After Too Long, I'm Selling Transocean

By Markets Fool.com

One thing that investors need to be wary of is something called thesis drift. This is what happens when the original thesis for investing into a company doesn't pan out, yet you convince yourself not to sell because of reasons X, Y, and Z, which generally have little do with the reason that you used when buying in the first place.

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After reviewing the six (!) times I purchased Transocean for the Messed-Up Expectations portfolio, this drift is what I believe has happened.

Let's review the record
The Messed-Up Expectations portfolio started out using just the idea of really low expected growth priced into a company's stock price, along the lines of what Michael Mauboussinwrote about in Expectations Investing. When I first bought Transocean in November 2010, that was pretty much the sole criteria I applied at the time. I explained that uncertainty about the legal ramifications from its role in the Gulf of Mexico spill from the Deepwater Horizon sinking was a reason for such low expectation, with the assumption that as that uncertainty cleared up, the share price would rise. I again made that point when I purchased shares a second time.

For the third purchase, I hit this point again as the legal orgy of suits against BP and Transocean was hitting its stride. I also pointed out that the world still needed oil and Transocean was a leading driller bringing it from undersea. Looking back today, that was the first sign of thesis drift.

The fourth purchase highlighted a better position for the company as demand for offshore drilling was climbing in general and Transocean was seeing better utilization rates. This should have been a warning sign as the original reason for buying (resolution of its legal troubles and bringing in more free cash flow than had been expected) was slipping further toward a more generalized thesis that could have been applied to any offshore driller.

By the time the fifth purchase rolled around in August 2012, I was talking about building new rigs under contract and higher dayrates being paid across the board thanks to higher oil prices. I did mention more cash flow, but that was pretty much the only tie back to the original thesis.

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The last purchase in June 2013 did highlight that the company had settled a major part of its problems with the Department of Justice arising from the Gulf spill, but focused more on the new dividend and paying off debt, two items that I wasn't even watching earlier.

What happened
I failed to appreciate two things during this time. First, while initially I had a reason for why the priced-in expectation for free cash flow growth was low, I did not have a reason for why the company would be able to produce more free cash flow growth than the fairly flat growth expected. In fact, the company's free cash flow has declined from $3 billion in the four quarters just before I first purchased to a negative $165 million TTM.

Second, as I went further along with this investment, the reason for investing got further away from being specific to Transocean. This is the thesis drift I mentioned above. It got to be so generic that it could have fitted any offshore driller. In fact, if I had applied it to Atwood Oceanics or Seadrill , I would have done better, climbing as much as 75% (for Atwood) or 50% (for Seadrill) from the time I first purchased Transocean.

I made another mistake, too, in failing to think through some of the implications from the fallout of the Gulf spill. Drillers wanted newer equipment (e.g., a second-blowout preventer as standard equipment), and Transocean's fleet wasn't the newest in the business. (Seadrill's was and it used this fact to grow rapidly.) Instead of the company generating more free cash flow, this fact started sucking it up as Transocean had to add equipment and start modernizing its fleet.

Why am I selling now
My thesis was flawed in several ways. The time to really take advantage of the drop in share price was directly after the Gulf spill hit and drove the share price downward. In my personal account, I did by buying several oil-related companies that summer. However, when the Real Money Stock Pick portfolio program was launched in November 2010, most of that effect had already played out. As this slowly became apparent, I let the thesis drift into a generic "high oil prices, high drilling demand, high dayrates" thesis that could have been applied to any offshore driller and would have been better applied to companies that didn't have the older fleet Transocean has. Lessons learned.

When even I realize that a mistake has been made (it can take a while, unfortunately), my job is to fix that mistake. Rather than letting the investment thesis drift even further into convincing me to hold on longer, I'm selling.

Yes, oil prices will likely recover and Transocean's price will almost certainly rise along with it. And I could easily convince myself to wait for that to happen, rather than suffering the pain of selling at a 67.5% loss for the combined position.

However, I don't need to make it up the same way I lost it by holding onto an underperformer, hoping the price will recover. Besides, the problems I pointed out above, such as an older drilling fleet, still exist for Transocean and that will take quite a bit of time (and a lot of free cash flow) to fix. There are several other companies in the oil space that have better prospects today than Transocean and whose share prices are also likely to rise with the expected price recovery of crude oil.

In conclusion, I will be selling the MUE portfolio's entire position in Transocean shortly and looking to redeploy that cash into other, higher quality investments. Come discuss the decision, and suggest other (and better) oil-related companies to invest in, over on the MUE portfolio's discussion board.

The article After Too Long, I'm Selling Transocean originally appeared on Fool.com.

Jim Mueller owns shares of Atwood Oceanics, Seadrill, and Transocean. The Motley Fool recommends Atwood Oceanics and Seadrill. The Motley Fool owns shares of Atwood Oceanics and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.