Inflation can do tricky things to markets. It creates distortions. In those distortions, an intrepid investor can find some big moneymaking ideas. I think we’ve got one opening up in oil and gas, and it is not without precedent in financial markets. In fact, it’s starting to look a little like the tail end of the 1970s in some respects.

In the spring of 1969, the Dow Jones industrial average stood at 969. By 1982, the Dow hit 1,071. That’s thirteen years of going nowhere. (We’ve had 10 years or so of going nowhere, though the ride between the poles has been anything but boring).

The problem is inflation makes that performance look better than it really was, like when a crooked judge makes a fight look close with a split decision even when the one fighter can barely walk to his corner and everybody in the building knows it was a rout.

Adjusted for inflation, or the weak dollar, the Dow was really more like 400. That makes it one of the worst stretches for the market since the 1930s.

The consumer price index, that flawed measure of inflation, doubled from 1960 to 1982. This is why a generation of people grew to believe that the best way to buy a house was to borrow all you could afford. And for a time, that looked brilliant. As Robert Sobel relates in a history of the period, a modest suburban home going for $30,000 in 1969 sold for $300,000 13 years later. With a lot of debt, your returns were much greater.

Of course, that kind of thinking eventually got us into a heap of trouble, as we now know.

But that period of time also had an effect on Corporate America’s balance sheets. When a company buys an asset, say a factory, it records its cost on its books. It will then depreciate this asset over time. So the value of the factory on its books will decline over time.

In a period of high inflation, its book value will be understated. The cost of a similar factory will be a lot higher in dollar terms, though the company will still show the old figure.

In other words, during periods of inflation, book values understate the true value of corporate assets. This happened in the 1960-82 period. Combine that with the stagnant market and you get many stocks trading for super cheap by 1982, when the great bull market began.

In fact, in July 1984, S&P reported that 30% of the stocks on the NYSE traded below net tangible book value. The old value mavens like Ben Graham would have had a field day.

What happened next, though, is what interests us especially. The low stock prices kicked off a takeover boom. The 1980s takeover mania was the busiest since the “age of Morgan at the turn of the century,” Sobel reports in his The Age of Giant Corporations. The 1980s was the age of the LBO, Barbarians at the Gate, Michael Milken and the corporate raider.

The oil industry also had its takeover boom. In fact, the outlines of the 1980s oil and gas industry look similar to today’s. In 1970s, there was a drilling boom as people thought that oil and gas prices would rise indefinitely. That collapsed and then you had oil and gas companies sitting on huge reserves they built up during the boom.

So in a time when it cost $15 a barrel to get oil out the ground, many oil companies traded for $5 a barrel in proven reserves. Getty Oil traded for $72 per share, with assets of $250 per share. Marathon’s stock went for $68, though each share had $210 in assets backing it up. And on and on it went.

Enter T. Boone Pickens. An Oklahoma-born geologist, Pickens was well aware of the value of these companies. He started going after them and making millions of dollars as bidding wars ensued. He lost several of these, but still cleared millions in profits.

There was a roll call of takeovers in the industry during this time — Shell bought Belridge Oil for $3.6 billion, DuPont bought Conoco for $7.4 billion and U.S. Steel took out Marathon for $6.5 billion. (Yes, U.S. Steel thought it would be smart to diversify). These were some of the bigger deals.

I won’t go too much into the history of this period, and perhaps I’ve already gone into too much detail. But I think something similar may be unfolding in today’s market.

We have the potential for high inflation thanks to the government’s monetary and fiscal stimulus. We also have a weak economy. In oil and gas, we have many companies trading cheaply in the wake of a drilling boom gone bust. What we need now is a T. Boone Pickens to shake things up.

Sincerely,
Chris Mayer

September 3, 2009

Chris Mayer

Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris is the editor of Capital and Crisis and Mayer’s Special Situations, a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks. In 2008, Chris authored Invest Like a Dealmaker: Secrets From a Former Banking Insider.

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