I recently asked a good friend of mine what he was buying in the stock market these days. Given his 40 years of institutional knowledge combined with his strong sense for fundamental value, I can honestly say he is one of the best investors I know. So when I get a chance to spend some time with him, I probe as much as possible.
His response to me (and mind you, I met with him back in mid-July) was to buy anything associated with oil. Drillers and exploration companies were of particular interest to him at the time.
Needless to say, I was surprised by his fanaticism with crude. Wasn’t oil just another bubble that was bound to pop?
He didn’t seem to think so.
Oil, in his opinion, was the only game in town and many of the companies operating deep in the patch were valued at deep discounts using his fundamental approach.
“Wait a second,” I said, “Aren’t these stocks simply a value trap due to their unsustainably high revenue?”
He shrugged, and said, “How else are we going to fuel the industrial economy?”
Okay, good point… or is it?
Why I’m Passing on His Advice This Time
I decided to remind him of similar investing scenarios starting with semiconductor stocks in the late 1990s. You remember those so-called lucrative days when it was all about microchips and limitless demand, don’t you? If not, let me refresh your memory: Even though stock prices had triple in value in most cases, semiconductor stocks were still cheap on a fundamental basis. We all know how that story ended. Semiconductor stocks crashed and are still struggling more than 8 years later.
How about homebuilding stocks? Historically low interest rates fueled the homebuilding sector like never before. Stocks of builders shot off the charts and still traded for low fundamental valuations.
Once again, we all know how that turned out. The revenue simply wasn’t there and stocks across the sector plummeted to all-time lows. In fact, many of them are still trying to find the bottom.
Enter stage left: The oil and gas industry.
High prices have resulted in record profits and huge revenue growth. That growth fuels the illusion of low valuations for stocks throughout the sector. Case-in-point: Chesapeake Energy Corporation (CHK).
CHK is a favorite stock of the value crowd (not to mention, my friend’s). Shares trade for just 10 forward earnings and with no end in sight to demand for oil and gas, CHK makes for a great investment. Or so goes the theory.
Confirming the interest was yesterday’s announcement that BP would be taking a 25% in a CHK shale oil asset. The $1.9 billion deal further demonstrates the ability to monetize interest in oil and gas. Well that is all well and good, but oil prices are now falling like a rock.
As we approach $100 for crude, one has to wonder if now is the right time to be buying oil stocks. As I told my friend, I would be a lot more interested in CHK when oil drops back down to $80 a barrel.
Sure he smirked when I made the comment, but with oil now down some $40 since we had our conversation back in July, I’m half way at my target price. I agree that the valuations are attractive, but the bubble in oil is bursting. Be patient, and you can own CHK at lower levels.
