In the third quarter of last year, a new position appeared in Berkshire Hathaway's (BRK.A, Financial) (BRK.B, Financial) investment portfolio. This position was the oil major Chevron (CVX, Financial).
According to the conglomerate's 13F report, it acquired 44 million shares in the company in the third quarter of 2020 and continued to increase its position in the fourth quarter. At the end of 2020, Berkshire owned just under 49 million shares in the oil group.
As this position was worth more than $1 billion, I do not think it is unreasonable to assume that the Oracle of Omaha himself, Warren Buffett (Trades, Portfolio), initiated the holding. He has said previously stated that he has input on any positions that are in the nine-figure mark.
In the first quarter of 2021, Berkshire reduced this position by around 50%. Based on the available information, the group still owned 23 million shares in Chevron at the end of June 2021.
As it turns out, this was an incredibly astute trade. Berkshire acquired the shares at an average price of around $72. Today Chevron is changing hands at $106 per share, and the stock could go higher based on what we are seeing in the energy markets. It also supports a dividend yield of 5%. Wall Street analysts have put a price target of just under $123 per share on the stock.
A contrarian trade
Buffett has not revealed exactly why he initiated the position in the oil group. When he was quizzed on the holding at the 2021 Berkshire annual meeting, the Oracle of Omaha said that he did not believe the group was an evil company and "If we owned the entire business, I would not feel uncomfortable about being in that business."
He went on to add, "I think Chevron has benefitted societies in all kinds of ways, and I think it will continue to."
Chevron has faced increasing pressure from environmental activists who want oil companies to reduce output and increase renewable generation capacity. To increase the pressure on these companies, activists have been asking asset managers to sell their stakes. This strategy seems to have been working. Asset managers worldwide have committed to divest fossil fuel holdings in order to reduce the danger of global warming and associated natural disasters, and the valuations of these companies have slumped.
Buffett doesn't pay attention to what other investors are saying when he makes investing decisions, though. It looks to me as if the Oracle saw an undervalued company, and he wanted to take advantage of that.
An undervalued business
In the two years before the pandemic, 2018 and 2019, Chevron generated owner earnings per share of $9 per annum and a free cash flow per share of $7.2 on average.
In both of these years, the stock traded at an average price-to-owner-earnings ratio of 12 and a price-to-free-cash-flow ratio of around 15. At a price of $70 per share, the stock was trading at a substantial discount to both of these ratios when Berkshire was acquiring it for its portfolio.
These figures suggest that the Oracle may have believed that oil prices would revert to the mean after the pandemic, and so would Chevron's valuation.
As it turns out, oil prices have rebounded faster and harder than many analysts expected. Not only will the stock benefit from a valuation uplift, but it should also see earnings growth, which in turn will support a higher earnings multiple.
This is the sort of Goldilocks environment any value investor dreams about. Of course, this is just speculation at this stage. However, if oil prices continue to rise, shareholders could see substantial returns. We don't know exactly why Buffett decided to acquire Chevron, but he made the right trade if he was betting on mean reversion.