Sunday, January 1

Week 26 - Commodity Plays: Risk vs. Reward

Situation: We’ve found few companies that produce a commodity and meet the ITR criteria for safety and dividend growth, but those few are all oil & gas producers: ExxonMobil (XOM), Chevron (CVX), Occidental Petroleum (OXY). To be certain that our assessment doesn’t miss other oil & gas producers that are close to meeting our criteria, we took a closer look (Week 20) at a shale gas province in the Western US. All of the major players (other than Apache (APA) are active in that geological province. All of the major hard-rock miners are also active nearby, recovering large amounts of gold and copper: BHP Billiton (BHP), Rio Tinto (RIO), Freeport-McMoran Copper & Gold (FCX), Newmont Mining (NEM), Barrick Gold (ABX). The fastest-growing mining & drilling activity occurs in 4 contiguous states (Wyoming, Utah, Nevada, Colorado), so it’s not overly inconvenient to perform on-site assessments of management and operations. But first, let’s use the internet to examine these players from the standpoint of risk vs. reward

In last week’s blog (Week 25), we chose metrics for risk:
   price volatility on 2yr Bollinger Bands;
   FCF/div less than 2.0;
   LT debt more than 1/3rd total capital (bonds + stock). 

In this week’s blog, we add our 3 favorite growth metrics:
   Dividend yield greater than that for the S&P 500 Index;
   5yr average dividend growth of at least 8%/yr;
   Return on Invested Capital (ROIC) of at least 10%.

What is this new metric (ROIC)? It’s operating earnings divided by common & preferred stock + LT debt. ROIC is important because it tells us about the one piece of the company, operations, which should matter most to investors. AND, it assumes that all of the money provided by investors, whether from purchasing a stock or a bond, has a single purpose--to support operations! ROIC ignores the other parts of the company, i.e., those that deal with investment activities (e.g. using retained earnings to expand) and financing activities (e.g. buying back stock and retiring bonds).

The accompanying spreadsheet <click here> shows the S&P stock rating, S&P bond rating, the 3 “return” columns (dividend, 5yr dividend growth, ROIC), and the 3 “risk” columns (2yr Bollinger Bands, FCF/div, LT debt). Values that don’t meet our standard for investment (re: ratings, growth, or risk) are red-flagged. That is, a dividend rate of less than 2%, a 5yr dividend growth rate of less than 8%/yr, ROIC of less than 10%/yr, 2yr BB price volatility more than 4 standard deviations away from the Dow Jones Composite Index (DJA), FCF/div of less than 2.0, and LT debt greater than 33% of total capitalization.

Six companies had clean S&P ratings (XOM, CVX, OXY, MDU, APA, CAT), 3 companies were well-managed from the standpoint of risk (XOM, ABX, BHP), and 6 companies exhibited growth sufficient to support a dividend increase (XOM, CVX, OXY, COP, NEM, BHP).  S&P ratings are never complete for companies based outside the United States (e.g. SLB, RDS, BP, ECA, ABX, RIO, BHP), so it is difficult to make comparisons between US and non-US companies. But based on other sources of information, Royal Dutch Shell (RDS), BHP Billiton (BHP), Rio Tinto (RIO), and Schlumberger (SLB) come close to the S&P ratings we find acceptable. In summary, this analysis of risk vs. reward has uncovered only one commodity-producer (besides XOM, CVX, and OXY) that we would consider for long-term investment: BHP Billiton (BHP).

Bottom Line: Before making any speculative investment, it is necessary for a knowledgeable person to observe operations first hand and meet with management. Backward-looking accounting data are not very helpful when evaluating capital-intensive mining & drilling decisions, where a company’s growth prospects can ride on what a geologist says is “worth a look.”

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