Tuesday, July 21, 2009

Uncertainty Can Kill You

CE Franklin (CFK) has the makings of a terrific value stock. It has a history of fairly stable revenues and earnings, and appears to trade at a discount to those earnings. From an asset point of view, the company's current assets cover all of its liabilities with enough room left over to cover the company's market value. There's just one problem: the company's industry.

CE Franklin distributes industrial supplies to the oil and gas sector. While maintenance and repair supplies, even to this sector, can be fairly stable, half of the company's revenue exposure relies on new capital spending by oil and gas companies. The amount of capital spending by oil companies can vary dramatically depending on the price of oil. While there are many who believe the oil price will rise again soon, and others who believe it will fall, there's no reason to make a bet in either direction if you don't have to.

Many intelligent people who follow the market will tell you that they don't know which way oil prices will move, and that's a perfectly fine position to take. We're not interested in guessing, but rather in finding opportunities with strong upside potential with minimal downside risk. CE Franklin certainly has the upside potential, as it trades at a discount to its assets, and a positive move in oil prices will likely result in strong price appreciation. Unfortunately, the downside risk is not minimal, as falling oil prices will result in shelved capital projects that would bring revenues dramatically lower.

An important theme of value investing is that one does not have to take a position on every stock. While other analysts tend to believe a stock will either go up or go down, value investors are content to say "I don't know" on a majority of stocks, and only invest in the ones they are relatively sure about.

Disclosure: None


jake_m said...

I enjoyed your article. Thanks!

At what point does a little risk become okay? If, say, only 25% of CFK's revenue was derived from new capital spending by oil and gas companies, would you be willing to take a positive position on this (or a similar) stock? How about 10%?

Saj Karsan said...

Hi Jake,

(Downside) risk is always ok, as long as you understand it, so that you can weigh that risk against the upside potential. The level of tolerance for this risk will vary by investor, and will probably also vary based on what other opportunities are available. For me personally, I don't know what the right answer would be for CFK's %age of revenue due to capital spending, I just feel like there are better opportunities out there.

Mike K said...

As an amateur investor, I find the attitudes and rationales behind all of the articles on this site to be a huge help in my own investing decisions. I stumbled here a long time ago and I could tell that I was in the right place. I'll admit I haven't read everyday, but when I need a reasonable voice to stop me from making a bad decision or push me towards a better one, this is my first stop. Congratulations on getting The Fund going, and I hope you can keep sparing some time for the little guy!

Saj Karsan said...

Thanks, Mike!

jake_m said...

I completely agree with Mike K. I have learned a lot from reading your posts and appreciate your taking the time to answer my questions.

Saj Karsan said...

Thanks Jake! No problem