Over the past few years, I have observed the different ways that companies conduct their share buybacks. This made me realise that the way a company conducts its share buybacks can have a profound impact on the long term returns of its stock.

Here are some share buyback strategies and what they mean for shareholders.

Opportunistic

The best way to conduct share buybacks is what I term as opportunistic buybacks. This means buying back shares aggressively when shares are undervalued and vice versa.

An example of a company that does this very well is the US-listed company Medpace, which helps drugmakers run drug trials. 

In 2022, when markets and its own stock price were down, Medpace took the opportunity to buy back its shares aggressively. The company tapped the debt markets to procure more capital to buyback shares, to the extent that its net-cash position of US$314 million at the end of 2021 flipped to a net-debt position of US$361 million as of 30 June 2022.

But as its stock price went up, Medpace became less enthusiastic about buying back shares and instead started to pay off the debt it incurred; the company ended 2022 with a lower net-debt position of US$180 million

This type of opportunistic buyback strategy is the most efficient buyback strategy in my opinion.

The plot below shows the amount spent by Medpace on buy backs over the last 3 years.

With its stock price now at a much higher level, Medpace has not conducted buybacks for the last four quarters. Medpace’s management team is likely waiting for its shares to fall to a lower valuation before they conduct buybacks again.

Regular buybacks

Another way to conduct buybacks is to do it on a regular basis. The parent of Google, Alphabet, is one such company that has conducted very regular buybacks. In the past 10 quarters, Alphabet has consistently spent close to US$15 billion a quarter on buybacks. This includes quarters when the company’s free cash flow was less than US$15 billion.

Although I prefer opportunistic buybacks, regular buybacks may be best suited for a company such as Alphabet which has to deploy large amounts of capital. Alphabet’s shares have also consistently traded at a reasonable valuation over the last few years, making regular buybacks a decent strategy.

The chart below shows the amount that Alphabet spent on buybacks in each quarter for the last 10 quarters. 

Poor timing

At the other end of the spectrum, some companies try to time their buybacks but end up being aggressive with buybacks at the wrong time.

Take Adobe, the owner of Photoshop, for example.

Adobe seems to change the level of aggressiveness in its share buybacks from quarter to quarter.

In the first quarter of 2022 , Adobe’s stock price was close to all-time highs, but the company was very aggressive with buybacks and spent more than US$2 billion – or 143% of its free cash flow in the quarter – to repurchase its shares. 

When its stock price started falling later that year, instead of taking advantage of the lower price, Adobe surprisingly cut down on its buybacks to slightly over US$1 billion a quarter, less than what it generated in free cash flow during those periods. So far in 2024, Adobe has again increased its buybacks after its stock price increased.

The optimum strategy would have been to do more buybacks when its stock price was low and less buybacks when its stock price was high.

Bottom line

Buybacks can be a great way to add value to shareholders. However, it is vital that companies conduct buybacks at low valuations to maximise the use of their capital to generate long term returns for shareholders. 

Medpace is an excellent example of great capital allocation, even going so far as to tap the debt markets to be even more aggressive with buybacks when its stock price is low. In the middle, we have companies such as Alphabet that consistently buyback shares. But on the other end of the spectrum is Adobe that seems to become more aggressive with buybacks at the wrong times.

Hopefully, more companies can follow in the footsteps of Medpace and make sure they put their capital to use only when the time is right.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe, Alphabet, and Medpace. Holdings are subject to change at any time.

In Pain Before Gain, I shared Walmart’s past business growth and corresponding stock price movement (emphases are new):

“From 1971 to 1980, Walmart produced breath-taking business growth. The table below shows the near 30x increase in Walmart’s revenue and the 1,600% jump in earnings per share in that period. Unfortunately, this exceptional growth did not help with Walmart’s short-term return… Walmart’s stock price fell by three-quarters from less than US$0.04 in late-August 1972 to around US$0.01 by December 1974 – in comparison, the S&P 500 was down by ‘only’ 40%. But by the end of 1979 (when inflation in the USA peaked during the 1970s), Walmart’s stock price was above US$0.08, more than double what it was in late-August 1972 (when inflation was at a low in the 1970s)…

…At the end of 1989, Walmart’s stock price was around US$3.70, representing an annualised growth rate in the region of 32% from August 1972; from 1971 to 1989, Walmart’s revenue and earnings per share grew by 41% and 38% per year…

…It turns out that in late-August 1972, when its stock price was less than US$0.04, Walmart’s price-to-earnings (P/E) ratio was between 42 and 68… This is a high valuation… at Walmart’s stock price in December 1974, after it had sunk by 75% to a low of around US$0.01 to carry a P/E ratio of between 6 and 7 the easy conclusion is that it was a mistake to invest in Walmart in August 1972 because of its high valuation. But as can be seen above, Walmart’s business continued to grow and its stock price eventually soared to around US$3.70 near the end of 1989. Even by the end of 1982, Walmart’s stock price was already US$0.48, up more than 10 times where it was in late-August 1972.”

In When Genius Failed (temporarily)*, I explored a little-discussed aspect of Teledyne’s history (emphasis is from the original passage) :

“Warren Buffett once said that Singleton “has the best operating and capital deployment record in American business… if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good.”

Singleton co-founded Teledyne in 1960 and stepped down as chairman in 1990… According to The Outsiders, a book on eight idiosyncratic CEOs who generated tremendous long-term returns for their shareholders, Teledyne produced a 20.4% annual return from 1963 to 1990, far ahead of the S&P 500’s 8.0% return. Distant Force, a hard-to-obtain memoir on Singleton, mentioned that a Teledyne shareholder who invested in 1966 “was rewarded with an annual return of 17.9 percent over 25 years, or a return of 53 times his invested capital.” In contrast, the S&P 500’s return was just 6.7 times in the same time frame… 

…based on what I could gather from Distant Force, Teledyne’s stock price sunk by more than 80% from 1967 to 1974. That’s a huge and demoralising decline for shareholders after holding on for seven years, and was significantly worse than the 11% fall in the S&P 500 in that period. But even an investor who bought Teledyne shares in 1967 would still have earned an annualised return of 12% by 1990, outstripping the S&P 500’s comparable annualised gain of 10%. And of course, an investor who bought Teledyne in 1963 or 1966 would have earned an even better return… 

…But for the 1963-1989 time frame, based on data from Distant Force, it appears that the compound annual growth rates (CAGRs) for the conglomerate’s revenue, net income, and earnings per share were 19.8%, 25.3%, and 20.5%, respectively; the self-same CAGRs for the 1966-1989 time frame were 12.1%, 14.3%, and 16.0%. These numbers roughly match Teledyne’s returns cited by The Outsiders and Distant Force”

My article The Need For Patience contained one of my favourite investing stories and it involves Warren Buffett and his investment in The Washington Post Company (emphasis is from the original passage):

“Through Berkshire Hathaway, he invested US$11 million in WPC [The Washington Post Company] in 1973. By the end of 2007, Berkshire’s stake in WPC had swelled to nearly US$1.4 billion, which is a gain of over 10,000%. But the percentage gain is not the most interesting part of the story. What’s interesting is that, first, WPC’s share price fell by more than 20% shortly after Buffett invested, and then stayed in the red for three years”

Buffett first invested in WPC in mid-1973, after which he never bought more after promising Katherine Graham (the then-leader of the company and whose family was a major shareholder) that he would not do so without her permission. The paragraph above showed that Berkshire’s investment in WPC had gains of over 10,000% by 2007. But by 1983, Berkshire’s WPC stake had already increased in value by nearly 1,200%, or 28% annually. From 1973 to 1983, WPC delivered CAGRs in revenue, net income, and EPS of 10%, 15%, and 20%, respectively (EPS grew faster than net income because of buybacks). 

Walmart, Teledyne, and WPC’s experience are all cases of an important phenomenon in the stock market: Their stock price movements were initially detached from their underlying business fundamentals in the short run, before eventually aligning with the passage of time, even when some of them began with very high valuations. They are also not idiosyncratic instances.

Renowned Wharton finance professor Jeremy Siegel – of Stocks for the Long Run fame – penned an article in late-1998 titled Valuing Growth Stocks: Revisiting The Nifty-Fifty. In his piece, Siegel explored the business and stock price performances from December 1972 to August 1998 for a group of US-listed stocks called the Nifty-Fifty. The group was perceived to have bright business-growth prospects in the early 1970s and thus carried high valuations. As Siegel explained, these stocks “had proven growth records” and “many investors did not seem to find 50, 80 or even 100 times earnings at all an unreasonable price to pay for the world’s preeminent growth companies [in the early 1970s].” But in the brutal 1973-1974 bear market for US stocks, when the S&P 500 fell by 45%, the Nifty-Fifty did even worse. For perspective, here’s Howard Marks’ description of the episode in his book The Most Important Thing (emphasis is mine):

“In the early 1970s, the stock market cooled off, exogenous factors like the oil embargo and rising inflation clouded the picture and the Nifty Fifty stocks collapsed. Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.”

Not every member of the Nifty-Fifty saw their businesses prosper in the decades that followed after the 1970s. But of those that did, Siegel showed in Valuing Growth Stocks that their stock prices eventually tracked their business growth, and had also beaten the performance of the S&P 500. These are displayed in the table below. There are a few important things to note about the table’s information:

• It shows the stock price returns from December 1972 to August 1998 for the S&P 500 and five of the Nifty-Fifty identified by Siegel as having the highest annualised stock price returns; December 1972 was the peak for US stocks before the 1973-1974 bear market
• It shows the annualised earnings per share (EPS) growth for the S&P 500 and the five aforementioned members of the Nifty-Fifty
• Despite suffering a major decline in their stock prices in the 1973-1974 bear market, members of the Nifty-Fifty whose businesses continued to thrive saw their stock prices beat the S&P 500 and effectively match their underlying business growth in the long run even when using the market-peak in December 1972 as the starting point.

You may have noticed that all of the examples of stock prices first collapsing then eventually reflecting their underlying business growth that were shared above – Walmart, Teledyne, WPC, and members of the Nifty-Fifty – were from the 1970s. What if this relationship between stock prices and business fundamentals no longer holds now? It’s a legitimate concern. Economies change over time. Financial markets do too.

But I believe the underlying driver for the initial divergence and eventual convergence in the paths that the companies’ businesses and stock prices had taken in the past are alive and well today. This is because the driver was, in my opinion, the simple but important nature of the stock market: It is a place to buy and sell pieces of a business. This understanding leads to a logical conclusion that a stock’s price movement over the long run depends on the performance of its underlying business. The stock market, today, is still a place to buy and sell pieces of a business, which means the market is still a weighing machine in the long run. This also means that if you had invested a few years ago in a stock with an expensive valuation and have seen its stock price fall, it will likely still be appropriately appraised by the weighing machine in the fullness of time, if its fundamentals do remain strong in the years ahead. 

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the first quarter of 2024 – was held two weeks ago and contained useful insights on the state of American consumers and businesses. The bottom-line is this: Economic indicators in the US continue to be favourable and American consumers are in good shape, but there are a number of risks on the horizon, so JPMorgan’s management is preparing for a wide range of outcomes.  

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

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1. Management sees economic indicators in the USA as favourable, but there are many risks on the horizon (including geopolitical conflicts, inflationary pressures, and the Fed’s quantitative tightening) so they want to be prepared for a range of outcomes; the economy always looks healthy at the inflection point; management thinks the US economy will be affected even if problems happen elsewhere

Many economic indicators continue to be favorable. However, looking ahead, we remain alert to a number of significant uncertain forces. First, the global landscape is unsettling – terrible wars and violence continue to cause suffering, and geopolitical tensions are growing. Second, there seems to be a large number of persistent inflationary pressures, which may likely continue. And finally, we have never truly experienced the full effect of quantitative tightening on this scale. We do not know how these factors will play out, but we must prepare the Firm for a wide range of potential environments to ensure that we can consistently be there for clients…

…But what I caution people, these are all the same results [referring to the comments in Point 2 and Point 6 below about consumers and businesses being in good shape] of a lot of fiscal spending, a lot of QE, et cetera. And so we don’t really know what’s going to happen. And I also want to look at the year, look at 2 years or 3 years, all the geopolitical effects and oil and gas and how much fiscal spending will actually take place, our elections, et cetera. So we’re in good — we’re okay right now. It does not mean we’re okay down the road. And if you look at any inflection point, being okay in the current time is always true. That was true in ’72, it was true in any time you’ve had it. So I’m just on the more cautious side that how people feel, the confidence levels and all that, that doesn’t necessarily stop you from having an inflection point. And so everything is okay today, but you’ve got to be prepared for a range of outcomes, which we are…

…I think that when we talk about the impact of the geopolitical uncertainty on the outlook, part of the point there is to note that the U.S. is not isolated from that, right? If we have global macroeconomic problems as a result of geopolitical situations, that’s not only a problem outside the U.S. That affects the global economy and therefore the U.S. and therefore our corporate customers, et cetera, et cetera.

2. Management is seeing consumers remain healthy with overall spend in line with a year ago, and although their cash buffers have normalised, they are still higher than pre-COVID levels; management thinks consumers will be in pretty good shape even if there’s a recession; the labour market remains healthy with wages keeping pace with inflation

Consumers remain financially healthy, supported by a resilient labor market. While cash buffers have largely normalized, balances were still above pre-pandemic levels, and wages are keeping pace with inflation. When looking at a stable cohort of customers, overall spend is in line with the prior year…

… I would say consumer customers are fine. The unemployment is very low. Home price dropped, stock price dropped. The amount of income they need to service their debt is still kind of low. But the extra money of the lower-income folks is running out — not running out, but normalizing. And you see credit normalizing a little bit. And of course, higher-income folks still have more money. They’re still spending it. So whatever happens, the customer’s in pretty good shape. And they’re — if you go into a recession, they’d be in pretty good shape.

3. Auto originations are down

And in auto, originations were $8.9 billion, down 3%, while we maintained healthy margins and market share.

4. Net charge-offs (effectively bad loans that JPMorgan can’t recover) rose from US$1.1 billion a year ago, mostly because of card-related credit losses that are normalising to historical norms; management expects consumer-spending on credit/debit cards to have strong growth in 2024

In terms of credit performance this quarter, credit costs were $1.9 billion, driven by net charge-offs, which were up $825 million year-on-year predominantly due to continued normalization in Card…

…And in Card, of course, while charge-offs are now close to normalized, essentially, we did go through an extended period of charge-offs being very low by historical standards, although that was coupled with NII also being low by historical standards…

….Yes, we still expect 12% card loan growth for the full year. 

5. The level of appetite that companies have for capital markets activity is uncertain to management

While we are encouraged by the level of capital markets activity we saw this quarter, we need to be mindful that some meaningful portion of that is likely pulling forward from later in the year. Similarly, while it was encouraging to see some positive momentum in announced M&A in the quarter, it remains to be seen whether that will continue, and the Advisory business still faces structural headwinds from the regulatory environment…

…Let me take the IPO first. So we had been a little bit cautious there. Some cohorts and vintages of IPOs had performed somewhat disappointingly. And I think that narrative has changed to a meaningful degree this quarter. So I think we’re seeing better IPO performance. Obviously, equity markets have been under a little bit of pressure the last few days. But in general, we have a lot of support there, and that always helps. Dialogue is quite good. A lot of interesting different types of conversations happening with global firms, multinationals, carve-out type things. So dialogue is good. Valuation environment is better, like sort of decent reasons for optimism there. But of course, with ECM [Equity Capital Markets], there’s always a pipeline dynamic, and conditions were particularly good this quarter. And so we caution a little bit there about pull-forward, which is even more acute, I think, on the DCM [Debt Capital Markets] side, given that quite a high percentage of the total amount of debt that needed to be refinanced this year has gotten done in the first quarter. So that’s a factor.

And then the question of M&A, I think, is probably the single most important question, not only because of its impact on M&A but also because of its knock-on impact on DCM through acquisition financing and so on. And there’s the well-known kind of regulatory headwinds there, and that’s definitely having a bit of a chilling effect. I don’t know. I’ve heard some narratives that maybe there’s like some pent-up deal demand. Who knows how important politics are in all this. So I don’t know.  

6. Management is seeing that businesses are in good shape

Businesses are in good shape. If you look at it today, their confidence is up, their order books drop, their profits are up.

7. Management thinks that the generally accepted economic scenario is nearly always wrong and that no one can accurately predict an inflection point in the economy

And the other thing I want to point out because all of these questions about interest rates and yield curves and NII and credit losses, one thing you projected today based on what — not what we think in economic scenarios, but the generally accepted economic scenario, which is the generally accepted rate cuts of the Fed. But these numbers have always been wrong. You have to ask the question, what if other things happen? Like higher rates with this modest recession, et cetera, then all these numbers change. I just don’t think any of us should be surprised if and when that happens. And I just think the chance of that happen is higher than other people. I don’t know the outcome. We don’t want to guess the outcome. I’ve never seen anyone actually positively predict a big inflection point in the economy literally in my life or in history.

8. Management thinks the US commercial real estate market is fine, at least when it comes to JPMorgan’s portfolio; management thinks that if interest rates rise, it could be roughly neutral or really bad for the real estate market, depending on the reason for the increase in interest rates

First of all, we’re fine. We’ve got good reserves against office. We think the multifamily is fine. Jeremy can give you more detail on that if you want.

But if you think of real estate, there’s 2 pieces. If rates go up, think of the yield curve, the whole yield curve, not Fed funds, but the 10-year bond rate, it goes up 2%. All assets, all assets, every asset on the planet, including real estate, is worth 20% less. Well obviously, that creates a little bit of stress and strain, and people have to roll those over and finance it more. But it’s not just true for real estate, it’s true for everybody. And that happens, leveraged loans, real estate will have some effect.

The second thing is the why does that happen? If that happens because we have a strong economy, well, that’s not so bad for real estate because people will be hiring and filling things out. And other financial assets. If that happens because we have stagflation, well, that’s the worst case. All of a sudden, you are going to have more vacancies. You are going to have more companies cutting back. You are going to have less leases. It will affect — including multifamily, that will filter through the whole economy in a way that people haven’t really experienced since 2010. So I’d just put in the back of your mind, the why is important, the interest rates are important, the recession is important. If things stay where they are today, we have kind of the soft landing that seems to be embedded in the marketplace, everyone — the real estate will muddle through.

9. Consumers whose real incomes are down are slowing their spending, but they account for only a small proportion of the overall population, and they are not levering up irresponsibly

And there are some such people whose real incomes are not up, they’re down, and who are therefore struggling a little bit, unfortunately. And what you observe in the spending patterns of those people is some meaningful slowing rather than what you might have feared, which is sort of aggressive levering up. So I think that’s maybe an economic indicator of sorts, although this portion of the population is small enough that I’m not sure the read-across is that big. But it is encouraging from a credit perspective because it just means that people are behaving kind of rationally and in a sort of normal post-pandemic type of way as they manage their own balance sheets. 

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Jeremy and I have not invested in an oil & gas company for years. The reason can be traced to the very first stocks I bought when I started investing. Back then, in October 2010, I bought six US-listed stocks at one go, two of which were Atwood Oceanics and National Oilwell Varco (or NOV). Atwood was an owner of oil rigs while NOV supplied parts and equipment that kept oil rigs running. 

I invested in them because I wanted to be diversified according to sectors. I thought that oil & gas was a sector that was worth investing in since the demand for oil would likely remain strong for a long time. My view on the demand for oil was right, but the investments still went awry. By the time I sold Atwood and NOV in September 2016 and June 2017, respectively, their stock prices were down by 77% and 31% from my initial investments. 

It turned out that while global demand for oil did indeed grow from 2010 to 2016 – the consumption of oil increased from 86.5 million barrels per day to 94.2 million barrels – oil prices still fell significantly over the same period, from around US$80 per barrel to around US$50. I was not able to predict prices for oil and I had completely missed out on the important fact that these prices would have an outsized impact on the business fortunes of both Atwood and NOV.

In its fiscal year ended 30 September 2010 (FY2010), Atwood’s revenue and net income were US$650 million and US$257 million, respectively. By FY2016, Atwood’s revenue had increased to US$1.0 billion, but its net income barely budged, coming in at US$265 million. Importantly, its return on equity fell from 21% to 9% in that period while its balance sheet worsened dramatically. For perspective, Atwood’s net debt (total debt minus cash and equivalents) ballooned from US$49 million in FY2010 to US$1.1 billion in FY2016.

As for NOV, from 2010 to 2016, its revenue fell from US$12.2 billion to US$7.2 billion and its net income collapsed from US$1.7 billion to a loss of US$2.4 billion. This experience taught me to be wary of companies whose business results have strong links to commodity prices, since I had no ability to foretell their movements. 

Fast forward to the launch of the investment fund that Jeremy and I run in July 2020, and I was clear that I still had no ability to divine oil prices – and neither did Jeremy. Said another way, we were fully aware that companies related to the oil & gas industry were beyond our circle of competence. Then 2022 rolled around and during the month of August, we came across a US-listed oil & gas company named Unit Corporation. 

At the time, Unit had three segments that spanned the oil & gas industry’s value chain: Oil and Natural Gas; Mid-Stream, and Contract Drilling. In the Oil and Natural Gas segment, Unit owned oil and natural gas fields in the USA – most of which were in the Anadarko Basin in the Oklahoma region – and was producing these natural resources. The Mid-Stream segment consisted of Unit’s 50% ownership of Superior Pipeline Company, which gathers, processes, and treats natural gas, and owns more than 3,800 miles of gas pipelines (a private equity firm, Partners Group, controlled the other 50% stake). The last segment, Contract Drilling, is where Unit owned 21 available-for-use rigs for the drilling of oil and gas.

When we first heard of Unit in August 2022, it had a stock price of around US$60, a market capitalisation of just over US$560 million, and an enterprise value (market capitalisation minus net-cash) of around US$470 million (Unit’s net-cash was US$88 million back then). But the company’s intrinsic value could be a lot higher. 

In January 2022, Unit launched a sales process for its entire Oil and Natural Gas segment, pegging the segment’s proven, developed, and producing reserves at a value of US$765 million. This US$765 million value came from the estimated future cash flows of the segment – based on oil prices we believe were around US$80 per barrel – discounted back to the present at 10% per year. Unit ended the sales process for the Oil and Natural Gas segment in June 2022 after selling only a small portion of its assets for US$45 million. Nonetheless, when we first knew Unit, the Oil and Natural Gas segment probably still had a value that was in the neighbourhood of the company’s estimation during the sales process, since oil prices were over US$80 per barrel in August 2022. Meanwhile, we also saw some estimates in the same month that it would cost at least US$400 million for someone to build the entire fleet of rigs that were in the Contract Drilling segment. As for the Mid-Stream segment, due to Superior Pipeline’s ownership structure and the cash flows it was producing, the value that accrued to Unit was not significant*.

So here’s what we saw in Unit in August 2022 after putting everything together: The value of the company’s Oil and Natural Gas and Contract-Drilling segments (around US$765 million and US$400 million, respectively) dwarfed its enterprise value of US$470 million.

But there was a catch. The estimated intrinsic values of Unit’s two important segments – Oil and Natural Gas, and Contract Drilling – were based on oil prices in the months leading up to August 2022. This led Jeremy and I to attempt to expand our circle of competence: We wanted to better understand the drivers for oil prices. There were other motivations. First, Warren Buffett was investing tens of billions of dollars in the shares of oil & gas companies such as Occidental Petroleum and Chevron in the first half of 2022. Second, we also came across articles and podcasts from oil & gas investors discussing the supply-and-demand dynamics in the oil market that could lead to sustained high prices for the energy commodity. So, we started digging into the history of oil prices and what influences it.

Here’s a brief history on major declines in the price of WTI Crude over the past four decades:

• 1980 – 1986: From around US$30 to US$10
• 1990 – 1994: From around US$40 to less than US$14
• 2008 – 2009: From around US$140 to around US$40
• 2014 – 2016: From around US$110 to less than US$33
• 2020: From around US$60 to -US$37 

Since oil is a commodity, it would be logical to think that differences in the level of oil’s supply-and-demand would heavily affect its price movement – when demand is lower than supply, prices would crash, and vice versa. The UK-headquartered BP, one of the largest oil-producing companies in the world, has a dataset on historical oil production and consumption going back to 1965. BP’s data is plotted in Figure 1 below and it shows that from 1981 onwards, the demand for oil (consumption) was higher than the supply of oil (production) in every year. What this means is the price of oil has surprisingly experienced at least five major crashes over the past four decades despite its demand being higher than supply over the entire period. 

Figure 1; Source: BP

We shared our unexpected findings with our network of investor friends, which included Vision Capital’s Eugene Ng. He was intrigued and noticed that the U.S. Energy Information Administration (EIA) maintained its own database for long-term global oil consumption and production. After obtaining similar results from EIA’s data compared to what we got from BP, Eugene asked the EIA how it was possible for oil consumption to outweigh production for decades. The EIA responded and Eugene kindly shared the answers with us. It turns out that there could be errors within EIA’s data. The possible sources of errors come from incomplete accounting of Transfers and Backflows in oil balances: 

• Transfers include the direct and indirect conversion of coal and natural gas to petroleum.
• Backflows refer to double-counting of oil-streams in consumption. Backflows can happen if the data collection process does not properly account for recycled streams.

The EIA also gave an example of how a backflow could happen with the fuel additive, MTBE, or methyl tert-butyl ether (quote is lightly edited for clarity):

“The fuel additive MTBE is an useful example of both, as its most common feedstocks are methanol (usually from a non-petroleum fossil source) and Iso-Butylene whose feedstock likely comes from feed that has already been accounted for as butane (or iso-butane) consumption. MTBE adds a further complexity in that it is often exported as a chemical and thus not tracked in the petroleum trade balance.”

Thanks to the EIA, we realised that BP’s historical data on the demand and supply of oil might contain errors and how they could have happened. But despite knowing this, Jeremy and I still could not tell what the actual demand-and-supply dynamics of oil were during the five major price crashes that happened from the 1980s to today**. We tried expanding our circle of competence to creep into the oil & gas industry, but were stopped in our tracks. As a result, we decided to pass on investing in Unit. 

I hope that my sharing of how Jeremy and I attempted to enlarge our circle of competence would provide any of you reading this ideas on how you can improve your own investing process. 

*In April 2018, Unit sold a 50% stake in Superior Pipeline to entities controlled by Partners Group – that’s how Partners Group’s aforementioned 50% control came about. When we first studied Unit in August 2022, either Unit or Partners Group could initiate a process after April 2023 to liquidate Superior Pipeline or sell it to a third-party. If a liquidation or sale of Superior Pipeline were to happen, Partners Group would be entitled to an annualised return of 7% on its initial investment of US$300 million before Unit could receive any proceeds; as of 30 June 2022, a sum of US$354 million was required for Partners Group to achieve its return-goal. In the first half of 2022, the cash flow generated by Superior Pipeline was US$24 million, which meant that Unit’s Mid-stream segment was on track to generate around US$50 million in cash flow for the whole of 2022. We figured that a sale of Superior Pipeline in April 2023, with around US$50 million in 2022 cash flow, would probably fetch a total amount that was in the neighbourhood of the US$354 million mentioned earlier that Partners Group was entitled to. So if Superior Pipeline was sold, there would not be much proceeds left for Unit after Partners Group has its piece. 

**If you’re reading this and happen to have insight on the actual historical levels of production and consumption of oil during the past crashes, we would deeply appreciate it if you could get in touch with us. Thanks in advance!

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life.  I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the fourth quarter of 2023 – was held two weeks ago and contained useful insights on the state of American consumers and businesses. The bottom-line is this: The US economy remains resilient, but there are significant risks that are causing JPMorgan’s management team to be cautious.  

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

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1. The US economy and consumer remains resilient, and management’s base case is that consumer credit remains strong, although loan losses (a.k.a net charge-off rate) for credit cards is expected to be “<3.5%” in 2024 compared to around 2.5% for 2023

The U.S. economy continues to be resilient, with consumers still spending, and markets currently expect a soft landing…

…We continue to expect the 2024 card net charge-off rate to be below 3.5%, consistent with Investor Day guidance…

…In terms of consumer resilience, I made some comments about this on the press call. The way we see it, the consumers find all of the relevant metrics are now effectively normalized. And the question really in light of the fact that cash buffers are now also normal, but that, that means that consumers have been spending more than they’re taking in is how that spending behavior adjusts as we go into the new year, in a world where cash buffers are less comfortable than they were. So one can speculate about different trajectories that, that could take, but I do think it’s important to take a step back and remind ourselves that consistent with that soft landing view, just in the central case modeling, obviously, we always worry about the tail scenarios is a very strong labor market. And a very strong labor market means, all else equal, strong consumer credit. So that’s how we see the world.

2.  Management thinks that inflation and interest rates may be higher than markets expect…

It is important to note that the economy is being fueled by large amounts of government deficit spending and past stimulus. There is also an ongoing need for increased spending due to the green economy, the restructuring of global supply chains, higher military spending and rising healthcare costs. This may lead inflation to be stickier and rates to be higher than markets expect.

3. …and they’re also cautious given the multitude of risks they see on the horizon

On top of this, there are a number of downside risks to watch. Quantitative tightening is draining over $900 billion of liquidity from the system annually, and we have never seen a full cycle of tightening. And the ongoing wars in Ukraine and the Middle East have the potential to disrupt energy and food markets, migration, and military and economic relationships, in addition to their dreadful human cost. These significant and somewhat unprecedented forces cause us to remain cautious.

4. Management is seeing a deterioration in the value of commercial real estate

The net reserve build was primarily driven by loan growth in card and the deterioration in the outlook related to commercial real estate valuations in the commercial bank.

5. Auto loan growth was strong

And in auto, originations were $9.9 billion, up 32% as we gained market share, while retaining strong margins.

6. Overall capital markets activity is picking up, but merger & acquisition (M&A) activity still remains weak…

We are starting the year with a healthy pipeline, and we are encouraged by the level of capital markets activity, but announced M&A remains a headwind and the extent as well as the timing of capital markets normalization remains uncertain…

…Gross Investment Banking and Markets revenue of $924 million was up 32% year-on-year primarily reflecting increased capital markets and M&A activity…

…So as you know, all else equal, this more dovish rate environment is, of course, supportive for capital markets. So if you go into the details a little bit, if you start with ECM [Equity Capital Markets], that helps higher — and the recent rally in the equity markets helps. I think there have been some modest challenges with the 2023 IPO vintage in terms of post-launch performance or whatever. So that’s a little bit of a headwind at the margin in terms of converting the pipeline, but I’m not too concerned about that in general. So I would expect to see rebound there. In DCM [Debt Capital Markets], again all else equal, lower rates are clearly supportive. One of the nuances there is the distinction between the absolute level of rates and the rate of change. So sometimes you see corporates seeing and expecting lower rates and, therefore, waiting to refinance in the hope of even lower rates. So that can go both ways. And then M&A, it’s a slightly different dynamic. I think there’s a couple of nuances there. One, as you obviously know, announced volume was lower this year. So that will be a headwind in reported revenues in 2024, all else equal. And of course, we are in an environment of M&A regulatory headwinds, as has been heavily discussed. But having said that, I think we’re seeing a bit of pickup in deal flow, and I would expect the environment to be a bit more supportive. 

7. …and appetite for loans among businesses is muted

C&I loans were down 2%, reflecting lower revolver utilization and muted demand for new loans as clients remain cautious…

…We expect strong loan growth in card to continue but not at the same pace as 2023. Still, this should help offset some of the impact of lower rates. Outside of card, loan growth will likely remain muted. 

8. Management is not seeing any changes to their macro outlook for the US economy

So the weighted average unemployment rate and the number is still 5.5%. We didn’t have any really big revisions in the macro outlook driving the numbers, and our skew remains as it has been, a little bit skewed to the downside. 

9. Management’s outlook for 2024 includes six rate-cuts by the Fed, but that outlook comes from financial market data, and not from management’s insights

[Question] Coming back to your outlook and forecast for net interest income for the upcoming year with the 6 Fed fund rate cuts that you guys are assuming. Can you give us a little insight why you’re assuming 6 cuts? 

[Answer] I wish the answer were more interesting, but it’s just our practice. We just always use the forward curve for our outlook, and that’s what’s in there.

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Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.