‘Another old paradigm that has come back to prominence is the peak oil hypothesis. This is a theory that the world is running out of oil. Each time the oil price cycle swings up, this one reappears.
Another new paradigm concerns end of the world scenarios based on global warming.
Maybe readers will remember when the internet was going to change the world. Old industrial companies would fade away. Imagine believing that rubbish.
Lots of people who lost large chunks of capital in the 1990s did believe it.
Before that it was canals, railways, electricity, the telephone, the motor car, radio, air travel, computers and television. Why would the internet be any different?’.
Colin Nicholson, late 2006.
When Nicholson wrote this he noted that the market had entered the rampant speculation phase of the cycle, where new participants weren’t interested in boring old investing ideas, instead speculating solely on prices, increasingly with the use of leverage (due to having missed out on the strong gains earlier in the cycle).
Stock market bubbles invariably seem to involve some form of ‘new’ tech.
And since humans don’t much learn from history, we’re doomed to repeat it.
The value of a business (a bird in the hand)
Around 600 B.C. the many-fabled Aesop noted that a ‘bird in the hand is worth two in the bush’, and this ancient adage lies at the very heart of the mathematics of investment.
As Buffett said, the intrinsic value of a company is the ‘present value of the stream of cash that’s going to be generated between now and doomsday’.
Due to the future’s inherent uncertainty and opportunity cost, cash generated today is considered more valuable than promised possible profits far into the future.
At this stage of the cycle, however, new market entrant speculators are often ignorant of earnings and cashflows (heck, even revenues!), preferring to gamble purely on stock prices in the hope of making a fast buck.
It will end in the same way it always does: painfully.
The ‘death’ of fossil fuels
In recent years, to diversify my portfolio, I’ve been acquiring as many of acres of cropland as I can afford – in the UK, where it’s inheritance tax free – because it’s a tax-effective asset, which I’m confident will still be producing crops for consumption or biofuel hundreds of years from now (or at least until it’s zoned for housing).
It’s been a quiet couple of years for stock market investments from a value perspective, because the US market has been so terribly overpriced.
It can take no small amount of patience to sit in cash, when bragging rights appear to be going to those speculating in the latest tech unicorn.
In the short run, remember, and during the rampant speculation phase, money flows into whatever is popular, such as cryptocurrencies or the latest ‘new tech’ story.
For some time now the market has been a voting machine or popularity contest, with little regard paid to free cashflow or earnings.
But at some point, a switch is flicked, and a level of rationality begins to return to markets.
And when the speculative gains dry up, investors all of a sudden begin to wake up and look at what businesses are actually worth.
At this point, the market becomes a weighing machine.
One sector which is gradually beginning to show at least some value is energy, having been a relative underperformer for 5 of the past 6 years (and, indeed, for 15 years).
The price of Brent crude is now pricing for a US recession, with oil prices collapsing 50% since January.
Looking back through history, it’s likely that oil prices can fall even further as demand has dropped off a cliff due to the coronavirus and the widespread measures being taken to prevent its spread.
Saudi Arabia is not keen on co-operating with Russia on supply, leading to chronic downward pressure on oil prices.
In the sector CapEx and then dividends may be cut.
The ‘ESG tsunami’ has also seen institutional investors panicking and fleeing fossil fuel companies towards so-termed ‘ethical investments’ or perceived greener companies.
Yet oil and gas will still be used hundreds of years from now, and even if the world transitions towards renewable energies, by 2050 oil and natural gas will continue to dominate energy sources (with much of these fuels being provided by the US).
Statistics over stories
Having begun this year at 80% in cash and only 20% in stocks in accordance with my allocation policy, it’ll be good to see a small handful of opportunities finally emerging to deploy some capital.
A bird in the hand, remember, is worth at least two in the bush.
The dividend yields of oil supermajors such as BP and Shell are now very high (although in the short term dividends could be cut), while Suncor is another energy giant coming onto the radar of value investors.
In 2019, Occidental Petroleum – a huge corporation founded 100 years earlier, and already with annual revenues of US$18 billion and net income of US$4 billion – acquired Anadarko Petroleum for US$38 billion in a controversial transaction.
The acquisition secured Occidental’s domination of the Permian Basin, a field half the size of California which produces more than 4 million barrels of oil equivalent per day.
The deal was in part debt-financed which led to downgrades, and a swathe of cuts to CapEx.
As the ESG tsunami takes hold (‘fossil fuels are dead!’) contrarian investors can buy the combined net proved oil and gas reserves of both Occidental and Anardarko a market cap of about US$10 billion.
Once the acquisition costs and integration have washed through, as the the largest producer in the Permian Basin Occidental will be pumping out 1.4 million barrels of oil equivalent per day.
Occidental has made 182 consecutive dividend payments, although markets will likely be questioning whether such a dividend can be defended while oil prices remain low and Occidental looks to repair its balance sheet.
When oil prices revert higher, this investment will ultimately represent prodigious free cashflow and a strong dividend – a very profitable bird in the hand.
What it’s not is some claim of supposed untold riches from digital media monopolies, ride-sharing, flexible workspace, plant-based burgers, lunar exploration, or other future technologies.
As predominantly an income play, I won’t even need to look at the stock prices of oil supermajors for the next 10-20 years, except in passing to note any future buying opportunities.
But contrarian investing always just sounds so boring during the rampant speculation phase of the cycle…
Choose your own strategy
These are not stock pick recommendations, of course, merely examples of my present line of thinking.
Circumstances differ, and you mightn’t be keen on a resources investment for ethical reasons, or even interested in a company paying strong dividend streams between now and doomsday.
But these will be good long-term investments for me, and because I know that stock markets mean revert, I’ll still be keeping a lot of cash ready on the sidelines for when the tech bubble bursts (again).
Although stocks have fallen sharply for a few weeks during February and early March, the US market is still historically expensive, which for my personal investment plan still demands a high allocation to cash.
If the CAPE ratio falls to around 20, then I can gradually move more out of cash and towards 50% invested in stocks.
Only when the CAPE is below 20 would I personally look to be up to 60% invested in stocks, moving closer to 80% invested in stocks if the CAPE ratio sinks to 15 or below.
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