The Survivor vs. Oblivion Investment Theory

If you owned a collection of ExxonMobil, Chevron, BP, Royal Dutch Shell, Total SA, and the legacies to ConocoPhillips and Phillips 66–which at times included things like DuPont–you would have earned compounded annual returns of 12.3% between 1956 and 2006. I find these fascinating not just because I am attracted to concepts that can beat the S&P 500 over a half-century with minimal work after making the initial investment, but because of the counterintuitive nature in which these returns have been achieved.

The long-term earnings growth of this basket of stocks was only 6.1%. That is the kind of growth that Wall Street scoffs at–how many salesmen can pick up investor clients promising that the investment selections will grow 6.1% annually over fifty years? Yet, when you throw in a 4.3% dividend, and reinvestment at decades of undervaluation, you get returns north of 12%. And considering that many people prize high yielders because it sends them actual cash to meet living expenses, it is easy to see how these oil giants can find a special place in many of the hearts of income investors.

My favorite aspect of all this is how repeatable this formula is for future success. You return the majority of cash flows to shareholders as dividends, you grow production by about three or four percentage points per year, you pick up another point or two from the long-term price increases in the oil commodities themselves, and then you reap a bit of an excess reward from nearly perpetually favorable reinvestment terms.

Although the oil sector is the most obvious demonstration of this value investing principle, it applies to any companies that get cheap and what Professor Jeremy Siegel calls survivability. On page 66 of his book “Stocks for the Long Run”, he offered this explanation for why the “Dogs of the Dow Strategy” has outperformed the remainder of the market in every decade except the 1930s:

“It can be shown mathematically that a contrarian strategy of choosing stocks that have fallen in value works much better with firms that are likely to be ‘survivors’ than with firms that are not. Playing a contrarian strategy does not work if the firm you have chosen to buy is actually heading for oblivion. But this almost never happens to companies that make up the Dow, which are chosen on the basis of being premier firms” (Siegel, 66.)

For instance, I have no problem discussing the wonderful merits of Royal Dutch Shell, which will likely be an excellent investment for anyone that buys the stock around $50 per share. Oil prices are in a rut, and it is still turning out $14.5 billion in net profits. Even at this low point, it still does almost a quarter of a trillion dollars in annual revenue. It’s going to be around for a long time, and it would not surprise me if investors received their full investment amount back in the form of dividends within about ten years or so. Large commodity companies don’t disappear–the earnings slump is the reason for the undervaluation–and that is why these are good value stocks.

Other companies, which come up in value investment discussion, are merely slogging their way towards bankruptcy.

Take Pitney Bowes. It earns $1.85 in profits. It trades at $21 per share. Usually, that kind of P/E ratio of 11 would get value investors interested. It makes mail postage equipment and creates most of the machinery you see around the U.S. Post Office. Post offices are shuttering, losing market share, and Pitney Bowes has not found a way to pick up meaningful customers outside the government mailing industry. Maybe it can pull a turn-of-the-century Wells Fargo and reinvent itself by entering a new industry, but that is unwarranted speculation at this point.

When post officers were cropping up across the country and bulk mailing was in its heyday, Pitney Bowes was an excellent investment. Between 1972 and 1992, the company compounded at 18.5% annually. It only took $31,700 to turn into a million dollars over twenty years. Since then, the mail equipment industry has been on a steady decline: shares have only compounded at 5% annually since 1992, and have lost 25% of their overall value since 1999.

It made $2.31 in 1999, and will make $1.85 this year. The business health reality is even worse, as Pitney Bowes repurchased almost 30% of its outstanding stock over this time frame. The management team has mitigated some of the damage and delayed inevitability by retiring low-priced shares, but the earnings still continue their multi-decade slope downward (profits of $790 million sixteen years ago have sloped downward to $350 million today.)

It reminds me of Blue Chip Stamps–the first big company that Munger and Buffett operated post acquisition of Berkshire. Instead of reinvesting into the business, Munger was adamant about making lemons out of lemonade and diverting the cash flow into Wesco, The Buffalo News, and securities investments. It took cash flow from a declining industry and used it to invest in growing industries (although it is funny to describe newspapers as a growth industry, the economics were much more favorable in the pre-internet era.) Heck, even Berkshire Hathaway itself managed to become worth billions due to Buffett’s decision to reinvest textile mill profits elsewhere. The problem with Pitney Bowes is that it has spent the past 20+ years reinvesting into a declining business.

I connect Siegel’s advice to the Peter Lynch adage that investors can make a surprisingly large amount of money quickly investing in blue-chip companies that have solvable problems. American Express, McDonald’s, and GlaxoSmithKline immediately come to mind. I ask myself: Will the profitability of this industry remain intact over the long term? Will there be significant share dilution that heavily dilutes existing stakeholder equity? If the answer to the first question is yes, and the answer to the second question is no, then it makes sense to run towards companies that get unusually cheap. Once you’re sure of a firm’s long-term survival, you should embrace volatility as something worthy of absorbing when you reinvest dividends, as it is a reliable way to outperform the market without owning stocks that actually have earnings growth higher than the S&P 500 at large. Knowing that energy firms tend to be good value pickups after a 50% fall is a good start, but it’s not enough. It’s better to get right to the heart of the matter and figure out the specifics of what animates those higher returns.

Originally posted 2015-11-28 07:35:19.

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