When Benjamin Graham taught Columbia students about his now famous "margin of safety" principle, he had two things in mind. The first is that, by purchasing stocks at a discounted price, excess money can be made when P/E expansion joins forces with earnings growth to deliver better returns than what you would expect from the business performance alone. And the second reason involves protection on the downside: even if business reality turns out to be worse than anticipated, the losses won't be so bad because the initial purchase price was built to absorb poor performance.
In February 2011, when BP (NYSE:BP) was resuming dividend payments for the first time after the oil spill, the stock was trading at $46.58. The price of oil was $89 per barrel, and the range of estimates for the total cost of the oil spill hovered between $10 billion and $25 billion. When the $1.68 dividend was reinstated, the yield on BP stock was 3.6% and the earnings per share were $8.06 (meaning the reinstated dividend only took up 21% of profits).
During the past four years, BP stock encountered many worst-case scenarios. The final settlement from the oil spill totaled $20.8 billion, the price of oil fell from $89 in February 2011 to under $40 at the end of 2015, and BP also had to address the unexpected impairment of some assets in Russia after receiving unfavorable treatment from the government. None of these conditions represent good times for BP's stock.
And yet, something happened these past four years to offset this bad news: BP kept making tons of profits, and kept sharing large chunks of those profits with shareholders. Not only did BP maintain its dividend payout these past four years, but it grew the payout. BP shareholders collected $1.68 in 2011, $1.98 in 2012, $2.19 in 2013, $2.34 in 2014, and $2.40 in 2015. This is an important element of consideration that has offset much of the trouble in the oil sector (and for BP specifically) these past four years. In sum, BP shareholders have received $10.59 per share in dividend income since the resumption of the dividend payment in 2011.
The result is that these adverse events - political trouble with Russian oil, the collapse of oil prices, and high-range settlement costs from the oil spill - have caused limited harm to BP shareholders that have stuck with the stock for these past four years. If you bought at $46.58 in February 2011, your current break-even point would be $35.99. The current price of the stock is $32.34. For every 100 shares of BP you bought in February 2011, you're only down $365. That's it. The support of the dividend has offset much of the plunging fundamentals and share prices that have resulted from the oil slump.
At current prices, BP offers a 7.42% dividend and an even greater margin of safety than existed in February 2011. Unlike many of its peers, BP still brings in nearly enough profit to cover the dividend. In 2016, BP is expected to make $7.0 billion in profits. The current $2.40 dividend puts some pressure on that, as BP is currently required to pay $7.2 billion in dividends to shareholders. If oil falls more, and stays low for an extended period of time, the possibility of a dividend cut becomes an increasingly realistic possibility.
The current downturn in oil prices is unprecedented for BP in the past generation - this oil decline marks the first time in the past 25 years that BP will not be able to organically fund its dividend. The worst experience BP shareholders previously had to endure came in 2009, when earnings fell to $4.47 against a $3.36 dividend. That was a dividend payout ratio of 75%. The current circumstances, in which BP is paying out a little more than it earns, is uncharted territory for the stock.
If oil remains low, BP does have the cash resources to make up the $200 million gap in which earnings do not cover the dividend. It currently has $31 billion in cash, and $20.8 billion of that will be earmarked for oil spill-related settlement payments. Usually, BP keeps between $5 billion and $8 billion in cash on hand. Even at current prices, the Board could maintain the dividend, continue to invest in high-return projects, and keep the cash position tolerable.
I find the current valuation of the stock, at $33 per share, to encapsulate an even greater margin of safety than existed in the years after the oil spill when no one wanted to touch the stock while the dividend was suspended. Even with an adverse subsequent four-year period, the $10.59 in dividend payments that have shown up for shareholders have offset much of the falling price activity that has occurred.
Even if BP only maintains its dividend for the next five years, shareholders stand to collect $12 per share in total dividends. At a price of $32.34, this means that the price of the stock would have to fall to $20.34 at the end of 2020 for shareholders to incur a loss at the current price point. And plus, even a modest uptick in prices will put BP in a position to again cover its dividend.
The uncertainty of the dividend payout has created the opportunity to seize value pricing. The company still pumps out $7 billion in annual profits, even at these levels, and a good chunk of that will be returned to shareholders even if the dividend is cut. The fact that BP returns a significant chunk of cash to shareholders explains why the losses during this period of falling prices is much, much less than you would guess by looking at a stock price chart alone.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.