How To Avoid Getting Burned With Oil Stocks

A counter-intuitive investment principle is this: running to a sector of the economy after it blows up often proves, in hindsight, to be one of the safest things you can do.

Take a look at something like the Nasdaq Fund, QQQ, which tracked the technology stocks affected by the dotcom bubble. Between the fund’s inception on March 10, 1999, and July 23, 2002, the fund lost almost 60% of its value. A portfolio with $100,000 in a basket of tech stocks in 1999 would have become $43,400 by the summer of 2002. And yet, history favored those that purchased technology stocks after the collapse.

From July 23, 2002 through today, the QQQ Fund has delivered 14% annual returns to turn $100,000 in July 2002 into $547,000. The same fund. The same exact assets. Yet a wildly different result based on whether you waited three years to start your investment. The principle that explains this phenomenon has been well-documented by Wharton Professor Dr. Jeremy Siegel. It’s all about valuation. When people turn negative on a sector, the expectations become so low that it sets the stage for long-term outperformance.

Just look at IAT, the bank stock fund. It’s returned 5% since the summer of 2008 (by the way, that’s not bad in its own right. If you told someone in early 2009 that a purchase the previous summer in banks would deliver positive returns over the next five years, people would have thought you’d been spending too much with the Elmer’s Glue.) And yet, since early 2009, the IAT bank stock fund has returned 15% annually. You would have turned every $1 into $2.5 over the past five years.

This is why Benjamin Graham was so devoted to the cheapest quintile of stocks as measured by book value (P.S. this is a lesson from Graham that is somewhat limited to his time. The rise of automation makes book value a somewhat irrelevant benchmark because many companies can generate high profits with very little assets. Graham didn’t live in a world where 1,000,000 cans of Coca-Cola could be produced by three dozen men and men. Furthermore, book value can often be wrong if you don’t actually look at what is being measured individually. I could get more money out of a 2015 Game 7 World Series ticket than $100,000 in purported book value from Smith Corona typewriters purchased in 1985).

That caveat aside, Graham’s focus on cheapness measured by book value was a useful heurestic, and he was indifferent to the stocks that went bankrupt because the outperformance of the remainders gave him superior performance. When he ran the Graham-Newman fund, he essentially applied the Siegel principle to its logical end: Cheap stocks have artificially low expectations attached, and this serves as the famous “margin of safety” that gives better returns going forward because even moderately decent news can give great investment returns.

I think you will see a similar phenomenon playing out with the energy sector from here. The BHP Billiton online message board was filled with people wondering whether the mining giant would cut its dividend. Many, if not most, indicated that they would sell the stock if the company did so.

That, in a sentence, is how you become one of those people from the Dalbar Study that earns 3% returns while general stock market benchmarks earn 9% or 10%. That is how you become one of those buy high and sell low people, having no problem with BHP Billiton at $72 last summer but suddenly finding it offensive to own at $35.

The question you should be asking is this: Over the coming ten to twenty-five years, will BHP Billiton be producing more iron ore, nickel, diamonds, natural gas, crude oil, and steel than it does now? Will it be at higher prices than it does now?

Benjamin Graham often spoke of the fat man test he used in evaluating stocks without very specific projections. The principle is that you don’t need to know a man’s weight in order to determine whether he could stand to lose a few pounds. You don’t need to have a specific dividend projection and earnings projection in mind to make the determination that a lot of dividends will be paid and a lot of earnings will grow over the coming business cycles, which is especially attractive compared to the current price of $35.

And, for what it is worth, BHP Billiton is expected to have the profits to cover its dividend this year. It is expected to make $3 per share this year (this does include the removal of South32 from the calculation) while paying out $2.48 per share in dividends. That 83% dividend payout ratio isn’t great, but it is a sign that there is enough after-tax profits flowing to the BHP Billiton to maintain the current dividend if it desires to do so. If there was a dividend cut, it would be the discretion of management rather than financial necessity driving the decision. That may not assure a widow relying on BHP Billiton dividends to make ends meet, but it does reassure the income investor seeking capital gains and large chunks of income in the coming years, even if the payout itself experiences year-to-year turbulence.

It’s just crazy how willing people become to discard great assets when they become cheap. The programming that drives us to desire sales, deals, and bargains in every other area of life doesn’t seem to carry over to the stock market. This comes, I think, from a failure to appreciate that buying a stock is a real-live ownership position in a business that you can maintain for the rest of your life if you do not sell. BHP Billiton makes real products. The profits are real. It has returned 12.5% annually since 1987, fueled in no small part from dividend reinvestment when the price gets cheap. It is at a bottoming point in its business cycle, and it is still making $8 billion in net profits. It would take every dollar that has ever been made in the popcorn industry to equal what BHP Billiton will generate after-tax on behalf of shareholders this year.

Selling in response to dropping profits, or even a dividend cut, doesn’t work well with oil stocks. It’s anti-value investing. Eventually, commodity prices rise, and profits snap back quickly. So does the stock price. And the dividends get fatter. That’s how the industry operates. That’s how it has always operated. Value investing has always been about going places others don’t, often because something is wrong. People didn’t want tech stocks in 2002. They didn’t want banks in 2009. And a more moderate application of that principle is that people don’t want oil stocks in 2015. These lowered expectations are what will propel the outperformance five, ten, fifteen years from now.