There is a lot of macroeconomic uncertainty hanging over us as we head into 2023. The yield curve has inverted to one of its deepest levels in decades, signaling that a recession is very likely to hit:
Despite this flashing red light, the Federal Reserve seems bent on trying to continue raise interest rates this year to stick a fork in inflation once and for all. This is making many businessmen such as Tesla’s (TSLA) Elon Musk nervous that the Federal Reserve is going to break the economy once and for all.
Adding to this risk is the fact that the geopolitical situation remains very dicey. When you combine the ongoing war in Ukraine (which may be escalating soon with the United States and its allies recently announcing that they are sending tanks to the Ukrainians, making the Russians furious in the process) with the heightened tensions in the Taiwan Straits and Korean Peninsula on top of the near-perpetual risk of war in the Middle East, the potential for major regional or even global conflicts providing a massive headwind to the world economy cannot be ignored.
Furthermore, life for investors is not exactly easy either given that valuations for the major indexes such as the S&P 500 (SP500, VOO) and Nasdaq (QQQ) remain a bit rich according to many highly regarded valuation models.
That said, we believe there are still plenty of opportunities that offer exceptional risk-reward, especially in the high yield space. In this article, we share two stocks that we believe are winning investments over the next five years, regardless of whether or not a serious recession materializes this year. We also share two stocks that we think offer very unfavorable risk-reward profiles and therefore are bound to be losers over the next five years.
Winner #1: Energy Transfer LP (ET)
ET is bound to be a winner over the next five years for the following reasons:
- Despite its remarkable outperformance over the past several years, its valuation remains steeply discounted relative to peers and its own history. As a result, we expect significant multiple expansion to combine with a very attractive high single digit distribution yield that is covered more than two times with distribution cash flow and substantial debt reduction and growth investment to drive outsized total annualized returns over the next half decade.
- Its assets are very well-diversified across energy commodity and geography. Furthermore, the vast majority of its cash flow is commodity price resistant and comes in through fixed-fee, take-or-pay contracts. As a result, regardless of whether or not a recession hits, ET’s distribution should be very safe, and its cash flow generation should be pretty stable.
- It is a leading player in LNG exports. With the de-globalization of the energy industry – particularly in Europe where the Continent’s dependence on Russia for energy needs to change as quickly as possible – ET’s LNG export business should boom in the coming years.
As a result, we believe that Energy Transfer is one of the most attractive high yield opportunities in the market today and are gladly long at High Yield Investor.
Winner #2: Brookfield Asset Management Ltd. (BAM)
BAM is another likely candidate to be a big winner over the next half decade for the following reasons:
- Its current 4% forward dividend yield provides a solid return baseline that should be boosted considerably by expected 15-20% annualized growth in both distributable earnings and the dividend per share in the coming half decade.
- This robust growth will be fueled by the ongoing alternative asset investment boom, where pension funds and other institutional investors are flooding into the sector searching for reliable and defensive high yields that also provide inflation protection. BAM’s leading global positioning alongside Blackstone (BX) and KKR (KKR) should enable it to snatch up a meaningful percentage of this capital in the coming years.
- BAM will also benefit from the infrastructure and renewable energy investment booms taking place in the coming years and decades, given its leading global scale and operating expertise in these sectors.
- BAM is also rapidly scaling its insurance and reinsurance businesses, providing a powerful growth vertical for the company.
With no debt on its balance sheet, billions in cash and financial investments, an A- credit rating, and sticky long-dated cash flows from its management fees, BAM is well-positioned to weather a potential recession while continuing to deliver very attractive dividends to investors. We are long BAM at High Yield Investor and have high conviction in it being a big winner over the next half decade. You can read our full thesis here.
Loser #1: AT&T Inc. (T)
While we are not bearish on T per se, we also see little to no reason to own this stock. Adjusted earnings per share have declined by nearly 30% over the past two years alone, while the company recorded another huge $29.4B pre-tax write down from rising interest rates and asset impairment charges during Q4.
With growth poised to remain anemic for the foreseeable future, management forced to pour its free cash flow into paying down debt and feeding the massive investment budget requirements, and a good but not great dividend yield, there is not much to get excited here. This is even more clear given that the EV/EBITDA multiple is currently half a turn higher than its 10-year average despite interest rates soaring recently and the dividend yield has lost a lot of its luster relative to long-term interest rates over the past year:
While T may not be a big loser over the next half decade, it is hard to imagine it being a winner given its growth challenges, continued impairments, cumbersome balance sheet, and unappealing valuation.
Loser #2: International Business Machines (IBM)
IBM is another old high yield stalwart like T that has had its day in the sun but is struggling to adapt to the 21st century. The stock has been plagued by a cumbersome bureaucratic corporate culture that is too obsessed with churning out new patents instead of making truly meaningful innovations, has sunk far too much capital into buybacks at bloated valuations, and remains committed to growing its dividend. While the dividend itself is not a bad thing, all of these traits have dragged the company down and prevented it from innovating on par with much nimbler big tech rivals in its cloud and A.I. businesses like Oracle (ORCL), Amazon (AMZN), Alphabet (GOOG, GOOGL), and Microsoft (MSFT).
As a result, today it finds itself as more of an I.T. utility business, with very sticky revenues from some key clients, but fairly weak growth prospects. Analysts expect it to grow earnings per share at a ~4% annualized pace over the next half decade alongside its 4.7% dividend yield. Meanwhile, we do not see any meaningful discount in the valuation multiple, especially when taking into account the higher interest rates. Its EV/EBITDA multiple is currently 11.04x, well above its 9.16x five-year average and 8.75x 10-year average. Meanwhile, the dividend per share is only expected to grow at a measly 2.2% CAGR through 2026, making the 4.7% yield look pretty unexciting relative to risk-free long-term interest rates:
When investing in the high yield space, it is crucial to insist on a wide margin of safety given the growing uncertainties and risks in today’s world. At High Yield Investor, that is our focus and has helped us to generate significant outperformance over the past two plus years since launching our portfolio, including generating a double-digit total return in 2022 despite the broader market selling off.
By investing in opportunities like Energy Transfer and Brookfield Asset Management, which offer huge upside potential with most major risks at least somewhat mitigated, and avoiding stocks like AT&T and IBM that offer little-to-no margin of safety, we are setting ourselves up for continued outperformance over the next half decade and beyond.