Dividends, Dividends, Dividends
With the tech-wreck of 2022 now behind us, investors face a brave new world–one where inflation remains a real threat and where interest rates are generating real yield. While there are still compelling growth plays to be considered (see our previous articles here and here for some examples), value and dividend-paying stocks that were once considered yesterday’s news are back in vogue.
Of course, you can’t simply pick quality dividend stocks out of a hat–selecting a company for their dividend-paying abilities in today’s environment depends more than ever on two things:
- The company’s ability to withstand inflation
- The impact of higher interest rates on a company
Mortgage REITS for example, like Annaly (NLY), deliver fantastic yields but suffer when interest rates rise. (Since the company’s business is holding mortgages, it effectively reacts like a bond fund.) Consumer products companies with otherwise-stellar dividends like Stanley Black & Decker (SWK), on the other hand, are particularly vulnerable to inflationary pressures.
So, where can investors look for yield while insulating themselves for these two threats?
We’re glad you asked.
Here we present the case for two high-yield stocks which we believe are set to deliver both superior returns and a buffer against this dual threat.
Benefitting From Higher Rates
SLR Investment Corp (SLRC) is a unique business development company in the sense that its operations are not a mystery. With a dividend yield of 10.9% paid monthly, SLR specializes in business lending to medium-sized companies for whom access to the syndicated capital markets would is either difficult or cost-prohibitive.
SLR’s lending operations take place in four main sleeves:
Sponsor Finance loans are loans originated by SLRC to mid-market companies in non-cyclical industries. These loans are first-lien and secured (more on that in a minute). The Asset-Based Lending and Equipment Finance divisions are also first-lien loans and are made primarily with non-cyclical, asset-rich companies per company executives. The smallest division, Life Science Finance, deals exclusively with companies in the healthcare space. The size of the Life Science portfolio has diminished in recent years as COVID-19 related capital infusions from the government have enabled companies to pack back loans at a higher-than-average pace.
Management has a deep understanding of each of these markets, and they have taken significant steps to de-risk the portfolio, primarily by eliminating second-lien loans and focusing primarily on first-lien.
This is important, and investors should take note. In a company’s credit stack, first-lien holders are the last in line to lose money, with second-lien holders ahead of them, and so on, all the way down to unsecured debt and equity holders. This layer of insulation from bankruptcy risk increases the strength of SLR’s overall portfolio.
How is SLR positioned to withstand the shock of rising interest rates? The answer is in its customer base, as mid-market companies get particularly pinched in rising interest rate environments. This is because banks tend to reduce lending activity to smaller companies during times of monetary tightening, leaving SLR to benefit. “With banks on the sidelines, lenders who can hold investments of $200 million or more, such as the SLR platform, are even in more demand and have greater pricing power and influence over terms,” said Michael Gross, SLR’s co-CEO, on the last earnings call.
Bruce Spohler, co-CEO, provided even more color on how SLR is positioned to succeed in this market, stating:
The recent market turmoil caused by the Fed tightening and indicators of a recession have resulted in a widening of yields in the syndicated bank loan market and a sharp reduction in banks’ willingness to assume syndication risk. As a result of the diminished supply of capital available to borrowers and the selloff in the liquid credit markets, we’re seeing a 200 to 300-basis point increase in the yields on our private debt portfolio compared to a year ago. With over 99% of our cash flow portfolio in first lien loans and a weighted average interest coverage ratio that exceeds 2.5x, our investments are well positioned to withstand any liquidity pressures that our borrowers are facing from rising interest rates.
Given SLRC’s positioning and its ability to absorb higher interest rates, we think investors should consider it as an option as a dividend generator in their portfolio.
What Inflation?
Despite strong inflationary pressures in 2022 that decimated most of the market, the Energy sector fared quite well. In the last 12 months, an investment in the SPDR Energy ETF (XLE) returned 40%, vs the S&P 500 (SPY) return of -12%.
The energy sector had a number of other tailwinds pushing it along including production spates between OPEC and the Biden administration and the Russian Invasion of Ukraine. The sector has shown, however, resilience in the face of inflation and stands to gain from a confluence of other factors in the coming year as well. These other factors range from the re-opening of China’s economy from zero-COVID conditions to the continued reticence of American producers to increase output.
Against this backdrop, we like energy producer Coterra Energy (CTRA). Formed in 2021 in the merger with Cabot Oil and Cimarex, the stock sports a 10.6% dividend yield as of this writing.
Coterra produces both natural gas (about 85% of its business) in the Marcellus Shale region of Pennsylvania. The remaining 15% of business is generated from oil in the Permian Basin and Anadarko basin.
The company is highly profitable, generating significant cash flows–it’s estimated to have kicked off $3.9 billion in 2022–of which the majority will be returned to shareholders.
The dividend also appears to be sustainable when the considering the company’s capital structure. Management runs a lean operation–Coterra has one of the lowest net leverages around, with a net debt to TTM EBITDA ratio of 0.2x.
Add in the production rates of its oil and gas properties, and Coterra looks to have a recipe for success. The biggest question in the minds of investors, of course, is likely to concern the price of natural gas, given that it is the source of 85% of the company’s revenue.
The above slide details estimated production and profitability of Coterra’s newest natural gas development, the Upper Marcellus field in Pennsylvania. In the estimate, the company states that with a flat price assumption of $4.25/mcf, the wells will turn a profit. (Note that this isn’t the company’s breakeven price, but simply a profitable level to compare the Upper and Lower Marcellus fields.)
The next question, of course, is are we likely to see natural gas prices support that assumption or anything close to it in the near future? After all–forecasts for natural gas prices show a significant drop in the near-to-medium term.
According to the U.S. Energy Information Administration, yes.
From the 2022 peak of nearly $9 per m/BTUs, price is expected to level off around the $5. While these forecasts are not always accurate, they are not back-of-the-envelope calculations, either, as they take into account a robust amount of forecasted consumption and production capacity.
Among energy players, we believe Coterra is well-positioned to reward dividend investors, both for its outlook and its shareholder-friendly management policies.
The Bottom Line
Of course, no stock or company is completely impervious to the large-scale economic forces that shape our world, but there are some companies better situated than others to endure the ride, whatever it may bring.
We believe dividend investors could benefit from the interest-rate insulated business of SLR Investment Corp. The chief risk to our idea is a full-scale recession in which large swaths of the mid-market corporate landscape declare bankruptcy. A lowering of interest rates would also have a negative impact on SLR Investment Corp.
Coterra Energy’s business has weathered high inflation quite well over the last year, and we expect that it will continue to do so in the future. Risks to this thesis are warmer-than-expected weather which could cause a drop in demand for natural gas, or a re-closing of the Chinese economy would could drop demand for oil and negatively impact the profitable oil portion of Coterra’s business.
Despite these risks, we are bullish on the outlooks for both these companies. Those investors seeking dividends should give them serious attention.
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