When equity markets go into correction mode, all news is bad. Brexit, which corresponded with a market low for world equities in 2016, has now become a “reason” for equity selling. The Tories in the U.K. are at war over how to move forward with Brexit. Meanwhile, global growth, a staple explanation for equity selling, has been taken off the shelf. China’s November retail sales grew at their weakest pace since 2003 and industrial output rose the least in nearly three years as the economy lost further momentum, heaping pressure on Beijing to defuse its trade dispute with the United States. The world’s second-largest economy has been losing momentum in recent quarters as a multi-year government campaign to curb shadow lending put increasing financial strains on companies in a blow to production and investment. Trump even chimed in this week, saying “China’s economy, if it’s in trouble, it’s only in trouble because of me”. Yes Donald, everything happens because of you. Recall that the January 2016 equity sell-off was also attributed to a Chinese growth scare. The difference this time is that valuations of U.S. stocks, in particular, are even more ridiculous today. Even in the unlikely event the world’s top two economies reach a durable resolution in their dispute, ebbing domestic demand, mounting household debt and a cooling real estate sector point to a further slowdown in growth next year. We believe that the risk of entering recession next year is real, even if the macro data has not yet turned down. The near-inversion of the U.S. Treasury yield curve in recent weeks has investors spooked and is leading to a pricing-in of recession for next year.
Macroeconomic data in the U.S. this week was light. The monthly inflation data showed no significant acceleration in prices. CPI was unchanged in November as expected. Year-to-year, CPI is rising at a +2.2% rate. PPI rose +0.3% vs +0.1% expected. On an annual basis, PPI accelerated to a +2.7% rate from +2.6% in October. Retail sales excluding automobiles, gasoline, building materials and food services surged +0.9% last month after an upwardly revised +0.7% increase in October. Industrial Production came in at +0.6% in November vs +0.3% forecasted. No red flags in the data this week, however these data series tend to lag.
The Signaling Power of Market Corrections
When the broad equity indexes just melt down like we’ve seen this week, we never feel like we have enough cash in our portfolios. However, at times investors just need to be content with having a well-constructed portfolio and beating the benchmarks in a down-market. The time is raise cash is not after a pair of sharp down weeks.
While waiting for another up-cycle, it pays to be observant during corrections and bear markets. The “market” (notably the Insiders and more-informed institutional investors) know which companies are solid and don’t merit getting sold off. Typically, the companies that don’t get sold as hard in a correction/bear market will be the winners in the next bull market. That does not mean that these companies will bounce more in shortcovering rallies (they won’t, in general), but over the long-haul your portfolio will outperform by moving into companies which savvy investors hold onto in corrections.
When markets are falling, greedy investors naturally want to add money to the stocks that have fallen the most (“cheap stocks”). In reality, these stocks may not actually be the cheap ones. We submit that buying the stocks that have fallen the most is a bad investment strategy. As basketball commentator Dick Vital often said “you need to be swinging for Pete Roses, not Reggie Jacksons”, meaning players should go for the higher probability small winners and not swing for the fences with potential big winner, but long-shot goals. We believe the same philosophy applies to investing in choppy and/or down markets.
Moreover, investing in choppy markets (unless you are trying to time the market swings) leaves lots of portfolio volatility and no interim returns. For this reason, we advocate holding onto stocks that pay a regular, high dividend to compensate you for suffering through market swings.
On our current Natural Resources Watch List, we see several oil companies that are resisting the global drop in the S&P Energy Index. In this week’s Commentary, we share three names which we believe may continue to outperform the Energy Index into the next year and merit holding a line in an energy portfolio.
1. Alliance Resource Partners, LP
Alliance Resource Partners (ARLP) is a diversified producer and marketer of coal primarily to major United States utilities and industrial users. We have had this company in our Ultra Yield portfolio for a while, due to its 10.7% dividend yield. As a Limited Partnership (LP), we have not placed this stock in the Natural Resources portfolio due to limitations in holding LPs in retirement accounts.
The two-year chart of Alliance Resource Partners is posted below. While both the Energy Index (XLE) and the Coal Index (KOL) are trading at 2018 lows, Alliance Resource Partners has been remarkably stable. While the Coal Index is down -24% from January 2018 highs, Alliance Resource Partners is only down -10.5%.
Our fundamental rankings for Alliance Resource Partners versus the Energy sector are also compelling. As a Yield stock, Alliance Resource Partners ranks 40th among the 385 tradable Energy companies in our model. More importantly, for a Yield stock, we see good profitability (score of 66.6) and a good balance sheet (Financials score of 63.1). Valuation measures are firmly in the top half of our Energy universe and Revisions are among the top 20% of all Energy companies.
2. Delek U.S. Holdings
Delek (DK) is a diversified downstream Energy company. The company has a broad platform of refining and logistics activity.
While the Energy indexes have continued to plummet in November and the first part of December, Delek’s stock has leveled off. The late summer sell-off in DK apparently shed the stock of the weak hands.
Fundamentally, Delek offers an attractive valuation, solid balance sheet, along with a 2.8% yield. Delek also has a decent ratio of valuation to growth (PEG score in top 63rd percentile). Due to the limited stock history (a little over 1-year) our risk metric calculations are of limited value (ie: the standard deviation of returns in reality may turn out to be higher than the 23% indicated in the Fundamental Allocation Model) . As Valuation is not a sufficient criterion to hold a stock (as any Value investor in this market will attest to), we are signaling DK more for the relative technical chart strength. As such, $35 is our risk limit in Delek. At this time, the resistance of the stock price to collapsing Energy sector stocks lead us to believe that the consolidation channel in the chart above will be resolved to the upside. But we won’t be dogmatic about Delek.
3. Surgutneftegas
Surgutneftegas (SGTPY) operates oil fields which are located in Western Siberia and Eastern Siberia. In addition to its oil field exploration, Surgutneftegas refineries produce petroleum products with high-quality performance and environmental characteristics, including motor fuels, aromatics, liquid paraffin, roofing and insulation materials.
With Surgutneftegas we are thinking outside of the box. As correlated U.S. Integrated Oil and E&P stocks are largely falling in unison, we looked to several non-U.S. oil companies bucking the 2-month massacre in the oilers. Surgutneftegas pops out among the non-U.S./Canadian oilers in our Fundamental rankings.
First, the stock price of Surgutneftegas looks completely decorrelated with the Energy indexes. This may be a Russian phenomenon, as Lukoil (LUKOY) and Gazprom (OGZPY) are also doing a lot better than most world oil service and E&P stocks.
We chose Surgutneftegas for its stronger Financials and Profitability scores vs. Lukoil and Gazprom. Surgutneftegas is among the most attractively-valued oil companies in the world and is offering positive EPS and Sales revisions. Again, Surgutneftegas pays a 2.3% dividend to hold their stock.
Russian stocks present a geopolitical risk. No need to think back further than the U.S. sanctions imposed upon Russia last year. However, in a diversified portfolio, a small allocation to EM oil companies will pay off in the long run…both for higher expected returns and decorrelation during periods such as the present. The U.S. listing for Surgutneftegas (a Pink Sheet ADR) is not very liquid. Nonetheless if an investor wishes to buy and hold onto Surgutneftegas, the bid/ask to get in is not excessive.
Conclusion
In a correction, look for relative strength rather than buying the big dippers. The Alliance Resource Partners, Delek, and Surgutneftegas are three clear examples. However, investors can find relative outperformance in some major names, such as BP (down -13% from 2018 peak) and Royal Dutch Shell (down -14% from late summer high), which we also both holding. In sum, if an Energy company is falling more than the Energy Indexes in this market correction, it either has too much sensitivity to oil prices or other company-specific business risk.
Trade Recommendations
We added to our position in Alliance Resource Partners this week. Alliance Resource Partners is one if our best picks for Fundamental ranking, Yield, and a construction price chart.
