Saturday, June 25, 2011

Forget Mutual Funds and Treasuries, Buy this Stock Instead (June 25, 2011)

Finding good stocks to buy is always a challenge, and mutual funds face that challenge just like individual investors. Although many studies find that the average mutual fund lags the market, some funds do have amazing long-term records and it is often a good idea to follow what the very best fund managers are doing. Mutual fund managers tend to have access to millions of dollars (if not billions) and a team of seasoned research analysts. In some cases, individuals can outperform the mutual fund itself, provided you are nimble and pick only the best ideas from a highly-rated fund.

Securities and Exchange Commission (SEC) filings show what mutual funds and other large investors are buying and selling. Looking through recent filings, I noticed that a mutual fund with a stunning long-term track record has put more then 10% of its assets into a single stock.

FPA Capital is a $1.3 billion fund which has been ranked among the top 10 mutual funds by Morningstar through the first five months of 2011, in the past year and during the past 10 years. Averaging returns of more than 15% a year for the past 25 years, Lipper also ranks it as the best stock fund over that timeframe.

For the short-term, FPA’s managers are bearish and have more than 30% of the fund in cash. Long-term, they are bullish on oil and have half of their investments in energy companies. One stock jumps out as their best investment based on the projected risk-reward ratio.

With a 2.6% dividend yield, offshore oil driller Ensco plc (ESV) is a stock offering strong upside from increased earnings, solid value and potential increases in its dividend. As an oil and gas company, it has a built-in inflation hedge. Oil prices generally keep pace with inflation, and this stock offers investors an income-producing inflation hedge. It’s a buy in this uncertain market.

Based in London, Ensco provides drilling rigs and crews on a contract basis to oil and gas companies. It owns more than 75 drilling rigs and has seven more under construction. The company operates around the world and its rigs are capable of drilling for oil 10,000 feet below the ocean surface. Ensco has an admirable safety record, with fewer reportable incidents than the industry average in each of the last seven years.

Dividend upside
Ensco yields a little less than 3%. Company management boosted the dividend in 2010 from $0.10 a share to $1.40 a share. The dividend is amply covered by cash flow and profits: Ensco still has about $23 a share in cash, enough to allow it to meet its capital spending plans, complete acquisitions and possibly increase the dividend in the future.

By contrast, 10-year U.S. Treasury note is yielding about 3%, but if you buy one you are guaranteed to receive only that interest for the next decade, no matter how much the inflation rate changes. Ensco is a stock offering a yield near the same rate along with upside potential, which can help you maintain buying power even if inflation picks up.

On the other hand, as economists love to say, if the economy slows down, then interest rates can fall. This would allow you to take some capital gains on that 10-year Treasury note, but growth stocks usually deliver bigger gains than bonds, since they can grow earnings faster.

Ensco’s price-to-earnings (P/E) ratio is about 16, which is in line with the overall stock market. Within its industry, the average P/E ratio is 21, meaning Ensco is undervalued on that basis. Analysts expect Ensco to grow earnings at about 9% a year in the future, almost twice as fast as the S&P 500.

A higher-than-average P/E ratio should be expected for a growth company like Ensco. Demand for oil and gas is growing around the world, and suppliers are struggling to meet the current needs. But the offshore industry is still recovering from the halt in drilling activity caused by the Deepwater Horizon oil spill in the Gulf of Mexico in April 2010. Drilling activity is slowly beginning to resume, and I think well-run operators like Ensco will have business back to normal in no time. Even if oil prices fall, then Ensco is protected by the fact that there are only a limited number of drillers and the barriers to entering this business are high: drill rigs take a long time to build and cost a lot of money.

When to buy
One thing many investors fail to consider is the obvious fact that buyers make stock prices go up. Value stocks don’t deliver price gains until enough investors notice the stock and believe it’s undervalued enough to buy. We can spot buying activity with the Rate of Change (ROC) indicator, which is shown under the price chart below.

The ROC indicator acts just like the speedometer in a car. It shows how fast a stock price is moving. And just as with a car, problems tend to pop up when a stock price is moving either too slow or too fast.

Bollinger Bands on the ROC indicator help define precisely what’s too fast or too slow. These bands (solid blue lines in the chart above) are drawn two standard deviations above and below the current value of the ROC, which defines the idea of what’s “normal” from a mathematical perspective. After the ROC moves outside of the bands, the direction of the trend of the stock price usually changes direction.

The ROC has repeatedly bounced back and forth between the two blue Bollinger Bands in the chart for Ensco. But now that the ROC is below the lower band, it means the stock is “oversold.” From the bottom, where it is now, I expect the Rate of Change to turn higher along with the price.

Action to Take–> Buy ESV now. The price chart shows support at about $50 a share, meaning a purchase price below $55 should limit losses to about 10%. On the upside, the chart shows a price target of $65, about 30% above the current price.