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Refine The Profits From Your Portfolio With Valero

July 07, 2014 | About:

Looking back over time to 1871, there have only been six of siteen bull markets in stocks that have exceeded the current 63-month run of the bull market in which we find ourselves today. Now, I am not saying this bull market is about to end; there are multiple factors, including loose monetary policy, that can continue to push asset prices much higher than anyone believes to be possible. However, by any estimation, this can no longer be considered a young bull market. Simply because a bull market is entering what is most likely the last half of its life does not mean that investors cannot and should not continue to extract exceptional profits from it; it only means that we need to become a bit more selective in our investment choices.

We must now ensure that our current investment choices position us in areas providing products and services that will be necessary without regard to the direction of the broader market as those businesses will provide us with greater protection in a down market. I always view my long stock positions as an ownership stake in the businesses in which I hold shares and I must have confidence that the business can safely reward me with annual returns that will meet my minimum expectation of 12% plus provide a reasonable chance that the returns could be much higher.

Why Should We Invest In Refining?

Energy is an industry that meets all of my requirements for investment when bull markets begin to enter the later stages of their cycle and in the case of the current market valuations, many energy producers are actually surprisingly inexpensive right now, especially in comparison to the overall market valuation today. One aspect of the energy market that has just popped up on one of my value screens is refining. The refining business that strikes me as a screaming buy today is Valero Energy Corporation (VLO). Valero is in the business of refining crude oil into useable products from gasoline to asphalt. In short, they make products that our society requires to function as we expect it to. Their most recognizable brand for most consumers will be Texaco. They possess exactly the kind of enduring value that investors should always seek but become crucial as bull markets begin to show their age.

Obviously, Valero is not the only refiner in the industry. Exactly what is it that makes it such a compelling value compared to its competitors? A review of the fundamentals will reveal the conclusive answer to this important question.

What Makes Valero Compelling?

The current consensus earnings estimate for Valero, by the analysts covering the stock, for 2014

While the dividend yield for this stock is only 1.97%, the company has increased it at an annual pace of 8.32% over the past 5 years and it still only requires a payout ratio of 16.89% to cover it. This leaves substantial room for increases in the future. But, with such a low payout ratio required to cover the dividend, it is reasonable to ask what else the company is spending investors’ money to accomplish. Isn’t it?

Between the end of 2006 and the end of 2013, Valero has reduced its share count by 14.65% from 627.5 million shares to 535.57 million shares. The company has also reduced the long-term debt from $7.16 billion to $6.6 billion representing a decrease of 12.57%. Both of these actions increase the value of the business owned by the shareholders and provide that value without causing the shareholders to be exposed to any current additional tax liability from it. Without actually handing shareholders a check, management is using its cash to reward them in a very effective and efficient way. When management buys shares at times when the price is high, I am an outspoken critic. When they use excess cash to purchase shares that are deeply discounted to fair value, you will not find a bigger fan than I am. In this case, I am a fan. Why?

The industry average price to earnings ratio and 5-year estimated forward growth rate are 15.85 times earnings and 10.2% projected annualized growth. Valero is currently changing hands at ratios of 7.87 times 2014 earnings and carries and estimated forward growth rate of 13.5% annually for the next 5 years. This stock would have to rise 71.5% just to trade at an earnings multiple equal to its projected earnings growth rate.

A further favorable comparison to the overall industry that carries a great deal of weight for me is the price to cash flow ratio. In this regard, once again, Valero shines. The current industry average price to cash flow ratio is 9.7 times; Valero is a dirt cheap multiple of only 6.5. To simply trade on par with the overall industry, Valero’s share price would have to increase 49%. This would certainly provide an exceptional capital gain for shareholders and given the overall fundamentals of the business it is difficult to explain why it should not trade at least on par with the rest of the industry in this metric.

Many value oriented investors like to consider valuations in terms of price to book value. Given the capital intensive nature of this industry and the high barriers to entry for new competition, this is an excellent measure of value as the existing businesses deserve a significant premium to the depreciated book value of the assets. The overall industry trades at a very reasonable price to book value of 2.14 times. Valero however, is again deeply discounted to the overall industry and would need to increase share value by 56% from its current multiple of 1.37 times book just to equal the industry average.

As an added indication that the price pressure on this stock should be upward in its nature, the consensus earnings projections for 2014 and 2015 have risen by 8.9% and 6.38% respectively in the last 90 days. So we are presented with a cheap stock possessing improving expectations.

What Is The Potential Downside Risk?

For stocks like Valero, that provide products and services critical to our way of life, I stay focused on my long-term projections for a business and do not spend a great deal of time worrying about short-term fluctuations. In this regard, it is difficult to see how our demand for refined petroleum products will do anything other than increase over time. Furthermore, it is even more difficult to reasonable predict that Valero will continue trading so far below the industry averages. A business in a critical industry, trading well below the valuation of other comparable businesses provides shareholders with excellent downside protection as this stock could hold value while the rest of the industry fell substantially and still not be overpriced in comparison.

This does not mean the stock cannot move lower; it does mean that it should be much safer than the overall industry and the overall stock market as well. We can never anticipate nor eliminate every conceivable risk when investing in any business. It is, therefore, imperative that we conduct sufficient due diligence to allow ourselves to minimize those risk. Selecting businesses that are critical to maintaining our way of life and standard of living is a good start. Adding a requirement that those businesses are trading at a discount to the market in general and their respective industries in particular reduces those inherent risks to a minimum.

What Is The Potential Upside?

The metrics by which most analysts I know value businesses is either the price to earnings ratio or the price to cash flow ratio. Generally, analysts will assign a per share value equal to 1 or 2 times the value of the current year’s projected earnings multiplied by the estimated forward five-projected growth rate of the earnings. In the case of Valero, this would produce an estimated fair value of $87.48/share based on the 13.5% projected growth rate times the 2014 projected earnings of $6.48/share. This valuation would provide a return of 71.5% for anyone buying the stock at the current price of $51.

Businesses being conservatively valued at a multiple of free cash flow can be assessed at a 10 times valuation. Assigning this valuation to the business would produce and estimated current fair value of $78.46/share. This result would create a 53.8% gain for those opening new positions at the current market price.

Closing Thoughts And Actionable Ideas

The simple approach for passive investors is to simply buy shares of Valero at the currently discounted valuation for this critical and undervalued business and wait for the market to push the value of the shares higher to more closely reflect the fair value.

Those deep value investors who insist on always buying at a discount and love getting paid while they wait can consider selling the $50 strike price put options with a July 19, 2014 expiration for about $0.65/share. Each of these contract sold will obligate the seller, at the option of the buyer, to purchase 100 shares of Valero at a price of $50/share at any time between now and July 19th. The premium received for selling these options equals an immediate return of 1.3% of the potential purchase price of $50/share and results in an annualize return on total capital required to purchase the shares of 36.4% over the 13-day life of the contract.

Those active investors who like to “juice” their returns quickly will certainly want to consider buying the shares at $51 and selling the $52.50 strike price calls with an expiration of July 19, 2014 for an immediate payment of $0.50/share. The option seller can sell 1 of these call options for each 100 shares of the stock that they own and the $0.50/share premium will provide an immediate return of 0.98% on the $51 purchase price of the shares. Over the 13-day life of the trade, this equates to an annualized return on invested capital of 27.44% if the shares remain below $52.50 on July 19th. Should the shares be trading higher than $52.50 on July 19th, the holder of the call options will take the shares and the seller of the options will receive a short-term gain of $1.50 (the difference between the $51 purchase price and $52.50 selling price) that when coupled with the option sale premium received results in a profit of 3.92% in 13 days or 109.8% annualized return on invested capital.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


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