Lessons Learned From Kinder Morgan, BHP Billiton, ConocoPhillips, And National Oilwell Varco

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Includes: BHP, COP, KMI, NOV
by: Khen Elazar

Summary

Previously, I published a summary of my portfolio and I included changes, mainly shares I bought and sold.

In another previous article, I shared with you some positive lessons that I learned while investing.

Learning from your investing experience, including your mistakes, is a crucial part of becoming a better investor.

Introduction

As an investor who wishes to improve constantly, I find it important to make some reflections over my moves. Experience doesn't come just by investing, it requires a whole process of analyzing and understanding my successful positions as well as my investment mistakes. Having this platform to share it will help me in analyzing my moves, and hopefully will help my readers as well.

I previously wrote a summary of my portfolio at the end of Q1 2016, and I described there several moves to my portfolio. These moves contain sells that were done due to dividend cuts, that I see as a failure of a business. It doesn't mean that the whole firm is a failure and it is going under, but it means that the management failed to execute its dividend policy.

I try to embrace my mistakes rather than ignore them and pretend I don't make any or not exist, as this is the only way to learn from them and become a better and more experienced investor. I share most of them with readers as I share my portfolio, and hopefully it will be helpful. I shared positive lessons in the past, that helped me acquire shares for cheaper prices, and now it is time to share some of my mistakes.

Stocks that taught me lessons

Kinder Morgan (NYSE:KMI) is the largest energy infrastructure company in North America. It offered investors a very high entry yield, which was well covered by the distributable cash flow. The company also had massive growth with billions of dollars invested in new projects. However, the decline in the share price of many energy companies made it impossible for KMI to raise money by offering equity, and its high leverage made it impossible for the company to issue more debt without losing its investment grade rating. The management had no choice but to cut the dividend, in order to pay its debt and keep growing the infrastructure.

I bought the shares in the company back in 2014, and added 10% more to the position in 2015. I learned that I should look very carefully at the balance sheet, and understand that leverage while important can be very dangerous for the business, if not used correctly. Leverage helps companies in achieving higher returns, but when the macro environment becomes more complicated, it can be devastating for the firm. KMI had no problem operating in a high debt environment as long as energy companies had easy access to capital.

My lesson here is that from now on, when I invest in companies and check their balance sheet, I should make my own stress test to see if the company can endure scenarios in which it has limited access to capital. I should avoid companies that operate with much higher leverage than the average, and if I do buy them, I must check that the reward is worth the risk, and I shouldn't allocate too much capital to them.

ConocoPhillips (NYSE:COP) is another company that failed me with a dividend cut. It is really unbelievable to hear the management reassuring again and again, that the dividend is safe and it is a priority for the board, and less than a month later the dividend is cut. This was the situation with COP. After the spin-off of its downstream business into Phillips 66 (NYSE:PSX), COP had only upstream business, which did poorly since the oil price declined. The company sustained heavy losses, and couldn't pay its dividends from its cash flow, but had to issue debt and sell assets. The company did so for several quarters until it was clear that uncertainty about oil prices is here to stay, and the company slashed its dividend.

The lesson I learned is that diversification is very important. Having a large downstream business is what keeps its peers Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) in a better shape. Not only that, it taught me a great lesson about the risk of the energy sector. COP or even its larger peers cannot price their product, that is a big disadvantage that must be taken into consideration. I should also be more conservative when I check payout ratios, I couldn't imagine COP losing billions, but the company's payout ratio was much higher than its peers even before the decline of the prices.

National Oilwell Varco (NYSE:NOV) is a leading worldwide provider of equipment and components used in oil and gas drilling and production operations, oilfield services, and supply chain integration services to the upstream oil and gas industry. The company showed amazing dividend growth over the past five years, and the payout was very sustainable. In fact, the company could pay its dividend for next several years with its cash position alone. However, the declining oil price made most companies invest less money, and therefore orders for equipment from NOV were cancelled. As the backlog was shrinking, the management decided to slash the dividend and reduce it by 90%.

The lesson that I learned here is that dividend streaks should be taken even more seriously. It made me appreciate even more companies that grew distribution for decades. NOV could easily maintain its dividend payments, it had low debt and a lot of cash, which probably could help it going through several harsher years. I will look now more carefully before buying shares of companies with short dividend raises streaks.

BHP Billiton (BHP, BBL) is a multinational mining, metals and petroleum company. It is the world's largest mining company. The company had a progressive dividend policy, and the management managed to raise dividends for every year in the past 12 years. However, as the price of iron ore and oil declined, so did the revenues and the company sustained heavy loses. The management didn't want to cut capex even more, and decided to slash the dividend payment.

I learned here several things. I got another lesson about volatility of energy and basic materials companies. They are all price takers with very limited ability to dictate prices, or raise them. Because of that I believe that investors should look very suspiciously at the payout ratio of these companies. I believe that the payout ratio of energy and materials firms should be around 30%-35% for them to be able to deal with extreme situations. I believe that the low payout is what allowed XOM to maintain its dividend so far. Even strong and leading companies like BBL are not immune, and they had to maintain the health of their balance sheet.

Lessons that I learned

If I need to summarize my lessons into key takeaways, I will go with avoiding risky leverage. Leverage should be considered compared to peers in the sector. I am against avoiding debt, as it allows companies to bring higher returns to shareholders. The debt burden should be controlled and debt level shouldn't be too high, so in harsher times the company will be flexible enough, with access to liquidity. That is why I bought Magellan Midstream Partners (NYSE:MMP) instead of KMI. The coverage ratio is healthy, and the leverage is much lower than its peers.

I also learned that companies that cannot decide their products' price should be analyzed differently, and "stress test" that I make while analyzing them should be more strict. Those price takers are more vulnerable to any change in their business environment, and therefore the analysis must show a very high level of endurance. I would like to have less exposure to price takers in my investment portfolio.

I also learned how important it is to look at the length of the dividend streaks. There are companies that raise dividends in good times, and cut them when the environment is less positive towards the business. I believed that I can "understand" which company is willing to become a dividend aristocrat and attract income investors, but I was wrong.

It is also important not to take every lesson here as ground rule or a major principal. I should take those lessons into consideration when I analyze stocks. For example, I would still consider buying Disney (NYSE:DIS) or Apple (NASDAQ:AAPL) with their short streaks, but I would probably won't buy companies with short streaks, high leverage and from the energy sector.

What I did?

I took several actions in order to lower the risk in my portfolio. I changed my desired sector allocation, so I won't have too much exposure to companies that tend to work with high leverage like REITs or MLP. I also want to lower my exposure to price takers in my portfolio.

Therefore, I changed my optimal sector allocation to include less basic materials, energy and REITs. I will also be very picky especially with REITs. I increased my exposure to other sectors instead. Sectors that usually have wider moat. This of course is again not a ground rule, but more of a guideline. I will buy more REITs or energy companies if I believe that I have an opportunity. I will just make sure that I implement my harsher criteria towards these companies.

Conclusion

Learning from my mistakes is a crucial element for me to become a better investor. I honestly believe that after I sold these positions and bought new ones according to the lessons I learned, I actually made my portfolio even stronger and better. Sure, it is not a good feeling to see a failed investment, but sharing it, analyzing my mistakes and learning from it make up for everything. Hopefully I will keep implementing my these lessons into my investment strategy.

Disclosure: I am/we are long DIS, AAPL, XOM, CVX, MMP.

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.