The long-term view
Josh Peters, CFA from Morningstar is always helpful to consult when returns in the high-yielding segment of the market feel depressing. For more than 10 years now he has insisted that short-term relative performance comparisons would not (1) define our success or (2) affect the way we manage our strategy. This has proven to be an excellent strategy.
As always, we remain focused on dividend and interest income (the golden eggs) and dividend growth that will encourage long-term capital appreciation (fattening the goose). But that doesn’t mean underperformance is fun, particularly when a number of our holdings aren’t just failing to keep up with a rising market but are actually declining in absolute terms.
On a total-return basis that includes dividends, the S&P hit its most recent record on May 21, but the Morningstar Dividend Leaders index topped out several weeks earlier, and the Dow Jones U.S. Select Dividend index hasn’t set a new high-water mark since Dec. 29, 2014. The recent highs for our portfolio were reached in May and since then have declined ~5%, while the Dow is now negative for the year…again.
Who’s been affected?
Nowhere is this underperformance more obvious than in our largest holdings in the energy sector: Chevron CVX, Magellan Midstream Partners MMP, Spectra Energy Partners SEP, Energy Transfer Partners ETP and Linn Energy bond. While utilities, REITs, and industrials have all lagged in recent months, these positions explain the bulk of our recent underperformance.
To a certain extent, we understand why these names are being tossed overboard. The price of crude oil is dropping again as Iran regains access to global markets and energy demand shows few signs of improvement. This can’t help but have a negative effect on Chevron and other oil producers’ near-term profits. Morningstar continues to believe $75 a barrel is a reasonable long-term oil price assumption, and at that level we expect Chevron and Linn to return to business as usual.
If the effect of a short-run drop in oil prices should be relatively minor for Chevron, it’s even less significant for pipeline operators like Magellan and Spectra. In general, low prices for both oil and natural gas will discourage drilling in North America, which in turn limits expansion opportunities for the pipeline operators. Growth opportunities for Spectra and Magellan may erode somewhat if energy prices remain low for many years to come. However, we remain highly confident in the pipeline selections.
The most aggressive position in the portfolio is in Linn Energy. This exploration and production company does not have as strong a balance sheet as Chevron, and we’re seeing the price of their bond swing as a result. We believe Linn will make it through these low oil days and as the price of oil moves closer to $60/barrel, the price of their bond should increase back to a more reasonable level. In the meantime the bond pays 10%+ interest while we wait.
How low will oil go? – The bottom line.
How low will oil go? No one really knows the answer to that, but Josh Peters, CFA, the Morningstar team, and we think the market is overreacting to bad short-term news in the energy sector and negative momentum in stock prices, and it’s hardly unusual for investors to toss the babies out with the bathwater. With the prices of these energy companies down near 20% year-to-date, we view this as an opportunity to rebalance the accounts and take advantage of these low prices.
We welcome your call to discuss further,
-Bruce & Tim