When Stocks Decline After You Buy Them

Sometimes when stocks drop after you've bought them it's because you've made a mistake: you bought stock in a troubled company (e.g., OPMR), or you bought stock in a good company at the wrong time after ignoring the relevant macro trend (e.g., BBSI), or you bought stock in a good company but at the wrong price (e.g., at a too-high multiple).

Stocks can also decline after you buy them even if you've made none of those mistakes. A recent example for me is Exxon Mobil (NYSE: XOM). When I bought Exxon, it was benefiting from the relevant macro trend (the secular bull market in energy), and it was trading at an enterprise value/forward earnings multiple of about 9x. I tend to view an EV/forward earnings multiple in the single digits as a conservative price for stock, considering that market average P/Es declined to 10 at the end of the last secular range-bound market in stocks (see graph above, via Vitaliy Katsenelson; for more info on his thesis, see this post, A Secular Range-Bound Market? Vitaliy Katsenelson's Thesis). I purchased XOM at $86.69, and today it is trading at $78.33, partly due to the recent correction in oil prices, which has put downward pressure on a lot of oil stocks (e.g., the oil royalty trust I mentioned that had hit a 52-week high of $107 per share in June, BP Prudhoe Bay, closed at $81.89 today. Fortunately, my average cost on this one is under $60 per share).

It's never fun to watch stocks drop after you buy them, but when those stocks belong to well-run, profitable companies such as Exxon¹, that have good prospects, are trading at cheap valuations, and have virtually bulletproof balance sheets, I'm not fazed. I'm content to hold these sorts of stocks, and in some cases would consider adding to them. I'm a little less sanguine when more speculative stocks I own decline.

¹Note that Exxon's mega cap size isn't what gives me confidence in the company. I have similar confidence in other, much smaller, companies thats stocks have declined since I bought them, e.g., Hudbay Minerals (TSX: HBM.TO), and Heidrick & Struggles² (Nasdaq: HSII) that are also profitable, trade at cheap valuations, have virtually bulletproof balance sheets, etc.

²Heidrick & Struggles, incidentally, reported a solid second quarter today, beating consensus earnings estimates by 6 cents.

Upstream versus Downstream Earnings at Two Major Integrated Oil Companies

One argument often made against investing in major integrated oil and gas companies is that rising crude prices hurt their "downstream" refining businesses. What percentage of their earnings come from their downstream businesses versus their upstream and chemicals businesses? Here are the data for Exxon Mobil and Chevron, from their most recent annual reports:

Chevron

- Total earnings from upstream operations in 2007: $14.82 billion
- Total earnings from downstream operations in 2007: $3.5 billion
- Total earnings from chemicals and other businesses: $370 million
- Percentage of earnings from downstream operations in 2007: 18.73%

Exxon Mobil

- Total earnings from upstream operations in 2007: $26.5 billion
- Total earnings from downstream operations in 2007: $9.57 billion
- Total earnings from chemicals business in 2007: $4.56 billion
- Percentage of earnings from downstream operations in 2007: 23.6%

What's Up Today: BPT, And a Few other Stocks

Despite the Dow moving into cyclical bear market territory today (closing at 11,346.51) and the decline of the S&P 500 and Nasdaq along with it, 15 of the 21 positions in my enterprising portfolio (my main stock portfolio; I am in the process of consolidating this into a more concentrated portfolio) are up today. I'm still down from my purchase price on many of these, especially the ones I bought last year, when I was still rigidly adhering to Joel Greenblatt's Magic Formula investing system (more on that in a later post), but the lack of correlation between this portfolio and the broader market indexes is partly a result of changes in my investment methodology over the last six months. Specifically, I began paying close attention to relevant macro trends for various stocks, and limiting my investments to those positioned to benefit from those trends. Some examples of those macro trends include the secular bull markets in energy, metals, agriculture, and the related infrastructure boom overseas, particularly in China.

One of the 15 stocks that is up today made a new all-time high, BP Prudhoe Bay Royalty Trust (BPT). Shares of this trust had been flirting with the triple-digit mark for the last few months, but finally closed above $100 per share today at $100.77. Despite the 50% total return for this trust over the last year, its stock still looks inexpensive, trading at only about 9x next year's estimated earnings. This is true, incidentally, of two other, radically different oil stocks I own: the integrated mega cap major ExxonMobil (XOM) and the small cap E&P Vaalco Energy (EGY) -- both trade with enterprise values at similarly low multiples to next year's estimated earnings. This demonstrates a point I and others have made recently, that despite the huge run-up in oil prices over the last year, the current high oil prices haven't been priced into many oil stocks yet. Perhaps this is because the biggest oil bulls have been investing in the commodity itself, via ETFs, and perhaps it's because many market participants believe oil will soon revert back to $70 or $80 per barrel.

Depletion is a concern for all American royalty trusts, of course, particularly one such as BPT that derives its royalties from a field as old as Prudhoe Bay. For detailed analysis and predictions on BPT's production and depletion rates, I recommend the occasional posts by "RoundRobinJack" on BPT's Yahoo! Finance message board. Here is a link to his latest Production/Distribution Update. More broadly, this man's posts demonstrate that although most comments on Yahoo! Finance message boards may be uninformed cheer leading, bashing, or just plain spam, occasionally you find an obviously knowledgeable poster whose comments are well worth reading. Just as with investing, sometimes you have to sift through the junk bin before finding something of value.

Of these three oil stocks, I currently have a GTC limit sell order on XOM. As Daniel Wahl has pointed out in correspondence with me, and in a post on his blog, integrated majors such as XOM have a few strikes against them, limiting their ability to benefit from the oil boom:

• Refining components. While the integrated majors may benefit on the exploration and production side of the business, their exposure to refining (where rising crude prices squeeze "crack spreads", i.e., profit margins on refined products) remains a liability.

• Their enormous size. This makes it difficult for new oil and gas discoveries to 'move the needle' in expanding the company's reserves.
  
• Their need (again, because of their size) to expand exploration and production in more politically unstable parts of the world, where their assets are subject to expropriation (e.g., as was the case with Exxon in Venezuela last year).
  

Despite these factors, I still think XOM is a value at these prices will probably do well over the next year. Nevertheless, I agree that there are investment opportunities in the sector with more potential, and the ideal sort of company to find would be an attractively priced small cap E&P with proven resources in a politically stable country such as the U.S. or Canada.