The oil spill in the gulf is an economic and environmental catastrophe. BP made some serious missteps that have cost the company and gulf coast residents dearly. While tragic, there are many lessons to be learned from the spill. There will be important takeaways for everyone involved or affected by the disaster. Most obviously, the oil and gas exploration and production firms will put greater emphasis on prevention and disaster response.
For investors there is one vital takeaway that must not be overlooked. Prior to the spill, BP was a global blue-chip. It was, and still is 3rd largest company in the world in terms of net income. BP paid a handsome dividend to shareholders and the company was rated Aa by Moody’s—only about 60 other companies in the world are rated Aa or higher. Until the spill, BP could have been considered a widows-and-orphans stock.
In an environment where T-bills yield 0.10% and 10 year treasuries yield 3.24%, who could have blamed an investor for loading up on BP shares? At my family-run investment company we owned the stock. We were attracted to the company’s dividend yield, strong balance sheet, and dominant market position. Importantly though, we owned BP in the context of a properly diversified portfolio.
My basic investment tenet is diversification and patience built on a foundation of value and compound interest. Diversification is the only free lunch in investing. With proper diversification you significantly lower risk without sacrificing meaningful return. No matter how much you think you know about an investment or its prospects there are always unforeseen risks.
I doubt anybody would have anticipated the magnitude of economic and environmental devastation of the BP oil spill. BP is down 50% in only two months. The company cut its dividend, its credit rating has been reduced, and the stock is now tainted in the eyes of the global investment community. Investors who owned BP in a portfolio that was not properly diversified have no doubt lost serious money. But those who owned the stock in a properly diversified portfolio have fared much better. By example, a portfolio invested 50% in fixed income and 50% in equities, with the equities portfolio invested in 32 equally weighted stocks, would lose only .78% if one of the stocks dropped 50% like BP did. That’s a manageable loss.
The takeaway for investors is to always maintain a properly diversified portfolio.