Being A Selective Investor In 2015

At Berkshire Hathaway’s annual meeting this past weekend, Warren Buffett mentioned that most stocks are likely a bit pricey right now unless interest rates remain low for the next 5+ years. You don’t have to consult the Oracle at Delphi to know that paying 28x earnings for Church & Dwight right now is going to lead to total returns lower than the company’s growth rate because Church & Dwight’s valuation tends to settle in the 18-22x earnings range during words of 5%, 6%, and 7% long-term U.S. bond rates. That story plays out across hundreds of stock across the nation.

That’s the bad news—we aren’t in 2010 or 2011 anymore where buying any large stock you’ve heard of before has probably led to great returns over the past four years. Instead, you have to zero in—pull out the magnifying glass!—and find those two or three dozen companies that either fall into the category of (1) good company at a discount, or (2) excellent company at a fair price. The types of companies that fall into the first category generally have some kind of issue to work through, and the expectations for the company lead to a stock price that overstates the problem. The types of excellent companies trading at fair prices are generally those with P/E ratios in the 20-22x earnings range but have a very high likelihood of 10% or greater earnings per share growth over the next 5+ years.

Microsoft stock between 2000 and 2015 is the emerging textbook example of how expectations for the business matter just as much, if not more, than the performance of the business itself. Between 2000 and 2015, Microsoft offered earnings per share growth and dividend payments that would suggest total returns between 8% and 12% annually. But that is not what happened.

The expectations for Microsoft have fluctuated wildly over the past decade and a half. If you bought Microsoft in 2000 and held to this day, you would have 4% annual returns. That is because back in 2000 people paid 40-50x earnings for the stock because the investor community was expecting Microsoft to colonize the corporate world with its Office products. The investor that bought Microsoft in 2010, meanwhile, has enjoyed 15% annual returns because Microsoft was a relatively dull investment choice compared to the sleeker and seemingly more innovative Apple competitor. Microsoft was trading as low as 12x earnings, and this valuation understated the $150 billion cash hoard and ability to grow revenues by 5% and earnings per share by 7-8% without factoring in share buybacks.

That’s the kind of search we should be on today—a company with dull expectations and a favorable valuation that nevertheless possesses very strong economics. There are a few candidates for consideration, but I keep coming back to BP, especially after its recent return to $41 per share. It has been a solvent enterprise for almost a century, and profitable in 48 out of the past 52 years. Its current balance sheet is much stronger than people give it credit.

BP is currently sitting on $29.7 billion in cash on hand right now, with the possibility that $22 billion could go towards Gulf of Mexico litigation remaining from the oil spill. Whether it was deliberate or not, BP’s decision to sell off a significant amount of assets in 2011 and 2012 proved fortunate timing as it was able to receive at least double (maybe triple) the value it would have received if it had begun selling off the assets after the summer 2014 slide in oil that took the price of barrels down to the $50 range.

And the remaining assets are still quite nice: When oil is at $50 per barrel, BP generates $275 billion in annual revenue. When oil is $100, it generates almost $400 billion in annual revenue. Perhaps the greater item of interest is net profit. When oil is at $50, BP makes somewhere between $6.5 billion and $7 billion in annual profits. When oil is in the $70s and $80s, the profits are somewhere between $12 billion and $17 billion. And when the price of oil exceeds $100, BP becomes one of the top dozen most profitable firms in the world with profits north of $25 billion.

Like Microsoft in 2010, I don’t think people have an appreciation for how strong BP is. I think people have gotten caught up in the 2010 dividend cut and the constant negative headlines and have substituted that information in place of an actual analysis of BP’s business model. Even at the bottom of the business cycle—or at least, a low relative place for commodity prices—BP still manages to make $7 billion in profits this year. It makes enough annual profits this year that, if it didn’t pay a dividend, the company could elect to purchase the Dallas Cowboys, New York Yankees, and Los Angeles Lakers outright. Or it could buy the St. Louis Rams seven times over and open a football colony in LA.

I wouldn’t expect much in the dividend growth front—right now, BP’s $0.60 quarterly dividend puts the company on the hook for $7 billion in annual payments while making $6.5 billion to $7 billion in profits. I would imagine the management team would borrow modestly to fund the dividend through this low price stretch because the $2.40 dividend provides a price floor of sorts for the stock and BP would probably be reluctant to impose short-term hardships on shareholders after the headaches of the past five years (despite all the criticism of BP management in the media, they have been quite rational from an interest of shareholders perspective in the aftermath of the spill). And for what it’s worth, the most recent annual report indicated that BP intends to increase the dividend when conditions allow it.

When I run the numbers on BP, it seems very likely that people can reinvest dividends so that the share position will compound upon itself like crazy over the coming decade as the price is low due to litigation uncertainty and low commodity prices. Imagine collecting $2.50 in cash dividend payments per year for a decade—you’d end up collecting $25 cumulatively from a $41 per share between 2015 and 2025. I would consider that a low end of reasonable projection. That could be your return assuming no growth, no capital appreciation, just good ‘ole BP pumping out the profits and dividends it does and maintains the status quo.

It is one of the most overlooked ways of building wealth because it requires a while to become lucrative and is invisible if you are accustomed to only making decisions based on changes in the price of a company’s stock. If you paid $41 per share for BP five years ago and reinvested through this day, you’re not treading water because the stock is at $41 today. Assuming dividend reinvestment, you have turned 100 shares into 120 shares. You turned a $4100 investment into $4,920, and saw annual income of $168 grow to $288 today. For someone who takes passive income seriously, BP has been great these past five years. The price has gone nowhere, but dividend reinvestment and some dividend hikes have brought your annual income up 71%. And this is while BP is still sorting through some difficulties.

There’s also something psychologically satisfying about buying cheap oil stocks while the price at the pump is cheap so that you position yourself to collect more in dividend payments from oil companies than you have to pay out of pocket for $4 per gallon gasoline during the next business cycle turn. I imagine that someone who purchases a couple hundred shares of BP and tucks it away in a retirement account to compound itself will be quite satisfied with the annual income 10+ years from now. It’s this virtuous cycle where 5% dividends provide high income which buys more share that, in turn, pay out a high 5% rate. These are the kinds of situations you want to look for in 2015—low expectations mixed with fundamentally sound enterprises that provide strong countervailing forces like high dividends.