Malcolm Gladwell in his book “Blink” explains the role of intuition in human decision making. Humans have the ability to process information almost instantaneously and gain a read on a situation that’s often extremely accurate.
As we get older we are taught both academically and by personal experience that quick responses can be flawed and as mistakes are painful we tend to park the intuitions and use the logical approach of cost / benefits; what can be gained and what can be lost?
One of the main reasons people invest unsuccessfully is that they use the same decision making criteria as in their business and personal lives, i.e. looking for patterns of repeated success as confirmation that a decision is likely to be correct and the outcome positive.
Indeed this is a logical approach, and hard wired into the psyche from way back when early humans wandered around the plains of Africa in fear of being attacked by large animals with lots of pointy bits. It was then and is to a lesser extent now a survival imperative.
However when this mental risk profiling model is run in relation to buying investments it often produces poor results. This same programme that searches for things which have been successful and excluding things which have not translates into.
Buying assets which have risen and are popular.
Selling or not buying assets which have fallen and are disliked.
This explains the recurring misstep of investors buying at close to the top of valuations and selling at close to the bottom; exactly the wrong way round!
The practice of contrarian value investing requires consciousness of thought and deed, recognising and counteracting confirmation bias and replacing it with a disciplined application of values based analysis.
A value investor must be comfortable that many assets become potential buys for a reason, and the reasons will likely be negative and then to establish whether the market is willing to accept a low price because they have over reacted to events or if the price is low for good reasons.
The aim being to exploit the emotional reactions to bad news to accumulate shares in fundamentally good businesses at great prices (buying them when they are deeply discounted).
There are a series of filters applied to weed out the few compelling opportunities (diamonds) from the majority which are actually broken (dogs).
- The company must be financially sound and able to weather the storm they are experiencing (so must have low levels of debt and cash flow positive)
- The company must have a great business model with strong competitive advantage, (their franchise must be enduring) i.e. they are not abacus manufacturers when the electronic calculator appeared
- That management is highly competent and shareholder focused
- That the negative event(s) impacting the share price will pass
- That the share price offers a significant discount to the intrinsic value of the business, measured by assets, liquidation values or replacement costs
- What would another company have to pay to recreate the same business? This can identify additional tangible and intangible value and also highlight asset values which are above carried book value, hidden from view in the accounts
As an aside this argument is made by Bruce Berkowitz of the Fairholme fund in relation to the Sears Property Holdings and Warren Buffet on the accounting value of Geico which is wholly owned by Berkshire Hathaway.
In the case of Sears much of their property is shown in their accounts at acquisition cost decades after purchase and which Berkowitz compares to still valuing Manhattan Island at the $24 paid to the Indians by the settlers in 1626.
Buffet points equally to the value in their accounts of Geico being the price Berkshire paid for the shares decades ago when Geico was a fraction of the size and profitability (because it is wholly not fractionally owned).
The case for BP
The Deep Water Horizon explosion and the pollution of the Gulf of Mexico in 2010 was a hammer blow to the company.
BP suffered enormous reputational damage particularly in the US.
It is likely they will pay around $40-60 billion in compensation and there is still outstanding US litigation from which there may be further costs as yet unknown.
They have sold $35 billion of assets with a further $10 billion pending to fund liabilities.
They stopped dividend payments after the disaster and then reinstated them at half the pre-crisis level which did significant damage as many long term investors held the shares primarily for the above average and increasing yield.
They hold a 19.6% stake in Rosneft which is Russian and effectively state controlled, this was only mildly concerning before Russia invaded Crimea and the West threatened major sanctions. So most investors won’t consider owning BP shares because of all the uncertainty, which makes it a classic contrarian investment candidate.
Is it a diamond or a dog?
- BP has sold assets to meet the expected costs of the Deep Water Horizon rig, it shouldn’t therefore need to raise further cash from disposals
- Expected profits this year are between $15-16 Billion
- The last time BP made $16 Billion in profits (2004) the share price was higher by over 40%
- It historically trades at a P/E ratio of around 13 times (price being a 13 times multiple of earnings) it currently trades at a P/E ratio of around 9 times 2014 profit estimates. By comparison Exxon is currently valued at over 13 times earnings
- It has a price to book ratio of 1.2, to buy BP in total at the current share price requires a 20% premium to its net asset value. By comparison Exxon has a P/B of 2.4 times (140% premium)
- The dividend yield is back to 5% and increasing
- It has 4.5 billion barrels of proven oil and 33 Trillion cubic feet of natural gas reserves. It has joint ventures in a further 4.5 billion barrels of oil
The best case scenario for BP is the outstanding litigation is settled without significant additional financial pain.
It has already raised the cash required to fund the majority of the expected costs and can return to a more ‘business as usual’ environment.
The plus side to the catastrophe has been to focus the company onto safety and maximising their assets, in short it appears a much better run company today.
It is plausible that profits increase by around 7-9% pa on average over the next five years.
In this scenario the dividend yield in 5 years’ time for shares purchased today (even assuming no ratio increase) would be an 8% per annum yield.
If BP returns to its historic average P/E ratio the share price in 5 years could be approximately double that of today.
The worst case scenario of continuing litigation and significant additional penalties, whilst certainly bad, does not appear to be of a magnitude to damage the company beyond having a stagnant share price and dividend yield. The worst that happens is a flat 5% dividend (the 10 year Gilt yield is currently 2.76%) and no capital appreciation.
So does BP meet the criteria for a contrarian value investor to buy shares?
- It is financially able to weather any outcome? YES
- Does it have wonderful assets and a strong business franchise? YES
- Is it very cheap to buy? CERTAINLY YES
- Is management talented, and shareholder focused? YES
- Will the current issues pass? YES (it’s just not clear when)
The final attraction for potential UK investor being that BP is a FTSE stock but trades in dollars (because oil is priced in $’s so it doesn’t have to convert the currency to £’s).
The pound is up over 10% against the dollar in the last year, a further 10% cheaper to a UK investor.
NOTE: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.