One of the more persuasive pieces of Benjamin Graham's logic that I have encountered is the notion of buying stocks that are so attractively valued that, even if future growth is not particularly impressive, you can still achieve satisfactory returns. And if the future growth does conform to your expectations, well, you'll end up making a lot of money.
There are different ways that you can try to implement this strategy, but my preferred method is to follow the Peter Lynch approach of looking for companies that have a much better underlying economic reality than the prevailing reputation suggests. One such company that fits this criterion is BP (BP).
We all know the story of what happened with BP over the past few years. The oil giant had spent the 1990-2010 generation building a reputation as one of the no-brainer blue-chip investments, eventually becoming the source of 10% of the total pension income generated in Great Britain. After the oil spill happened, BP had to load its balance sheet up with debt, sell off significant assets, and address an ongoing set of litigation claims.
As large amounts of the dust have settled, BP's economic engine has continued to be more impressive than the headline risk might indicate: over the course of 2013, even after accounting for the asset sales following the spill, BP still has managed to generate $14.17 billion in net profits for shareholders (as a reference point: Coca-Cola (KO), which does business in 208 countries, brings in $9.2 billion in net profits).
The dividend of $0.57 per share is quite well covered in relation to the company's current profits. Right now, the dividend consumes about half of the company's profits: about $7.1 billion gets paid out in dividends while the company continues to pump out $14.17 billion. The management team must be seeing good things ahead in profitability, as they will continue to evaluate the dividend policy on an every-other-quarter basis (that's why BP has had three dividend increases in the past six quarters, from $0.48 per share to $0.54 to $0.57). There aren't a lot of places in the world where you can find a yield between 4.5% and 5.0% that is set to grow in the 8-12% range over the next five years, and therein lies the opportunity presented with BP stock.
The principal threat to BP's economic engine is that it could be forced to sell off more assets in response to a worst-case-scenario finding of "gross negligence" at trial for the oil spill. BP has indicated a willingness to divest $10-$15 billion more in assets if it needs to raise short-term money to pay off its legal obligations, and that could create a dilemma for the company to decide which assets to divest. Should BP sell its U.S. refining division, which is currently operating at a loss (as of the third quarter) and engage in the practice of "selling low"? Or does the company sell off highly profitable drilling assets that could demand a good price, but are a good source of cash flow to shareholders?
That kind of concern is compounded by the fact that BP's replacement rate is still hovering in the 75-85% range. That is problematic: energy companies target for a replacement rate above 100% because that means you are running perfectly sustainable operations for the long run, but when your reserve rate falls below 100%, then you are slowly depleting assets, and this is a condition that needs to be reversed.
Personally, I reached the conclusion that BP has the earnings power to weather the storm of the next few years. On its balance sheet, the company possesses 4.5 billion barrels of oil in proven reserves and approaching 35 trillion cubic feet of natural gas. And when you include the company's equity interests as well, you will see that the company has another partial claim to almost 6 billion barrels of oil and another 8-10 trillion cubic feet of natural gas. The breadth of these assets grants BP the flexibility and time to weather a potential $10 billion more in asset sales and the need to refocus on improving the company's reserve replacement rate.
In Wayne Gretzky parlance, investing is about investing to where the puck will be, rather than where it is. A high-quality company working its way through problems and enduring a low share price as a result can be a lucrative investment; even without the likely dividend increases over the next few years, investors are set to collect at least $6.84 in total dividends on every $48 share of BP purchased today. You're being paid respectable amounts of cash to wait for the damage caused in 2010 to finally clear. Even if the worst case legal scenario plays out and BP has to sell off $10 billion more in assets, BP still has the proven reserves to be a good investment at this price. And if these worst case scenarios don't play out, BP could be the investment of the decade for you as you benefit from a starting 4.5%-5.0% dividend yield that experiences rapid growth, and the P/E ratio adjusts upward to its historical range to reflect the storm clouds finally dodged.