When you read Charlie Munger’s biography by Janet Lowe (“Damn Right”), you will frequently encounter the financial premise that dominated Munger’s thought process from the age of thirty onward: he sought ownership positions in assets that pounded out cash. The spectacular personal success was the result of being patient enough to get a good price on those very assets that pounded cash.
The unique aspects of Munger’s life is that: (1) he did not mind the subsequent volatility of stocks he purchased, often seeing some of his stocks slide more than 50% after he made his initial purchase, and (2) he got in the business of using money to make more money, taking income from undervalued cash-generative assets to buy other assets that meet the same conditions. As time passes by, you get to reap the benefits of receiving income from the original assets that paid dividends and then you get the new assets that create regular income as well.
For some, this may be stating the obvious, but it is worthy of repeating because it is the North Star against which everything else is affixed. During the throes of the financial crisis, Munger was buying Wells Fargo at $16 for the Daily Journal. Then, when it went down to $8, he bought a lot more. It was incredibly rational behavior when the rest of the world was losing its mind.
There is a surprisingly large faction of the investor community that thinks a good deal is somehow undermined when the price of a given security subsequently drops. If a scalper sells you World Series tickets with a $300 face value for $150, your good deal isn’t undermined because some other guy was able to get $100 tickets from a scalper. With Wells Fargo now trading at $54, the decision to pay $16 in 2009 was a great investment decision. The beauty of the $16 per share Wells Fargo investment isn’t blemished because you could have also bought those shares at $8. Once a stock gets cheaper than fair value, you don’t have any right to expect an even better deal than that, and you should have a posture of gratitude any time you get a deal better than that.
This concept was on my mind when I started following various investor message boards in response to the recent decline in oil. Volatility in the oil sector has been with us since the advent of the Standard Oil Trust in 1882. Chevron, which is the original Standard Oil of California, has delivered 12% annual returns since 1969. It has had price declines of at 40% on eight different occasions since then. The dividend gets frozen when oil collapses (see the late 1990s for an extended period of this) and then marches upward when the energy market turns and gets more expensive. All this happened while the price of oil hemmed and hawed between $10 and $135.
The sentiment towards oil stocks is subject to quick and sudden emotional changes. Do a custom controlled google search for articles about Exxon and Chevron in the summer of 2008. Pundits were writing about the indispensable nature of the asset, the lack of price competitiveness among alternative fuel sources, and the growing demand for global energy that exists over the long term. That brought the price of both stocks to north of $100. People couldn’t help themselves from piling in.
Now, people talk of an oil glut and can’t get away from the energy sector fast enough. It is amazing to repeatedly observe the disconnect between people who nod their head affirmatively at the notion of value investing and getting assets cheap, yet never actually engage in the practice when the abstract theory gets applied to specific circumstances. The power of knowing the right mental and analytical models lose all value if they cannot be applied to the real-life examples that present themselves.
Since Chevron merged with Texaco, there have only been a few brief periods when the dividend yield exceeded 4% (2002, 2003, 2009). At no point has the yield become 5.65% like we have now. Since the modern Chevron got created in 2000, the current valuation gives investors the highest starting yield out of any point in the past fifteen years.
It still passes the “pound out cash” test. Even with oil projected at $45 per barrel, Chevron is still targeted to make $8.5 billion in profit. I dare you to find more than three dozen companies in the world that currently make more profit than that. The current profits do not support the capital expenditures plus dividends without requiring additional borrowing, but $75 is a more than fair price to pay for an asset that churns out $8.5 billion in profits during the bad times and can quickly churn out more than $20+ billion in annual profits based on a reversion to profits regularly seen in the past ten years.
The advantage of owning Chevron, compared to a fast growth company like Visa, is that you regularly receive cash that you can direct towards your personal life or use to make brand new investments. It is a case of compounding that provides regular income to alert you to the beneficial aspects of the growth. If your Visa position grew to $100,000 in market value, you would only be receiving $670 in annual income. Unless you sell, there is no benefit to the company. Of course, it is growing so fast that it’s fun to be along for the ride, and of course very few portfolios will regret holding onto Visa for the long term.
But there is also a place for Chevron in the portfolio. With a $100,000 Chevron market value, you get to collect $5,650 in annual income. That alone is the equivalent to 10% of what the average American household generates in a year. It can provide immediate cash to pay the bills, save for college, go on vacation, or build up reserve buffers. There is value in that.
Also, the results become pronounced if you do choose to reinvest into Chevron outright. Imagine putting that $5,650 right back into more shares of Chevron. You’d automatically be picking up 75 more shares next year at current market prices. Even if the dividend didn’t get raised, you add $321 to your dividend stream as you wait for more favorable conditions ahead.
Cyclical companies are notorious for experiencing fluctuations in market value that exceed actual changes in the fundamentals. For someone that doesn’t appreciate a company that is producing over 1.5 million barrels of oil per day, it can be easy to be disconcerted by the quick changes in the stock price.
But good investing requires an abandonment of recency bias, and instead forces us to identify intrinsic value and then acknowledge that any given stock is perfectly free to trade at an even greater discount to intrinsic value.
I would classify the wide band between $85 and $105 per share as the “fair value” range for Chevron. As the company trades into the $70s, the discount has continued to become greater. For people with long horizons that recognize the long-term global appetite for energy, any further declines in Chevron stock should be regarded as an opportunity for an opportunistic addition.