Jeremy Glaser: How do you weigh risk and reward in stock investing? I'm Jeremy Glaser with Morningstar.com. I am here today with Stephen Ellis, equity strategist for Morningstar Opportunistic Investor. He'll take a look at some frameworks for thinking about risk and reward and to look at one particular example that he has recently invested in. Stephen, thanks so much for taking the time to talk with me today.
Stephen Ellis: Yeah, no problem, thank you for having me.
Glaser: First off, when you are thinking about stocks and you are trying to figure out, does the riskiness of the stock, are you going to get payback with the reward? How do you go about thinking about that?
Ellis: Well, opportunistic investor will try to look for investments to have risk/reward ratio that's very favorable with the reward, as you know, many times at the downside. So I mean if we can get 3-to-1 whether stock can triple on best case scenario versus downside would be maybe 10%, 20%, 30%, I mean that's a pretty attractive scenario.
Glaser: Oftentimes, there is a single news event that really drives the stock way down and has a lot of risk or uncertainly. So, for example, Transocean, which is the company that you have recently looked at, has a lot of uncertainty with the oil spill in the Gulf. How do you assess if that uncertainty is so great that you just can't invest or that you really going to get the amount of reward that you would need to get back.
Ellis: Well, Transocean is a pretty interesting situation, because I mean the balance sheet of the company is quite good. It has about a little more than $11 billion in debt and has a $28 billion backlog, and the cash flow downside with the backlog will pay off the debt. But of course, we have other potential issues with the legal liabilities and as well as the moratorium.
And basically, the way we look at it is we think that it has to be a pretty draconian scenario for Transocean to be worth where it is trading right now and below where it's trading right now. So we think the upside is pretty good.
Glaser: And there is lot of talk about the drilling moratorium, that's – Transocean obviously drills a lot of wells, how could that moratorium impact the stock? Could that end up being its downfall?
Ellis: Well, as we know right now, the moratorium is for six months in the Gulf of Mexico and basically what they have done is the Minerals Management Service has said that you cannot drill any new deepwater wells. However, you are allowed to drill different types of wells, such as completion workover wells or waterflood wells, so that option is fully operated.
Operators can also move rigs internationally will move the rigs to shallow waters. However, given the moratorium, many of the operators are now seeking to cancel the contract with Transocean. Transocean has 14 rigs in the Gulf, so they are trying to cancel their contract from force majeure.
Transocean, given the options I mentioned previously, believe that we are not in the force majeure situation. That being said, if the contract is cancelled, Transocean should be able to get a termination payment that's equivalent to the value of the remainder of the contract or at least a good chunk of that.
So the impact really is I think, in the short-term, could be fairly small. However, the long-term uncertainty, of course, is if it allows the rigs to get released, then there can be additional supply on the global rig market, which will force Transocean's dayrates lower, which could be particularly unattractive.
Glaser: So you're looking at companies and you're trying to find one that just can't be killed, that given, the outlier events that you see as being possible, just that they are not going to go away. What are some of the factors that go into that consideration to see if the company will be able to survive any of your reasonable assumptions?
Ellis: Well. That's pretty much what we're trying to do. We're trying to see if we can kill the company then that would not be something we'd want to invest in. But if we can't kill the company and in this case I think it's pretty hard to kill Transocean, given its financial picture and the likely – the good position it is in terms of its contracts, the company is the largest offshore driller in the world. So we think it's a pretty hard company to kill.
Glaser: So, a lot of other investors obviously disagree in the marketplace right now, where do you think that they are focused in on and where do you think that they are putting too much weight on some of the downside scenarios?
Ellis: Well, I think, one of the major downside scenarios is the legal liabilities from the spill. I mean as we've seen the BP's legal oil costs is going up pretty much on a daily basis, tens of billions now, we're looking at. Now, Transocean under the standard contract is protected and indemnified. BP has indemnified Transocean from any of the oil spill or environmental costs.
However, given the scale of the disaster, we think BP is likely looking at way to try and break through those indemnifications and sue Transocean to recover at least partial amount of its costs. As well, Transocean could be on the hook if it turned out that they've committed a massive error at some point down the road that we don't know about, that would also result in legal liabilities.
So I mean that's probably one of the biggest uncertainties and it's a significant tail risk for Transocean. However, they're having over $1 billion worth of insurance, and we think that even if they do end up paying substantial liabilities over a period of many years, it would be pretty manageable.
So, we think they are in a pretty good position, and even if you assume a fairly draconian scenario for Transocean, I mean we still think the stock is pretty attractively priced.
Glaser: Steven, thanks so much for talking with me today.
Ellis: Thank you very much for having me.
Glaser: For Morningstar.com, I am Jeremy Glaser.