Our goal over the past few months has been to find stocks with measurable downside protection and a real potential for very large upside surprises.
Clearly, not every one of them may deliver. And even if we’re right and these companies do deliver in terms of free cash flow, dividends, etc., they could still go down further for a while in this market. But even so, at least investors will have the solace of knowing that their investments are performing well as companies… and from there the stock prices will take care of themselves in the longer run.
By the same token, certainly not every stock is going to deliver an upside surprise just by the definition of “surprise.” But if we’re able to recommend, let’s say 10 stocks, and three or four do have surprises to the upside, and the vast majority of the others hang in there, you’re going to have a really great and very strong portfolio.
Our latest recommendations along these lines come from the most unloved part of the market right now: energy.
Schlumberger Ltd. (SLB) is our top pick in this area, as its forte is truly the entire oil service sector. It has been the acknowledged technology leader in this space for almost as long as I’ve been in this business (and trust me, that’s a long time). Its special strength is in exploration, which includes seismic, reservoir analysis and information, and all those technologies that tell oil companies how much oil they have, how and where to drill, etc. They’ve also become expert in offshore technologies.
What’s changed about Schlumberger in the past decade or so is that previously, when times were good they would invariably make some acquisition totally unrelated to their core focus on oil. For example, one such acquisition was in the credit card industry. But for the last decade or more, the company has kept its focus on energy services.
Back in the mid 80’s and late 90’s a less well run Schlumberger would be left holding the bag when oil prices fell: for example, it saw a 70 percent decline in earnings in 1999 and deficit earnings in 1985 and 1986. But during the worst of the recent decline in energy prices, Schlumberger’s earnings have held up very well. And indeed, unless oil prices continue to fall sharply (something we don’t expect), Schlumberger’s earnings in 2012 should reach record levels. Balance sheet metrics are also exceptional.
All this is occurring only three years since their last trough, whereas in the past the company was lucky to get back to record levels in six to twelve years from similar declines. The stock also currently sells at or close to its lowest valuation in memory, in both nominal and relative terms.
Another energy company we especially like is one whose earnings, like Schlumberger’s, are likely to blast through previous records in 2012.
This isn’t surprising, because it’s the largest provider of offshore drilling equipment – a wonderful area in which to have a franchise, which this company decidedly does.
True, the Deepwater Horizon catastrophe in the Gulf of Mexico may have slowed down offshore drilling; but the demand for additional hydrocarbons made the slowdown a very short-term one. And at the same time, the catastrophe itself has dramatically increased demand for blowout protection -- an additional multi-billion dollar opportunity for this corporation.
Also like Schlumberger, this company has a strong balance sheet, outstanding free cash flow and superior management. You can find it in the Growth Portfolio of our flagship newsletter, The Complete Investor, along with other valuable investment recommendations and strategic insights.
Clearly, the two stocks we’ve discussed here have plenty of downside protection at current prices. Indeed even if oil were to drop another 10 percent or so, each would easily hold its own. And then the upside catalyst for each would be at a minimum a leveling off of oil prices, but better yet, higher oil prices.
The very simple bottom line is that if the world is going to grow, oil prices are inevitably going to go much higher. And in such a world the oil service companies we’ve mentioned here will be sitting in the proverbial catbird’s seat.
Just one note of caution: these are not recommendations that should be treated like trades. In the short term oil prices could drop further, and so could these stocks. But as we have pointed out, each of them will still give you balance sheet protection, cash flow protection and the protection of superior management. And over the next couple of years each could yield outsized gains in an otherwise turbulent market.