Dividend Investors’ Obituary Syndrome

About a month ago, Berkshire Hathaway disclosed that it had purchased 26.5 million shares of Kinder Morgan at a price of nearly $400 million, at an average somewhere near $15 per share. In the past month, a combination of rising oil prices and the disclosure of the Berkshire investment has increased the per share market value of the holding to $18.62, for a gain of 24% in the past month.

On January 22nd, I wrote in my article titled “Kinder Morgan Stock at $13” that “[t]here will come a time when the price appreciation and dividends from this low $13 price point will be enormous.” That turned to be one my most e-mailed predictions of the past year, with some readers strongly disagreeing with that analysis and others wanting to know how I could be certain that Kinder Morgan would avoid corporate death through bankruptcy or a corporate half-death through share dilution/necessary capital raising while the price of the stock was cheap.

Regarding the latter claim, I can never be “certain” of anything. The best I can do is make educated guesses about the odds, and try to stick to estimates where my guesses have a confidence level of 90% or greater (or stand to experience a high magnitude of upside in the situations where the confidence level is lower).

Because Richard Kinder and the rest of management owns over 17.6% of the outstanding stock, I have made the assumption that they would want to avoid any equity raising events with the stock priced in the teens because of the dilutive effect it would have diminishing per share returns during the recovery.

And the reason why I regarded a bankruptcy as a remote possibility is because I try my best to think clearly about what a share in the ownership of a corporation represents. Each share that you purchase makes you a residual claimant in the corporation, meaning you get what’s left over after all the taxes are paid, all the creditors are paid (debt), all the employees are paid, all the torts and legal judgments are paid, and all the outstanding claims against the corporation are settled.

I use this to remind myself that a dividend cut is not the end of a corporation. It has become common practice for a lot of finance writers that cover dividend stocks to write an obituary for a stock after it cuts its dividend, often in an emotional, hand-wringing tone that suggests some type of betrayal from the Board of Directors or “proof” that the investment thesis turned out to be defective.

This mindset is foolish in many circumstances because you have to make projections about the future recovery potential of the stock as part of your analysis of any dividend cut, but it is doubly foolish to rush to judgment when a corporation cuts its dividend while earnings it profits in the commodities markets.
What I liked about the Kinder Morgan dividend cut is that it actually provided more certainty to me that an adverse event like a capital raise or disaster in the form of a corporate bankruptcy would be less likely.

Even with oil trading at $30, Kinder Morgan stood to generate $3.740 billion in cash flow from operations. If oil stayed that low from 2016-2020, a low probability event, Kinder Morgan stood to generate $18 billion in cash flows. The lowered dividend would cost $1.1 billion per year, or $5.5 billion assuming no hikes between 2016 and 2020. And the debt obligations would require $11.7 billion. You’d have $17.2 billion in dividend and debt commitments against $18 billion in cash flow, and in the unlikely event that oil stayed at $30 from 2016 through 2020, Kinder Morgan also had the possibility of cutting its dividend, lowering costs, and shifting to lower-margin yet reliably profitable energy transportation routes.

In short, you could see how Kinder Morgan could survive if you drew up the hypothetical terms of a sustained, disadvantageous status quo. There wasn’t much wiggle room, and certainly nothing that would give an investor advantageous returns if oil stayed around $30, but the corporate stockholders did have a high probability of surviving intact without a bankruptcy or capital raising share dilution event.

Then, the next line of inquiry is asking yourself: Do you think oil will stay low near the $30 range for a five year or so period of time? My answer is a strong “no.” Baker Hughes began counting the number of rotary rigs in use in 1949, and the 2016 figure of 480 is the lowest since they began counting. By their estimates, you would have to go back to 1860 or 1900 to find a time when the rig count got this low.

And the trend is still downward. There were 489 rotary rigs in service as of March 4th, 2016. By March 11th, 2016 the number dwindled down to 480. The idea of going to the gas station and paying $1.50 for a gallon is not something that was meant to be sustainable. The primary reason why it has taken two years for the active rig count to get so low is that mini mid-sized oil firms award executive compensation based on total oil production.

This creates a perverse incentive where the financial interest of the officers is in conflict with the best interest of the shareholders–the top officers get paid based on hiking production, which is different from maximizing margins over the full course of the business cycle. The latter is hard to define ex ante, and explains why it is so difficult to get the incentives of merit-based compensation packages correct.

When Kinder Morgan was at $13 following the cut, it didn’t take a whole lot going right to send the stock price upward. A moderate uptick in the price of oil has already sent the stock higher 43%. The $2.04 dividend that existed before the fall in prices was probably too lofty to see again, but that doesn’t meant that great gains in dividend income wouldn’t await the shareholder that purchased at $13.

When the profits are tied to the price of an underlying commodity, the capital gains and dividend hikes can come back almost as quickly as they went away. If oil gets up to the $70-$80 per barrel mark, we are talking about $6-$7 billion in cash flow being generated at Kinder Morgan. That could handle the debt load, hike the dividend to $1 per share annually, and then leave $2 billion or so left over for reinvestment. The investor that bought at $13 could easily be collecting a yield-on-cost of 8% within three years.

What are the takeaway lessons?

First: When a stock cuts its dividend, there has almost certainly some adverse business developments that have lowered earnings. This almost always corresponds to a lower stock price. You have to figure out whether you are being well-compensated for those business difficulties. At the time of the dividend cut, the answer is usually yes.

Second: If you are truly interested in long-term investing, you need to make sure that you are not just someone buying the stocks that are typically generational holdings but also attaching a twelve to twenty-four month time frame in your evaluation of the stock. This ties in neatly with recency bias, when you project too much of the recent portion of the business cycle into your overall evaluation of the business cycle.

Third: Ask yourself how the company generates profits. If there is regular volatility in the price of the good being sold, then you shouldn’t expect slow and steady rises in the share prices, dividends, earnings reports, and so on. If Coca-Cola saw its true, normalized profits fall by 60%, that would be a big deal because it would mean the product was being rejected. If that happens to Exxon, it is a natural characteristic of a business that experiences wildly large fluctuations in supply and demand.

Fourth: You should diversify so that the poor performance of one sector doesn’t diminish the overall strength of your asset foundation. I saw a message board recently where an investor was touting his S&P 500 fund because it didn’t have the price declines of Exxon and Chevron. That viewpoint is nonsense, as the S&P 500 has put 5% of its assets into Exxon and Chevron.

If you invest $100 into the Vanguard S&P 500 Index Fund, you are putting $5 into Exxon and Chevron. It’s just that when you own Exxon and Chevron, you see the full volatility of the individual holding. If you own it through an index fund, it is packaged together among hundreds of other companies so that the individual fluctuations are not pronounced. Don’t get your measuring sticks wrong–an entire portfolio of common stocks should be compared against the S&P 500 if at all, not an underperforming sector of a portfolio against the S&P 500.

Imagine if someone owned Reynolds American or Altria these past few years. The decline in oil prices had led to lower volume decreases in cigarettes, and the price of the major cigarette brands have increased by 8% annually since 2014. The fact that this coincides with a period of cheap gasoline is not a coincidence. If you build a portfolio that owns both the sunscreen and the umbrella company, you will profit regardless of the investment weather.

Fifth: Remember that the true value of a company is the amount of profits that it will generate from now until Judgment Day, discounted back to present value. A dividend is a useful heuristic, but is not a perfect substitute for a true analysis of a company’s long-term cash-generating power. A dividend cut is not proof of a corporation’s death, but rather, an indication that it is not currently generating the companywide profits to share the cash with shareholders in line with past expectations. It’s your job to figure out where the profits will head over the coming five to ten years, and then compare it to the prevailing price of the stock. You must do so in a way that avoids both anchoring bias and recency bias which can duel to cloud your analysis.

But most of all, do not fall prey to the obituary syndrome of acting as if a dividend cut is a corporate death. It’s not. A dividend cut is a natural moment for reassessment of the business, but it is not proof that the original thesis was wrong. In the case of cyclical companies, you shouldn’t even adopt a *presumption* that a dividend cut means a failure of judgment when initially evaluating the stock.

Source Consulted: http://www.wtrg.com/rotaryrigs.html