Don't misconstrue my title: Warren Buffett is a great value investor. My view, however, is that he isn't the best and his followers have overly discarded the efficient market hypothesis. Moreover, Buffett is so widely cited in financial stock analysis that it is unfortunate how trite his name has become. In my view, Carl Icahn is an investor that we comparatively hear too little about.
Based on Forbes research, Buffett may be the richest pure stock investor at a $39B fortune, but Carl Icahn still takes the #4 spot by this measure at a $13B fortune behind George Soros (#2) and John Paulson (#3). The Princeton graduate likens his investment strategy to a game of chess wherein the players think in terms of game theory and plot out actions multiple moves ahead. After all, Icahn is no ordinary value investor: he is an activist investor meaning that he buys large stakes in companies and then pushes for a variety of changes whether they be financial, corporate governance, strategic, etc. His fund generated a 35% return in 2011 while Buffett's Berkshire Hathaway (BRK.A) fell 4.7%.
Recently, Icahn made headlines with his more than 7% stake in Chesapeake Energy (CHK), the second largest natural gas producer that has come under criticism for, in my view, overblown corporate governance matters. Since Icahn first went public with his position, the stock has soared 15.1% while Berkshire was roughly flat. Moreover, Chesapeake has already committed itself to long-term value creation by injecting new blood into the board that better represents shareholder interests. Four of these new board members will be nominated by Carl Icahn and Southeastern Asset Management (another large holder of Chesapeake stock).
At the same time, Chesapeake has also taken the appropriate measures to sell off irrelevant assets and gain liquidity. The $4B pipeline sale to Global Infrastructure Partners was nearly valued at one-fourth of the company's market capitalization. While this sale demonstrated that Chesapeake can indeed make attractive sales despite its weak financial position, more work still needs to be done. The firm currently generates operating cash flow that is more than half of its market value, and the parts are worth more than the whole. Debt concerns and bearish natural gas projections, however, have unreasonably kept the stock down. Chesapeake neither needs to spend the amount of capex that it has in the past nor faces weak macro trends. With natural gas at a low, it is likely to considerably appreciate as other sources become ever-scarce.
But Chesapeake isn't the only attractive oil & gas stock right now. ConocoPhillips (COP) is valued at less than 6x past earnings and offers a 4.9% dividend yield. While it is cheap enough for Icahn to make a 10% investment in and still have half of his net worth left, it is unlikely to be targeted by the activist investor given its impressive management. Chesapeake still generates more operating cash flow relative to market cap, but Conoco is still cheap at roughly 3.5x operating cash flow. Moreover, the energy titan also has positive free cash flow. Many oil & gas firms have negative free cash flow due to large capex investments in wells and new projects - the ability of Conoco to remain positive in this metric over the recent past presents a bullish case for the future.
As it stands, Conoco is anticipated to grow EPS by only 0.3% over the next 5 years. Going off of the $6.76 2012 EPS consensus, this means $7.67 EPS by 2016. At a 12x multiple, this puts the future value of the stock at $92.04. Present valuing earnings at a 8% discount rate yields a $62.64 price target - roughly in-line with consensus. On top of the 4.9% dividend yield, Conoco offers compelling risk/reward.
Conoco may be a safe investment, but there are still instances where the upside is even greater. Marathon Oil (MRO) has a $36.25 price target according to FINVIZ.com, which is at a roughly 50% premium to the current value. EPS is also anticipated to grow by 8.4% annually over the next five years on top of a reasonable 2.8% dividend yield. At the same time, gross margins are also terrific at 56.1%. My one concern with the company is the poor quick ratio of 0.74, which indicates liquidity issues. This issue, however, is dwarfed by the long-term growth prospects for the rising energy firm.
Hess Corporation (HES) and Valero (VLO) are also worth a look. Hess trades at a respective 10.6x and 5.7x past and forward earnings versus corresponding figures of 8.7x and 5.4x for Valero. On a 1 to 5 scale with "1" being a "buy", the Street rates both companies a 2.3. Their price target on Hess is nevertheless at a higher premium to current market value: 70% versus 20%. There has also been more insider buying at Hess than at Valero. I, however, am more optimistic on Valero. In addition to being cheaper on a multiples basis, Valero also offers a dividend yield that is roughly 160 basis points higher at 2.5%. Moreover, the oil & gas refiner also has a higher quick ratio, return on assets, and return on equity.
With the oil & gas sector looking cheap overall, I anticipate Icahn to continually outperform the market. By backing companies where he can specifically unlock value through strategic and corporate governance reforms, Icahn provides a catalyst of his own that Buffett lacks. The mere announcement of an Icahn position typically sends shareholder value at least 5%, and we can only hope that he intervenes more in the sector going forward.