Buy, Sell or Hold: Time to Take Profits on Diamond Offshore Drilling (NYSE: DO)

On Monday March 9, barely three months ago, I strongly recommended buying Diamond Offshore (NYSE: DO) as part of Money Morning’s “Buy, Sell, or Hold” feature.

Both the stock and the Standard & Poor’s 500 Index had both hit 52-week lows the Friday before.  But oil had already bottomed three weeks prior, and the lax fiscal and monetary policies of governments around the world seemed almost certain to promote reflation.  Additionally, since the earlier oil bottom, Diamond Offshore stock had been outperforming the market.

Diamond not only had compelling fundamentals, it sported an incredibly high dividend yield, particularly if you combined both the regular and the special dividend payouts. That made the stock a compelling buy.

Not only has Diamond Offshore’s stock turned around since that early-March recommendation, the U.S. stock market as a whole turned around.

Making an investment at a market bottom is a rare opportunity. It is both risky and difficult to try and time the market, but that is precisely what we have done with two of our Buy, Sell, or Hold recommendations. I recommended the iShares MSCI Brazil Index exchange traded fund (ETF) (NYSE: EWZ) on October 27, and the fund went on to appreciate 92% in the subsequent eight months.

Now, Diamond Offshore stock has climbed more than 60% from a March 9 bottom of $54.29 a share, to its current level above $90.

I have consistently advised readers to slowly build stakes in our recommendations over a period of time. And that strategy helps mitigate risk and take advantage of panic selling.  In the cases of the iShares Brazil ETF and Diamond Offshore, we were actually able to boost our profit exponentially by starting our investment at the very bottom.

Diamond Offshore’s special dividend yielded an incredible 13% when we bought it. Since the stock has run up in value, however, that same special dividend has been reduced to a 7.4% yield but remains considerably high.  

As I pointed out in my previous recommendation, Diamond Offshore likely will keep paying the dividend in order to help recapitalize other holdings of its experienced and savvy majority holders. And some analysts question whether this is sustainable over the long-term.  Obviously, Diamond Offshore at some point will depart from this special dividend, but I don’t expect that to happen anytime soon.

Still, with the strong gains that we’ve seen so far, it would be prudent to take some profit by selling half of the position and allowing the rest to ride on a pure valuation and risk-management call. 

Let me explain.

The whole investment was predicated on three general types of factors: Macroeconomic, company fundamentals and the special dividend.  And everything I expected worked like clockwork, without any negative surprise showing up from nowhere to derail our initial investment thesis. 

On the macro side, all the factors we analyzed are playing out as we expected. Oil prices have been very supportive.  This is not only supported by the monetary and fiscal reflationary policies I have outlined but also by strong demand from China.  The monetary base expanded significantly.

The type of massive fiscal stimuli deployed by the United States and China is common knowledge.  And China is doing its part by supporting its economy with massive investment and taking advantage of its $2 trillion in foreign exchange reserves and to gobble up resources at low prices.

On the company-specific side, Diamond Offshore did indeed beat earnings expectations by a mile and expanded margins as we predicted.  This was aided by sharp rebound in oil prices and strong execution on the part of management.

Similarly, the dividends were paid out and the special dividend likely will stay in place for a few more quarters.

But even with all of this upside, there are many uncertainties about the market that are could reinforce headwinds and spur more profit taking.  The Iranian elections could result in a more moderate regime that might ease tensions in the Middle East and allow some rapprochement between Iran and the United States.  This might be conducive to lower oil prices, even though the risks of Iran’s continued pursuit of nuclear weapons under the veil of a nuclear electricity policy will remain. 

The Federal Reserve’s balance sheet expansion and the large issuance of U.S. Treasuries is coming under criticism from many quarters and has already achieved the normalization of many financial markets.  We could see a slowdown in any of these stimuli deployments.

In addition, the heightened risks of inflation, dollar weakness, and interest rate increases in the longer term have brought long-term interest rates up.  Higher rates have already increased the cost of mortgages and put renewed pressure on the already badly hit housing market. Together with higher oil prices, this could put the brakes on future economic growth.  It does not mean that the recovery will stall, but continued increases in job losses, as is typical in recessions will keep damping prospects.

Profit-taking also poses a risk ahead of the earnings season, as the United States and other stock markets have seen strong gains over the past three months.  Should this transpire, we could see a counter-trend correction due to a temporary fly-to-safety into bonds for a while, a strengthening of the U.S. dollar, and a drop in commodity and pro-cyclical stocks.  This could affect Diamond Offshore in the short term.

We must also consider Diamond Offshore’s opportunistic purchase of a semi-submersible unit PetroRig I.  We will not have the price and terms of this deal until closes on or around June 25. 

Some analysts believe that this purchase – or the possibility that Diamond will get more aggressive in serving Brazilian oil major Petroleo Brasileiro SA (NYSE ADR: PBR), also known as Petrobras –could jeopardize the special dividend, but I disagree.  The issuance of a $500 million, ten-year debt placement will cover this purchase and raise the operating and financial leverage of the company, thus raising the potential upside for earnings-per-share (EPS) in this new pro-cyclical bull market for commodities.  And I believe the recapitalization needs of the sister company in the group has some more length to go.

Recommendation: Having obtained already very strong profits, sell half of your holdings in Diamond Offshore Drilling Inc. (NYSE: DO) in light of heightened risks that could materialize. Set a 20% trailing stop on the remainder.  I have little doubt that over the long-term we can expect DO to consistently outperform the market.

(**)  Special Note of Disclosure: Horacio Marquez holds no interest in Diamond Offshore Drilling Inc. (NYSE: DO).

[Editor's Note: Veteran Wall Streeter Horacio Marquez is the author of Money Morning's hugely popular "Buy, Sell or Hold" series, and is also the editor of the longstanding "Money Moves Alert" trading service.

In a new free report, Marquez has identified a category of stocks he has labeled "rocket stocks," which display key characteristics hinting that they're ready to move. One such characteristic: Heavy insider buying. In fact, one particular sector right now is seeing especially heavy insider buying - and many investors will be surprised to discover just what sector it is, and what companies top executives are buying into. For a free report that details these "rocket stock" plays, and that outlines this torrent of insider buying, please click here.]

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