Tuesday, July 17, 2007

Parisian Hoodlums and Bloodthirsty Indigenes

As you all know, Jim Jubak of MSN Money is one of my favorite writers on day-to-day investing. But even so, he sometimes uses logic which I find to be a little peculiar, to say the least. Sometimes he uses funny logic so consistently that it's worth discussing in its own right.

One of the weirdnesses which Mr. Jubak performs consistently is to use calculations of a stock's potential value in five, ten, or twenty years as a basis for recommending it for Jubak's Picks, his imaginary portfolio "for a 12- to 18-month time horizon". Recently he used such logic to recommend the oil exploration and production company Apache Corporation (APA). His logic in that article is entirely based on the growing scarcity of cheap oil "over the next five years". Unfortunately, even given the fact that oil exploration stocks usually rise in tandem with oil prices, I don't understand how he knows that oil prices will be high over the next 12-18 months because supplies will be tight over the next five years. The stock market discounts the future, and the oil futures market discounts the future, but neither of them is that efficient or that predictable as a discounting mechanism. Recent experience seems to suggest that significant changes in oil prices over the short term are more likely to have political causes - including causes related to the arcane internal politics of OPEC - than causes related to conventional economics.

Mr. Jubak also considers Apache Corporation undervalued relative to its peers. "The stock is a relative bargain in the oil industry, trading at a forward price-to-earnings ratio of 11.5 versus 13.1 for Devon Energy (DVN) or 12.90 for ExxonMobil (XOM)." If these numbers were very precise, I might say that that's not bad; let's call it, for the sake of argument, a 15% discount relative to its peers. Unfortunately, we're talking about a "forward price to earnings ratio", in other words, an estimate, or a guess. Except for those companies who use 'creative accounting' always to beat the consensus earnings estimates by one cent, it's not clear that the margin of error on these forward estimates is smaller than that discount. My impression is that the anonymous author of an article which recently appeared on Reuters thinks that it is not. In any case, I'd be happier if I could find some evidence that it is not only smaller, but significantly smaller.

There is another repeating problem with using P/E ratios or other standard ratios of value in the context of a 12 to 18 month recommendation: The use of these ratios is based on the idea that earnings somehow positively correlate with stock prices, over the long run, and that therefore as the earnings of a company rise, the price of its stock should also rise, to maintain an 'appropriate' ratio. But what evidence is there that this readjustment takes place within a 12 to 18 month period? Maybe the lag before the famous 'reversion to the mean' is longer. Maybe much longer.

There may be many good reasons to buy Apache, including those listed by Mr. Jubak. But with oil prices having recently reached new local highs for reasons unrelated to Mr. Jubak's long-term calculations, and given that noone will be stunned if stock prices correct somewhat this August or September, perhaps taking Apache's down price with them, I am not well convinced.


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