When I'm searching for long term investments, there is one thing that I consider to be most important: Does the company have a durable competitive advantage? If it does, it doesn't matter as much if I buy it when it's a little overpriced. Over the years, it will outpace the market.
The second thing I look for is a tendency to return cash to shareholders. If the company buys back a lot of shares and especially if it pays dividends, that makes it that much more attractive. Over the long term, you can hold the company even when it is somewhat overvalued. The dividend it will be throwing off can be invested in more attractively valued securities, and you don't incur trading costs.
If you are certain there is a large value gap, you should still switch, of course. The final decision to buy any stock is dependent on the price being right. No matter what secure competitive advantage and huge dividend it pays, if the price is outrageous, you can't buy it and expect to outperform.
The energy space is very much on my radar lately. I think there are some bargains to be found there, and today I present you with three of my favorites and will explain why I like them:
|Enbridge, Inc (NYSE:ENB)||pipelines are like railroads||2.8%||54|
|Exelon Corp (NYSE:EXC)||largest fleet of nuclear power plants||5.85%||20|
|Exxon Mobil Corporation (NYSE:XOM)||economies of scale and low cost of capital||2.68%||11|
Exxon Mobil Corporation (XOM)
The most important competitive advantages that give Exxon its edge over smaller competitors are its low cost of capital and its economies of scale. Overhead required to run a global energy juggernaut is carried by operations totaling yearly revenues of $400 Billion, and that means operating margins others can only dream of can be achieved (14%). Smaller operators have a lot of problems achieving similar operating margins.
Its healthy cash flow, humongous market cap, diversified operations and reputation also allow them to drill the capital markets at rates that are hard to obtain for others. This gives them another advantage over smaller and less efficient competitors and allows them to further outperform with returns on equity.
Exxon is well known to return large amounts of capital to shareholders, and is a favorite of mine in that respect. As I wrote earlier this year: 6 reasons Exxon Mobil Is Currently A Buy.
With its P/E of 11, it compares favorably to the S&P 500 from a valuation perspective. If seen in the light of its financial position and track record of returning cash to shareholders, the company is a steal.
- Low cost of capital
- Economies of Scale
- Attractively valued
Exelon Corp (EXC)
Exelon derives its competitive advantage from its existing fleet of nuclear plants. Nuclear power plants produce energy at extremely low cost once they are up and running. They are also very clean from a emission perspective, which is an advantage in the current climate.
Perhaps going forward it will slowly dilute its competitive advantage by investing outside of nuclear energy, but currently, it has an asset base that can produce energy at costs that are impossible to match by other energy companies.
It takes years and years to build nuclear plants. In addition, the industry is under intense regulatory and community scrutiny. Together that makes it extremely hard, even when someone has the capital to go for it, to match the fleet of nuclear power plants Exelon owns.
The company's P/E is not that attractive, but given that it trades at only 1.1 times book value at a price/cash flow of 4.3 and throws off 5.9% of dividends, the company is still attractively valued, in my opinion.
In my article of October 1 on Exelon, I used a discounted cash flow model to estimate the true value of Exelon.
First, I tried to determine what more normalized earnings would look like - based on 10 years of historic earnings but adjusted for an increased revenue base - and then factored in a small growth rate from there for a short period of five years. What I ended up with were normalized earnings of $3.5 per share. I discounted against the S&P 500.
This exercise leads me to believe that $39 / share is not an unreal valuation for Exelon while it's currently trading at $28.61 That would mean the company is over 30% undervalued.
- fleet of low-cost to operate Nuclear plants that can't be copied
- undervalued by about 30%
Enbridge, Inc (ENB)
Enbridge's main competitive advantage is its wide network of pipelines. Once a pipeline is in place in a certain geography, it's pretty hard to compete with. It works the same way as with a railroad. If one is already in place, very often there is not enough demand to carry the development of a second one, but the first can do very well. Even if a competitor would want to build a copy of the initial pipeline, it's hard to get the regulatory approval, and the original pipeline can upgrade its capacity at lower cost than the development costs of the incumbent. Basically, a pipeline can operate as a monopoly in a specific geography, though its returns are somewhat limited by regulators and substitutions.
Valuing the company just by P/E is dangerous, as it trades at 44 times ttm earnings and a price/cash flow of 12 or 4.6 times book. This is not exactly reassuring that the company can be acquired at a fair price. However, ttm operating margins of just 5.9% are the lowest number it has posted over the past ten years, with the operating margin usually around 10%. Return on equity is also at its lowest in the past 10 years, with the average return on equity closer to 16% than the current 8%. Perhaps that return on equity is too much to expect from a much bigger company, but still I expect management to get the operation back on track. Especially because the company does have a durable competitive advantage with its network of pipelines.
- network of pipelines
- bad TTM numbers, obscuring potential
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.