The Peter Lynch Investor » Newsletter » Sometimes a stocks story changes

Sometimes a stocks story changes

When I first started investing after reading One Up on Wall Street, one of the things that I noticed was how the story behind a stock can change. I bring this up because right now I’m going through the process of redefining the story of a stock.

The story of a stock is maybe better said as your reason for owning a stock. For every stock you own you usually have a reason why you believe it’s a good investment. Lynch talks about this in One Up on Wall Street when he talks about “developing a story.” It’s a hypothesis that you can come back to at some point in the future. If your hypothesis is correct, you’ll have made money.

A little more than a year ago, I invested in a Canadian natural gas producer. The reason for my purchase was that the company was trading at a price/book ratio of about 0.20. I bought it shortly after the Covid pandemic hit and the price had gone from roughly $7.00 to $2.00. I wasn’t sure when the company would return to profitability but the equity value was too good to pass up. In my mind, this was an Asset Play.

Fast forward a year-or-so later (September 2021) and the story has changed. The company was merged with another natural gas producer. The price/book ratio of the merged company sits at 1.20. It’s not the Asset Play that it was a year ago. So I have to ask myself, is this company still worth owning?

The Covid pandemic is receding and the company is selling more gas than it was a year ago. This isn’t unique to this company. Most oil and gas producers are selling more now. Demand for their products is coming back as the economy opens again. Since the fortunes of this company follow the fortunes of the economy we can consider it a Cyclical. The story has changed.

Timing is everything in cyclicals, and you have to be able to detect the early signs that business is picking up or falling off. If you work in some profession that’s connected to steel, aluminum, airlines, automobiles, etc., then you’ve got your edge, and nowhere is it more important than in this kind of investment.

– Peter Lynch, One Up on Wall Street

Seeing that it’s now a Cyclical and no longer an Asset Play I can reorient my hypothesis for owning the stock. As the economy continues to improve this should improve the fortunes of this company. Things that are reinforcing my belief in owning the company are:

  • the price of oil and gas
  • the improving free cash flow
  • the measured approach to capex spending
  • the increasing dividend yield
  • the buyback of shares
  • the generally favourable sentiment towards natural gas

The price of oil has increased to roughly $70/barrel and natural gas is around $4.50. At the bottom of the pandemic oil was $0.00 (hard to believe but true) and natural gas about $1.50. Previous to that Canadian producers were struggling when oil was roughly $60/barrel and gas was $2.00.

In the chart below you can see a 10-year overview of free cash flow. At over $500 million, the cash flow hasn’t been this good in over a decade.

Arc Resources 10-year free cash flow

Capex or capital expenditures are always something investors in oil and gas producers are watching. They’re capital intensive businesses and they can easily chew into profits. Right now, Arc is keeping its capex spending reasonable at roughly $500 million.

The dividend yield for Arc is 2.79% after raising it 10%. I suspect that this dividend will continue to grow considering the amount of free cash flow.

The company plans to buyback 10% of its shares over the next 12 months. Again, thank the increase in free cash flow for the buyback and the wisdom of Arc’s managers.

Generally, the sentiment towards fossil fuels is poor. However, natural gas is cleaner than oil and seen as a bridge to the green future. Policy makers are more lenient on natural gas which should make them more palatable to the public. Investors nervous about the prospect of seeing their capital perform dismally in an industry that gets no love from the public can feel better about investing in natural gas.