Investors Alley

As promised last week, I want to go back and explore the thesis advanced by KKR’s (KKR) macroeconomics team. Henry McVey and his team suggested that one of the best ways to earn high returns on your money over the next few years is going to be owning companies that are growing their free cash flow and dividends.

That hypothesis is easy to agree with, given that free cash flow and dividends are two of the three legs of my long-term investing trinity.

Here’s why, and two stocks that fit to buy today…

I am a huge fan of free cash flow. After all the bills are paid and the necessary expenditures to keep equipment, facilities, and plants up to date have been taken care of, leftover cash is what is used to grow the business and increase the stock price over time.

(The third leg of the long-term investing trinity, of course, is asset value, but we can save that discussion for another day.)

The first company that is growing its free cash flow and dividends at a double-digit pace also fits into another investment theme both KKR and I think will provide huge returns in 2023. (Judging by how often I find KKR’s thinking aligns with my own, I have to think they have a bunch of really smart people working there…).

Owning infrastructure that moves oil and gas from point A to Point B for a fee will continue to be a great business. These assets throw off high levels of cash.

One of the largest owners of energy-related infrastructure is Kinder Morgan (KMI). Kinder Morgan owns about 70,000 miles of natural gas pipelines that handle about 40% of all natural gas shipments in the United States. The company has pipelines connected to every important natural gas field in the country, including the Eagle Ford, Marcellus, Bakken, Utica, Uinta, Permian, Haynesville, Fayetteville, and Barnett gas fields.

Kinder Morgan also owns another 9,500 miles of pipelines that transport liquids like gasoline, jet fuel, diesel, natural gas liquids, and condensate. This business segment also owns 65 liquids terminals that store fuels and offer blending services for ethanol and biofuels. And, the company is the largest independent terminal operator in North America. Kinder Morgan has 141 terminals that handle renewable fuels, petroleum products, chemicals, vegetable oils, and other products for its customers.

The company will generate over $3 billion in free cash flow for the full year 2022, which will be used to pay dividends, reduce debt and buy back stock. In fact, Kinder Morgan has grown its free cash flow by an average of 20% yearly, and has been generous about sharing that cash with shareholders. As a result, the dividend over the past five years has grown by 19% annually.

This a stock you can buy and hold for a very long time. While oil and gas are its dominant business today, Kinder Morgan is positioning for a green future and will be a big player in renewable infrastructure as the need develops over the next few decades.

Another stock that fits the free cash flow and dividend growth description is Advance Auto Parts (AAP). This company is, obviously, in the auto part business. Currently, Advance Auto has 4,687 stores and 311 branches in the United States, Puerto Rico, the U.S. Virgin Islands, and Canada. The company also services 1,318 independently owned Carquest branded stores in Mexico, Grand Cayman, the Bahamas, Turks and Caicos, and the British Virgin Islands.

Advance Auto has been in turnaround mode for several years, but appears to be getting its act together. Over the past five years, the company has grown free cash flow by 20% annually. In addition to using the cash to improve the business and make smart acquisitions, Advance Auto has also been buying back stock and increasing the dividend, which it has grown by 64% annually for the past five years. The shares currently yield about 4%.

Advance Auto Parts is on my “buy ugly” list. It is the type of stock I want to buy when the market collapses and good companies are trading at ridiculous prices. This company is starting to hit on all cylinders, and management has proven to be very shareholder friendly.

In general, buying companies with growing free cash flows and rising dividends makes a lot of sense in the current market environment. In a slowing economy, companies that can produce free cash flow and use that cash to reward shareholders should be handsomely rewarded by the market.
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In these early days of 2023, I often find myself thinking about how attractive Master Limited Partnership (MLP) investments look as we move into the year. After a great 2022, energy infrastructure companies are poised to perform well again this year. The big choice is whether to invest in midstream MLPs or shares of midstream corporations.

Here’s what I found – and the best investment to make now…

The terms energy midstream and energy infrastructure are interchangeable. These are the assets and companies that provide gathering, transportation, storage, and terminals between the upstream operations (oil and gas drilling) and downstream operations (refining, chemical manufacturing, utilities).

Before 2015, most midstream companies were structured as MLPs. The prevailing business model involved funding growth projects with a combination of equity and debt. The growth generated growing free cash flow, most of which was paid out as distributions to investors. For at least two decades, MLPs were outstanding dividend growth investments.

The energy sector crashed from 2015 through 2018. The debt-heavy MLP business strategy stopped working. The energy sector crash was a period of massive business restructuring among midstream companies. Companies reduced leverage ratios and cut back on distribution payout levels. They transitioned to paying for growth out of internally generated cash flow.

Additionally, many companies chose to restructure into corporations, leaving the MLP sector behind.

Currently, midstream companies are in excellent shape. Leverage is low, and free cash flow is high and growing. Dividends are well covered, with many companies showing more than two times coverage of the distributions paid to investors. The choice for investors now revolves around whether to focus on midstream companies organized as corporations or as MLPs.

Master limited partnerships often get passed over because they send out Schedule K-1 forms for tax filing. Also, if MLP shares are owned inside a qualified retirement-type account, they can cause tax issues.

Let’s compare the relative valuations of MLPs versus corporations in this sector.

First, three of the larger midstream companies are organized as corporations. I want to look at the current dividend yield and the dividend growth over the last year:

Kinder Morgan Inc. (KMI): Current yield: 5.9%. Year-over-year dividend growth: 2.78%.

ONEOK, Inc. (OKE): Current yield: 5.3%. Dividend growth: 0%.

The Williams Companies (WMB): Current yield: is 5.2%. Dividend growth: 3.66%.

Now let’s look at the three biggest holdings of large-cap, representative MLPs on the Alerian MLP ETF (AMLP).

Energy Transfer LP (ET): Current yield: 8.4%. Dividend growth: 73.6%. (Yes, 70% year-over-year dividend growth!)

Enterprise Product Partners LP (EPD): Current yield: 7.7%. Dividend growth: 8.89%.

Western Midstream Partners LP (WES): Current yield: 7.1%. Dividend growth: 54.8%.

Last year, MLPs kicked in the afterburner for dividend increases. I expect the group to continue with high single-digit annual increases. The numbers above highlight the superior return potential of MLPs.

If you want to stay away from K-1s, investing in MLPs through an ETF like AMLP converts their distributions into 1099 reported income. AMLP tracks the Alerian MLP Index. For an actively managed MLP ETF, I recommend the InfraCap MLP ETF (AMZA).
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Utility stocks are historically seen as dull but dependable. After all, they have assured demand despite limits on profitability due to heavy regulation. Investors also see these stocks as regular dividend payers—bond proxies, in effect—with investors confident of solid income streams, leading to low but highly reliable total shareholder returns with relatively little capital risk.

That may be true – but some, like this one, can be very profitable…

National Grid in the U.K. and U.S.

One such utility company that has often been called ‘reassuringly dull’ comes from across the pond, the U.K.’s National Grid plc (NGG). The company operates the U.K.’s electricity grid, connecting electricity generation from all sources (power stations, wind farms, solar, and hydro) to end users. National Grid also has energy investments in the northeastern U.S. as well as electricity interconnectors with Europe.

National Grid makes its money by acting as an intermediary between the generators of electricity and the local electricity distributing utility companies. It charges fees for maintaining the integrity of the network and the carrying of energy that is passed on to the consumer, so it is largely unaffected by the actual price of electricity charged by the generating firms.

In other words, NGG is a very defensive stock, because National Grid forms one of the key and largely indispensable parts of national (UK) and regional (US) infrastructure. So even if electricity consumption is reduced or generation methods are changed, power still needs to flow through a grid and the networks need always to be managed and balanced by the grid operator.

In the U.K., long-term rate structures have offered solid earnings and dividend growth at least in line with inflation. During the 2013-21 period, regulators allowed National Grid to earn a 7% real return on its transmission assets plus incentives; however, for the 2021 to 2026 timeframe, real return on equity of electricity and gas transmission networks have been cut to 4.3% and 4.6%, respectively.

National Grid earns about 45% of its profits from the U.S. After many years of high investments in the

U.S., the significant asset reshuffling announced in March 2021 was a turning point. The company agreed to buy PPL’s U.K. electricity distribution assets, Western Power Distribution, for a £14.2 billion ($17.45 billion) enterprise value, implying a significant 60% premium to the regulated asset value. National Grid funded part of the purchase by selling its Rhode Island networks to PPL for £3.7 billion ($4.55 billion), for an impressive enterprise value to regulated asset value (RAV) of 2, and by selling its U.K. gas transmission assets at a 45% premium to the RAV.

The rationale behind those transactions was to increase the weight of electricity networks over gas networks in light of the ongoing energy transition.

Latest Results and Dividend

National Grid’s latest results (reported in mid-November) were darn good, showing that first-half underlying operating profit jumped 51%, to £2.1 billion ($2.57 billion). This is thanks to higher revenues from its new distribution network assets in the U.K. Earning per share went up by 42% to 32.4p ($0.40) per share.

The firm did raise its fiscal 2023 underlying earnings per share growth guidance from a prior 5% to 7% to a new range of 6% to 8%, implying earnings per share for the year to total 69.6p ($0.85). The guidance upgrade is driven by the positive impact of high inflation on revenue and higher profit growth at National Grid Ventures, notably on higher auction prices across interconnectors.

The interim dividend was 4% higher at 17.84p ($0.22) per share. And it’s a good bond proxy—the dividend has not been cut since 1996. National Grid is also a Dividend Aristocrat, having raised its dividend every year since 1998 and delivering an impressive 6.3% average annual growth over the period. NGG has always had a high payment ratio (dividend as a percentage of earnings per share) of around 80%.

National Grid has an interesting dividend policy based on U.K. inflation. The target policy is to grow payments in line with CPIH (consumer prices index, including owner occupiers’ housing costs) inflation: a measure which extends the consumer prices index to include regular costs of living associated with home ownership and it is running at nearly a double-digit rate.

National Grid’s Outlook

The company’s stock de-rated a lot in 2022. Stronger recent updates and those interim results in November stopped the rot.

Despite the relatively high debt level, National Grid’s balance sheet appears sound because the company’s high leverage is supported by low revenue cyclicality and low operating leverage.

The NGG dividend looks safe enough. Thanks to the aforementioned high selling price of the U.K. gas transmission assets, National Grid should be able to continue to grow dividends in line with inflation. And with an attractive yield of 6.78%, NGG is a buy anywhere in the low-$60s.
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I make no secret of the fact that I pay very close attention to what the big private equity (PE) and alternative asset managers are doing with their cash. I am frankly shocked that more people are not paying attention to what the giants of alternative investing, like KKR & Co. Inc. (KKR), Blackstone Inc. (BX), Apollo Global Management Inc. (APO), Carlyle Group Inc. (CG), and other leading alternative investment firms, are doing.

And right now, they are telling us we should all be investing right here…

It is not just the fact that these PE giants have stellar track records, although that is certainly part of the equation. One of the best-kept stock-picking secrets is that private equity firms do not just excel at buyouts—their public equity portfolios tend to be top performers as well.

I have stolen as many wildly profitable ideas from Leonard Green and Partners and Apollo as I have from Seth Klarman and Jeffery Smith of Starboard Value.

The other reason I pay close attention to the leading private investment firms is that they have boots on the ground all over the world. Employees of these firms are talking to corporate executives and looking under the hood at companies everywhere from Baltimore to Bangladesh and everywhere in between.

This allows the big alternative asset managers to form macroeconomic opinions on data and inputs most economists do not see.

By far, the private equity macroeconomist that makes the most of the collected information is Henry McVey of KKR. Mr. McVey is not only the head of global macro, balance sheet, and risk at the firm but also the chief investment officer of the KKR Balance Sheet investment portfolio.

The firm invested billions of its capital based on Mr. McVey’s macroeconomic insights, and there is a good reason for it: I have been reading his quarterly macro-outlooks for years, and they have been a road map through the last several years of economic and geopolitical turmoil.

Thanks to McVey’s outlooks, I have been able to sharpen my own macro-outlook and combine that with my valuation and fundamental analysis to steer through much of the madness of the past few years. In his 2023 initial outlook piece released as the year got underway, McVey reiterated a common theme of the past few years. He favors companies that are generating increasing cash flows that can be used to increase dividends.

He is not necessarily looking to own the highest overall yielding company, but rather for those that can grow their payouts at a high rate for extended periods of time.

I used McVey’s criteria to build a list of stocks, and then put on my value hat and looked for companies that fit the theme—undervalued, with a wide margin of safety in their financial statements.

One of the first to come up is Comcast Corp. (CMCSA). I hear all the hollering about how horrible Comcast is and how rotten customer service can be. But I am a Comcast customer myself—I am getting older, so I still have cable as I find it far more convenient than the cord-cutting services—and other than occasional minor problems, I am quite satisfied.

I have the highest speed internet connection Comcast makes available, so all in all, I am a pretty satisfied Comcast customer.

While there is a lot of talk about cord-cutting, the truth is that for most Americans, access to a fixed-line internet service is only available from phone companies and cable companies.

For almost half of the country, that cable company is Comcast.

Cable companies, including Comcast, have a significant advantage over phone companies, having led national expansion of high-speed internet by installing fiber networks back in the late 1990s and early 2000s.

Phone companies are trying to roll something similar out now. However, the high cost of running fiber to homes is one reason that services like Verizon Communications Inc. (VZ) with their Fios network have yet to be able to compete on either price or speed.

Looking at free cash flow-based valuations, I can use some fairly conservative projections and come up with a valuation for Comcast of twice its current stock price. And if results come up within a horseshoe or hand grenade of Wall Street expectations for 2023 profits, the stock should gain 50% or more this year.

Comcast shares yield about 2.8% right now—but more importantly, free cash flow has been growing by 13% over the past five years, and the dividend has been boosted by 12.8% a year.

The free cash and dividend growth story should be big in 2023, so we will revisit this theme later with some more stocks that fit McVey’s criteria and pass my analysis.

I would be remiss if I did not point out two more things about KKR’s 2023 outlook…

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My favorite among the major pharmaceutical companies remains AstraZeneca (AZN). One of the main reasons is that the company specializes in one of the areas where personalized medicine is making the greatest strides: oncology, in which AstraZeneca is the recognized leader.

AstraZeneca already has three blockbuster oncology drugs. Here’s what Morningstar said about these drugs in 2022:

Overall, the company looks well positioned for growth with the recently launched cancer drugs carrying strong pricing power that should have an amplified impact on the bottom line. We expect the first-line lung cancer indication for Tagrisso combined with the likely gains in adjuvant lung cancer will drive peak sales above $9 billion annually. Also, cancer drug Imfinzi should gain share in Stage III lung cancer where treatment options are limited and the drug holds growing potential in other cancers. Additionally, BRCA-focused cancer drug Lynparza is well positioned to gain further market share in new indications.

And now, another of AstraZeneca’s cancer treatments—Enhertu—is viewed as the next big thing in oncology and rightly so…

Enhertu: The Next Wonder Drug?

Enhertu is an antibody drug conjugate (ADC), a type of therapy designed to do minimal damage to healthy, non-cancerous cells. It works by attacking tumors that test positive for a protein called HER2, which is associated with worse disease outcomes.

Known as “biological missiles,” ADCs are part of the new generation of personalized cancer treatments that target tumors with specific features, or biomarkers. Some dozen ADCs have received regulatory approval to date, while more than 100 others are in various stages of development.

The potential for Enhertu is incredible.

Breast cancer recently overtook lung cancer to become the world’s most commonly diagnosed cancer. Every year more than 255,000 cases of breast cancer are diagnosed in the U.S. alone.

The reality is that one in eight women will get breast cancer in their lifetime—and Enhertu has the potential to change treatment for half of them!

David Fredrickson, executive vice-president of the oncology business at AstraZeneca, said the drug could become: “…one of the most important medicines ever.” He also said Enhertu had the potential to become a “multi-blockbuster” medicine by being transformative in treating different types of breast cancer, as well as certain gastric, colon, and lung cancers.

Enhertu was first approved by the FDA in 2019 for a subset of patients with cancers that have high levels of HER2. About 15% to 20% of breast cancers are HER2-positive, but last June, a trial revealed the vast potential for Enhertu, showing the drug could double the time patients can live without their cancer progressing, even if they have low levels of this protein. About 20% of the participants in the trial (550 patients) with metastatic cancer—normally considered to be incurable—had complete responses: scans could not detect their tumors.

This was the first time such a targeted therapy had improved survival rates in patients suffering from HER2-low metastatic breast cancer, a category that covers up to half of all late-stage breast cancer patients.

The clinical trial found those using the drug had a 49% reduction in the risk of the cancer progressing and a 36% reduction in the risk of death compared to those who received the standard form of chemotherapy treatment. It recorded progression-free survival, the time during which the tumor was stable or shrank, of 10.1 months with Enhertu, compared with 5.4 months for those who received chemotherapy.

AstraZeneca’s Bright Future

Wall Street analysts believe that Enhertu has the potential to become a key growth driver for AstraZeneca. Estimates are that sales could reach possibly as high as $10 billion, up from a negligible level now.

As far as sales of Enhertu go, it is split 50/50 with Japan’s Daiichi Sankyo (DSNKY), which began work on the drug years ago. AstraZeneca struck a deal in 2019 worth up to $6.9 billion with Daiichi Sankyo to develop and sell Enhertu.

To make the most of Enhertu’s vast potential, the two companies are planning 40 trials, one of the largest programs ever in the industry. These trials will attempt to answer questions such as: does Enhertu work in earlier stages of breast cancer? On how many more types of cancer could it be effective?

The partnership is deeper than just one oncology drug. In 2020, AstraZeneca agreed to pay Daiichi Sankyo up to $6 billion to develop and market a potential lung and breast cancer drug, the second large oncology megadeal between the companies.

These joint ventures are a win-win for both companies. It may send AstraZeneca to a whole new—and much higher—level in terms of growth potential, as well as boosting profit margins at Daiichi Sankyo.

The company is already doing very well. Morningstar said:

The oncology products continue to remain well positioned for future growth supported by new indications, including adjuvant lung cancer for Tagrisso, small cell lung cancer for Imfinzi, early-stage breast cancer for Lynparza, and earlier stages of breast cancer for Enhertu. Outside of cancer, key new drug launches are progressing well, including Saphnelo (for lupus)…Additionally, the recent approvals of Beyfortus (treatment for respiratory syncytial virus in infants), Imjudo (in combination with Imfinzi for liver cancer), and Enhertu (earlier line HER2-low breast cancer) set up significant new growth drivers.

The company has been aggressively investing in research and development over the past several years with its R&D spending as a percentage of sales ranging in the low to mid-20%, above the industry average of high teens. That has led to one of the best portfolios of drugs, supporting industry leading sales growth. Major investments in innovative new drugs (largely targeting areas of unmet medical need, especially in cancer) also helps fortify AstraZeneca’s future.

In summary, AstraZeneca’s drug pipeline is one of the strongest in the industry. That makes its stock a buy anywhere in the $65 to $75 range.
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With stock prices turning positive over the last few weeks, it’s easy to lose sight of the fact that share prices for many sectors remain down a lot from their early-2022 levels.

I was surprised when I recently reviewed some 30-day stock price changes. There remain tremendous, high-yield values in which to invest.

Here’s three to buy for high yields right now…

I maintain a watch list of stocks that are not current Dividend Hunter recommendations, but are companies and stocks I want to keep an eye on. Last week, when I updated the watch list data I share with subscribers, I was surprised by how much share prices had dropped over the previous month. It didn’t feel like high-yield shares had fallen by the 5% to 10% that occurred.

When I realized that share prices had dropped over the last month of the year, I wanted to find a few high-yield stocks that looked particularly attractive.

When the yields on high-yield stocks go very high, the fears of dividend cuts pop up. The fears are especially prevalent when every third word on the financial news networks rhymes with recession. In reality, many companies have stable dividends that are not at risk of being cut. Yet with share prices down, many of these quality income stocks yield over 10%.

The most important aspect of buying a high-yield stock when prices are down is understanding the business to know whether their dividends are sustainable. The first step is to look at the dividend history. If a company had cut dividends in the past when the economy turned rocky, the odds are that it could happen again. On the other hand, if a company has maintained steady-to-growing dividends through the economic cycles of recession and expansion, odds are good the dividend will keep going.

A deeper analysis involves looking at the free cash flow generated over the last several quarters. Free cash flow is not the same as earnings per share. Companies will break out cash flow separately, calling it funds from operations (FFO) in the REIT world, cash available for distribution (CAD), or distributable cash flow (DCF). You want to see the company generating more cash flow than the dividend. That’s some simple math.

To shorten your journey, here are some high-yield ideas.

Last week I sent out Starwood Property Trust (STWD) as the Stock of the Week to my Dividend Hunter subscribers. Normally, STWD trades for $24 to $25, yielding 7.5 to 8%. When it drops below $19, the yield goes to 10%, as it did recently. Back up the Truck!

And here are a couple of stocks from my watch list you can research:

Sixth Street Specialty Lending (TSLX) operates as a business development company (BDC). The company has grown its dividend by 10% over the last year and currently yields 9.8%.

Like STWD, Blackstone Mortgage Trust (BXMT) is a commercial finance REIT. The company has paid the same quarterly dividend since 2015. BXMT yields 11.2%. The typical historical yield is around 7%.
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Last year, the energy sector was the only market sector to post a positive return—and it did a heck of a job! The Energy Select Sector SPDR (XLE) gained 60% last year.

One-year gains like that may make you cautious about committing to energy this year, but I believe your portfolio should continue to hold an above-average energy weight.

Let’s look at some of the fundamentals…

The mega-cap energy companies give a good view of the sector. With a $440 billion market cap, Exxon Mobil Corp (XOM) is one of the ten largest U.S. companies. Exxon is an integrated energy company with operations that include drilling for oil and gas, refining, and even retail. For the 2022 third quarter, the company reported earnings of $19.7 billion—yes, the company made almost $20 billion in one quarter!—and had $24 billion of cash flow from operations. For comparison, Alphabet (GOOG), with twice the market cap, earned $14 billion for the quarter. Despite appreciating by 65% over the past year, XOM trades at a P/E of 8.

Chevron Corp (CVX), with a $340 billion market cap, also operates as a fully integrated energy company. Chevron earned $11 billion in the third quarter, with $12.3 billion of free cash flow. After gaining 43% over the last year, CVX trades at a P/E of 9.

These large-cap energy companies will remain very profitable at current energy commodity prices. If oil and natural gas prices go up during the year (which I think is very probable), the share prices could post similar gains. I think both will beat the Wall Street estimates for fourth-quarter results.

However, I have a better idea for the energy sector for 2023. I predict energy midstream will generate very attractive total returns. Midstream companies operate gathering systems, pipelines, and terminals. The business operates on a fee basis with long-term contracts. Revenues and cash flow to pay dividends are stable and growing.

In the midstream sector, you find corporations and master limited partnerships (MLPs). Currently, I favor MLPs. Both camps have the same growth prospects, but the MLPs start the year with higher current yields.

Midstream companies will grow dividends by high single digits this year. Combine that growth with similar starting yields, and you end up with total returns in the mid teens.

Here are three MLPs with near 10% yields:

Crestwood Equity Partners LP (CEQP)

NuStar Energy LP (NS)

MPLX LP (MPLX)

MLPs do come with Schedules K-1 for tax reporting. They also pay tax-advantaged distributions. If you don’t want the hassles of K-1 reporting or want to own MLP investments in a qualified retirement account, I recommend the InfraCap MLP ETF (AMZA). AMZA pays stable monthly dividends and yields 8.6%—and there is a good chance of a dividend increase when the fund announces its January dividend.
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