Black Gold (Energy Part I)

My great-grandfather, Ignatius Aloysius (“I.A.”) O’Shaughnessy, was born in 1885, exactly 100 years before I was born. From very humble roots in Stillwater, Minnesota, he built one of the country’s most successful private oil companies: Globe Oil. Once honored as the “king of the wildcats,” I.A. built a huge fortune and then slowly gave it all away (mostly in support of education and ecumenicalism, click below to check out the letter from the pope to I.A.s wife after he died).

It is the ultimate irony, given my profession, that I.A. distrusted stocks. According to his son (my grandfather) “[I.A.] didn’t like those people on Wall Street. He thought that what was going on economically in his companies shouldn’t be determined by Wall Street and its fluctuating stock prices…he tended to invest directly in companies that made money, not in the market. He didn’t play the market…he relied on his own business to create companies that were prosperous in finding oil and refining it.”

For his entrepreneurship and philanthropy, I.A. is one of my idols…but I have to disagree with him on the stock market! Building an oil business requires hard work and lots of luck, but investing in energy stocks is much easier. Given that oil (and gas) are the lifeblood of modern society, it is a fascinating sector to explore. This will be the first of two parts on the energy sector, laid out in a format similar to the two-part series on Consumers staples (Part I here and Part II here).

Sector Overview

Given oil’s ubiquity in our lives, it is amazing that the industry is only about 150 years old. The U.S. oil industry started when “rock oil”—so called to distinguish it from whale and vegetable oils—was first discovered in Pennsylvania and proved to be an excellent “illuminant” for lamps. The oil industry became massive providing only lamp oil, but ballooned once cars and planes started using gasoline as fuel.  By World War II, both Japan’s attack on Pearl Harbor and Hitler’s invasion of the Soviet Union were driven in large part by the desire for oil[ii]. Today, behemoths like Exxon, Royal Dutch Shell, Petro China, and Chevron sit in the top 15 companies in the world by market capitalization.

The energy business has the same objective today as it did in Pennsylvania in the 1850’s: find oil (and gas), get it out of the ground, transport it, and sell it. Most modern energy companies still fall into one or all of these categories. We can group energy stocks into sub-industries using the global industry classification standard (GICS), which breaks out the energy industry as follows:

At the industry level, oil & gas dominate over energy equipment & services, here is the number of stocks in each industry and their total market cap through history.

Within oil & gas, there are three primary lines of business called upstream, midstream, and downstream. Upstream (also called exploration and production, or E&P) involves finding oil and getting it out of the ground. Midstream involves processing and transporting oil. Downstream involves refining oil & gas into consumable fuel for end consumers.  Some companies focus on just one element, but the largest energy companies—like Exxon—are categorized as “integrated” because they participate in all three stages.  

Here is a look at the historical breakout between these three stages of the oil business. You’ll notice interruptions in the “midstream” companies, because at various points they were classified as utilities. This is inconvenient for this analysis, but they represent a fairly small part of the overall energy market.

Integrated oil and gas stocks, along with upstream E&P stocks, dominate the market.

Competition and Concentration

In its early years, the energy industry was dominated by Rockefeller's Standard Oil, which had up to 90%  market share. Today, the energy industry is much more competitive, despite a few top companies like Exxon and Chevron controlling large chunks. One convenient way to measure concentration is the “four firm concentration ratio,” which simply adds up the market share (% of total sector sales) of the top four firms in the energy industry group. 

Of the 24 industry groups in the entire stock market, energy stocks are the 12th most concentrated industry.

Historical Returns

The returns for energy stocks have been strong relative to the nine other economic sectors, but with an annual standard deviation of 24.1%, they have also been the second most volatile (trailing only technology stocks)[iii].  Note that in this chart, the results are slightly different than in Part I of consumer staples, because here I have included ADRs in the universe to capture the large global energy stocks that are an essential part of the energy market.

The returns for the energy sector as a whole are quite volatile, but this is especially true of companies that focus on upstream, E&P operations. Exploration and Production companies have by far the worst risk-adjusted return (Sharpe ratio) of the major sub-industries within the energy sector.  I don’t have complete data for midstream companies at this point, but relative to E&P stocks, returns are better for refining companies and significantly better for the vertically integrated oil & gas companies. This latter group represents a small sample size (only around 20 integrated companies today), but they have delivered very impressive historical returns.

Oil & Energy Returns

“Oil is almost like money ”
— Robert O. Anderson

The price of oil has an obvious relationship with the success of energy stocks. To price oil, I use two primary benchmarks: Brent Crude, and West Texas Intermediate.  Data for Brent goes back to 1957, and today Brent Crude is used to price two thirds of crude oil globally. Here is the real price of oil (adjusted for inflation, shown in terms of today’s dollars).

When you compare the price of Brent crude to the energy index I’ve created, you see a clear relationship, especially in the 1975-1985 period and in 2008.

A Hyper Cyclical Sector

Some energy stocks have delivered outstanding long term returns, but the sector as a whole is very volatile. The previously explored consumer staples sector has had very stable returns on equity (ROE); but the energy sector is much more cyclical. Below are the historical ROE for the sector at large, and for the key individual industries.

The sector has huge swings relative to the market, but things get very interesting at the sub-industry level. The giant integrated oil & gas stocks drive the sector’s ROE, and are (relatively) more stable. By contrast, refiners and E&P stocks are much more cyclical. Early wildcatters, like my great grandfather, were not faint of heart. Not much has changed. Energy in general, and upstream E&P specifically, remains a tough business for entrepreneurs and investors alike--but those that have succeeded have earned huge returns. 

 

 

Notes: I have only just begun to explore this sector, and am contemplating a much more comprehensive (~50-100 pages) e-book. If you have any interesting resources (books, articles, white papers, anything really) on the sector please send them my way at patrick.w.oshaughnessy@gmail.com

For the custom “indexes” I’ve created in this post, I constitute each index in December and include all stocks with a market cap > $200MM adjusted for inflation and equal weight them (this gives a fair representation of the opportunity set). The indexes are then rebalanced and reconstituted each December. I use GICS codes to determine industries.

 

[ii] The Prize: The Epic Quest for Oil, Money & Power by Daniel Yergin (THIS BOOK IS PHENOMENAL)

[iii] These returns differ somewhat from the first post on consumer staples because I am including ADRs

Boring Is Good

I’ve always liked investing rules, because they impose discipline. Here is one rule I find useful: boring investments are good investments. The more boring the investment, index, or asset class, the better it will probably be for your portfolio. This has been true throughout market history, and the rule manifests everywhere:

·         Trading less often isn’t as fun, but it leads to lower costs (trading and taxes) and therefore higher long term returns.  

·         Index funds are plain and dull, but they outperform a significant majority of active managers over the long run.

·         The best performing U.S. sector for the past 50 years is consumer staples, which includes companies that sell simple, boring products which rarely change.

No matter where you look, dull trumps exciting.  Consider, for example, two very different industries at opposite ends of the dull/exciting spectrum: food, beverage & tobacco (Coca-Cola, Altria, Kraft Foods--BORING) and technology hardware & equipment (Apple, Qualcomm, Cisco—EXCITING).

The technology sector is almost always the most exciting part of the stock market, because technology companies offer new and exciting products and services. The market is rabidly speculating about every detail of the upcoming iPhone 6, but no one gives a crap about (or expects) some revolutionary new flavor of Coca-Cola.

So here is the remarkable fact: since 1963, the boring stocks (food, beverage & tobacco) have had a return of 13.6% per year (or 69,402% total), while the exciting stocks (technology hardware & equipment) have had a return of just 9.2% per year (or just 8,464% total).  

You often hear that earning higher returns requires taking higher risk, but the opposite has been true for these two industries. Food, beverage & tobacco stocks have been HALF as volatile as technology hardware stocks (14.2% annual volatility versus 29.5%).  You can see the difference, here is the rolling five-year return for each industry for the past 50 years.

Technology is an incredibly competitive industry with a very high rate of change. It is impossible to predict what technologies will emerge in the future, and equally impossible to predict what companies will profit from those new technologies. 3-D printing may be revolutionary, but we have no clue what company will emerge from what will be an extremely competitive playing field.

And yet, even with such an unpredictable future, investors have almost always paid a premium for technology stocks, because they excite and inspire.  Here is the historical valuation percentile (higher = more expensive) for the two industries in question.

This means that, historically, investors have paid more for stocks in one of the most competitive industries, where it has been the hardest to succeed and stay on top.  

Change generates excitement, but as Warren Buffett has said, “We see change as the enemy of investments...so we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.”  

Your smartphone has more power than the first super computers; hardware has evolved at an unbelievable rate.  Over that same time frame, here is what has happened at Coca-Cola.

Stick with boring, and you’ll win. 

 

 

Calculation notes: The industry returns are based on an "equal weighted" custom index, which includes all stocks in the industry with a market cap > 200MM, inflation adjusted. The index is rebalanced/reconstituted annually in December 

Consumer Staples, Part II

 “We see change as the enemy of investments...so we look for the absence of change. We don't like to lose money. Capitalism is pretty brutal. We look for mundane products that everybody needs.” Warren Buffett

In Consumer Staples, Part I, I explored the unique nature of consumer staples stocks and their impressive historical returns. In this part, I’ll explore how to find the best individual consumer staples stocks.

Some aspects of security analysis require a heavy touch. For example, evaluating the value of a brand, or the sustainability of a “business moat” requires hands on work and deep knowledge of each company. My approach is, instead, quantitative.  In this sector series, I’ll highlight “factors” that can be quickly calculated and compared across a wide universe of stocks. I’ll cluster these stock selection factors into several key categories: valuation, profitability, momentum, and quality.  I’ll also include some factors that do not add value historically, despite their appeal.

As we will see, the secret to success in the consumer staples sector is similar to the secret to success in the broad market: focus on high quality, cheap stocks. Value has been the most successful factor for choosing consumer staples stocks, but the value strategy can be enhanced by insisting on strong profitability and a shareholder orientation.

What Matters for Stock Selection

There aren’t that many consumer staples stocks. Today, there are just 108 U.S. stocks in the sector with a market cap greater than $200MM. If you include international stocks listed on a U.S. exchange (usually as an American depository receipt (ADR)), there are 161 stocks.

Because there are so few, my analysis of factors separates the universe into quintiles (buckets that represent 20% of the market sorted by a factor, or roughly 32 stocks each today) rather than deciles (which I normally use in a bigger universe). I’ve tried to include as many factors as possible that are available at free screening services like www.finviz.com, but I’ve also included some factors that are not available from the free screening services.

Value

Given that consumer staples stocks have had such high returns on their equity for so long, it is curious that they are have been, on average, the second cheapest sector after utilities over the past 50 years[i]. And their valuations have been steady. Look at the thick black line in the chart below. Measured against all stocks, consumer staples are almost always cheaper (i.e. their average valuation percentile is less than 50).  In this chart, 1 means cheapest and 100 means most expensive.

The sector is often cheap, but investing only in the cheapest stocks within the sector has yielded even more impressive results. The panel below breaks the universe of consumer staples stocks into quintiles based on different valuation factors. The analysis is run since 1963, and the quintiles are rebalanced on a rolling annual basis (so if you were to run a similar strategy, you’d want to hold positions for 12 months—this holds true for all other factors referenced below).

Clearly, buying cheaper stocks works. All four value factors can point you to sector-beating stocks, but EBITDA/EV and Earnings/Price work best.  Where do these factors point you within the staples sector? Here is the historical valuation percentile (similar to the one above) for the three industry groups within the staples sector.

Food & Beverage companies have tended to be cheaper while Household & Personal Product companies have tended to be more expensive. Take Altria Group (formerly known as Philip Morris) for example. It is the single best performing stock since 1963, but has spent a lot of time as one of the cheapest stocks in the entire market! Pretty amazing. Bottom line: buying the cheaper staples stocks leads to superior results.

Quality

The term ‘quality,’ like the term ‘smart beta,’ can mean a lot of different things. I’ve included a number of different factors here that I think are applicable to the staples sector.

Several lessons stand out.

·         High ROE is the defining feature of the Staples sector: the sector as a whole has earned market-beating returns on equity for 50 years. But buying the stocks with the highest individual ROEs has not been a winning strategy. Return on invested capital has been a better measure of profitability and a better way to select stocks.

·         I remember thinking the cash conversion cycle was very compelling during my CFA days, but it is not a helpful selection factor in this study.

·          A focus on strong free cash flow can help you find the best staples stocks. By avoiding stocks with low free cash flow/ sales and avoiding stocks with low free cash flow / short term debt, you can sidestep stocks that have tended to underperform the broad sector.

·         A focus on earnings quality (change in net operating assets[ii], and total accruals to total assets) can also give you an edge.

Yield

Two measurements of yield are very effective in the consumer staples sector: dividend yield and shareholder yield[iii]. I’ve only included the top 25 stock portfolio for dividend yield[iv].

Buying stocks with higher yields has been a very effective strategy. Companies paying regular dividend (whose yield is high because the stock is out of favor) have been reliable investments, and companies buying back shares have done well.

Momentum

Buying stocks with strong momentum has worked well in the broad market, but hasn't added much value in the staples sector. This could be a coincidence of history, and I cannot think of a reason why it hasn't worked that well in this sector, but it is interesting nonetheless. 

Combining Factors for Superior Results

So what happens when you rank stocks on a combination of the best factors? Below are the results of a strategy that combines EBITDA/EV, shareholder yield, change in operating assets (earnings quality), and free cash flow/short term debt (financial strength).  Each stock is given a rank 1 to x and the 25 stocks with the highest average ranking are selected by the model.  The annualized return is similar to some of the factor portfolios above, but the Sharpe ratios are significantly improved. The annualized return is 17.5%--slightly better than the 17.3% for the cheapest stocks by EBITDA/EV listed above. But the volatility is just 14.6% for the four-factor strategy, versus 16% for EBITDA/EV.  That means the four-factor strategy has a Sharpe ratio of 0.85, a big improvement over the 0.76 Sharpe ratio for EBITDA/EV.

BONUS FACTOR

In my research, I found one final factor very interesting: Research & Development expenses divided by market value. I didn’t include it above because not all companies have R&D, so you cannot compare all companies to each other. But among those that do spend on R&D, it is a very effective factor. It is part value factor, part earnings quality factor. It measures value because the denominator is price, but also measures earnings quality because of an accounting quirk.

R&D is an investment meant to provide a long term benefit, but it must be “expensed,” meaning subtracted from earnings during the period that the spending takes place. This stands in contrast to other investments like property, plant and equipment which can be “capitalized.” Capitalizing just means that you only count a fraction of the cost—of say a machine—against current earnings. If a machine is going to last 10 years, you only subtract 1/10 of the cost of the machine in the first year. Capitalizing makes sense and smoothens earnings. You can argue that like a machine, R&D spending will have an impact over the course of many years, so the fact that companies have to expense R&D costs can make earnings look weaker than they are and lead to nice future earnings surprises and therefore nice future returns. Here is the factor, split out by quintile.

As always, let me know your thoughts by commenting below or emailing me at patrick.w.oshaughnessy@gmail.com

IMPORTANT DISCLOSURE! These backtests do not include any costs whatsoever and so should be taken with a grain of salt.  While a once-per-year trading strategy is fairly easy to trade these days, the costs can still be significant when trading in small cap names. These test also have a fairly small sample size. With just about 150 stocks at any given time, the staples sector is small. The good news is that the factors that work in the staples sector work in the other nine sectors too, as we will see over the course of this series, and also work in international and emerging markets (which are nice out of sample tests).

Calculation Notes: everything, as always, is rebalanced on a rolling annual basis to avoid seasonality in the results. Only stocks with an inflation adjusted market cap above $200MM are included in the sample. Going smaller can improve results, but leads to trading and liquidity concerns.  Due to several comments about excluding international stocks in part I, I’ve included non-U.S. stocks that have a U.S. listing in this study. Results are similar if the universe is U.S. stocks only, but are improved for the most part with a larger (global) universe. The inclusion of ADRs is the reason the consumer staples overall sector return is slightly different from my first post.


[i] Cheapness measured using a composite of value factors: p/sales, p/earnings, ebitda/ev, etc.

[ii] Net Operating Assets = non cash assets minus non debt liabilities. A large positive percentage change is bad: it means things like accounts receivable, inventories, and property plant and equipment are growing at a rapid pace, which has historically boded poorly for future returns.

[iii] Shareholder yield = dividends yield plus buyback yield (% change in shares outstanding in prior year, negative better)

[iv] Dividend yield doesn’t “quintile” cleanly because of a group of stocks with zero yield.

The Best Performing Sector (Consumer Staples, Part 1)

When Jeremy Siegel and Jeremy Schwartz were doing research for the book The Future for Investors, they wanted to find the best performing stock from the original 1957 version of the S&P 500[i]. What they found wasn’t an exciting technology stock, or a behemoth oil company, but rather a simple consumer stock: cigarette maker Philip Morris (now called Altria Group). What’s more, Siegel and Schwartz found that 11 of the top 20 long-term performers came from the same boring economic sector: consumer staples.  The sector is defined by great brands, wide economic “moats,” and above market returns on equity. So how can you use consumer staples stocks in your portfolio? My plan is to answer that question in a multi-part sector series.

For each of the ten economic sectors, I’ll write two parts. Part one will be an overview. I’ll tell a quick history, highlight important companies, and discuss any interesting trends or characteristics. In Part two, I’ll explain how you can find the best investments in each sector, and discuss when the sector does well across market cycles. (Click here for Part II)

At first, I’ll focus on American stocks for a few reasons. First, they are more recognizable and therefore more interesting to U.S. investors. Second, U.S. stock data is clean, broad, easy to work with, and has a deep history. Depending on the popularity of this sector series, I may expand globally as well, perhaps collecting a similar analysis into an e-book (so let me know what parts you enjoy and what you find boring).  We’ll start with the consumer staples sector which, as we’ll see, has been the best performing sector in the U.S. market since the early 1960’s.

A Peculiar Sector

The reason consumer staples stocks caught my eye was a bit of research I was doing on returns on equity (ROE). Over the past 50 years, consumer staples stocks have had persistently excellent returns on their equity. They haven’t obeyed the same ROE mean reversion that other economic sectors do.  Because outsized profits and rates of return on equity should attract stiff and serious competition into an industry, it’s fascinating that an entire sector could enjoy above market returns on equity for so long. 

Such sustained excellence must mean that these companies have had impressive “moats” around their businesses—barriers to entry in the form of brand, economic scale, or other advantages that make it very hard for newcomers to knock off the market leaders. Warren Buffet, Charlie Munger, and other great investors have often said that a good moat is one of the most important attributes for any company. For more information on moats, read this great piece by Michael Mauboussin.

The consumer staples sector is divided into 3-primary groups (known as industry groups) by S&P’s Global Industry Classification Standard (GICS). These are food & staples retailing (think Wal-Mart), food beverage & tobacco (think Coca-Cola), and household & personal products (think Proctor & Gamble). Here are the number of stocks in the sector (and in each industry group) over time.

There have never been more than 200 consumer staples stocks in the all stock universe[ii]—it has always been a fairly concentrated and top-heavy sector. One convenient measure of concentration is to measure how much of any market is controlled by the top companies. One well known measure is the “four firm concentration ratio,” which simply adds up the market share (% of total sales) of the top four firms in each industry group. Here is the historical concentration of each group:

Today, roughly 75% of the sales in both the food & staples retailing and the household & personal products industries come from just the top four companies.

Historical Returns

Though it is populated by companies that seem plain vanilla and don’t excite with new technologies, the consumer staples sector has been the best performing of the 10 economic sectors since 1963. Below are the annualized returns for each of the ten economic sectors[iii].

In addition to delivering the highest returns, consumer staples stocks have had the second lowest annualized volatility, trailing only utilities for lowest annual standard deviation of returns.

Within the sector, returns for the food, beverage & tobacco industry group are especially impressive, while household & personal products have had returns similar to the rest of the market.

So why do these two industry groups do so well? Part of the answer is extremely effective economic moats, mainly resulting from powerful and iconic brands. Warren Buffett has ridden this trend to success—to this day three of his largest holdings are Coca-Cola, Anheuser-Busch (Beer), and Proctor & Gamble.

Food, Beverage & Tobacco

The largest (and best performing) industry group is food, beverage and tobacco. Some of their success comes from the fact that as a group they’ve earned exceptional returns on their equity across history, well above the rest of the market as seen below.  Unlike an industry like automobiles—which are the ultimate cyclical stocks—these companies do not show strong mean reversion in their collective return on equity.

It is amazing, but market trends like these often come down to just a few companies. Coca-Cola and Pepsico, for example, represent about 25% of the food, beverage & tobacco industry group’s common equity. Since both have had high ROEs, they are a major reason for the sustained dominance of the industry.

Outstanding Long-Term Returns

Thinking back to The Future for Investors, I wanted to update the research on long-term returns by looking for the best performing stocks in the U.S. since 1963 (using all stocks as a universe rather than just the S&P 500).  My criteria was that the stock was around in 1963 and survived through the present.  Sure enough, Philip Morris (now Altria) was the number one performing stock with an annualized return of 20.23% per year since 1963—that is a total return of more than one million percent! Other consumer staples stocks peppered the top thirty stocks: Hormel Foods, Anheuser-Busch, Pepsico, and Coca-Cola (among several others) were all near the top of the list.

Clearly, consumer staples stocks have been great investments over the long-term. Lucky for us modern investors, we can buy staples using a low cost ETFs.  Of course, sector ETFs are market-cap weighted so there may be a better way. Improving on a market-cap weighted strategy will be the subject of part two: how to find the most attractive consumer staples stocks in any given market. Stay tuned!

SIDE NOTE: With each of these posts, I am learning. I would love to hear from you with ideas, questions, or disagreements about what matters most in each sector. Email me at patrick.w.oshaughnessy@gmail.com with any thoughts.

 

[i] Pg 36 of The Future for Investors by Jeremy Siegel

[ii] All stocks = any stock in the U.S. with an inflation adjusted market cap>$200MM

[iii] Each custom sector index (and industry group index) is constructed as follows: first, every stock with an inflation adjusted market cap floor of $200M or higher is included. Stocks must be domiciled in the U.S., so no ADRs. Stocks are then equally weighted in the index and the index is rebalanced using the same criteria once per year in December.