Berkshire Ruminations

Friday, July 28, 2006

Quit whining about gas prices and buy oil!

The following is not a Buffettesque stock pick. It is also not a political statement, as politics is something I choose to stay as far removed from as possible to the extent they don’t affect my pocketbook. Rather, this is what I feel to be a shrewd financial strategy, at least for anyone so obsessed with oil prices that paying $3.00 for a gallon of gas can cause nausea. I fall in to that category, but only because I am cheap. At a later date perhaps I will analyze the behavioral biases to which I am succumbing by behaving in this way…

ExxonMobil reported earnings yesterday of $10.36 billion in the second quarter. Surely this will get the ignorant public and federal lawmakers (whose job it is to appease this ignorant public) upset. And to some extent it upsets me too, but it isn’t that magnitude of the company’s earnings that is outrageous, it is the company’s earnings relative to the capital with which they are working. At the beginning of the quarter, the company had about $216 billion in total assets – of which only $6 billion was paid for with long-term borrowing – and $112 billion in equity. This means that a fairly unlevered company was earning an annualized return on equity of nearly 37% and an annualized ROA of 19%. The PE is now about 10. Numbers like this generally spell good investment.

There is more to it than this though. For instance, the company will be spending substantially more on exploration and capital expenditures this year. They had better, since they got yelled at by Congress after they made $10 billion in Q4 of 2005. (Note, though, that nothing came of these hearings, indicating that it was done merely for political show.) If you are going to make so much money, the argument went, you should at least spend it looking for oil at home. Well they have, and if they do indeed increase the supply of oil this should help gas prices, making me happy.

What I am trying to suggest is that a purchase of XOM may not be such a bad idea. Not as an investment, but as a hedge. This hedge will make the important assumption that oil company profits and gas prices are strongly correlated, but this assumption is supported by past data.

My gas-guzzling SUV often provides me no more than 15 miles of in-town driving per gallon of gas. Living in a small community with a short drive to work, this translates in to about $40 at the gas pump every two weeks. $40 X 26 = $1040 per year. Now assume that XOM will go up 20% in the next year and the market will go up 5%. If I buy 100 shares of XOM for $6600 and earn 20% I will have $990 more in one year than I would have had I invested in the market. So even if gas prices nearly double, I have locked in the current price of around $3/gallon.

Now assume that gas prices actually decline to around $2.50. XOM now earns me only 3%, but the market still returns 5%. In this case I will have earned $230 less by purchasing XOM than I could have otherwise, but my annual cost of gas is also less, now $866. (that is, $1040*[2.50/3.00]) My effective annual cost of gas in this scenario is now $866+$230 = $1096, so again I have locked in a price of around $3.00/gallon.

Of course there are other ways to hedge against this risk. Purchasing oil futures contracts is perhaps the most direct, but is probably not practical. However anyone with a brokerage account can easily set up this hedge right now. Then again, if you are bearish on oil stocks, then this hedge doesn’t make sense. But I don’t think you will find many people bearish on oil for some time.

So if gas prices hurt you as they do many people, I would suggest a purchase in the oil sector. For me, it would be a rational, but yet emotional, decision. I really hate paying a lot for gas. But if I can fill up my gas-guzzling SUV while knowing that my XOM stock is going up, I won’t hate it nearly as much.

Monday, July 24, 2006

A few thoughts on dividend policy

Famously, Berkshire Hathaway has never paid a dividend. In theory, dividends represent a way to distribute money to the owners of a business should the business have no better use for that money. A textbook might say that in the absence of any “positive NPV projects” a company is better off paying a large dividend. Again, the analogy to the small business owner is one that I think best illustrates the theory behind a dividend policy.

Imagine you are a sole proprietor and, as such, have a right to all the income your business earns. You would then have two options as to what to do with this newly acquired cash. You could reinvest the income in the business (retain earnings) or you could pay yourself, the individual, a large dividend. Which would you prefer?

Your preference ought to be determined by where you could best deploy that excess cash. If you as an individual see a great investment opportunity outside your business – say for instance shares of WAG selling at a huge discount - you might want to pay yourself a dividend to take advantage. But you should only do this if your business looks to be an inferior investment. That is, it would make no sense for you to pay yourself a dividend and buy WAG if your business is growing wildly, say for instance at a 40% annual rate and you could expand it should the business retain those earnings.

Such is the justification for Berkshire’s no-dividend policy. Mr. Buffett has always felt that he would be able to earn a return for Berkshire in excess of what the typical investor could earn should Berkshire pay them a dividend. Additionally, there is an obvious tax advantage to avoiding dividends, all else equal.

But in my opinion, this dividend-avoiding strategy only will work in the presence of rational, level-headed managers like Warren Buffett. Far too many managers will pay too small a dividend merely to leave themselves extra cash to play with, potentially squandering the funds through excessive compensation for themselves or perhaps poor acquisitions (which lead to higher compensation under the empire-building assumption).

Too much cash sitting around is very dangerous for the typical company, inviting managers to do foolish things with it as mentioned above. This phenomenon has come to be know as the “free cash flow problem” and was first documented by Harvard Professor Michael Jensen in “Agency costs of free cash flow, corporate finance and takeovers,” American Economic Review, 1986. Not everyone agrees with this theory, but to me it makes intuitive sense and is well-supported empirically.

So a dividend-paying stock is often an attractive investment to me, not just for the quasi-guaranteed return, but because it makes it that much harder for management to waste my money. Ideally, all managers would behave like Warren Buffett and allocate capital in such a way as to maximize my (the shareholder’s) return. But that is simply too idealistic. Perhaps this is one reason why, as is widely recognized, over time dividend paying stocks outperform.

Tuesday, July 18, 2006

And who says you can't predict the market?

Occassionaly Mr. Buffett teams up with his good friend Carol Loomis of Fortune to write a piece in his own words. Two of the most notable articles were written 1999 and 2001, and despite the very different market environments existing at each time, the message was the same: The markets cannot do as well in the future as they have in recent history. The reason is simple, interest rates will be going up.

Discouraging insight, for sure. Let us take a closer look, though. A value investor believes that a stock is worth the present value of some stream of cash flows that it will produce in the future. Mr. Buffett calculates this value by projecting out future “owner earnings” and discounting them back to present. The key variables, therefore, are the future owner earnings and the discount rate.

First, assume that our opinion of future owner earnings doesn’t change so as to isolate the effect that the discount rate will have on value. You can think of the discount rate as the opportunity cost of investing in Stock A over Stock B or Investment C. Now, if interest rates rise, so should our discount rate, since we would have more opportunities to do more with our money elsewhere. And since discount rates and present values are inversely related, value will decline, all else equal, as the result of a rise in interest rates.

From 1964 to 1981, the stock market went exactly nowhere. In aggregate, no money was made by investors during this period. But yet GDP nearly quadrupled. How is this possible, you may ask. Well, also during this period, interest rates rose dramatically. The rate on long-term government bonds went from a mere 4.2% in 1964 to 13.65% as the 1980s began. This had a devastating effect on stock prices. Then, as we are well aware, from 1981-1998 stocks rose more than tenfold. This can easily be explained by the remarkable drop in interest rates – all the way from that 13.65% in 1981 to next to nothing at the start of this decade. (GDP growth, by the way, was actually lower in this second period than it was in the first.)

It is easy to understand how interest rates affect bond prices. No one will want to buy a bond paying 6% if the going rate has risen to 8%, so the price drops. But keep in mind that the fundamental source of value for a stock is derived in the same way. Investors buy bonds to receive coupon payments in the future. Well, investors buy stocks to receive “coupons” that take the form of earnings per share, or perhaps “owner earnings” per share.

So the recent rise in short-term rates should dishearten the bullish stock investor to some extent. There are plenty of variables that will affect the stock market, but the one most fundamental to value is nearly certain to hurt stock prices, especially after long-term rates catch up to the recent increases in short-term rates. A 10% clip in your portfolio looks to be somewhat optimistic, at least until the rate hikes stop.

And by the way, just because I can predict the market doesn't mean I can predict it correctly. ;)