Nothing like Valuentum’s optimistic article last week, January 21, in Barron’s to get the energy markets popping, “Is Kinder Morgan on Road to Recovery,” would you say? Of course, we say that in jest.
The equity markets January 28 were defined by optimism that two of the globe’s major energy resource producers, the cartel OPEC and Russia (RSX), would finally come together to alleviate the pain that has been exerted on the price of the black liquid the past 12-24 months with a “meeting.” What we found to be peculiar, however, is that instead of OPEC letting what turned into a “rumor” run, helping to further drive crude oil prices higher, OPEC delegates quickly denied the talk of a potential meeting with Russia. That didn’t stop crude oil prices from advancing though, perhaps on the belief that Russia may act unilaterally to cut its own output. We doubt, however, that Russia would act alone in earnest at its very own expense. OPEC won’t meet again until June.
We’re viewing OPEC’s quick denial of potential “talks” to mean that not only is the cartel dedicated to “overproduction,” but that, even in response to a near-term bounce in the price of crude oil (USO), which it shares in the benefits, the cartel was quick to bat them down…by denying the rumor. From where we stand, OPEC wants crude oil prices to be “lower for longer,” whether to wage political war against Iran, “Bye Bye Energy MLPs,” or to put shale oil independents back “in their place,” or both. It’s also very likely that any unilateral production cuts by Russia, if carried out (a big “if”), may only stimulate more production from OPEC or US shale independents, as both seek to absorb incremental market share. Russia can’t stand to lose alone, in our view, and we doubt it will put further economic pressure on its own country, absent “shared pain” from OPEC. The chess game continues.
That said, we think it’s important to note that we’ve moved closer to “market-neutral” on the energy sector with the October addition of broad-based exposure via the form of the Energy Select Sector SPDR (XLE), “Transaction Alerts: Moving Close to Market Neutral on Energy,” even as we continue to emphasize the “oversupply” situation and point readers to the January 22 data from the EIA: “At 494.9 million barrels, U.S. crude oil inventories remain near levels not seen for this time of year in at least the last 80 years.” With the bounce in energy shares January 28, however, the energy sector is now outperforming the S&P 500 (SPY) so far in 2016, meaning that it hasn’t declined as much as the broad-based index. Short-term measures of performance matter little in the context of long-term goals, but we think there are a few takeaways to be gleaned by this recent move.
For starters, even if we have been decidedly “bearish” on a fundamental concept on a sector or industry grouping, portfolio sector allocations and broad-based valuations can impact our decisions within the context of the newsletter portfolios to achieve stated goals. In this case, in October, we opted for broad-based diversified energy exposure among the strongest players in the Energy Select Sector SPDR–Exxon Mobil (XOM) and Chevron (CVX) account for ~35% of the ETF’s assets–to avoid any firm-specific, adverse outcome in the event energy resource pricing continues its swoon. This isn’t the first time we’ve implemented tactical moves within the newsletter portfolios and within energy specifically, however.
For example, in 2014-2015, we purposefully underweighted the energy sector in both newsletter portfolios during the entire collapse in energy resource pricing, and by doing so, we were able to add incremental “alpha” to both the Best Ideas Newsletter portfolio (which had zero energy exposure) and the Dividend Growth Newsletter portfolio, where we removed the two upstream weightings in advance of the energy resource pricing swoon. We removed the position in ConocoPhillips (COP) at ~$63 in May 2013 for a significant gain, “The Transaction Log of the Dividend Growth Newsletter Portfolio,” and in April 2015, we removed Chevron from the Dividend Growth Newsletter portfolio at ~$102+, near its cost basis. Shares of ConocoPhillips and Chevron are now exchanging hands at ~$38 and $85, respectively.
Through most of the collapse in energy resource pricing, however, we still retained exposure to the “better-performing” midstream space, however, if only in the Dividend Growth Newsletter portfolio. As a result, we were able to generate significant “alpha” within the energy sector itself, while retaining option value in the low-probability event (at the time) that energy resource pricing might abruptly turn higher, something that would benefit all energy-related names as a whole. However, as energy resource pricing continued to swoon into 2015 and the risks to midstream business models mounted with credit quality deteriorating, it then became time, in our view, to remove midstream exposure. In June 2015, we removed Kinder Morgan (KMI) from the Dividend Growth Newsletter portfolio in a high-profile piece, “5 Reasons Why We Think Kinder Morgan’s Shares Will Collapse,” and then in August 2015, we removed Energy Transfer Partners (ETP) from the Dividend Growth Newsletter.
Tactically speaking, the newsletter portfolios generated significant outperformance from a relative standpoint in terms of stock selection within the energy sector in 2014/early 2015 by removing upstream but retaining midstream, and then in an alpha-creating sector move by moving out of the midstream space altogether in 2015 when the risks related to energy master limited partnerships increased, not only with respect to their business model itself but also in conjunction with the heightened uncertainty of both collapsing energy resource pricing and tightening credit markets, which we expected to challenge their financially-engineered payouts. The cut in Kinder Morgan’s dividend in December spoke to those risks, and we’ve now inched closer to market neutral on the sector, generating “alpha” in the newsletter portfolios all-around. That’s quite a mouthful, but we hope this explains how and why our opinion can change even over short 3-5 year periods.
Facebook (FB) and PayPal (PYPL) are propelling the markets higher, and we continue to like the latter in the Best Ideas Newsletter portfolio as we consider the former, which is having such a strong day that it has already closed much of the gap relative to our fair value estimate of shares, “Giddy Up – It’s Earnings Season.” Other “high-beta” equities are catching a bid today, as well, and one in particular, Under Armour (UA), reported a rather strong fourth-quarter report where net revenue leapt more than 30% and operating income jumped 20%, perhaps allaying fears that unseasonable weather may have had impact on its product assortment. We love Nike’s (NKE) younger brother, and the company is a tremendous entrepreneurial success story, but at ~80 times reported trailing earnings, negative free cash flow generation in 2015 (-$343 million versus +$78.5 million in 2014), and a bloating net debt load, we’re not ready to jump in head first. Even one quarterly slip up could result in Under Amour giving back all the gains (+20%) had in the market January 28.
Potash (POT) announced its first dividend cut since its initial public offering in 1989, and the Dividend Cushion ratio added yet another company that it highlighted abnormal risk to the payout in advance of a disappointment. The Dividend Cushion ratio is found in Valuentum’s dividend reports for each company, and broadly speaking, a ratio meaningfully above 1 signals that a company has the flexibility to keep paying its dividend and expected growth in it over the immediate, forward 5-year period. A ratio below 1, or 0.8 in the case of Potash, suggests it may encounter trouble. If you are interested in learning more about the predictive nature of this innovative, free-cash-flow based measure of dividend health, please have a read, “The Dividend Cushion Beats the Aristocrats.” Potash new quarterly payout will be $0.25 per share, was $0.38.
Though Caterpillar (CAT) put up a “better-than-feared” outlook January 28, we think it may be among the most likely candidates in the 30-member Dow Jones Industrial Average (DIA) to cut its payout, “Caterpillar Prepares for Continued Pressure, Slashing Our Fair Value,” as miners cut back capital spending to preserve credit quality and in some cases, their respective dividends. BHP (BHP) and Rio Tinto (RIO) have been cutting capital spending materially, as iron ore prices, in particular have wreaked havoc across much of the mining equipment space. In mid-December, mining equipment maker Joy Global (JOY) slashed its dividend 95%, and just recently, Moody’s placed a swath of mining firms under review for a downgrade, “Moody’s Puts Oil & Gas and Mining Sectors on Review.” We’re expecting multi-notch downgrades in several cases.
Former Best Ideas Newsletter portfolio holding, Ford (F) reported January 28, and while the company issued record full-year 2015 pre-tax profit for the year, we still believe there may be a better time to re-consider the equity, with the company now dipping to mid-$11 per share. We took profits in Ford when shares were close to $15 each in September 2014, “The Transaction Log of the Best Ideas Newsletter Portfolio,” and we’re being patient in this globally-exposed, cyclical industrial before considering reestablishing any position in it or General Motors (GM), two equities that we believe are starting to “get cheap.” Also facing weakness January 28, following a fourth-quarter report, is Alibaba (BABA), and we opted to rid ourselves of that equity in the Best Ideas Newsletter portfolio a number of weeks ago, “Alerts: Seeking to De-risk the Newsletter Portfolios.” The performance of China’s local stock markets, Shanghai and Shenzhen, give us considerable pause.
The fourth-quarter performance of Best Ideas Newsletter portfolio holding and Dividend Growth Newsletter portfolio holding Altria (MO), released January 28, could have been better, but we generally liked its outlook for 2016, and particularly how the price of the company’s equity has been acting amid the market’s swoon to start the year. Altria has tremendous financial flexibility in what we would describe to be its “hidden assets,” adding a cushion to its dividend payment unlike that of even other strong dividend payers, “Altria Receives Augmented Stake in AB-Inbev-SABMiller Combination.” Altria is one of the strongest and highest-yielding, as it is defensive, corporates in today’s market, with a payout of $2.26 annually, good for nearly a 4% dividend yield. Its valuation, however, is worth watching, but flight into “recession-resistant” entities may become a major theme this year. We’re available for any questions.
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