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.

Conclusions

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.       

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Enterprise a Port in Storm

With energy investors in a state of near-panic, the $6 billion acquisition announced on Oct. 1 by Enterprise Products Partners (NYSE: EPD) has already been almost forgotten. Yet the deal for the Gulf Coast petroleum storage and port facilities owned by Oiltanking Partners (NYSE: OILT) and the master limited partnership’s privately held German sponsor showcased Enterprise’s faith in continued growth of North American oil production and, eventually, exports.

Enterprise is paying $4.6 billion, almost evenly split between cash and equity, for OILT’s general partner and most LP units, plus another $1.4 billion in equity to exchange all OILT units held by the public for those in EPD. Because this is a merger between two master limited partnerships, there are no tax implications for investors.

OILT limited partners will not get a premium in the exchange, but they will get EPD units’ higher yield and much greater scale and diversification, albeit with less spectacular growth. The timing was fortunate for them, because without the deal OILT would likely have fared much worse last week as a leveraged play on domestic crude production.

EPD, meanwhile, was very briefly down 12% Friday on a huge spike in volume (and 22% below the record intraday high set exactly one month earlier). But it quickly recovered to finish 1.4% lower on the session. Following the predictable 5.8% year-over-year distribution increase announced Friday, units now trade at a prospective yield 4%. That yield is backed by mostly fee-based long-term contracts that have delivered 54% more cash than Enterprise has needed to pay its distributions during the first half of the year.

For its $6 billion Enterprise gets ownership of Oiltanking’s marine terminal in Houston, which it was already using to export liquefied petroleum gas, another marine terminal in Beaumont, Texas, and 24 million barrels of adjacent storage capacity. These assets will allow Enterprise to continue to play a leading role in US energy exports, assuming the current slump in crude prices doesn’t stop shale development.

It likely won’t. Many shale producers are well-hedged well into the future, and many can continue to make a profit at the current price. Global demand growth is likely to require plenty of US shale development as well in the long run. Enterprise certainly has the financial strength and the long-term contracts to withstand lots of near-term volatility in commodity prices.

After the smoke from this selloff clears and the crude and equity markets stabilize, this Conservative Portfolio mainstay will likely be among the first we’d recommend buying again. For now, EPD remains as safe a Hold as you are likely to find in the energy sector.

 — Igor Greenwald