SIF Portfolio: Oil Stocks Make Me Question Dividend Rules

19th Jun '18 by Roland Head

6 comments 5189 reads

Last week I wrote about the SIF portfolio’s heavy exposure to cyclical stocks. The cyclical companies I was referring to are mostly stocks dependent on consumer spending or the construction market.

One cyclical sector SIF isn’t currently really exposed to is the energy sector. Although the portfolio has made some money from the the mining sector in the past (PAF, CAML, S32 & RIO), it’s never owned an oil and gas stock.

Why is this? When I last looked at oil stocks in October 2016, OPEC and Russia had just agreed on joint production cuts. At the time, I said that my screen “isn’t intended to pick up cyclical stocks exiting a major downturn. The screen is designed to identify companies that are already profitable and have the potential to deliver above-average returns.”

Nearly two years later, oil companies are in a very different place. The OPEC-Russia deal was very successful. The price of a barrel of Brent Crude has since risen by more than 50% to about $74 (at the time of writing). Oil companies’ costs are down, cash is flowing and profits are rising fast.

Russia and OPEC are in the headlines again this week, ahead of a meeting where they’re expected to consider whether to increase production. Despite this, there are still no oil stocks which qualify for my screen. Do I need to consider tweaking my screen so that SIF can invest in oil? Or is this a tricky sector that’s best avoided?

Bad timing or a bad business?

The oil sector doesn’t have a great track record of generating the kind of sustainable, above-average returns I’m looking for.

While oil traded above $100 per barrel almost continuously from 2011 to mid-2014, Royal Dutch Shell’s return on capital employed fell from a peak of 18% in 2011 to 7.5% in 2014.This was accompanied by a fall in operating margin from 9.1% to 4.7%, as both costs and spending ballooned:

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It was a similar (or worse) story elsewhere in the sector. This suggests to me that by 2011, it was probably too late to profit from the last oil bull market. When oil prices flattened out, it was an early sign that the cycle was turning.

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kkaddo

19th Jun '18

Good article. Very insightful.

jjis

Hi Roland, in answer to the questions you posed at the end of your post.
1) Yes I find them essential but also nice to have!
2) I've seen lots of research which suggests focussing on dividend payers and growers tends to offer higher returns with lower risk, although mostly in equally weighted portfolios.

Zero yielders tend to offer lower returns and greater risk, so I'm happy to exclude them, but of course there will always be exceptions to that.

Thus I tend to look for growing yield stocks & I'm happy to exclude zero yielders from my universe of stocks that I Score.

There is also research which suggests that picking yield stocks on the basis of total shareholder yield is more effective - which means factoring the yield from dividends and share buy backs - which is something that you alluded to in your post. Unfortunately this is not easily screenable in Stockopedia apart from having a look at change in shares outstanding as a rough and ready proxy for it.

Regards
Jamie
Website : Compound income

Merlotman

Roland
Like Jamie I look for dividends for my long term portfolio because there is lots of research that concludes that dividend growth when compounded makes up the lions share of stock market returns. Whether companies paying dividends represent a lower risk is open to more conjecture but I would argue that for most companies so long as the dividend is well covered it is a better use of spare capital than going on an acquisition spree!

PS Like you I have tended to avoid O&G shares but recently took a smallish position in BP (LON:BP.) encouraged by the fact that it was gradually putting its problems behind it and was starting to benefit from the increase in the oil price. Not one for the long term however.

LongValue

Of course, it's a broad generalisation but there seems to be a large proportion of non-dividend paying companies that generously reward senior managers, regardless of the share price performance. Virtually all the resource exploration and production companies that I have come across pay their managers substantial amounts in cash and yet many pay no dividends. They simply leave dangling the carrot of a potential takeover and, therefore, capital gains.

Resource companies such as Cairn Energy (LON:CNE), Central Asia Metals (LON:CAML) and SOCO International (LON:SIA) have all returned a large chunk of their profits to shareholders. But for each of these, there are many resource stocks that provide neither income nor exit route for shareholders. In my view, it's easy to forget that resource stocks will often have depleting reserves. The managers of most of these companies are clearly intent on extracting cash for themselves on an on-going basis. But the rewards for shareholders are largely back-loaded and that's presuming they crystallise at all.

Roland Head

Hi LongValue,

Thanks for your comment. I couldn't agree more re. directors' pay and rewards for shareholders at resource firms. Any money they do make tends to be reinvested in new prospects and directors' yachts. It's rarely returned to shareholders.

The companies you mention are honourable exceptions, but I'd still argue that good research, good timing and a long horizon are needed for investors to have a chance of outperforming the market with these stocks.

Cheers,

Roland

Without wishing to labour the point, I am unsure whether investors are aware of what their Directors are contractually bound to do. There seems to be an implicit assumption that the Executive Directors are working full-time on the company's behalf. However, this may not be the case and I suspect that this is an acute problem with resource stocks. The Directors often appear to act under little or no supervision and have operations in out of the way places where there is a lack of public scrutiny. How much time they actually spend on the company's business is largely unknown. How much overlap there is with their private interests is completely unknown. The NED responsible for the Directors' remuneration may also be on the gravy train.

It's an awful phrase but the term “Lifestyle company” springs to mind. Forget about dividends, forget about profits. For some, it appears to be all about just keeping it going for as long as possible. Putting the shareholders, including institutions, on a promise and then simply milking the company in a variety of ways for personal gain. Maybe as investors, we need to differentiate more clearly the difference between gambling and investing.

SIF Portfolio: Oil stocks make me question dividend rules

Bad timing or a bad business?

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Roland Head

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