The latest U.S. Census Bureau statistics show more people currently on some form of means-tested public assistance than working full-time. Fortunately, that dismal employment statistic is not evenly distributed across all industries in our economy. One industry in particular that has been relatively isolated from the jobless recovery is the oil and natural gas sector.
For individuals fortunate enough to live in a part of the country where large deposits of shale oil are located or lucky enough to have chosen a career in the oil and gas industry, things couldn't be better. From the start of 2007, the U.S. Bureau of Labor Statistics showed roughly a 1% increase in the overall private sector employment while the oil and natural gas industry increased by more than 40%. Over the last decade, the performance of oil and gas commodity prices paint a similar picture to the fat paychecks of a new generation of wildcatters digging in the Bakken Shale of North Dakota. As indicated on the chart, a dollar invested in unleveraged oil and gas commodities vastly outperformed stocks over the worst decade in a hundred years.
Over this dismal ten-year span, oil sitting in a warehouse tripled in value (excluding storage and insurance costs) while the S&P 500 lost money in nominal terms. Natural gas also experienced solid price increases. The chart shows natural gas more than doubling in value while a stock index fund stunk about as bad as sour crude during high wind. I wonder how many employees working in the petroleum industry know that stocks lost money over the last decade? It must feel good being comfortably insulated from the shock of losses on a 401(k) statement thanks to hefty matching contributions coming from your benevolent employer in Big Oil.
For a moment, let's set aside the "feel good" matching contributions that hide the pain of gazing down a dry hole on your 401(k) statement. If stock mutual funds aren't any good, what should an investor riding high in the oil and gas sector do with surplus capital that's not reinvested in his business? The answer is to diversify a small portion of your money out of oil and gas and invest in deep-value stocks. Consistent with a world that has dug out of the ground most of the easy oil close to the surface, successful stock investing has to go deeper than a stock mutual fund and embrace a particular form of value investing. The stocks I'm referring to are ones trading below liquidation value.
Determining the liquidation value threshold of a company is a simple mathematical calculation. The current assets (the most liquid assets on a company's balance sheet) are subtracted from all liabilities, including preferred stock. This calculation is then converted to a per-share figure. The investment strategy involves purchasing only shares of stock trading at a price point below this measure of liquidation value.
Let's assume an investor only purchased stocks that were trading below seventy-five percent of liquidation value. Assume no more than ten percent was invested in any one stock, and all the stocks were held for exactly one year. If few stocks could be found trading below liquidation value, the balance remained idle in a money market fund. Unlike a stock index fund, the deep value stock picks outperformed oil and gas in a decade when energy was near the top of the class in the commodity hierarchy. As indicated from the previous chart, stocks as an asset class didn't make any money, but that's not true of deep value stocks. Reviewing the alternate chart below, stocks trading below liquidation value not only hit pay dirt, they outperformed the stellar price appreciation achieved in oil and natural gas.
Both of the previous charts give off the stench of a snake-oil salesman trying to wheedle precious capital off a shrewd oilman. One can make a credible argument that we're data mining; picking a nice decade out of the bunch to make stocks trading below liquidation value look fantastic relative to other asset classes, including select commodities in the energy space. Does the strategy of diversifying out of the oil and natural gas sector work over a longer time horizon? Let's assume I'm trying to convince the proud owner of a working-interest in an oil well to diversify out of energy commodities. With the image of future royalty income checks dancing in his head, I can't imagine a more difficult person to persuade into buying stocks below liquidation value. Why should he or she change around a good thing when new wells in the Eagle Ford Shale of Texas are pumping on all cylinders?
Forget about the merits of not keeping all your eggs in one energy basket. Let's focus for right now on the brass tacks of portfolio performance over the long term by diversifying into deep value stocks. Through some arm-twisting, let's assume someone working in the oil and gas space agreed to diversify ten percent of their portfolio out of energy commodities and buy stocks trading below liquidation value. This minimum level of diversification into the unknown doesn't require an oilman to abandon his beloved commodity investment. As indicated on the graph, only a baby step of a ten percent weighting in deep value stocks needs to be made to achieve a more than incremental improvement in terms of portfolio performance.
The chart shows that even a limited exposure to stocks trading below liquidation value beats the oil and natural gas unleveraged commodity over the long term. Substituting a 10% weighting into a stock index fund instead of deep value stocks shows improvement over energy commodities alone, but still is sub-optimal. Diversifying into stocks trading below liquidation value puts an additional 30 cents on the dollar in our oilman's pocket over an index fund. It's not simply the act of diversifying into stocks that matters. Choosing select stocks that conform to the value investment criterion also makes a difference in terms of optimizing performance over the long term.
The evidence shows that deep value stocks and an oil and gas commodity portfolio seem to go together like hydraulic fracking and horizontal drilling. It not only drives up the average return, but portfolio drawdowns are also reduced. The combination of lower risk and higher return is a winner. People who draw all of their wage income, royalty income, and capital gains from the oil industry might view a 10% diversification into deep value stocks as a move in the right direction.
For those who have an interest in deep value stocks, follow us on Twitter @WendlFinancial.