Join our community of smart investors
OPINION

The American dream

The American dream
August 9, 2018
The American dream

That would be doubly fortunate because the US index, which actually has 505 constituents, is decidedly short of high yielders. It has just 14 that would readily fit that description, in the process crimping my scope to uncover ‘Brexit-free’ income stocks Stateside. 

Part of the reason for this is that US companies tend to distribute less of their net profits than UK companies – average dividend cover for the S&P 500 is 2.5 times earnings compared with 2.0 for the FTSE All-Share index. But more so it’s because US stocks are serially rated higher and right now the S&P trades on 21 times 12-month rolling historic earnings against 14 times for the All-Share. Consequently, dividend yields are lower. 

The putative growth stock is The Williams Companies (US:WMB), which runs a big chunk of the US’s gas pipelines – perhaps 20,000 miles-worth, which shift about 30 per cent of the nation’s gas supplies. Its major channel is the Transco pipeline, which includes about 10,000 miles of pipes that take gas from the Gulf of Mexico to upstate New York, stopping off at the Big Apple on the way. Next is the 4,000-mile Northwest pipeline, which moves gas from the San Juan Basin in New Mexico to the Pacific north-west. 

The basis for Williams’s growth-stock status is the cheap price of natural gas compared with oil in the US. As of April, the price of gas passing through Louisiana’s Henry Hub distribution point was less than a quarter of that for the corresponding amount of oil – $2.75 (£2.14) per unit of energy compared with $11.3 for West Texas crude. That price differential, says Williams’s chief executive, Alan Armstrong, “is impossible to get away from”. He told industry analysts in May: “It’s as fundamental a driver as you will ever see in picking a fuel source.” 

As a result, US consumers of various sorts are switching to gas, raising demand. From a steady 2.2 per cent annual growth from 2012 to 2017, energy-industry analysts at Wood Mackenzie reckon that demand will accelerate to 2.8 per cent a year from 2018 to 2022. While gas consumed heating homes and offices stays stable, the surge in demand is likely to come from three sources. The first will be power generation, where coal-fired plant – which still generates just over 50 per cent of the US’s electricity – is shut down and 60 per cent of the replacement capacity is gas-fired. Second, companies increasingly favour gas as the fuel source for new industrial plants – which is enough to raise demand in that sector by 3.7 per cent a year until 2022. Third – and coming from nowhere – gas turned into liquid natural gas (LNG) and exported, mainly to China and south-east Asia, is forecast to grow by 30 per cent a year from 2018 to 2022.

Meanwhile, the gas price is only indirectly relevant to Williams. What really matters is the volume of the stuff going through its system, so low prices, to the extent that they stimulate demand, are a boon. 

Put these factors together – include fat amounts of capital spending that have added 25 per cent to Transco’s capacity in the past year – and you should have a business that generates predictable, and steadily growing, revenues and cash flow. Williams has paid a dividend every quarter since 1974 – albeit sometimes at only a nominal rate – and its bosses are sufficiently confident to forecast that payouts will rise by up to 15 per cent this year and next. With the share price at $31.2, that takes the prospective dividend yield well clear of 4.3 per cent. 

Williams is also in the process of tidying up its corporate structure. Most of its pipeline capacity is housed inside Williams Partners (US:WPZ), a listed limited partnership of which it owns 74 per cent. However, it has agreed to buy out the minority partners with an all-share offer. The chief effect may be to make Williams’s shares more attractive to institutional investors – especially in Europe – first because it eliminates the partnership structure that was sometimes a barrier to them investing and, second, because it raises Williams’s debt to investment grade. 

Sure, it does not do to get carried away. Williams is not an easy business to analyse quickly and, at the end of the day, it is a regulated utility where a limited number of contracts account for a high proportion of its revenues, some of which are long-term and fixed price. Contract prices are also overseen by an agency of the US Department of Energy, based on assumptions familiar to investors in UK utilities, such as costs, volumes and allowed rates of return. So the company is unlikely to morph into a fully fledged growth stock. Even so, it looks to be in a sweet spot currently, one that looks especially nice for UK investors. 

Another possibility – although it is emphatically not a growth stock – is chain-stores operator Macy’s (US:M), which is almost as much a part of US popular culture as, say, McDonald’s, Dunkin’ Donuts or the New York Yankees. The chief investment draw with Macy’s is the ease with which the company pays the dividend, which generates that 3.8 per cent yield (see table). In the past six years, the biggest chunk of free cash that the dividend payment absorbed was 52 per cent in 2015-16 and, over that whole period, the average payout ratio was just 36 per cent of free cash. 

Yet that did not mean a static payout. Albeit from a low base in 2012-13, Macy’s has grown its dividend by almost 14 per cent a year since then. Sure, that pace is slowing to a crawl and it would be unrealistic to expect anything more than nominal growth in the coming years. 

That’s because, as I say, you’ll hardly mistake Macy’s for a growth stock. The operation, which has been through the mill of multiple restructurings in the past 20 years, is now shrinking. Sales have contracted by 2 per cent a year for the past five years and operating profits by 10 per cent a year. Despite that, Macy’s remains decently profitable. Return on capital is well clear of 8 per cent and that is leveraged up to a claimed return on equity of over 30 per cent. Meanwhile, net debt is under control. It is currently at its lowest level for six years and is a third lower than it was three years ago. 

Managing decline has also meant hacking away at capital spending, which has been running at little more than half the rate of depreciation and goes a long way to explain that excess free cash. Still, even that contains the possibility of hope. Imagine that Macy’s started looking for growth once more – as company bosses have a tendency to do – so its capital spending returned to the level of depreciation. That would still leave bags of cash to cover dividends. Even under those circumstances, dividends would not have sucked up more than 62 per cent of free cash in any of the past six years, averaging just over 40 per cent over the period. 

True, this little résumé has focused entirely on the financials. I haven’t yet looked at the operational well-being of Macy’s, although, if and when I do, I’m almost certainly going to find a business under similar pressures to those that grind down the UK’s non-food retailers. So, I would buy the stock – if I did – despite, not because of, the company’s operational limitations. I would think of it as a quasi dollar-denominated bond, churning out the cash flows that assured the dividend that, in turn, prevented the stock price getting trashed. 

Something similar could be said about shares in Kraft Heinz (US:KHC), the third of those that grab my attention from the table. Like Macy’s, Kraft Heinz is a repository of famous brands that somehow belong more to the tinsel era of America in the 1950s than to the present day. However, in management style, Kraft Heinz is likely to be far removed from Macy’s. It is the product of the 2015 takeover of Kraft by Heinz, which was driven by private equity and cheered on – incongruously – by Warren Buffett’s Berkshire Hathaway (US:BRK.B). 

It is still too early to judge the enlarged group. Predictably, employee numbers have been cut – by 3,000, or 7 per cent – since the companies were merged. Furthermore, profit margins are wider than the former Heinz in its final days, which is feeding into a fatter return on capital metrics. 

Whether that will be sustainable, who knows? Making a living – or a fortune, in the case of the guys who run Kraft Heinz – by gobbling up low-growth businesses requires that the trick be repeated again and again, not least because continual change fudges the issue sufficiently that hype and promise can always win out against dull reality. This process, which is about image as much as reality, requires steadily rising dividends, which are both a symbol of success and a totem of management’s brilliance. In which case, I might be ashamed to put Kraft Heinz’s shares into the Bearbull Income Portfolio; except that the predictability of the dividend stream coming through – and in a currency untainted by Brexit – may overcome my shame. 

And remember that this is where we started two weeks ago – on the need for Brexit-free income for the Bearbull fund (Mr Bearbull, 27 July 2018). There are possibilities in Europe (Mr Bearbull, 3 August 2018) and now in the US. However, I want to run these companies through some checks of their productivity, which I will deal with in the column next week. 

email: bearbull@ft.com

The S&P 500's high-yield stocks
CompanyPrice ($)% ch on 3 mths% 5-year highMkt Cap ($bn)Div Yield (%)Payout Ratio (%)PE ratioDebt to equity (%)Profit margin (%)
Seagate Tech'y52.62-37615.54.8619.97415.4
General Mills46.0666327.24.35315.26917.4
The Williams Co's31.75215224.54.35228.55821.8
Interpublic Group22.55-4888.53.75213.14712.4
Altria58.68576110.34.84714.84751.0
Ford Motor10.04-115640.17.3437.3813.5
Invesco26.99-56411.24.44110.04626.0
AT&T31.97-274232.46.3389.15114.9
Cardinal Health49.95-215515.63.83410.1561.7
H&R Block25.16-9675.24.0339.07924.0
Verizon Comm's51.64691216.94.63111.26822.4
Macy's39.73295512.33.82911.0506.5
Kraft Heinz60.2586273.54.12716.03327.8
CenterPoint Energy28.48129412.13.92617.86410.3
Source: S&P Capital IQ