Professional and small retail investors alike constantly rely deliberately or unconsciously on story narratives. That’s the way we human beings understand our complex world, how we try to make sense of events and bring different elements into a kind of consistent framework.
There are thousands of different media reports on a daily basis on individual companies and their shares, the whole stock market, and the economy. These often circle around paradigms and standards investment narratives. It’s important to be aware of the fact, that these “common truths” can shift and alter rapidly and turn the perspective on certain developments completely around.
For long-term oriented buy-and-hold investors in particular this requires extreme caution in order not to face an unnecessary drag on performance which could be easily be coupled with an enhanced risk preposition.
Let’s look at just two examples to show the importance of a very skeptical view on standard narratives.
Example one: Flawed oil market assumptions
For decades, millions of investment portfolios were constructed around various assumptions and wrong conclusions from the “Peak-Oil-Theory” formulated by geology and BP-oil expert Marion King Hubbert of 1956. The term “Peak Oil” in a nutshell plain and simply states that crude oil production for a region, the country reaches its peak, a plateau from which it inexorably declines.
Commodities are scarce, finite resources extracted from the earth.
The “Peak-Oil-Theory” is fine, but let’s look at the standard assumption or narrative that has been derived from that very simple theory. For decades, investors and companies had the implicit or explicit assumption that there is a kind of oil price floor that cannot be undermined simply due to the fact that it is a finite resource. People thought that in fact that it is likely that the price dynamic will literally be on a never-ending upward trend, which would justify more and more huge investments of oil and commodity enterprises. And for a certain time, this seemed to be all correct assumptions. With an oil price well above USD 100 a few years ago, oil supermajor company ExxonMobil was in the group of the most profitable companies on earth.
The assumption that prices of all commodities would be in a steady upward trend was seen as the “standard truth”.
And wow, just looking at the gigantic investment projects that were initiated to support production expansion, it was breathtaking, and in hindsight even megalomaniac. For instance, back in 2011, Chevron started liquified natural gas (LNG) projects in Wheatstone and Gorgon in Australia. The latter was a venture where ExxonMobil and Royal Dutch Shell participated with roughly 25 % each. Both investments in Australia combined had anticipated project costs of around USD 100 Bn back in 2011. Due to diverse delays, geological and environmental challenges the costs will be ultimately higher and draw a daunting resumé. In fact, I highly doubt that these projects will ever break even.
One had to have extreme conviction back in 2011 on a prosperous future of the oil sector and a sheer unending demand on that commodity. It’s just with such a conviction a company can be at ease to sign contracts in the total amount of USD 100 Bn. On top of that multi-year investment spree of epic dimensions, Chevron launched a stock buyback program in the amount of USD 20 Bn. a committed itself to continue its progressive dividend policy to reward its shareholders.
Just think of that. Today, Apple is a USD 2 Trillion market value company with over USD 100 Bn in cash at hand. It is one of the most gigantic businesses on earth. Shareholders would go terribly mad if Apple started a project or made an acquisition in the amount of USD 100 Bn. We all know, that in technology things can change pretty start, even a leader can be easily disrupted (e.g. look at Nokia’s company history) or even be put out of business. Even tech companies are far more prudent capital allocators than commodity companies, as their assumptions don’t circle around a never-ending upward trend.
Back to our oil story of the last few years. In 2016, there was a huge oil and commodity glut in the markets, mainly driven by new technologies (fracking) and a terribly uncoordinated and weak OPEC policy. Oil prices crashed by 70 % in a matter of a short time. In the following years, prices recovered and climbed back, regaining a part of their 2016 losses. 2020 though, with the COVID-19 pandemic and lockdown measures around the world was a huge blow to the industry again.
The oil sector in particular is also facing the severe threat of major tech disruptions. Tesla, the iconic electronic car producer is just one example to lead to the conclusion or assumption, that we already have seen “Peak Oil Demand” and that the following years will show a constant decline, putting enormous pressure on prices, profits, and the oil industry as a whole.
Today, it’s not rare to hear the “standard narrative” that “Oil is dead”.
Well, here again, an assumption, that led to drastic investment decisions. In 2020, while the tech sector has been booming due to the shift to “stay at home stocks”, oil shares have been thrown out massively from institutional and retail investors, at any price. To some extent, this is understandable, the huge pressure and the uncertainties surrounding the oil sector.
But looking at the history of oil and the Standard Oil Company founded by J.D. Rockefeller, you could easily come to the conclusion, that we are talking about an incredibly volatile commodity, translating into moderate stock valuations. Don’t let us make a mistake: even with a low oil price, oil supermajors churn out massive amounts of cash. It’s amazing. Just think of the potentially positive impact of heavily cut investment projects and lower overall cost basis. Profits of oil supermajor can be huge even with an oil price below USD 70, and really gigantic with levels beyond that.
So, let’s also be careful with the all too often heard narrative “Oil supermajors have seen their best days” because that’s far of being certain. Demand for petrochemical products is increasing fast, the world economy is on a strong recovery path and oil supermajors slashed their project and operative costs dramatically.
Example 2: How Big Tobacco defying the odds became hugely profitable
I have no tobacco stock positions anymore in my stock portfolios but am also invested in ETFs/index funds (e.g. S&P), a certain exposure is still there. I try to have very limited exposure to tobacco companies as I feel uncomfortable with their business model which is built around an extremely harmful product.
Despite the moral aspect, the tobacco industry can serve as a very interesting example for a group of companies that prospered amid extremely adverse factors – or let’s state it late that: because of a series of bad occasions, a handful of tobacco enterprises became the most profitable entities in the world and built huge fortunes for their shareholders.
Let’s get back a few decades. In 1998, the four largest US tobacco companies Philip Morris, Reynolds, Brown & Williamson, and Lorillard entered into an agreement with the states to settle lawsuits against the industry for the recovery of their tobacco-related health care costs. These companies agreed to pay a minimum of USD 206 Bn over the first 25 years of the agreement. The tobacco companies also agreed to curtail or cease certain tobacco marketing practices and to pay, in perpetuity various annual payments to the states to compensate them for some of the medical costs of smoking-related illnesses. Other tobacco companies around the world have been facing litigation costs and regulations as well.
In practically all western countries, nicotine marketing is increasingly regulated and some forms of tobacco advertising are banned in many countries.
Today, tobacco companies are literally confronted with a complete tobacco advertising ban and in some countries, cigarettes have plain packaging.
But there are much more fronts of heavy headwinds: for decades, tobacco consumption has been on a decline in many companies.
With billions and billions in litigation costs, falling demand in several key markets, and huge regulations, “The fall of Big Tobacco” was one of the standard narratives back in 2000.
But interestingly, twenty years later, these companies churn out huge cash flows. Why is that?
There has been a combination of different factors: higher regulation, huge litigation costs, etc. built barriers avoiding new competitors getting into the markets while at the same time, a consolidation process took place. Smaller tobacco businesses were acquired and today, there is literally an oligopoly. Today, only a very small number of very large firms have most of the sales and profits in the industry: British American Tobacco, Altria, Philips Morris, Japan Tobacco, Imperial Brands, and China Tobacco.
Their business models are extremely capital-light, production efficiencies and scale effects to some extent compensate the fall in tobacco demand in key markets. And of course, there is one key factor: tobacco resp. nicotine is addictive, which puts tobacco companies into a position to increase their product prices which makes big tobacco-free cash flow machines.
Due to their tremendously strong global presence, big tobacco companies can also benefit from some markets where regulation is not that strong and consumption even increasing.
Again: personally, I don’t like the business model of big tobacco. But despite the moral aspect, it serves as a good illustration and reminder, that writing down whole industries or companies can be premature. In fact, it is likely, that the tobacco industry will be profitable for years and years to come.
Also, let’s bear in mind, that many countries and states rely on payments of the tobacco industry in form of taxes, fines, litigation payments. You don’t crush the hand that is feeding you, do you?
The big tobacco example could repeat itself in a regulation spree on Big Tech. Companies like Alphabet, Apple, Microsoft, Facebook, and Amazon became extremely powerful and have an incredible impact on the media landscape and various areas in our daily lives. Their data practices, content and media control, and tendency to misuse their market power could lead to regulations by governments around the world. Personally, I am of the opinion, that at least a couple of the Big Tech companies could be forced to be split up.
This could easily alter the extremely positive narratives currently surrounding Big Tech and suddenly make these companies unfavoured by investors.
You could have seen it more than a hundred years ago when the Standard Oil Company was split up. Or a few decades ago in the 2000 Microsoft antitrust case. I remember very well when the investor community has laterally written down Microsoft, being of the opinion, that this company has already seen its best days. Well, today, that company has a market cap of over USD 1 Trillion and firing from all cylinders showing an incredible growth pattern.
Again. Always be careful with the standard narratives surrounding companies, their stocks, specific industries, and the economy as a whole.
You are responsible for your own investment and financial decisions. This article is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action.