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July 01, 2006

Multiple Problems Or Opportunities, Which Is It?

Multiple Problems Or Opportunities, Which Is It?...One of the first lessons every young and hungry securities analyst who enters the investment business learns, or at least better learn and fast, is that cyclical stocks carry high valuations during troughs in their earnings cycles and low valuation multiples at or near earnings peaks. As you'd imagine, it only makes common sense. Sensitivity to valuations of companies with cyclical cash flow and earnings streams is mandatory if one hopes to be a successful investor in this neck of the equity market woods. Forget this very simple truism and one will soon be parted from their hard earned capital in a hurry.

We want to spend a few minutes looking at current valuations in primarily the energy sector, but our conceptual arguments also apply to many commodity oriented issues. Historically, these stocks and their ongoing valuation movements have resembled the classic cyclical stock. Multiples have contracted near earnings peaks and expanded near troughs. Certainly, this ebb and flow of both earnings/cash flow and valuations has coincided with the price direction of headline energy and commodity prices themselves. Pretty simple stuff. But, if one believes in a longer term scenario of growing global energy supply tightness to come along with the inevitability of ongoing growing global energy and commodity demand, particularly exacerbated by the forward needs of poster children such as India and China, then just how does this realization potentially change the equation for the forward valuation of energy stocks? Will energy and some commodity oriented companies ultimately be accorded higher valuation multiples based on what appears to be a very bullish longer-lived secular outlook for energy and some commodity prices in light of global supply and demand dynamics? Or will these issues continue to see valuation contraction and expansion based primarily on the relatively still intact short term cyclical perceptions of the broader investment populace?

Let's start by having a look at where we stand today with a number of energy issues. In the table below we're looking at the thirteen top components of the energy sector Spider (the XLE). We're using consensus analyst earnings estimate numbers for '06 and '07 to derive forward P/E multiples. We've assumed an S&P selling at 16x's to derive the current relative P/E multiple on '06 earnings in the far right hand column. For the ten-year average relative multiple, we've literally gone back to 1996 and averaged the yearly valuation experience. As you know, this period encompasses trough earnings in the late 1990's when crude actually sold near $11 per barrel (can you believe it?) and the recent experience with crude above $70. In our minds, this gives us an average of what have really been two extremes periods for macro energy prices. We're fortunate in contemplating current and forward valuation appropriateness to have such dichotomous recent valuation history against which to benchmark. Have a look.

We can make some simple observations from the table above. The major oils, the large intermediates, and big refiners such as Valero, currently sell at very modest single digit multiples. Higher growth areas such as the energy service sector have been accorded higher near term valuations given their explosive earnings growth prospects over the next few years, but forward P/E's values remain well below expected five-year earnings growth rates. As has been the case for many years now, and as has been a so far completely incorrect assumption for those same many years now, analysts expect flat to down earnings for all but the service companies in '07. Will the analyst community finally be right after literally three or four years of being incorrect about forward flat to down earnings prospects for the group? And importantly, current relative (to the S&P) P/E multiples are well below average experience of the last decade. We think it's a pretty fair statement to say that "the market" has priced this group as if we are at peak earnings right here and right now. Moreover, it's essentially priced the energy group as a classic cyclical in which we should expect meaningful earnings erosion to come after the supposed cycle earnings peak, which by the numbers above is again theoretically now. So the question of the moment for the energy sector becomes, are we at peak cycle earnings or not? Forget having to guess whether we face peak oil production anytime soon and focus on the earnings potential of the group. Trying to keep the concept and thinking as simple as possible, if indeed we're watching unsustainable peak earnings right here, then the market is fairly valuing the group by according them their current modest valuations. Simple enough, case closed. And if indeed we are at some peak earnings experience there may not be massive downside potential as the markets have already priced in the peak experience through the low absolute multiples of the moment. But if this is not peak earnings for the energy companies, and there is not meaningful earnings erosion to come directly ahead, then we think it's a very fair statement to say that this group is undervalued. Perhaps in a very big way.

We certainly do not expect the large majors, for example, to immediately trade at a market multiple overnight. But in like manner we do not believe they should be trading near the multiples of true cyclicals like the homebuilders. Simple question. Over the next five years which would you rather own, energy stocks or homebuilding stocks? Take your pick. So what would cause the market to bid up the current multiples of energy sector stocks? Certainly an earnings downturn and a stable price would do the trick in a heartbeat, the hard way, of course. To be honest, we can't identify an immediate specific catalyst to start the higher revaluation process, but in our minds the current pricing of the group as hardcore cyclicals at theoretically peak earnings displays the investment attractiveness of and potential opportunity in the group over the longer term. Current valuations for the group absolutely reflect distrust in sustaining even current levels of earnings. If indeed we see higher energy sector earnings over time and this group displays less earnings cyclicality than has been seen in the past, it's very hard for us to believe that current multiples will not be revalued higher. And what's going to lead to this potential multiple revision is the reality of higher and more sustainable earnings prospects. Translation? Energy prices remaining higher than is currently expected. In other words, the catalyst, per se, for higher valuations ahead is not an event, but rather a process or change in investor perceptions and thinking that will necessarily take time. Although this may sound wildly simplistic, if earnings for the group continue higher ahead, absolute multiples (and relative multiples) will follow. That's really the opportunity we see.

As has often been the case in the past, meaningful investment returns can be achieved by identifying a market premise that is incorrect and betting against it. In this case we have the potential for a double pronged investment return - higher actual earnings and higher multiples paid for those earnings streams as the market comes to realize earnings dynamics for the energy sector will be less cyclical than past experience. It's very important to remember the sheer power of the multi-decade macro bull market for equities in the 1980's and 1990's. What drove prices during the period was not just higher earnings, but most importantly it was valuation expansion. We began the early 1980's with high single digit P/E multiples for the major equity averages in the US and ended the bull of a generation well into double digit multiple valuation territory. That alone was a massive tailwind for equity prices in the '80's and '90's. And the poster child for P/E multiple expansion in the 1990's especially was the tech sector. Once upon a time in a stock market far, far away, tech stocks were indeed valued as cyclicals. Prior to the recession of the early 1990's, the equity market at the time indeed valued techs as if they were cyclical stocks at peak earnings. Much like we see today with energy stocks. But as the decade wore on, techs were no longer "seen" as earnings boom bust cyclicals and their valuations expanded accordingly. Although in no way do we expect energy stocks to ever wander through a 1990's tech stock look alike experience, the following table will give you a feeling for what can happen to former cyclical stock valuations when they untether from being perceived as cyclicals and move into the magical land of being perceived as growth issues.

Is the above an extreme example of perceptual change translated into real world valuation expansion? Of course it is. But it gets the concept across of how powerful multiple expansion can be to investment performance. If indeed we're anywhere near correct about energy prices long term being stronger than most now expect, we could experience a bit of a conceptual replay with the energy stock group over a reasonable period of time ahead. In fact, until solidly proven otherwise, this is what we think ultimately comes to pass. But in terms of expectations, we'd be tickled to death if most energy stocks simply attained a market multiple, let alone trading at 30 or 40 times earnings. Is that too much to ask for a sector facing what seems to be decidedly advantageous longer term supply and demand characteristics ahead? Let's face it, the chance for earnings growth and valuation expansion is every equity investor's dream. These types of sector opportunities just don't come along everyday. We'd suggest that what might appear to be "multiple" problems for energy stocks at the moment may in fact be multiple opportunities. That's how we see it.

Speedbumps...So what gets in the way of potential multiple expansion in the energy sector near term? Let's be realistic and list a few true life concerns:

• In our minds, probably the greatest risk to energy stocks is that of a domestic and ultimately global recession. A temporary recession driven pause or blip down in demand for energy on a macro basis could easily lead to earnings dips for these companies, let alone setting off at least short term perceptual change in terms of how investors view the group. And if a domestic economic downturn was transmitted globally, the dip in demand could be meaningful. But, again, this would be a short term cyclical event set against the backdrop of growing secular energy demand globally. In our minds, any "dip", per se, in demand that led to falling stock prices in energy would be an opportunity for longer term investors.

• Although this is not yet being widely talked about on the Street, 2007 may be set to bring us one of the larger increases in incremental non-OPEC crude supply in some time. High prices for some time now is finally bringing out additional supply. No huge surprise. It very well could be that we see an incremental supply increase of in excess of 1.5 million barrels per day of production. IF for some reason this supply increase were to intersect with a slowing global economy, the near term perceptual impact on energy stock prices could be meaningful. Longer term, we believe it will be a drop in the proverbial bucket, but in today's world characterized by close to $1.5 trillion in hedge assets, companies like Goldman deriving a substantial portion of earnings from short term proprietary trading, and 65+% of NYSE volume being program trading driven, looking out twelve months in terms of investment time horizon might as well be the hereafter. This is something to keep an eye on and be aware of primarily because we see almost no one talking about it. You've been warned.

• The ebb and flow of global liquidity is a real issue for the group. If you read our May monthly open access discussion you know our thoughts on the importance of global liquidity and how excess liquidity has affected global asset prices over the last decade. The trail of influence is from stocks to residential real estate and now to commodities and hard assets. As the BOJ contracted the Japanese monetary base in April and May, financial markets and many a commodity price swooned in May and June. But as the BOJ panicked a number of weeks back and reinjected funds back into their financial system, financial markets began to stabilize as did a number of commodity prices including crude. Just in the last few weeks, the Fed has accelerated open market operations in front of the late June Fed meeting. And as the markets interpreted the most recent FOMC comments as the all clear sign (or more correctly, "we made you blink"), up went oil, gold, copper, silver, etc., as well as financial asset prices. Point being, we're convinced the global economies and financial markets are extremely coincidentally dependent on sustained excess liquidity/credit creation. As we've said far too many times over the years, we're living in a credit cycle, not a business cycle. IF global central bankers truly clamp down on liquidity creation ahead, crude prices could easily be a short term casualty. Question being, do global CB's really have the nerve to do the tough job? So far the answer is no. As of now, global CB's continue to remain in dire need of spinal implants.

• Are energy stocks, and commodity stocks broadly, in a bubble? It's a question we've heard again and again. It's clear that hot money is in the group. That's self evident. The post Fed meeting/quarter end window dressing equity rally in the latter days of June was all one would have needed to see to know that. But valuations argue that energy stocks are anything but a bubble. In our minds, bubbles are characterized by the simultaneity of two characteristics - price and supply. Dotcom stocks were a bubble. Prices went to the moon and Wall Street, being the generous souls they are, created all the paper supply investors could have ever dreamed. That episode of bubble magic was followed up by residential real estate prices zooming higher joined with the fact that new building activity mushroomed when excess liquidity and ease of credit found housing as an asset class this decade. But although energy and many commodity prices levitated meaningfully in recent years, it's a stretch to suggest that supply has increased commensurately. In fact, quite the opposite. Lack of increased supply is certainly one of the most bullish longer term supports to energy and commodity oriented issues. IF a slowing global economy caused a temporary demand lull for energy and hard commodities, hot money leaving the group could leave one big price hole in its wake. The reality of the weight and movement of large pools of institutional investment money at any point in time must factor into our decision making.

• For years now, we've been treated to the comment that "there is a $10-15 per barrel terrorism premium in crude prices". For years now, we've also listened the executive heads of such organizations as BP, Exxon, as well as the Saudi oil minister, tell us that oil prices were headed down in a pretty meaningful way. So far, the vote of the markets has overridden all of these comments from direct industry participants. What may be more correct, however, and certainly related to a comment above, is that there may indeed be a premium in current energy prices related to a bid from hedge, prop desk and other short term performance motivated investment money. Financial terrorism, if you will. From a long term perspective, a very important issue is that we're seeing a global realignment in geopolitical, military and energy relationships as is embodied by such examples as the SCO (Shangai Cooperation Organization). To ourselves, the thought of a terrorism premium in current crude prices pales in comparison to the implied message and potential outcome of these geopolitical realignments. That's the issue that's not simply going to go away and ultimately has direct implications for both energy prices and supply dynamics.

Speed bumps are a fact of life in any asset class bull market experience. Investors always have an ongoing choice in terms of involvement. Either buckle up or get off the road. Take your pick.

Deal Or No Deal...Very quickly, if indeed we are anywhere near correct about a long term bull in energy and commodity sectors, we'll at some point experience an acceleration in consolidation. We've seen a little bit of this over the past few weeks. When it starts, it's important to watch the structure of the deals. As you know, Anadarko is taking out Kerr-McGee and Western Gas. We believe the important message in the deal character is that it's being done for cash. And this is after an already tremendous run in APC stock price. APC management refuses to use stock as they believe it's too cheap. As per the initial announcement, APC believes they can return their balance sheet to current debt ratios within 18 months with follow up asset sales. Talk about being sensitive to stockholder interests. As you'll remember, in the late 1990's and early in this decade, every tech deal in the land was being done with paper (very expensive stock). We're nowhere near that point in the energy sector yet and that says a lot about the cycle as of this point.

Alternatively, the Phelps Dodge deal for Inco and Falconbridge is being done with cash and stock. First, PD had hedge fund Atticus breathing down their proverbial backs to "do something" with their cash. But secondly, we need to remember that PD probably left $3+ dollars per share in earnings on the table over the last few years by their hedging practices. Wildly aggressive management? We don't think so. They clearly did not believe the price potential of the very commodity that underpinned their business could do what it has done over the past few years. Suffice it to say that in general, managements in the energy and commodity sectors have been anything but aggressive either in public statements or in management practice. In contrast, the management style, public communication record and stock issuance practices of folks like John Chambers at Cisco a half decade back makes these folks look like choir boys.

Let's look at a few indicators we hope will be helpful in monitoring both energy as a commodity and the stocks as a group ahead, both shorter term and longer term.

Doctor's Orders?...For anyone with even passing interest in the financial markets, we're sure you are more than familiar with the term "Dr. Copper". Copper as a metal has been given that nickname as the price of copper is highly sensitive to any change in real world economic growth. But as you look at the chart below, perhaps we should be establishing a doctor's lounge, so to speak. It's clear that over the last decade at least, directional movement in the price of copper and crude has been highly coincidental. Both reflecting economic change as well as supply and demand fundamentals. Looking ahead, we believe both will be beneficiaries of secular growth in emerging economies, yet at the same time both will ultimately be sensitive to shorter term movements in near term global economic direction. Should we be looking at copper as potentially corroborating short term movements in crude? We think so. If for some reason copper drops big time from here, it's a good bet crude will be heading south. And vice versa, of course.

Another doctor in the house, if you will, is the Korean equity market composite, or the Kospi. In recent years, the term "Dr. Kospi" has also been heard now and again in Wall Street quarters. And for good reason. The Korean economy is highly sensitive to global economic change, and these days quite sensitive to the Asian region specifically. As you look at the chart below, it's clear that the Kospi has been a bit of a leading indicator for the forward direction of crude. Bottoms in the Kospi and crude have been relatively close in proximity. But tops are a different story. As you can eyeball a bit, in 2000 and 2002, the Kospi peaked a good nine months in front of a short term peak in crude. Will it be so again? Although we can't know in advance, we'd take a meaningful downturn in the Kospi as a warning sign for potential weakness in crude on a cyclical basis.

Finally, in terms of monitoring the short term, let's take a look at a few technical indicators that are near and dear to our hearts. If we're to get into trouble in energy stocks ahead, we believe strongly that the following will be meaningful technical confirmation. And we mean BIG trouble, not just a passing correction. First, watching the 21 week RSI is mandatory. Any sustained trip below 50 is an initial warning sign. In the chart below we're using the XLE purely as an example, but we'd certainly apply this to individual stocks as well. You can see that when the 21 week RSI has been above 50, it's been a great time to own the XLE. Secondly, the interplay between the 17 and 43 week EMA's is important. As long as the 17 week EMA remains above the 43 week EMA, longer term trends are intact. These lines simply do not cross very often. Crossings are separated by years. But when they do cross, one better be listening. As you know, these measures will never get one out at the top or in at the bottom. The point is to keep us out of BIG trouble on the downside or in synch during meaningful upward movements. These are some of our favorite macro risk management tools.

So although our comments about valuations and multiples of the moment tell us that meaningful longer term secular opportunity exists in the energy group, sensitivity to the ebb and flow of shorter term cycles is mandatory in terms of timing purchases or additions to positions. To be honest, we believe this discussion really applies to the greater commodity oriented equity universe of the moment in addition to the energy sector specifically. Although this is a very generic statement, we see these issues currently priced as hardcore cyclicals at the moment. Their stock price treatment by investors over the past few months only reinforces that thought in our minds. Will it be that they are valued as growth stocks some time before this secular energy/commodity cycle is over? If so, a whole lot of upside lies ahead. Again, we're speaking as long term investors focused on a secular trend, not as short term traders.

A few very last comments for a bit of perspective. Although the energy group as a whole has been powering higher, especially as we look at the macro S&P energy sector numbers each quarter, it has really become much more selective as of late. This year, it has really been the service companies that have held up macro sector performance. It just so happens that many of the large majors and intermediates have been in a sideways correction for some time now. This, of course, tells us why multiples have compressed as earnings have continued to move forward. Here's a little look at where some stock prices are today compared to where they have been over the past few years. It tells us that for many, a silent correction has already been a key phenomenon for the group over the last year to year and one half. Has this simply been a prelude period to eventual multiple expansion? Or is this one big topping process? Is the market discounting multiple problems for the group in this sideways action, or presenting us with multiple opportunities? Looking ahead, the charts will ultimately help give us the answer.

Market Observations
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Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

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