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Thursday, June 10

Where a Frugal Miser is Investing Right Now

In day to day life I look for bargains. For example, I've been looking at GPS units the last few months. I bought my current GPS unit in 2006 and about once a week I get this dreadful black screen with nothing but red text on it telling me there is an internal memory failure. It always "fixes" itself a few hours later, but still... I won't buy on impulse. When the right opportunity comes, I'll pounce.

Like a cheetah on the prowl, waiting in the underbrush for his next catch, I'm always on the hunt. This is particularly true with investing since I don't buy a lot of material things. I mean, I'll probably use the GPS unit until smoke starts coming out of it.

What does this have to do with investing? Probably not much, except I think a successful investor shops for bargains in the same way a frugal shopper heads straight for the Clearance aisle at K-Mart. Why pay full price if you can buy for 50% off?

This week I bought shares of Diamond Offshore (DO). The company has been brutalized the last couple of months because of the BP oil spill. Diamond leases offshore drilling rigs. It has been on my list for the last few weeks. In January the stock reached a high around $107 per share, but by the end of February it was down to $87. On April 20th, the day Transocean's (a direct competitor of Diamond, by the way) Deepwater Horizon exploded, Diamond closed at $91.20.

April 20th: $91.20/share
June 8th: $56.94/share (I bought mid-day at $55.23/share)

So What's Going On?
  • Uncertainty, mainly. There's a 6 month ban on new drilling, ordered by President Obama.
  • Throw in a dash of falling oil prices. Diamond leases their rigs to oil companies, and while the day rates may be locked in during the term of the lease, those leases expire at some point. When they do, if oil prices remain lower, the value of drilling for oil falls. It's typical supply and demand. Diamond won't be able to command the same rates for their rigs if oil companies can't make as much from drilling as before.
  • New rigs coming online could pressure prices even more.
So What do I like?
  • The dividend. This company makes a lot of cash. Since January 2006 the company has issued $23.88/share in dividends. They pay a special dividend each quarter that varies with profitability. That dividend was lowered in 1Q2010... from $2 a share to $1.50 a share. Still, that's $6 a share annually. Maybe it will be lowered again, but that's not the point. The point is, the company is doing the shareholder-friendly thing with its cash. I believe owners of a company should be paid for their ownership stake, and Diamond certainly agrees.
  • The valuation. The trailing P/E ratio is just over 6. In other words, I am buying $1 in annual profits for $6. Meanwhile, the historical P/E for the S&P 500 is about 11. So, for the "average" company, investors have historically been willing to pay $11 for $1 in annual profits. Note: the P/E ratio will likely be higher for Diamond in the next 12 months (might go to 7 or so) if profits are lower, which I expect will be the case.
I'm somewhat skeptical of our economic recovery and think it will take some time for the global economy to recover. But I'm absolutely certain it will recover. When it does, demand for energy will increase. That has to happen until we figure out a way to get all our energy from the sun or the wind or some other way. As long as oil is a major part of our energy infrastructure, supply and demand will take care of prices. In other words, my long term opinion is that oil prices will go up, not down.

Higher oil prices should help Diamond Offshore, while the threat of offshore drilling bans should scare away potential competitors.

If you're interested in Diamond Offshore, here's a homework assignment: read their first quarter earnings call transcript here. Then decide if the company is worth further investigation.

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