Thursday, February 5, 2015

BHP Billiton stock’s role in a dividend growth portfolio

It provides exposure to resource prices, foreign exchange markets, foreign stock markets, and indirectly to developing economies

The impact of the strong dollar on BHP Billiton is complicated and easy to underestimate: its output is priced in dollars.

Thus, there are numerous reasons to think the stock is attractive now, including the price of the stock

As a leading global resource company, BHP Billiton is widely followed and well-known.  BHP Billiton trades under two symbols BBL and BHP.  Which is the most attractive investment for an individual depends on tax considerations which are beyond the scope of this posting.  Rather, throughout this posting the reference will be to BBL since it is the appropriate vehicle for most US investors.  Because BBL is so well known, this posting skips doing a detailed description of the company.  However, a few things are worth noting because they relate to the thesis of this posting. 

BBL is actually in two businesses.  One is the operation of extractive activities (mines and wells).  The second is the allocation of capital across the development of those resources including the acquisition and sale of those mines and wells.  The company's history would suggest that it is good at both businesses.  One might argue that there is a third activity: acquiring the right to develop the resources, but as is done above, it is equally legitimate to just consider acquiring rights as a part of acquisition and sale of those mines and wells.

Commodity prices can fluctuate over long cycles where the change in prices can be quite substantial and open to being confused with a trend.  At the same time, commodity prices can react violently over very short periods of time.  Nevertheless, BBL has been able to maintain a reasonably stable dividend.  Yet, the instability in commodity prices and the consequent fluctuation in the price of BBL’s stock deters some dividend growth investors.  The thesis of this article is that BBL provides diversification that belongs in a dividend growth portfolio, and now is a good time to add that diversification.

Many dividend growth stocks are consumers of natural resources.  That is less true of the pharmaceuticals and consumer staples than the industrials.  BBL’s exposure to resource prices is the opposite of many industrial firms and thus provides a mild hedge.  It is only a mild hedge because the same economic prosperity that affects industrial demand can also affect the demand for resources.  However, the lead times for developing extractive resources are quite different from those associated with investments in industrial activities. Therefore, commodity cycles can develop independent of the business cycle.

For US investors, BBL also provides access to foreign stock markets, a form of diversification recommended by many financial advisors.  If unhedged for the foreign exchange risk, it provides diversification across currencies.  Also, developing economies are often the major consumers of natural resources.  Thus, BBL provides exposure to developing markets indirectly. Consequently, BBL’s stock can be quite volatile, but overlong holding periods it is not highly correlated with general market volatility.  The beta for BBL is less than one (about .9).  Thus, despite the volatility of BBL’s stock price, it can work to stabilize a portfolio.  The volatility in the stock's price means that the timing of purchases is very important.

BBL is a global company with operations in many countries.  Its Australian mining operations are often the focus of analyses, but they are hardly the totality of the company.  That is an important consideration because, as a multinational, BBL is operating in many different currencies.  It also develops a broad range of extractive resources, and the prices of most of the commodities BBL develops are quoted in US dollars.

A recent analysis of BBL on SeekingAlpha focused on iron ore prices, “BHP Billiton: A High-Yielding Wait For The Iron Ore Turnaround.”  This is very good analysis covering both the company's current strategy and the stock’s valuation with a good description of why iron ore is becoming increasingly important to BBL.  However, when reviewing the analysis, one should keep in mind that iron ore prices are presented in US dollars.  The strong US dollar means that, while iron ore prices may continue to drop for US consumers, they could simultaneously rise in weak currencies because of the dollar’s affect.  As pointed out above, that is true of many of the resources BBL develops.  They are priced in international markets in US dollars.

The dollars affect could benefit BBL in a number of ways.  First, when it comes to operating their businesses, they may produce and sell in areas where the currencies are weak relative to the dollar.  At the same time, their pricing is based upon the dollar.  Thus, they reap the benefit of operating in weak currency environment without the pressure of having to sell priced in that weak currency.  In terms of the spread between their cost and their prices, the foreign exchange impact is as if they produced in weak currency and sold in a strong currency country.  Second, since they operate in multiple countries, they can gear down or sell operations in strong currency environments and gear up in a weak currency environment.  At a global level that will reduce their cost. 

Because the currency effects are secondary to the issues addressed in the analysis in the article cited above, they often get ignored.  Many investors will just trust the management of the company to navigate the issues associated with currency fluctuations.  In the case of BBL, the inclination is to recognize the management has negotiated currency fluctuations in the past and assume that they are continuing to do so.  Further, there continue to be indications that faith in BBL's management is justified.  For example, the article cited above mentions that BBL is exiting its low margin coal business in South Africa, but unlike some of the other divestitures, it is not exiting the coal business.  Rather, it is just adjusting which assets it retains in which countries.  Similarly, BBL is gearing back its exposure to oil and gas in the US at the same time it is analyzing the desirability of increasing its exposure in oil and gas in Mexico.

In summary, for US investors a strong dollar will make the dollar price of BBL’s lower, but the company’s performance should not be adversely affected by the strong US dollar.  In fact, the company may actually benefit from the strong US dollar.  The company operates in so many countries that it is probably best to just view it as operating in an environment of multiple countries with weak foreign currencies.  Those countries include both the sources (i.e., points of production) and markets for BBL.  The net effect is that it is a multinational company that is not adversely affected by the US dollar.  It is producing in weak currency countries and selling at prices quoted in a strong currency.  Many dividend growth stocks are going to be adversely affected by the strong US dollar.  Thus, BBL may offset some of the negative impact.

A previous posting on the Hedged Economist (Rebalancing and Risk) discussed selling two international stock mutual funds that had been long-term holdings and shifting to individual stock positions where the foreign currency risk was easier to understand and more appropriate given the rest of the portfolio.  BBL fits that description perfectly.  That BBL is a potentially good fit in a dividend growth portfolio has been true for quite a while.  However, because the stock fluctuates with commodity prices and foreign currency rates, prudence required waiting a number of years until it became attractive.  The combination of the strong dollar and the overreaction to the commodity cycle has finally made it an attractive purchase. 

Unlike the author of the SeekingAlpha article entitled “Recent Buy: BHP Billiton PLC,” I did not try to average in.  The reasons for thinking it is attractive are the same as those discussed in the article (PE, yield, restructuring, etc.).  Nevertheless, perhaps out of frustration after waiting for a number of years for the opportunity, a need to maintain international exposure, or just out of overconfidence, when the stock was under $44 it seemed to justify making the entire planned purchase.  BBL now has my targeted portfolio weight and contributes my targeted portion of the dividend flow from my portfolio.  At $44 a share, that has been accomplished at a reasonable price.  However, both in terms of portfolio benefits and the stock’s valuation, purchases at any price under $50 seems justified.