Exxon Mobil (XOM) has been among the dogs of the Dow for a long time and was just recently removed from the index after almost 100 years.
The reason for that has not been so much bad management as it was the ongoing structural change in the Energy sector, combined with the rise of tech giants which are the new leaders in the Digital Age.
Thus, Exxon Mobil’s capital intensive business model is now being replaced by the asset-light cloud-based customer relationship management service of Salesforce (CRM).
Without a doubt, the latter is the future, while the old fossil fuel businesses are not a very exciting investment opportunity.
The problem, however, is the extent of this divergence as it cannot continue to widen indefinitely, and at some point, the exciting future proof tech giant would need to cool down, while the beaten-down dog would revert to the mean.
As the valuation gap between has been slowly widening over the last 10 years, it reached extreme levels over a very short period of just a few months.
This extreme performance was largely driven by a one-time event – the recent pandemic. It acted as a significant boost for CRM which is capitalizing on more business digitalization as work-from-home is becoming the new normal. At the same time, the pandemic dealt yet another blow to the already troubled oil & gas sector. Companies in the space were already struggling with slowing global growth, a move towards new alternative energy sources combined with the trend towards more socially responsible investing.
Following the pandemic, the divergence in valuation between the two names culminated in the exclusion of XOM from the Dow Jones and the addition of Salesforce.
Implications for index additions and exclusions
History doesn’t repeat itself but it often rhymes.
A comprehensive research study done by Rob Arnott, Vitali Kalesnik, PhD, and Lillian Wu from Research Affiliates has found that additions to the similarly popular S&P 500 index have historically performed as follows:
for the period from October 1989 through December 2017, additions outperformed the market, on average, by 523 bps over the period between announcement date and effective date
Between the announcement and effective date, Salesforce outperformed the S&P 500 index by 28% as it also coincided with its blowout Q2 2020 report.
On the contrary to additions, deletions from the S&P 500 index were found to:
In contrast, we find that discretionary deletions (those not related to corporate actions such as a merger or acquisition) underperformed the market by an average of 429 bps over the grace period.
Since the closing on Friday – 21st of August – XOM did underperform the S&P 500 by 5.6% which is again in line with the findings above.
The paper also finds that the gap in share price performance between additions and deletions is almost always substantial over the 12 months prior to the announcement.
we observe that additions, on average, outperform deletions monotonically with the gap between additions and deletions accumulating to 63.80% over the 12 months prior to the announcement
In the case of XOM and CRM, the last twelve months’ performance was reinforced by the recent pandemic, which pushed the gap in performance relative to the S&P 500 between XOM and CRM even further to 85% over the 12 months prior to the announcement.
So far, the two companies have been performing as history has predicted, both 12 months prior to the announcement and between the announcement and effective date.
However, if history is any guide, in the year following the index rebalancing, the stock being added to the index returns around 1.28% less than the market. On the contrary, the stock being excluded outperforms the market by a staggering 19% on average.
According to the research paper, the main reason for the reversal in performance in the year following the inclusion is a combination of the value effect and mean reversion.
In the case of XOM and CRM, we have both factors in place as:
- Exxon Mobil is heavily exposed to the value factor (HML)
Source: author’s calculations based on data from Fama and French and Yahoo!Finance
- the valuation gap between the two companies is enormous
Source: prepared by the author based on data from Seeking Alpha
The long-term view
Although large-cap oil & gas companies like XOM will most likely never trade at multiples similar to those of tech giants such as Salesforce, prudently managed companies in the oil & gas space are not going away anytime soon.
To begin with, energy consumption is on the rise as more developing countries continue to move up on the UN human development index and thus require more and more energy per capita.
Source: Exxon Mobil investor presentation
Even though electrification and switch to renewable sources of energy will be the highest growth area in the energy space, gaseous and liquid fuels are here to stay as overall consumption continues to increase in line with the higher share of renewable energy.
On top of that, large-cap oil & gas companies are the best positioned to expand into hydrogen, biofuels, and even some areas of renewable energy.
Source: Royal Dutch Shell Investor Presentation
In addition to all that, as oil and natural gas prices hit a record low, bankruptcies continue to mount.
What that means is that all the small and inefficient players will be pushed out of the market or get acquired by the larger and stronger players. Moreover, less Capex spend on exploration and production would mean only one thing in the future – higher returns for the survivors. Thus, the strongest players in the space are more likely to experience reversal to the mean in the future as returns improve.
As one of the strongest and worst hit players in the space, Exxon Mobil could also be one of the best performers as mean reversion takes place.
As Exxon Mobil’s Return on Equity reached one of its lowest levels since the 1980s, so did its valuation once we take into account the level of interest rates. Thus, a small improvement in the company’s ROE could have a strong impact on its P/S multiple.
On the other hand, in spite of the high top-line growth, Salesforce’s sky-high valuation will become increasingly hard to justify as it needs to earn ROE significantly higher than its cost of capital to back up a P/S multiple of nearly 13x. This way, CRM’s valuation could easily remain flat or go down even if the company continues to grow its top-line.
Based on analyst forecasts for the next two years, it appears very likely that Exxon Mobil’s EPS will likely reach its bottom in 2020.
Source: Seeking Alpha
At the same time, Salesforce’s profitability would most likely stay flat during 2021, as the benefits from the pandemic lock downs subside.
Source: Seeking Alpha
Assuming Exxon Mobil achieves EPS of $1.57 in FY 2021, it will have a P/E ratio of around x26 at the current price. In the case of Salesforce, however, the FY 2021 EPS will have to increase almost threefold in the years after to reach a similar P/E multiple of XOM and trade closer to the average of the S&P 500.
Source: author’s calculations based on data from Seeking Alpha
Although it is highly unlikely that these two names will trade at similar multiples anytime soon, this simply shows just how much future growth is already priced in CRM valuation. Even worse, its sky-high valuation does not only factor in extraordinary top-line growth for years to come, but it also assumes a massive improvement in the company’s return on equity which at the moment is merely 7.5%.
Exxon Mobil and Salesforce are two companies that for the time being perfectly fit into the historical narrative of companies being excluded from and added into one of the world’s most popular stock market indices. The former has been suffering due to a number of coinciding factors and was pushed down even further by the recent pandemic. The latter, on the other hand, has been benefiting from the recent lockdowns while the excitement around hot technology names has reached extreme levels. Therefore, it seems more likely than not that the history is bound to repeat itself in the year following the exclusion of Exxon Mobil and the addition of Salesforce into the Dow Jones.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ SEC filings. Any opinions or estimates constitute the author’s best judgment as of the date of publication and are subject to change without notice.