BP Update: In-Depth Stock Analysis, Part 1

 |  Includes: BP, XOM
by: Mike Stathis

A couple of weeks ago, I released a report discussing how I was able to get in on Merck (NYSE:MRK) for big gains, while virtually everyone else left the company for dead after the Vioxx scandal played out. I used that as an example to illustrate what one needs to do to determine whether a stock should be bought after a catastrophe, and when exactly to buy it (I show several other examples in The Wall Street Investment Bible). Finally, the article explains that one needs to have an exit strategy in advance. It was a prelude to a report I would be writing for BP (NYSE:BP).

Despite the problems for BP, it is apparent that Wall Street has been unwilling to let the knife fall as much as it should. The support for BP shares (relative to the nature of the oil well leak and the uncertainty involved) has been overwhelming. I have already discussed BP in last month’s newsletter (and the recent special report). Here, I am going to provide readers with a charting analysis that should help them understand whether and when to buy BP.

Note there are many other things one should consider. However, a charting analysis is perhaps the most time-effective manner by which to determine whether and when to catch a falling knife, at least for blue chips.

As subscribers of my newsletter know, yesterday BP hit my initial entry price of $45. Meanwhile, a lot of suckers have been buying shares all the way down; shares that others have been wise enough to unload. Much has changed since then, when it was floating around $52:

  1. Oil prices have collapsed.
  2. Attempts to contain the leak have failed.
  3. The stock market is down.
  4. Washington is discussing modifications of liability limitations for oil spills.

Given these developments, shares have held up rather well in my opinion. As a result of these new developments and the relative share strength, I am holding off for now and waiting for further weakness in the market. I want to see as well whether the weakness in oil will worsen or at least persist. If either of these conditions is met, it is likely that shares will decline further.

If neither of these conditions is met, it won't matter because (for me) shares must be trading at a very compelling price after factoring the uncertainty and current risks. All that says is that I have a certain use for BP as an investment. Others might see compelling value in the share price right now, which is fine as long as they understand the scenarios and know how the position fits within their portfolio.

As these new developments progress, I expect the overwhelming support for BP by Wall Street to fade, sending shares down to the low 40s, at which point I will reexamine a partial entry. Of course, the ability, or lack thereof, of BP to contain and stop the leak will have a significant impact on the direction of shares.

Furthermore, there is a pretty good chance that shares will mount a considerable rally prior to falling further. Such a rally could be sparked by news that BP has stopped the leak (only later to have problems, or later the damage estimates will flood the media) or by a rally in oil and/or the stock market.

The first chart represents the closing price of BP from the past month (April 20 to May 17). As you can see, shares have fallen from nearly $61 to $46.57 ($45.57 intraday on May 17). A few days earlier, shares actually hit the year-high of over $62.

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You should note that yesterday’s intraday lows are very close to the year-low of $44.62 made in early July of 2009.

The second chart puts this price decline into perspective. As you can see, since April 20, 2010, shares have declined by nearly 25% versus just over 4% for the DJIA and about 8% for Exxon Mobil (NYSE:XOM).

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The next two charts represent the historical share price of BP and XOM respectively. First, you should compare the relative volatility between each chart. This is a very important exercise that very few investors (including professionals) bother to perform because they fail to realize its utility.

So why is it such an important exercise to perform? Virtually every (sophisticated) investor looks at beta to determine price volatility. Of course they do this in order to understand how the security might affect their portfolio. Fund managers actually use individual betas to determine a composite portfolio beta, which gives them a good idea how volatile the portfolio is.

The problem is that beta values only go back to around three years. And economic cycles don’t really change much over that time frame, so you don’t know how the price volatility changes throughout the economic cycle. In addition, other events occur, some company-specific, others industry-specific, and even others that are more widespread. These changes alter the volatility of each security in a specific manner. Thus, examination of longer-term price volatility can tell you much about the stock and even the company. However, beta often does not give you an idea how the security reacts to these events because the time span of data used to calculate it is relatively short.

So beta is fine if you’re a short to intermediate-term trader. Long-term investors need a better gauge of volatility. But why? After all, long-term investors aren’t so concerned with volatility right?

Theoretically, yes. However, by understanding the volatility, even long-term investors can better determine entry and exit points based more on long-term price volatility cycles rather than short-term price inefficiencies (which are more reflective of beta values).

So how does one examine longer-term price volatility patterns?

By examining the long-term chart of the security of interest and comparing price movements to peer securities and appropriate indexes. Even short and intermediate-term traders can benefit from studying longer-term price volatility patterns.

Think of it this way. The best way to understand an individual’s personality is by knowing how they developed from an infant through adulthood. Parents have a chance of understanding their offspring better than anyone because they have tracked their development for many years; they have more data. In contrast, strangers (who have not seen the person develop and mature) are more apt to misinterpret a person based on their own perception because they have less data to go on.

Now if you think securities price movements have nothing to do with understanding human behavior, I suggest you get up to speed. Investors can achieve the same level of understanding about a stock by examining the historical price chart. Therefore, if you want to better understand the “personality” of a security, you want to examine the historical price chart. The better you understand the personality of a security, the better you will be able to predict how it responds to a variety of variables.

Make no mistake. This is a very powerful tool when used appropriately. It is something that I learned on my own while managing assets on Wall Street. But this is the first time I have ever revealed this secret to the public.

As the following chart illustrates, shares of BP have experienced cyclical periods of high volatility:

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Now let’s compare BP’s chart with that of XOM:

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As you can see, BP has been considerably more volatile than XOM. In part, this may be explained by the difference in business for each company. XOM is more diverse than BP. For instance, its retail business is much larger than that of BP. Furthermore, XOM sells oil to consumers and service facilities that provide oil changes. In addition, XOM has numerous express oil change facilities. While BP may also operate similar business lines, XOM has a significant retail component.

There are many other differences, but these few examples offer possible reasons that might explain the difference in price volatility. Whether or not these differences have accounted for variations in price volatility and securities performance cannot be conclusively determined. There are certainly many other variables. What is most important is to note the difference in price volatility regardless of the reason.

The next two charts are the same as the previous two, except I have drawn in a red and green line to show a rough estimate of the long-term fair value of each security. These lines have been drawn based on numerous variables.

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The variables are firm-specific, industry-specific, and market-specific. However, there are additional variables I have not factored in (in order to keep the exercise simplified) which would alter these valuation estimates. For instance, valuation is a reflection of earnings, or how much profit the company is expected to generate. Valuation is also a reflection of business risk, or the likelihood that the company will or will not be able to continue delivering projected earnings.

Valuation directly affects the stock price. But the stock price is also affected by the equity-risk premium. Now if you don't know what the equity-risk premium is and how it should be used to determine asset allocation, chances are you have been reading investment books filled more with hot air than valuable insights. I suggest you get a copy of The Wall Street Investment Bible. Furthermore, valuation is a refection of the dividend yield, the dividend policy and so forth.

So what does each of these lines mean?

The red line is the current fair value estimate based on the current price of oil and the current price of the stock market. There is around a 5% to 6% elasticity built into these variables. In other words, I would not expect these valuation estimates to be altered by up to 5% or 6% fluctuation in price of oil or the stock market.

It should be easy to understand why the price of oil affects the valuation of these securities. But also remember that the overall market price (market valuation) also affects the valuation of all securities, even bonds (due to the equity-risk premium). As you can see, for BP this value comes in at around $43 based on the red line. The green line comes in at about $35. For XOM, the red line comes in at around $49 to $50, while the green line comes in at around $35.

What about the green line?

This line represents my estimate for the fair value of each security after factoring in the fair value of the stock market (taken to be the DJIA, the real market gauge). In other words, the green line provides an estimate of the downside risk if the stock market were to collapse (or gradually decline) to fair value, which is currently around 6500 based on my analysis.

Now don’t panic. Similar to individual securities, the stock market can and very often remains overvalued for a long time. The reason for this is due to the continuous pressure from those in control of the economy (Washington and the Federal Reserve) to create bubbles.

In addition, you need to keep in mind that when the stock market (or an individual security) corrects from a long period of overvaluation, it almost always undershoots the mark, or falls below fair valuation. That is, the security or stock market becomes significantly undervalued. Therefore, the green line does not illustrate the absolute downside risk, although it’s a good measure since these undershoots are usually short-term.

>> Continue to Part 2

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Disclosure: No positions