Choosing The Correct Equity-Bonds To Construct A Long-Term Portfolio

Includes: BP, CL, CVX, XOM
by: Alexander J. Poulos

The term "Equity-bond" is a term attributed to Warren Buffett in the book "The Warren Buffett Stock Portfolio." The term is used for companies that have a long lasting competitive advantage over their peers. Due to this competitive advantage, the company's revenue stream becomes predictable similar to what can be expected with a bond. I found this simple idea to be quite fascinating and have been applying it to my portfolio selections. The article below will detail the figures used to enter into a position in Exxon Mobil (NYSE:XOM), British Petroleum (NYSE:BP) and Colgate Palmolive (NYSE:CL).

At first glance, the inclusion of a commodity producer such as BP and XOM seems to run contrary to Buffett's philosophy of seeking out companies with a durable competitive advantage. The production of a commodity undergoes a classic boom/bust cycle with very little to distinguish between producers. I prefer to look at the energy sector and the oil producers in general from a different view. The production of energy is vital to modern life, with price shocks causing immediate economic pain felt the world over. The oil spikes that were witnessed in the early 70s and again in the 2000s led to significantly higher prices that led to far lower GDP growth. The following link leads to an excellent website with historical data on the price of oil starting in 1946. I used the price of oil in 1980, which happened to be a peak year, to generate my calculations. For the time frame beginning in 1980 and ending in 2012 the price of oil grew at a CAGR of 2.65%. My interpretation of the data is as follows. The worldwide demand for energy, especially oil is strong with occasional periods of a collapse in prices. The price collapse tends to be during a recession with prices recovering once economic activity rebounds. The data gives me confidence in holding the integrated oil companies for an extended period of time similar to a long-term bond.

BP Dividend Chart

BP Dividend data by YCharts

I would like to begin with my thesis along with the math behind my acquisition of BP. BP is currently involved in significant litigation stemming from the 2010 Gulf of Mexico oil spill. This unfortunate event has depressed the price of the equity offering long-term patient shareholders an attractive entry point. Prior to the disaster, BP had an envious record of consistently raising its dividend. The company paid a yearly dividend of $1.35 per share in 2000, which grew at a CAGR of 9.55%, ending 2009 at $3.36 per share. Using the current yearly dividend rate of $2.16 per share, I will use a CAGR rate of 5% going forward. I anticipate this rate to be extremely conservative however in light of the ongoing litigation I think a more conservative number is prudent. At a CAGR rate of 5% the dividend should grow to $3.52 per share, slightly higher than the rate paid in 2009. At the current share price of $42 per share the yield would work out to 8.38%.

BP shares are trading roughly at book value, a significant discount to peers such as Chevron (NYSE:CVX) and XOM. The shares are being held back in my opinion due to the uncertainty of the ongoing litigation. At some point over the next couple of years the litigation will come to an end and the company will move on. By simply allowing the dividend to reinvest, I expect to be able to compound at a double-digit rate.

XOM Dividend Chart

XOM Dividend data by YCharts

The investment case for XOM is similar yet not as potentially lucrative. XOM currently pays a 3% yield, which it has managed to grow at a CAGR of 8.32%. I expect the company to continue the current rate well into the future. XOM has some major capital projects coming online in the next few years, which will significantly boost production levels. As production levels accelerate higher, I expect current shareholders will be nicely rewarded. At a CAGR of 8% the current yield will reach 5.4% based on current share price of $86. The company also has an active share repurchase history that has managed to retire roughly 31% of shares outstanding since 2003. I realize the repurchase program is a sore spot for many intermediate holders of XOM shares. Earnings have gone basically nowhere since 2008, with the share price significantly underperforming the SP 500 and its most similar competitor CVX. Many would prefer a more robust dividend rate versus a share repurchase program. I am a fan of the repurchase program and believe it will pay off handsomely in the future. I suspect once the LNG terminals are up and fully operational (2015-2016 timeframe) and natural gas is actively exported, XOM revenue will accelerate along with its profits. At that point the significantly diminished share count will lead to much higher earnings per share and hence higher share price. Between the buyback program, which removes roughly 3% of shares outstanding per year, and the dividend rate, I expect to compound at an 8-10% clip by holding XOM and reinvesting the dividend. The upside with BP is much greater, however there is a bit more risk involved. In my view XOM is a true "equity-bond" and will remain a core long-term holding.

CL Dividend Chart

CL Dividend data by YCharts

The third company I will discuss is CL, which in my opinion processes all of the characteristics that Mr. Buffett looks for in his companies. CL operates in a predictable, easy to understand business. The predictability of the business allows one to make a more accurate prediction of the company's future prospects. CL products are affordable the world over and the company has a major international presence. Internationally, CL has a larger market share than perennial Buffett holding Procter & Gamble (NYSE:PG). A couple of key metrics make CL in my opinion a better holding than PG. The following numbers were examined over a 10-year time frame, which smooths out any temporary fluctuations and in my opinion gives a more accurate picture of the health of the company. Net profit margins for CL ranged from 12.8-14.5% similar to PG's range of 12.2-14.5%. Return on capital for CL ranged from 32.9-41.3% whereas PG ranged from 9.3%-23.7%. Interestingly, PG reported 9.3% in 2006 and has only bounced back to roughly 13.8% since. The final number is return on equity with CL's ranging from 73.5-160.2%. PG reported a range of 39.6-13.8%, however since hitting the trough number of 13.8% in 2006, it has only managed to rebound into the 17% range.

For my projections, I examined CL sales, earnings and dividend growth over the past 10 years. CL produced a CAGR in sales of 5.61%, which led to an earnings growing at a rate of 7.69%. The earnings growth allowed the company the financial wherewithal to increase the dividend at a 10.49% rate. For my projections, I will be using a CAGR of 4% for sales, 7% for earnings and 8% for dividends. At a reported earnings rate of $1.22, a CAGR of 7% nets out to $5.08 per share. I will assign an 18 P/E to that rate, which is lower than CL's average rate over that 10-year time frame. The math works out to an anticipated share price of $91.44. Using the above mentioned criteria the company's dividend rate should grow to $2.64 per share, which works out to a 4.4% yield. An investor can significantly enhance returns by reinvesting the dividends. CL engages in an active share repurchase program, which has managed to shrink the outstanding shares by 12% over the last 10 years. The active share repurchase program should augment earnings going forward. My thesis for an investment in CL is a conservative gain of 5% per year in capital gains combined with a dividend rate starting at 2.3% and rising. The total return should range in the 8-10 range similar to what is offered by XOM. I suspect my figures for CL will be proven to be pessimistic. I prefer to be "pleasantly surprised" instead of wildly optimistic.

In summary, similar to Warren Buffett I seek out boring, stable companies in easy-to-predict businesses. My goal is to generate a rising predictable dividend stream that will help offset income lost during retirement. I view the above mentioned companies as equity bonds that offer a more compelling payout than what bonds currently offer. Thank you for reading and I look forward to your comments.

Disclosure: I am long BP, CL, XOM. 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.

Additional disclosure: Thank you for reading the article. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.

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