oil prices as markets have reached all time highs. However, if these unfavorable conditions persist for energy companies there could be unforeseen consequences that have yet to be played out. In particular, the chain reaction will have major ramifications on many foreign countries that are dependent on high oil prices to fund their government budgets. As these countries fall into deficit, they might actually be forced to pump more oil out of the ground to increase revenues rather than cut prices to decrease supply.

The most important assumption that investors must now make is how prolonged oil will remain at these levels. If OPEC members are trying to protect market share against the shale boom occurring in the US, we could be in for a protracted period of lower oil prices. If oil prices remain at these levels, we believe that many US shale energy companies will be forced out of business. Similar to the tech boom in the early 2000’s, the US has experienced a shale boom in recent years. There has been a substantial build up of capital in the energy sector and we could be more in a period of capital destruction in the next few years.

Another major implication will be that energy companies maybe forced to cut their dividends or even worse raise debt to sustain their dividends.  We have analyzed the cash flow statements of all the major energy producers and conclude that if these companies do not cut back on capital expenditures they will not have enough cash flow to fund dividends or buyback their company shares.

The margin of safety for investing in the energy sector is no longer in place. In our view, the true intrinsic value for energy companies is too difficult to estimate at these levels. We have completely avoided the energy sector and will continue to do so. We believe that the larger more diversified energy companies remain vulnerable at these levels. In our opinion, the time to buy the major energy producers will be when they announce dividends cuts. Many large institutional managers who are overweight energy will be forced to sell into a falling market as these cuts take place. We witnessed a similar meltdown of banking shares during the great recession as those companies were forced to cut their dividends. In hindsight, the time to buy was when banks cut their dividends. It is impossible to predict the direction of oil and we prefer not to make predictions; however, we will protect our clients’ capital from this vicious cycle. In addition, we will also not invest in any renewable energy technologies, which have seen their stocks drop 30% over the past month. Alway’s keeping Buffett’s rule at heart, we prefer to not risk investors capital during periods of unprecedented market stress.

Our recommendations are not suitable for all investors but, our clientele have trusted us to make tactical decisions on their portfolios. Our major criteria for selecting investments is that companies must actually have the financial capacity to pay their dividends from free cash flow and not from debt.  Investors with long-term investment horizons could potentially gain from buying these energy companies at lower levels, but we would rather wait for a better entry point.  Against this backdrop of falling energy prices, low interest rates, a strong US dollar, low inflation, strong corporate earnings, and falling unemployment, there are just better areas to make investments.

Please read our disclosure statement regarding the contents of this post and our website as a whole.

Advisory services offered through Constant Guidance Financial LLC, a registered investment adviser.