Adding Risk or Compounding Profits?
Adding Risk or Compounding Profits?
The easy path to finding deep value stocks
Finding Cross-Sections Of Risk
I was reflecting recently on how all of my most profitable trades and best stock picks in the last 2 years had one characteristic in common.
The best stocks are hated for multiple reasons at once.
These are stocks that are out of favor for several of multiple reasons like:
“wrong” country
“wrong” industry
bad reputation
geopolitical risks
high debt
politically unpopular
un-woke
And the best have been the ones combining 2-4 of these factors.
For example:
Transocean (RIG)
This an offshore drilling company, and it ticks almost all the marks:
Offshore drilling is disliked even by oil bulls, for its remarkable boom & bust cycle
The ENTIRE industry went bankrupt in the 2010s, except for RIG. This gives a reputational hazard to everyone in the industry.
Debt: because it did not default, RIG is by far the most indebted in its industry.
Politically unpopular / un-woke: this is a company drilling for oil & gas. It is as far from ESG compliant as you get, even if they pay lip service about “reducing their carbon footprint”.
This is the kind of company that sends Greenpeace activists into a frenzy, with foam at their mouths.
Petrobras
The national oil company of Brazil.
Wrong country: Brazil is a country SO out of favor with investors, its entire index trade with a 10% dividend yield. Latin America in general is scary anyway, it’s full of socialist governments, not all like the EU … right?
Debt: the company has a lot of debt, and after paying off part of it, plans to stay at current levels, preferring to raise capex and give away VERY generous dividends.
Wrong sector: fossil fuels are supposed to go the way of the dodos, replaced by solar panels and Teslas.
Un-Woke: one of the only oil companies planning to aggressively rise production. Guess how it fits with ESG mandates.
Bad reputation: it got involved in a nationwide corruption scandal a decade ago, involving the very same politician that is now back as president.
The Maths Of Undervalued Stocks
Economists will tell you that lower ratios and valuation are a measure of risks.
Actual investors and behavioral economists will tell you it is a consequence of the opinions of market participants. It might or might not be connected to reality and risks.
Combined risks are additive:
Probability of losing money = risk of bad outcome A + risk of bad outcome B
But the psychology of risk PERCEPTION is exponentially multiplicative when it comes to valuation.
So if stock 1 is “safe”, it will trade at let’s say 16 P/E
Stock 2 has one risk factor, so it might trade at 8 P/E.
Stock 3 has two risk factors, so it might trade at 4 P/E.
Stock 4 has three or more risk factors, so it will trade at 2 P/E.
Everyone is scared of touching it. If something goes wrong, you likely get fired from your well-paid investment job. After all, who is stupid enough to think it was a good idea to invest in a company in a bad country, a bad industry, and with a reputation for corruption?
So Stock 4 is trading close to its yearly earnings, because, for most money managers, it is a potential career killer to even mention it, even less put a lot of money on it.
The example above is illustrative, but real life gives you a close enough example:
Exxon: “safe”, even if in a bad industry, so it does not trade a tech level of valuation, but still a solid 8 P/E.
CNOOC: oil + China, getting scary here, P/E of 4.5
Petrobras: DO NOT TOUCH sign for any investing professional: P/E of 2.02
The funny thing is that oil stocks are mostly bought for 2 reasons, dividends, and capital appreciation. Capital rise is dependent on the sector becoming popular again. Dividends are more certain.
Exxon: 3.2% dividend yield
CNOOC: 11.5% dividend yield
Petrobras: 50-70% dividend yield
Now if you consider these yields, do you really care about Petrobras’ stock value?
Of course not, the ONLY question is to know if the dividends will last. Anything else is irrelevant, market opinion of the stock getting better would be nice, for sure, but who cares when you are making these kinds of returns?
Judging by dividend yields, is Petrobras really 20-30 times riskier than Exxon? Pay attention that it means that with a risk to lose money as low as 4% with Exxon (rather optimistic I think), that would put Petrobras at an 80-90% chance of losing money.
Seriously?
Perceived vs Real Risks
With oil stock, the danger is coming from 2 directions:
oil prices crashing.
government taxing to death the company or hindering it in other ways.
The first risk is real, as that is why even the “safe” Exxon trades an 8 P/E. That’s fair.
Now tell, me, which government is the most likely to screw with these companies?
Exxon: borderline declared enemy public number one by the US administration, and actively accused to destroy the planet through Global Warming by the whole Western press.
CNOOC: a relay of power for China, and a steady source of technology, energy security, and cheap oil.
Petrobras: the company giving every year tens of billions in dividends to its first shareholder, the Brazilian State. And tens of billions more to national pension funds, national banks, and a lot of retail investors.
Judging Brazil’s Risk
Imagine that Petrobras suspends the dividends or reduces production.
Do you think failing the national pensions will help Lula politically? What about a banking crisis? Or millions of pissed-off small investors?
Oh, it would also make angry fellow BRICS China who likes oil prices to stay stable and cheap enough.
And Lula would need to cut social spending massively, probably causing an instant paralysis of the country with strikes, protests, and outright insurrection.
Judging US risk
Can I imagine big oil being taxed to death to finance the green transition in the US and the EU?
Or even forcing them to cut production.
No need to imagine, this is already happening.
In A Landmark Case, A Dutch Court Orders Shell To Cut Its Carbon Emissions Faster
Biden Administration Cancels Drilling Sales in Alaska and Gulf of Mexico
That’s what I would call political risk and the “wrong” countries.
Investing works if you buy cheap. And cheap is often found when the PERCEIVED risk is much higher than the real risk.
Tell me again why I should pay x4 more for Western oil stocks? …