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The Lazy Person’s Path To Energy And Profits

July 10, 2014 | About:

All of my friends who are exercise enthusiasts are always touting the extraordinary amount of energy they have as a result of the effort the expend in their workouts. I know many people who also claim that hard work is the key to making profits in business. I am quite sure that there is a great deal of truth contained in both of those assertions. However, what about something for those who would really like to have more energy and profits but just don’t feel all that motivated to work out extensively or put in long hours of dedicated work on their jobs? Take heart, all is not lost. I think I have found a solution to our quandary.

We Can Simply Allow Our Capital To Do It For Us

One thing the vast majority of people I meet have one thing in common. They work hard for their money. While I believe people who do this do it for all the right reasons, I also think they should spend some time re-evaluating their views on money and who should be working for whom.

One thing I have noticed about almost every truly wealthy person I know is that, while they do have a tendency to be much more productive than the average person, they are very insistent that their money constantly be working much harder for them than they do for it. Think about it. Shouldn’t your possessions bring you more enjoyment, fulfilment or security than it takes to acquire or maintain them? If, like me, you believe the answer is yes, then our money should produce more energy and profit for us than it takes us to acquire it. Not only do I expect this, I demand it. I like to think of the service sectors of important industries and the suppliers of “picks and shovels”. During the gold rush days, very few miners actually struck it rich, even though they all endured great hardships in their quest for the yellow metal. However, virtually all of the people who stayed in the comfort of town and sold them the necessities of the trade, the picks and shovels so to speak, were rewarded with great wealth and excellent returns on their deployed capital with much less effort than those digging and panning for gold.

When it comes to making my money work hard to produce energy and profits for me, it is difficult to find a more reasonably valued industry supplying a product more critical to our lifestyles than today’s energy industry. There is no question that the most undervalued and widely overlooked segment of the energy industry today is the offshore drilling industry. And service sector of this industry is even more ignored and undervalued, especially the contract drillers.

Why Does This Opportunity Exist?

I believe the opportunity in the offshore drilling industry is a function of the mistaken view that hydraulic fracturing and horizontal drilling onshore will somehow produce all the oil and gas the US needs to grow and prosper. I believe they are sadly mistaken.

For a time, the energy producing regions of the world, while they always merit watching, seemed to be in a state of relative calm. Coupled with the explosive growth in production from the new shale oil production in the US, the world suddenly seemed to be drowning in cheap, available energy. Global production of oil and gas soared and the more difficult aspects of production, such as deep water drilling, lost the attention of investors as they chased the latest hot trend in hydraulic fracturing. This is the perfect setup that creates the opportunity to acquire great assets at low prices. However, just because prices are cheap today does not mean they will rise tomorrow. A catalyst is required to light the flame, even in the oil and gas business.

The Middle East And Russia Lit The Flame

Over the past year, we have seen the Middle East erupt in violence and revolution. On top of that, the Ukraine has fallen into turmoil as it engages in a small proxy war with Russia, which could pose a threat to the major source of natural gas to Europe.

There has been conflict raging in the Middle East since the beginning of time and it will probably continue until the end of time. When the primary purpose in life for one group of people is to kill another group, it just doesn’t leave much room for a peaceful outcome.

In the case of Russia, we have a former world power that wishes to re-establish itself as the dominant power in its region and to once again assemble a group of “supporting” countries; by any means necessary it seems.

And, as the Middle East burns, the foolishness of depending on such a volatile region for our energy supplies will soon become much more obvious and the offshore and deep water drillers will once again gain the attention of the mass of investors. Those who act now will be there to collect the profits when the herd finally clamors to acquire these stocks. I have previously recommended Seadrill (SDRL) within the pages of GuruFocus and today, I have identified and equally attractive opportunity in the shares of Diamond Offshore Drilling (DO).

Why Diamond Offshore Drilling?

Diamond Offshore has actually been on my radar for a while now. I came across it when I was researching the offshore drillers as a group and made a note to revisit it this summer. Why now? Diamond Offshore has an existing fleet of 40 drilling rigs with an additional 5 under construction. As I type, one of these new rigs is on its way to the Gulf of Mexico where it will set up shop to drill under contract beginning this summer. As the other four ships come on stream, revenues will rise substantially, as will profits.

However, as those who follow my research will already know, I really like to consider the 5-year average annual returns on equity, assets and capital compared to the overall industry when considering the allocation of my capital and assessing fair value of a business. The table below shows the spectacular performance of Diamond’s management in these three metrics in general and the absolute crushing of the average results for the industry.

Metric

5-yr Return on Equity

5-yr Return on Assets

5-yr Return on Capital

Diamond Offshore

23.3%

14.1

18.1

Industry

8.86

4.5

5.26

The kind of numbers being produced by Diamond’s management within these important metrics would be very impressive in any industry but in the capital intensive world of offshore drilling, they are simply stunning.

The price to cash flow ratio is another valuation tool I like to use. I find it particularly useful in industries that require large capital expenditures to maintain a business. I normally like to see a ration under 10 as that indicates that there is at least 10% of free cash available with which management can reward shareholders. This industry trades at a dirt cheap multiple of 6.73 times free cash flow and Diamond Offshore trades at an additional 7.5% discount to that. How do you beat a discount over dirt cheap?

You beat it with a projection from analysts covering the stock that it will grow its earnings by 18% annually over the next five years. If you are having trouble understanding how a stock with this type of growth projections can be trading at these stupid cheap valuations, go back to the beginning of this article with the understanding that most investors find the most comfort in following the crowd. This is the perfect example of what value investors live to find.

This is a stock that closed at $48.40 on Wednesday and, in my estimation should be trading closer to 18 times this year’s projected earnings or $63/share. This would represent a 30% increase from the current price.

Final Thoughts And Actionable Ideas

There should be no question remaining that the offshore drilling industry provides an excellent home for investor’s capital at current valuations. There should also be little reason to question the compelling current valuation the market herd has assigned to Diamond Offshore Drilling. The only real question is how to invest in it.

Passive investors can simply buy the shares and wait for the market herd to recognize and rectify its pricing mistake. I don’t know when it will happen; I have great confidence that it will. This is a buy and hold position that could easily produce an annualized return of 15% for the next 5 years.

Those investors who don’t care how undervalued a stock might be today and still insist on buying at an ever greater discount, might wish to consider selling the August 16, 2014 $45 strike price put options for a premium of about $0.70/share. Selling this option would impose on the seller the obligation, but not the right, to purchase 100 shares of DO for each contract sold at $45 each and represents a 7% discount to the current market price. The $0.70 premium collected from the sale of the options produces an immediate return to the seller of 1.56% against the potential purchase price of $45 or 14.98% annualized return over the 38-day life of the trade.

Aggressive investors who find the current valuation of Diamond Offshore irresistible where it is today but still want to add a bit of extra energy to their portfolio can look at buying the shares and selling the $50 strike price August 16, 2014 expiration call options for a premium of around $1.00/share. This premium would provide and immediate return on the purchase price of 2.06% on the capital allocated to the trade and produce an annualized return on capital of 19.83% on capital. Should the share price not exceed $50 on August 16th, these options would expire worthless and the seller would keep the premium collected from the option sale and continue to own the shares.

Should the share price be above $50 on August 16th, the option holder will exercise their right to acquire the shares at $50 and the seller will collect an additional capital gain of $1.60 (the difference between the purchase price and the exercise price). This would result in an additional gain of 3.3% for a total return of 5.36% over 38 days for an annualized return of 51.45%.

In conclusion, Diamond Offshore presents what I call the Grand Slam of investment opportunities. An undervalued business with three excellent choices through which to open a new position; it just doesn’t get much better.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


Rating: 4.5/5 (2 votes)

Voters:

Comments

ozzy
Ozzy - 2 weeks ago

Nice call on this one. I like the option ideas. Do you have much experience in doing options? Aren't they dangerous?

Ken McGaha
Ken McGaha - 2 weeks ago

Hi Ozzy,

The people who would like to charge you for managing your money would certainly like you to believe options are dangerous and it is also true that most people who trade in options lose money. However, used properly, options actually carry less risk than simply buying stock outright in the market.

If you visit my website and read the article titled: Options 101, it will explain the approach I use with options and the approach being taken by those on the other side of the trades I make. If you have any further questions after looking over the information on my website, please send me an email through the site and I will be happy to address them through that venue. The Tracking Portfolio for the options portion of the website has delivered a 29% annualized rate of return between July 20, 2012 and June 30, 2014.

Thanks for the excellent question.

Best regards and better profits,

Ken

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