Is This the Best Time to Buy Stocks of Energy Companies?

Oct 12, 2015

In this issue:
» India lags China in urbanization
» RBI opens up state level debt markets
» ...and more!

The past many months have not been exactly great for global commodities. Factors such as excess supply and subdued demand from the slowdown in China have led to a meltdown in prices.

Oil has been no exception.

Global oil prices have remained volatile in recent times. One of the reasons prices plummeted in the first place was too much supply. As the US shale gas revolution boomed and OPEC chose not to curtail production, the global market was flooded with oil. It didn't help that China was not absorbing this supply because growth issues back home.

None of this has deterred Warren Buffett though. Indeed, just a couple of months back, Berkshire Hathaway purchased Precision Castparts Corp, a company operating in the aerospace and oil and gas sector.

At the time, Precision Castparts' performance had, to some extent, suffered because of the weakness in the US oil industry. But Buffett has a different way of looking at things. And he certainly refrains from predicting where oil prices are headed in the short to medium term, preferring to take a broader call on oil prices in the long run. And so his decision to invest in this company was based on the strength of the business rather than the short term price movements of oil.

That also explains why just last month, Berkshire Hathaway disclosed a US$4.5 billion stake in Phillips 66, an energy company. For Buffett, the numbers for Phillips were once again eye-catching. The dividend yield stood at an attractive 3%. The balance sheet was strong with very little debt. Plus, the company was trading at a P/E that was quite low compared to the average P/E of the S&P 500. The management was also reputed to be shareholder friendly. All classic Buffett-would-Buy attributes.

But interestingly, what also caught Buffett's eye was that even though Phillips is an energy company, it was relatively immune from volatile oil prices compared to many of its peers in the oil & gas sector. This is because the company is present in the downstream segment and does not suffer from the problem of low oil prices as its peers do in the upstream space.

And that is where he sensed an opportunity. Indeed, during times of extreme bullishness or bearishness, markets typically tend to paint all the companies in a particular sector with the same brush. So in a situation where commodity prices are cooling off, stocks of most companies in the energy, commodities, and metals spaces get a drubbing.

This is something we have been seeing in India as well. For instance, low commodity prices have taken a severe toll on the stock prices of most metals companies.

But not all companies are alike. And like Buffett, a true value investor will actually perceive the general bearishness in a particular sector as an opportunity to separate the good companies from the bad. And then take advantage of this pessimism to buy those good companies at very attractive prices. Based on the numbers of Phillips, that certainly appears the path that Warren Buffett has taken. And not surprisingly so.

Is a low price scenario the best time to purchase stocks of commodity companies? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
India's rate of urbanization has been lower than that of China in the past two decades. In India, only one-third of the population resides in urban regions. In contrast, nearly half of the population in China lives in urban areas. And one of the reasons for the divergence is agriculture which still remains the dominant source of employment in India with close to 50% still earning their livelihood from farming. On the other hand, a large part of the Chinese population earns its livelihood from industrial and services jobs, thereby pulling more of its population in urban areas.

But as per the World Bank report, India's urban population is much higher at around 55% based on agglomeration index. This index also takes into account the population density and the spread beyond official city borders. As per the report, these regions have strong urban characteristics even though they are not officially recognized as urban. Therefore the suburbs are growing more rapidly than the city centres.

To address the need of the fast growing urban population, the Indian government has launched a scheme 'Housing for All by 2022' aimed at urban areas. In order to provide a fillip to the demand for affordable home loans, recently the government increased the amount that can be lent by banks to purchase homes. In addition, the government has also allowed six new entities to function as housing finance companies that will focus mainly on the affordable housing segment.

India lags China in urbanization

In an important development that would bring in more efficiency in the management of funds by states, the RBI has opened up state level debt market for foreign investors. For the first time, states will be competing with each to sell debt to the tune of US$ 7.6 billion to foreign investors. The biggest draw for overseas investors will be high yields of around 8.16% for a 10-year bond that is second highest among Asian emerging markets.

The entry of foreign investors is expected to push states with weak fiscal positions to clean up their finances to attract funds. The implicit sovereign guarantee alone cannot act as a shield for states that indulge in wasteful spending. The fiscal discipline by states assumes importance at a time when there is a big shift in the devolution of financial power from the centre to the states.

Indian stock markets had a rather volatile trading session today as they oscillated to either side of Friday's close. At the time of writing, the BSE-Sensex was trading flat. Gains were largely seen in metals, auto and banking stocks, while IT and FMCG stocks were at the receiving end. IT stocks were out of favour despite Infosys having announced a strong set of numbers for the second quarter ended September 2015. The company has reported an 8.9% QoQ growth in sales and a 12.1% QoQ growth in the net profit.

 Today's investing mantra
"If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall." - Warren Buffett

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This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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