The Gulf of Mexico oil spill is a tragedy by any definition, and it's hard to blame anyone for wanting to steer clear of BP stock for its central role in the problem. But for contrarian-minded investors who can hold their noses, the big slide in BP shares may look like an opportunity, too. Any time a company of BP's reach and past profitability drops by nearly 50% in market value, it's only natural to wonder if it's time to give it a look.
To be honest, I have no idea what the "right" price is for BP--it could be 100p, it could be £10. Morningstar's stock analyst on BP, Catharina Milostan, also gives her fair value estimate a very high uncertainty rating, meaning that the company's future liabilities are too open-ended to calculate with any certainty what the company is truly worth. (Read Milostan's analyst report here.)
What I do know, however, is that it's a mistake to venture into any badly beaten-down, company--whether its BP, Citigroup, General Motors (now trading on the Pink Sheets as Motors Liquidation, or Enron--without a thorough analysis of all that could go wrong.
Understand the Risks
No doubt about it, the idea of buying a blue-chip stock at its absolute nadir, only to see it double or triple in a short period of time, holds a lot of appeal. But when a company finds itself at the centre of a catastrophe as large as BP has with the Gulf oil spill, the risks of any such situation are as enormous as the upside potential.
For starters, BP's problems and its liabilities are extremely open-ended, and that's usually true of any company whose share price has dropped a lot in a short period of time. You may be able to lock in a low price, but you also have to accept that there's an awful lot you don't know. It's nearly impossible to put a dollar amount on what it will cost to stop and remediate the spill, not to mention the other costs for which BP will be liable.
Although the company recently agreed to a $20 billion fund to address the economic harm associated with the spill, both BP and President Obama made clear that that amount was just a starting point, not a ceiling. (Morningstar's Milostan estimates BP's civil liabilities could run between $4 billion and $46 billion, a huge window.) With the midterm elections looming this fall, it's also safe to assume that political pressures could exert downward force on BP and its share price, but it's hard to quantify what the damage is likely to be.
A similar set of uncertainties also existed for would-be shareholders in Citigroup (the extent of its subprime-related exposure), Enron (the extent of its fraud), and General Motors (the company's viability in a changing marketplace). To make a lot of money, you have to be willing to take a lot of risk.
It's also worth noting that troubled companies often boast tantalising dividends that would appear to offer at least some buffer against further losses, but they too can be in jeopardy. Just a week ago, for example, BP boasted a lush dividend of nearly 10%, a function of its shrivelled stock price. But last week the firm announced that it would suspend dividend payments for the next three quarters as it builds up the fund to compensate workers in the Gulf region. Similarly, dividends on many financials stocks jumped into the high single digits (or even higher) during the financial crisis, but were slashed shortly thereafter. Here again, political pressures can also exact a toll.
And even though many great investors have made their fortunes by investing in highly liquid, blue-chip stocks when they were in a trough, giant companies such as BP also receive a lot more scrutiny than smaller ones, particularly when their travails are splashed on the head of daily newspapers. That can make it harder for small investors to exploit any price inefficiencies. Size can be a disadvantage from an operational standpoint, too, as it's harder to turn around a troubled giant company than it is a smaller one.
So does that mean that investors should avoid BP stock--or the stock of any highly troubled blue chip--altogether? Not necessarily. Here are a few rational routes to consider.
Investigate With Pessimism and Do Your Homework
If you're still interested in a company that's under a black cloud, as BP is now, it's essential that you spend even more time trying to quantify the company's downside potential as you do thinking about what the upside may be. What's the worst-case scenario for cleanup costs and other liabilities?
The best bargain-hunters are pessimists, meaning that they build themselves a big margin of safety in case things don't work out for a company as they had hoped. If everything went wrong, would the company still be a good buy? If you don't have the time or wherewithal to do the investigative work and model a troubled company's downside, in pounds and pennies, recognise your purchase for what it is: a speculative bet.
Consider the Alternatives
When you're thinking about truly troubled companies, it's helpful to consider their capital structures, remembering that debtholders stand ahead of stockholders in case of bankruptcy. Those with the temerity to buy the bonds of a troubled company are apt to receive income payments and better investment protections than stockholders, and they may also earn equitylike returns if the bonds' prices rebound. Just be sure to consider the bonds of a troubled company as an equity alternative rather than as part of the safe sleeve of your portfolio usually reserved for fixed income.
Alternatively, when one company struggles, so do others in its industry. During the past three months, for example, the average energy stock in our database is down roughly 6%--energy stocks haven't fallen for nothing; the broader concern is that the BP spill will make energy production a less profitable business for everyone in the industry. But market traumas like this one often give investors the opportunity to buy much less troubled competitors on the cheap. ExxonMobil, for example, currently trades at a sizable discount to our analyst's estimate of its fair value, but it doesn't carry nearly as much baggage.
Outsource to a Contrarian Fund
One last idea for investors who are attracted to troubled companies for their upside potential is to look to a contrarian fund run by a manager who can do the dirty work for you. When a company like BP hits the skids, you can be sure that scores of value-oriented managers are working to determine whether there's a buying opportunity there.
