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This article is part of our Rising Star Portfolios series.
Hello, and welcome to the Messed-Up Expectation portfolio and its first purchase. This portfolio is a small pot of money that The Motley Fool has given me to run as my very own, making all the buy and sell decisions in real time, in front of all of you. For more information on why TMF is doing this, you can read this.
I'll get to what the first purchase is going to be and why in a moment. First, I want to explain what Messed-Up Expectation (MUE) means and how it will play a role in this portfolio.
As Michael Mauboussin described in Expectations Investing, most analysts build elaborate models on what they think will happen for a company into the future, often for several years. After all, it's the cash flows that a company can produce over the rest of its life that determine its value today. So predicting what those cash flows will be makes sense. Except there's a big problem. Two, really.
First, predicting the future is really, really difficult. Make one change about how fast a company will grow revenue, for instance, and the predicted value of the company can change drastically. Second, the models can get very complicated, with lots of moving parts, and each affecting the result. You could be right on nine variables out of 10 and that one wrong one could cause you to miss a great investment.
Instead, he suggests looking for companies where the current price is expecting a level of growth much lower than the company has shown it can achieve and where reasonable analysis would predict. For instance, in spring 2009, Apple was selling for about $90 per share. At that price, the expectation was no future free cash flow growth again, ever, which was obviously a mistake given that Apple was selling iPhones and computers like crazy in the midst of a recession. Investors who saw that have made more than 200% since then. In late 2008, Garmin, at $19 per share, also had zero growth priced in. That, too, proved to be a MUE. Today's price around $32 would have given investors 60% returns in less than two years.
Today, I think I've found another MUE opportunity.
Transocean (NYSE: RIG ) is familiar to us as the company that operated the fateful Deepwater Horizon for BP (NYSE: BP ) , the oil drilling rig that sank in the Gulf of Mexico. But it's more than that. Transocean is the world's largest offshore drilling contractor with 139 rigs currently operating around the world. Locations include the Gulf, Africa, the North Sea, South America, and Southeast Asia. Only 12 of those rigs operate in the Gulf.
It contracts the operation of these rigs to various oil companies, such as ExxonMobil (NYSE: XOM ) , BP, and Anadarko (NYSE: APC ) . These companies pay Transocean a "dayrate" ranging from $50,000 to $650,000 per day, depending on the type of rig. Ultra-deepwater rigs, those that can drill in water up to 40,000 feet, command the most, while standard jackups command the least.
Unfortunately for the company, and probably contributing to the low expectations, 11 of the 12 rigs in the Gulf are ultra-deepwater and right now, they are mostly not operating. When (or if) all those rigs can get back to work isn't known yet, despite the U.S. government lifting its moratorium on drilling in the Gulf recently. One reason is that tougher regulations will certainly be coming, which will cost money to satisfy. Europe is also considering toughening its regulations, and other regions will likely follow suit.
Yet another concern is the ability to negotiate high dayrates going forward. Many rigs have moved out of the Gulf, increasing competition elsewhere. If Transocean follows, that competition could hold down what it can charge.
Finally, there is legal liability to worry about. Despite having indemnity clauses in its contracts, investors are concerned that Transocean will be found at least partially responsible for the oil spill in the Gulf. How much that liability might be is unknown, but it could potentially run into the billions.
So why am I buying?
Transocean brought in just under $3 billion in free cash flow over the past four quarters. At a stock price of $63.36 and using a discount rate of 15%, that implies the company can grow that number by just 0.7% for each of the next five years, then by 0.4% for the following five years, followed by no more growth forever.
Now consider the following. Over the past five years, Transocean has grown free cash flow by an average of 41.7% per year. Over the past year, it managed 4.9% growth. Given the concerns above, yes, it might have a bit of a problem growing free cash flow for the next couple of years. But, a lot of that concern is going to be resolved over the next few years with the likelihood of higher expectations baked into the price, which means higher prices.
And, between it and its competitors, it has the lowest expectations at current prices. Noble (NYSE: NE ) is expected to grow at 8.5% for five years, 4.3% for five years, and 2.5% after that. Diamond Offshore (NYSE: DO ) is expected to do 15.2%, 7.6%, and 2.5%, which might be a bit high, as it actually shrank free cash flow by 12.9% between the years ending June 30, 2010, and June 30, 2009 -- the same period Transocean grew its free cash flow.
All in all, Transocean provides a compelling opportunity to take advantage of some really low expectations from the market. I believe Transocean will either be able to restart those rigs in the Gulf or move them, and it is bringing three more rigs on board shortly. The world's demand for oil is not declining despite what happened in the Gulf, and Transocean will continue to play a leading role in extracting it while adapting to new regulations.
Buffett reminds us that we pay a hefty price for a cheery consensus. There is definitely not one surrounding Transocean today, but waiting until the risks are resolved will not serve us well.
The Fool will be purchasing approximately $340 of stock, representing a 2% opening position, sometime tomorrow. I expect to add to that position, putting a total of 4% of the MUE Portfolio's $17,000 to work. This will be a middle-sized position, not a full-conviction 6%, because of the legitimate legal risks Transocean faces and its debt level when compared to its peers.
Join me in discussing Transocean on the MUE Port discussion board where I'll expand more on this decision and where we can discuss investing, who and what has influenced us, and how all that should play out in the MUE Port. Hope to see you there!
This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. Click here to see all of our Rising Star analysts (and their portfolios).