The Rational Cloning: Weekly Ideas #76

Smead Capital on Drilling For Oil on the NYSE, Tweets/Ideas That Make You Go… Hmm 🤔

The Rational Cloner

Mar 19, 2023

Welcome to the 76th edition of the Rational Cloning Newsletter (Weekly Ideas Series).

Helping you discover the best ideas of others.

Happy cloning.

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Weekly Investment Ideas

(1) Red Deer Investments - Prepare The Umbrella Before It Rains

I’ve written over 10 pages in the past two weeks and discarded them all. Sometimes, things just don’t click, and I find it better to start over than to finish a concept that doesn’t hit the mark. However, there’s a fine line between that and paralysis. Today is the day to get some words on the page to break the cycle.

While rain is nothing new in Seattle, it can take many by surprise in other places. Not checking the weather and being unprepared with an umbrella can ruin an otherwise survivable day. The same approach tends to apply in capital markets. When fear grips pricing, homework must have already been done. Learning about businesses when liquidity is falling apart is a challenging endeavor, similar to shopping for an umbrella at the beginning of a strong rainstorm.
Knowing one’s psychology is also crucial to understanding whether to duck into a restaurant and have a meal to wait it out or brave the storm to reach the next destination. In his book, Steve Schwartzman outlined this point:
The best time to buy is when there’s blood in the streets. That’s when you get bargains. But it’s also when you have to be most careful. You don’t want to catch a falling knife. You want to wait until it hits the floor and bounces back up a bit.
What It Takes: Chapter 16 (Why There Are No Old Brave People In Finance)
Others take a different approach and “catch the proverbial knife” by buying on the way down.
As financials took a beating over the past few days, unlike in the past when I was unprepared, this time I had a name in mind that I wanted to own but was waiting for the right price. OneMain Holdings is a market-leading sub-prime consumer lender with a 20% share of the installment lending market. It’s a sandwich of AIG and Citigroup’s legacy subprime consumer lending businesses, shepherded by Fortress in the prior decade. In essence, it is similar to a bank in that it borrows money and lends it out. However, its borrowings come from long-term fixed-rate bonds and medium-term fixed-rate securitized debt, not deposits.
In some sense, it is constructed inversely to the regional banks feeling pain this week by having longer duration liabilities than assets when one considers the unsecured bond liabilities and non-recourse match funding on the securitized funding side (there is nuance, but keeping it simple).
It runs a highly efficient operation, with low operating costs, charge-off rates, and high cash generation. It currently trades for a market cap of $4.3B with total adjusted capital of $3.2B. It generally underwrites to a 20-30% return on total adjusted capital or $0.8-1.2B annually. It returns about $500M to shareholders via dividend and returns incremental earnings to shareholders via repurchase (~$280M last year but likely much lower this year). More importantly, as a banking business, the company prioritizes discipline and consistency over growth. Here’s what the CEO had to say:
“We try to stay disciplined and stick with our discipline. I’ve talked before about we actually don’t manage the growth. Growth is an output. We have our credit box. It’s very specific and granular. We want to put customers in loans, they can afford and pay us back. That’s good business for our customers. It’s a good business for us.” - Barclays Financial Conference, September 2022
Bigger picture, the major questions I ask myself about this business are whether consumer credit will grow or shrink over the next 5 years and whether unemployment will rise to deeply recessionary levels (say 8-10%)? Both questions I am unqualified to answer, but willing to bear the downside risks given diversified portfolio construction.
As Schwartzman outlined what works for his psychology, deep concentration in home-run like ideas doesn’t match my personality. I tend to find greater confidence and comfort in a diversified portfolio with a material yield to anchor on. To each their own. I bought a small amount of shares, specifically roughly 1/15th the largest concentration I would take in a new single stock (which is roughly 3%). But as the portfolio is designed for yield, not market timing, with each month that passes with the pricing being acceptable, I’ll be able to grab a bit more.

(2) Smead Capital - Drilling for Oil on the NYSE

As a young stockbroker in the 1980s, I was very enamored with T. Boone Pickens. Pickens recognized the huge value that built up in common stocks in the inflationary 1970s and began to use the financial backing of the Junk Bond King, Michael Milken, to become an activist on Wall Street. His little company, Mesa Petroleum, started investing in undervalued large cap oil stocks and threatened to do large leveraged buyouts (LBOs) with the assistance of Milken’s firm, Drexel Burnham Lambert (my employer).
Pickens said, “It is cheaper to drill for oil on the New York Stock Exchange than it is to drill directly.” After reading Pioneer Natural Resources CEO Scott Sheffield’s comments recently, we at Smead Capital Management believe we’ve reached that point again:
“Crude oil prices likely will climb to ~$100/bbl by this summer and end the year in the low 90s, Pioneer Natural Resources (NYSE:PXD) CEO Scott Sheffield said Thursday during the company’s post-earnings conference call.
Sheffield nevertheless reiterated that capital discipline will remain the priority, and Pioneer’s (PXD) shareholders have not changed their view on that.”
Intense political pressure from Federal and State levels of government is scaring oil and gas companies away from drilling for environmental reasons! Since common stock investors want to benefit from scarcity, Sheffield is not alone in this attitude. If he is correct, the largest capitalization oil companies should be on the hunt to replenish oil reserves via acquisition.
The larger oil stocks are more popular primarily because the large investment pools came hunting for oil stocks in 2021 and 2022, but only the largest of the bunch could absorb the massive capital. My co-portfolio manager, Cole Smead, liked to say, “it is like blasting a fire hose into a teacup.”
The entire energy space bottomed in 2020 at a measly 2.4% of the S&P 500 Index and now sits at a still very depressed 4.79% of the index. It produces a much bigger part of the S&P’s total profit. If Sheffield is correct on oil prices and the inverted yield curve has its usual effect on the economy, oil and gas profits could become one of the only games in town, like last year.
“We had a record year in 2022… about $8.4B in free cash flow,” the CEO said on the call. “We returned $8B of it back to the investors in regard to both dividends and buybacks… [so] no change at all.”
This attitude toward shareholder friendliness is very economic. Nothing could be better than producing addictive fossil fuel energy at higher and higher prices for the next decade. Just look at what Philip Morris did in the U.S. from 1970-2010, when they were vilified, divested and saw adult smoking decline radically. With local, state and federal taxes along for the ride, the price of a pack of cigarettes went from 20 cents to $5. Big “Mo” was the best performing NYSE stock over those 40 years. It was Peter Lynch’s largest position in Fidelity Magellan from 1977-1992 when he retired.
Sheffield continued:
“The company plans to spend $4.45B-$4.75B on capital projects this year, up from $3.8B in 2022; Sheffield said the 2023 range includes growing its rig total to 24-26 and assuming prices for equipment, supplies and labor will rise ~10%.”
We believe that a huge valuation spread, as represented by enterprise value/debt-adjusted cash flow, exists between mid-cap/large-cap oil companies and the mega-caps like Exxon and Chevron.
Investment bankers will get busy expanding oil production via acquisition rather than the smallish increases in capital spending like the numbers for Pioneer Natural.
Since we work for investors who fear stock market failure and believe that Pickens and Sheffield are right, we like Occidental Petroleum (OXY), ConocoPhillips (COP) and Ovintiv (OVV) in the U.S. And we like the very undervalued Canadian companies like Cenovus (CVE) and MEG Energy (MEG.TO) in our international strategy.