The most valuable quality of any portfolio manager is the ability to change his or her mind, and not look back. When the facts change, so should the thesis. And the facts have changed with Dividend Growth portfolio holding Chevron (CVX).
A look at the oil giant’s fourth-quarter results revealed a balance sheet that we flat-out were hoping to avoid, particularly for a commodity-producing entity. What was once a healthy net cash position just a few quarters ago has now ballooned into a $15 billion net debt position and a $27 billion total debt position overall. The pace of change has been incredible, and Chevron continues add more leverage as we write. Just last week, it sold another $6 billion in bonds.
There’s nothing necessarily wrong with adding more leverage to the balance sheet during difficult times, especially when the price of its product has been cut in half, but this is just the beginning of its debt-raising cycle, by our estimate. For Chevron to sustain its massive capital spending program and its healthy dividend, the firm will have to keep coming back to the debt markets. Chevron is simply spending too much. Its $31 billion cash capital and exploratory budget for 2015 is too high. Chevron burned through $4.8 billion in cash during the most recent quarter alone.
Almost our entire dividend growth thesis on Chevron has hinged on the firm’s strong balance sheet position as a backdrop to (an insurance policy for) the inherent unpredictability of crude oil prices. The firm’s AA rating from Standard & Poor’s still speaks to its strong credit health, of course, but being able to refinance debt via an assessment of the probability of bankruptcy (which a credit rating measures) is much different than assessing the company’s ability to satisfy shareholders (which are interested in capital appreciation and income growth). Shareholders are lower on the hierarchy of the capital structure than debt holders.
We find the pace of deterioration in Chevron’s balance sheet shocking. A look at the firm’s presentation slide decks from a few years ago reveals a management team that was highlighting its net cash position relative to its major peers. They were highlighting it. And then, poof, that favorable aspect of its business and our dividend growth thesis has become tarnished. Such writing may seem sudden for new members, but when the facts change, so does our thesis. We’re removing Chevron from the Dividend Growth portfolio, at roughly its cost basis.
In its place, we’ll be swapping the Energy Select Sector SPDR ETF (XLE), which incidentally holds a 13% position in Chevron. In light of the collapse in crude oil prices, a diversified approach to address the credit deterioration across the energy space makes the most sense regarding dividend growth at the moment. If Chevron has to resort to such aggressive and accelerated debt-raising efforts, much of the rest of the energy sector will as well. Balance sheets across the sector will look much different in the coming quarters, and it won’t be pretty.
The dividend yield of the Energy Select Sector SPDR is ~2.5%, a much better risk-adjusted dividend growth idea in light of recent developments. We have to be very clear about this change, however. It is not about being right or wrong on Chevron, but appropriately pursuing the best risk-adjusted idea within energy that serves the goal of the Dividend Growth portfolio, which is sustained income growth.
In other news, Dividend Growth portfolio holdings Apple (AAPL) and Altria (MO) keep powering ahead, and while the share price of the latter is starting to get pricey, we’re holding until its technical and momentum indicators roll over (this is a core part of the Valuentum process). Both companies have been blockbuster winners in the Dividend Growth portfolio, and we’ve pounded the table time and time again on them in the past. Profit taking on them and others, however, is drawing nigh, particularly as valuations become increasingly stretched.
Even some of steadiest companies on the market are trading at multiples not seen since the bubble days of the dot-com era. Please don’t become complacent or overconfident.
Price almost never equals value. Price is what you pay for a company, and value is what you get, as measured by a company’s net cash on the balance sheet and its future enterprise free cash flow stream. Just like stock prices can overshoot valuations to the downside as in the panic bottom of March 2009, they can overshoot to the upside as well (e.g. the dot-com era). A “frothy” market is the environment we’re in right at the moment, and there’s no question about it. Don’t overreact, however.
An overpriced market can still get more overpriced, and we’re not necessarily taking on added risk by letting winners run. In fact, selling too early or at fair value is a major pitfall of the “value” process, which truncates overall returns. Many pure “value” investors, for example, have been out of the equity markets for years. Bargains are certainly few and far between, but we’re still uncovering underpriced gems with high probabilities of price-to-fair value convergence. We think 2015 still has the makings of a difficult year for the equity markets as a whole, but this just means that stock-selection is that much more important.
The Dividend Growth portfolio does not follow an indexing strategy, and while overall market forces will impact portfolio performance in coming periods to a degree, we’re looking to (our goals are to) generate outsize returns and achieve above-average income growth, not accept the mediocre returns of an index. We have no intentions, however, to be fully invested at today’s valuations. The markets will do all that it can to try to bait us to add to the portfolios at these lofty levels, but that’s why discipline is so important.
Just like the American patriots at the Battle of Bunker Hill, “don’t fire until you see the whites of their eyes.” As they always do, the markets will eventually come closer to bargain-priced levels, and we’re keeping some dry powder just for that moment. We don’t waste ammunition until we have a clear sight to outperformance. Our favorite dividend growth ideas are included in the Dividend Growth portfolio.