The highest ranking stock according to this screen was that of a Canadian company called Cipher Pharmaceuticals (TSE: DND). The second highest ranking company per this stock screen was Whiting USA Trust (NYSE: WHX).

Whiting’s entry on this list is interesting for a couple of reasons. First, it is a royalty trust, which has some similarities to a master limited partnership (MLP). Investors in trusts and MLPs enjoy tax deferrals on the income they receive, and the financial metrics of these investment vehicles are often not easily comparable to those of corporations. When doing stock screens, this must be understood. The same holds true when comparing companies across different industries.

But the main reason it was interesting to see Whiting on the list is that back in August, a compelling case was made that Whiting was significantly overvalued. The reason is that Whiting is a terminating royalty trust that is scheduled to terminate in March 2015. In August, WHX was trading at $2.29, yet the sum of the projected distributions between August and the termination date amounted to less than $1.40 based on Whiting’s own projections. In fact, Whiting acknowledged as much in its August distribution announcement:

“To the extent that the Trust units are trading at a price substantially in excess of the aggregate distributions that may be reasonably expected to be made prior to the termination of the Trust, the market price decline in Trust units is likely to include one or more abrupt substantial decreases.”

Thus, based on the projected remaining distributions, Whiting was overvalued at that time by at least 64%, and therefore an obvious candidate to sell short. In August, several articles were written that highlighted the unusual situation, and short interest shot up by 65%.

But oddly enough, the unit price began to rise and before the end of September the price reached $2.68 — 17% higher than the value on Aug. 19, when three separate articles were published calling attention to Whiting’s situation.

What caused Whiting’s price to rise? Did management revise projected distributions upward? No. Apparently what drove up the unit price was that Whiting started to show up on various stock screens (as shown in the table earlier), and investors bought into what appears to be — according to a number of metrics — a seriously undervalued company. In reality the underlying value of Whiting should reflect its remaining distributions, but this isn’t something that would show up on a stock screen. A second level of due diligence would have uncovered this, and investors who were interested in the trust would have recognized the downside risk.

Instead, not only has the careless use of stock screeners exposed investors to downside risks they may not appreciate, it drove up the unit price into even more unsupportable territory — generating losses for those who shorted this “no-brainer” opportunity.

Conclusions

Today Whiting is valued at 78% above its remaining projected distribution. Buying Whiting is like spending $45 on a $25 gift card. Eventually Whiting’s price will start to reflect its intrinsic value, and there will be “one or more abrupt substantial decreases” in the unit price as management has predicted.

There are several lessons here. One is that things can go wrong even with the most ironclad no-brainer investment ideas. Second, it confirms that markets can certainly behave irrationally. Finally, it shows what can happen when too much emphasis is placed on a tool as blunt as a stock screener. Those are useful for identifying investment candidates, but investors should always apply additional due diligence in order to protect themselves from risks that the screener can’t identify.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Targa Keeps Growth Plans on Track

With crude futures beaten down to 18-month lows and some of the riskier shale drillers trading as if they might never drill another well, midstream processors and shippers have been a relatively safe harbor for energy investors. These companies, which have their ear to the ground in all the key shale plays, are pushing ahead with growth plans, a hopeful sign for a market desperately in need of some.

On Monday, Targa Resources Partners (NYSE: NGLS), the operating arm of Growth Portfolio holding Targa Resources (NYSE: TRGP), said it would buy and install two more cryogenic gas processing plants, a 300 million cubic feet per day (MMcf/d) one on the western end of the Permian Basin in Texas, and a 200 MMcf/d facility serving the Bakken drillers in North Dakota. The latter is set to come online late next year, while the Texas plant is expected to be operational in early 2016. Since gas production in the Permian and the Bakken has been largely incidental to crude exploration, Targa clearly believes the recent correction won’t significantly alter its customers’ growth plans.

Targa’s shares have traded in a tight range since it rejected takeover interest from Energy Transfer Equity (NYSE: ETE) earlier in the year, and at the current price continue to provide plenty of long-term value. TRGP remains a hold for subscribers who took our advice to lighten their positions when it was trading $5 above the current price in late June.  

— Igor Greenwald