The Lessons of Chapter 11
Despite the current declines across the energy sector, I firmly believe that energy should be a core long-term holding in most portfolios. As a result, I haven’t sold any of my core energy holdings in response to the recent volatility. Investors in the energy sector shouldn’t panic if they are investing in quality companies.
However, I have personally avoided speculative energy holdings this year given my expectation that oil prices would soften. Next week’s Energy Letter will elaborate on this theme. This week, I want to discuss a recent bankruptcy by a supplier to solar energy equipment manufacturers, because there are lessons there for investors in every sector.
Last week a company called GT Advanced Technologies (NASDAQ: GTAT) caught investors completely off guard when it declared bankruptcy seemingly out of the blue. GTAT is a supplier of materials used to make polysilicon, a key ingredient in solar cells and wafers, and of crystallization furnaces used in the manufacture of photovoltaic cells. In addition, the company was partnered with Apple (NASDAQ: AAPL), and had been expected to supply sapphire glass for either the new iPhone 6 or the Apple watch. As a result the share price of GTAT ran up by more than 100% this year leading up to the September announcement of the new iPhone.
Shares sold off by about 40% after Apple announced it would not be using GTAT’s sapphire glass in the iPhone 6, but a June update from GTAT had indicated that the company still had $333 million in cash on hand. Analysts reassured investors that the long-term future was still bright, and numerous investors accumulated on the dip.
Then, on Oct. 6, with no previous warning, the company declared bankruptcy. The share price immediately dropped 93%. There are a number of lessons here for investors, and given the deep recent declines across the energy sector, they are worth repeating.
1. The single most important lesson is to diversify.
I have read many accounts now of people being overly concentrated in this company. Those investors saw wealth vanish in the blink of an eye. Though very bullish on the long-term outlook for the energy sector, I still have less than 30% of my portfolio in the sector. I do admittedly have 15% of my portfolio in one company, but it’s a blue chip that pays a good dividend, has a solid long-term business, and consistently reports good earnings. Which brings me to my second point.
2. Pay attention to the balance sheet.
I rarely invest in a company that isn’t consistently profitable, but if you do invest in a business that’s burning cash, keep an eye on the burn rate and the balance sheet. If you invest in a company that is consistently cash flow negative, you are naturally at greater risk no matter how bright the outlook might seem.
3. Invest in management you can trust.
In the GTAT case, investors may have learned that lesson too late, but I avoid companies in which management frequently provides disappointing guidance or makes moves that are unfriendly to shareholders. It doesn’t matter how cheap a stock appears to be, if you can’t trust management then you can’t really trust that it offers good value.
Just look at Westport Innovations (NASDAQ: WPRT) or Eagle Rock Rock Energy Partners (NASDAQ: EROC) – both of which have made a habit of disappointing shareholders. I am frequently asked whether I would be a buyer of either at the prevailing price, and my answer is always the same: I don’t trust management. I lost trust in Westport when it was trading at $28/share. Right now it’s at $6.05. I lost trust in EROC when it was at $8.50. Today it closed at $2.95. Management worthy of your trust doesn’t guarantee a good return, but it can limit your downside by providing realistic guidance.
4. Don’t invest in a company that is overly dependent upon one supplier or one customer.
In the case of GTAT, the relationship with Apple was critically important for its survival. When that relationship apparently soured, GTAT really had no other options.
5. Pay attention to significant insider transactions.
Heavy insider selling is always a red flag. In this case, GTAT CEO Tom Gutierrez was definitely not putting his money where his mouth was, dumping 75% of his stake ahead of the iPhone 6 announcement. This also speaks again to investing in management teams you can trust. If they are providing rosy outlooks but selling their shares, those actions speak louder than words.
Over the past 10 years, the energy sector has led all sectors three times in annual returns, and was the runner-up once. Never has it been the worst-performing sector. The energy industry will weather this storm as it has weathered every storm before. But there are winners in the worst-performing sectors and losers in the best-performing sectors. Invest in quality companies, apply the lessons from GTAT’s bankruptcy to protect yourself from nasty portfolio shocks and you will profit despite some periodic volatility.