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  • Exxon – Value Trap Or Just Cheap? 0 comments
    Dec 16, 2013 11:26 AM

    When two experienced investors take completely opposing viewpoints it's always worth investigating the situation, especially when one is the world's most famous investor, Warren Buffett - and the other a renowned hedge fund manager and short selling specialist, Jim Chanos. The stock in question? Number three on the Fortune 500 - ExxonMobil Corp. (XOM.N).

    It's an investment classic - is XOM cheap (the Buffett camp) or cheap for a reason (Chanos)? In investment terms, is it a "value trap" - a stock that superficially looks cheap on various measures but when you analyze the company, you realize the stock price is likely to flatline or become even cheaper.

    We take a look at XOM to try and understand the stance of each camp.

    First, the obvious: XOM remains well correlated to the price of oil, despite the shale gas revolution underway in the U.S. As the U.S. moves from being a major oil importer to self-sufficiency, it's clear that the oil majors without major exposure to the boom in fracking/shale gas will suffer. Of course, no one is sounding the death knell of oil and at a global level, oil demand remains robust.

    Second, over a long time frame (since Jan. 1, 1990) XOM has delivered significant outperformance over a broad index of large U.S. stocks - here we've used the S&P 500.

    (click to enlarge)
    Source: Thomson Reuters Eikon / StarMine

    Oil exploration is a new game

    Chanos' argument (from this week's Reuters Investment summit) is well covered here; but the distilled version is that the dynamics of the company are changing and it's become more expensive to identify future sources of oil - and that the costs of delivering that oil will result in lower margins than XOM has experienced in the past. Therefore those expecting margins/ROE based on historic averages will be disappointed.

    If you assume that the U.S. shale oil boom will continue, it seems clear the oil majors will need to seek their reserves in less accessible parts of the world - deep offshore, and/or in less politically-stable parts of the world. Neither should excite investors. Let's look at the current valuation compared to historical averages and see how much of this scenario may already be reflected in the price.

    (click to enlarge)
    Source: Thomson Reuters Eikon / StarMine

    Underperforming the benchmark

    Equally you can see the screenshot from the Intrinsic Value page that shows the current market implied growth rate that's baked into the current share price. This simply reverse engineers our valuation model - using the current share price as the valuation - to measure what level of EPS growth would be required to meet the current share price. It's a very useful metric for measuring current buyside expectations.

    Is Chanos' view the hedge fund consensus view? One way to measure that is to look at the StarMine short interest model, which measures how much of the available liquidity is being used for short positions, using U.S. exchange data. The model also looks at the potential for a short squeeze. Very clearly the market has not adopted a particularly aggressive short stance on the stock, with only about 1% of the stock currently being held short. In my view, that's unsurprising given XOM's undemanding valuation.

    (click to enlarge)
    Source: Thomson Reuters Eikon / StarMine

    Who will be proven right?

    Buffett is famous for taking a very long view and freely admits that he has no idea what the market is going to do today or tomorrow. So this is maybe a manufactured argument - as hedge hunds are generally short a stock over a much shorter time horizon than Buffet's. Chanos could be right that XOM is likely to have a tough six months, or two years, as the market adjusts to lower margins (if his premise is correct) and yet over a five to ten-year view the stock may prove fundamentally cheap - with another oil shortage, unexpectedly strong demand (or geopolitical crisis) likely to drive up valuations in the sector at some point. Commodity prices are fundamentally cyclical, after all. Both positions could be money-making, capitalizing on volatility over different time horizons.

    So for those thinking about their strategy, the clear question is time frame. For the patient investor, XOM will likely offer an attractive exit point at some point over the long term, however for the ADD-type short term trader, the jury is still out. If the oil majors are likely to experience a structural decline in their margins then Chanos may also have his time in the sun. Upon such determinations are large sums won and lost.

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