Most investors lack the skill of reading between the lines and thus end up with poor returns. Being able to read behind the lines is rare and certainly not as easy as some investors consider it to be. That's why Warren Buffett has advised individual investors to purchase a low-fee index ETF, such as the SPDR S&P 500 ETF (NYSEARCA:SPY), and stick with it without attempting to pick stocks. In this article, I will present an example that shows how risky it is to perform first-level thinking without digging below the surface.
A few days ago, I read an interesting article, which characterized Noble (NYSE:NE) as the top pick for 2017. As the article made it to the top 10 of SA, it was undoubtedly a very well-written article, from a competent author and with ample data to support the main thesis. However, I disagree on a single point, namely the interpretation of the chart below:
As the chart shows, Noble has one of the youngest fleets. Therefore, it is quite easy for investors to conclude that Noble has one of the most attractive fleets and hence exhibits a competitive advantage over its peers. For instance, oil producers certainly prefer young platforms, which offer great advantages even though they are more expensive, than the old ones.
However, successful investing is not as easy as first-level thinking is. More specifically, the main conclusion from the above chart should be quite the opposite. The off-shore drillers who have the youngest fleet are the ones who heavily invested in the expansion of their capacity at precisely the worst moment, i.e., a few years ago, just before the prolonged downturn of the oil market began.
Therefore, these off-shore drillers, such as Seadrill (NYSE:SDRL), Atwood (NYSE:ATW) and Noble, are the ones under the most financial stress, as they have not had a chance to see decent returns on their huge investment projects. As the dayrates have collapsed during the ongoing downturn of the oil market, it is very doubtful whether these investments will ever pay off. Even if they do, they will probably pay off after more than a decade. The picture becomes even worse if the high interest expenses of these companies are taken into account.
Seadrill is the most distressed by far, as it has total current liabilities of $4.9B while its total current assets are only $2.9B. In other words, it has a $2B deficit for this year, which cannot be covered by its operating cash flows, and hence, the company is in talks with its banks, trying to restructure. Thus, it is not accidental that the bonds of the company that expire in 8 months are currently trading only around 50% of their par value.
The remarkably poor timing of the investments of these companies also reveals the incompetence of their managements. Of course, some investors will claim that almost no one saw the collapse of the oil price coming about 3 years ago. However, while this is true, the managements of the oil companies are paid millions for exactly this reason, i.e., to determine which part of the cycle they are at. If they cannot make a good estimate on this question, then their decisions may prove devastating for their companies. That's why Seadrill is running the risk of defaulting later this year.
From the above, it becomes evident that first-level thinking can prove quite dangerous for investors. If they select the stock with the youngest fleet from the above chart, they run the risk of facing a default later this year or in the future. Therefore, they should carefully evaluate all the available data and draw conclusions based on the thorough processing of this data. If this seems too complicated to some investors, they should not be disappointed. Actually, it is too complicated and that's why the Oracle of Omaha recommends purchasing a low-fee index ETF.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.