Transocean: A Case Study of Risk vs. Reward

The current issue of Barron's has a feature story by Andrew Bary, Crude Calculations, that points investors to the group of offshore drillers. We own two of these investors, Transocean, Inc. (RIG) and GlobalSantaFe Corporation (GSF) for individual clients and in our funds.

Let us look first to Barry's observations. We will then compare that to our own risk/reward analysis. He writes:

These and similar stocks trade for 7-to-11 times estimated 2007 earnings, and 6-to-7 times 2008 projections, among the lowest P/Es anywhere.

The drillers carry such low valuations because Wall Street is concerned the current profit boom won't last as a slew of new rigs hits the market by 2010. The industry historically has had volatile profits, reflecting wide swings in daily rig-leasing rates, or "day" rates. The drillers operated at around breakeven as recently as 2004.

Uh-oh!! That must look risky to many investors. Is this danger or opportunity? Let us digress to consider risk and reward -- and time frames!

The Objective of the Game Determines Time Frame

CNBC's stock contest has hundreds of thousands of entrants and gets hourly publicity on the station. Each program has a celebrity (full disclosure -- the old guy doesn't know all of these supposed heavyweights. I need help from Ryan and Renae) that gets on and makes picks.

It seems like anyone watching should be able to understand a few key ideas:

1. The celebrities do not know anything about stocks.
2. The rules of the contest require that participants beat a million other folks in a short time period.
3. The only way to do this is to take risk -- big-time risk -- and get lucky.
4. No investment manager could pass the Series 7 without understanding all of this.

Does it surprise anyone that plenty of those in the audience are trying to follow the winners? Not us? As participants in plenty of cocktail party conversations, we have learned that everyone wants a "hot tip." No one has ever asked me for suggestions about risk-adjusted return!

Roll the Dice

Bill Luby at VIX and More has been doing a nice job with one of his entries. (He is an expert on sentiment, options, and many topics that take us back to our own CBOE days. We have been following Bill's blog and now add it to our list of recommended sites.) Bill would not buy RIG or GSF for the contest, since there is not enough short-term potential.

The time frame of the investment is crucial, as we discussed here, and Bill did here.

Bill was alarmed to discover that a reader was putting his IRA money into one of his high-beta "shots." Maybe the reader was joking, and maybe he was not. After all, more than 30% of the people cannot name the Vice-President. Some County Treasurer in Michigan invested in a Nigerian scam.

Risk Control

At the other end of the risk spectrum is the wonderful job being done by David Merkel on his blog. David carefully explained how investors who managed risk had better long-run performance than those who did not. We would add that David's investors also sleep well -- very well. The drillers probably do not fit David's criteria very well either.

Why We Like RIG and GSF

When analyzing stocks on the fundamentals, we look for two things -- an inefficient market and a catalyst:

Inefficiency. The market is too focused on the past and the overall cyclical nature of the business. Few have done the requisite homework. These stocks have a solid earnings base of locked-in contracts for two years, with plenty of upside. Do you think that oil prices are dropping below $35/barrel? Neither do we.

More from the Barry article:

Some investors fear a drop in oil and gas prices will send day rates plunging; they have weakened recently for rigs that operate in the shallow waters of the Gulf of Mexico. But Transocean CEO Bob Long downplayed worries in a November conference call, saying "we're pretty comfortable that...oil prices down to $40 a barrel and maybe even down to $35 would have little or no impact on the deepwater market.

A Catalyst. This is always a problem. The consistently-excellent Kirk Report recently discussed William F. Eng's book (which we have not yet reviewed). Charles summarized the rules and we were struck by #46 -- yes, we read the entire list.

46. The smarter you are, the longer it takes.

Put another way, deep insight requires patience.

Here is Barry's suggestion for a catalyst:

One way the drillers could boost their share prices is by paying higher dividends, as Ole Slorer, an oil-services analyst at Morgan Stanley, advocates. Slorer figures their shares could rise 50% if they adopt a policy of paying out most of their earnings.

Back to the Risk/Reward

There are two ways of looking at risk in the offshore drillers -- absolute risk and volatility:

Absolute Risk. Since we do not believe that oil is going back to below $35/barrel, and we like the locked-in earnings. We see the absolute risk as very low.

Volatility. Drilling stocks are part of various energy ETF's. Many hedge funds, not schooled in the Chicago futures tradition, do not use futures in their trading. Many financial consultants also make aggressive moves in these ETF's since the transaction costs are low. Stocks like RIG and GSF swing around based upon the front-month oil spot price, even though this has little to do with their long-term prospects. In fact, the oil futures forward curve, the best read on market prices, shows little backwardation. The stocks caught up in this thrashing about show unwarranted volatility, and this exaggerates traditional risk measures like the Sharpe ratio.

Reward. The catalyst might require market recognition of the factors we cite. In the case of GSF, there is also buyout speculation, although we never use this as a fundamental buying rule. Barry notes this:

Investors also could benefit from takeover activity or leveraged buyouts in the sector. Seadrill (SDRLF.PK), a fast-growing Norwegian driller with the highest P/E ratio in the group, is believed to be weighing acquisitions. In a recent note, Citigroup analyst Geoff Kieburtz identified GlobalSantaFe and Noble as the most likely targets for Seadrill.

Conclusion

These offshore drillers are among our favorite positions. The market is wrong on risk as well as reward. We hold them in all accounts. We bought RIG two years ago, so we have a near-double already, but the stock has languished recently. While we make trades in them at the margin, the overall risk/reward balance is so favorable that it would take a massive repricing for us to sell the entire position.

Full Disclosure: We own RIG and GSF for individual clients and in our funds.

RIG 1-yr chart

GSF 1-yr chart