All That Glitters Is Not…Oil?

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I must say that I have a special affection for the energy sector. In fact, it was a decision to pile into oil stocks in the late 1990s that provided some of the most lucrative investing experiences of my lifetime. Sure, it was partly luck, but it was also the belief that oil at just over $10 a barrel didn’t make sense.Market Dad was also involved, as his passionate fling with energy trusts was about to transform itself into a serious, long-lasting relationship. No conversation about investments was complete wihout him mentioning Pengrowth, Enerplus, and all the early names in the patch. Having been a mutual fund investor and GIC refugee, I only had a few years of experience with equities and many of his arguments for energy trusts were very appealing. He also recognized my love of income product and speaking of energy trusts cast him in the role of dealer to my addict. Hey, it worked. Back in those days (I now wax poetic) I remember talking with others about income trusts and the common response was something like, “yeah, but what about Nortel?” Well, good luck with that.

Fast-forward a few years and oil is now around $50 and I find myself feeling uneasy. That’s why the current edition of The Market Guy is devoted to a couple of recent trades in the energy patch and an exploration of the madness behind my method.

Trading notes

I have sold 50% of my position in Real Resources (RER on the TSX) at $10.45. As I mentioned in MG #21, the shares were purchased in August at $7.40. That works out to a gain of roughly 42% in 2 months. Two factors at play here: 1) The upward trend in the price of oil; and 2) the company approaching production levels that have seen many others converting to the trust structure. I really don’t care what’s involved. You could tell me it’s all about Venus and Saturn being aligned in a certain way and my only response would be “great!” This remains a speculative play and so, once again, luck has a substantial amount to do with it. Thanks luck! In fact, I’d like to take this opportunity to congratulate luck and all the fine things it has done for me, lo these many years. We don’t have enough national holidays in Canada , so perhaps we should have one devoted to luck. I’d certainly get behind a Luck Day. Where I work, all of the psychologists would call it External Attribution Day. That’s good too. Besides, the underlying meaning would resonate with me about 800 times more than Victoria Day. I’ll bet there’s a significant portion of the population that couldn’t pick Queen Victoria out of a lineup (with a fair number believing that she’s actually available for the lineup).

In a related story, I have sold 1/3 of my position in ARC Energy Trust (AET.UN on the TSX) at $16.96. The full position was acquired in May of 2003 at a price of $12.09. I still love this royalty trust, with its conservative payout ratio, solid management, quality assets, neat balance sheet, and long reserve life. More importantly, I’ve enjoyed the $0.15 a unit each and every month. Don’t you just love distribution day? It’s such a beautiful, perfect, wonderful day. The sun is shining, the birds are singing, and the only thing I have to contend with is unbridled joy. I trust you are same.

The yield on my originally invested capital is almost 15%, but with the price appreciation, any new investors would capture just over 10%. And I know what you’re thinking. Why is this guy cutting back on his energy holdings as oil inventories are low, we’re heading into the winter season, and there are more bulls in the energy sector than in Pamplona. Sure, taking profits in this environment is hard because you’re doing the exact opposite of what most others are doing. But for me, it’s all about risk management at the portfolio level, sector level, and individual level. Let’s have a look at each factor involved:

a) Managing the risk to my portfolio

First off, I’m not eliminating my exposure to the energy sector. In fact, I can’t imagine a circumstance in which my portfolio would be completely devoid of energy names. That would feel wrong. Rather, I’m cutting back to avoid overexposure. With the gains, energy was about to disproportionately influence the performance of my portfolio. Warren Buffett says that you have to assume overweight positions from time to time or else you are destined to generate market returns, at best. True, but I’d prefer to be overweighted in a sector that has fewer gains on the table. As any stock rises (especially among my speculative plays), I have to ask myself if the expected return is high enough to justify the risk. I take an overall approach, meaning that I’m looking at how the gains have changed the sector allocations of the portfolio. The paring of RER and AET.UN represent an attempt to restore an appropriate level of diversification, thereby reducing my risk.

Overweight, underweight, welterweight. When you have over $40 billion (like Warren Buffett, shown here) it’s all gravy.  

b) Managing the risk associated with energy price movements

Second, I remember the last time everyone was so excited about energy…and then the price of oil collapsed to around $10. I’m sure you’ve all been hearing “it’s different this time” coming from the mouths of analysts and commentators alike. Maybe it is different this time. But I’m not prepared to stick my neck (or my hard-earned cash) out on a bet. And let’s be clear about something: Nobody knows where the price of oil is going to be in a year. If I told you it’s going to be $65, we could all generate explanations for this possibility, each making perfect sense (e.g., cold weather, more pipelines blown up, and Chinese demand continues to skyrocket). Alternatively, I could suggest that it’s headed to $35 and we could all generate explanations for this possibility, each making perfect sense (e.g., warm weather, fewer pipelines blown up, and Chinese demand misses expectations). Well, if either possibility is reasonable, that indicates the presence of considerable risk. My recent trades represent an attempt to manage against these risks and reduce my exposure to a sector that can move with alarming speed.

How much for a barrel of oil? As others have remarked, prognosticators predict not because they know, but because they are asked  

c) Managing the risks associated with being me

There is something you should know about me. It’s fairly significant, but I feel comfortable that I’m not breaking any social conventions regarding personal disclosure. Here it is: I almost always sell too early. There it is, off my chest. My investment history is littered with good investments that were subsequently compromised by premature liquidation. Yes, my name isMarket Guy.and I’m a premature liquidator. I’ve come to accept my problem, even have it fully integrated into my investing self-concept. If only there was a way to see if my sell decisions could be used to improve the world, if only in a small way. Surely I’ve become so predictable that a mathematical function could be developed to determine how much money is still to be made after I sell. If you could arrive at such a function, the Nobel Prize for Economics would surely be yours.

Having identified my problem, the next logical step is to determine if I am unique. Do others exhibit similar tendencies? You bet they do, Chester!

In order to make sense of what’s involved, we need to hit the books from my old intellectual stomping grounds, the world of behavioural finance. Here the focus isn’t on what economic decision-makers should do. Rather, the attention is paid to what investors actually do. There are often substantial differences between the two and behavioural finance is interested in charting these differences. Some of the most influential theories in the field belong to Daniel Kahneman and Amos Tversky. Their prospect theory (1979) notes we tend to be risk-averse when faced with a gain situation and risk-seeking when faced with a loss situation. The idea has been applied to a number of different areas, including business studies. For example, it can be used to explain why so many companies escalate their commitments to losing strategies (i.e., throwing good money after bad).

Hersh Shefrin and Meir Statman (1985) took prospect theory and applied it to the realm of investments. Their disposition theory noted that we tend to sell winning investments too soon and hold on to losing investments for too long. In terms of selling our winners early, this reveals a tendency to behave conservatively and protect our profits even if that means leaving possible future gains on the table.

Assuming all of this is true, then what is a small investor to do? Here’s what I’ve been playing around with: I much prefer to pare back a quality holding rather than blowing it out of the portfolio altogether. Think of it as a hedge against myself. If the stock continues to rise, then I get to participate (but to a lesser extent than before). I may decide to sell the remaining shares at a later date, depending on my overall portfolio makeup and a variety of other factors. If the stock goes down, then my paring has left my butt less exposed to the wind. By taking some profits I’m less concerned about the performance of the shares I didn’t sell. At this point, RER could completely collapse and I’d still be ahead of the game; same goes with AET.UN.

In response to my tendency to first pare back a holding rather than eliminate it altogether, loyal reader Pat in Ottawa suggested that such holdings must be sizeable in order for paring to make sense. Partly true. However, using a discount broker with competitive fees can allow you to pare even a modest-sized position without incurring unreasonable costs. Again, fees matter (seeMG#22 for the definition of the word, “rot”). If I were paying a full-service broker, the extra trades would render my “self-hedge” completely ineffectual.

Here are the punchlines: You can know about investor tendencies, even conduct research in the field, and still commit some of the fundamental decision errors that compromise performance. Gotta be me. The fact of the matter is, I much prefer to book a few profits on the way up so that I can minimize my risk and my potential regret. I have always been very risk-averse when dealing with gain situations. I mean, is there anything worse than having substantial gains and then watching them vanish before your eyes? Heck, you might as well be a Yankees fan. At least investors have a chance to get out with gains at a point of their choosing.

The Yankees would have sold after Game Three. Thankfully, the sports world plays by different rules…andThe Market Guy can’t stop giggling about it!  

So I’m eager to lock in some profity-goodness and move the fresh, newly-minted capital elsewhere. There’s nothing sweeter than newborn capital. You fall in love the moment it comes into this world. You want to pick it up, hold it, and protect it with all you have. And let’s be honest: It smells beautiful. Come to think of it, maybe all that glitters…is oil!

The Market Guy is an Instructor with the Department of Psychology at Carleton University. He’s not a professional advisor. He’s just a guy who loves investing and talking about the markets. Next week he’ll be dying his hair for the local United Way campaign and his students will be picking the colour. It could be pink, red, orange, blue. It’s all about making some green over at mail@marketguy.ca