Our readers probably could easily tell that our investment philosophy is heavily influenced by Ray Dalio. In his mind (and ours too), the picking of specific stocks and the diversification across different stocks (or even sectors) is the LAST step of investing. The grand investing scheme starts with risk isolation, asset class allocation, geographical diversification, and consideration of macroscopic cycles. That is why both in our own accounts and in our marketplace service, our first step is always risk isolation using a barbell model. Then the second step is asset allocation across classes that respond differently to fundamental economic forces as shown in the chart below. Only after these steps, do other more detailed steps follow.
Today I will focus on two other Dalio insights after risk isolation and asset allocation: the role of geographical diversification and the need to think in macro cycles – even, or should I say especially – cycles that you may not have experienced in your own lifetime. And specifically, the thesis will argue that two oil stocks, Petrobras (NYSE:PBR) and Suncor Energy (NYSE:SU), fit nicely into his scheme. They both enjoy strong support from the new commodity cycle and offer geographical diversification, especially for investors who are primarily exposed to the U.S. More specifically, in the remainder of this article, I will argue that:
- Both companies are well positioned for near-term gains given the geographical conflict in the Russian/Ukraine region and also the high oil prices.
- Both companies are also well positioned for long-term gains given the structural supply-demand imbalance, which is a problem accumulated over years of underinvestment.
- And finally, with the strong cash provided by the recent tailwinds, both companies are at their strongest financial strengths in a decade and enjoy capital allocation flexibility. With the recovery in both ROIC (return on capital invested) and reinvestment rates, healthy long-term growth can be expected now.
Profitability, Financial Strength, and capital allocation
The past few years are not the best years for oil stocks and PBR and SU were no exception. These stocks faced a multitude of headwinds ranging from regulations, unfavorable oil price fluctuations, and also disruptions caused by the COVID pandemic.
However, the picture is not totally different as seen below. The oil sector, and especially PBR and SU, is putting in a strong showing. To cite a few key profitability metrics, PBR enjoys a gross margin of 50.8% and SU even higher, 61.5%. To put things under perspective, the following table also shows the gross profit margin of Exxon Mobil (XOM) and Apple (AAPL). The reason for including AAPL here is not to compare apples against oranges. I am including it as it is often cited as the most profitable company and its high margins. As seen, PBR’s gross margin is more than 1.58x higher than XOM’s 31.99% and about 18% higher than AAPL’s 43.3%. As seen, SU’s gross margin is almost 2x higher than XOM’s and about 1.43x higher than AAPL’s.
In terms of bottom-line metrics, their margins are also equally impressive. PBR enjoys a net margin of 28.4% and SU about 18.5%. These levels are again competitive when compared to leaders in the oil sector such as XOM (whose net profit margin is 10.9%) or beyond like AAPL (25.71% net margin).
As a result of the strong profitability, both companies now enjoy strong financial strength and capital allocation flexibly. As shown in the top panel of the chart below, PBR’s long-term debt has been decreasing constantly since 2014 from over $120B to the current level of $31B only. Its long-term debt resided at a reasonable 36% of total capital. Moreover, when the second quarter concluded, its cash and equivalents resided at around $19.1 billion. Also, close to $9.5 billion was available through several lines of credit. The picture for SU is equally strong as you can see from the bottom panel in the chart. SU’s long-term debt has decreased sharply from a peak level of over $14B to the current level of $11B only. And its long-term debt resided at an even more conservative level of 27% of total capital.
Thanks to strong profitability and low debt burden, both companies now enjoy excellent capital allocation flexibility as illustrated by the interest coverage requirement shown below. As shown, PBR’s interest coverage (defined as interest expenses divided by EBIT) has peaked above the 15x+ level twice in the past decade – the first time was in 2014 and the second time is now. Its debt coverage ratio has been on average 3.2x in the past decade. And its current ratio of 15.38x is far above the average and means it only requires 6.5% of its EBIT earnings to service its debt now.
And again, the picture of SU’s interest coverage is equally strong. Its interest coverage has peaked at 16.8x in the past decade and has been on average 5.39x in the past decade. Its current ratio of 11.17x is again far above its historical average and also close to the peak level in a decade. Currently, it only takes less than 9% of its EBIT earnings to service its debt.
ROIC and growth potential
After addressing their financial strength and capital allocation, let’s move on to analyze their growth and potential returns. When you think in long term as a business owner, the long-term growth rate of a business is simply the product of ROIC and reinvestment rates.
The ROICs of PBR and SU over the past decade are shown below. As seen, both were suffering miserable ROIC most of the time during the past decade due to the headwinds mentioned above. All told, PBR was able to maintain a 3.41% ROIC on average in the past 10 years. And SU is not much better. Its ROIC on average has been 3.43% in the past 10 years. And you can also see that both of their ROICs nosedived to the negative ~10% in 2020 after the COVID pandemic broke out, halting travel and disrupting many other aspects of energy consumption.
Now as seen, their profitability has staged a V-shaped recovery and current hover around a record level. To wit, PBR’s ROIC stands at 27.6% now, and SU’s at 17.5%. Assuming a 10% reinvestment rate (which is consistent with both companies’ recent track record), they can expect healthy mid-single-digit growth rates sustainably now. More specifically,
- PBR’s real growth rate would be about 2.7% (27.6% ROIC x 10% reinvestment rate = 2.7% growth rates). And adding 3% of inflation adjustment can bring the nominal growth rate to about 6%.
- SU’s real growth rate would be about 1.7% (17.5% ROIC x 10% reinvestment rate = 1.8% growth rates). And adding 3% of inflation adjustment can bring the nominal growth rate to about 5%.
Valuation and projected returns
Despite the robust demand ahead and high margins, both stocks are undervalued both in absolute and relative terms. As seen below, PBR is trading at 2.03x of its operating cash flow (“CFO”) only and SU at about 3.93x. Such valuations are substantially lower than the overall market, their peers in the US such as XOM (which trades at 6.4x CFO), and also their own historical averages.
Historically, the valuation for PBR has fluctuated in the past decade between 6.2x CFO and 0.7x CFO with a long-term average of 2.72x. And its current valuation of 2.0x CFO is below its historical average by more than 26%. The valuation for SU has fluctuated in the past decade between 2.0x CFO and 17.9x CFO with a long-term average of 7.13x. Therefore, its current valuation of 3.9x CFO is below its historical average by almost 45%.
Assuming a valuation reversion to the mean in the next five years, both stocks can easily deliver double-digit annual total returns considering their growth potential analyzed above. More specifically,
- PBR is projected to deliver a total annual return of 12.3%, consisting of 6% growth and about 6.3% from the valuation expansion.
- SU is projected to deliver an even higher total annual return in the upper teens, around 17%, consisting of 5% growth and about 12% from the valuation expansion.
Risks and final thoughts
Both stocks face some risks though. For PBR, it is facing some political uncertainties. There was a (another) sudden change in the CEO spot at Petrobras recently. Jose Mauro Coelho resigned in June after serving just around two months. Media reports state that this occurred because of a disagreement with Brazilian President Jair Bolsonaro over the company’s fuel pricing policy. Its CEO has changed a few times since 2021, reflecting the political uncertainties the company is facing.
In SU’s case, it is dealing with cost control. It raised its 2022 budget to the range of $4.9 billion-$5.2 billion from the initial $4.7 billion (a 7.5% increase). Compared to last year’s outlay of $4.56, it is an even large increase of 10.7%. Such an increase reflects the inflationary pressures and rising operating costs.
To conclude, turbulence in the market only offer more and better opportunities for long-term investors. And now is a good time to apply Ray Dalio’s thinking to identify such opportunities and strengthen our portfolio. In particular, both PBR and SU fit nicely into Dalio’s grand investing scheme. They both enjoy strong support from the new commodity cycle, both offer geographical diversification, and both provide double-digit annual return potentials.