By Joseph Cerqua, CFA
EVERYTHING SEEMED FINE
In April of 2010, I was on a routine business trip. Two colleagues and I had a slate of meetings with several energy companies based in Houston. It was an opportunity to probe managements on topics ranging from current conditions to long term strategic moves. Some we were just getting to know while others were companies that we had already done some due diligence on. The last meeting of the day was with one of those companies. Back at the office, I had modeled their potential earnings under different scenarios. In a tight market for their product, I believed they could earn $19 per share. As our meeting was wrapping up, my partner suggested that I run that number past them. Their representative gave a quick reply that they could certainly reach that level under those conditions. At the time, analyst earnings estimates for the company were around $12 per share. None of us present were predicting that this hypothetical “tight market” was coming any day soon. It did however give us confidence that we were modeling their financials accurately and the opportunity was present to buy shares as the stock was being valued based on earnings that were well below the company’s potential. We thanked them for their time, packed up our stuff, and left pretty pleased with the day’s work.
Within five hours of leaving that meeting, there was a pressure kick in an oil well deep below the surface of the Gulf of Mexico. Safety equipment built to contain such an event failed and a stream of flammable gas raced to the deck of the drilling rig above. It spread across the rig and ignited, resulting in a massive explosion that took the lives of eleven workers, left a gush of oil spewing into the water, and completely demolished the rig. That rig was called the Deepwater Horizon and its owner, Transocean Inc., was the company we parted ways with just hours earlier feeling so good about.
From there, the dominoes started tumbling. The stock initially took only a modest hit as the revenue generation of the Horizon was extracted from its valuation. That was not nearly their biggest problem.
The crumpled infrastructure of the well left oil pouring into the Gulf of Mexico. Drilling at these depths was new to the industry and initial attempts to control the well failed miserably. The optics of a growing environmental disaster brought a swift political response. The Obama administration put a moratorium on new drilling in one of the most active basins in the world. The rig market tanked and Transocean’s stock never recovered. Ten years later, it now trades below $2 per share.
WHAT CAN WE DO ABOUT IT
If these tail risks cannot be forecasted, is there anything investors can do to protect themselves? Yes. Even without a crystal ball, there are ways to reduce the chances of being torpedoed. Below are some attributes of companies that you are safer steering clear of.
I am always reluctant when someone asks if I have a good stock tip for them. Even with a well thought out investment thesis, anything can go wrong with a single stock pick. Taking risk is necessary but that doesn’t mean you should take any risk. Minimize exposure to stocks with the attributes listed above. Don’t “bet the ranch” on any one idea. Hedge your portfolio with negatively correlated assets. Although these events are rare, that fact will not provide much comfort to you when they hit. Consider these measures to keep you and your portfolio above water.