Jim Chanos is the most prominent and successful short seller in the world, but I bet even his face went white on discovering Warren Buffett was buying the Exxon Mobil shares he was selling.
In a presentation at the Reuters Global Investment Outlook Summit last week, Mr. Chanos disclosed a short position in U.S. oil giant Exxon Mobil Corp., describing the stock as a "value trap." Only days previously, Berkshire Hathaway regulatory filings disclosed that Mr. Buffett had built a $3.5-billion long position.
Adding to the intrigue, Mr. Chanos cited cash flow sustainability and return on equity (ROE) as the reasons for his skepticism – the exact two multiples that form the foundation of Mr. Buffett's investing approach.
Warren Buffett is arguably the best investor of all time, so usually investors can dismiss opinions that contradict him out of hand. But within financial circles, Mr. Chanos is almost as revered.
Mr. Chanos is the founder of $6-billion hedge fund management firm Kynikos Associates (kynikos is the Greek work for cynic). He rose to prominence with wildly successful short positions in Enron Corp., Hewlett-Packard, Tyco International Ltd. and more recently, Caterpillar Inc. and Chinese real estate development stocks.
In Mr. Chanos's view, Exxon's declining return on equity and cash flow make it a value trap – a cheap stock that will just get cheaper as profitability deteriorates. The accompanying chart shows he has a point. Exxon's return on equity – the most widely used measure of a company's ability to turn revenue into profits – hasn't come close to pre-crisis levels and has trended lower throughout 2013.
The other line on the chart, cash flow per share, is likely what Mr. Buffett is looking at. His investment style, stated simply, is to buy companies with cash flow streams that are near-bulletproof – rarely changing from year to year – at times when the stock's price-earnings ratio is at least 30 per cent below the long term average.
Exxon fits the bill in terms of cash flow. Despite the decline in ROE, quarterly cash flow has rarely been outside of a $2 to $4 range. This is a remarkable feat in light of crude price volatility.
The current trailing price-earnings level is almost exactly in line with the 10-year average of 12.0. But, there's been numerous times this year when the stock traded at P/E levels in the 10.5 times range, which would have offered a valuation discount to history.
At the risk of being branded a heretic, I suggest that Mr. Chanos has this right. Mr. Buffett's belief that Exxon's cash flow will remain consistent is predicated on oil being as profitable to find, pump to the surface and transport as it has been in the past. Much of Exxon's stable cash flow in the past 10 years has been accompanied by return on equity levels above 30 per cent. The current ROE, only marginally above 20 per cent, suggests profitability is already declining and that future cash flows are increasingly threatened.
It is also unlikely that Mr. Buffett acquired his position at the usual steep valuation discount.
The outlook for North American crude prices also supports Mr. Chanos's skeptical outlook. Sharply rising U.S. oil production and increased exports from Iran will pose a major hurdle for the West Texas Intermediate (WTI) spot price.
Betting against Warren Buffett has been among the worst investing strategies imaginable, so I'm not about to suggest investors join Mr. Chanos in shorting Exxon. But investors should think very hard before blindly following Mr. Buffett this time.