Can You Make Money Investing In A Commodity Business?
Before we run off into the numbers, I wanted to give a quick overview of Graham-style value investing to set the stage. If you are already familiar with value investing, you can skip down to the case study below.
Arguably the three most important concepts in value investing are thinking about buying the entire business, Mr. Market, and margin of safety. I’ll explain each briefly below:
a) Think Like a Business Owner:
It is easy to forget that buying stocks is the same as buying a part-ownership of a business, but that is exactly what it is. You are not just trading ticker symbols like lottery numbers, but rather investing your money into an enterprise that you hope will generate good returns in the future.
One good way to keep this in mind is to imagine that you have enough money to buy the entire business and to ask yourself if you would do so at the current price.
Tesla, which only recently started making a profit, is selling for a market cap of almost $850 billion. This is some 154 times the net profit it earned in 2021, meaning that $10,000 invested in Tesla today only got you just under $65 in 2021 earnings.
Compare that to Apple, which even after a massive price increase is selling for around 28 times earnings. $10,000 invested in AAPL buys you almost $360 in 2021 earnings or more than five times more earnings per dollar invested than Tesla.
Now, Tesla might compound at a faster rate (or it might crash and burn), but if you wanted to buy an entire company, would you prefer to buy Tesla with moderate earnings and a highly uncertain future at a sky-high price, or Apple with much stronger earnings and a solid future at a much more reasonable price?
If you think like a business owner rather than a trader of ticker symbols, you will start to change the way you make investing decisions.
b) Mr. Market
The second critical concept to understand is Mr. Market. This is how Benjamin Graham personified the variability of the market on a day-to-day basis.
He encouraged us to think about being in business with a manic-depressive friend. On some days he would be depressed about the business, see no future in it, and offer to sell you his half at a low price. Other days he will be all pumped about the same business, optimistic about its future, and offer to buy your half for a high price.
The underlying business itself is the same in both cases, but some days he loves it and some days he hates it. This is what allows us to buy and sell securities at prices different from their value.
In the past month, Apple stock went from $182 per share to $155 per share and back up to $170 per share. Well, Mr. Market, which is it? The same company cannot be worth 15% less and then 10% more in the space of a couple of weeks.
The point is, people react to news differently, and many overreact. If you know the value of a company, and you patiently wait, you may one day see it selling for a price that is “too good to be true”. That is how you can take advantage of market fluctuations, selling again in the future once the market has realized the value of the company once again.
c) Margin of Safety:
We can never know everything about a business. While the more we know, the better decisions we can make, we are much better off always investing with a margin of safety. This is called a “safety factor” in engineering.
Just as you hope the engineer who designed the bridge you are on made sure it could withstand a lot more cars than it actually sees, you want your investments to be able to withstand mistakes and unforeseen market circumstances that could otherwise cause you to lose money.
If you estimate a business to be worth $100 today and more in the future, you shouldn’t run out and load up at that price. You should patiently wait until the price falls for some temporary reason to a much lower number, ideally 50% less. If you buy a company worth $100 for $50 and wait patiently, chances are high that you will get a solid return on your investment.
Many things can go wrong: you may make a mistake in your calculations or assumptions, the business environment may be worse than you estimate or be down for a longer time, the company may struggle more than you estimated, etc.
If you use a large margin of safety, then you will be more selective of the companies you pick, and you will do better overall.
Now armed with a basic understanding of value investing, I will run through an actual investment I made last year in a commodity business with low growth prospects and show how it turned out.
Valero (VLO) is primarily a refiner and seller of transportation fuels in the US and a few international locations. Drivers in the US will know their service stations, which sell gasoline and related products at lower prices than the branded stations (Chevron, Exxon, etc).
As I started diving into companies during the early stages of the pandemic, looking for value opportunities, Valero popped up as the price had tumbled from around $100 per share down to less than $50 per share.
This was obviously in response to lockdown and people driving much less. But I believed the reduction in driving to be a temporary problem and wanted to dig further into Valero to see what I could learn.
I will summarize here for brevity but note that before Covid, Valero had an average return on equity of almost 15% and an average return on investment of almost 12%. Their nine-year average operating income was $4.2 billion on an average of $109.8 billion in revenue (3.9% operating margin).
As per the June 2020 10-Q (quarterly report), Valero had a current ratio of 1.7 and total debt of $12.7 billion, which though substantial could be paid off in under four years of average earnings. The dividend of $3.92 was also just under 50% of average earnings, meaning there was some room for earnings to go down before having to cut the dividend.
I won’t go through the entire process here, but I estimated the value of Valero stock based on the fundamentals of its earnings power to be around $90 per share.
The price for VLO as of Sept / Oct 2020, when I did the analysis, was under $50 per share. Mr. Market was worried about the shutdown from the pandemic impacting the bottom line of Valero. While I knew that the company would have problems, I had to think through if I believed these problems to be temporary or permanent.
This was not Valero being overtaken by a competitor or by electric vehicles, this was a reaction to a virus with unknown consequences. Having watched oil prices my entire career and also believing that life would eventually get back to some sort of normal, I made the judgment that the impact on Valero’s bottom line would be temporary, meaning it could have laster a few years, but not forever.
I’m always willing to hold a stock for at least three years to see if my analysis is proven right, which gives me a huge advantage over people and institutions that only focus on short-term results.
If you are worried about the short-term, then you have to sell Valero and other companies as their prices tank because you don’t know how long it will take to come back, even though you likely believe they will.
Since I believed that the impact on Valero’s business would be temporary, I didn’t see a huge shift in the long-term fundamentals of the company. I knew they could have a rough year or three, but I believed they would eventually get back to earning money as they had done before.
That being said, I was looking at a solid company with a great ability to generate earnings during “normal” times that was selling for a significant discount to its value based on what I presumed was an over-reaction to the temporary reduction in economic activity.
So I invested.
I purchased a total of 800 shares of VLO in Q3/Q4 of 2020 for an average cost of $49 per share. I entered these positions by selling puts, which I won’t discuss here in detail, but the numbers below are broken out to show the full picture.
- total investment = $39,200 ($49 / share)
- premium earned selling puts = $2,393.52 ($2.99 / share)
- net investment = $36,806.48 ($46.01 / share)
As discussed, I was planning on holding for 3+ years, but I found that within only one year the price had gone up to my calculation of intrinsic value as people realized that it wasn’t the end of the world and started driving again.
One note is that because Valero took on so much debt and had (predictably) poor results in 2020, my value estimate dropped to +/- $75 per share.
Valero paid around a 7% dividend yield on my investment while holding, and I also earned some additional premium selling covered calls to exit the position.
- dividends earned = $2,548
- premium earned selling calls = $1,730.21 ($2.16 / share)
- cash received selling shares = $57,999.46 ($72.50 / share)
- total cash received = $62,277.67 ($77.85 / share)
Altogether, this put my one-year return at around 69% on this transaction. This investment turned $36,800 dollars into $62,300 before tax.
Not bad for a “dead” style of investing, is it?