PetroChina: Case Study Of A One-Foot Hurdle
I don't try to jump over 7-foot hurdles: I look for 1-foot hurdles that I can step over.
Warren Buffett
PetroChina was an unusual investment for Berkshire Hathaway in a lot of ways. First, it was unusually profitable, even by Buffett’s standards. A $488 million investment made between 2002 and 2003 turned into $4 billion by the time Buffett sold it between 2006 and 2007. That’s north of a 50% IRR!
PetroChina is also unusual because of what it is — a commodity business controlled by a foreign government. Buffett rarely invests abroad and had never invested in China before this. However, there are no bad assets, just bad prices. In this case, the price made it an easy decision to buy.
Last, PetroChina is unusual because Buffett discussed why he invested several times over the years. This makes it a great case study and provides insight into how Buffett thinks.
Berkshire first disclosed its investment in PetroChina in its 2003 annual report. A few weeks later, at the annual meeting, a shareholder asked Buffett about it. He replied:
We don't make any great judgment about China. You probably know more about China than I do. We simply look at investments around the world, and we try to buy into things that we think offer the most value.
And if they’re in the United — we might prefer, slightly, that they be in the United States, and we might have strong preferences against — or strong biases against certain countries.
We would regard the United States as number one because we understand the game the best here. We understand the tax laws and all that sort of thing, and the corporate cultures and so on. But we would regard a number of other countries as virtually equivalent to the U.S.
And there’s others that would have been marked down some, and then we’d have a whole bunch we wouldn’t go into under any circumstances because we just don’t understand them well enough.
But, you know, we think we understand something like the oil business in China reasonably well. And at a price relative to what we think the future cash generation is, we would make a decision on something like that.
In other words, Buffett thinks PetroChina is in his circle of competence. He understands oil, and he understands China. He prefers to invest in the U.S. but isn't opposed to investing elsewhere if the price is right.
In 2005 Buffett fielded another question about PetroChina at Berkshire’s annual meeting. This time the question was from Molly Fanner, an eleven-year-old from Long Island. Buffett said:
We bought PetroChina a few years ago, again, after reading the annual report. And fortunately, it was in English.
It was the first stock — Chinese stock — and really the last. I mean, it won’t necessarily be the last, but it’s the only one that we’ve owned so far. We put about $400 million into it.
At the time, and still, it produces about 3 percent of the world’s oil, which is a lot of oil. It produces, probably, 80 percent or so as much as ExxonMobil will produce. And it’s a huge company.
Last year it earned $12 billion. Now, if you look at the Fortune 500 list, my guess is you won’t find more than about five companies in the United States that earn $12 billion or more. So it’s a major company.
At the time we bought it, the total market value was $35 billion. So we bought it at about three times what it earned last year. It does not have unusual amounts of leverage.
It — is the annual report, they say something which very, very few companies do say, but which I think is actually fairly important. They say they will pay out about 45 percent of the amount they earn.
So, if you can buy it at three-times earnings, what turned out to be three times earnings, and you get 45 percent of 33 percent, you know, you’re getting a 15 percent yield on your — cash yield — on your investment.
…
Charlie, do you have thoughts?
CHARLIE MUNGER: Yeah. It would be nice if this sort of thing happened all the time, but that hasn’t been true in recent years.WARREN BUFFETT: But we never — I should emphasize — I mean, the annual report of PetroChina, which, like I say, it’s easy to read. Understandable. They declare their policies. Anybody could get it. You can read it.
We did not — we did not go over and — we never had any contact with the management before we bought the stock. We’d never attended an investor presentation or anything of the sort.
I mean, it’s right there in black and white, in a report that anybody can get.
And we just sit in the office and read those things, and we were able to put 400 million out that’s now worth about a billion-two or something like that.
It was interesting. At the time — I think I’m right on this — at the time, Yukos, which is the big oil company in Russia, was probably far better known among the investment community in the United States than PetroChina.
And I compared the two. At the time, I thought to myself, would I rather have the money in Russia or in China? PetroChina, in my view, was far cheaper. And I felt that the economic climate was likely to be better in China, you know.
Would I have — if it had been selling at the same multiple as a U.S. domestic company, would I have regarded it as more attractive? No.
I mean, there are some disadvantages, always, to being in a culture that you don't perfectly understand, or where tax laws can change, your ownership rules can change.
But the discount at which PetroChina was selling, compared to other international oil companies, was, in my view at the time, ridiculous. So, that’s why we bought it.
The valuation Buffett paid jumps off the page. Just three times earnings! You don't have to be a professional investor to know that it is cheap. However, a statistically low valuation doesn't guarantee that a business is a good value. The business could be over-leveraged or sell a product facing obsolescence. Or, management could be using the profits to enrich themselves rather than shareholders.
These weren’t the case at PetroChina. Buffett explicitly mentions that the company didn’t have a lot of leverage. He also calls out PetroChina’s capital allocation policy. PetroChina planned to return 45% of earnings to shareholders as dividends. Because the stock was so cheap relative to earnings, this produced a 15% dividend yield. This provided Buffett a substantial margin of safety. Even if management incinerated the other 55% of earnings, Berkshire would still earn 15%. A low P/E and a high dividend yield also provide a lot of room for oil prices to collapse before the investment begins losing money. Like Buffett, we love businesses with a clear and sensible capital allocation policy. It increases the likelihood the company’s profits actually end up in your pocket.
Buffett thinks like a handicapper. He's not looking for the fastest horse or the horse offering the biggest payout. He's looking for a mismatch between a horse's odds of winning and the odds offered. He reveals this when he says that he wouldn't buy PetroChina at the same valuation as a U.S. company. In other words, it's not that he thinks PetroChina is the best business ever. It's merely attractive relative to its price.
It’s also notable that Buffett mentions that he bought the stock after reading the annual report. He didn’t talk to management or hire a consultant to forecast the price of oil in Shanghai. More on this later.
PetroChina next comes up in Berkshire’s 2007 annual report. The company reports that they sold the position for $4 billion. Buffett wrote:
We made one large sale last year. In 2002 and 2003, Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value: the price of oil had climbed significantly, and PetroChina's management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion.
A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government – defense, social security, you name it – for about four hours.
Buffett says that the gap between PetroChina's price and value had closed. Its price was low, both outright and relative to peers. Now, it was average and in line with peers. PetroChina's low valuation was the primary reason Buffett bought. So, when its valuation increased to the appropriate level, he sold.
It's worth pointing out that Buffett sold early. The chart below shows that the stock trended up from 2002 to 2006 and went parabolic in 2007. It briefly became the most valuable company globally and the first to top a $1 trillion market cap. Even huge companies like PetroChina become severely mispriced.
I point this out because value investors tend to sell too early. It's a side effect of demanding a margin of safety. Buffett's investment thesis revolved around PetroChina's price to value. It didn't involve a forecast of oil or how enthusiastic investors would be for oil assets. So, Buffett sold when his thesis played out. This happened to be early, but that's okay. Buffett's "system" isn't designed to forecast transitory enthusiasm for stocks. He might have left a little meat on the bone, but he still went home full.
PetroChina’s Stock Price
Source: Yahoo Finance
The last time Buffett mentioned PetroChina was in 2008 when a shareholder asked him why he didn’t do any due diligence on PetroChina beyond reading its annual report. Buffett answered:
Yeah. Well, it was in 2002 and 2003, and the report came out in the spring, and I read it. And that’s the only thing I ever did. I never contacted any management. I never got a brokerage report. I never asked for anybody’s opinion.
But what I did do is I came to the conclusion that the company — and it's not hard to understand crude oil production and refining and marketing and the chemical operation they have. I mean, you can do the same thing with Exxon or B.P. or any of them, and I do that with all — I look at them.
And I came to the conclusion it was worth a hundred billion, and then I checked the price and it was selling for 35 billion, roughly.
What’s the sense of talking to management? I mean, basically, if you talk to management of almost every company, they’ll say they think their stock is a wonderful buy, and they’ll give you all the good stuff and skip over things that — it just doesn’t make any difference.
Now, if I thought the company was worth $40 billion and had been selling for $35 billion, then at that point you have to start trying to refine your analysis more. But there’s no reason to refine your analysis.
I mean, I didn’t need to know whether it was worth $97 billion or $103 billion if I was buying it at $35 billion.
So any further refining of analysis would be a waste of time when what I should be doing is buying the stock.
So we really like things that you don’t have to carry out to three decimal places, you know.
If you have to carry it out to three decimal places, it’s not a good idea. And, you know, it — with something like PetroChina — it’s like if somebody walked in the door here and they weighed somewhere between 300 and 350 pounds. I might not know how much they weigh, but I would know they were fat. (Laughter)
That’s all I’m looking for, is something that’s financially fat. And whether PetroChina weighed 95 billion dollars or 105 billion didn’t make much difference. It was selling for $35 billion. If it had been selling for 90, it would have made a difference.
So if you can’t make a decision on something like PetroChina off the figures, forget about going further, and that’s basically what we did. It’s a straightforward report, just like reading another — just like reading Chevron’s or ConocoPhillips or something like that. Just as informative.
And you weren’t going to learn more, you know, by going out and deciding whether you thought — they’ve got one huge field in China where the life of it was 13 years or 14 years or something of the sort. They should hit you between the eyes.
Buffett reiterates that he bought the stock after reading the annual report. For most people, this wouldn’t be enough. But it’s plenty for Buffett because he’s been reading annual reports for decades. That knowledge compounds. He knew off the top of his head where oil supermajors usually trade because he’d been reading their annual reports for years. Dan and I wanted to start Eagle Point when we were relatively young to give ourselves a long runway for our reading to compound.
Buffett also hints at his process. His order of operations is notable. He read PetroChina's annual report, estimated its value at $100 billion, and then checked the price. Investors who look at the market price before they value an asset are likely to anchor to the market price. Buffett forces himself to think independently by valuing the business without knowing its market price.
Buffett also hammers home the idea of avoiding false precision. False precision or "physics envy" is a plague in finance. Just because a spreadsheet can calculate a figure to 4 decimal places doesn't mean those decimal points mean anything. The future is inherently uncertain, which is why it's best to buy assets at a massive discount to their worth.
Buffett doesn't try to buy assets at a five or ten percent discount to their intrinsic value. He looks for massive discounts that scream "value." He wants to be able to value the company in his head, using rounded numbers and conservative assumptions, and still find that it's still glaringly cheap. As Ben Graham said, "You don't have to know a man's exact weight to know if he's fat." Similarly, you shouldn’t need a spreadsheet to know a business is a great buy.
PetroChina's 33% earnings yield and 15% dividend yield screamed "value" to Buffett. Investing in a situation like this is easy. The hard part is finding them. That takes a lot of reading — a day-to-day grind. Sticking with that process and refusing to compromise your investment standards takes patience and discipline. Anyone could have read PetroChina's annual report and come to the same conclusion as Buffett. His edge wasn't informational or analytical. It was behavioral.
It's not that Buffett is necessarily smarter than everyone else (though I'd bet he's in the upper decile), but that he's more patient, more thoughtful, and better read. The good news is that Buffett doesn't have a monopoly on these qualities.
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