Retail investors intuit that much goes on at the operational level of companies that one does not wish to see streamed in HD 1080, any more than one wants to see gall bladder operations on YouTube, even though we know that these bloody operations happen, are glad that they happen, and delight that they usually succeed. Similarly, well-run cyclical companies often find themselves reporting poor earnings, issuing debt, and cutting dividends when the price of commodities are low. We all know that this is a characteristic of the company’s story, but our ability to receive real-time updates and see the difficulty up close may cause enough to encourage some people to sell their stock.
In the past, there have been two ways that would give investors the ability to hold through cyclical downturns.
The first is genuine naivete: For most of the 1900s, people tended to believe the best about companies that seemed to be part of the public vernacular, and there would be no inquiry into the quality of the balance sheet. A look at 20th century trust funds (or individual stocks designed to serve as a trust even if it didn’t use that legal wrapper) reveals that people took their 5%, 6%, or 7% dividends from AT&T and didn’t care much where the dividend came from. If the payout ratio was 60%, 90%, or 110%, it didn’t matter to the casual retail owners.
That lackadaisical approach to investing doesn’t work much anymore; the parade of bad news for a given company make even the most willfully uninformed investors became aware of the short-term deficiencies of their investment selections.
This leads us towards a second way to develop the gumption to hold on through tough times: thoroughly understand the business you own, and recognize that it is not unusual for an adverse cycle to last three to five years.
BHP Billiton, which trades under the symbol BBL for the London shares that make the most sense for American investors to own, is one of my favorite companies in the world. It returns a good chunk of cash to shareholders every year, has increased its production by 16% annually over the past ten years if you include the assets of the recent spinoff South32, and tends to give capital gains that exceed the stock market at large.
It is a great way for American investors to diversify, as it principally does business in the United Kingdom, Australia, Chile, and South Africa.
If someone bought the stock on the eve of the 1987 crash, and held through the present day, the returns would have been north of 10%. If you measure the returns from that date through the summer of 2014, the annual returns would have been 14% (even after a 25+ year measuring period, the valuation of the stock still contains to exert a strong weight on the overall returns.)
It amazes me, though, what happens when you buy stocks during periods when they are cheap and continue to hold through thick and thin thereafter. If you bought the stock during the oil stock collapse of 1986, you would have 11.5% annual returns through the present day and nearly 16% annual returns from 1986 through 2013. Good things happen to long-term investors that gravitate towards the stocks that nobody else wants.
BHP Billiton’s current dividend payout of $2.48 per share amounts to $6.5 billion per year. That was not an issue between 2007 and 2013, as the company’s overall profitability fluctuated between $13 billion and $23 billion. The dividend was always well covered by profits, and the high amount of retained earnings permitted BHP Billiton to grow production of iron mines, oil fields, and mineral facilities at a steady clip.
Now, BHP Billiton operates under the shadow of those former profits. It makes $3.5 billion per share in profits based on the current price of oil, iron, nickel, copper, and steel, meaning it would need to borrow about $3 billion per year to make the current dividend payment, and would need to borrow additional funds to continue building out production.
Additional aggravation has been needlessly caused by BHP Billiton’s CEO Andrew Mackenzie declaring last year that the $2.48 annual dividend would not be cut. The Chairman Jac Nasser indicated yesterday that protecting the Grade A component of the balance sheet must come first, with many interpreting the comment as a signal for a dividend cut at the February 2016 meeting. This would be the first dividend decline for the ADR holders since 1999.
Gratuitous promises can be a dirty game. News reporters obsessively document every public declaration of executives, and people prod executives for future indicators of dividend growth. The words “it depends” is the answer to every business question, and anytime executives give an assurance that cannot be met–investors cry foul. If anyone imagines that predicting on earnings and dividend promises is always crystal clear, that person is uninformed and unimaginative about what the world can do.
I don’t get carried away in judging forward-looking statements harshly because any promise will ultimately be measured against the earnings of the company. If the fundamentals decline, past promises can’t usually be honored. In late 2014, the business conditions at BHP Billiton indicated the payment could be met indefinitely. Prices declined more, and stayed down, and hence, we re-evaluate.
People still begrudge General Electric CEO Jeffrey Immelt for promising to maintain the GE dividend before it was cut. Many sold their shares in anger upon the dividend cut. The problem? This disgust acted as a low point for the stock, and General Electric has returned 17.8% annually since its dividend cut.
Over the next ten years, it won’t really matter which direction BHP Billiton makes in the short term with its dividend. If it maintains the $2.48 dividend payout, it will have an extended dividend freeze when commodity prices recover and investors will only collect 2%, 3%, or 5% dividend increases along the way. If there is a steep dividend cut, BHP Billiton is able to reload faster by accumulating retained earnings and then give shareholders 8-12% dividend growth during the recovery years. That is what General Electric, Wells Fargo, and American Express did in the years after the financial crisis.
I find value in diversification when I think about a company like BHP Billiton. If you own 30+ companies, and BHP is only 4% of your overall income, it’s not hard to find the gumption to ride out the storm. Even a 50% dividend cut would only cut your overall portfolio’s income by 2%. If BHP Billiton were one of only five stocks in your portfolio, you would have to steel yourself to get through the next few years.
BHP Billiton hasn’t traded this low since 2005. It is an exceptional company that is still making $3.5 billion in annual profits despite slumps in every single business segment. As people become discouraged, the value offered by the stock continues to escalate. In ten years time, it would not surprise me to see the stock pay out $3 per share in dividends. Even if you spent every dividend in the meantime, you’d find a way to collect over 11% on your initial purchase price.
This is a solid company producing 98.6 million barrels of oil. It produces 1.7 million tons of copper. Over 4.3 million tons of aluminum. Over 786 billion cubic feet of natural gas. Even at this current low point, it is still making $10 million per day in post-tax profit when you compare the commodity sales against all expenses. It is doing what cyclical companies typically do during downturns in the economic cycle, and it is quickly becoming one of the best buys in the market at large as the investor community continues to run away from it.