"Warren Buffett's Exxon Bungle"
Comment of the Day

November 20 2013

Commentary by David Fuller

"Warren Buffett's Exxon Bungle"

Here is a middle section from this interesting column but Barry Ritholtz for Bloomberg

What premised this morning's discussion is Buffett's recent purchase of Exxon Mobil (XOM). In case you missed it, Berkshire just bought ~40 million shares of XOM, a ~$3.4 billion purchase. The buy gave Berkshire a stake in the second largest market cap firm in the U.S. (indeed, the world) after Apple.

We can make an educated guess as to the appeal of the oil giant to a value investor such as Buffett. XOM trades at 11.8 times forward earnings estimated, about 23 percent cheaper than the S&P 500 forward earnings multiple. Its dividend yield is better as well, at 2.69 percent against 2 percent for the SPX.

But more interesting than the details of this buy is the simple fact that Buffett had previously owned Exxon, back in 1984. And he blew that trade in the same way many rookie traders ruin a good investment -- by taking profits too early. With the benefit of time and hindsight, let's see if there may be any investing lessons to be learned for us mere mortals.

According to Berkshire's 1984 Annual Letter to Shareholders, Exxon was Berkshire's fourth largest holding. It held 3,895,710 shares of Exxon Corporation.

In 1985, Buffett sold Exxon at $6.75 -- it was a fast 44 percent gain in less than two years. Seems pretty hard to argue with that.

How has XOM done since Buffett sold it?

Since 1985, Exxon has had several two-for-one splits: Sept., 15, 1987; again a decade later on April 14, 1997; and most recently on July 19, 2001. Hence, that original purchase would now consist of 31,165,680 shares. That assumes dividends were not reinvested. If they were, it would be a considerably higher amount. (Hmmm, what is that Bloomberg function to calculate dividend reinvestment?)

Regardless, not counting dividends, that original ~$173 million dollar purchase would be worth about $3 billion today. That's a back of the envelope return of 1,946 percent. And while a 44 percent return is good, a 1,946 percent return is better.

David Fuller's view

So why did Warren Buffett invest in Exxon Mobile, which incidentally, now looks temporarily overextended near historic resistance? The initial, obvious reason is that it is cheap relative to the S&P 500 at 12.8 times earnings on both a current and estimated basis. It also yields 2.65%, which is more than the S&P. As the world's second largest company in capitalisation terms, there was no liquidity problem for Buffett.

Among the less obvious reasons, Buffett obviously thinks the world will still be consuming lots of oil and perhaps, particularly natural gas over the next many decades. I agree. Yes, there will be lots of energy sources but renewables such as solar and wind are not about to replace oil and natural gas. Moreover, nuclear is still too controversial and costly as a consequence of Fukushima. Moreover, there is no satisfactory solution to the problem of nuclear waste from spent fuel.

Oil shares are cheap for a number of reasons, starting with the commodities sector being out of favour during this period of slower global GDP growth. Oil does not have the current fashionable appeal of retail industries which target the world's growing middle classes. Moreover, Exxon Mobile and other oil giants have been spending billions signing up and developing additional resources. This enormous outlay provides little or no return in the short to medium term. Moreover, it is certainly not without political and geological risks.

Nevertheless, this is an extremely interesting time for the energy industry. The safest forecast is that demand for energy will continue to rise, due to global GDP growth in terms of both wealth and population. Yes, we will be using energy more efficiently but we also have so many more applications for it. Consider all the useful machines and communication devices that you are using today, compared to twenty years ago.

This is also an interesting era for the energy industry because the traditional national suppliers of oil and gas in the second half of the last century are slowly losing their near monopoly control. Technology, including hydraulic fracking, is responsible for this change. Huge supplies of unconventional oil and gas are becoming available, and the leading oil companies are in a strong position to assist in the development of these resources within individual countries. The longer term payoff should be substantial.

Here are some of the other top oil and gas companies for comparison: Chevron est P/E 10.7, Y 3.2% - Royal Dutch Shell (B) est P/E 9.9, Y 5.2% - BP est P/E 10.4, Y 4.8%.

In the interests of disclosure, RDSB is one of my top personal holdings.

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