The perfect investment formula seems simple: buy great companies with wide moats while they’re cheap and hold them for the long term. It seems simple enough. But as buy-rated Exxon Mobil (NYSE:XOM) stock shows, it’s not easy to follow this seemingly simple advice.
Why? That’s because the perfect investment formula omits one key hurdle: great companies will ONLY find themselves in the bargain bin during hard times.
In Exxon’s case, oil prices plunged to a record low in March. Despite crude oil prices recovering to $40.70 in recent weeks, it’s no wonder investors still cautiously tiptoe around Exxon Mobil stock rather than jumping in. Here’s why long-term stock investors should buy XOM at $44 today.
XOM Stock Has a Strong Underlying Business
Over the years, Exxon had invested heavily in vertical integration. Today, the company has connected 80% of its global refining capacity to its chemical and base stock facilities. The integration has given Exxon an enormous boost to its competitiveness. Despite producing just 25% more barrels per day than rival Chevron (NYSE:CVX), Exxon generated 83% more revenue and 390% more profits in 2019. Put another way, XOM downstream facilities extract far more value from each barrel of its oil.
Exxon’s high-quality balance sheet reflects its business quality. At the start of 2020, Exxon was one of only three companies in the world that held the highest Aaa rating from Moody’s, a bond rating agency. The other two are Microsoft (NASDAQ:MSFT) and Johnson & Johnson (NYSE:JNJ). Years of careful debt management had given Exxon Mobil one of the best debt to book capitalization in the industry.
At $44, Exxon Is Amazingly Cheap
The coronavirus pandemic has created a golden opportunity for investors to buy Exxon shares. In 2020, West Texas Intermediate (WTI) oil plunged from $61.1 to $11.2 after coronavirus-focused negotiations broke down between OPEC members and Russia. The value of Exxon’s meticulously selected low-cost oil reserves nosedived.
The market’s reaction was quick. Moody’s swiftly reduced Exxon’s Aaa rating to Aa1. “Even with large cuts in costs and investments, the company’s negative free cash flow generation and debt increases,” Moody’s analyst Peter Speer wrote to investors on April 2. “Moody’s low commodity price case … could weaken Exxon Mobil’s credit profile and result in a ratings downgrade.” Exxon’s stock tumbled on the news.
So why buy Exxon?
How to Find the Best Investments?
The best investments aren’t usually the ones that politely knock on your front door while wearing their best Sunday outfit. These well-dressed investment darlings are almost always highly valued by the market. Shares of Amazon (NASDAQ:AMZN) today, for example, trade at 85 times 2021 earnings (forward P/E ratio).
Instead, the best investments are often those that are going for cheap. In 2015, Amazon shares tumbled after investors raised fears about profitability at Amazon Web Services (AWS), the firm’s data center division. Shares briefly traded under 40 times forward earnings. Far-signed investors buying Amazon at $260 would have seen their investment return over 1,000% over the following four years.
Becoming the Next Warren Buffett
It’s never easy following magic formula investing. In 1963, American Express (NYSE:AXP) got involved in a stunning fraud case that eventually became known as the Salad Oil Scandal. The company had leased four major oil storage facilities to commodities broker Anthony “Tino” De Angelis. On investigation, authorities found that De Angelis had filled the containers with just a thin layer of oil to hide seawater underneath. Shares in American Express plummeted as investors rushed for the exits.
And then a quirk of history happened: a then-little-known investor named Warren Buffett decided to invest. The young investor, believing in the long-term value of American Express, sank 40% of his partnership’s assets into the company. As the scandal blew over, American Express shares eventually recovered and the modern iteration of Berkshire Hathaway was born.
Long-Term Investors Should Look at Exxon
At $44, Exxon’s battered-down shares trade at just 10.4x average 7-year earnings (the typical length of an oil cycle). And on a price-to-book value (P/BV), the company at 1.05x P/BV has rarely been cheaper.
Oil prices will eventually recover as higher-cost producers leave the market. “Global oil supply is set to tumble by a massive 7.2 mb/d on average in 2020,” wrote the International Energy Agency (IEA) in its June report. Reflecting that sentiment, the US Energy Information Administration (EIA) estimated that US oil prices would settle back at $49 by the end of 2021, just $2 shy of its 5-year average. For XOM, the top-5 equity analysts as ranked by Institutional Investor puts an average target price of $53.4. That’s a 21% upside from today’s prices.
It’s never easy to buy a company when the bottom has fallen out of its market. But when the energy market eventually returns to equilibrium, patient stock holders in XOM stand to gain.
Tom Yeung, CFA, is a registered investment advisor on a mission to bring simplicity to the world of investing. As of this writing, Thomas Yeung did not hold a position in any of the aforementioned securities.