Exxon Mobil: Did Warren Buffett Just Invest In a Value Trap?

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

U.S. stocks broke their three-day losing streak today, with the S&P 500 gaining 0.8%. The narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) gained 0.7%, closing above 16,000 for the first time.

Last week, I highlighted three reasons why Warren Buffett bought ExxonMobil (NYSE: XOM  ) for Berkshire Hathaway's (NYSE: BRK-B  ) equity portfolio. (He did so in size, too -- the position was valued at $3.4 billion at the end of the third quarter.) This week, short-seller Jim Chanos, who famously bet against failed energy company Enron, offered a few reasons of his own -- for steering clear of the shares, characterizing ExxonMobil as a "value trap." Is Mr. Chanos right? Did the Oracle of Omaha just make a monumental mistake?

At the Reuters Global Investment Outlook on Tuesday, Chanos described his negative thesis regarding the energy supermajor's business and its stock:

In terms of the integrated oil companies, the business demonstrably has gotten worse and it's for a simple reason: the cost of finding and replacing reserves has gone up. Let's just use Exxon as an example. Their revenues are down year-over-year yet the amount of capital they've employed in the business continues to grow. Their cash flow has dropped dramatically and, where in the past Exxon had been able to finance dividends and its buybacks out of free cash flow, it's no longer able to do that. It only basically finances half of that (dividends and buybacks).

Exxon used to have returns on capital of around 30% -- an amazingly profitable business. Well, it's been cut in a third in the past year. Now it's about 20%. So, it's telling you that on the margin, these companies are increasingly finding it difficult to cheaply replace reserves. And, I've basically called them 'liquidating trusts'. They're not the values they used to be. They're having now to borrow to finance a lot of the financial engineering that they're doing to keep their shares up at the same level.... It's not a value stock, it's a value trap.

Presented with Buffett's investment, Chanos replied: "He's got his reasons but unmistakably the returns are dropping." Let's be clear: The only reason Warren Buffett buys a stock in size is because he thinks he will make market-thumping returns over a very long period of time.

I don't disagree with many of the points Chanos makes in the two paragraphs above. Many are simply factual observations one can quickly verify by looking at the company's financial results. But I disagree with his conclusion: Yes, profitability has dropped and, yes, ExxonMobil may no longer be the value it used to be. Nevertheless, a 20% return on capital remains well in excess of ExxonMobil's cost of capital. Furthermore, the company does not need to deliver the same returns it has produced since 1970 (a better than 375-fold total return) in order to provide investors with a more than adequate return during the next 40 years.

Finally, costs outpacing revenues is not an irreversible trend, contrary to Mr. Chanos' implicit line of reasoning. Hydrocarbon resources are in finite supply, yes, and the price of extracting dwindling reserves may increase. I want to emphasize may -- this isn't a matter of certainty -- not for some time, in any case; but oil prices aren't static, either. As Mr. Buffett's longtime right-hand man, Berkshire Hathaway vice-chairman Charlie Munger told an investment conference this summer: "Oil is absolutely certain to become incredibly short in supply and very high priced... The oil in the ground that you're not producing is a national treasure."

Did Warren Buffett just invest in a value or a value trap? Jim Chanos is a very astute investor, certainly someone you don't want to dismiss out of hand; but I'm siding with Mr. Buffett here.

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