Oil prices have been absolutely crushed this year with the price of the commodity dropping more than 60% over the past 12 month. And as the price of oil goes down, so do the companies that produce the commodity. Investors absolutely hate oil stocks at the moment. This provides a perfect opportunity for small investor to buy into oil companies on the cheap.
Baron Rothschild famous stated that the best time to buy was “when there is blood in the streets.” In other words – when everyone is selling, it’s a great time to buy! This appears to be very sound advice at the moment as it is a great time to buy into oil companies.
When investing in beaten down sectors like oil is at present, it is important to invest in quality companies. Even if your absolute return is less than a low quality/high leveraged name, you can take a bigger position in the quality name and sleep better at night. Why take the risks when quality companies can still give you fantastic returns.
Quality companies in the oil industry can be easy to spot. They have strong balance sheets, have been around for ages and pay an ever growing amount of dividends. The last point is particularly important because companies that pay a dividend typically outperform those that don’t and those that regularly increase their dividend typically do even better.
When looking at quality oil companies, there are a few oil majors that come to mind: BP, Shell, ExxonMobil, Chevron, Total and Eni. As an investor in the UK, most of these companies were dismissed instantly as the dividends they pay would be subject to withholding tax. Thus I was left with BP and Shell, two stellar British oil majors with fantastic track records and high dividend yields.
In this instance, I chose to buy BP instead of Shell as the risk adjusted returns I could get were better. BP trades at a cheaper price to shell and has a higher margin of safety with a PB ratio of about 0.8.
As an investor, one of the things I like about BP is that it is a play on Russia. BP has a stake in Russian oil unlike any other oil major with its 19.75% stake in Russian powerhouse Rosneft. Rosneft is itself hugely undervalued due to investors shying away from the Russian market at present. The cost of extracting oil in Russia is one of the lowest in the world and if oil was to stay lower for longer, BP would cope better than many other oil companies due to having a significant stake in the cheaper to extract Russian Oil.
I bought BP stock during the late September meltdown of this year. For just under £1,800 I was able to get 538 pieces of stock in the company. The average price per stock was 334p (£3.34). As the company is paying a dividend of about £0.25 a share at the moment, I was able to lock in a huge 7.47% dividend yield!
As a dividend investor, one of the golden rules is to never go chasing yields. You need to instead find dividends that are sustainable in the long term. I believe that with BP, it is one of the rare companies that you can get a high yield that is sustainable (provided that oil goes back to about $60 a barrel in the medium term).
When a stock has a high dividend yield like BP has at the moment, it is a result of a plunge in the share price. This plunge is often a signal that the market is losing faith in the company’s ability to maintain the payout. A falling share price can indicate a dividend cut or, worse, the elimination of the dividend. So the question needs to be asked, how safe is BP’s dividend? The companies earnings depend largely on the oil price and an increase in oil prices to above $50 or $60 a barrel will mean dividends will be more sustainable. At current oil prices, the companies earnings for this year just about meet the dividend payments and the story is likely to be the same for next year. What BP has going for it is its strong cash rich balance sheet. At the end of June, the company reported a cash and short-term investment balance of $33bn which is huge albeit is still has to pay fines for the Gulf of Mexico oil disaster.
Since buying the stock, the price has jumped by 4.5% to stand at 349p (£3.49) at the moment.
At the price, I believe that the stock is still undervalued substantially. According to my calculations, I would value the stock at about 400p (£4.00). Remember that this is only my opinion and it is up to you to do your own research and make your own decision.
BP valuation: Discounted Cash Flow method
If you use the Discounted Cash flow (Free cash flow to equity) method as many investors like to use, the value per share of BP comes to :
Discount rate = Cost of Equity = Risk Free Rate + (Levered Beta * Equity Risk Premium)
Discount rate = 10.11% = 1.92% + (1.014 * 8.08%)
Terminal Value = FCF2019 × (1 + growth) ÷ (Discount Rate – growth)
Terminal Value = $12,874 × (1 + 1.9%) ÷ (10.11% – 1.9%)
Terminal value based on the Perpetuity Method where growth (g) = 1.9%: $160,176
Present value of terminal value: $98,953
Equity Value (Total value) = Present value of next 5 years cash flows + terminal value
Value = Total value / Shares Outstanding ($127,532 / 18,306)
Value per share (USD): $6.97
Exchange rate USD/GBP = 0.66
Value per share (GBP): £4.59
(It is important to be cautious with the above valuation method as it relies heavily on the prediction of cash flows of a business and this in turn depends on the price of oil. With oil being so volatile at the moment, cash flows are hard to predict with reasonable accuracy).
Buying BP will make you rich over time
BP may be a ‘boring stock’ but these types of stock are usually the ones that make investors very rich over time. When investing, you should not be chasing Monte Carlo size wins, because you really don’t need that to secure your future through investing in shares. All you need to do is compound your money by 8% or so a year and keep doing it consistently.
With BP, my holding period will be forever. And this is the holding period most individual investors should look to hold for. Contrary to what the financial media bombards us with on a daily basis, there’s nothing glorious about buying and selling equities. If you follow the strategy of constantly cycling in and out of stocks, you’ll wind up emulating the proverbial hamster on the wheel rather than Warren Buffett. Don’t get me wrong, I’m not blindly advocating buy and hold. I am suggesting that in order to build wealth, you should focus on building your base of assets; whether it be dividend paying stocks or another asset class that you are more competent with.
I don’t know how many times I have herd the phrase ‘investing should be for the long term’. Whilst this phrase is constantly thrown in our faces in every other investment article, I cannot emphasis how important this is. By taking a long term view and allowing dividends to bolster your overall returns, you can easily sail through turbulent markets whilst still receiving your regular dividend payments. Even if we were to enter a recession tomorrow, I will not panic about my decision to invest in BP. I know that baring a major catastrophe, like the Gulf of Mexico, I will receive a constant stream of dividends which I can use to re-invest, spend or simply give to charity.