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Oil: 1 Story for Legitimate Fundamental Stocks Investors Only

By Alex Dumortier, CFA - Apr 26, 2016 at 12:53PM

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Despite their financial resources, even oil majors could inflict dividend cuts on their shareholders.

U.S. stocks are little changed in early afternoon trading on Tuesday, with the S&P 500 (^GSPC -0.02%) and the Dow Jones Industrial Average (^DJI -0.29%) (DJINDICES: $INDU), up 0.20% and 0.08%, respectively, at 12:35 p.m. ET. Perhaps it's because the Federal Reserve's Federal Open Market Committee convenes today for its two-day April monetary policy meeting.

However, let's be clear: If you are focused on this event, don't you dare call yourself a fundamental equity investor. More interesting -- certainly for shareholders -- is Apple's quarterly earnings report after today's close. Incidentally, Apple is the largest of three of four top companies in the S&P 500 that are reporting this week, along with Alphabet Inc and ExxonMobil Corporation. In aggregate, these three names represent nearly one-and-a-half trillion dollars in market value. That's the kind of weight that moves markets!

Buy cheap, sell expensive
Interviewed by CNBC at the Investors Choice Awards in London last week, Harald James Otterhaug, Managing Director of Oslo Asset Management, made his fundamental orientation clear, stating with admirable concision: "[W]e try and buy cheap stocks and sell expensive stocks."

Of course, plenty of people try to do the same thing, but Oslo Asset Management has apparently had some success pursuing that strategy: Otterhaug cites a 17% annualized gross return (i.e., before fees) over the past 10 years.

What does Otterhaug have his eye on these days? One fundamental theme he believes remains under-appreciated affects oil companies:

In the last four or five years, some of the inefficiencies that have been building are partly due to the cyclicality of oil prices and the traditional business cycles, partly due to all the fiscal and monetary policies that are being applied aggressively globally.

One of the things that we've seen that has been more structural is that a lot of [oil] companies have adopted dividend policies that are unsustainable and have been rewarded by the financial markets that don't sufficiently question the sustainability ...

Return of capital vs. return on capital
Why so unsustainable?

[A] lot of that unsustainable dividend has been financed by easy access to credit markets and equity markets ... [L]ast year, when the equity and credit markets shut down for a lot of these companies, it became pretty quickly evident that the dividends weren't sustainable and investors realized that a lot of the dividend that they've received in recent years has actually been return of capital rather than return on capital and there wasn't much capital left ...

I think that was a big theme for us that played out last year, but, again, it's still in the early innings; I think there's plenty of opportunities out there yet ... [Dividends will have to be cut further yet] for a lot of companies that have adopted policies that are unsustainable.

This theme does not concern only marginal, highly leveraged energy companies, either: ExxonMobil paid out over 100% of its earnings in dividends in the fourth quarter. Based on current earnings estimates and assuming no cut in the dividend, the same will be true through the third quarter of this year, at least.

(Today's loss of its coveted triple-A credit rating from Standard & Poor's does nothing to alleviate the situation, even if Exxon will continue to be able to raise debt at historically low rates.)

Last September, this column warned that Royal Dutch Shell plc, which has increased its dividend every year since the end of the second World War, is at risk of having to cut its dividend.

There may be legitimate reasons to buy (or continue to own) shares of oil majors at this time, but I'm going to agree with Otterhaug that a permanent dividend is not one of them.

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