XOM - 3 Energy Dividend Picks That Are Intrinsically Undervalued

2023-07-07 09:03:14 ET

Summary

• The energy sector offers significant potential for long-term returns due to high dividends and undervalued stocks. The sector has become more investable due to cost-cutting measures and a focus on shareholder interests.
• Despite a challenging year in 2022, the energy sector provided a safe haven for investors. Companies that are undervalued and offer solid dividends present the best opportunities for successful compounding.
• Exxon Mobil, Phillips 66, and EOG Resources are highlighted as top energy stocks for dividend investors, offering good prospects for continued dividend growth, quality management, and solid growth prospects.

The stockholder wants both income and appreciation, but in general the more he gets of one the less he realizes of the other.

Benjamin Graham

It is easy to forget that a significant portion of all returns in the stock market come from dividends. You can see a yield that looks paltry, but the benefits of compounding over time are quite amazing. Thus, if you have time, you have most of what you need to be a successful investor. The usual obstacles that ensnare others recede from your attention as your time horizon for investment stretches out and you let the miracle of compounding work.

The long-term proportion of the S&P 500's total return that is comprised of dividends is an awe-inspiring 41% !

However, the yield is only one side of compounding. The other side of it is the appreciation of the share price itself. When you select companies that are both undervalued and that have solid dividends, your chances for successful compounding are all the better.

The Energy industry was nearly left for dead in 2020 and was trading for barely above book. However, during the especially painful bear market of 2022, where stocks and bonds went down in unison, the Energy sector was the only place to hide. Seeing the sector providing a safe haven during a challenging year is always nice. However, staying an owner of Energy and using price weakness to build a position and lock in a higher yield will have a high potential to achieve compounding.

One of the main reasons to own Energy should not be as a hedge but for the long-term total return potential created by the generous dividends needed to attract shareholders. Some Energy firms were forced to cut dividends during COVID due to the incredible nature of the risks.

What some may forget who don't pay close attention to Energy might forget, though, is that the price of oil went negative in 2020, shortly after the acute COVID concerns. The oil demand dropped so rapidly that you had to pay someone for them to accept delivery (the meaning of the negative price).

This hardened the industry, and most companies involved in upstream began dramatically reducing their break-even production prices. As a result Energy companies have made major changes from the pre-COVID industry.

• The industry has lower break-even prices and has slashed costs.
• Management has implemented strict capital discipline to hedge against regulatory developments and to entice shareholders.
• Capital return policies have become focused on dividends and growing FCF to the benefit of shareholders.
• As a result of this, many firms have underinvested in the CAPEX necessary to maintain sufficient levels of production to keep downward pressure on price.
• So, the industry has become more investable from many vantage points out of necessity and self-preservation.
• Activist shareholders and management feeling pressure from all sides have both resulted in Energy companies taking genuine efforts to have a seat at the table of decarbonization (rather than being on the menu.)

It is rare to find such a great alignment of high dividends with good prospects for growth and continued safety paired with intrinsically undervalued companies that offer an excellent opportunity for compounding and wealth preservation.

One thing that Energy compliments nicely in a portfolio is Technology. The low valuation and high dividends are a nice counterbalance to companies with a high portion of intrinsic value derived from earnings that are far in the future. Energy was once known for being a very tough sector to invest in.

However, the rise of concerns about industry externalities and global warming has decidedly shifted the balance of power toward the shareholders and away from the management of what used to be the world's most powerful industry. This means that Energy has even more of an incentive to keep the dividend safe and to their best by shareholders. Please the shareholders or potentially go out of business is a pretty good incentive.

It's also easy to forget just how many people are employed by the Energy industry. Many people want this industry to succeed so that people can keep feeding their families, and there are critical things the Energy industry is currently doing, like natural gas production that serve as crucial stepping stones along the path toward a less destructive global energy footprint.

As you can see, Energy is the most undervalued sector by far in the S&P 500. However, if you look at the rally that has occurred in both on a YTD basis, and on a monthly basis, Energy has been a noticeable laggard.

As you can see, Energy even lags behind the heavily cyclical Dow Jones Industrial ( DIA ) on a YTD basis, and even IWM significantly outperformed the sector. However, recent developments around economic data in the United States suggest that there could be a very soft landing, or even that we have begun an expansion and bull market.

If this is the case, and inflation remains subdued, you can expect Energy to join the party, even if the price of oil doesn't spike parabolically. This isn't your 2010's oil industry and most companies could make plenty of money and continue rewarding shareholders at prices far lower than current levels.

For the long-term dividend investors, the Energy industry provides particular opportunity for compounding. One of the best ways to achieve this is through periodic buying when the valuations are suppressed like they are now. So, even if there is a recession and demand and prices plummet, the discerning dividend investor with a long time horizon knows this is an opportunity.

For my five favorite Energy stocks for dividend investors, I don't simply pick the highest yield obviously. I take a mix of quality, dividend growth and safety, and of course share price appreciation potential primarily based on relative and intrinsic valuation. All of the stocks I've selected have:

• Good prospects for continued dividend growth
• An attractive dividend
• Quality management focused on building FCF and shareholder interests
• Solid prospects for growth
• Taking solid action to mitigate climate impact and be a part of climate solution

My three Energy dividend picks are below:

Exxon Mobil ( XOM )

Of course, an oil major has a lot of benefits of both vertical integration and size. Furthermore, Exxon in particular took a more aggressive upstream strategy that will likely enable it to continue getting market share at the expense of its rivals.

As you can see, the stock is undervalued when using the Dividend Discount Model, but it is also significantly intrinsically undervalued when using a DCF.

The firm is also significantly undervalued when using the Peter Lynch Fair Value method, which I think is a good metric for a firm like Exxon.

Exxon is a dividend aristocrat and its management has shown that it prioritizes shareholder interest through thick and thin. It's dividend safety is only a B- now, but I think that will diminish when more upstream capacity comes online. Also, the firm does a lot of refining and fundamentals should be good in that business.

As you can see below, the firm has also prioritized making its earnings less cyclical. This is always a plus for dividend investors.

The actions taken by management to increase resiliency ultimately benefit dividend investors and make the cuts that used to occur from extreme price cycles less likely. Exxon Mobil is obviously a company you can feel comfortable owning for the long haul.

Phillips 66 ( PSX )

Phillips 66 is a stalwart midstream play with some of the best refining assets in the business. Building shareholder value and doing right by those who own the stock is a passion amongst the management at this firm, and they have shown they can deliver.

As you can see there is considerable upside implied with a Dividend Discount Model. The firm is also undervalued by several intrinsic methods based on earnings as well.

Firstly, you can see that the discounted cashflow model suggest the firm is dramatically undervalued. You can also see that with an Earnings Power Model, the firm is shown to have significant upside.

This company may benefit from what some analysts have postulated will be the " Golden Age of Oil Refining. " As supply dynamics will likely favor the industry and barriers to entry in refining are incredibly high, Phillips 66 has a nice and entrenched competitive position.

The dividend investor wants to see stability and so focusing on Energy firms that have made themselves less cyclical and more resilient to the inevitable undulations of economic activity is always an advantage. The firm also has some genuine projects to improve the environment that should keep Uncle Sam off it's back a bit.

As you can see, this stock has a juicy yield that is slated to improve and it has a payout ratio below 20%. The firm's initiatives on cost-cutting and improving efficiency of assets makes me think this is a safe dividend for the foreseeable future.

EOG Resources ( EOG )

EOG Resources is the new face of the shale industry. The rise of the American shale industry was largely a good thing as it established as one of the world's leading Energy producers, but the early days of the industry were marked by a lot of capital destruction and angry shareholders. While the industry used to have a bad reputation, perhaps no firm more than EOG Resources turned it around with exemplary behavior from a shareholder perspective.

As you can see the firm is fairly undervalued when using the Discount Model, but when you use the Peter Lynch Fair Value method it shows that there is the potential for triple digit upside.

The firm also is undervalued when using the Earning Power methods, although certainly less so then with the previous methods. EOG Resources does enjoy a premium compared to some peers but that's because of its technology leadership and premium positioning in the Permian Basin.

Like the other firms in this article, EOG's management has shown an absolute and unwavering commitment to the shareholder that can help the dividend investor sleep well at night.

EOG Resources has 23 years of consecutive dividend payments and 5 years of consecutive growth. The lower yield compared to peers is partially the function of a premium valuation, but I think it is more than compensated for with an industry-leading position on dividend growth.

Risks and Where I Could Be Wrong

The Energy sector is made up primarily of companies who make money drilling holes in the ground. So, there are plenty of risks from massive oil spills and the reputational damage that can accompany it, to making wrong moves in allocating capital in an industry where mistakes can be unforgiving.

As you can see, oil prices are not expected to be too hot for the rest of the year, but their decline is not expected to be precipitous either. However, if there is a recession that is severe and demand for oil significantly falls below the current expectations, it is possible that there could be some threats to the dividend. However, this is incredibly unlikely. Nonetheless, any of these following risks could jeopardize my thesis.

• Escalation in Ukraine or Taiwan.
• Fed Policy Error.
• Banking Issues Worsen.
• Return of Inflation.
• CRE meltdown.
• Write-downs of Private Assets.

There are idiosyncratic risks to the Energy industry from government and regulation as well, but I'd say these are mitigated in the medium term by the fact a crucial pillar of the current Republican legislative agenda revolves around regulatory relief for the American Energy sector.

Conclusion

There is a lot of bullish activity going on in the most exciting corners of the market, but remember the most successful retail investors identified by Fidelity were those who forgot about their accounts .

The proven way to beat the market is with dividends, price appreciation, and time. The Energy Industry right now is a great opportunity because it has fantastic yields and is intrinsically undervalued.

The three above companies are a balance of yield, quality, and potential for share price appreciation. I also am a fan of all three management teams.

When valuations get so low as to suggest the Energy industry doesn't have much of a future, this is a golden opportunity for discerning Energy investors. Take advantage of what I call " rhetorical arbitrage ," and build long-term wealth through the miracle of compounding.

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