28 Aug Want Yield? Fuel Up
We saw a wild week on financial markets capped by a President Trump tweet storm. Trump started the week by welcoming a small recession, which would be a “small price to pay to win the Trade War”. We quickly dismissed this statement because Trump also said that he wants a weak U.S. dollar and a strong economy, evidence that he has no clue in the realm of economics. On Friday, Jerome Powell delivered a moderately dovish speech at Jackson Hole, which helped neither the cause of equity Bulls nor Bears. Also on Friday, China struck back with retaliatory tariffs on the U.S. Having a bad day already on Friday with China’s tariff retaliation, the President Genius, believing that the Jackson Hole symposium was a policy meeting, lashed out at Powell for not cutting rates. In a “can this get more bizarre” moment, Trump tweeted Fed Chair Powell was an enemy of the United States. Trump then went on to order, by tweet, a declaration in which he “hereby orders all U.S. companies to stop doing business in China”. And we thought the week was already weird on Monday when Trump made a proposal to buy Greenland from Denmark!
On the markets, we saw the 10-year/2-year U.S. yield curve invert several times this past week. Many are dismissing this recession indicator. It is true that we have no experience of judging the predictive power of an inverted yield curve in a negative global interest rate environment. It has also been observed that we have not seen an inversion of the 10/2 yield curve through the 10-yield coming down below the 2-year yield. Typically, we see the 2-year yield rise (backed by Fed rate hikes) above the 10-year yield to get the yield curve inversion. Demand for the 10-year T-Note with a positive 1.61% yield (pushing down rates) is not surprising given German 30 yield Bunds were auctioned this week at -0.11% yields. In other weirdness, it now costs more to borrow money overnight in the U.S. than to borrow money for 10-years. Dismiss the inverted yield curve at your own peril.
In terms of macro data, we only saw reports for the leading economic indicators (LEIs), the Markit PMIs, and housing. Interestingly, with economic slowdown worries, the LEIs jumped +0.5% in July. The slowdown is clearly concentrated in manufacturing, as evidence by the August Markit Manufacturing PMI at 49.9, in contraction territory. The housing data was mixed, with New Home Sales slipping in July and Existing Home Sales improving.
What Do You Do When The World Falls Apart?
Friday’s price action showed once again just how vulnerable risk assets are to the strange economic and political situation we are living through. We saw the Dow down over 700 points for the second session in as many weeks. All assets fell, except high quality bonds and gold-related stocks. Buying either asset at this stage is a pure defensive play. We are not saying that these trades aren’t a good move near-term, but investors should not be comfortable in buying government bonds yielding 1.5% in nominal terms (with negative real rates). Gold stocks offer essentially no yield and are again a panic trade that will unwind quickly.
So, besides holding cash at 0% interest (or actually negative rates in real terms), an investor should begin thinking about where he/she can earn yield on investment savings, without buying overvalued equities with downside risk that should keep investors up all night. It is certain that central banks will not let up – policy interest rates will be driven to zero (and below), and will stay at low levels for a very long time. We don’t know yet if the U.S. economy is are going into a recession in 1-year or in 3-years. But we do know recession and a nasty bear market will hit at some point and that return of capital will become more important than return on capital. As such, equity investors need to ensure that the companies that they invest in will withstand the storm of the next recession, all the while generating regular dividend income.
For us, the best yielding assets today are in the Energy sector. Energy is unloved and may not turn around any time soon. But we ask a rhetorical question – in one-years’ time, which index is more likely to be trading above current price levels AND offer the higher Total Returns, the Nasdaq-100 or the S&P Energy Index? Readers responses may likely be determined by their trading style, trend-following (Nasdaq) or contrarian (Energy). This is also a test of David (Value and Energy) versus Goliath (Growth and Tech) in the market juggernaut which, for several years, has crushed all things Value and elevated all Growth companies.
For readers who recognize that Energy will not fall forever and that Technology will not grow to the heavens, and who believe that Value stocks will again have their day, please keep reading.
What should attract long-term oriented investors to Energy is Y-I-E-L-D. Dividend yields are obscenely attractive in many companies in the Energy sector. Value stocks alone should not be of interest, yet. But when adding the regular income to the value offered by some Energy companies, we believe getting paid to ride this roller coaster is a slam dunk trade, provided that your investment horizon is at least a year or two. With the Energy sector down yet another week, we believe that yield-seeking investors should not hesitate to fuel up on select Energy stocks.
Energy Companies Trading At Discount To Oil Prices
The main reason to buy any company is prospects for higher futures profits. Obviously, Energy company profits from driven by oil prices, so the price of West Texas crude oil is always the main driver of Energy company share prices. We have witnessed a decoupling of oil exploration & production stock prices from the price of crude oil this year. The chart below plots the S&P Oil & Gas Exploration & Production Index versus West Texas crude oil prices since the Energy complex bottomed in early 2016.
The chart confirms the oil stock prices “hug” the West Texas crude oil price curve. In early 2017, oil stocks raced ahead of oil prices on specualtino, but then came back down to as crude oil prices languished. Today we have the opposite situation, oil stocks are plummeting, but crude oil prices are not. If the trading algos are unfairly punishing oil stocks, then there is an enormous opportunity in Energy companies today. If oil stocks are anticipating a drop in oil prices, then we can surmise that Energy company stock prices have already adjusted and a subsequent drop in crude oil prices should have a limited impact on Energy stocks. In either case, investors should get long Energy stocks relative to crude oil prices.
Energy Stocks To Short-List
It may be scary to buy with Energy Indexes sinking each week. However a thorough analysis of Energy company fundamentals will allow investors to sort the wheat from the chaff. Here are the key metrics that we are looking at to ensure that our Energy stocks will bounce back strong:
- Financial Situation. We only want Energy companies in the top decile of our fundamental rankings for Financials. This means that our various balance sheet metrics (Debt/Equity, EBITDA/Interest Expense, Cash Flow /Total Liabilities, etc) for our companies stand above their Energy sector peers.
- Profitability. If a company is not solidly profitable, it may become difficult to maintain the dividend in a recession. We calculate our profitability score using many measures, including profit margin and EBITDA margin.
- Yield. If, in balanced portfolios, we are going to hold onto a company stock through a potentially extended turbulent period, we want to see large dividend payments coming into our account. With some of the beaten down Energy stock prices today, the dividend yields are more than compelling. This is where we should be looking to over-weight sector holdings and positions.
Our Energy Holdings
In normal times, our selection methodology relies heavily on earnings estimates and staying invested in companies that enjoy positive consensus EPS revisions. In selecting high-yield Energy stocks, this will not be possible. All companies in the Energy space are getting decimated and analysts keep revising EPS and revenue down for the sector. As mentioned in the opening, what we believe will matter soon is return of Among the European Energy names, three companies stand out to us.
Total is a French-based integrated oil company. One of the largest companies in Europe, Total has a market cap of €115 billion ($130 billion). At only 9.5x forward earnings, this is a P/E that investors should be buying at. Total’s Financials score in our ranking system places the company in top 25% of peers, although profitability is a bit below that of the average Energy company. Total has been paying a steadily increasing dividend for years, now at $0.74/share. We are comfortable in the capability of Total to maintain its nearly 6% dividend through a period of global crisis. Total’s Risk Score is 1 out of 5, the lowest risk level. Volatility of the stock is relatively lower than the market and down-down risk from the current stock price is reduced.
As far as Energy company stock performance goes, Total’s weekly chart looks very good going back to the Financial Crisis of 2008. To alleviate risk concerns, it is reasonable to prepare for a move back down to towards the bottom of its multi-year channel, so be patient when accumulating Total.
Royal Dutch (RDS.A)
The Royal Dutch Shell plc explores for crude oil and natural gas around the world, both in conventional fields and from sources, such as tight rock, shale and coal formations. It is also a mega-cap on European exchanges. Royal Dutch is very similar to Total – solid balance sheet, lower risk, and a 6.7% dividend yield. Royal Dutch is slightly for expensive in terms of P/E at 11.0x forward earnings versus Total, but still much cheaper than the broad market. This is a dividend that investor should be able to count on over the long-term.
British Petroleum (BP)
BP p.l.c. is an integrated oil and gas company. Again, very similar Risk, Profitability, and Financials profile as Total and Royal Dutch. BP may be trading at a slight Brexit discount, as seen in the long-term weekly chart below. The stock has paid a steady $0.60 dividend per quarter (for the U.S.-listed shares), which just got bumped up to $0.615/share in July 2018. At last check, the divided yield is up to 6.95% 6.68% dividend yield. Despite the slow revenue growth that has plagued the Energy sector, we otherwise have an overall Buy rating on BP.
Moving to North American Energy companies, we like two names in particular. These companies should keep paying out a strong dividend while offering downside protection from already cheap valuations and strong balance sheets.
Vermilion Energy (VET)
Vermilion Energy is a Canada-based international energy company, which focuses on conventional and semi-conventional exploration and development projects. The company primarily deals in light oil and liquids-rich natural gas. Vermilion is not as cheap as the European Energy companies above, but offers higher Profitability (top quartile) and a much higher dividend yield at 13.6%. The reason for our Strong Sell in the Growth category (and hence overall Sell) is due to the very poor PEG score in our ratings system. The stock is too expensive relative to its EPS and Revenue growth rate. Of all our recommendations here, Vermilion is the most speculative. Its balance sheet is no worse than the median Energy company, so financial troubles are not yet showing up here. Analysts have 3 Strong Buys, 8 Buys, and 6 Holds on Vermilion. Insiders are buying the stock. The plunge in the stock price is unlikely a precursor of some unknown company-specific problem. This is a 13.6% yield to reach for.
Yield investors have until October 29 before the next ex-dividend date. No need to rush in yet with the knife falling.
Occidental Petroleum (OXY)
Occidental Petroleum Corp is an international oil and gas exploration and production company. The Company has operations in the United States, Middle East and Latin America. Despite the higher volatility in Occidental’s shares (Risk Score up to 2), this is a name we like for the long-term. Profitability and Financials score are in the top quartile within our Energy sector rankings. Almost all analysts have a Hold on Occidental, but we note that insiders are buying shares. The stock is on the expensive side within the Energy space, but we note that Occidental has historically traded at higher valuations relative to the sector. Most importantly, the stock is paying a 7.46% dividend yield as of Friday’s close, compared to and S&P 500 dividend yield of 1.79%.
If you accept our argument that Occidental is not going into financial troubles, investors looking past this insanity need to find a big trailer, back it up, and load their portfolios up on OXY.
Helmerich & Payne (HP)
Helmerich & Payne, Inc. is engaged in contract drilling of oil and gas wells for others. The Company operates in the contract drilling industry. The Company’s contract drilling business consists of three segments: U.S. Land, Offshore and International Land. The shares of Helmerich & Payne have been hit hard by falling EPS and Revenue forecasts. And on top of this, the company is not particularly cheap. Helmerich & Payne’s MV/EBITDA, for example, is in the bottom 29th percentile of Energy companies. Our only hope with Helmerich & Payne is that, with one of the strongest balance sheets in the sector and a positive Profitability score, the company will continue to pay the 7.6% yield while the stock searches for a bottom in the share price.
This stock chart shows capitulation. Bill is holding Helmerich & Payne in our Natural Resources fund but we are waiting on to add more to the position. Yield investors have until November 13 to buy the stock and participate in the next dividend pay-out. Perhaps the stock will get cheap between now and then, but a simple return to the 15-year mean would imply a share price of $55/share, about +50% from Friday’s closing price.
Evolution Petroleum Corporation (EPM)
Evolution Petroleum Corporation is an independent oil and gas company. The Company is engaged in the acquisition, exploitation and development of properties for the production of crude oil and natural gas, onshore in the United States. Evolution Petroleum is a pure yield play for us. Financials and Profitability scores are ranked in the top 10% for Evolution Petroleum. The dividend will keep getting paid, which is what matters for yield investors. And at 7.2%, this is a yield worth having in our portfolios.
Evolution Petroleum is another stock in free fall with no major support in sight. Yield investors have time to build a position in Evolution Petroleum.
Finally, we conclude with two Chinese Energy stocks worth short-listing. There is certainly a Trade War discount in these stocks, meaning a price boost can be expected whenever the U.S. and China decide that this spat has gone on long enough.
China Petroleum & Chemical Corporation (SNP)
China Petroleum & Chemical Corporation is a China-based energy and chemical company. Most company revenue is generated through the Exploration and Development segment and Refining segment. There are lots are reasons we like this stock, in addition to the 10.7% dividend yield. SNP has solid Financials (top 20th percentile among Energy companies), very attractive valuation scores with a 8.0x forward P/E multiple, and moderate risk.
China Petroleum’s chart looks much like sector peers. A major buying event is setting up.
CNOOC Limited (CEO)
CNOOC Limited is a Hong Kong-based investment holding company principally engaged in the exploration, production and trading of oil and gas. Its businesses include conventional oil and gas businesses, shale oil and gas businesses, oil sands businesses and other unconventional oil and gas businesses. CNOOC is a very solid business, with strong financials and profitability. The stock is reasonably valued with Energy and attractive versus the broad market. This is a steady 6.3% dividend yield for your portfolio, with capital gains coming on the Trade War resolution announcement.
The CNOOC stock is seeing its 40-week moving average roll over, so we will be patient in accumulating shares.
Yield investors can start turning to Energy names with dividend yields at 4 to 5 times yields offered by the broad market. With any market in free fall, investors need to ensure that their holding period is long enough to be able to withstand near-term draw-downs. Depending on investors risk tolerance, we recommend adding slowly from this point. The bottom in Energy share prices will likely be in a V-shape, so those waiting for prices to form a bottom may be buying 20%, or more, above lows.