October 30th, 2014
by Robert Rapier, Investing Daily
You want to be greedy when others are fearful. You want to be fearful when others are greedy. It's that simple. -Warren Buffett
That's pretty good general advice from Warren Buffett. Buy when the market is selling, sell when it is buying. However, it requires conviction because it means you are constantly buying and selling against conventional wisdom. The market has certainly been selling off energy stocks. The general sentiment is bearish. Should we adhere to Buffett's advice now and buy? If so, buy what?
One problem is that his advice is very subjective. There is no measure of what "others" stands for. Are you supposed to buy when 50% of investors are fearful? 90%? And how would you measure that anyway? If the price of oil plunges from $110 to $40 a barrel, wasn't it clear that "others were fearful" after the price had dropped $30?
In any case, I think Buffett's philosophy here provides a good guideline. At least it does for me. Here is how I have applied it.
Fearful in 2014
At the beginning of 2014, I was "fearful" that oil prices were going to decline. As a result, my colleague Igor Greenwald and I wrote a number of articles about downside risk, and the potential for lower short-term oil prices. This year we believed the supply/demand fundamentals would start to favor a growing oil supply. In fact, lower oil prices in 2014 was one of my annual predictions in January.
That prediction looked wrong during the first half of 2014 - at least for West Texas Intermediate (WTI). Even though I believed the oil market was behaving somewhat irrationally, by July I was pretty sure that I was going to end up on the wrong side of this prediction.
But so far in the second half of the year it seems as if oil prices are trying to make up for their lofty levels in the first half. A month ago, I noted that the price of West Texas Intermediate would need to average below $92 a barrel (bbl) for the rest of 2014 in order for my oil price prediction to prove accurate. The price has since declined below $92, and is trading at $83.40 as I write this.
Given my "fear" of lower oil prices this year, how did that affect my own investment decisions? First, bear in mind that your risk tolerance may be very different from mine. I am fairly risk averse, but I will hold a quality company through a 25% correction unless I feel the long-term fundamental outlook has changed. This doesn't make my style right or wrong. Investors have to be comfortable with their own balance of fear and greed so as not to sell after the market has crashed and buy once it has surged.
My style generally sacrifices some of my upside to protect the downside. I prefer to invest in consistently profitable companies that aren't highly leveraged. As a result, I generally avoid the high flyers - especially when I feel like oil prices will soften - so I kept some cash on the sidelines as 2014 unfolded, while holding on to some holdings that I felt had limited downside.
Steering Clear of the High Flyers
With my expectations for 2014 oil prices in mind, here is how I tend to view a company like Laredo Petroleum (NYSE: LPI). Laredo is a pure-play Permian Basin oil and gas producer, with crude accounting for 58% of recent production. The company has managed to grow output by a compounded annual growth rate of 30% for the past three years. Laredo also has much of its near-term oil and gas production hedged. For 2015, the company has hedged some 90% of its expected output at a weighted average floor price near $81/bbl. But Laredo is also highly leveraged, with a debt/equity ratio above 100%.
In 2013, Laredo's share price nearly doubled before pulling back and ending the year with a gain of almost 60%. Because I expected oil prices to fall in 2014, and because I am a risk-averse investor, I have avoided companies like Laredo this year - understanding full well that I am sacrificing some upside. I did lose out on some upside when I was wrong about oil prices in the first half of 2014. The price of WTI remained above $100/bbl, and during the first half of the year Laredo rose a further 12%.
But when oil prices did fall, Laredo's share price went into a tailspin, declining more than 40% between July 1 and mid-October. In fact, Laredo is now down 36% year-to-date, and has wiped out nearly all of last year's gains. This is where my aversion to risk protects me. I know I am giving up some of the upside should the market rally, but I don't worry a lot that my portfolio is going to drop 35% in a short time.
Time to Get Greedy?
However, when my expectation shifts to higher oil prices, I am not totally opposed to buying a company like Laredo - especially given the recent sell-off. In fact, if I expected oil prices to firm soon, a stock like Laredo is exactly what I would buy now. For more than a year I have felt like the smaller oil producers were too richly valued for my investing style, but now they have been significantly de-risked.
I may buy a stock like Laredo after the sort of steep correction the energy markets have recently seen. But then again, I am very patient with my investments. I would buy such a stock knowing that it could fall another 30%. Think "Black Monday" after the market had already made a significant downward move. I know that I may have to wait two to three years to see a significant return.
My style may not suit you, but over time it has paid off for me. The key to it is a long time horizon and patience. Don't panic when the market is panicking. But also be very cautious when opening a position in a stock trading at high multiples relative to its history or peers. In some cases paying up might be justified, but all too often you would be acting on your greed when fear would be more appropriate.