Why Oil Stocks Are Perfect Candidates For Long-Term Dynastic Wealth

 [first part redacted]…Tim, why does it matter whether some stocks are perpetually overvalued or undervalued? You talked before about home some stocks like Altria are always cheap, and others like Hershey are always expensive. But if that condition persists for years and years (decades?) then why does it matter? Doesn’t it all work out the same in the end? [rest of conversation redacted] –William

Hi William. That’s a wise question. You’re right to point out that, if a stock price does not change its valuation (that is to say, it always trades at 15x profits, or always trades at 30x profits), then it seemingly takes away your opportunity to benefit from “buying low” because buying low is just a non-nerdy way of saying “anticipating P/E expansion.”

But there are three things you need to take into account before reaching the conclusion that there is no difference between companies that are perpetually undervalued and perpetually overvalued.

First, there is the obvious—the condition could change. It’s not hard to imagine a world in which some perpetually expensive companies like Brown Forman and Hershey came down from trading at 30x profits to 20x profits. That potential for a 30% permanent hair cut is always there. With oil companies, on the other hand, people often confuse the fact that oil stock prices are especially volatile in the short term with the fact that its shares tend to trade at a discount because its annual earnings aren’t as predictable as the Krafts, General Mills, and Nestles of the investing world.

For oil companies that can maintain and usually grow their dividend (I’m thinking Exxon, Chevron, and Conoco), the undervaluation gives you benefits it two significant ways: dividends and stock buybacks.

I’ll use Exxon as an example. Since 1995, it has grown its earnings by about 11%, and its dividends by a little bit less than that, at 10.5%. If the stock were perfectly valued during that entire period, you would expect total returns of somewhere between 10.5% and 11.0%, right?

Well, here’s the fun thing: Because Exxon is super large, and super reliant on commodity prices which fluctuate, Wall Street analysts tend to discount its future ability to grow, and therefore, it’s almost always a good time to add Exxon to your portfolio if you can’t find anything else particularly compelling. It’s perpetually at a fair price or a slight discount.

What are the consequences of this? Let’s say you have a situation where Exxon should be worth $115 per share but is trading at $105 per share. That 9% difference means that the buyback is going to increase the earnings per share that you own at a 9% accelerated rate.

With dividends, you can see this more tangibly: Right now, Exxon pays a $0.69 quarterly dividend. Imagine that you own 5,000 shares of the stock, and you happily reinvest. If Exxon were perpetually fully valued at $115, you would receive a dividend check of $3,450 that, upon reinvestment, would add 30 shares to your account total. During the next dividend payout, you would collect an additional $20.70.

Now, let’s take a look at what happens when Exxon shares are perpetually undervalued, and you get to reinvest at $105 instead of $115. That $3,450 check is going to buy you 32.85 additional shares. During the next dividend payout, you’d be collecting an extra $22.67. If you went through your life on reinvestment autopilot, that extra $2.67 is a gift from the market; it is allowing you to lay claim on future earnings and dividend checks than you would otherwise be able if the stock were always trading at the right price.

Now, $2.67 sounds look an absurd thing to get excited about. That might get you a slab of chicken and a soda at McDonald’s. Over a twenty-year period, that $2.67 creates .02 of a share in Exxon that will start collecting its own dividends from now until eternity. And those dividends will benefit from the perpetual 9% discount over time. And then, you get another dividend payment the next quarter that will replicate this process.

Over a twenty-year period, you sow eighty seeds of free money due to the undervaluation that start spitting out their own dividends and replicating this process over and over again, in a very small way that evades the notice of most Wall Street types, yet becomes a significant source of wealth over time.

How significant are we talking? During the 1995-2014 period that we are examining in which Exxon grew earnings by 11% and dividends by 10.5% (even though its P/E ratio remained between 7 and 8 for the start and end of the measuring period), you would have compounded your wealth by 13.1% per annum. Basically, every dollar put into Exxon twenty years ago turned into a little over $10, assuming you had good tax strategy. You’d be collecting $250 in annual dividends on every $1,000 investment.

Why don’t people notice this? Why don’t they talk about? Because most of the change was invisible. Every 100 shares purchased turned into 153 total shares after twenty years of compounding. Most people just take a quick look at the change in the price during this time, and decide from there whether a stock is a good candidate for reinvestment. Some investors reach the conclusion that they are doing their full due diligence by looking at the dividend history as well, and then make their own conclusion. But really, if you want the full picture, you have to take into account the reinvestment and the prices that you were able to do so. Exxon has created a whole lot of wealth over the past two decades, and yes, 11% of that was the result of honest business growth plus share buybacks. But it was the favorable price at which you could reinvest that took you from great investment to excellent investment, as your total returns shifted from 11% to 13%.

That’s why reinvesting oil stock dividends is almost like a religion to some people. The shares are almost always a fair shake, and so your total dividend income quickly grows when you’re dealing with Exxon, Chevron, and Conoco. You don’t see investors in those companies get upset when the stock price declines, because that is where the big money gets made—it’s those reinvested dividends at low points in the business cycle, plus the nonchalant times of plain vanilla undervaluation, that turbo-charge the dividend income.

Perpetually expensive stocks do this process in reverse; you go through life reinvesting dividends at $115 when they should be reinvested at $105, and this permanently hampers returns (although in the case of Hershey and Brown Forman, both are such excellent businesses that this observation should be considered a minor quibble, and both of those companies due things that compensate for their perpetual overvaluation). But still, there is a reason why oil stocks, bank stocks, and tobacco stocks have usually been some of the best dividend investments you could make if you’re intending to reinvest. It’s because they’re always at a discount for one reason or another, and that turbocharge starts to amount to something when you’re reinvesting for a decade or two.

But you should check this stuff out for yourself. Look at how the old Philip Morris grew at 11% for a century, yet their investors received total returns of 17% annually because the stock was severely cheap for long periods of time, and the dividend got very high so a lot of money got reinvested at those low prices. Bank stocks that maintain their payouts in crisis (admittedly, they didn’t do too good of a job this past time around) also benefit from this effect. Although it seems like an academic argument when people say things like “perpetually overvalued” or “perpetually undervalued” when talking about certain stocks, it does have consequences. It varies a bit based on the degree of under/overvaluation, the size of the dividend payout, and the duration, but finding those perpetually undervalued stocks can add one to three percent annually to your returns. In the case of Exxon, it’s the difference between turning $10,000 into $98,000 and $108,000, based solely on the price you reinvest. Both outcomes would have been fine, but it’s that perpetual undervaluation that gives you a nice little edge.

Originally posted 2014-08-06 08:00:25.

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