When someone buys individual stocks, it seems to me that investing skill comes in three stages. You have that first stage where you struggle to dissociate changes in the price of a stock from changes in the enterprise that it represents. In the second stage, you’re not worried about Wal-Mart falling from $63 in 2008 to $46 in 2009 because you know that earnings are growing from $3.42 to $3.66 (with a dividend increase to boot) so you can tune out the noise and assess the health of the enterprise.
The third stage is the tricky one, where even the best will still make errors: trying to figure out which stocks are “value investments” when the price of a stock falls while earnings deteriorate. The purpose is trying to figure out whether the amount of the earnings impairment is less than the amount of stock price decline, as well as figuring out the length of such an impairment.
I approach this issue in two, maybe three, steps:
Step 0: Figure out whether there is a clear purpose to owning cyclical or temporarily depressed firms. Valid reasons include sought-after diversification, superior capital gains, higher dividend yields, or recognition of high barriers to entry in the industry that give you the confidence to reinvest. Other valid reasons exist. But you could also get very, very wealthy dumping cash into Nestle, Colgate-Palmolive, Coca-Cola, PepsiCo, Kimberly-Clark, Hershey, McCormick, Procter & Gamble, and Johnson & Johnson. If this matches your comfort level, there is no reason to move beyond it–especially just to appease the itch I call FOMO syndrome (fear of missing out).
Step 1: Figure out what the poor periods in the business cycle look like, and assess the company’s “survivability” during this period. Is it still profitable? Is it covering debt obligations easily? Will it have to dilute shareholders? Is there any bankruptcy risk? While I don’t delight in dividend cuts, I don’t use it as an indicator with cyclical stocks because it will frustrate your ability to reach correct conclusions–precisely at the moment when earnings are falling fast and the dividend is cut usually accompanies the moment when the stock is cheapest. Some investors miss this because they cannot see past the falling stock price, and others become wedded to things like P/E ratio without realizing that the “E” portion of it is subject to quick swings upward when the business cycle turns more favorable.
Every investor has their skill set advantages. An advantage that I possess is that I do not believe perception is more important to, or equal to, reality. The personal downside of this character trait is that I tend to underestimate circumstances in which a snowball of perception rolling down a hill quickly creates an avalanche of politics and public sentiment that ends up infecting reality. But it serves me well when analyzing the most dominant firms in cyclical industries.
There are countless articles these days telling people to sell oil stocks, even including ExxonMobil and Chevron. There are a lot of people out there who own these two stocks that will be tempted into selling them because there are a lot of articles telling them to sell. If online investment boards didn’t exist, I would have no idea this self-imposed type of pressure existed. But because I know it exists, I can now address it as I try to become a more effective writer.
But for me, the rudimentary analysis is this: Even with oil in the $30s, Exxon still literally pumps out $17 billion in net profits. If the price of oil does not advance during 2016, 2017, 2018, 2019, and 2020, Exxon will still generate $85 billion in profits. It is currently obligated to make $24 billion in debt payments over this time. This will give Exxon an estimated $61 billion in cash flow to pay out dividends, invest in large exploration, chemical, or refining projects, or even repurchase stock consistent with its sixteen-year history of reducing the share count from 6.9 billion to 4.1 billion.
That’s my downside analysis. For Exxon to face a risk of share dilution or overleveraging of the balance sheet, oil would have to trade below $22 per barrel for at least five years straight. It is comparing the cash flow during realistic worst-case scenarios against current and projected debt obligations that acts as the north star of my analysis. It is not the public sentiment towards a stock overall that affects my posture towards a potential investment–I treat negative articles about a stock as a gift to double-check my analysis to see if there are any variables that I missed or mischaracterized–it is not an occasion to lament someone being critical of what you own.
Step 2: After weeding out the companies that do not offer a reasonably high chance of surviving realistic worst-case scenarios, assess whether the returns in the good times are enough to subject yourself to the cyclical volatility. In other words, why buy Exxon at all when you can just double down on Johnson & Johnson and avoid dealing with the earnings fluctuations?
In the case of Exxon, you can study the 16% annual returns since 1960, 14% annual returns since 1970, 13% annual returns since 1980, 11% annual returns since 1990, and 6.5% annual returns since 2000. If you consider Exxon undervalued, you should remember that the long-term returns are affected by this fact. For instance, if you compare Exxon’s performance from January 2000 through January 2014, the results are 9.2% annualized instead of 6.5% annualized. As a stock becomes cheaper, the historical returns also decline and you should be aware of how this could frustrate your purpose (it is something I have to always keep in mind when studying something like Nike, as the elevated P/E ratio indicates exceptional long-term returns but it requires the additional homework task of figuring out which of those gains are attributed to the growth of the business and which are attributable to the lofty increase in the valuation of the business).
Jeremy Siegel provided strong insights into why Exxon outperforms–it maintains its dividend during bad times, and this acts as a total return accelerator when the stock is cheap. When the price of oil rises, Exxon is flooded with new profits that can fund large production increases or stock buybacks. And because oil stocks rarely get super-overvalued, a strategy of perpetual hell-or-highwater buybacks doesn’t cause shareholder harm in a way that Facebook shareholders would suffer if the Facebook Board of Directors adopted a like-minded policy.
Once you decide that you want to invest in cyclicals, you should estimate profits in realistic worst-case scenarios. Is the profitability high enough during such a scenario to keep its balance sheet within a range of reason? I am driven by concern for bankruptcy or share dilution risk, and as such, I compare the profits in down times against the current and expected liability payments that are required. Then, I estimate what the good times will look like to figure out if it is worth it.
The omnipresent risk forever lurking in the shadows is a corporate buyout during such a period of distress, and the only hedge against that is diversification.
The approach to cyclicals is straightforward: Do you need them? Do you have confidence the firm will survive a realistic worst-case scenario? Do you gain a lot during the good times by doing this? The stronger the yes to all three questions, the more likely you should buy blue-chip stocks in cyclical industries.
Originally posted 2016-01-09 05:00:57.