2 Investments to Add To

This article is part of our real-money portfolios series.

Of the 17 different positions I currently hold in my Messed-Up Expectations portfolio, 12 of them are in the green (from 3% to 144%), while only five are in the red (from 4% to 49%). My two biggest losers (Bridgepoint Education, down 49%, and Dendreon, down 35%) also happen to be very small positions, so they aren't having a large negative effect on the portfolio.

Instead of watering those weeds, I'm going to put some more money to work into two of my flowers, by buying more shares of hard-disk-drive, or HDD, manufacturer Western Digital (NASDAQ: WDC  ) , up 40%, and oil refiner Western Refining (NYSE: WNR  ) , up 144%. Let me share why I like them (besides the healthy investment returns) and why I'm buying more of each.

The cloud runs on HDDs
Western Digital is one of two companies that control nearly 90% of the HDD market -- the other being Seagate Technology (NASDAQ: STX  ) , but I prefer Western Digital's balance sheet situation more. The accepted story seems to be that this industry is in trouble because PCs are in decline, being replaced by tablets and other mobile devices, and everything is shifting to the cloud. Five-year growth estimates for the company are a measly 1.5%.

Yet that ignores the fact that we are creating more and more data in the form of pictures, sensor logs, Facebook posts, and so on. Further, more and more of this data is being stored either in the cloud or in devices like standalone storage devices that we can access wirelessly. Some estimates put worldwide data production at more than 750 terabytes per minute. Even if we store only 10% of that amount, that's a lot of storage requirement! And HDDs are still the cheapest mass-storage devices around.

When I purchased additional shares last September, I pointed out that the market was expecting the company to produce only about $1.6 billion in free cash flow annually (discounted at 15%), with no future growth. At recent prices, that expectation is now about $1.75 billion. Yet the company produced more than $3 billion in FCF over the past four quarters, while blowing past analyst earnings estimates by an average of 28% per quarter. Big disconnect between what's expected and what's happening, which is why I'm buying more.

Two kinds of spread
Western Refining makes its money between the cost of the oil it refines and the price at which it sells the resulting gasoline, diesel, aviation fuel, and other products. This is called the crack spread, a phrase taken from the nickname for the chemical process of "cracking" the oil into its derivative products.

Yet the company has another advantage going for it, and that is the spread between the two popularly quoted prices of crude oil: Brent and West Texas Intermediate, or WTI. Oil that is produced in the North Sea (and elsewhere around the world) is usually priced at the Brent price, while oil produced in central North America is usually priced at the WTI price. Historically, these two prices have been fairly close to each other, but in the past few years, Brent oil has become quite a bit more expensive, currently about $20 more per barrel than WTI-priced oil.

The reason is that the supply of oil coming from central North America has increased a lot, which has driven the price down. Western Refining is taking advantage of that situation, because it buys WTI-priced oil but sells the products into markets where the price is determined by Brent-priced oil. 

Right now, the market is pricing shares as if the company could produce no more than $480 million in FCF a year going forward (discounted at 15%). Yet the company produced more than $750 million over the past year.

I think the disconnect comes from the belief that the glut of oil at Cushing is going to be relieved fairly soon, by either reversing the flow direction of oil pipes connecting it to refineries located along the Gulf Coast, building new pipelines, or shipping oil by rail down to the Gulf. (These refineries tend to use Brent-priced oil.) This would relieve some oversupply pressures at Cushing, letting the price rise and reducing the arbitrage that Western Refining is currently enjoying.

While the oversupply at Cushing is probably going to be solved, eventually, I don't think it's going to happen as quickly as the market believes. New extraction techniques are part of what is contributing to the oversupply in the first place, and those aren't going away. Plus, new pipelines bringing oil into Cushing are in the works. Even a new pipeline being built between Cushing and Houston (with completion expected later this year) is thought not to be enough to relieve the oversupply.

Given all that, I believe that Western Refining's advantage is going to last longer than believed, which is why I'm willing to buy more, now, adding to my position.

Come and discuss these and other investments on the Messed-Up Expectations discussion board.

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