Reasons not to invest

I generally do not invest in the stock ideas mentioned in The Cohan Letter for three reasons:

• I am very reluctant to invest in individual stocks because I do not understand what moves their prices up and down;
• Even though I have developed some rules of thumb that appear to link financial performance and prospects to stock price, unexpected events can eliminate the usefulness of these rules; and
• I find that once I have invested in a stock, I lose some of my objectivity. I tend to place less weight on information that suggests I might have made the wrong decision and to place more weight on information that confirms my decision.

These reasons come to mind in thinking about why I did not invest in the three energy stocks – Suncor, Tesoro Petroleum, and Devon Energy -- which I had mentioned in the previous issue of The Cohan Letter. All these stocks had enjoyed tremendous increases in value over the previous year and had benefited from the rise in oil and natural gas prices.

During October, all of these stocks plunged as much as 10% or more from their prices at the end of September. By applying this newsletter’s 2% stop-loss rule, anyone who had invested in these stocks would have limited their losses.

The companies were financially strong, were leaders in their industries, and several of them had tremendous earnings growth prospects, according to analysts.

However, their stock prices depended on a continued rise in the prices of oil and natural gas. A month ago, this seemed like a safe bet for three reasons:

• Since hurricane season, which had knocked out so much gulf coast oil and natural gas production, was still in full swing. Another big hurricane or two could have delayed the return to production of much gulf coast capacity – or added to the damage;
• A terrorist attack on oil refining or production facilities in the Middle East was always a possibility; and
• A blast of cold weather in the Northeast and Midwestern US could have increased demand and caused a spike in heating oil and natural gas prices.

What actually happened was that supply of oil and gasoline increased in October causing prices to drop. The new hurricanes that happened in October did not damage the energy production facilities and no terrorist attacks occurred. I noticed prices dropping from about $3.30 per gallon to about $2.50 for mid-grade unleaded gasoline. And a forecast for warmer than normal weather in the Northeast during the first two weeks of November caused natural gas prices to fall from their peak.

In some respects, investing in energy is easier than in other industries because at least prices are publicly available. Such is not the case in, say, the pharmaceutical or technology services industries. But the basic point is that stock prices can move based on the perception of how an industry’s profits might change in the future. In the energy industry, there are several factors that could move those profits and many different scenarios for how those factors could evolve. Given the difficulty of knowing which of these scenarios is most likely, committing capital to their stocks is quite a gamble.