Investor’s Dilemma

Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Whether you are an aggressive, shoot-for-the-moon investor or a conservative coupon clipper, you are constantly faced with an oft-debated investor’s dilemma. While in a perfect world, we would all love to buy companies at 52-week lows AND whose business execution is at an all-time high. However, in reality, it boils down to whether to invest in a company with a rising stock price and improving business outlook, or a falling stock amid near-term disappointment. Deep value investors tend to favor the cheap stock price and the rationalization that business fundamentals will improve. This works sometimes, but the stock universe is littered with companies that never came back: Best Buy, Eastman Kodak, Compaq Computers, and Research in Motion, to name a few. In fact, the evolution of business is such that death is the ultimate outcome - it's just a matter of time.

I personally tend to favor companies that are seeing improved business execution, especially if I believe this can persist for the next several years, even if the stock price and valuation have moved notably higher. At some point, the valuation just runs too far and imbeds expectations that just can’t realistically be met. This is clearly the time to sell. However, this often comes well after the stock has been bashed by value investors or value publications such as Barron’s or Morningstar. Let’s take a look at some companies currently presenting investors with such a dilemma.

U.S. energy boom

One of the best performing industries in the S&P 500 for the last year has been refiners. The S&P refining index has surged 31% in 2013 and returned 89% in the past year. This would normally scare off value-based investors who couldn’t stomach adding a position after such a strong move. But, the fundamentals are exceptionally strong now and likely for at least the next two years. Ever hear of the booming U.S. shale gas? Of course you have, but it isn’t just gas that's booming. Oil production is surging in the midwestern United States as well. The chart below shows the rapid increase in U.S. oil production.

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The result is a massive glut of oil in the Midwest that needs to be shipped to the coast for export delivery. Seems simple enough, expect that most of the infrastructure is designed to move oil from the coast to the Midwest. It takes several years to build up the necessary infrastructure to handle significant flow in the other direction. In the meantime, West Texas Intermediate oil trades at a notable discount to Brent and creates huge margins for refiners.

The name I continue to favor in the space is Marathon Petroleum (NYSE: MPC). I highlighted the stock a year ago, ahead of the spin-off of MPLX. Barron’s made it one of their ten stocks for 2013 and has thus far been proven accurate. I favor the company for their balanced refining network. They have 7 refineries with capacity well balanced between the coast and Midwest, along with a balanced mix between sour and sweet crude. Plus, they still own a controlling interest in MPLX to go along with more than 1,400 Speedway convenience stores.

Valuation is very tame with a price-to-earnings ratio of just 10x and an EV/EBITDA under 5x. These screams value, but remember these are peak earnings in one of the most cyclical industries. Marathon Petroleum was spun off from Marathon Oil in 2011, so there isn’t a long history, but the chart below depicts Valero’s (NYSE: VLO) operating income over the last decade.

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VLO Operating Income Annual data by YCharts

Valero has made a move this year, but still remains one of the weaker performing refining companies, despite several favorable attributes. First, the company is the largest independent refiner in North America with more than 15 refineries and favorable geographic and product mix. The table below shows the total return of refiners over the last 350 trading days, which marked the first trading day for Phillips 66 following its spin-off from Conoco Phillips.

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Valero has underperformed and may well be positioned to close the gap in the coming quarters. Their bullish thesis stems from heavier reliance on coastal refineries and likely makes for the name to own for low-turnover accounts. The stock will likely underperform if there are substantial delays in getting infrastructure developed, as peers with more exposure to Mid-Continent cheap oil will see higher margins and earnings. But, eventually, Valero sits ideally positioned to benefit as new pipelines and rail options bring Midwest oil into their complex refineries.

Waiting is the hardest part

On the other end of the spectrum are cheap stocks that carry uncertainty regarding fundamentals. Value investors should give Hospira (NYSE: HSP) consideration. The stock has languished for the last year and a half and sits roughly 50% below its 2010 high. The market leader in generic injectable drugs has been saddled with FDA scrutiny that has reduced capacity at one of its main plants and caused remediation costs that put huge dents in operating income. I was cautious on the company during all of 2012 and thought 2013 would bring favorable FDA news and improving earnings. Shortly after becoming bullish this year, the company reported that an inspection yielded negative results again. The stock tumbled on the news as this process will now push into 2014. Such is the risk when fishing for underperforming stocks.

The stock continues to have long-term appeal owing to their dominance in generic injectable drugs. This process is very complicated and probably gives the company a small economic moat. The complexity makes new competition less likely, but also can be a thorn when problems arise. Earnings have been hit by the large remediation costs, so it remains tough to value the company on such metrics. Eventually, these issues will be resolved, margins will return to favorable levels and the company can return to generating strong returns on invested capital.

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HSP Return on Invested Capital data by YCharts

The EV/Sales ratio highlights the cheapness of the stock, but the question remains one of timing. Another setback later in the year would be a huge blow to the stock and could cause patient investors to finally throw in the towel. Alternatively, the market could surge 10-20% while Hospira meanders, waiting for an FDA ruling. This stock has long-term appeal, but isn’t without its near-term risk. Such is the investor’s dilemma.

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HSP EV / Revenues TTM data by YCharts

The Foolish Bottom Line

Investing can be tricky at times and there's no such thing as a sure thing. The investor’s dilemma usually separates value investors from momentum investors and both adhere to their own philosophies in an almost religious way. Riding a stock with a rising price and rising fundamentals can leave one holding the bag if results disappoint and shares plunge. Conversely, weak fundamentals can take longer to turn around than initially anticipated. Such a scenario is the so-called value trap and is an equally costly mistake. The key to constructing a winning portfolio is to include stocks from both investing camps. Thus, Marathon Petroleum and Hospira make for great additions to a portfolio when added in combination.

Justin Carley has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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