The trouble with writing about investments is that you almost never hear about your big winners.

We have heard plenty of concern about the SandRidge trusts, and if you’ve read the story above you’ll know that these are now Sells, and why.

How we got here, though, says something about who I am and how I can best help you going forward.

I am, as described in greater detail in October, a highly successful energy investor, industry expert and chemical engineer.  

When I came on board last fall, I eliminated some portfolios (e.g., Field Bets) and began to sell off underperformers. I recommended refiners and companies involved in natural gas infrastructure, but the general direction was toward a smaller, more focused portfolio. I did not want to shake things up too quickly and possibly generate short-term capital gain consequences for investors, but was slowly making the various portfolios my own.

I was not especially bullish on the oil and gas trusts, but they provided no compelling reason to sell, either. That recently changed along with their long-term outlook.

And as the great investor John Maynard Keynes observed, “When the facts change, I change my mind. What do you do, sir?”

What we won’t do is make knee-jerk reactions without carrying out a thorough analysis, nor will we attempt to time short-term market moves.  

If I feel a company has a compelling story, I am not going to sell solely because the share price falls. In fact, Chevron (NYSE: CVX), one of our Conservative Portfolio holdings, saw its share price decline by 14 percent during October and November. But its outlook remained bright and I suggested buying if the share price fell below $105. It did, and investors who bought in have seen a rally of 11 percent in just a couple of months.

However, our risk tolerances may differ. If you simply can’t afford the notion of a 15 percent decline, please reconsider the risk factors inherent in stocks.

I have heard from a couple of people who said that the drop in the value of the trusts was more than they could bear as conservative investors. That tells me two things.

First, many investors didn’t really appreciate the inherent riskiness of these trusts.

Second, it’s important to understand your personal risk tolerance–and that of anyone making picks and pans. For me, a 15 percent decline in a stock with strong fundamentals will often spell opportunity. But if that is an unacceptable level of volatility for you, you need to have your own exit strategy.

Now about those trusts. Royalty production trusts are investment vehicles that are used to finance development of natural resources like oil and natural gas. After each quarter the trusts pay distributions to investors based on oil and gas sales in the quarter. The distributions decline over time as the properties are depleted. Most trusts have a specific termination date, at which point the remaining assets are distributed to investors.

There is a number of risk factors with these. The major ones are the price of the commodity and the production volumes. The latter will be influenced by the level of drilling activity, the level of depletion and the split between the production of oil and natural gas. A trust that is expected to produce primarily oil could see shares drop sharply if the mix turns out to have less oil and more natural gas (based on current prices for oil and natural gas.)      

Tax policy is another serious consideration. The trusts pass profits through to shareholders, who then pay ordinary income taxes on part of the distributions (part is considered a return of capital). As a result, royalty trusts in the US are not presently subject to corporate income taxes and avoid the problem of double taxation at the corporate and individual level. A change in tax policy such as a decision to assess corporate taxes on the profits would obviously diminish the trusts’ appeal.

But it was the more routine production shortfall that recently tripped up the Sandridge Mississippian Trust II (NYSE: SDR), resulting in a disappointing quarterly distribution. Sandridge will pay 53 cents a share to shareholders, but analysts had expected the distribution of 71 cents a share,  on average.

The market reacted swiftly. SDR shares opened 15% lower the next day and kept dropping after a Raymond James analyst downgraded the trust from Outperform to Underperform. Others soon piled on. Raymond James noted that production fell despite a big increase in drilling by Sandridge.

Most investors are attracted to these trusts for the high yields, which often run in the range of 10 to 15 percent. But note that many investors have been attracted to junk bonds on that same basis — and at times have absorbed much larger capital losses. In both cases, those high yields come with risks that are too high for many conservative investors.   

In the specific case of SDR, the lower distribution was a result of two factors. First, production was lower than expected. Second, there was reportedly a higher fraction of natural gas than expected. Because natural gas prices are presently depressed, this weighed upon the shares.

But the more worrisome aspect was that the lower production occurred in spite of increased drilling by Sandridge. Production could be lower due to unplanned maintenance and it wouldn’t necessarily signal a long-term concern for the trust. In this case where drilling increased and production still declined more than expected, the market immediately lowered the value of the trust.

These trusts should be recognized as speculative investment vehicles despite the lure of a regular and lofty yield. It doesn’t mean that all such trusts are bad investments. But we’re not going to be counting on SandRidge’s projections in making such decisions..

My experiences in energy is hands-on. I view the refining sector as someone who has worked in refineries. I view oil and gas production as someone who managed a team of engineers in the North Sea oil and gas fields. If I don’t understand the core business of a company, I will not invest in it. I buy stocks whose long-term outlook I deem positive, and sell those when that outlook changes, or when a stock becomes expensive relative to its peers. This is an approach that’s worked for me and I believe that it can work for you as long as we understand how each of us handles risk.