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Warren Buffett, COP, And PSX

07/26/12 08:52:23 AM
by Billy Williams

Two stocks have the interest of investing great Warren Buffett.

Security:   COP, PSX
Position:   Buy

In mid-July, Warren Buffett announced that he was holding shares of Conoco Phillips (COP), an oil and gas producer based in Houston, TX, to the tune of 2.3% of Berkshire Hathaway's portfolio but he was looking to divest itself of COP's shares in favor of Phillips 66 (PSX, a recent spinoff of COP).

Over time, COP found itself involved with both the downstream and upstream aspects of the oil industry and was looking to split itself in order to streamline operations for maximum effect. It is this separation of operations that offers a unique opportunity in an industry that is experiencing a rising demand over the long run as energy needs rise.

The oil and gas industry is broadly divided into upstream and downstream components with the upstream business involving activities like fracking, digging wells, and exploration for oil and gas while downstream operations involve selling refined oil and gas to industrial clients and individual consumers. See Figures 1 and 2.

FIGURE 1: COP. COP is consolidating in a price range and is close to its ideal buy point for a long-term value play. The potential for a solid investment is high and can be enhanced by selling naked puts at a lower strike price. You can earn income and if the stock's price falls, then you can pick up the stock at an even bigger discount.
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Even before PSX was spun off from its parent company, COP sported an impressive balance sheet with $65 billion in stockholder equity at the end of 2011, return on equity of 18% plus, a strong return on assets of 8.73%, operating cash flow of just under $22 billion, and cash on hand of just over $4 billion. In addition, the company had a book value of $52.61, which was every value investor's dream since it was well below that since early May after experiencing a huge gap to the downside.

For a long-term investment, COP is sitting in the sweet spot where it finds its current shares trading at around $55 a share, where its Graham number (assets - liabilities = X, then divide by total outstanding shares) is at $51.76 a share. For an investor following Benjamin Graham's value theory, anything below this number allows you to buy a business whose value is greater than what it is being traded at. Anything below gives you a strong margin of safety against taking a loss if the company had to be sold today, protecting your capital against a worst-case scenario.

FIGURE 2: PSX. Spinoffs tend to outperform the market and PSX is already beginning to trend higher as value investors are attracted to its stock price that is trading under its book value.
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In fact, you could sell naked puts at strike prices well below that number so that you could earn income, but if the stock price fell, you could pick up a strong stock at well below its Graham number at a bargain.

Looking at PSX, the spinoff does have an edge almost straight out of the gate in that spinoffs tend to outperform the market. With PSX divested of COP's upstream operations, it is free to focus solely on downstream operations joining companies like Valero, Chevron, and Exxon in the marketplace but without the baggage of a large cumbersome company slowing its trajectory.

Spinoffs tend to unmask the hidden value of a company that is often overshadowed by its parent, which is why COP will retain oil, gas, and exploration and leave refining, retail, chemicals, and transportation/distribution with PSX.

While PSX has a lot to prove, super-investors like Buffett are optimistic about its future and with a current book value of $39.84, the shares are trading at around $35 and enticing more investors to acquire them.

Both are attractive investments for the long term and offer attractive valuations. However, in order to attain a greater margin of safety, you could sell puts at lower strike prices to generate a combination of income and the potential to pick up shares at much lower values to enhance your overall returns.

Billy Williams

Billy Williams has been trading the markets for 27 years, specializing in momentum trading with stocks and options.

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