Back in October I covered the curious case of Whiting USA Trust (NYSE: WHX) in With Trusts, It Pays to Verify. Whiting is a terminating oil and gas royalty trust formed by Whiting Petroleum (NYSE: WLL). The trust was scheduled to terminate on March 31, 2015. What that means is that the trust was projected to pay out distributions until that date, and then dissolve.

That in turn means that the unit (share) price should be much lower than would otherwise be expected given its distribution, since there will be no more distributions after the trust terminates. That in turn distorts metrics based on the share price such as yield, and may make the trust’s units seem much more appealing than they are. For example, over the past year the trust has paid out $2.10 per unit in distributions, but is currently trading at $0.40 per unit. It would be hard to beat that (backward-looking) yield!

The reason I highlighted Whiting in that October article was that it had been ranking highly on several stock screens due to the distorted metrics, and I wanted to use it as an example of how stock screens can be deceptive. Last August units had been trading at $2.29, yet the sum of the projected distributions between August and the termination date amounted to less than $1.40 per unit based on Whiting’s own projections.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.”

The gap between the unit price and the sum of the expected remaining distributions in August implied that Whiting was overvalued by at least 64%, and thus an obvious candidate to sell short. But instead of declining, the unit price began to rise in August and before the end of September reached $2.68 — up 18% from August despite what seemed to be a no-brainer shorting opportunity. On Nov. 17 it topped out at $3.07 per unit, up 34% from its already overvalued level of August.  

Helping to drive up the price were the many stock screens that showed a very undervalued company. In reality Whiting was worth the sum of its remaining distributions, but that sort of information doesn’t show up on a screen. Using a stock screen to buy into Whiting’s supposed value story exposed investors to unappreciated downside risks and it drove up the unit price despite the fact that Whiting was already clearly overvalued. (It may be hard to believe that there are investors out there like that, but there are plenty.)

Here is an example:

This screen is based on the so-called “Free Lunch” strategy that can be found in the 2015 Stock Trader’s Almanac. The idea is that stocks that make new 52-week week lows in mid-December tend to subsequently outperform the market averages through mid-February. Whiting certainly fell into that camp, and was therefore one of the “bargain stocks” that showed up on this screen.

This was a classic case of an irrational valuation, and incidentally one reason I don’t short stocks. I can buy a stock based on my long-term conviction about how it will perform, and if it declines in the short-term I can live with that as long as I am not investing on margin. However, if I shorted a $100 million company, and irrational investors bid the value to $500 million before sending it to $10 million, I would incur huge losses and would certainly have been forced to sell regardless of whether I am correct on the long-term fundamentals. When investing long-term, I need to be right over the long-term about the direction of the company. When shorting, I need to be correct on the direction, but also on the path it takes to reach its destination. I can lose many times my initial investment if a short takes an irrational path.   

But eventually irrational market moves reverse, which is good news for those of us who are patient, long-term investors. In the case of Whiting, if the shorts held on through the 34% rise into mid-November, they would have finally been richly rewarded:

Since closing above $3 a share on Nov. 12, the unit price has dropped 87%. As management had warned, there were in fact “one or more abrupt substantial decreases” in the unit price. The sharpest came on Jan. 20 when the trust announced that based on its reserve report for the underlying properties as of year end it would fulfill its obligation by Jan. 31 — therefore terminating two months earlier than originally planned.

Investors who had been holding onto WHX despite the irrational valuation watched the price plunge 78% in a day, which was not at all unreasonable if you knew the underlying story. So the expected decline in WHX really was a “no-brainer,” even if it took a circuitous route to its destination.

The lesson here is not to rely on stock screens or technical indicators when buying or selling stocks. They only tell part of the story, and therefore should only be used as tools for identifying potential picks. With Whiting, those who used only one tool ultimately got hammered.

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

Portfolio Update

Taking the Long View on NOV

A leading industry supplier isn’t going to lead investors anywhere they want to go if the industry it has been supplying is retrenching. For National Oilwell Varco (NYSE: NOV), nicknamed No Other Vendor in the oil patch for the unrivaled breadth of its product lines, the oil price crash has been a calamity.

As of Labor Day, we were up 18% on a recommendation added to the Conservative Portfolio three months earlier. By now that gain has turned into a 28% loss, one that won’t be reversing any time soon based on management commentary following the release of quarterly results on Feb. 3.

While fourth-quarter earnings exceeded analysts’ average estimate, the accompanying press release was sobering. “We face a very challenging market,” it noted. “Our customers are sharply reducing their oilfield activity and expenditures.”

“Our forecast for the balance of the year seems to be changing by the day,” said the CFO on the subsequent conference call. The CEO reported a widespread business deterioration in January as customers began to cannibalize idled rigs instead of ordering parts from NOV.

He likened the downturn to the cyclical slumps that buffeted the company in 2002 and 2009, suggesting this one could, like those, last no more than a year or two. If so, NOV’s share price might not be that far from a bottom, despite multiple downgrades and estimate cuts from analysts following the downbeat commentary.

In the longer run NOV remains an indispensable supplier that’s likely to come back strong once demand returns, as it inevitably will. The balance sheet is rock solid with more cash than debt, and while analysts now expect a 35% decline in earnings per share in 2015, the ample free cash flow and what is now a 3.5% dividend yield should provide some support.

Expect National Oilwell Varco to buy back more stock with free cash flow, hunt for acquisitions on the cheap and to benefit from pent up demand for parts and upgrades once the market turns.

So while it will not be an easy stock to hold in the coming months, it should still prove one of the best stores of value in the energy sector over the longer term. NOV remains the #12 Best Buy below the reduced target of $60.      

— Igor Greenwald