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2 Stocks to Avoid (and 1 to Buy)

By Reuben Gregg Brewer - Apr 24, 2016 at 9:46AM

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If you're looking for bargains in the oil patch, here are two companies to stay away from and one worth the risk.

Image source: Chevron.

The oil price meltdown that started in mid 2014 took a lot of investors by surprise. And with the lower-for-longer story taking hold in the media, investors have a dim view of the oil patch today; companies like Linn Energy (LINEQ) and Vanguard Natural Resources (NASDAQ: VNR) have proven that opinion out.

Still, there are some names that may be worth the risk, and one of them offers a hefty dividend to pay you while you wait for an oil rebound.

"Get out"
There's a joke about a family going into their newly purchased house and hearing a scary voice that says, "Get out!" Of course, because it's a horror movie, the family stays and, well, horror ensues. In the investing world, there are times when all of the signs point to the exits, and going against the grain will make you a lot of money. However, there are other times when you should just go with the crowd and listen to the scary voices.

Right now, Linn Energy and Vanguard Natural Resources are two stocks you should be avoiding. These companies are structured as pass-through entities. When times were good in the oil industry, unit holders received large, tax-advantaged distributions. This pair was, at one point, in the "market darling" category.

But with so much money heading out the door to shareholders, the only way for these companies to grow their businesses was via acquisitions funded with debt and equity sales. When oil prices were high, that wasn't a problem. When oil prices took a nosedive, debt quickly turned into weight around Linn and Vanguard's respective necks.

That's why both have eliminated dividends and been forced to restructure their debts. Needless to say, the units are well off their highs. But, because they're pass-through entities, the trouble doesn't end with the stock price. It's a little arcane, but when this pair restructures debt, or if they end up in bankruptcy, unit holders will have to pay taxes on any debt forgiveness, even though the unit holders won't see a penny from the move.

With the two still struggling mightily, you shouldn't be tempted to bottom fish in these waters. It could still get much worse from here.

LINE Chart

LINE data by YCharts.

Better positioned in the patch
That said, not every oil-focused stock is in as bad shape as that, or structured in a way that shareholders get hit even when they don't benefit. For example, Chevron (CVX 0.57%) sports a yield of around 4.4%, has a widely diversified business, and isn't likely to surprise investors with bad news.

On the dividend front, this integrated oil major has increased its annual disbursement every year for 28 years. While it's not completely clear that this streak will make it to 29 years, Chevron's leaders have pretty much pledged to support the distribution despite the weak oil market. So, on that score, investors should be pleased. And even in the scenario of a dividend cut, Chevron is a long way from the sorry state of Linn or Vanguard, so a dividend of zero isn't likely to be in the cards.

Part of the reason for Chevron's strength is its diversity. Linn and Vanguard are oil and gas producers -- that's basically all they do. Chevron's biggest business is drilling, but it also has material chemical and refining operations. Those businesses tend to do better when oil prices are low because their input costs go down. So, Chevron's business model has an inherent offset to volatile oil prices. And while that hasn't kept Chevron's bottom line out of the red (it lost money in the final stanza of 2015), it has provided an important ballast in the storm.

Image source: Chevron.

The last reason to like Chevron over cellar dwellers like Linn and Vanguard is that there really aren't any hidden risks beyond the basic risks of being in the oil business, like a surprise tax hit from debt restructurings. Yes, Chevron is working through a bad market. Yes, Chevron is taking on debt to support its dividend and fund growth projects. But its corporate structure, long history in the public markets, and financial statements should give investors looking for bargains confidence that it can handle a little adversity.

Listen to the voices
So, while you're watching the oil industry horror show, there's good reason to listen to the scary voices on Linn and Vanguard. But that doesn't extend to every company in the industry. In fact, if you have a little bit of a contrarian bent, you might just find that Chevron is currently pricing in a storm that the company will survive -- and you'll be paid a nice 4.4% yield to wait it out!

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Stocks Mentioned

Linn Energy, LLC Stock Quote
Linn Energy, LLC
Chevron Corporation Stock Quote
Chevron Corporation
$167.82 (0.57%) $0.96

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