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Wednesday, October 30, 2013 - 14:30

Get Income And 30% Upside From This Oil Giant

Wednesday, October 30, 2013 - 2:30pm

In one old western movie I saw as a kid, a young entrepreneur took a job driving a nitroglycerin wagon down a rocky road to a mine. He was willing to get paid well to do a job no one else wanted to do, so in time he grew rich and eventually bought the mine.

Similarly, I like the stocks of companies that do the job no one else wants to do or go where no one else wants to go. The stocks are typically undervalued, but the companies make tons of money and reward their shareholders.

The French oil giant Total (NYSE: TOT) fits this profile perfectly.

Formed in 2000 with the merger of TotalFina and Elf Aquitaine, Total operates in over 130 countries and boasts annual sales of more than $230 billion. Shares have gained nearly 20% this year, but the combination of Total's fundamentals and macro-environmental conditions should send shares even higher in the near future.

When I profile large, vertically integrated oil companies, I like to see what veteran investment strategist and energy analyst Bill O'Grady of Confluence Investment Management has to see. O'Grady contends (and I agree) that the difference between cheap oil and expensive oil boils down to where the black stuff is underground. Expensive oil is somewhere you would want to raise children. Cheap oil is found in places you would not want to raise children. Total searches and has reserves in the latter. That's the risk, but with risk comes reward.

The risk is that of Total's 11.3 billion barrels of proven reserves, more than half lies beneath Africa and the Middle East -- not exactly proposed sites for new Disney theme parks. However, the reward is that Total enjoys better margins than vertical companies that conduct their exploration and production business in more developed areas. Not only does Total look for oil in the frontier, it also looks to those emerging areas as a big growth driver.

Lately, I've been somewhat fixated on finding opportunity in frontier markets -- Africa in particular. The possibilities are enormous. The majority of the population of sub-Saharan Africa subsists on $2 a day. While that level of poverty is probably unimaginable to most readers, it's also inspiring from an investment standpoint.

As African economies begin to truly develop, improving living standards tend to follow. If you're living on two bucks a day and that goes up to three, your standard of living increases by 50%. That's huge, and investors can benefit. The challenge is to position yourself correctly.

In addition to identifying quality investments, one of my tasks as a portfolio manager is to prudently manage risk. Investing in directly frontier markets such as Africa is extremely risky. Financial markets are hard to track. Accounting standards are different. Research is very thin. So the best way I've found to successfully take advantage of frontier investing is by owning stocks of large multinational companies that have a strategic presence in the frontier market you're looking to own.

More than 30% of Total's reserves are in Africa. This means that the company's infrastructure is already in place. What's more, Africa represents only 7% of the Total's annual sales volume comes from continental Africa. Remember, as Africa's economies expand, so will consumption -- and growing economies consume energy. Total is already there and should profit from this trend.

Besides being positioned to take advantage of frontier market growth, Total's fundamentals are rock-solid. The stock trades at an almost ridiculously cheap forward price-to-earnings (P/E) ratio of 9.5. Management is committed to sound metrics: low debt to capital, a reasonable dividend payout ratio and a generous dividend. Debt to capital is at an extremely modest 23%, the dividend payout ratio is a comfortable 41%, and Total pays a dividend of $2.62 a share.

The forecast for Total looks good as well. Earnings should grow an average of 5% over the next two years. Analysts expect the company to earn $6.40 per share for 2013, up from $6.07 last year. 2014 projections call for $6.70 a year. 5% annual earnings growth is impressive for a business as large as Total ($137 billion market cap.

Risks to Consider: The biggest risk to investing in Total is the high concentration of assets in Africa and the Middle East. Despite the growth potential, political instability is a constant threat -- and new regimes love to nationalize energy resources, especially oil. However, Total has been in these areas for decades and has successfully adapted to many different regimes.

Another risk factor is oil price volatility. The stock prices of oil-related companies always react to the fluctuation in the price of the commodity. The price of Brent crude has seen lows of $96 a barrel to highs of $114 a barrel this year alone. Be prepared.

Action to Take --> Although shares have returned a handsome 20% this year, there's more upside left thanks to low valuations combined with frontier market growth potential. Look for Total's forward P/E to rise from 9.5 to 12, which is still a 16% discount to the S&P 500's forward P/E of 14.3. This translates into a $77 price target for TOT. Add the 4.2% dividend yield for a total return of nearly 30%.

P.S. In our latest report, "The Top 10 Stocks For 2014," we've uncovered several more investments that are similar to Total. They dominate their markets and put shareholders first. To learn more about these stocks, including several names and ticker symbols, visit this link.

Adam Fischbaum does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.