ExxonMobil: Morningstar Sides With Buffett Over Chanos

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Another record high for stocks today, with the S&P 500 gaining 0.5% to close at 1,800 for the first time. The narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) was up 0.3%, having closed above 16,000 for the first time yesterday. In that context, it's little wonder that chatter about a bubble in the stock market has ramped up: According to Google Trends, the volume of searches for "stocks bubble" has nearly trebled this month, to its highest level since August 2011.

This morning, I wrote that the broad market is not in a bubble per se (although it certainly doesn't look cheap), but that initial public offerings look like pocket of froth in today's stock market. I was not aware then that apparel company Vince Holding was going public today. Investors proceeded to send the shares up 43% from the $20 offer price, which, in turn, was higher than the top end of bankers' $17-$19 pricing range. That pales in comparison with the 88% first-day return online flash sales platform Zulily put up a week ago, but it does hint at the enormous pent-up appetite for growth issues in a low-yield/ low-growth environment -- ideal conditions to fuel speculative excess.

Morningstar likes ExxonMobil
Yesterday, I looked at the claim by famed short seller James Chanos that Warren Buffett's latest major addition to Berkshire Hathaway's (NYSE: BRK-B  ) equity portfolio, ExxonMobil (NYSE: XOM  ) , is "not a value stock, it's a value trap." My conclusion was that the energy supermajor's "return on capital remains well in excess of [its] cost of capital" and that it "does not need to deliver the same returns it has produced since 1970 (a better than 375-fold total return) in order to provide investors with a more than adequate return during the next 40 years."

This morning, research firm Morningstar published a detailed analysis supporting its decision to continue awarding a "wide moat" rating to ExxonMobil -- the only such rating among the oil and gas producers it covers (a "wide moat" refers to long-term competitive advantage -- a key source of excess returns). The full report, which can be found here, is required reading if you own or are considering buying ExxonMobil shares, but I've highlighted some of the key points below.

Chanos argued ExxonMobil a "value trap" on the basis that:

In terms of the integrated oil companies, the business demonstrably has gotten worse and it's for a simple reason: the cost of finding and replacing reserves has gone up. Let's just use Exxon as an example. Their revenues are down year-over-year yet the amount of capital they've employed in the business continues to grow.

However, Morningstar's analysis shows the reality is more nuanced:

Like its peers, Exxon has seen its F&D [finding & development] costs rise during the past 10 years. However, relative to commodity prices and measured against peers, Exxon remains highly competitive. F&D costs for Exxon have remained relatively stable during the past 10 years despite increasing in absolute terms. If we look at Exxon's F&D as a percentage of oil prices, it has actually fallen.

However, that measure ignores the shift toward natural gas in the reserve base. Measuring F&D as part of revenue per barrel of oil equivalent of production, however, takes into account the shift to natural gas as percentage of reserves and production during the past 10 years. By that measure, Exxon still appears competitive, suggesting it should continue delivering excess returns on capital in its upstream segment... Compared with peers, Exxon continues to replace reserves at a competitive cost. In fact, it has registered improvement since 2009.

In conclusion, Morningstar writes:

Exxon's low cost of capital plays a part in its wide moat rating. Although not the lowest of its peer group, it still provides a low hurdle rate to earn excess returns. Combined with higher returns on capital, Exxon generates greater excess returns. This wide spread between returns on invested capital and the weighted average cost of capital, or the size of the excess returns relative to peers', gives us confidence in Exxon's ability to generate excess returns for 20 years, earning it a wide moat. The magnitude of peers' excess returns is less, providing less of a margin of safety and earning them only narrow moats.

That paragraph reads like a ringing endorsement of Buffett's decision to add ExxonMobil to Berkshire's portfolio and the one to reduce the existing ConocoPhillips (NYSE: COP  ) position. However, I should note that Morningstar currently rates ExxonMobil as a three-star stock, which, according to their methodology, indicates that the current stock price is close to their fair value estimate and that the stock "should offer a "fair return," one that compensates for the riskiness of the stock." The Oracle of Omaha likes to make investments in the expectation that they will earn a return that's more than fair, but, given the size of Berkshire's portfolio, "fair" would hardly be a shameful result.

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