Are all energy stocks undervalued?

The buyback craze suggests some are not

There is a rash of Canadian oil & gas companies rushing to buy back stock in a market where free cash flows are robust and money managers like Eric Nuttall are urging companies to “return capital to shareholders” through dividends (which do make sense) and buybacks (which do not). Free cash flow is only “free” once debt has been repaid and cash not needed for operating the company and meetings its production objectives should be used to fund dividends in my opinion.

Buybacks are another story. The money is not being “returned to shareholders” but is being paid to “former shareholders” who have decided to get out and take the company’s buyback offer whether made through a Normal Course Issuer Bid or Substantial Issuer Bid. Regardless of whether a company uses its surplus cash for dividends or buybacks, that money leaves the treasury of the company. What is left is a financially weaker (not necessarily weak but certainly weaker) company. The recipient of the cash receives a risk free asset and the shares of the company have more risk than before the funds left. With fewer shares outstanding, trading in the shares post buyback will be less liquid. Expecting the buyback to increase the share price is generally a bad bet. There are exceptions but in reality they are rare.

The concept of valuation of a company as the present value of future dividends first gained acceptance around 1938 when John Burr Williams put pen to paper to describe this approach to valuation. As a set, all investors get from a company is dividends. Sure, the composition of the set of investors can change but gains and losses between those who buy and those who sell is a zero sum game. Increasing value can only come from a higher present value of future dividends. For buybacks to add value, they must imply a greater flow of future dividends and since the money has been disbursed (as it has with dividends) that greater flow boils down to the same flow but with fewer shares participating. The buyback has added no value, just affected the arithmetic on who will benefit.

The idea that the shares of all companies in a given industry are “undervalued” which seems to be the conventional wisdom regarding Canadian oil & gas companies today is a bit absurd. Markets are pretty good at price discovery and the market as a whole is valuing the energy names at where the consensus of buyers and sellers is the prevailing price. The investors who believe a particular stock is undervalued are offset by other investors who think the shares are overvalued and the equilibrium of those views is the current share price. That is how markets work.

When you are excited about company’s in which you hold shares announcement they will buy back shares, you can safely conclude that (a) the managers see a benefit for themselves in the buyback and (b) if the shares are in fact undervalued there must be a lot of investors who are missing something that you are fortunate enough to see. Ask youself, what precisely is that something and why are you seeing it but the market as a whole is not?

We have all seen Eric Nuttall’s impressive analysis in charts that show the low multiples at which energy names are trading and listened to his almost evangelical claims that this is a “generational opportunity” to invest in energy. And he may well be right.

We have all been impressed by Eric’s analysis of how little time it would take these names to “go private” if they could do so at today’s commodity prices and stock trading prices.

So ask yourself, why are these stocks all trading at such low prices? Then ask yourself what you think would happen to oil and gas prices if:

1. Vladmir Putin decides to use nuclear weapons in Ukraine and launches one? [Putin has threatened to do so, I say the risk is as high as 10% that he does]

2. Interest rates rise into the double digit rates of the late 1970’s and the world economy collapses into a deep recession? [Inflation rarely abates until real interest rates (rates less inflation) are positive, and that implies double digits. I put the risk of a deep recession at 20%].

3. Joe Biden suffers a heart attack or other issue and dies? [The risk of death of an 80 year old in the next year is about 6% from all causes].

4. An earthquake shakes Japan and a tsunami destroys Japan’s coastal industries including (in a repeat of Fukishima) its nuclear power plants? [I put this risk at 1% - that is a once in a century risk].

5. China invades Taiwan? [I put this risk at 2%, arbitrarily].

6. A new highly transmissible and highly toxic variant of COVID that is resistant to existing vaccines begins to circulate? [I put this risk at 1%, arbitrarily].

The joint probability that one of these events will happen is 1-(.9 x .8 x .94 x .99 x .99) = 34%. A one in three chance over the next year if you buy my estimates of probability. I bet this is higher than you thought.

All of these events are possible while none are likely. But there is no doubt any of them would roil markets and energy names would trade for a fraction of today’s prices. Fair value for an energy company is often seen as 4 x EBITDA. Weight that with a 34% chance of a major risk factor in the next year and fair value might be 2.64 x EBITDA, about where some of the cheapest of the names Eric lists trade today and an indicator that the 10 names on the right of the chart may be overvalued. I have sold my positions in MEG, CVE and SU owing to their buyback plans.

Savvy investors recognize that risks are real and in times of great uncertainty build cash positions to protect themselves as well as be in a position to buy stocks when there is “blood on the street”. I always keep cash in reserve. It came in handy in the spring of 2020 when COVID caused a massive sell off and I was able to buy Birchcliff at CAD$0.88; Peyto at CAD$1.04; and, Whitecap at $0.90 a share. Had I not had cash that would not have been possible. I still hold those positions which now provide CAD$0.60 per share in dividends for Peyto; CAD$0.44 per share for Whitecap; and, an expected CAD$0.80 per share for Birchcliff. I hold 90,000 Birchcliff; 25,000 Whitecap; and 20,000 Peyto and my dividend income next year on these three holdings should be $111,000 on an original outlay of $122,500, an annual return over 90% my cost.

The problem with buybacks is you either have to sell into them (and cut your investments when management thinks they are undervalued) or keep them (and run the risks I mention. A dividend has the same effect on the company’s balance sheet as a dollar for dollar buyback but a different effect on each investor - it adds to their cash reserve and they can choose when to spend the dividend and on what. This is a serious difference.

Eric and his throng of fans should get off the “buyback” train which is based on a belief (that may prove both right or wrong) that the tailwinds in the energy industry have legs. A solid cash reserve benefits you whether the hoped for increase in commodity prices materializes and manifests itself in higher returns on your existing energy holdings or commodity prices tank and you can add to those holdings at favorable prices.

Buybacks and trading have in common a requirement to time the market. No one I know has ever been successful over the long term with a trading strategy, and for the market as a whole one person’s gain is another’s loss. Buying value at distressed prices, holding those stocks for the long term and benefitting from an enduring dividend stream is an investment strategy. Trading is a betting game.

As a one time boxing champion, I can tell readers that the punch that knocks you out is the one you don’t see coming. Who expected COVID in 2020? Who expected Paul Volker to made a radical change to Fed policy in 1979 that led to a massive market sell-off in 1982?

The recent “buyback” craze in the oil patch may work out but I doubt it. Energy CEO’s have no track record in calling markets, as many have demonstrated with disastrous losses on their hedge books. There are too many investors wanting buybacks and too many risks to the economy and to markets to provide me enough comfort to buy into “buybacks” so I avoid those companies whose primary way of returning money to shareholders is through issuer bids. My preference is for companies whose management has the common sense to repay debt and then pay excess cash out in dividends keeping a cash reserve in the company to deal with surprises.