The power of reinvestment and compounding returns

This post should not be news for anybody in finance, but it is worth refreshing fundamental principles of compounding and equity.

The most attractive feature of equities vs. debt is the effect of compounding. Stocks can rise infinitely while bonds have an effective price cap at the risk-free rate of interest.

To get on the equity gravy train and make outstanding returns, you need to have capital invested in a business with great prospects for reinvestment.

We will use an example of a debt-free company earning a perpetual $10 per year on a $100 investment, but the investment is of a style that does not scale upwards with further reinvestment. The long-term risk-free rate of interest is 2%. Our dream world also does not have income taxes or management expenses.

In this instance, the company can choose the following policies (or a blend thereof):
1) Give the money back to shareholders.
2) Bank its cash and receive 2% on that capital,
3) Speculate on other (preemptively higher-yielding) ventures.

If the policy option is (1) then in theory the valuation of this firm will be $500 (the risk-free rate of interest). The company will still generate $10/year for its shareholders whether the valuation is $100 or $500. An investor would be indifferent to sell the business for $500 and invest in the risk-free bond or just keep holding onto the business – you have magically created $400 of capital profit and you can clip dividends or bond coupons. With your $10/year you can do what you please, or put it in a risk-free 2% yourself.

This example is a constraint of reinvestment – after the re-valuation, your equity has effectively turned into a bond with no chance of compounding beyond the risk-free rate of interest.

If the policy option is (2) then you will see your returns in the appreciation of equity value. After the first year, your firm will generate $0.20 more in income and this will translate into $10 extra equity value, and this will compound at the rate of 2%.

Policy option (3) introduces the concept of risk – can management pull off the reinvestment? If there was an attractive investment at 5%, they would be able to generate $0.50 extra and this would translate into $50 of extra equity value for its holders, again, capitalized at the 2% risk-free rate.

So far we have made the assumption that the equity value follows lock-step with the risk-free rate of return. Of course in the real world, it never works that way and there are wildly divergent capitalization percentages used.

What is interesting is in this fictional example, the results you get if the initial equity investment does not trade at the risk-free return rate, but rather it trades at a higher rate, say 5%.

In this instance, the company would trade at an equity value of $200.

We will then consider a fourth policy option with the generated cash returns:
4) Buy back your own stock

This option requires a willing seller to the company (something that isn’t available to a 100% wholly owned firm!). Passing that assumption, an incremental deployment of $10 into the company’s own stock (a 5% reduction in shares) would result in continuing shareholders receiving 5.3% more returns in the future. Shareholders as an aggregate will still receive $10/share in returns, but the return per share will be 5.3% higher than before due to the reduced shares outstanding. This is a far better outcome than policy option (2).

The principle is the following: If a company is earning sustainable, long-lasting cash flows, it is to the benefit of shareholders that either the inherent business of the company has a capital outlay that offers higher returns on capital OR failing that, that the market value of the company’s equity is low to offer another conduit for reinvestment. Barring these two circumstances, returns should be given out as dividends.

This is unintuitive in that sometimes companies engage in really destructive practices with share buybacks. They are not universally good, especially if the future cash generation of the business is spotty. Likewise there are circumstances where buybacks work to massive benefit (a good historical example was Teledyne). However, in all of these cases, investors must possess a crystal ball and be able to forecast that the cash generation of the existing business (in addition to any other potential future capital expenditures) will be sufficiently positive over the required rate of return.

For example, Corvel (Nasdaq: CRVL) has a very extensive history of share buybacks:

The Company’s Board of Directors approved the commencement of a stock repurchase program in the fall of 1996. In May 2021, the Company’s Board of Directors approved a 1,000,000 share expansion to the Company’s existing stock repurchase program, increasing the total number of shares of the Company’s common stock approved for repurchase over the life of the program to 38,000,000 shares. Since the commencement of the stock repurchase program, the Company has spent $604 million on the repurchase of 36,937,900 shares of its common stock, equal to 68% of the outstanding common stock had there been no repurchases. The average price of these repurchases was $16.36 per share. These repurchases were funded primarily by the net earnings of the Company, along with proceeds from the exercise of common stock options. During the three and six months ended September 30, 2021, the Company repurchased 165,455 shares of its common stock for $25.6 million at an average price of $154.48 per share and 284,348 shares of its common stock for $39.8 million at an average price of $139.81, respectively. The Company had 17,763,576 shares of common stock outstanding as of September 30, 2021, net of the 36,937,900 shares in treasury. During the period subsequent to the quarter ended September 30, 2021, the Company repurchased 49,663 shares of its common stock for $8.7 million at an average price of $176.02 per share under the Company’s stock repurchase program.

We look at the financial history of the company over the past 15 years:

This is a textbook example that financial writers should be writing case studies about up there with Teledyne (NYSE: TDY) as this has generated immensely superior returns than if they had not engaged in such a buyback campaign. Share repurchases made over a decade ago are giving off gigantic benefits to present-day shareholders and will continue to do so each and every year as long as the business continues to make money.

The question today is whether this policy is still prudent. The business made $60 million in net income and there stands little reason to believe it will not continue, but should the company continue to buy back stock at what is functionally a present return of 2%? The business itself cannot be scaled that much higher (they primarily rely on internally developed research and development expenses and do not make acquisitions).

It only makes sense if management believes that net income will continue to grow from present levels. One has to make some business judgements at this point whether the company will continue to exhibit pricing power and maintain its competitive advantages (in this respect it looks very good).

Another example we are seeing in real-time is Berkshire (NYSE: BRK.a) using its considerable cash holdings to buy back its own stock. In the first 9 months of this year, they have repurchased just over 3% of the company. There’s more value right now in Berkshire buying its own massively cash-generating options than there would be on the external market – the last major purchase Berkshire made was a huge slab of Apple stock in 2017/2018 which was a wildly profitable trade.

In the Canadian oil and gas industry, right now we are seeing the major Canadian companies deal with the first world problem of excess cash generation. They are all in the process of de-leveraging their balance sheets and paying down (what is already low interest rate) debt, but they are also funneling massive amounts of money into share buybacks.

For example, Suncor (TSE: SU) and Canadian Natural (TSE: CNQ) are buying back stock from the open market at a rate of approximately 0.5% of their shares outstanding each month. Cenovus started their buyback program on November 9th and intends to retire 7% of shares outstanding over the next 12 months. The financial metrics of these companies are quite similar in that with oil at existing prices, an investment in their own stock yields a far greater return than what you can get through the uncertainty of opening up a major project (good luck getting through the environmental assessment!). My estimate at present is around 15% return on equity for these buybacks and needless to say, this will be great for shareholders.

It is why an investor should want low equity market values as long as these buybacks continue and the pricing power of the companies remain high. In the oil patch, this of course requires a commodity price that by all accounts should remain in a profitable range for companies that have had their cost structures streamlined and capital spending requirements that have been curtailed due to a hostile regulatory regime. The returns from these share buybacks are likely to be immense, barring a collapse in the oil price.

The MEG Energy Takeover Sweepstakes

Following up on my article “When will Cenovus or CNQ buy out MEG Energy?

Things have evolved since Husky Energy tried to take out MEG Energy at $11/share back in October 2018:

At the time of the Husky offer, WTI oil was at US$75/barrel, MEG had 297 million shares outstanding (today they are at 307 million), and they had $3.2 billion net debt (today they are sitting at under $2.6 billion). Annual production in 2018 was 87.7 kboe/d, while in 2022 it will be around 95-96 kboe/d.

By all accounts MEG is in better shape today than it was 3 years ago. Will it be CVE or CNQ to first offer a stock swap for a 30-40% premium over the current price?

The big hidden asset not readily visible comes from the following two paragraphs on MEG’s financial statements:

With WTI at US$70/barrel, it will take a very, very long time to dig through these tax pools. Simply put, $5.1 billion in non-capital losses represents an additional $1.2 billion of taxes that can be bought off in an acquisition. With the way things are going, Cenovus will be able to eat through their tax shield mid-decade (they also inherited a tax shield from the Husky acquisition), and CNQ’s tax shield is virtually exhausted at this point (they did acquire some with their announced acquisition of Storm Resources on November 9th, but this will go quickly as Storm had about half a billion in operating loss and exploration credits).

Either way, this tax pool is a ‘hidden’ asset and will bridge the differential between the current market value and a takeover premium. Since valuations in the oil patch are still incredibly depressed (enterprise value to projected free cash flows are still in the upper single digits across the board), a stock swap makes the most sense.

Operationally this is the most likely course of action – without a major capital influx, MEG is constrained to around 100kboe/d of production and things will be pretty much static for them after this point. The only difference at this point is whether Western Canadian Select valuations rise (having Trans-Mountain knocked out for two weeks did not help matters any) and what the final negotiated value will be. The acquiring entity will be able to integrate MEG’s operations to theirs quite readily and shed a bunch of G&A after they pay out the golden parachutes.

Needless to say, I’ve had shares of this at earlier prices.

Large Cap Canadian Energy

A briefing note. I do not think any of this thinking below is original by any means, but it needs to be said.

On May 26, Suncor (TSX: SU) guided at WTIC US$60 in 2021 and US$55 in 2022 (which is presently US$68 and US$62 for the year-end contracts, respectively) a free cash flow of $7 billion. This is after a $3 billion capital expenditure in 2021.

The guidance was notable in that the 9 megabyte slide deck they provided went through great pains to downplay the amount of cash they actually were going to generate (in typical Canadian fashion, it is like they are embarrassed to admit they are making this much money), but let’s play along.

Suncor’s enterprise value is about CAD$60 billion, about $45 billion market value and $15 billion debt.

Let’s do some basic math. This is grade school finance.

It means if the company can produce cash at the present rate (which, in general, they can given the nature of what they are mining at the present capital expenditure rate), if directed to debt and equity, they will be able to pay off all their debt and repurchase their entire share stack (at current prices – it will rise over time) in 8.5 years.

This doesn’t include changes in the selling price of oil, which the above figure is currently below market.

This is a little more complicated to calculate the sensitivity to commodity pricing. Companies give out sensitivities and for every dollar on Brent (not quite WTIC, but deeply correlated), Suncor changes its funds flow through operations by about CAD$300 million. Very roughly, subtract royalties and taxes (no more tax shield, they made too much money already) and it is about CAD$200 million leftover.

I note that at current pricing, an $8 positive oil price difference over the model (note: do not confuse with the Canada/USA differential) changes the 8.5 years alluded to above into about 7 years.

You just need to make the assumption that oil pricing will stay steady.

If this is the case (or heaven forbid, oil rises even further), Suncor is ridiculously undervalued.

This doesn’t even factor in the WCS/WTIC differential, which is likely to close once Line 3 is completed (end of the year) and TMX is finished (2022?). This will be the freest money for all stakeholders involved. An extra US$5 off the differential (it is now about US$15) on Suncor’s capacity is about US$1.5 billion a year – suddenly 7 years now becomes 6 years.

Not surprisingly, the company is buying back stock like mad, probably because there isn’t anything else they can really do with the excess cash flow.

In the past couple months, they’ve bought back US$375 million in stock, 17.2 million shares (about 1.1% of the outstanding). They should aim to buy back the maximum they can at current pricing.

As this continues, the stock price will rise and make future buybacks less attractive. After the appreciation, they should jack up the dividend.

Normally businesses would also invest in capital expenditures, but in Canada, we are closed for business for any significant natural resource projects. We mine what we have left, which makes the decisions easy – harvest cash.

What is the thesis against this?

The obvious elephant in the room is the sustainability of oil pricing.

I have no doubt in 100 years from today that fossil fuel consumption, one way or another, will be seriously curtailed. It will likely be too expensive to use in most applications that we see today.

But in 8.5 years? Get real. Oil sands reserves are measured in decades.

The other obvious component of “Why are they letting me have it so cheap?” is political correctness in the form of ESG. Much demand is sapped because of this. Many institutions cannot touch oil and gas, including Berkshire Hathaway.

Eventually through buybacks and dividend payments, the market will adjust this.

The margin of safety here is extremely high and nothing comes close in the Canadian marketplace, at least to anything with over a billion dollar market cap.

The same reasoning above also applies to Canadian Natural Resources (TSX: CNQ) and Cenovus (TSX: CVE). They are also in the same boat in terms of their FCF/EV valuation, and also with similarities in their operations. Once they reduce leverage, they will be buying back stock like crazy if it is still at the current price. I don’t know how long this will last.

Sometimes things are so obvious in the markets you really wonder what the trick is, but with this, it is the closest thing I can think of picking up polymer cash notes on the street. Efficient market theory would tell me that those cash notes wouldn’t be there. Perhaps traditional finance theorists might be right, we will see. At least I can take some solace when I am at the gas station and seeing record-high prices.

When narrative and reality collide – ESG, politics and markets

One rewarding aspect of finance is that participants that correctly perceive reality are eventually rewarded with additional capital, provided you stay solvent longer than the market remains irrational.

As markets are an amalgamation of sentiment, there is an element to psychological timing with regards to asset prices. The prices that are currently seen represent the baked in assumptions of marginal buyers and sellers, each trading with their own motivations – some extremely short-term, some extremely long-term. Another vector is the advent of environmental, social and governance (ESG) driven investing. Formerly labelled as “socially responsible” or “ethical” investing, ESG has generalized this to refer to politically correct practices.

As the politicization of financial markets continue, it is obvious that a focus on ESG and politically sensitive institutional investors (e.g. public pension plans and the like) will take a factor in investment decision making. This has long-since been baked into certain asset prices. Political favourites, such as renewable energy initiatives, have resulted in such assets receiving premium valuations and hence low returns for current investors. Such assets are typically aided by government subsidies (in the form of attractive power purchase agreements, or in the case of Tesla, outright tax breaks and subsidies).

This sort of gaming goes on all the time in most industries, as participants jockey for position. Large entities try to assert control through rent-seeking techniques. Nothing is a better example than how various entities are reacting to COVID-19 – companies such as Amazon are cheering for continued lockdowns as they continue to eat away at conventional retail. The medical industry, both private and public, are cheering their nearly unassailable position as nobody can question the quantum of spending in relation to the overall benefit – “anything to save a life” is the current expectation. By the time it comes to pay the bills, the blame will be attributed to other factors.

On the flip side, we have the ‘enemies’ of ESG, which generally constitute a list of firms in politically incorrect industries. One of these industries that are deeply politically incorrect at present (especially in North America and Europe) is oil and gas exploration.

When looking at core valuation of the major Canadian oil and gas firms, there is a major valuation gap between what the ambient market is offering versus what cash is being generated by the companies in question.

For instance, Canadian Natural Resources (TSX: CNQ) gave out guidance on May 6, 2021 that assuming a US$60/barrel of West Texas Intermediate (right now it is US$63.50 on the spot contract), they will be able to generate around $5.7 to $6.2 billion in cash flow, and this is after their capital expenditure and dividend payout (which is another $5.4 billion). Backing out their $2.2 billion annualized dividend to zero, that’s around $8.2 billion in free cash flow (FCF).

Recall that CNQ’s enterprise value is currently around $67 billion, so a rough valuation would be an EV/FCF of 8 times. This means if things continue at current prices, CNQ could pay down all their debt and buy back all their shares outstanding (at current prices) in 8 years. This isn’t an isolated case. The other Canadian large players, Suncor, Cenovus, Tourmaline, are roughly the same (plus or minus one or two points). There are no other ‘substantially Canadian’ plays that have a market cap of above $5 billion at present (Imperial Oil is 70% owned by Exxon, and Ovintiv, the former EnCana, is now primarily a US producer).

You cannot find valuations like this anywhere else on the large-cap market. A typical utility such as Emera (TSX: EMA) trades at roughly 18 times EV/operating cash, never mind capital expenditures! Royal Bank (TSX: RY) trades at 15 times earnings. Perhaps the only outlier I can find in this respect is E-L Financial (TSX: ELF), which posted a 2020 net income of $129/share (on a current share price of $948).

Needless to say, Canadian Oil and Gas looks cheap, and one reason for this (other than the horrible regulatory climate) is the investment ineligibility due to ESG. The irony is that this creates opportunity for returns for those that want higher returns, such as international investors that do not take North American ESG into their investment consideration.

I can think of one analogy in the past which reminds me of today – the plight of tobacco companies in the late 90’s. Tobacco companies (most specifically, Philip Morris) were vilified in the 90’s for having the gall to produce a product that caused lung cancer and collectively denying it until they had lost all public support. The watershed moment was a US$200 billion settlement with the states in 1998, but in reality, this agreement secured incumbency rights for the existing players. The Philip Morris example (now known as Altria) has them earning $3.20/share in 1999, while the stock closed at $23/share for the year. They bought stock like mad during the dot-com boom and shareholders got very rich. Incidentally, Philip Morris was right up there with Microsoft in terms of generating shareholder value over decades (not really the case today anymore, although tobacco continues to remain very profitable).

I’m going to make a much looser analogy with Warren Buffett buying Apple stock in 2017 and 2018 (at his cost basis of $34/share to the tune of some 907 million shares he currently holds today) is giving him a current earnings yield of about 15%. There are of course key differences – with Apple, you have to assume they can continue selling iPhones, iPads, Macbooks and ‘iApps’ at their monstrously high margins indefinitely. With oil and gas you have to make an implicit assumption that the underlying commodity prices will stay steady. This is another argument for another post, but please humour me by granting this assumption.

Buffett, by virtue of his size and relative fame, is constrained by political considerations. The cited justification for selling off his shares in airline companies at the onset of the COVID-19 crisis was politically motivated – the chances of airlines getting public money bailout with (deep pocketed) Berkshire being a 10%+ shareholder was much less, so they had to sell (I am not sure if this is retrospective analysis that actually went on during the sale, or whether it was a simpler case of the original investment thesis being broken). This is not the only example.

In the most recent 13-HF, we had Berkshire disclose that it had sold half of its Chevron stake and all of its Suncor. Chevron is obviously going to be completely divested by next quarter. There is nothing in Berkshire’s public holdings that relate to oil and gas production going forward. This is very intentional, and I believe it is for political reasons.

Buffett is the son of a former US Congressman and should know a lot about the political dynamics that is going on with ESG currently. There were two shareholder resolutions that came up during Berkshire’s last annual meeting. One was from Calpers and the Quebec Pension Plan, two very credible institutional investors:

In order to promote the long-term success of Berkshire Hathaway Inc. (the “Company”) and so investors can understand and manage risk more effectively, shareowners request that the board of the Company publish an annual assessment addressing how the Company manages physical and transitional climate-related risks and opportunities, commencing prior to its 2022 annual shareholders’ meeting.

The other (from a generally unknown proponent) was:

Shareholders request that Berkshire Hathaway Inc.’s (“Berkshire Hathaway”) holding companies annually publish reports assessing their diversity and inclusion efforts, at reasonable expense and excluding proprietary information.

Normally such shareholder resolutions get voted down, heavily. The Board of Directors almost universally recommend a vote against such resolutions.

However, the actual results of the votes got somewhat close:

There were approx. 548,000 votes cast in the meeting (some votes are not cast due to them being held by brokers that do not vote). The directors control 272,900 of the votes (the vast majority of this is from Buffett himself). So the vote result was a foregone conclusion.

However, excluding the directors’ votes, both resolutions passed with a slim majority.

This has to be interpreted to be a warning shot across the bow to Berkshire and almost any other corporation out there with a large public presence. They are not immune from activist politics and the politics driven behind institutional shareholders.

You can imagine how Buffett might be frustrated in not being able to deploy capital into a field that is liquid enough to make an impact on Berkshire. However, with the world examining his holdings every quarter, he must take politics into his investment considerations.

ESG, just like most political interventions, cause market distortions between perception and reality that can last for years if not decades. Hundreds of billions of dollars of capital are being invested not with a return in mind, but rather with a heavier consideration to other factors, including those that are acceptable today (which may or may not be acceptable tomorrow). Pharmaceutical companies were completely vilified before COVID-19, and now they are being showered with immunity from Covid vaccinations and have a gigantic regulatory shield to work with (until they are no longer in favour again for making outlandish profits). Today’s enemies are those relating to climate change, but this may change in the future as demand for fossil fuel energy outstrips available supply.

I am not making a moral judgement on ESG and its intentions. I am claiming, however, that ESG-driven considerations are causing significant distortions in the returns of investments that would have not otherwise existed.

Ultimately for equity investors, cash flows will dictate returns. It might take some time for political fashions to turn, but just like Philip Morris investors in the late 90’s, they were very well rewarded. Eventually the paydown of debt and payments of dividends and buyback of shares trading at single digit multiples will result in higher equity pricing, no matter which trends are politically correct.

Canadian Energy Update

Here is a quick post on the state of Canadian energy production companies – especially as the federal government continues to destroy the industry. As of September 30, 2020 there are 12 companies listed on the TSX that are over a billion dollars in market capitalization. There are 24 between $100 million and $1 billion, and some of these names are in very bad shape indeed. Also out of these 36 companies, some are TSX listed but have the majority of their operations outside of Canada.

For this post, I will focus on those above $1 billion. Companies that are under this threshold are still invest-able but one has to pay careful attention to whether they will survive or not in the hostile regulatory environment.

If your central thesis is that fossil fuels are going to decline and die in a relatively short time-frame (e.g. 20 years) then you probably won’t want to invest in any of these. Demand destruction will impair pricing and the ability to produce supply will not accrue excess gains to any names.

However, this is not going to be the case from a simple perspective of energy physics (laws of thermodynamics if anybody is interested in studying). Renewable sources do not scale to the magnitudes necessary. It also costs massive amount of up-front investment to implement renewable energy sources. It is relatively easy to ramp up energy usage from 0% to 5%, but above this, it becomes very obvious what the deficiencies are of renewable power sources (California discovered this in the summer). Putting a long story short, the more renewable (intermittent) sources you have on a grid, the better will be for on-demand generation sources – this means either you go with natural gas (fossil fuel!) or hydroelectric (we’re mostly tapped out in North America). Batteries make sense in smaller scale operations but not in state-province level grids. Or you can rely on imports, which just like liquidity during a stock market crash, is generally very expensive or not even there when you need it the most.

With respect to transport fuels, we will classify this as passenger, freight and aviation. For passenger vehicles, we all see Teslas and the like on the road, but the infrastructure required to refine and produce the battery materials to replace a substantial portion of the automobile fleet is still a long ways away. For freight, battery-powered transport automobiles are an illusion due to the requirements of existing freight haulers (you need to be able to transport 80,000 pounds of goods at a long distance and also cannot afford to spend 12 hours at a charging station to refuel).

My opinion will change if nuclear becomes a viable option again for power generation (from a political and cost perspective, not a technical perspective).

Some pithy notes (these are the C$1B+ market cap companies):
SU, CNQ – Clearly will survive and represent playing a very long game. Personally like these much more than the big majors (e.g. XOM, CHV, COP, BP, etc.).
IMO – Majority foreign (US) held (XOM), wonder if they will make an exit
CVE – The best pure-play SAGD oil sands player (maybe to be contaminated by HSE acquisition)
TOU – Spun off another sub, largest of the Canadian NG players, FCF positive
HSE – Soon to be bought by CVE – will be interesting to see how CVE makes more efficient
OVV – Mostly American now, with big major style culture and cost structure (i.e. $$$)
ARX – Second NG/NGL play, FCF positive
PXT – Substantively all Colombia operations, that said their financial profile is quite good relative to price
PSK – Royalty Corp (royalties are not my thing – just buy the futures, although pay attention to price, if they get cheap enough, royalties are typically a better buy)
CNU – Chinese held, illiquid security
VII – Liquids-heavy gasser, FCF positive (barely), a bit debt-heavy