Stock Market Smarts: Beware the Falling Knife

Energy stocks are at rock bottom – or are they?

 

The falling knife scenario is back! That’s when you buy a stock on the way down, thinking it’s about to bottom, only to have it drop further.

We last saw it in 2008-2009 when the global financial system almost collapsed. Share prices of banks, trusts, mortgage companies, and everything else connected with the industry plunged to what seemed like rock bottom. Then they fell even more. We saw bankruptcies, bailouts, forced mergers, and vulture acquisitions. It was the financial equivalent of blood in the streets.

 It got to the point where no one had any idea where the nadir might be. Even supposedly sound Canadian banks saw their prices drop to multi-year lows. At one point, Bank of Montreal stock traded as low as $24.05 to yield 11.6 per cent as investors bet on a dividend cut that never came.

By the time the crisis ended, many once powerful companies had disappeared (e.g. Lehman Brothers, Washington Mutual, Wachovia) while others were subsisting on life support.

At some point, we are likely to see some of the smaller companies go under and there will almost certainly be an uptick in merger and acquisition action as larger companies with cash reserves go bargain hunting. Suncor’s (TSX: SU) $4.3 billion hostile bid for Canadian Oil Sands (TSX: COS), which has been extended to Jan. 8, is probably just the beginning.

It seems very clear at this point that COS will be gone as an independent company before the end of 2016. It’s just a matter of who scoops it up. Management was able to persuade the Alberta Securities Commission to give it a little more time to find a white knight and the company claims to have four credible suitors. But it is clearly vulnerable and it’s only a matter of time.

Suncor is offering a share swap deal – one quarter of a Suncor share for each share of COS tendered. At the time of writing, Suncor was trading at $36.28 so the offer on that basis would be the equivalent of $9.07 for a COS share. At that point, COS was trading at $8.46 so the Suncor offer represented a premium of 7.2 per cent. The COS board maintains the Suncor offer is “undervalued, opportunistic and exploitive”. There may be some truth to that but with results continuing to deteriorate it won’t be easy to find someone willing to top it.

For the record, COS reported a third-quarter loss of $174 million ($0.36 per share) compared to a profit of $87 million ($0.18 per share) in the same period last year. Cash flow from operations plunged from $302 million ($0.62 per share) to only $82 million ($0.17 per share).

As I said, this is probably just the beginning. The year ahead could be a trying time in the oil patch as the scavengers move in. The difficulty from an investment perspective is knowing when and what to buy.

The key is to focus on assets and balance sheets. We’ve seen this kind of bust cycle in the energy sector before and we know it will eventually recover. When it does, the companies with the most extensive and cost-efficient assets will be the ones that offer the greatest profit potential. Suncor and Imperial Oil (TSX: IMO) are in that group.

Companies with weak balance sheets but decent assets are the most likely takeover targets. If oil prices remain low, as expected, they are going to be squeezed to the wall and management will be looking for an out.