In an old letter to clients, Tweedy Browne’s managers once stated that investors should be prepared to hold on to an undervalued stock for at least five years in expectation of the stock reaching fair value. Certainly, you can make the case that stocks can remain cheap for ten years or longer—Abbott Labs, Altria, and even Johnson & Johnson have proven that at different points in the past fifteen years. The only additional counsel given by Tweedy Browne is that the longer a stock remains undervalued after the five-year mark, the more likely it is that an investor is wrong about the valuation.
I don’t share the Tweedy Browne view, even though I think it contains some truth. I would modify their guidance to this rule as follows: Unless you can clearly articulate a reason based on facts and probable inferences that explain why a stock continues to be undervalued, you should adopt a growing presumption that your valuation may be wrong the longer a stock remains undervalued beyond the five-year mark.
If you are going to engage in value investing with stocks that have long periods of chronic undervaluation, then you can make your life easier by finding the ones that generate large cash flows compared to the price of the stock and have a demonstrated history of returning large amounts of cash to shareholders in the form of dividends.
BP and Royal Dutch Shell seem like the kind of companies that warrant extended patience. In BP’s case, you have the legal costs of the oil spill mixing with the short-term 45% decline in the price of commodities to explain why the stock seems to have been hovering around that $40 mark for the past five years.
Pete at Mr. Money Mustache had a good post in the spring when he talked about he began rapidly increasing his wealth after he retired at age 32. He mentioned that his personal financial security enabled him to have a sense of patience for just about every business fluctuation that he experienced thereafter. He could grind it out with his rental home difficulties and a challenging Colorado housing market 2008-2011. He was able to achieve 12% average interest rates through his lending investments, turning himself into a fortress-like bank that weathered the storm when the default rate crept up. And he had enough money coming in during the swoons in the stock market to keep adding to his investments even as stock market prices declined.
He refers to this as the position of strength, and it shapes how you look at fluctuations. Someone who needs capital growth in a hurry would grow quite impatient with something like BP—it’s essentially been a 1990s U.S. savings bond in terms of total return since 2010, all while providing wild stretches of volatility that you would not get with a plain vanilla government investment. A need-to-get-rich-now mentality is a great recipe for participating in large chunks of the bad days and getting out before you receive any of the good fortune that greats the patient investor.
Someone with a decades-long orientation might think along these lines: Large oil stocks are the fourth-best performing asset class over the long term in the entire economy, with a historical record that only lags tobacco, healthcare, and consumer staple stocks. A large reason why oil has done so well is that the stock frequently fluctuates and trades at a cheap valuation for years on end, and the long-term investors receive better returns from reinvested dividends than would be the case if the companies were always rationally valued. It is the $2.40 dividend reinvested at $40 when the stock should be at $50 that adds the juice to returns.
BP is a stock that historically yields between 3% and 4%. I have discussed previously how 100 shares purchased after the oil spill before the re-commencement of dividend payouts would result in the position growing to 120 shares even though clouds still hang over the company while commodity prices have declined over 40%.
The current yield of 6.1% for BP is historically high—not something you could find for a consecutive year of the stock’s trading at any point in the past 25 years. We’re at the point where it would only take 16 years for you to collect the entirety of your initial investment back in the form of cash dividends. And that is a very conservative assumption that does not: (1) permit for the possibility that BP’s annual dividend will average higher than the current $2.40 rate in the next 16 years, (2) and nor does it take into account the turbo-charged effect of reinvested dividends that will get you there faster as your share count increases.
Royal Dutch Shell tells a similar story, albeit for a different reason. The company spent much of the 2000s investing heavily into a natural gas at a time when it was unfashionable; however, the recovery in natural gas prices never quite matched up to Shell’s loftier expectations for long-term pricing. By not investing into exploration and production or transportation of oil, Shell did not participate in the commodities boom of the 2000s nearly as much as Exxon, Chevron, and the split-up Conoco and Phillips 66.
As a result, the dividend payout ratio came under pressure and the company now pays out over 80% of earnings as profits. Even if oil recovers, Shell will still be paying out 50% or so of its annual profits as dividends. This is much higher than the 30% rate from Exxon during $85-$105 oil barrel pricing, and that different in the payout ratio provides some explanation for why Exxon is able to buy back stock and grow its reserves at a better rate than its peers.
That is why I would not expect Shell’s $3.76 dividend to experience much growth in the coming years. A static dividend, or negligible dividend increases, is absolutely on the table and is probably the most likely outcome. At the time I am writing this, Shell is trading at $57 per share. The dividend payout of $3.76 represents a yield of 6.6%. The time last summer, Shell was at $88 and barely offered investors a 4% yield.
The amount of cash you stand to collect from a Shell investment, even if the dividend remains static, is sure to help you enter that territory where you have ownership positions that fund themselves. Over the next 36 months, you’d stand to collect $11.28 in cumulative dividends for every $57 share you purchase today.
If you owned 400 shares of Shell in an IRA, you are going to collect $4,512 in dividends alone in the next three years that you can use to make new investments or purchase more shares of Shell.
Even though the ride is rocky, oil companies have this demonstrated history of passing the cold, hard cash test that can really complement the amount of money that you earn from your labor.
It is a shame professional athletes do not internalize this fact because it would make their post-career lives so much better if they understood the concept of income replacement when you transition from your labor to living off investments.
Think of someone like Marlins slugger Giancarlo Stanton, whose recent hand injury may have reminded him of the fact that he will not be playing baseball forever. He is set to earn $325 over the remainder of his contract (which are much more binding than other sports, especially football, and actually contains language that would enable Stanton to opt out after five years but does not provide an opportunity for the Marlins to buy out the contract unless Stanton commits a felony or gets caught twice with steroids.) After taxes, Stanton earns around $200 million.
If he decided to become an oil baron, he would have the capacity to acquire 3.5 million shares of Shell. He would collect over $13 million per year in dividends alone from the oil giant, which would give him $10 million annually after the dividend and Obamacare tax. As an aside, this walk-through explains why I echo William F. Buckley’s sentiment when he said “I ought to electrocute anyone who uses the words ‘fair’ and ‘taxation’ in the same sentence.”
You can’t demonize the rich when you understand the mechanics of how often income gets taxed along the way: You earn a high income in a particular year, then you end up sending the government around 39.6% of that. Then, you invest in a company like Shell. Shell has one of the highest tax rates in the world, paying out 40%. As an owner, you end up paying that tax on the profits, even though it is never directly taken out of your account nor is it a ball you pay. It’s like a mutual fund where the expenses are withdrawn on their own without you ever seeing it. Then, when Shell pays you a dividend, you have to pay 23.8% in taxes again if you are in the highest tax bracket. And presumably, you will eventually use that money to buy something, which again will require a tax payment. I understand why some affluent investors eventually conclude, “Screw it, I’m buying Berkshire Hathaway.”
Anyway, Stanton could easily collect $833,000 per month in perfectly spendable dividends from his Shell holdings that would replenish themselves with a new payment every three months. It would be entirely self-sustaining, and Stanton could spend every dollar of passive income sent his way and still grow richer as he completes his life. If he reinvested a bit, he’d easily reach $1 million per month in passive income net of all tax payments within a few years.
Certainly, you would not actually put your entire net worth into one stock. I use Shell as an illustrative concept of higher-yielding companies that have been around for 100+ years that give lots of cash to shareholders over the long haul. A portfolio built on AT&T, GlaxoSmithKline, Chevron, BP, Royal Dutch Shell, and Philip Morris International in the early stages can lay the necessary foundation to regularly receive cash throughout the rest of your life that you can spend or deploy elsewhere into new investments.
I continue to remain convinced that the best values for long-term investors remain in the oil sector. The most conservative accounts should certainly stick with Exxon. Those with conservative inclinations should go to Chevron. Those who could tolerate dividend payment fluctuations and just want large amounts of income compared to their purchase price should look to BP and Shell. They will likely feel great about their decision if oil recovers soon, but would likely wish they looked to Exxon or Chevron if oil traded at $50 per barrel for five years. My personal preference is probably Chevron, as you get that 4.5% starting dividend yield and also have the higher certainty that the dividend will not get cut if adverse conditions continue for an extended period of time. The Noah’s Ark of approach of buying all of them probably works as well, as these are companies that will be solvent and returning cash to shareholders for many decades to come even if the initial ride is much bumpier than you’d get with something like Hershey, Coca-Cola, or Colgate-Palmolive.