SAM Partners’ Inaugural Call November 17, 2020 [edited transcript]
Updated: Aug 22, 2021
Good afternoon everyone and thank you for joining us today. This call should last about thirty minutes. In the email we sent out, you will have received a presentation entitled, “Infrastructure Income Strategy” and an essay, “A World Without Fossil Fuels.” Supporting documentation for most of my remarks today can be found in these handouts.
The high-level takeaways that you should get from this call are:
(1) The Biden Presidency should be positive for clean energy investments but not necessarily a significant negative for energy stocks.
(2) Coronavirus vaccines will lead to strengthening world economies and a rebound in energy demand. A positive for cyclical stocks and energy stocks in particular. A long awaited rotation from growth stocks into value stocks may be under way.
(3) A contrarian approach to investing should be considered. In my 30+ years on Wall Street I have never witnessed such negative sentiment toward energy investing. To invoke the often used Mark Twain quote, “The demise of fossil fuels is greatly exaggerated.” Please take a look at the essay I recently wrote, entitled, “A World Without Fossil Fuels.”
(4) The trend toward the adoption of renewables and transition to net zero carbon emissions is accelerating and presents investment opportunities, but the energy transition will take decades to achieve.
(5) The energy sector is adjusting and the successful companies are embracing capital discipline, decarbonization and ESG. I have strong conviction that a portfolio that combines energy and renewables can deliver an attractive current income stream and competitive risk adjusted returns. In fact, it makes sense in my view to allocate a portion of one’s investment portfolio to the energy sector.
This is my inaugural hosting a conference call as Siegel Asset Management Partners and I’m particularly pleased to team up with ELCO Management as a sub advisor on their platform. ELCO (they’ve been in business since 1995) and I share a research driven philosophy, core principles of behavior and commitment to consistently delivering favorable returns for our clients. It’s Back to the Future for me.
I started my career working for Dan Tulis, who is still quite active and the senior member of the ELCO team. I’m really excited to be working again with Dan and being able to collaborate with the entire ELCO team.
I recently formed Siegel Asset Management Partners where I am managing an Infrastructure Income Strategy for Separately Managed Accounts. The strategy seeks to provide sustainable income and growth in conjunction with capital preservation. This is accomplished by investing in a concentrated portfolio of high-quality midstream energy companies/master limited partnerships, utilities, renewable energy companies and special situations. As you probably are all too well aware, energy investing has been a losing proposition for 5 of the last 6 years and value investing has underperformed growth investing for well over a decade. However, I believe that we are nearing an inflection point at which there will be a reversion to the mean and energy infrastructure stocks, such as oil and gas pipelines, can generate very attractive returns for shareholders. I also acknowledge that the clean energy and decarbonization train have left the station and we intend to be onboard. A portfolio that combines energy infrastructure stocks with clean energy, renewables and utilities that are embracing renewable energy, should be a winning strategy in my view. A World Without Fossil Fuels is just not feasible, at least for the next several decades.
Let’s now elaborate on some of the points I’ve highlighted.
The Biden Presidency. Here I think the bark is worse than the bite. As long as there is a split Congress, it will be extremely difficult to pass major legislation such as a $2 trillion dollar Green New Deal. The bigger threat may be re-engaging with Iran and allowing Iran to export crude oil. This incremental supply could put additional pressure on oil prices. This obviously would be negative for U.S. producers and U.S. oil production.
A ban on fracking on just federal lands may come to pass via an executive order. However, the drilling on already permitted leases will not be affected, so I don’t think there will be much of an impact for several years.
The U.S. probably rejoins the Paris Accord. This in my mind will largely be a symbolic move. The U.S. has already made huge strides in reducing carbon emissions primarily because of natural gas displacing coal in power generation and secondarily because of the increasing usage of renewables for power generation. In the U.S., from 2005 through 2019, carbon emissions declined by 33% while electricity generation increased by almost 2%. According to the U.S. Energy Information Administration, natural gas accounted for more than 60% of the reduction. Natural gas’ share of electricity generation increased from 19% in 2005 to 38% in 2019. Renewables accounted for about 19% of power generation in 2019.
The tougher Obama era environmental regulations that Trump eliminated are likely to be reinstated such as on methane emissions. Here too I’m not that concerned. I’m a capitalist, and market forces are requiring companies to become better stewards of the environment. It’s not a bold prediction on my part to suggest that the best performing energy stocks will also be the companies with the best ESG scores. Just a reminder, ESG stands for environment, social and governance.
Tax credits for wind and solar projects may be extended. This would benefit renewable companies and the YieldCos that we have in our portfolio. YieldCos are publicly traded companies. Their focus is on providing wind and solar generation to utilities and other creditworthy counterparties under long-term Purchase Power Agreements. Similar to MLPs, YieldCos distribute a portion of their available cash flow and offer a value proposition of yield plus growth.
The permit allowing Keystone XL Pipeline that would transport crude from Canada into the U.S. is likely at risk. This is a TC Energy (TRP-NYSE) newbuild project and construction has not yet started in the U.S.
In contrast, we do not expect the Biden Presidency to have an impact either way on Energy Transfer’s (ET-NYSE) controversial Dakota Access Pipeline that has been in service for more than 3 years. Environmentalists are attempting to shut down the pipeline until a more comprehensive environmental review is completed by the U.S. Army Corp of Engineers. Currently, this issue is being reviewed in the lower courts. Stay tuned.
Finally, I think it’s important to note that most of the environmental initiatives emanate from states. For example, New York has a ban on fracking. So I don’t believe a Biden administration will have much influence on state priorities.
Vaccines: A quick observation on vaccines. A return to a semblance of normalcy will be a boost to world economies and energy demand. Technology and so called Covid stocks have significantly outperformed this year. Recently, energy stocks have gotten a boost from the positive vaccine announcements last week and yesterday. The big question is this: Is the rotation from the growth investment style to value just a head fake or is it sustainable? Value investing has underperformed for more than a decade after many decades of outperforming other investment styles. I’ll admit that my bias is tilted toward value and believe a mean reversion is well overdue. With great humility I quote in my presentation Lord Maynard Keynes, “The market can stay irrational longer than you can stay solvent.” I also quote the great Warren Buffet, “We simply attempt to be fearful when others are greedy and to be greedy when others are fearful.”
I think it’s time to be greedy and a contrarian…
Contrarian Value: The energy sector is nearing an inflection point and has undergone its own transformation that is underappreciated by investors, in my view. The best companies have acknowledged that the energy transition to a net zero carbon future is well under way. They have made significant strides in reducing methane emissions and embracing ESG. Some have issued comprehensive sustainability reports. Corporate governance is improving and management incentive compensation plans are changing to be better aligned with stakeholders and ESG. Midstream companies are exploring ways to invest in clean energy such as hydrogen. Enbridge Inc.(ENB-NYSE), the largest energy infrastructure company, is investing in offshore wind and 5% of their earnings come from renewables.
The energy sector has transitioned from rapid growth to maturation and free cash flow generation. My focus is on the midstream or infrastructure part of the energy value chain because it generates stable and predictable long-term cash flows. This has always been the case – even in this pandemic year, cash flow has proven resilient and is down only about 5% on average. Third quarter earnings were generally strong and exceeded expectations. The ditch that many companies fell into occurred because they were financing ambitious billion-dollar expansion programs when stock prices collapsed in tandem with the oil price collapse in 2015. Companies had to take on too much debt, balance sheets became overlevered and stock prices never really covered. Companies restructured and cut dividends to repair balance sheets.
However, the major capital projects have been completed. Capital expenditures are declining rapidly. Midstream companies are deleveraging and as we look to 2021, our portfolio of companies will have cash left over after funding capex and dividends. The excess cash flow will be used to pay down debt and buyback shares. The buyback programs can be significant and these companies in essence will create their own demand for their stock. This is a significant reversal of many years of stock issuances.
Midstream stocks are trading at attractive relative and absolute values. For example, Enterprise Products Partners (EPD-NYSE), the premiere MLP, sports a yield of about 9.5%, trades at a cash flow multiple of just 9x, several turns cheaper than its historical average, and has a strong investment grade credit rating. There is a disconnect between equity valuations and bond valuations. During this past summer, EPD was able to issue a 30-year senior note with a coupon of 3.2%. In other words, its equity is yielding 6% more than its debt. I believe that is unprecedented. Talk about cognitive dissonance. Either the equity market has it right or the bond market has it right. I think the bond market has it right.
EPD has embraced ESG. It is the world’s largest exporter of LPGs, which is essentially propane and butanes. EPD suggests that U.S. exports could eliminate up to 20 million metric tons of CO2 emissions when compared to using coal, wood and animal waste for heating and cooking, most notably in developing countries.
This is a good segue to natural gas. Natural gas needs to be part of the solution. LPGs come from natural gas. Natural gas is required to back up wind and solar power because these are intermittent sources of energy when the wind is not blowing and the sun is not shining. Demand for natural gas will continue to grow globally as it will be used to displace coal as well as support global population growth. The U.S. has become a major exporter of liquefied natural gas (LNG). This is a trend that will continue and we’re participating through our investment in Cheniere Energy (LNG-NYSE), the largest U.S. player that will also begin generating free cash flow next year.
The popular perception is that fossil fuels consumption will disappear and these oil and gas assets will have no value. This is a gross misperception and I addressed this in my “A World Without Fossil Fuels” essay. Fossil fuels are essential for everyday life, from generating electricity to transportation to making the chemicals, drugs, plastics and synthetic materials that are in nearly everything we use. I would argue that existing pipeline infrastructure may be worth more in the future because it has become so difficult to receive permits for any new construction. Natural gas pipelines that serve growing end use markets as power generation along the east coast and LNG export facilities along the Gulf Coast will be winners. I’m thinking Williams Cos. (WMB-NYSE), that arguably may own the best pipeline system in the U.S.
A word on renewables and utilities. Today, natural gas is the dominant source of electricity generation in the U.S. and its usage is expected to increase through at least 2050 according to the U.S. Energy Information Administration. However, the fastest growing source of power generation is renewables such as wind and solar. Today, renewables account for about 20% of electricity and this grows to about 38% by 2050.
We think the best way to invest in renewables is through the YieldCos. NextEra Energy Partners, L.P. (NEP-NYSE) is the largest and fastest growing. Its parent, NextEra Energy, Inc. (NEE-NYSE) is the world’s largest provider of wind and solar power and its backlog of projects is unmatched and growing.
Utilities are also embracing renewables and abandoning coal. We believe that utilities with renewable and natural gas exposure offer superior growth potential in the form of higher relative earnings and dividend growth. Two examples are NextEra Energy and Sempra Energy (SRE-NYSE). The latter has a growing LNG export business that generates stable and growing cash flow that in our view is not reflected in the value of its stock.
Finally, I would like to finish with the following observation:
Investing is a dynamic not a static process. The future winners in the energy sector will be the best allocators of capital and free cash flow and they will invest and embrace the energy transition and ESG. My job is to find and invest in these companies.
Turn it back to Paul for questions.
Q: Please describe the Infrastructure Income Portfolio allocation.
A: Right now, the portfolio allocation is just under 60% in Midstream, 20% Utilities and 20% Renewables. My thought process is that the Midstream sector is so undervalued and I think there are such good companies that have such high yields that I really want to have exposure to those names over time. I would expect that the portfolio over time will migrate more toward Renewables. Most of the exposure is represented by YieldCos that I described in my prepared remarks. I want to be disciplined, mindful of valuation and not chase stocks. The stocks of Renewables companies have done quite well in 2020 and I suspect will continue to do well under a Biden administration. But I do want to pick my spots. As it relates to Utilities, the sector represents good relative value based on p/e multiples relative to the S&P 500. Again, I want to invest in those companies that are embracing decarbonization. I also think there are opportunities with utility companies that have excellent midstream assets that may be monetized. I’ve already mentioned Sempra Energy. Another stock that looks really interesting is DTE Energy (DTE-NYSE). The company recently announced its intention to spin-off its midstream business to shareholders. DTE has a wonderful track record of growing this natural gas focused business that should do very well as a stand-alone entity, in my opinion.
Q: What is your sell-discipline?
A: There are several things that we look at when deciding to either trim or sell a position:
(1) Fundamentals. Both ELCO and Siegel Asset Management have a research driven mindset. So we pay careful attention to company fundamentals and if we see company fundamentals deteriorating or if there is an event such as a bad acquisition (in our opinion), we’ll exit the position.
(2) Technicals. I’ve learned this with a lot of humility. If a stock is down 10%, we’ll take a hard look at it to determine if we’re missing something. Has the investment thesis changed? And if it’s down 20%, we’ll probably just have to sell the stock because maybe the market is telling me something that I just don’t understand.
(3) Valuation. If the stock has appreciated and the valuation looks frothy, we’ll trim the position.
(4) Better opportunity. We will sell a stock to buy a stock of a company that appears to have better fundamentals and valuation.
Q: Describe the risks to the portfolio.
A: Over the next several weeks we could see tax loss selling. More significant is the Senatorial election in Georgia. It will not be beneficial if the Republicans lose control and no longer could check some policies from the more progressive faction of the Democratic party. Another broad lockdown due to the spike in the Coronavirus will be detrimental to our economy and energy demand. On the supply side, if OPEC+ opens the spigot and Iran barrels come back onto the market, that would also put pressure on oil prices and perhaps energy stocks.
However, I should have mentioned this in my prepared remarks. The U.S. oil and natural gas producers (the upstream) have done a remarkable job in cutting costs, lowering their breakeven price and demonstrating financial discipline. This part of the energy value chain is in much better shape going forward and has a lot more staying power. If there is a risk to oil prices, I think it may be to the upside. Well, that’s because the oil and gas producers have substantially reduced their capital expenditures and drilling activity, and that is not just in the United States; it’s global as well. If demand comes back strong, we could see a real big push on pricing to the upside.
Q: What are your thoughts on midstream companies buying back their shares and potential for M&A (Mergers and Acquisitions)?
A: Fund flows into the energy sector and midstream in particular, have been negative. There really has not been demand for these stocks. It’s debatable how impactful stock buybacks have historically been to the broader stock market. However, I do believe that it could be very meaningful for a relatively small sector, in terms of market capitalization, such as midstream. In essence, midstream companies can generate demand for their shares via stock buybacks. I think it could reverse a negative feedback loop and create a positive feedback loop. The buybacks push stock prices higher, the dividend yields go down and investors feel more comfortable that the dividends are sustainable.
In preparation for this call, I was speaking to a friend. He said that typically when a stock yields more than ten percent, that raises a yellow flag. Well if that yield goes down to six or seven percent because of stock price appreciation, I think that sends a message that the dividend is sustainable and that would create its own buying demand. So I think it could create a real positive feedback loop and I don’t think you need a whole lot to move this sector higher.
As it relates to M&A — companies are still being very disciplined and their first priority is to repair their balance sheets. They want to continue to deleverage and the companies that have strong balance sheets see more value creation by buying back their own shares than taking on the additional risk of consolidation. We are seeing consolidation among the upstream companies where cost savings and synergies are more easily attainable.
I think it will still be a little while before we see significant consolidation among midstream companies. We are more likely to see continued optimization of existing assets through discrete asset sales, joint ventures and repurposing assets. For example, converting a crude oil pipeline to a natural gas liquids pipeline.
Q: What is your total return expectation for the Infrastructure Income Strategy?
A: There are three components to total return. The first is income, the second is growth in income and the third is change in valuation. The portfolio currently yields about 7-8% and I expect will have modest growth of 2-3%. Some companies are not growing their dividends, while others, such as NextEra have robust dividend growth. That would suggest 9-10% total return. I’m not a market pundit, but I would suggest that this yield plus growth can provide a very competitive market return. The kicker could come from a valuation uplift because I hopefully conveyed that the midstream sector is trading well below its historical average and could re-rate higher by several points.
The energy transition is a mega trend that will take many years to play out. Fossil fuels are not disappearing and natural gas will continue to be an important piece to further decarbonization. The energy sector is at an inflection point of free cash flow generation. Investors have yet to realize that dividends are sustainable. In coming years, companies will choose between further debt paydowns, stock buybacks or dividend increases. Companies with strong balance sheets will choose buybacks if their stock prices remain depressed.
Thank you for your attendance. My email is firstname.lastname@example.org. I welcome your questions, comments and of course investment dollars. Have a Happy Thanksgiving next week!