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My Year in Cities: 2009

I spent at least one night in these cities last year:

San Francisco, CA
Piedmont, CA
Omaha, NE
Dayton, OH
Palo Alto, CA
Mountain View, CA
Phoenix, AZ
Playa del Carmen, MX

11 Jan 10

Warren Buffett's ConocoPhillips Post-mortem

Beginning in 2006 Warren Buffett was secretly purchasing a large stake of ConocoPhillips, the major integrated oil and gas company. Mystery surrounds Buffett's original valuation and intentions in acquring Conoco. He didn't speak publicly about it (to my knowledge) and made certain filings and disclosures confidential under SEC allowances. Was it expected to turn a quick dollar with an undervalued stock in the context of anticipated increases demand for commodities, similar to Buffett's investment in PetroChina? Or perhaps it was because Buffett intended to make a long-term investment. He could have seen a strong business with good management, consistently high returns on equity, and heavy natural gas and oil exposure to the most energy-hungry economy in the world (i.e. the United States).

At the time Buffett began buying Conoco shares, the spot oil price was on an upward climb past $70 per barrel. Buffett continued to purchase shares in the first half of 2008 as the price of oil approached $147 per barrel. Natural gas also exceeded $13 per MBTU in 2008.

The current forward-month price is around $80 per barrel now, and under $40 per barrel earlier this year. Natural gas is also down dramatically with the current forward-month price close to $5 per MBTU and under $3 only last month.

This precipitous drop in commodities prices has made Conoco tighten its belt. It plans to sell underperforming refining and E&P assets. It also laid off over 1500 employees. The dividend is well covered, helped by the company's cost cutting measures that are expected to save $1.4 billion by year-end. As a testament to Conoco's financial resilience despite the downward turn in commodities prices, it is spending $12.5 billion this year in capital expenditures. It also continued its high-yielding $0.47/share quarterly dividend through the downturn in commodity prices, and raised the quarterly dividend to $0.50/share in October 2009.

These efforts would still not result in a short-term turnaround in Conoco's share price. In his 2008 annual letter, Buffett called the purchase of Conoco shares when commodities prices were soaring a "major mistake". He goes on to say:

I bought a large amount of ConocoPhillips stock when oil and gas prices were near their peak. I in no way anticipated the dramatic fall in energy prices that occurred in the last half of the year. I still believe the odds are good that oil sells far higher in the future than the current $40-$50 price. But so far I have been dead wrong. Even if prices should rise, moreover, the terrible timing of my purchase has cost Berkshire several billion dollars.

The average purchase price per share in that letter I calculated was $82.55. With the commodities and equities markets scuttled in March 2009, Conoco dropped to a low of $34.12. James Mulva, the Chariman and CEO, stated at the Conoco annual meeting that his goal is to get the share price back to $100 before splitting it again. However, a roughly 60% increase compared current prices is a long way to go for Buffett to break even on his purchase.

Buffett has since trimmed his ownership about 25% and claimed in SEC filings the intention to harvest these losses to offset taxable gains from prior years. It remains unknown whether Buffett will maintain his remaining position in Conoco. A bigger question is whether Buffett will purchase Conoco shares at $50 after the tax losses are harvested.

The future rebound for Conoco is promising if commodity prices and worldwide economic activity increases. Conoco's significant U.S. exposure will greatly increase windfall revenues if commodity prices rise from worldwide demand. Will Buffett hold on? Curious minds want to know!

Disclosure: The author of this article is long COP.

2 Nov 09  •  {0 comments}

Are Stocks Undervalued?

Yale economist Bob Schiller of "Irrational Exuberance" book fame and the Case/Schiller home price index talks about stock market price/earnings valuations here. You'll probably want to spend the 5 minutes watching that before continuing reading below.

Economists and analysts currently disagree over whether stocks generally are undervalued or overvalued just measuring by price/earnings ratios. The reason for the disagreement is that there is not simply one standard of p/e valuations.

There are three simply methods to measure p/e ratios: historic numbers (trailing), the current year's estimates (forward), or a mix of historic and current estimates (median). Historical performance is no guarantee of future performance, but can be used as a guide. "Forward" p/e estimates are always subject to revision... and in this economy, the revision trend has been invariably downward.

Since stock is a share of a company (and thus a share of the earnings if management pays dividends), p/e ratios let you figure how much you pay today for an estimate of future earnings. For the S&P 500 companies, 2009 earnings estimates went from as high as $113 a share last April to $64 today. At $64, the S&P 500 p/e ratio is at 11. Some analysts are estimating as low as $40 a share. At $40, the S&P 500 p/e ratio is around 17.

But if your time horizon for investment is, say, 5 years, you might expect earnings to rebound to prior levels. For example, let's predict that we'll pull out of the recession and have earnings of $128 a share in 2014. I'm personally hoping it will be higher, but it's not much more than the highest 2009 estimates. If you don't mind waiting to share in S&P 500 companies' earnings until 2014, you'd be paying a p/e ratio of 5.5 today. Currently, the ratio is even lower for some individual companies. A p/e ratio of 2-3 is LOW. Of course, there is probably risk that the company's earnings estimates are all over the map.

Schiller advocates another measure -- averaging the past 10 years of earnings. It's called the cyclically-adjusted price-earnings ratio (CAPE). There are problems with this method, too, as a good company's earnings are consistently increasing. So even buying stocks at an "average" historic p/e ratio is a good price if earnings are expected to increase. On the contrary, a risky company has erratic earnings over 10 years, so it's even more difficult to use CAPE as a good measure. (Random analogy: Is it unwise to use CAPE for a stock index when the economy has been erratic over the past 10 years??)

Further, combining two measurement problems - what measure to use and the constantly changing estimates of future earnings - makes it impossible to predict whether a stock market index is overvalued or undervalued. Yet individual companies' earnings and prices are much easier to compare. If a company has an understandable and predictable business, applying these different perspectives can greatly inform you as to that individual stock's valuation. When all p/e measures are below average, then a stock undervaluation is more certain. An index with weighting or average multipliers such as the S&P 500 or Dow Industrials 30 is less certain.

One has to remember that the current economic conditions are not the norm. Investing requires optimism that the future will have better conditions. When signs of a recovery appear and earnings estimates are revised upward, p/e ratios of all measures are going to look even better than before.

Updated: 3/9/2009

3 Mar 09  •  {0 comments}