Time to Diversify Further?, Part I

Market prices of stocks sensitive to interest rates have moved up a lot over the past year. Is it time to spread some gains to other sectors, to be ready for the next bear? And if so, where?

Questions of portfolio strategy and tactics are always present. But somehow it seems they captivate me most strongly in October. So here we are.

Strategically I feel comfortable. A primary focus on income with a small fraction of the portfolio devoted to upside continues to make sense to me, in my context as a retiree of limited means.

Still I have discussed making the income part of the portfoilo “breathe,” by broadening its holdings in good markets and focusing them when opportunities arise. Markets are pretty good at present.

This will be the first of at least two articles developing and sharing my thinking about various sectors. The hope is to better understand the options and possibilities.

First let’s discuss how the broad markets go. This sets the context for looking at sectors.

Market Declines

Significant declines (more than 10%) of the broad markets occur every few years. Smaller corrections are more common. Here is the S&P 500 for the 2010s:

Those drops look small and brief. Even moreso if you look at a price plot that spans decades.

But they sure don’t feel that way when they happen.

They generally start with a rapid price drop. Prices then stay down for month after month. Recovery seems to take forever.

More recently, both the market-weight (SPY) and equal-weight (RSP) S&P 500 dropped several tens of percents across most of 2022. They had recovered by the end of 2023.

This is useful perspective for the trends one experiences in individual stocks. And these often seem to move with the broad market day to day. But over months or years they tell their own two stories.

The first of these is the story of their sector. The second is the story of a specific company.

Today we take this up for Midstream energy firms and then for energy Supermajors.

Midstream Energy

Here are the long-term total-return histories of some midstream firms:

There are overall trends, present across the entire industry. Midstream followed upstream as the shale era led to explosive growth in oil output after 2010. That “Drill, Baby, Drill” era led to many financially unsound midstream projects.

The oil price crashed in 2014, and languished near $50/bbl for the rest of that decade. The details, including the influence of OPEC, are too involved to discuss here.

Midstreams needed to change their structure and approach, to become sustainable businesses that could attract investors. The result was what we see today: a collection of firms in a great position to grow their earnings and to return a lot of cash to shareholders.

Before the late teens, nearly all midstream firms were actively issuing equity to fund their projects. That’s fine if those projects make enough money. But the mid-teens collapse was damaging.

After that these firms progressively shifted to funding growth out of cash flows, without issuing new equity or doing so rarely. Those that were structured as Master Limited Partnerships (MLPs) began buying out the Incentive Distribution Rights from their sponsors, which made the story of returns to shareholders more definite.

By the end of the decade, one could make a good case that the midstream sector was significantly undervalued. The pandemic took prices down by a lot from there. But then they stared climbing, from late 2020 through mid 2022. A flat year after that was followed by a return to upward growth in recent months.

An astute investor, knowing of the changes in the industry, could have tripled their money by buying during 2020, reinvesting distributions, and holding until now. But that was then.

Henceforth, these firms seem to me to be great income holdings that should steadily grow earnings and distributions. But the era of getting multiples is past.

You can see on the plot that there are more intricate individual stories. As always in any industry, idiosyncratic factors may offer opportunities for increased gains for any one company.

But look across 2022. Midstream prices surged and then held up even as much else crashed.

The obvious question is whether we expect this next time and can use midstreams as a hedge. There are two sides to this.

On the one hand, these firms will see their earnings hold up even in recessions. The earnings will even grow a bit, thanks to the nature of their contracts. There is much less of a spectre of an earnings collapse in this sector than in others.

On the other hand, these firms own long-lived hard assets that most often retain their earnings power for decades. Their NPV reflects decades of future earnings. The value of this aspect should be strongly sensitive to interest rates through the impact on discount rates.

So what to make of the past two years of price action? My view is that the midstream sector is has pretty much gotten back to reasonable valuations, finally. Also, that a next spike in interest rates may well produce stock-price declines.

We can confirm this perspective by considering dividend yields. For secure midstream corporations with strong balance sheets, these are now below 5%. That is not far above the yields of the Supermajors. Examples include Williams Companies (WMB), Pembina (PBA), and Keyera (KEYUF).

The midstreams with higher yields today have reasons for being valued at a discount. Some have high debt, notably TC Energy (TRP) and Enbridge (ENB). Others are structured as MLPs. My view is that the MLPs should be discounted, but not by as much as they are.

But will this change and when? No predictions here.

My view today has two pieces. The first is that midstreams are unlikely to provide general protection against market declines.

The second is that they still may help as markets drop. The trick will be to sell what has yet to drop and buy what has already dropped. Different companies and different sectors usually are not completely in lock step there.

Supermajors

Now consider Supermajors. My view is that smaller upstream firms are generally too speculative to be income investments.

My primary focus here is Exxon Mobil (XOM) and Chevron (CVX). The European firms have too much history of letting politics influence their decisions, or just plain being dumb, for my taste.

As to CVX and XOM, the price behavior of these two has been near that of the midstreams, without the final spike in 2024:

These two firms yielded more than 5% in the early 1990s, but since then their yields have generally been much smaller. Let’s look at the period since 2010:

You can see the disruption in the mid-teens following the oil price crash. But the taper tantrum does not stand out. Similarly, the weak markets in late 2018 appear to have contributed to a yield spike (which followed the drop in the S&P 500 quite closely). But that spike was small compared to other changes over time.

During 2022 prices rose for these two as they did for midstreams. Since then they have taken different, idiosyncratic paths as the market has been less enamored of CVX.

The oil production industry is turbulent over time. Despite that, these two firms have paid out sustainable and growing dividends (about a third of Cash from Operations or CfO today):

They spend most of the difference on capex. Despite that capex, CfO/sh is roughly flat since 2010 (and is volatile). Because of this, my view is that one should value these firms based on dividend payments and growth.

The dividend growth rates are just under 5% for XOM and just over 6% for CVX. I will use 5.5% as a reference rate, with the caveat that the future is uncertain.

Long-term, CVX and XOM have generally been priced to yield 3% to 5%. In other words, the dividend multiple is 20x to 33x. One can make no sense of this without assuming that the dividends continue and grow indefinitely. In these cases, I don’t mind.

That makes it simple to estimate the discount rate. It is just the yield plus 5.5%. So a 10% discount rate is a 4.5% yield and the market discount rate has usually been a bit below that. This seems reasonable to me.

So where does that leave these stocks as portfolio broadeners? It seems to me that:

• Like everything they will follow the market when there are big drops, unless there is lots of drama in the oil patch at the moment.

• At other times they will go their own way, providing opportunities for exploiting idiosyncratic differences with other stocks.

• I could be wrong, but my guess is that the Supermajors will prove more stable than the midstreams going forward. That mainly reflects their size and long track record as dividend growers.

Takeaways

Midstream stocks generally were a great value in 2019 and a better one in mid-2020. But having increased 3x since then, more or less, they are more or less fairly valued now.

So while single-company idiosyncratic developments may provide opportunity, the sector as a whole does not. On top of that, going forward I expect those stock prices to be much more sensitive to interest rates.

It is also far from clear that the midstreams overall can produce the amount of long-term growth that the Supermajors are likely to. At the same dividend yield, I would rather own a Supermajor.

That said, a smaller midstream with a unique focus, like Keyera, might manage to outgrow the Supermajors. But I would not expect it of bigger firms such as WMB.

The analysis shared here will feed into decisions about how to distribute my portfolio from now until we next get some serious opportunities for bigger gains. Next up will be to consider REITs and other categories.