President Obama likely has no time to read this missive, but he has reached our conclusion that firing the CEO of British Petroleum (NYSE: BP) might be a good idea. The stock is in free fall, and as we advised on June 4 -- the only current viable strategy is to stay away. Since we said that, the shares have fallen from $37.14 to as low as $29 this week quite expeditiously.I laughed when someone mentioned that BP shares are trading at five times earnings. So what?
Lukoil (OTC: LUKOY) is also trading at five times earnings, but is the U.S. President about to fire its CEO and send it a bill for who-knows-how-many billion dollars? Lukoil's CEO has an excellent relationship with RussianPresidentPrime Minister Putin, which counts for a lot in Russia. Which company is a better deal at five times earnings?
Balance Sheets: More Important than Income Statements
I am all for being contrarian and making winning trades, but not stupid ones. When considering buying stocks in a precarious situation like this, it is a great idea to also look at the bonds -- they are often smarter. That is another way of saying -- do you know what the stress on BP's balance sheet will be?
In early 2007, the bond market told you that a near collapse of the U.S. financial system was coming when the silent crash of mortgage-structured securities happened. Still, the S&P 500 made a comical all-time high in October of that year as the balance sheets in the biggest market sector -- banks -- were imploding. It was not a great time then to be a buyer of stocks when looking at a crashing bond market, but many stock market participants failed to pay attention to the story of the bond market -- to their detriment.
So what are BP's bonds saying now? Well, in my opinion, the bonds were proclaiming their junk status even before the credit rating agencies downgraded them to junk. No surprise that BP's credit default swaps just reached a record price on June 10.
Bloomberg recently reported: "BP's $3 billion of 5.25 percent notes due in 2013 fell as low as 89.94 cents on dollar yesterday, a record, pushing the yield to 7.57 percentage points more than Treasuries. The spread compares with an average of 7.26 percentage points for junk bonds, Bank of America Merrill Lynch indexes show. The cost to protect $10 million of BP debt for a year with credit-default swaps more than doubled over the past two days to $734,000, according to CMA DataVision. It was $29,000 on April 30."
Now that is a big change.
So, it looks like the winning trade here was not bottom-fishing in BP's stock, but rather in its CDS. Considering that there is a rumor that they have already hired a bankruptcy lawyer, I believe that staying away from BP for now is the better strategy. If you want to buy a big oil stock that trades at five times earnings, buy Lukoil.
The same goes for another "cheap five PE" stock -- Goldman Sachs (NYSE: GS) -- with a balance sheet of $848 billion that is impossible to understand ($778 billion in liabilities and $70 billion in book value). It may be the smartest investment bank in the U.S., but do you really want to be bottom-fishing in this stock in an election year?
When the mess broke in April, we observed that the ancient Chinese curse of "may you come to the attention of those in authority" was at play here and there were more investigations and lawsuits coming -- and there have been quite a few since.
The stock on April 20 closed at $160 and as I write this it just traded as low as $131.30. Sometimes knowing what not to buy is as important as knowing what to buy. If you want to buy a financial that does not have the litigation risk and years of growth ahead of it, consider China Life Insurance (NYSE: LFC). This is a smarter buy, especially since the BRIC rally has already started -- as Robert recently discussed in his latest issue of China Strategy.
Dumbest CFA Candidate I Ever Met
Speaking of balance sheets, I have a recent amusing memory to share. A CFA designation behind a person's name in the securities business stands for "certified financial analyst" and is supposed to reflect a person's ability to grasp security analysis. The test comes in three stages and the designation is a requirement for many jobs in New York.
The conversation was going on about Lehman Brothers -- that since Bear Sterns was taken over at $2 (later at $10) by JPMorgan Chase and the firms had similar business models; they were exposed to the mortgage market disproportionately. And then I heard: "Lehman is a good company, they do great work, it's just that it has a balance sheet problem, that's all."
The person -- a junior mutual fund manager of sorts -- was advocating bottom-fishing in LEH stock in the $40s, when actually I thought it was a great short precisely because of that balance sheet problem. My jaw dropped and I wrestled to disguise the confounded look on my face that indicated this was one of the dumbest things I have ever heard from a person in finance.
And you wonder why 80% of mutual funds underperform their benchmarks over five years?
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