As I was running and making zero forward progress on the treadmill last night (as part of the marathon training we are going through at the moment), I had the Nightly Business Report playing on PBS as I usually do when I run on the treadmill and a light bulb in my brain suddenly clicked – a file cabinet in my brain sprung open, information coalesced, and the problem I had been thinking about on and off for several months made crystal clear sense. I had been chewing over the problem of cyclical industries and the dangers of peak earnings and investing value traps. What was puzzling me was that, although it made perfect theoretical sense to me at an instinctual level when I read about it, I just couldn’t fully master it, if that makes any sense. I was missing a vivid example that resonated with me, an example that would make it all come together in a clear, coherent picture. Running, pondering about our energy holdings, and the Nightly Business Report segment on oil last night made it all come together.
The Peak Earnings Value Trap
As a new investor, you can fall into the danger of value traps by purchasing at peak earnings in a cyclical industry. What does that even mean? It means that if you are not aware that certain companies operate in cyclical business cycles of boom and bust (such as commodity driven businesses, car companies, and oil companies) and you rely too heavily on merely the earnings per share figure, what you believe was a golden nugget will turn out to be a turd nugget.
When cyclical companies are at the peak of their earnings cycle, the P/E ratio will appear low. As an inexperienced investor, you might see these companies when you screen for low P/E ratios and think it is a textbook case of value investing, especially if you’ve only read The Intelligent Investor or other Benjamin Graham readings thus far.
Chevron as an Example
As you are all aware, oil prices started collapsing a year ago, with the slide starting in July 2014. Now, it doesn’t take a genius to realize that oil companies cannot make the same levels of profit when the price per barrel of oil is hovering at $50 versus when it is +$100. For example, Chevron posted it’s lowest quarterly profit in 13 years making $5 billion less in quarterly profit this most recent quarter versus the same quarter a year ago.
If you look into the history of the petroleum industry, you will see that there are cycles of boom and bust – it’s a cyclical industry influenced heavily by the price of the underlying commodity, oil.
To see the commodity cycle in action, we need data stretching back to 1998. Back in 1998, the price of oil was hovering around $12 dollars per barrel (around $17 adjusted for inflation). Chevron was trading, on average in 1998, at a price-to-earnings of 40. Right before the commodity price of oil was about to take off – and subsequently the profits for Chevron – it appeared to be trading at its most expensive.
Another look at the data, this time the Earnings Per Share in relation to the price of oil:
And looking at the P/E to Earnings Per Share, you can see the relationship between how higher EPS leads to a lower P/E ratio:
Now, let’s take a look back to last year. In the March 2014 tear sheet on Chevron by Value Line, the trailing P/E was listed at 10.4. If you saw this, you might have thought this was a classic example of a perfect value investing opportunity.
However, it was an illusion. Chevron appeared cheapest when in fact it was at its most expensive. If we take a look at the most recent Chevron tear sheet by Value Line in July 2015, we can see the updated forward projected P/E ratio was 22.5 based on share prices at $103.29.
Here is what happened to oil prices between these two Value Line reports:
Herein lies the danger of a value trap such as this: if you loaded up on Chevron at $114.97 last spring, thinking that P/E of 10.4 was a steal, you would have seen your shares collapse in price to $103.29 by July 2015, and to ~$85 by the beginning of August 2015. If you don’t have the temperament to ride out the volatility, there is the danger you might panic and sell at a loss, leading to permanent capital lose. Rinse and repeat this a few times and you are going to be compounding your money in the wrong direction.
You can’t rely strictly on P/E to screen your investments. If you are inexperienced – or can’t handle the volatility – peak earnings may fool you into a value trap. You must be very aware of cyclical industries when making investments.
Always remember Circe’s warning and do not be tempted by the Sirens of value traps, for you risk straying into dangerous waters.