Lessons in investing in a cyclical business - Valero Energy Corp (VLO)
I wrote about how to think about valuing a cyclical in this article. That was back in July 2010, when VLO was trading at 0.7x book value. I wrote two other articles after Q2 and Q3 earnings. I felt VLO was on the road to recovery after Q3 and had two positive EPS quarters. VLO was trading at $18 as late as Oct 26,2010.
Today VLO trades at $25.37 and is up almost 40% since the last article. The valuation gap has reduced and VLO trades at 0.9x book value. I have learnt some good lessons from this experience though I am only about break even with my investment since my earlier purchase was around $40. You can read about the original investment history in this article.
Let’s look at the last 11 years Sales and EBIT numbers along with the P/E, P/B, EPS, EV/sales and average EPS uptil that year.
|Year||Sales ($billions)||Op Income ($millions)||P/E||P/B||EPS||Average EPS||EV / Sales|
Oil refining is clearly a cyclical business.
Graham said that a P/E ratio based on last years earnings is of limited use and instead suggested to look at the "average earnings" over a business cycle.
The reason I present the average EPS for each of the years in the table above, is to consider using that average earnings number to compute the P/E. So, in 2007 when I sold VLO at $70, the average EPS (from 2000 to 2007) was $4 v/s the reported earnings of $8+. The stock was trading at 70/4 = 17.5 v/s the trailing P/E of 9. In 2007, the stock was clearly not cheap and potentially way overvalued. I was lucky to sell at the peak.
Computing the average EPS over the 11 year period from 2000 - 2010, I get $2.27. Dividing the price on 1/28/2011 ($25.37) by this average earnings, I come up with a P/E = 11.2. (Clearly not as cheap as it was when the last article was written.) 11x average earnings for a cyclical company seems about fair value to me.
However, as we are in the upcycle in the business there is room to improve EPS and hence average EPS. Plus, most investors and analysts will consider the latest years EPS that is printed. So, if VLO does a $3-$4 EPS in the next two years, you could see a $30-$40 stock. From the table, you can see VLO has done $8.88 in 2007 so $3 cannot be ruled out. There is significant operating (and financial leverage) in this business.
The average P/B over the same 11 year period is 1.24 v/s the current P/B of 0.9. VLO seems bit more attractive when looking at average P/B. VLO also trades slightly below tangible book value. Tangible book value per share is $26.8 (CapitalIQ). There could be a 30% upside if VLO were to trade close to the last 11 year multiple on book value.
I added another metric for this article - EV / Sales ( or you can use P/S). Average EV / Sales for VLO for the 11 year period is 0.33. Current EV / Sales is 0.23 so once again VLO is trading below the average. In 2008, 2009, VLO was trading at 0.1x Price / Sales as per GuruFocus. If VLO were to trade closer to the average multiple of Sales, there is a 40% upside potential
I read a good value investor suggesting to always use P/S and P/B for cyclicals as these are more stable than earnings. After my 3 year investment history with VLO, I certainly agree that it makes sense to use these two metrics and look at them over an entire business cycle to spot when a stock is cheap or expensive. One thing is for sure. Trailing P/E is the least reliable measure of valuation. Average P/E over the cycle should always be looked at.
I had written back in one of my articles…..
“If I am patient and do not get scared by the current terrible economics of the refining business, VLO could turn out to be a good potential investment. The question is can they hang in there till their earnings turn positive. Investing in cyclical companies is typically contrarian in nature and embodies the buy low and sell high mantra. You want to buy shares when the business is at its lowest point (indicative of high P/E or negative P/E) and sell when the business is doing really well and indicated by low P/E. I would not deny that there is an element of timing to this kind of investing. However, using the average earnings should help along with an eye on the news about the company. When there is fear and panic regarding these companies, it is the best time to buy. That is value investing for you.”
Clearly, being patient worked in my favor. I am at break even and considering my next move. It does seem that waiting for another year or two could give another 20-40% upside from here. Also, there is a slight margin of safety as VLO still trades below tangible book value. However, it is not the best business in the world and if profit erosion takes place, I could be back to square one. This one is a conundrum to me at this point.
Disclaimer: I have a long position in shares of Valero at the time of publishing this post. My position may change at any time without any further updates. Please conduct your own research before considering investments based on these or any ideas on this blog.