Catching a Falling Knife?

As I'm sure you have been reading in the last few days, the oil spill in the Gulf continues to vex both the companies involved as well as government officials.

We spent a considerable amount of time this morning at our regular Wednesday Investment Policy Committee (IPC) meeting talking about the companies involved. Specifically, a number of our clients hold significant positions in both BP and Transocean (ticker: RIG), which are the companies most affected.

While I can't say that we came to any consensus, most of us agreed that the stocks remain good long term positions. In particular, BP pays a very healthy dividend (6.6% yield) and now sports a P/E of around 8x trailing 12 months earnings. It seems like a safe bet, then, that both companies will emerge from this disaster with their reputations tainted but their financials largely intact.

That said, the question then becomes: Should we be buyers of BP and RIG?

Here again there was no consensus, but I'll give you my opinion.

One of the lessons that we have learned from the last decade of stock investing was that it usually makes sense to be patient when investing in stocks that have declined precipitately, which is certainly the case for both stocks (BP has declined by -15% since the rig explosion on April 20, while RIG has dropped -21%). True, the market might be overreacting, but what do we really know at this point?:

• The oil continues to gush out at 5x the rate that officials originally forecast, with no end in sight;
• While the current legal liability for offshore drilling is capped at $75 million, legislation was just introduced to raise this limit to $10 billion - and the bill would include the current crisis;
• There is growing frustration voiced by political figures from the President on down as to the appropriateness of the response by the companies involved.
  

In other words, on a purely financial level, you can say this is the time to back up the truck on both stocks, yet it seems to me that the huge uncertainties surrounding the situation urge caution.

When the tech stock bubble first began to burst, investors tried to argue with the stock market, believing the future was brighter than market reaction would suggest. However, in retrospect it seems that the collective wisdom of the market was often correct after all, and that investors who bought positions in good companies whose stocks were in freefall were way too early.

And so I feel this is where we are today on these stocks. For accounts that hold the stocks (and probably have pretty big gains, even after the recent swoon), I don't see any reason to sell. However, I also believe that buying stocks that are dropping like falling knives is a dangerous way to invest, and so I believe in being wary at this point.