“You pay a high price for a cheery consensus.” No wonder everything always comes back to Warren Buffett. How can you impart more investing wisdom about the importance of getting the valuation right than those nine words?
That quote was on my mind when I reviewed the various possibilities for someone purchasing shares of BP at different price points since 2010. An incorrect intuition that I sometimes have is the notion that, over medium periods of time, investors in the same corporation ought to earn somewhat similar results. If you buy shares of BP, you are the owner of an entity producing 1.2 million barrels of oil and oil equivalents per day, and whatever the business results of that may be, that is going to be a close approximation of what you get.
Of course business performance is important, but valuation is such an important variable that it prevents business performance alone from becoming the destiny of your investment.
After the 2010 oil spill, BP shares fell to a low of around $27 per share. It has gone on to pay $12.99 per share in dividends since then, or $14.37 in cumulative dividends if you reinvested. With the stock trading at $33.71 per share today, you would be looking at a total value of $48.08. The investors that bought after the Gulf oil spill have compounded at 10% annually.
And if you had the worst timing? That would be in 2014, when oil was over $100 per barrel and BP was indicating certainty regarding its legal liability and had shed assets to build up a $30 billion cash position to resolve its $20 billion bill.
The outlook was sunny, and the stock price was $53 per share. You got to collect $4.80 since then, but you’re still down from $53 to $37.80 in value. That is annual negative compounding of 15.5% per year for a loss of about a third of your investment value.
This helps me understand a little bit better why Benjamin Graham was impatient with the question “Do you like Stock X?” because it is incomplete. The question: “Should I buy BP stock?” is incomplete. The answer to that question in parts of 2010 was yes, the answer during the first part of 2014 was a no.
I mention this not as a journey in hindsight bias. Instead, it is because I want to point out how sentiment shapes future returns. After the oil spill, no one wanted the stock. That is when the valuation was so favorable that the stage was set for high subsequent returns. The losses of 2014 are probably more explained by bad timing than a poor investment process–a day will come when the investors that bought at $53 per share in 2014 and held for the long haul will report double-digit returns.
My own view is that the current price of BP at $33 per share is analogous to the cheap pricing that was available after the oil spill. Here, the reason for the risk is uncertainty about the dividend payout. Investors have a very reasonable basis to think the dividend payout is ripe for slashing. But a higher than usual possibility of a dividend cut is not the same thing as a bad long-term investment. It is the most common delusion that I see educated investors make. Even if your goals are tailored to income production, you shouldn’t use that as a plausible cover to give in to your quick sell impulses. Right now, BP isn’t earning enough to cover its $7.4 billion dividend commitment. But the company also has $23 billion in cash, so it could wait a year or so to see if prices rise above $60 to cover all of its pre-existing commitments.
This uncertainty of the future of the dividend is a reason why you are setting the stage for capital gains.
The post-spill to modern day results are a vindication of Graham’s “margin of safety” principle. The valuation was low then, and it is low now, and you still got 10% returns. Rushing in during periods of uncertainty lock you in because (1) the dividend cut may not be as extreme as projected, if it materializes at all, and (2) given the fluctuating nature of the commodities business, there can be a quick turnaround in which the dividend starts growing annually within a year or so of a hypothetical cut.
The investors that got in low at $27 in 2010 earned 18% annual returns from 2010 through the summer of 2014 (a low to moderate comparison period) and 10% annual returns from 2010 through 2016 (a low to low comparison period.) This is exactly how getting the valuation right ought to operate. If poor business results follow, you still get mid single digit returns. If things are just OK, you set yourself up for double-digit gains. And if things go well, you are looking at five-year returns in the 15-20% annualized range. The past three years haven’t been great for BP’s stock price, but recency bias can easily give you the wrong lesson if you project this past onto the future. As the price has come down, the probability of impressive future total returns increases.