It's a lot of fun to reverse engineer Buffett. You can often tell a lot by second-derivative analysis of his deals. For instance, he didn't buy Heinz (HNZ) the stock, he didn't even buy Heinz the company, but he was happy to be part of a deal where he got paid the first call on cash flow (in the form of interest) and would participate substantially on any upside. When you take a step back and think about it, he might be saying that he still really likes consumer brands as businesses, thinks their cash flows are stable, thinks they might get the growth they are looking for in emerging markets (although he doesn't want to be the one out on a limb), but doesn't want to put money directly into their equities at the current prices. So you have a wise view not just of a company but of a whole sector. You can infer his confidence level in ongoing business, the level of discount he applies to the growth story, and his lukewarm view of the current valuation. You can do the same with his restructuring of the Goldman Sachs (GS) options: willing to take his profits in Goldman shares, unwilling to lay out new money for a bigger Goldman position. There's a clear nuanced message.
So how about Buffett putting close to 4 billion into Exxon (XOM)? First of all, was it Buffett himself? Well, I think so. The two new guys have been great, but they are jazzier than Buffett, looking for more unusual mispriced stocks requiring a kind of analytical detail that Buffett used fifty or sixty years ago more than today. Also, 4 billion would be huge size in the portfolios they currently command, especially for a dull company like XOM. So I'm pretty sure it was Buffett himself, as he is the guy with at least 25-30 billion investable cash he's getting zero return on and no deals on the immediate horizon. If it wasn't Buffett I promise a future article on why I was wrong.
Buffett has a mixed record when it comes to timing oil investments. I know this, you know this, so I am fairly sure Buffett knows this. Buffett is the kind of investor who admits his mistakes and learns from them, so I am pretty sure he didn't buy Exxon because he believed he had any special insight into the workings of the oil market. The future price of oil is an area in which he probably assigns standard probability distributions with a large range of possible error. So it's probably not a bet on the immediate, or even the distant, future of oil prices.
So: why Exxon and why Exxon NOW?
Exxon and Berkshire Hathaway
Exxon and Berkshire Hathaway (BRK.B) are quite possibly the two most similar large companies in the world. What makes them so similar is that the invisible driving force behind them is and has been for a very long time exactly the same: return on capital employed (ROCE). It's such a simple thing that you might argue that it is the foundation of all businesses, and by that standard all businesses are exactly alike. Except for one thing: they are not. ROCE is not an article of faith but an article of bad faith in the majority of corporations. For lots of reasons, many of them self-aggrandizing and empire-building and others merely stupid, almost all managements fall short in their emphasis on ROCE.
Only a handful of businesses are rigorous in emphasis on ROCE, and the two at the top of the list are Exxon and Berkshire. It's not an accident that they have arrived near the top of the heap by market cap. Buffett has always said that his primary skill - the skill that translates directly from picking stocks to running a large company - is his skill as a capital allocator. Lee Raymond, the immediate predecessor of current Exxon CEO Rex Tillerson, made ROCE - roh-see, as he pronounced it - THE word among Exxon managers. And Raymond built upon a focus which had shaped Exxon over the VERY long term.
When looking at stock price CAGRs over the very long term you can see ROCE in action. ROCE as a company aggregate is return on invested capital (ROIC), and a company's growth rate over the long haul is pretty much its rate of compounding ROIC. Stock prices fluctuate with market fashions, of course, but companies that stay around and vital for a long period tend to have a stock price CAGR that closely resembles their long term ROIC. Exxon and Berkshire both have very persistent long term stock price CAGRs (a good place to look this up is the BMW Method site set up to compare current stock prices to CAGR channels bounded by one and two standard deviations). The CAGRs of Exxon and Berkshire are close to their long term ROIC numbers, and both companies, incidentally, have tended to hug the central CAGR much more closely than the market as a whole - Exxon remarkably so until the last five years or so. Inverting, both have relatively low volatility.
I think focus on ROCE is the number one similarity between Exxon and Berkshire, but there are two others worth noting. Both stand out for the quality of managers and employees at all levels. I first learned this about Exxon about thirty years ago when I called a number of recent Exxon retirees for help with a project in Indonesia. I was absolutely stunned by the level of honesty, the straightforwardness, and the keen intelligence I encountered. Simply put, they were classy. They radiated competence - the world's most underrated quality - and had a friendly willingness to share their knowledge. Buffett is famous, of course, for hiring people like this and buying companies run by people like this. He then leaves them free to run things with only two rules: integrity and ROCE.
The third similarity between Exxon and Berkshire is focus on the long term. Anyone who wants to assess the future of the oil business should start with Exxon's forty-year estimates. Never mind that the present work force will mainly be retired or dead. Exxon is like the Marine Corps: Marines die, but the Corps goes on. Exxon thinks like that. So does Buffett. Every brick in the edifice of Berkshire has been set in place for the day when Buffett himself is no longer around. He knows which businesses are growing, which are stable, and which are declining, and he knows how he thinks about each of them, and what he or his successors should do about them.
So Why NOW?
I have owned a significant position in Exxon quite a bit longer than Buffett, but I think some of my reasons may be the same as his. To own Exxon is to believe (1) that the energy business has a long term future which will generally not be too different from its recent past and (2) the stock is priced to provide a risk-adjusted return on your own investment capital competitive with other good investment opportunities. The risks with Exxon include (1) the increasing difficulty in replacing reserves at reasonable cost and (2) the outlier Al Gore argument that an increase in public alarm about environmental harm will lead to negative changes for energy companies and produce "stranded assets." The first threat is obvious and real. The second is unlikely but cannot be entirely dismissed.
I think Buffett accepts the two reasons to own Exxon pretty much as I do. I think he has taken the problem of reserve replacement into account and is not troubled by it. I also believe that he probably feels that we should be open to changes in our way of living in order to save the environment, but that radical changes to the energy industry are not likely any time soon. In any case the two positives and two negatives have been around for quite a while. What is different RIGHT NOW?
For one thing, the market has been angry with Exxon, and to a large extent angry for the wrong reasons. The acquisition of XTO for 41 billion of precious Exxon capital is often cited as the big mistake. I agree that Exxon paid a good bit more than it might have, with better timing. On the other hand XTO was a huge asset and would have been hard to construct out of smaller deals if it had gotten away. It also fits the Exxon long view. Natural gas assets may be a drag at the moment, but they may be a very good thing to have as the environmental problem deepens and natural gas becomes the bridge fuel available in meaningful quantity. For many decades the stock CAGR of Chevron (CVX), another wonderful company, was just a smidge lower than Exxon's, as was its ROIC. After the XTO deal Chevron began to forge ahead, benefiting from being an "oilier" oil stock and also from an apparent advantage in reserve replacement.
But let's look at this from Buffett's perspective. Maybe XTO was a bit of a mistake, or looks like it at this moment, but even if that is so, Exxon shot itself in the foot, not in the head. Think of this: on its 40-year price CAGR (in the case of both oil giants very close to ROIC) Chevron is sitting right on fair value while Exxon is sitting two standard deviations below it. Did Exxon screw up badly enough to knock its value down this far? If not, Exxon may be radically undervalued.
As for the problem of replacing reserves, there are two ways of looking at that. I'm sure that Buffett would like for Exxon to replace 100% of its reserves annually, or more. So would I. But at what cost? The ROCE principle very much applies. Where does Exxon get the most bang for the buck? Exxon takes a cool and balanced view. It wants to stay in business, but it doesn't want this in such a panicky way as to get silly about it. What Exxon does is buy back shares, which at current prices, in the Exxon view, provides excellent ROCE. I agree with this policy, and I think Buffett does too. When I see writers berate Exxon for not replacing reserves more fully, I think that they are forgetting part of the argument, but when I see writers who think Exxon should stop buying back shares aggressively and start paying out more as dividends I have to think that they are out to lunch.
Consider the impact of share buybacks on Exxon and Chevron (and I love Chevron too, and own both companies). Over the past ten years Chevron has bought back about 10% of its shares, which is nice, a little kicker. Over the past decade Exxon has bought back 31% of its shares, which is HUGE! What it means is that a shareholder who held his shares of Exxon over that period not only collected dividends and price appreciation but owns almost half again as much of Exxon the total company as at the beginning. Is Exxon slowly, incrementally, taking itself private? If so, it's OK with me, I would be happy to be one of the private owners, and I'm sure Buffett would too.
I believe that Buffett's principal reason for buying Exxon right now is that it is priced in a way that punishes it for virtues which the market misunderstands as vices. The slightly more ominous motive Buffett may have for buying Exxon right now is the as-against-what factor. What else could he buy with a comparable likelihood of decent return at relatively low risk? Most of the time the answer would have been: lots of stuff, just watch tomorrow's buyout news. But Buffett selected Exxon for his adopted child, picked it out of all the babies in the world. For Buffett to be buying Exxon fairly screams a message about his view of the market as a whole: his cash is earning squat, but he doesn't want to go very far out on the risk curve at current prices. I noticed, Warren. Others take heed.