When I switched from deep value investing to defensive value investing in 2011, the first stock I purchased with the new approach was BP.
Six volatile years later, this has turned out to be a mildly disappointing investment. That’s partly because of bad luck, but it’s also because I paid too much in the first place. That’s a mistake I don’t plan on making again.
Here are the headline results:
- Purchase price: 494p on 04/03/2011
- Sale price: 529p on 05/01/2018
- Holding period: 6 years 10 months
- Capital gain: 7.1%
- Dividend income: 34.0%
- Annualised return: 5.9%
Back in 2011 my defensive value investing rules were barely formed and much has changed in the intervening six years, but the basics were there. I was looking for consistent dividends and profits, consistent growth, combined with high profitability, low debts and an attractive share price relative to ten-year average earnings.
BP certainly had most of those features in 2011, with revenues, profits and dividends growing steadily and rapidly since the beginning of the 21st century. Debts were reasonable, returns on capital employed were good and the share price was low as a result of the 2010 Deepwater Horizon disaster.
So I invested, and the result was a volatile, slightly disappointing, but not entirely fruitless investment:
Buying a cyclical company too near the top of its cycle (again)
As with Braemar Shipping and Rio Tinto, both of which have left the model portfolio in recent months, the late 2000s were a time when BP was riding high on the back of the commodity super-cycle. When BP joined the portfolio its track record reflected the huge run-up in oil prices since the turn of the millennium:
The chart also shows the near-total reduction of the dividend in 2010 which was one of the early financial impacts of the Deepwater Horizon disaster. The chart also ignores BP’s financial liability relating to the disaster, which at the time was estimated to be close to $40 billion.
Obviously, $40 billion is a huge amount, but I wasn’t overly worried. BP’s then-recent average post-tax profits came to almost $19 billion, so the estimated liability was “only” a little over two years’ profit.
My assumption at the time was that BP would be able to cover the financial costs without too much trouble. The usual array of options would be open to management, from increasing efficiency (i.e. reducing costs) to re-focusing on the core business (i.e. selling off non-core assets) as well as dividend cuts and rights issues.
So despite the disaster-related cloud hanging over BP at the time, I was happy to invest.
Holding on as BP sold off assets and faced an oil price crash
In the years following the Deepwater Horizon disaster, BP’s disaster-related financial liabilities increased from around $40 billion to a final figure of just over $60 billion. As expected, BP has so far funded much of this liability by selling non-core assets, raising more than $50 billion to date. As a result, BP has shrunk, but that was the least of its problems.
A much bigger problem came from something far less controversial and far more predictable than the Deepwater Horizon disaster: The price of oil.
It may seem ridiculously obvious to say that an oil exploration and production company like BP is highly sensitive to oil prices, but it’s a fact I woefully under-appreciated when I bought BP in 2011. Put simply, companies like BP have lots of relatively fixed costs (oil rigs, refineries, pipelines, etc.) and virtually no ability to set the price of the product they sell.
For example, if the price of oil goes from $20 to $150 (as it did between 1999 and 2008) then companies like BP are going to make huge profits even if the CEO is a complete idiot. If the price of oil goes from $150 to $30 (as it did between 2008 and 2016) then companies like BP are going to see their profits fall, even if the CEO is the greatest genius on the face of the earth.
Even worse, high oil prices and good results over several years are often followed by lower oil prices and bad results over several years. That’s because high oil prices and high profits typically lead to an increase in oil supplies as companies desperately try to find and extract more of that black gold (or partial alternatives such as natural gas).
It may take a while, but once supply increases then economics 101 says that prices will decline. And of course, once oil prices decline, profits decline. Boom turns to bust and investors who expected the glory days to last forever are left high and dry when share prices collapse.
This is exactly what happened to BP. When the oil price declined from $100 in mid-2014 to $30 in early 2016, BP’s shares went from about 520p to less than 340p. Remember, this is one of the most analysed stocks on the planet, so I think it’s safe to assume that most investors (including me) failed to see the oil price decline coming.
While a falling share price can be unpleasant, it shouldn’t really matter as long as the company can grow its revenues, earnings and dividends over the long term. If the oil price decline is reversed fairly quickly then its impact on profits may be negligible. But that isn’t the case here because the price of oil is still “only” $60, far below its $100 price tag from 2011.
As a result, BP’s earnings for the past two years have been much lower than in previous years. That’s true even if you look at “replacement cost profit”, which excludes the impact of falling oil prices on the value of the company’s existing oil inventories (reported profits, which include the impact on inventories, have been negative for the last two years).
My point here is that while BP has undoubtedly done lots of good work over the last few years, sucking untold amounts of oil out of the ground so that we can burn it for fuel or turn it into plastic, that was not the most important thing. The most important thing was the oil price, a factor which is both volatile and unpredictable.
You can see the overwhelming importance of the oil price in the following chart, which shows BP’s financial results up to 2016 (using the more optimistic “replacement cost profit” figures for 2015/2016):
Selling because growing debt and pension liabilities make BP a highly uncertain investment
If BP’s falling earnings were the only problem then I might have been willing to continue holding, waiting and hoping for an oil price recovery which would underpin the sustainability of the dividend.
To be honest, that’s the approach I’ve taken for much of the last few years, during which time BP has consistently been one of the least attractive holdings according to my stock screen.
But BP now has other problems too, which have become serious over the last year or so. Chief among them is its growing financial obligations in the form of debt and pension liabilities.
When I bought the company in 2011 it had borrowings of about £29 billion, which was high relative to the previous five years where borrowings had averaged £16 billion. Today, despite earnings which are far lower than they were back then, BP’s borrowings have ballooned to more than £47 billion.
This gives BP a debt ratio (the ratio of debt to five-year average post-tax profits) of 11.3 using reported profits or 7.5 using replacement cost profits. Either way, the ratio is far above 4.0, which is the most I’m comfortable with for cyclical stocks.
I don’t know for sure, but I have a sneaking suspicion that these debts have been piling up so that the dividend can be maintained despite weak profits. If that’s the case then it’s a dangerous game for the CEO to play as this is a highly unsustainable strategy.
Another problem is BP’s defined benefit pension obligation, which has grown from £27 billion in 2011 to £40 billion today. This liability, combined with the company’s borrowings, gives BP a debt plus pension ratio (the ratio of borrowings plus total pension obligations to five-year average post-tax profits) which is far above my preferred maximum of ten.
The pension fund also has an almost £7 billion deficit, which is effectively another form of debt. Adding that deficit onto the company’s existing borrowings gives BP a debt plus deficit ratio of 8.5 or 12.3 (depending on whether you use reported or replacement cost profits), which is higher than my preferred maximum of 4.0.
So not only is BP a highly cyclical company, it’s also one which is loaded up with financial obligations, and that is not a combination I want in the model portfolio.
Lessons learned from a highly cyclical investment
There are no new lessons from BP. Instead, the lessons are the same as those learned from the Braemar Shipping and Rio Tinto investments. The key lesson relates to what is an attractive purchase price.
For less cyclical companies such as Unilever (an extreme example), a higher price relative to past earnings and dividends may be acceptable because there’s a good chance those earnings and dividends will be higher in the next decade than they were in the last decade.
So for Unilever, a purchase price which is 20 or even 30 times the average earnings of the last decade may only be ten times the average earnings of the next decade. In other words, the price may seem expensive relative to past earnings, but it may actually be cheap relative to (higher) future earnings.
For highly cyclical companies that logic is much less likely to apply.
If a highly cyclical company doubled its earnings over the last decade, it may seem reasonable to expect the company to double its earnings again over the next decade. And yes, it might, but it might also earn the same amount as in the previous decade, or it might earn less.
The fate of the company will depend on its industry cycle more than anything else.
I have no interest in trying to predict industry cycles. Instead, I would rather use strict valuation rules to limit purchases of highly cyclical stocks to periods where they are very likely to be near the bottom of their cycle.
This should help to reduce downside risks and increase the chances of the share price increasing whenever the cycle eventually turns upwards again.
This isn’t an exact science, but having crunched the numbers on a variety of companies these last few months, my rule for investing in highly cyclical stocks now looks like this:
- Only buy a company from a highly cyclical sector (Mining; Oil & Gas Producers; Oil Equipment, Services & Distribution; Home Construction) if its PE10 and PD10 ratios are below 10 and 20 respectively.
These limits of 10 and 20 for PE10 and PD10 respectively are far lower than my standard limits of 30 and 60. While 30 and 60 may be reasonable limits for Unilever and its defensive peers, they are not suitable for highly cyclical stocks like BP.
If I’d followed this new rule back in 2011 then I probably would have purchased BP at 380p in September 2011, rather than 494p in March 2011. That lower and more recent purchase price would have produced an 11.3% annualised return rather than a 5.9% annual return. That’s a fairly significant improvement in returns.
And because the purchase price would have been lower, the maximum share price decline (i.e. the moment of maximum stress for the investor and the point at which they’re most likely to panic-sell) would have been much lower. In fact, when the shares fell to about 340p in early 2016, the “paper loss” would have been a mere 10% or so compared to the actual decline of 30%.
So in summary, buying at a lower price would have increased returns, reduced risk and reduced stress. What’s not to like about that?
John, Personally I think it’s a good move, as like you I haven’t the foggiest clue as to what will happen to the oil price. The trouble with forecasting is that it involves the future as they say and therefore it’s off the reality radar.
I adopted the same thought patterns when I sold Glencore and RIO of late. Having watched both companies crater to unbelievably low levels and then both recover to offer me an escape with some 30 and 35% capital gain + divis (in RIO’s case mostly), I saw this as an opportunity to escape, set my accounts straight and recover some sanity.
I’m not saying never, but cyclical commodity companies no longer appear at all in my portfolio.
I think also the issues you pointed out regarding the shrinkage of the business at BP and at the same time the expansion of the debt, calls into question whether the company is in fact in the process of liquidating itself. The PE10 PD10 rules you are setting yourself does offer you a much wider margin of safety and probably helps ensure (well almost) you are buying closer to the bottom of the cycle.
My sphere of market coverage seems to get smaller by the month, now that builders, constructors, most banks and commodities don’t really feature lol !
Happy New Year and — nice one on the BP exit — at least you made a profit and got paid with a decent dividend in the process — can’t be all that bad can it?
Hi LR, no, it wasn’t all bad, and the lessons learned are the most important bit anyway. As for BP liquidating itself, that could well be the sensible thing to do anyway. According to the research of Carbon Tracker and other climate-related think tanks, a much smaller BP (Shell, Exxon, etc) by mid-century is probably the best option for shareholders and non-shareholders alike.
John — On another subject, I know you are into or once was into BAE, have you ever considered Qinetiq at all. It seems a more appealing prospect than it once was, now that it is debt free, net cash and a reasonably solid (as it ever can be I suppose) order book going in to 2018?
The events at Ultra have knocked the whole sector, which has also dragged it down quite a bit. The directors have been heavy buyers over the last 6 months.
Qinetiq is very much more consulting, training and services based, compared traditional defence contractors, and perhaps less dependent on capital intensive projects — but obviously requires the capital intensive projects to be in place to enable it prosper.
It’s off today almost 3% on no specific news or RNS that I can see.
Regards LR
Qinetiq doesn’t rank well on my screen. The yield is only 2.6%, implying high expectations for future growth, but the results over the past decade seem to be very volatile and there are no obvious signs of above average growth. Profitability is reasonable and there seems to be no debt, but the track record doesn’t justify the price, at least as far as my stock screen is concerned.
Obviously that’s just a high level view, so don’t take it as gospel…
Mmm, looks a good exit point !!!
We also hold the very cyclical sideways tracking commodities via BRCI (Commodity Income IT). BRCI too has been an interesting ride, much of it underwater!!! The reason for the holding is the very different path traced versus the main indicies, so a good diversifier. One advantage for us is that we are not averse to adding to a position when underwater, or reducing should it climb, rather than limiting transactions to outright buys or sells.
Again thanks for an interesting, quite riveting read. Has wider implications.
Hi Magneto,
“very different path traced versus the main indicies, so a good diversifier”
That’s exactly why I don’t want to just rule out highly cyclical stocks. They can produce good returns when purchased at the right price, but they often zig when defensives zag. Although my strategy is “defensive value”, I don’t want to restrict my portfolio to defensive stocks because they might all be in favour and therefore expensive at the same time (which is largely true at the moment).
Dearest John,
“I paid too much in the first place” in once again the key phrase. Similar to your RIO experience, your mistake was buying high. There was logic selling BP during the summer and many did to exit the uncertainty taking advantage of the recovery. The uncertainty for the sector has since greatly reduced and the dividend is no longer under the same pressures as in recent year. Your exit now is mostly a psychological “remedy” given your entry woes, it can not be generally recommended given industry situation and external factors (Brexit on GBP, search for dividend during inflation, etc.) and the timing is rather odd. Are you actually reinvesting any of these or just keeping the cash? Your methodology will give slim pickings or suggest certain stocks for wrong reasons e.g. GSK.
Hi HH
“Similar to your RIO experience, your mistake was buying high” – Totally agree. Hopefully my new tighter rules on purchase valuations for highly cyclical stocks will remedy this, but only time will tell.
“Your exit now is mostly a psychological “remedy” given your entry woes” – No, the exit is due to the company’s low rank on my stock screen relative to other holdings in my portfolio and also the company’s high debt and pension obligations. The risk/reward tradeoff (as I measure those factors) just doesn’t fit my criteria.
“timing is rather odd” – I had this comment quite a lot on Seeking Alpha, where the post was republished. The idea seems to be that oil prices are rising, the global economy is recovering and BP’s major problems are behind it, therefore the company and share price will do well going forwards. That may be the case, but it may not, and if it was so obvious then it would already be in the price and therefore future returns would not be attractive (assuming the efficient market theory is even remotely correct). Personally I just stick to my investment process and whether my “timing” is odd relative to other investors is irrelevant.
“Are you actually reinvesting any of these” – Yes, I’ll be reinvesting the proceeds into a new holding next month, although I have no idea yet which company that will be.
“Your methodology will give slim pickings” – Perhaps, but so far the returns have been acceptable.
Some good lessons here for sure John, thanks for the write up. I was in a newly renovated BP this morning and thought maybe it was time to re-visit their company data, so this has been a welcome summary.
Since getting your book I had a good look at Monadelphous – another cyclical company but analysed it roughly 6-months to a year after it was nearer its cyclical bottom. This newer rule is useful though, because it would have limited the buy price for MND to around $10 (at it’s bottom, the price was around $6 2016). It’s now at $17 and although I suspect it has some room to continue rising, it had exceeded any margin of safety some time ago. 10 yr growth rates on cyclicals are also often interesting, naturally appearing much lower during a down cycle and seeming most robust near the peak of the cycle. So I’ll watch MND and BP with interest but will be on the sidelines for the next few rounds at least.
Best wishes for your new year,
WF30
“10 yr growth rates on cyclicals are also often interesting, naturally appearing much lower during a down cycle and seeming most robust near the peak of the cycle”
That was the main problem with highly cyclical companies. My stock screen looks at rate and consistency of growth over ten years, and highly cyclical stocks can look like highly attractive fast growing defensives over that sort of time period. In some cases it’s only when you zoom out to 20 or 30 years that their true nature becomes visible. But I don’t want to have to look back that far as the data is hard to come by, hence the strict valuation rules instead which should limit my purchases to somewhere near the bottom of the cycle, hopefully.
Yeah, no one knew how much the disaster was going to costs BP. Given that it happened in the most powerful nation in the World, the U.S., BP is unlikely to have a say in how much compensation it was going pay.
Also, it takes more than studying the fundamentals of a company to become a successful investor.
Finally, I pulled this quote from your post: “For example, if the price of oil goes from $20 to $150 (as it did between 1999 and 2008) then companies like BP are going to make huge profits even if the CEO is a COMPLETE IDIOT..”
It kind of reminds me of people investing in Cryptocurrencies and thinking to themselves as geniuses as prices go hyperbolic! I wonder what happens if prices start crashing, they may think of themselves as a COMPLETE IDIOT for believing in the hype!
I guess anyone can make money if their dart hits the bullseye.
Hi Walter
“what happens if prices start crashing” – Can’t say I know much (anything) about Bitcoin etc., but it seems that much of it is “purchased” on margin, via spread bet-type products:
https://ig.forex/forex-markets/bitcoin (disclosure: I own shares in IG Group)
(losses can exceed deposits… apparently)
Bonkers as far as I’m concerned, but each to his own.
Hi John
A very understandable move. There‘s no doubt, BP is a good company but there are many uncertainties, as you described.
I also like your point with regard to the entry point/price resp. the margin of safety. I bought shares of Royal Dutch Shell in 2009 and that position is a little cash machine providing me with YoC of almost 10 %. It‘s easier to ride price roller coaster when there is a sufficient margin of safety.
But there are some cyclical positions in my portfolio where I bought too early and paid too much, and as you write, risk-reward profile is satisfactory but much less attractive (e.g. XOM for around USD 90).
Cheers
Hi FS, you’re right. With highly cyclical stocks the price paid is much more important than it is for quality/defensive/dividend growth stock.
If a company can grow its dividend at 10% per year for 50 years then over those 50 years you’ll get a solid double digit annualised return almost regardless of the entry price. The problem of course is finding companies that can grow like that.
But with highly cyclical stocks their long-term growth prospects are typically far less certain, and if you overpay the investment might never make a profit. However, these companies are much easier to find; you just have to find them at the right price!
So either way it’s not easy, but then again if beating the market was easy everyone would do it.