AMM Dividend Letter Issue 19: Why the Average Investor Underperforms & ExxonMobil (XOM)
This is from the AMM Dividend Letter released May 7, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
The chart below, from Richard Bernstein Advisors via Business Insider, shows the 20 year annualized returns for major asset classes. The little red bar on the far right is the 20 year annualized returns of the “average investor” as calculated by Dalbar.
The average investor has drastically under performed every major asset class for the past 20 years ending in 2013 except for emerging market Asia and Japan. The “average investor” even under performed cash as represented by 3-month T-Bills. Why? The average investor chased performance.
When an asset class has outperformed over a certain time period the “average investor” pours money into the asset, usually near its peak. When an asset has underperformed for a period of time the “average investor” pulls money out of that asset. For example, the chart below shows the total money flowing into and out of U.S. equity mutual funds at various peaks and troughs of the S&P 500.
How can an investor overcome performance chasing?
Fidelity Investments found one interesting way.
During an interview with Barry Ritholtz on Bloomberg’s Masters in Business James O’Shaughnessy discussed a internal research report Fidelity Investments did on which individual accounts had performed the best overtime.
O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was…”
Ritholtz: “They were dead.”
O’Shaughnessy: “…No, that’s close though! They were the accounts of people who forgot they had an account at Fidelity.
We don’t want you to forget you have an account. You need to know where your money is. The next best thing is to have a well defined investment plan in place and then stick to it.
“Everyone has a plan ’till they get punched in the mouth” – Mike Tyson
A investment plan is not a real plan when it is thrown out at the first sign of trouble or the first sign of under-performance. It’s easy to stick to a plan when things are going well. The plan is there to get you through the troubling times. It is there to prevent you from making a short-term emotional decision. It’s like a well practiced fire drill. Instead of being left fearful and reactionary, you know what to do when the time comes.
AMM’s Dividend Growth Investing Plan
Focus on high quality companies. Our definition of quality is a company that can consistently generate above average returns on tangible capital. In a true competitive market high returns are competed away until all competitors are equal. Some companies are able to resist this reversion to the mean through specific competitive advantages and maintain above average returns on capital. We want to own these companies because they have the ability to dominate a market space for a very long time.
Dividend growth. After we’ve determined which companies are high quality companies we then want to identify the companies that pay a dividend and have a proven track record of increasing their dividend year-in and year-out. We will occasionally buy companies that have recently started paying a dividend like Apple (AAPL). We will do this when our analysis says the company has the ability to continue growing their dividend well into the future.
Do not overpay. Overpaying for any asset even the stock of high quality companies leads to poor returns. We need to make a reasonable estimate of what the business will be worth in the next 3-5 years. When the company’s stock trades below our estimate of fair value we will buy it. Trusting our valuation work prevents our investment decisions from being controlled by our emotions. It is emotional investing that leads to performance chasing.
Having a plan does not mean that periodic bad outcomes will not happen, they will. By sticking to a plan we expect to lessen the odds of bad outcomes occurring and improve our odds of successfully navigating difficult environments.
Your Portfolio Management Team
Dividend Stock in Focus
ExxonMobil (XOM): $87.60*
*price as of the close May 7, 2015
Open up any U.S. History book and the names John D. Rockefeller and Standard Oil are synonymous with anti-competitive behavior and monopoly. This is mostly due to the famous piece of muckraking journalism “The History of the Standard Oil Company” by Ida Tarbell. What history books usually don’t mention is that Ida Tarbell was the daughter of a small entrepreneur that was put out of business by Standard Oil. Also, Ida’s brother William Walter Tarbell was an executive at Pure Oil Company, Standard Oil’s largest competitor. William Tarbell funded Ida’s education and was one of her main sources of information in building her case against Standard Oil and John D. Rockefeller.
John D. Rockefeller and Standard Oil did crush their competition but they did so in a way far ahead of their time.
Discovered in the mid-1800s by Abraham Gesner, Kerosene was a new and cheaper fuel source replacing whale oil, which only the wealthy could afford. Entrepreneurs flocked to the Ohio and Pennsylvania oil fields to strike it rich in the new burgeoning industry. As with all new industries there was a lot of operational inefficiencies, excess costs, and waste but given the high demand and low refining capacity for Kerosene, large profits were easy to come by. Rockefeller attacked the inefficiencies, excess costs, and waste to make Standard Oil the most profitable refiner.
Refining kerosene is a simple process but a hard process to consistently produce a high quality product. Rockefeller paid meticulous attention to his refining process making sure every step was done perfectly and consistently so his kerosene was always a “standard” high quality.
Rockefeller hated the waste and inefficiencies of the refining process. Each step produced byproducts that others usually discarded. Rockefeller plowed money into R&D to find other uses for the byproducts to increase his refining profits. These efforts created new types of lubricants, common grease, paraffin wax, paint, and the precursor to Vaseline.
Rockefeller also pursued businesses strategies that are common now but almost unheard of back then. Standard Oil implemented vertical integration and economies of scale to squeeze every last penny out of a barrel of kerosene. A wooden barrel to transport kerosene use to cost $3. Rockefeller bought his own forest and produced his own barrels at a cost of $1 per barrel. John Rockefeller was able to negotiate lower transport costs with the railroads not through some corrupt conspiracy but by offering the railroads a consistent and growing supply of product to ship in Standard Oil’s own tank cars. This lowered the Railroad’s cost of operations and allowed them to offer Standard Oil lower shipping rates versus Standard Oil’s inconsistent competitors.
In 1865 when Standard Oil was still a small company the cost of a gallon of Kerosene was $0.58. In 1880 when Standard Oil controlled 90% of the kerosene market the cost was $0.09 and a decade later with still 90% of the market a gallon of kerosene cost $0.07. This doesn’t factor in inflation either. The U.S. consumer benefited greatly from Standard Oil.
But never to let the facts get in the way of populist fervor, the Sherman anti-trust act was passed by congress in 1890. Standard Oil was one of the law’s first victims. The company was forced to break up into a bunch of much smaller companies. However, over time the new companies grew and merged back together. The 3 largest U.S. Oil companies are all descendants of Standard Oil and ExxonMobil (XOM) is the largest of the 3 super majors.
Over the last 10 years ExxonMobil has grown its dividend per share at a compound annual rate of 9%.
ExxonMobil’s current payout ratio is 36%. If oil prices remain low longer than expected, our analysis suggests ExxonMobil has enough of a cushion to maintain its current dividend payout. If one or more of the catalysts below come to fruition, ExxonMobil is well positioned to continue to increase its dividend in the future.
Catalysts for Dividend Growth and Price Appreciation:
Over the last 5 years the super major Oil companies including ExxonMobil have invested a lot of capital in new projects. These projects are now coming on line, capital spending is declining, and cash will be flowing in as long as the price of oil stays above certain prices. For ExxonMobil that price is $61 per barrel of brent crude after paying its dividend. The current price of brent crude is around $65 per barrel. At higher prices of oil ExxonMobil will generate even more positive cash flow from these new oil projects.
Early in his career, John D. Rockefeller had the choice to either get into oil exploration or to buy a refiner. John knew that exploration and production of oil for kerosene was potentially more lucrative than refining but also much riskier. The chance existed that he would never find a good source of oil. If he bought a refiner John knew it would be less profitable but he would never be out of a source of business; the oil would come to him. Rockefeller bought the refiner and the rest is history.
Carrying on the tradition of Standard Oil, ExxonMobil has significant downstream operations also known as refining. When oil prices are high refining margins contract but when oil prices are low refining margins expand. The refining business is a diversifying business for ExxonMobil and during periods of low oil prices like now it helps to offset the downturn in profitability from their exploration and production business.
There are a good number of oil projects that produce a barrel of oil at low break even prices but the companies that control these assets are highly leveraged. The companies took on the excess leverage when oil prices were much higher so even with low break even prices any drop in oil prices makes it hard for these companies to cover the cost of operations and service their debt. The chart below from Goldman Sachs Investment Research highlights these assets (lower right hand oval). ExxonMobil has tremendous room on its balance sheet to acquire some of these assets at favorable prices.
ExxonMobil also has the potential to make a transformative acquisition. During the last oil rout 5 years ago ExxonMobil bought XTO Energy for $25 billion in stock. It has been speculated during the current oil rout that ExxonMobil would buy BG Group or BP Plc. Royal Dutch Shell just announced that it will buy BG Group for $70 billion and this has put BP Plc, the company behind the infamous Gulf of Mexico oil spill, in play in speculators minds. ExxonMobil has a proven history of doing these type of deals during periods of distress.
BP Plc may be too big to buy and too cumbersome to integrate into ExxonMobil’s existing infrastructure but we expect ExxonMobil to be active on the M&A front if oil prices remain low.
Pre-Mortem (Potential Risks to our Thesis):
Low Price of Oil
If the price of oil drops below $61 per barrel of brent crude and stays there for a significant amount of time then ExxonMobil will not be able to increase its dividend. If the price drops too far and remains there for too long then ExxonMobil will need to further rethink its capital spending and capital allocation. This includes its dividend.
Energy conservation, efficiency, and renewable energy technology is an emerging trend in the developed world. In the U.S. we now have the technology to build net-zero energy homes and cars that don’t need gasoline. This is only the beginning of the trend. It is very possible that the oil consumption convergence mentioned above flows in reverse as energy efficiency technology and renewable energy sources get cheaper and make their way to the developing world.
Oil consumption in the developed world appears to have plateaued and is possibly declining.
If the oil demand curve in emerging markets curves down then the cost of a barrel of oil will come under pressure too.
It is the unfortunate state of the world that a good amount of proven oil reserves exist in countries where the rule of law and property ownership is fungible at best. ExxonMobil “owns” or operates assets in many of these countries with more recent projects in Kazakhstan and Russia. Political relations between the United States and these countries will affect ExxonMobil’s ownership and operation of these assets. Any political setbacks can be setbacks for ExxonMobil’s business.
ExxonMobil is a defensive oil investment. Yes, there are other companies we could buy that would provide larger potential capital appreciation if the price of oil rebounds. What if the price of oil does not rebound? We want to know that we are investing in a company that could survive an extended period of low oil prices and can acquire assets during a period of distress. We want to know that cash will continue to flow and that the dividend is secure. ExxonMobil is that company.
As of this writing, with a price of a barrel of oil at $65, we value ExxonMobil at $92 per share and if the price of oil continues to rebound our estimate will rise with it. At $70/bbl our estimate of fair value approaches $100 per share. This estimate is before any potential asset acquisitions.