Today I will revisit my views on the long term fundamentals of the Energy sector. Today Paul Samuelson passed away at the age of 94. When a colossus who has influenced my life in some small way dies, I pay respect. Paul Samuelson’s text books have given me a passionate interest in economics; for that I thank him; may his soul rest in peace. We are governed by the laws of economics and understanding those laws has come to my aid time and time again. My understanding of those laws is by no small measure thanks to the passing colossus.

Let me start by saying that in my view, the energy sector is led by demand factors. Demand is the desire to possess the commodity backed by the willingness and ability to pay for it. Demand for oil is expected to close 2009 at 85.8 million barrels per day; this is a trough demand level. Since 1990, demand for oil has grown at an annualized rate of near 1.5%. Assuming energy intensity (the amount of energy required to produce $1 of GDP) of 30% and a long term real global GDP growth rate of 4.2%, I estimate annual demand growth of 1.25%; however to err on the side of caution, I will reduce the long term growth rate to 1% and use a growth rate of 0.75% for the five years ended 2014. With rising prices, energy alternatives and energy efficiency can be expected to reduce energy intensity. Using these demand growth parameters, demand for oil in 2014 can be expected to reach 89 million bpd by 2014 and 93.6 bpd by 2019.

Dell (DELL) investors need to be patient; yes, more patience is needed for the turnaround to take hold. For 2009, adjusted earnings can be expected to come in at $0.95; that is $0.28, $0.24 and $0.21 ex items as reported and a further very conservative $0.22 for the next quarter. (See earnings call transcript.) Everyone knows that Dell is more leveraged to corporate spending than to the consumer and corporate spending can be expected to rise next year. Once visibility on growth is stronger, the shares will rise.

Do not underestimate the power of the Dell supply chain; they saw the fall coming well ahead of the curve and now they are looking for a powerful recovery next year.

Sterlite (SLT) is trading at a very reasonable value; no doubt higher than the bad bear values, but with sufficient upside potential for both long term investors and speculators. Please access “The Quant Report” here (or link straight through to the Sterlite file) for data based on which below commentary is based.

Operating Risk

I liked Transocean's (RIG) earnings release (conference call transcript here). You may want to visit Transocean's website here and download the power point presentations at the end of Q2 09 and Q3 09 to see the information based on which my comments are made.

Guidance indicates strengthening confidence in day rates. At the end of last quarter, Q4 09, high spec average day rates were estimated at $408k/day; the November release shows expectations creeping up to $419k/day.

Wipro (WIT) is a good company. For some reason it has never quite caught investor interest in the way that Infosys (INFY) has. Azim Premji is a formidable leader; he has a great track record and is well respected in India. On stewardship quality WIT is INFY's equal; but on valuation WIT is the winner. Access The Quant Report here for data based on which below commentary is based.

Operating Risk

I looked at ICICI Bank (IBN) and HDFC Bank (HDB) today; both are interesting, unfortunately I came up with a simple hold vidw. The numbers discussed below are based on data contained in “The Quant Report”; you can access the quant report here.

Operating risk

Companies return and create shareholder value through dividends, buybacks and earnings growth.

In looking at Tata Motors (TTM), the first thing that jumps out is the poor condition of the balance sheet. On 31 March 2009, the debt on the balance sheet was Rs 392.134 billion ($8.7 billion); that is an astounding Rs 763 per share ($17). After reducing cash and cash equivalents, the net debt comes in at Rs 683 per share ($15). Shareholder equity was Rs 59.406 billion ($1.3 billion) or Rs 116 per share ($2.6). The net debt to net debt plus equity ratio is 86%. This is well over debt levels I consider prudent.

My tolerable net debt to net debt plus equity ratio is 30%. For a car maker, a slightly higher than 30% is okay in some circumstances; they typically use a quasi financial services business to drive sales growth through financing buyers. For instance, when I last looked, Honda Motor Company (HMC) has a ratio of 48%.

India has four Dow Global members. These include Reliance Industries (RS), Tata Steel (TATLY.PK), Bharti Airtel and Infosys (INFY). In this post I want to cover Infosys which reported earnings earlier today.

Infosys is a core long term holding for any global portfolio. But valuation is an issue; and valuation is something which must always be borne in mind.

In 1994 you were finally mine. But then as I aged, you remained young. You were too fast for me; I could not keep up with the pace. By 2000 our value systems bore no resemblance and we parted ways; you represented growth, I value. Since then, I have watched you grow; I have yearned for you; I made a mistake, will you ever take me back?

Pepsi (PEP) is what I see as a classic mistake I made. I bought the shares during 1994 and exited during 2000. I am a cycle investor, but I tend to book capital and let the profits ride. With Pepsi, in 2000 I took a full exit and I lost a great company, with good defensive characteristics, which help limit the pain during cyclical contractions.

India never had a recession this time round. There was a small cyclical de-gradation evident in the earnings cycle when Sensex earnings fell from Rs 775 to Rs 765 between the years ended 3/31/2008 and 3/31/2009. Estimates for the year end 3/31/2010 are at Rs 874, so earnings growth has resumed. There is scope for further upside revisions for 3/31/2010; in my view it is likely that the year will close with earnings closer to Rs 925. Consensus estimates for the year ended 3/31/2011 are just short of Rs 1,000; in my view these are overly pessimistic and will rise to Rs 1,100 before long. Earnings visibility is high and there is high confidence in long term growth.

The market looks expensive on traditional valuation measures and while multiple expansion might be done, there is still money (both short and long term) on the table from earnings upgrades. For foreign investors interested in India, in my view an over-weight on emerging markets makes sense; it adds to portfolio return potential. Within the emerging markets, an equal weight allocation to India makes sense. Investors from outside India stand to gain more; funds flow into India is high for both direct and portfolio investment and this raises the demand for the Rs. This strengthens the Rs.

Inflation

Capacity utilization is at multi year lows. This is indicative of low levels of inflation in future years. Offsetting this is the sheer size of liquidity which is indicative of rising future inflation levels.

If you bought $100 of ConocoPhillips (COP) at average annual prices prevalent during 1999 and reinvested dividends received over the years, by now the capital value would be $327.525 and you would have a dividend income flow of $13.634. Between 1999 and 2009 earnings for COP have grown at an annualized rate of 12.48%, while dividends have grown at 10.7% and the median payout ratio has run at just over 18%. And while the expected payout ratio in 2009 is expected to be 53.71%, in my view the dividend is safe, provided that oil prices sustain at levels above $60. The company has exhibited exceptional ability to generate free cash flow ahead of its competitors which is supportive to the ability to maintain dividends through temporary disruptions in the market. At recent prices, the dividend yield is a healthy 4.2%.

The company also returned considerable value via share buybacks during 2007 and 2008. With the benefit of hindsight this might not appear to have been a great idea because the share prices peaked during these years; however, it must be noted that the share buybacks were conducted when PE ratios ran at between 6.7 and 7.84, which are indicative of good value.

If you bought $100 of Chevron (CVX) at average annual prices prevalent during 1999 and reinvested dividends received over the years, by now the capital value would be $310 and you would have a dividend income flow of $11.787. Between 1999 and 2009, earnings have grown at an annualized rate of 9.8%; dividends have grown at 7.93%. The median payout ratio has run at just below 30% and while the expected payout ratio in 2009 is expected to be 66.50%, in my view the dividend is safe, provided that oil prices sustain at levels above $60; the balance sheet is strong which allows CVX to maintain sustainable policy unaffected by temporary disruptions. At recent prices, the dividend yield is a healthy 3.8%.

The company also returned considerable value via share buybacks during 2007 and 2008. With the benefit of hindsight this might not appear to have been a great idea because the share prices peaked during these years; however, it must be noted that the share buybacks were conducted when PE ratios ran at between 7 and 9 which are indicative of good value.

I am looking at Vodafone (VOD) and I like what I see. Earnings have grown at an annualized rate of 21.8% while dividends have grown at 20.45% during the 1999 to 2009 period. Net debt divided by net debt plus equity is 29.75% which is within my 30% extra due care required threshold. Operating cash flow is strong and growth in estimated free cash flow (EPS + debt – capex) has been strong growing at over 17% annualized over the past decade. The stock is yielding over 6% and is trading at a multiple of 8.21X 2009 expected earnings and 9.18X average 6 year EPS (including 2009 estimated EPS).

This is cheap. The payout ratio is up at 58.7% which is considerably higher than the 44% median payout level which rand during 1999 to 2008; however I believe the dividend is safe provided buyback activity is kept on the backburner until EPS growth catches up with dividend growth. Vodafone has used buybacks as part of its strategy in returning shareholder value.

When I read McDonald's (MCD) had increased their dividend, I almost fell out of my chair. The company has done a good job of increasing earnings over the years; about 10.72% between 1999 and 2009. The dividend has grown over 25% during the same period. It also has great international exposure, which is a driver of future growth.

The payout ratio is over 58% which compares with historic payout ratios of 28% at median levels over the past decade. What this means is that a lower multiple must be applied - if value is returned via dividends, the value delivered via capital appreciation must fall. The rate hike puts a lid on future dividend increases.

Honda Motors (HMC) has grown earnings at negative 5.41% annualized between 1999 and 2008. By the end of 2009 the annualized rate is expected be negative 10.91%.

When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the average year on year change in EPS for HMC during the 1999 to 2009 period was 5.22%; the damage to earnings was inflicted on HMC during 2008 and 2009; it is pretty clear that the stock as suffered as a consequence of the crushed consumer following the popping of the property bubble and debt bubble.

HD has grown earnings at 6.62% annualized between 1999 and 2008. By the end of 2009 the annualized rate is expected to fall to 3.42%. When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the average year on year change in EPS for HD during the 1999 to 2009 period was 8.28%; the damage to earnings was inflicted on HD because of negative earnings growth during 2007, 2008 and 2009; it is pretty clear that the stock as suffered as a consequence of the popping of the property bubble. What is encouraging is how well they have held up in very poor industry wide conditions. HD has grown dividends at an annualized rate of over 23% 1999 and 2009. This is good, but the payout has risen to over 64%; not really a problem in that the dividend is safe, but it does hint at a slowdown in future dividend growth. HD uses a mix of dividends and buybacks to return shareholder value; the payout ratio including buybacks has run at a median of 40%.

As with the vast majority of buyback programs, HD’s program is disappointing; they have reduced share count by 3.35% annualized between 1999 and 2009 but they have purchased shares during 2004, 2005, 2006 and 2007 – years when the shares were trading at a premium to fair values. Buybacks are good; they boost earnings growth and it offer a tax effective method through which continuing shareholders in effect reinvest dividends with no tax consequences. But they are also bad, because they remove choice; personally I would not re-invest dividends in a stock which was trading at a premium to fair value; I would prefer to pay the tax and invest net proceeds elsewhere.

Johnson & Johnson (JNJ) is a great defensive play. The balance sheet is unleveraged, cash flows are strong; sector is defensive and not prone to cycle volatility. Earnings growth between 1999 and 2009 can be expected to come in at an annualized rate of 11.69%. During the same time, dividends have grown at an annualized rate of over 13%. Much to my annoyance, management used buybacks to return value during 2006, 2007 and 2008 while shares were trading at a premium to fair value; why do they do this?

Earnings have sailed through both the recessions without volatility of any significance or a hint of trouble. The stock looks cheap relative to the SP500 on a 2009 earnings basis; yet on a cycle basis, the stock is expensive – the stock PE 6 (Average Annual Price / 6 year average EPS) relative to the SP500 PE6 is at 1.09. The stock can weaken as investors pursue risk in the early expansion; $49 is an attractive entry price.

Between 1999 and 2008, GE had grown EPS at 5.82% per annum. The 6 year average EPS grew at 6.48%. Dividends grew at 10.87%. Then came 2009; by the end of 2009, annualized EPS, 6 year average EPS and dividends were negative 0.67%, positive 4% and negative 2%. When you compare two points in time ignoring the period in between, you get a good handle on annualized rates, but you do not get the trend. For example, the median year on year change in EPS for GE during the 1999 to 2009 period was 7.02%; a single devastating year has caused the annualized growth rate to fall to negative 0.67%.

All in all, GE is a decent investment opportunity priced at $16. Industrials are a sector with some significant growth triggers coming from emerging market; GE is well situated to capitalize on that growth potential. The big drag on US industrials such as CAT, DE and GE is the degree of leverage. Each has a balance sheet where the debt to debt plus equity ratio is just over 80% because of their involvement in financial services. CAT and DE’s leverage is effectively an investment in growth; they finance buyers of their equipment and profit from both the “industrial” business and “financial services business”; this is not something I like, because I feel they should focus solely on their core business and leave the financial business to financial institutions.