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Is it possible to learn something about stock selection at an Art Students League class in watercolor painting? Believe it or not, the answer is “Yes!” No artist, no matter how precise, careful, thorough, obsessive, etc., can completely control what happens when watercolor paint is applied to a surface. Skilled technicians can generally get the result they anticipate and are usually content with modest variations. Sometimes, though, the paint just runs where it wants and produces a completely unexpected result. One might simply discard the painting and begin again, but that’s likely to lead to very low output since accidents happen all the time. The ideal is where the accident actually works to enhance the painting, a phenomenon referred to as the “happy accident.”

So what on earth does this have to do with stock selection? Everything!

Stock investors are often led to believe they can control the selection process. We know macro factors such as interest rates or GDP trends are not controllable. But so, too, are other aspects of selection, such as growth rates that aren’t what they appear because of unusual items, which can add a noteworthy element of unpredictability when using stock screening tools, such as I typically do.

In my 1/4/12 article entitled Exploring for Supercharged Oil Stocks, I described a model created to identify groups of small oil-producing companies that have produced back-tested performance well in excess of the iShares Dow Jones U.S. energy ETF (IYE). But I cautioned that we may, once in a while, see some odd names when Thomson Reuters, the data vendor used by (the platform I use) makes some debatable determinations when deciding whether to classify particular companies as oil-and-gas producers. Indeed, that was the case with the latest running of my screen, which picked up Longwei Petroleum (LPH) and SMF Energy (FUEL), both of which distribute refined petroleum products. Because they don’t explore and drill for oil, I consider their inclusion in the results to be data accidents. It’s not like anybody did anything wrong. Business variety is far too great to permit an industry classification scheme that will raise zero dissent. Hence investors who care about such things will often find things with which they can quibble. I consider the FUEL and LPH accidents to be of the “happy” variety because I really like and own shares of both companies. I can certainly understand why an investor seeking oil producers would choose to bypass these names (and I expanded my planned five-stock listing to seven to accommodate such decisions). But to me, one of the most under-rated and exciting things about stock screening is the way it often exposes users to intriguing ideas one hadn’t thought to look for.

Now, on to the happy accidents du jour:

SMF Energy

This company’s main business is mobile refueling mainly for customers’ truck fleets and storage tanks. In other words, client trucks need not go to gas stations because the gas station comes to them. This can be quite valuable: It’s much more efficient for fleets to be refueled in their yards during off hours, it facilitates centralized inventory management and tax reporting, it avoids the baggage (i.e. insurance) associated with on-site fuel storage, it diminishes risk of fuel theft, and it offers customers ready access to emergency supplies.

SMF is certainly not the only firm in this business, but many rivals are tiny and can’t come close to matching SMF’s bulk-purchasing capabilities, service levels (transaction recording is often still done by smaller firms on paper instead of electronically, and SMF has the capacity to stay on top of the particular needs of each customer) or geographic reach (many fleet operators prefer the convenience of a single source that can cover all portions of its fleet, even if geographically dispersed).

Actually, though, this business can be interpreted more broadly, as being about a distribution infrastructure rather than about fuel. This is exactly how SMF is thinking. The company is now broadening beyond fuel to also distribute a variety of lubricants and chemicals to industrial companies engaged in utility, energy, petrochemicals transportation and general manufacturing). This sort of thing can lead to more revenue being generated without proportionate gains in fixed costs. We saw this sort of operating leverage at work in the September quarter, when a 45% year-to-year revenue gain (from $51.1 million to $74.2 million) helped EPS jump from $0.01 in the year-ago quarter to $0.10 in the latest period. After some balance-sheet overhaul in 2009, the company is well positioned to pursue “roll up” acquisitions wherein smaller less-efficient players are acquired by leaders like SMF.

The stock trades at 13.6 times trailing 12 month EPS and has a dividend yield of about 2.1%, rare for a stock I initially found in connection with my low-priced stock newsletter.

Longwei Petroleum

This firm is also engaged in distribution rather than drilling, but you may need a roughneck temperament to play this one. That’s because it operates in China, the country investment commentators have lately loved to hate. I’m not going to recreate the entire debate here except to suggest that one needs to look at companies case by case rather than rely on soapbox stereotypes. Indeed, a fascinating and fresh case in point can be found right here on Seeking Alpha in a 1/1/12 article newly entitled Mattress Firm Should Provide More Details To Investors (the original title, still visible on Yahoo! Finance as of this writing, referred to the company as a “Timebomb”). The key for us is that articles of this type have often been written about Chinese firms that go public in the U.S. through what is known as reverse mergers which, according to critics, bypass the valuable vetting to which companies are supposedly subjected as when they go the standard IPO route in the U.S. Here’s the punch-line: Mattress Firm (MFRM) is a U.S. company (headquartered in Texas) and it came public via IPO. I encourage readers who are considering the China issue to read the rather detailed MFRM article and notice how the so-called US IPO quality-vetting process is nothing more than a figment of the collective imagination of the anti-China crowd. While this stock has not thus far suffered based on the concerns articulated in the Seeking Alpha article, we do see other instances where accounting questions have hit non-China shares, one example being Green Mountain Coffee Roasters (GMCR). Bottom line: Look at the companies, not the stereotypes. And as to companies, Longwei is one of many Chinese firms that have had no suggestion of ethical lapses.

Actually, though, Longwei did something else many investors today may despise; it openly contemplated issuing new shares, thus raising the scepter of dilution.

First off, the hysteria surrounding this issue is largely misplaced and, actually, bizarre. Dilution is not calculated by dividing a specific amount of profit by a larger number of shares (a process that would always produce a lesser per-share number). Before dividing by the increased number of shares, we have to adjust increase the profit figure based on what we expect the company to earn as a result of the newly-raised capital. Sometimes that will still produce a lower per-share result. Sometimes it won’t. You have to run the numbers case by case. That’s the basic first step. Next, we must do the actual analysis. We need to recognize that we are not looking at one-day scenarios. So even in cases where added profit is not sufficient to offset the greater share, we have to develop reasonable assumptions about how this will play out over a reasonable time frame (another case by case decision). This conforms to common sense. Addition of equity capital is an instantaneous thing; one minute, the company doesn’t have the extra shares and extra capital, another minute (after the formal closing of the deal), it does. But deployment of capital occurs over a period of time.

In any case, with all the angst surrounding Chinese companies, Longwei management came to the pragmatic realization that it can wage just so many public-relations battles. It can’t help being Chinese and, hence, has no choice but to deal with negative sentiment on this front, but it did choose to abandon its plan to raise equity and finance a planned acquisition using internally-generated funds and debt. Meanwhile, the business is fine, the stock has not recovered at all, and the shares now trade at about 1.75 times trailing 12 months EPS.

The basic business is actually a good one. The company buys gasoline, diesel fuel, fuel oil, etc. from refineries and sells primarily to large-scale gas stations (i.e., chain operations), independent gas stations and coal-fired power plants in Shanxi, an interior industrial province in China. This activity is similar to that conducted by many U.S. master limited partnerships (MLPs). But there are several very interesting aspects to LPH’s China-based setup. One is the fact that Longwei holds two important hard-to-obtain licenses allowing it to wholesale gasoline and oil within China and another allowing it to transport oil. Competitors (which tend to be much smaller) typically have one or the other but not both. Another advantage is Longwei’s being based in Shanxi Province, an industrial area where demand for energy is especially strong, and which is land-locked, ringed by mountains, and lacking in refineries or pipelines. Hence the act of getting refined products from elsewhere to local customers, especially those that ask product on short notice, is not something that can be taken for granted. Longwei is well positioned in this regard given that its in-province storage capacity is tops among non-state-owned distributors, which focus mainly on larger customers, in effect leaving Longwei to pursue medium and smaller-scale outfits.

Presently, Longwei has operated in and around one particular city in Shanxi; Taiyun, where it has storage tanks capable of holding 50,000 metric tons of products as well as a railroad for use in deliveries and a vehicular loading-unloading station. In 2010, the company added operations in a second city, Gujaio, where the tanks add 70,000 metric tons to Longwei’s original capacity thus increasing the company’s reach within Shanxi. The company is also looking to expand to other provinces.

The recent drama centers around Longwei’s plans to acquire Huajie Petroleum, a storage depot in northern Shanxi with 100,000 tons of storage capacity. As noted, Longwei abandoned plans to issue equity to finance the purchase and now plans to finance the purchase using internal funds and has already set aside a deposit of $86.3 million toward the planned $109.9 million purchase price and is working to finalize the deal.

For U.S. MLPs, acquisitions like this are the main source of growth with external financing being the norm (as partnerships, they are expected to distributed all profits to shareholders rather than reinvest in growth ventures). So but for the extreme anti-China and anti-new-equity sentiment that arose recently, there would have been no reason to raise an eyebrow at Longwei’s strategy. I particularly like the idea of equity financing, perhaps because as a former junk-bond fund manager, I’ve seen problems with debt leverage that may not be apparent to contemporary bloggers. But as noted, Longwei is not a U.S. partnership and, hence, has the leeway to reinvest profits toward the Huajie purchase and has a balance sheet that can comfortably accommodate whatever borrowings it might need. Beyond acquisitions, bear in mind that China, particularly Shanxi, is more oriented to heavy industry than the U.S. While the rhetoric from China now centers around the idea of soft landing, long-term, basic demand growth is still likely to catalyze a lot more basic economy-driven growth than U.S. MLPs can anticipate, and a heck of a lot more than is reflected in a 1.75 P/E.

Source: Happy Accidents In Oil Country