I have previously shared with you my view that the increasing prevalence of index funds creates some market distortions because investors perpetually buy stocks based on market-cap weights rather than fundamentals. When a business owner sells his $10 million business and puts $6 million into the S&P 500 Index, he is placing a buy order for $180,000 worth of ExxonMobil stock automatically. It’s the nature of the programming behind the index. Exxon is the second-largest business domiciled in the United States based on market cap, and all buy orders reflect the fact that Exxon Mobil’s market cap of $300+ billion is about 3% of the $15+ trillion stock market index.
Whether oil is $50 or $100, or the oil giant’s profits are high or low, you are purchasing the stock if you hold investments keyed to an index. This by definition corrupts the principle of fundamental analysis because people aren’t making buy and sell orders based on the specific price that they think a business is worth, but rather, they are buying a fixed percentage of something simply because it is big right now.
I thought about that as I digested today’s shell-shocking news that Exxon is on the verge of writing off 20% of its reserves–about five billion barrels of oil and oil equivalents–because the cost of extraction from Canadian sands doesn’t make sense if oil stays in the $40s for an extended period of time.
If index funds didn’t exist, this is the kind of news that would send Exxon shares down at least 5% immediately. Instead, you’re seeing the much more muted decline of 1.2%. So much money is indexed into Exxon on an ongoing basis through funds and ETFs that you don’t see many direct responses based on fundamentals anymore.
With oil at $48, you can’t really say that Exxon is undervalued at $84 per share. Normally, you would hope to see Exxon come down to the low $70 range so you could make a clear value investment that would net you 5% in dividend income and give you adequate returns if oil stayed low and excellent returns if oil returned to $100. Instead, the rise of indexing means that you don’t quite see that undervaluation in Exxon right now. At $84 per share, you don’t quite get that safety net if oil stays low and you don’t get those 12% annual returns if oil shoots back up to $90 per barrel and stays there.
Instead, you have to go the British route to big oil and look at Shell and BP which don’t have as much money indexed to them (BP used to be programmed for purchase for nearly 10% of pensioner accounts in the UK prior to its dividend cut, but the formula has since been revised. I imagine history will regard the timing of this revision as selling low.) The drawback is that the BP and Shell dividends aren’t as safe as Exxon’s, and aren’t as well equipped for 5+ years of low oil, but offer much more recovery potential and have a high chance of beating the S&P 500 from this valuation even if they do cut their dividends.
But the role of index funds in affecting market movements is there if you are paying attention. I was surprised that Exxon only came down 1% today. During the 1970s through early 2000s, this news would have led to a steep drop in stock price that might have permitted a value investor the opportunity to pick up some shares. Instead, the persistent auto-buying is preventing ExxonMobil from becoming undervalued during a time of pessimism and difficulty in the commodity sector.