Market participants often point to charts when making an argument. You'll have a hard time finding a 10-minute segment on financial television where no chart of some kind will be thrown at you. The same is true for all other visual media, be they books, newspapers or the internet. Some even think they are able to predict the future price of anything if they only have a chart of its past prices.
Personally, I like looking at charts like an historian or archaeologist. The charts tell you what has happened in the past, and how the valuation of an asset has evolved over time. It can also show you the value creation or destruction that has occurred over a period. Like any kind of historical artefact, financial charts can be very misleading or easily misunderstood or misinterpreted. Let me give you a brief but enlightening example.
In 1821, the English geologist Gideon Mantell discovered several large teeth and bones in Sussex that he thought were dinosaur fossils. Other prominent scientists of the time dismissed this idea, and thought they belonged to a more recent fish or mammal. Georges Cuvier even thought at first the remnants belonged to a rhinoceros. Mantell nevertheless held on to his idea and named his creature Iguanodon, since the teeth resembled those of an iguana. The scientific community gradually warmed to the idea and finally accepted the Iguanodon as a dinosaur. But again, they were misled in their interpretation of what had been found. The sharp and pointed spike that Mantell and others had found was placed as a “horn” on the nose of the skeleton. It was only about fifty years later, in 1878, that a sensational find of several complete Iguanodon skeletons in a coal mine in Belgium revealed that the “horn” was actually the animal’s thumb.
Like Mantell examining the few fossilized dinosaur bones at his disposal, the investor looking at incomplete charts can be lead to very erroneous conclusions. A chart is nothing more than a two-dimensional plot of a set of data – in the case of stock, bonds, commodities or other financial products it is usually a time and a price. The chart is thus only the graphical representation of a time series of prices. If the price of the financial product is impacted by external factors which are not inherently affecting the inherent value to the holder of the product, looking at the time series can give a very wrong impression of the return derived by holding such product. Normally, the charts could easily be corrected to reflect these external effects – but in my experience charts are very rarely adjusted to show the real return derived over time. When the dinosaur carcass lies rotting, no scavenging animal leaves a note detailing which bone it has removed.
The following “bones” are most commonly missing in stock charts:
- Dividends. On long-term charts, even small periodical dividends can add to a substantial effect over time. Large “special dividends” often leave the impression of a crash in stock price when in fact no such thing has occurred.
- Stock splits. These are mostly corrected in charts when the effect is obvious, like a 10:1 split. However it is very often not corrected in the case of smaller “bonus issues” like a 11:10 split. Some utility stocks often periodically issue such bonus issues or stock dividends, and the effect of the issue is often not reflected in the historical prices.
- Spin-offs. Sometimes companies distribute stock of subsidiaries to shareholders rather than selling the company or offering stock to the public. Such a distribution, while not changing the value of a shareholder’s total holding at all, can have dramatic effect on the stock price chart – and the effect is almost never corrected. Look at a long-term chart of Altria (MO). You will often see a sharp decline in the price of the stock in March of 2007 and 2008 – that was when Kraft Foods (KFT) and Philip Morris International (PM) were spun-off to shareholders. Even when the value of the spin-off on the day of the spin-off is accounted for, the later evolution and gain or loss from the spin-off is rarely considered. In the case of PM, today’s value of the spin-off received (including many dividends) vastly exceeds the value recorded on the day of the spin-off.
- Mergers. Mergers are not a problem when the company in question acquires another company and is the surviving entity. But when the company gets acquired, its stock history is wiped out from most publicly available databases. Monsanto (MON) was founded in 1901 and has been publicly traded for most of the century, but all the charts you will find only have a price history that goes back to 2001 – when “new Monsanto” was spun off by the merged entity of Pharmacia, Upjohn and Monsanto – while the remaining entity was bought by Pfizer (PFE). Calculating the total return to an investor that bought Monsanto stock in the 70s, 80s or 90s becomes very difficult.
- Capital increases and rights issues. When a company conducts a capital increase, it often issues new stock at a discount, while existing stockholders in most cases have a right to acquire the stock at the discounted price. The value of this subscription right is substracted from the stock price on the day the capital raising begins, and this effect is also often missing from historical charts. Good examples are European banking stocks which have raised a large amount of capital over the past years. Pay attention when looking at the stock charts of HSBC (HBC), Lloyds Banking Group (LYG), ING groep (ING) or Royal Bank of Scotland (RBS).
As you can see, “stock palaeontology” often requires looking beyond what Yahoo, Google, Bloomberg or Reuters present you as “the chart” of a company to judge the real return of a past investment.
Getting to the Point
Let me give you a beautiful example – the 10-year history of the shipping company Frontline (FRO). It mainly operates oil tankers, and if it were a dinosaur it would be the Tankersaurus Rex. If you look up the price and chart of the shipping company, you will see the chart plotted below:
[Click all to enlarge]
What conclusions would you draw from this chart? You see a stock price that has wildly fluctuated, going from under $10 in 2001 to over $60 in 2004, plunging back to $30 in 2005 and 2007, only to rally back over $70 and then crashing to sub-$20. A brief rally in 2009-10 doubles the stock again to $40 and today it is back in the $10 range. You’d say that this was probably a great stock for traders, but the long-term investor made no money in ten years. Ten years ago, the stock was around $10, and that’s about today’s price. What are you missing? You’re right, it’s the dividends, but that’s not all.
A large part of what is missing in the chart above is all the cash that the company has distributed to its shareholders over the past ten years. And I’m not talking small change here. The dividends have been massive (here is the dividend history). From August 2001 to July 2011 (that's 10 years), the company has distributed a total amount of $55.99 in cash dividends to its shareholders. Add this amount to the current stock price and you will get a total current value of $67.80 for an initial investment of about $10 per share in the fall of 2001. That is already a very sizeable return and does not even consider any reinvestment of the cash received over the years. But there’s even more to the story.
In 2004, the management of Frontline decided to change its fundamental structure. It used a model derived from the hotel industry to reshape its business. In the hotel industry, the property owning company (“prop-co”) which owns the real estate is often separate from the operating company (“op-co”) that operates the hotels. Frontline decided to separate the company in a similar way. It transferred the ownership of a large part of its fleet to Ship Finance (SFL) (the “prop-co”), which would receive a fixed long-term “rent” for the tankers from the op-co, Frontline – which would be responsible for the day-to-day management and operation of the ships, and keep any excess returns generated above the fixed charters for itself. Ship Finance would be able to pay stable and safe dividends, while Frontline’s dividends would be more volatile and dependent on the business conditions prevailing in the market, just like a hotel that can have good or bad seasons. The stock of Ship Finance was gradually distributed to shareholders over time (see spin-off history), and Ship Finance has kept its promise of continuous dividends. Ship Finance was not the only part of Frontline that was spun off to shareholders. In the beginning of 2005, Frontline also distributed its dry bulk shipping operations to shareholders by distributing its entire shareholding in Golden Ocean (GDOCF.PK) to stockholders. Starting in 2007, Golden Ocean has also been paying substantial dividends to its shareholders.
So what has been the total return for a shareholder that bought into the company in the fall of 2001, at about the same stock price that Frontline commands in the market today? Assuming the investor held on to all shares distributed to him, and thus also received the dividends issued by the entities spun off from Frontline, the total return is the following:
Frontline stock, today’s price
Frontline dividends 2001-2011
Ship Finance stock, today’s price
Ship Finance dividends 2004-2011
Golden Ocean stock, today’s price
Golden Ocean dividends 2007-2011
That is a very sizeable return; in fact it turns out an investment in Frontline was a 10-bagger over the last 10 years. And this wasn't achieved by a wild exuberance in stock prices, in fact nearly 70% of the returns are cold hard cash distributed as dividends.
Reconstructing Tankersaurus Rex
Now that we have found the missing bones to Frontline’s skeleton, let’s reconstruct Tankersaurus Rex in all its glory. In the chart below, I have reconstructed the total return achieved by an original 2001 investment in Frontline stock through all the dividends, spin-offs and respective dividends.
The lowest part (in blue) shows the original “raw” chart of Frontline like you would see it on Yahoo, Bloomberg etc. The red curve shows Frontline stock including only the cash dividends distributed by Frontline. The green curve shows Frontline stock including cash dividends, as well as the Golden Ocean spin-off and its dividends. The violet curve shows the total return including all components: Frontline stock, Golden Ocean stock, proportional Ship Finance stock and the proportional dividends received from Frontline and the spin-offs. The black curve shows only the cumulative cash distributed by Frontline and the respective spin-offs.
Historical perspective and outlook
Now that we really know and see what the total return has been for a stock investment in Frontline 10 years ago, what conclusions can we draw from it? First, we see that the best time to get out, like with most common stocks, was in the summer of 2008, when the total value of the investment had reached a high of $180. You probably wouldn’t have had to go through all the trouble to figure that out, the “raw” chart of Frontline would have told you the same.
What is much clearer is the fact that the value of an investment in Frontline has held up much better than one would expect from the “raw” chart. Including dividends (the red line), the return is still positive from 2005 onwards, something the “raw” chart would not tell you (the price action would tell you the stock has dropped by around 75%). You can also see that the return contribution from Golden Ocean and especially Ship Finance, as well as their respective dividends, has been substantial.
Also, if we compare the financial data of Frontline from 10 years ago and today (with a lot of the value now in separate companies), there is not that much difference:
Ten years ago, Frontline had about $3bn in assets; today it has $3.7bn. The equity has been depleted by nearly $500m (around $6 per share) as a consequence of the spin-offs and dividends. Considering the value that has been generated, this is not much. The share count has hardly changed, which is extremely positive when you think of the dilution that has occurred at other companies over the past 10 years.
Today the tanker market is not great. This is what the management of Frontline said in its last statement (Q1 2011):
It is hard to see a strong recovery in the tanker market as long as the net supply of tonnage grows faster than the total ton mile demand. As we stated in our fourth quarter 2010 report, Frontline will in case of a continued challenging market situation focus on having financial flexibility and a healthy balance sheet to be better positioned than peers to tolerate a prolonged weak trend in the tanker market and be able to react to attractive market opportunities that may occur.
Based on the company's trading results achieved so far in the second quarter, the board expects the weak trend in the first quarter results to be extended into the second quarter.
However, this is what Frontline said in Q4 2001 (.pdf), nearly 10 years ago:
With no signs of an immediate recovery in the global economy, the expectations for the tanker market’s performance in the first half of 2002 are necessarily low. As a consequence, we believe active scrapping of older tonnage will continue. The older vessels do not cover their operating costs at current rates and, as modern tonnage has become more available, older tonnage suffers extended waiting periods before getting employment, which further reduces income. Continued scrapping of older tonnage is a prerequisite for balance of supply since the newbuilding delivery program for 2002 comprises 40 VLCCs and 24 Suezmaxes, mainly with delivery scheduled for the second half of the year.
Much like Frontline’s stock price, it seems like not that much has changed in 10 years. But in the same timeframe, an investment in Frontline has been multiplied by a factor of 10, an annual return above 25%. Past performance is no guarantee for future returns, but sometimes history can repeat itself. Maybe Tankersaurus Rex is not yet extinct.