The Perfect Investment?
How to spot a "Perfect Storm" investment opportunity, and how Oasis Petroleum checked off all the right boxes
Some of you have asked me what I look for in my investment picks, and so I wanted to dive into this topic today using my favorite oil stock pick Oasis Petroleum (OAS) as well as a few other stocks as recent case studies. Oasis checked all 5 of the criteria I look for in my investments, and therefore was a Category 5 “Perfect Storm” investment opportunity earlier this year when I recommended it.
There are many investment styles that one can follow, ranging from momentum stocks, growth compounders, technical analysis, meme stocks, deep value, etc. There is no absolute right or wrong style of investing, as long as it can generate superior risk-adjusted returns to meet your financial goals.
For me the 5 criteria I focus on when picking my investments would be:
Undervaluation (I’m not talking 10% haircut, but massive Black Friday clearance type of undervaluation)
Special situation (spinoffs, forced selling, post-bankruptcy emergence, etc.)
Turnaround / Management Revamp
Hidden Asset
Benefit from Secular and/or Cyclical Tailwinds
When an investment exhibits at least 2 of the above 5 criteria, I start getting excited. If it checks off all 5 of these criteria, then I know to top off my boat with as many shares as I can responsibly buy.
Let’s dive a bit deeper into what these 5 criteria look like, using some real-life examples:
Undervaluation
For deep value investors, this criteria is paramount. A margin of safety in terms of low expectations baked into the stock price puts the odds in your favor.
When Macerich was trading for 7x depressed 2021 FFO, this was a clear buy signal.
When Wells Fargo (WFC) was trading for less than tangible book value last year, this was yet another buy signal.
For Oasis, the stock was trading for less than 2x EV/EBITDA earlier this year after stripping out its ownership of OMP shares, compared to 3-4x EV/EBITDA for similar oil producer peers. This too was a clear buy signal.
But just because a stock is cheap doesn’t mean it can’t get cheaper. Therefore, I like to buy stocks that are not just undervalued but also checks the box on my other 4 criteria.
Special Situation
Legendary investor Joel Greenblatt popularized special situations investing for the masses through his book You can Be a Stock Market Genius. In the book he shows that investing in spinoffs shortly after the initial share distributions can result in outperformance, since many of the investors holding the new spun off shares will liquidate their holdings and artificially depress the share price. Special situation investing applies not just to spinoffs but also:
Liquidations (a major shareholder that is looking to get out of a position and artificially drives down the price)
Post-Bankruptcy
Merger Arbitrage
Index Inclusions / Deletions
In the case of Oasis, the share price was artificially depressed coming out of bankruptcy as former creditors who received shares sold to monetize their stakes, and many big institutional funds can’t buy companies that just emerged from bankruptcy. This created a bargain price and the potential for big outperformance for nimble retail investors (like me) who could jump on the opportunity.
Turnaround / Management Revamp
This criteria is easy to understand but hard to put in practice. Management will always put a positive spin for investors in their presentations and on earnings calls. But instead of paying attention to their WORDS, look at the INCENTIVES and DECISIONS made by management.
In the case of Oasis, the board of directors had several former creditors who were incentivized to run things conservatively so they could be made whole on their former loan-turned-equity investments. Management incentives included bonus clauses tied to free cash flow (vs. just production growth).
In terms of actions, management implemented both a share buyback program AND a dividend program shortly after emerging from Chapter 11. All of these actions demonstrated to me that Oasis was focusing on free cash flow generation and keeping leverage manageable, which was a 180 turnaround from its previous free-wheeling ways which had led to the bankruptcy in the first place.
Hidden Asset
Benjamin Graham and other early value investors made a fortune buying companies with physical assets (e.g. land, equipment, inventory, etc.) that were worth a lot more than stated on the balance sheet. The game of finding hidden assets is much more difficult today, but can still be done.
To give a recent example, Another of my top 10 picks Advanced Emissions (ADES) will have almost $5/share in cash after receiving some tax credits later this year, which provided a hard floor for the share price. Earlier this year the stock was trading at $5 and change, implying that the operating business was being valued at almost zero after stripping out the cash (which made no sense in retrospect).
For Oasis, the hidden asset was its original 68% stake in OMP shares, which was as good as cash as OMP shares are publicly traded and liquid. After stripping out this hidden asset, one could see that Oasis stock was grossly undervalued (going back to criteria #1).
Benefits from Secular and/or Cyclical Tailwind
It’s easier to sail with the wind behind your back rather than against a stiff headwind. The same applies to stock picking. For cyclical industries like energy, materials, shipping, industrials, etc. you absolutely want to ride the upcycle and not invest at cyclical peaks.
Oil in 2020 is a classic example of riding a big up-cycle. If you threw a dart at any random oil stock last year to buy, you would have done really well.
In addition to cyclical tailwinds, there are also secular tailwinds like digitization, data & analytics application, growth in elderly population, continued new household formation (and therefore new housing demand), etc. If you can find reasonably valued companies that will benefit from these secular tailwinds for many years to come, those stocks would represent attractive compounding opportunities.
After an phenomenal run of outperforming its peer group (as proxied by XOP) after emerging from bankruptcy last year, I think Oasis is still undervalued but no longer a slam dunk. In the past 3 months, Oasis stock is up ~60% while XOP is up ~12%, so an outstanding 48% outperformance! This is what a Category 5 Perfect Storm investment can accomplish for your portfolio.
I’m still holding onto my Oasis shares for now as I’m bullish oil, but won’t be adding anymore at these levels.
Also I’m always open to hearing about other “Perfect Storm” investment opportunities you may have found, via either Twitter @hiddenrockcap or in the comments section below.
Finally if you found this article helpful, please share within your network!
I put OMP and OAS on my watch list after I started reading your articles. I must say that I am very much puzzled on why OMP and OAS are so strong. If you compare OMP with other midstream companies, its revenue and distribution is nothing special. It's a good company but so is SHLX or MMP. I really don't understand why both companies have been running up like crazy.
OAS owning a big chunk of OMP can't be the only reason why people are buying. It's not possible for OAS to sell its stake in OMP without tanking OMP's price.
I'm not chasing it though. I think I missed the boat already on it.
Hey @hiddenrockcap! Loved the article. I'm curious how you go about finding interesting 'perfect storm' opportunities to look into? For instance - how did you hear about Oasis/realize you needed to dig into it? I assume post-bankruptcy is not heavily covered in the news....
Would love to hear about your process! Thanks!