- Investing in businesses that supply products their customers must have, provides an excellent margin of safety.
- Buying at the right price is a critical component of any investment decision.
- Past performance is not a guarantee; but, it certainly provides evidence of skill and ability.
- This trade offers a veritable buffet of investment options.
It is hard to turn on the news today without hearing about the resurgent oil and gas industry in the United States. In some circles, the United States is now being referred to as the Saudi Arabia of natural gas. What is generating all the attention directed at the US energy business these days is a process called hydraulic fracturing, or fracking, by which it is more commonly known.
However, profitable investing records are not built by throwing money at the last big thing, they are achieved by looking below the surface to find the profitable opportunities that are not currently receiving widespread attention. That is what I believe my current research has revealed. Over the last several years, offshore drilling, that had formerly been the mainstay of US oil production, has faded from the headlines after the catastrophic explosion of the Deepwater Horizon platform in the Gulf of Mexico that threatened to bankrupt BP and others.
I like industries that supply products or services its customers need to survive; it provides an extra margin of safety for my investment. I also like industries that require specialized expertise from the companies that operate in them as that provides insulation from new competitors.
In the offshore drilling industry, I am able to achieve even one more, and very significant advantage over most investments, the companies performing the services get paid whether a particular well location produces oil and gas or not. These businesses lease their drilling rigs and operating crews at a fixed rate per day of service and they are normally extended term leases as well. It is quite simply, a great industry in which to invest even with the risk of accidents. When the number of significant accidents is measured against the number of rigs operating and the generally hazardous environments in which they function, the safety record is actually not too bad compared to other hazardous occupations.
In Noble Corporation (NYSE: NE), we have a business that provides an indispensable service to businesses producing products the world can't function without and, even better, they are paid without regard to the success or failure of a particular well they drill.
The Price Is Right
The best business in the world can be a terrible investment if not purchased at the right price. Fundamental analysis is the primary tool I use for determining my estimation of fair value of a business. The primary purpose of my fundamental analysis is to determine whether or not the business is, in my view, undervalued based upon its current price and prospects and offers sufficient upside potential to offset the risk involved in the investment. The secondary purpose is to determine what I believe to be the future value of the business over the next three to five years and establish the profit potential that would exist should it reach that value.
In the case of Noble, the numbers appear to be fairly attractive for a business with the kind of protections previously discussed and it is priced cheaper than the industry averages. Noble currently trades at a price to cash flow multiple of just 4.2; compared to an industry average of 6.64 times free cash flow. It is also priced at a significant discount to its industry in relation to its price to book ratio of 0.99 versus the industry average of a very reasonable 1.3 times book. These measures indicate the business is currently undervalued 30% to 50% compared to its competitors.
However, if a business has not performed well in the recent past, it could explain a great deal about a low current valuation. Returns on equity, assets and capital over the past five years tend to be good measures of past performance. In these metrics, I like to see percentages of return that when added to the dividend will meet or exceed my long-term expectations for annualized returns. For these three measures, Noble has produced annualized returns of 12.1%, 8.3% and 9.1% respectively. If I take the average of these three figures and add the dividend, it produces and expected rate of return equal to 14.35% per year.
A very popular and quick valuation metric for stocks is the price to earnings multiple. As a general rule, most investors consider a stock to be fairly valued at one to two times the projected 5-year earnings growth rate times the current year earnings. Using this metric, the fair value of Noble would be $3.45 (projected 2014 earnings per share multiplied by 13 (the projected earnings growth rate for the next five years. This calculation produces an estimated fair value for the stock of $44.85. Its 52-week high of $41.60 was within reach of this figure which tends to provide a bit more assurance that it is realistic.
Past Performance Is Not A Guarantee Of Future Results, BUT….
It is a standard disclosure statement is just about any financial disclaimer you will read: "Past performance does not guarantee future results." However, in the business world, management teams that build successful businesses do not tend to lose that ability overnight. Therefore, the records are worth a serious review.
Since the end of 2003, Noble has increased its gross income from $146.09 million to $782.7 million at the end of 2013. During the same period, reported earnings per share have grown from $0.55 to $3.09. This is impressive growth and performance by just about any measure that comes to mind.
The Opportunity Is Significant
If absolutely nothing changes in the way the market is valuing Noble Corporation today, the company's projected earnings growth rate plus the 4.52% dividend should produce an annualized return of 17.52% based on a conservative estimate. To reach my currently estimated fair value for the business of $44.85, the stock would have to rise by 35.2% from its current level. These figures indicate that this stock could rise by 50% over the next 12 to 18 months and still be well within the range of fair value for this business. Even if the more conservative calculation past performance of average return on equity, assets and capital plus the dividend is used, it still produces a very attractive expected rate of return equal to 14.35% per year.
Should oil prices continue to rise, this could increase demand for offshore drilling services and put upward pressure on contract prices for these special rigs and drive valuations much higher.
Closing Thoughts and Actionable Ideas
I always like to consider various possibilities when determining where and how to allocate my capital. Even after I decide on the where option by selecting a business in which to invest; I still have to evaluate the best way to open a new position. In the case of Noble, I see three interesting possible approaches.
For a more passive approach to a buy and hold position, I can simply buy the shares and wait for the market to move the stock closer to my estimated fair value while collecting the generous 4.52% dividend along the way. As previously stated, I would expect this approach to deliver something in the neighborhood of 14% annually over the next three to five years.
If I were to wish to take a bit more of an active approach with a higher probability of short-term profits, I can buy the shares at the current price of $33.17 and simultaneously sell a corresponding set of call options against the position. As of this writing, the $35 strike price July 19, 2014 call options are bid at $0.37/share. This means I can sell these options and collect $37 (1.057%) per 100 shares of stock I own and immediately receive a premium representing an 11% annualized return on my capital. Furthermore, if the stock fails to rise above $35 by July 19th, I will keep my shares and the premium I receive for selling the options. If the share price is above $35 on July 19th, I will lose the shares but keep the $0.37 premium received plus make an additional capital gain of $1.83 (the difference between the $33.17 purchase price and $35 sale price). This scenario would produce a 35-day gain of 6.6% for an annualized return of capital of 69.17%.
For those who simply insist of getting everything at a discount, selling the $32 strike price at $0.54/share would produce an immediate return of 1.69% (17.6% annualized) on the total capital required to buy the shares at $32 should they close below that level on July 19th and allow the seller to be assigned the shares at a 3.5% discount to the current market price.
It is hard not to like a situation that presents such attractive potential profits in a cafeteria-style approach. Just move through the line and pick the offering that appeals to your particular taste.