ET - Buy Alert: High Yield Sectors To Buy Hand-Over-Fist

Summary

• Overall, the market looks overvalued right now with several potential crash catalysts.
• That said, there remain a few high-yield sectors that look particularly attractive at the moment.
• We share two that we are buying hand-over-fist.

Overall, the market looks overvalued right now with several potential crash catalysts. Indexes like the S&P 500 ( SPY ) ( VOO ) and Nasdaq ( QQQ ) remain quite elevated relative to their recent and all-time histories and the housing boom has left prices in bubble-like territory:

These elevated prices are largely due to the fact that interest rates remain near historically low levels and the expectation that the Federal Reserve will continue to fight to keep them in a lowish band due to the heavy debt burden on the U.S. government's balance sheet:

Meanwhile, the macroeconomic outlook is negative, with many calling for a recession, and a wide variety of market valuation models (including the Yield Curve, Buffett Indicator, P/E Ratio, and S&P 500 Mean Reversion models) indicate stocks are overvalued. As a result, Charlie Munger of Berkshire Hathaway ( BRK.A ) ( BRK.B ) recently predicted that "considerable trouble" is coming:

What we're getting is wretched excess and danger for the country. Everybody loves it because it's like a bunch of people getting drunk at a party; they're having so much fun getting drunk that they don't think about the consequences. Eventually, there will be considerable trouble because of the wretched excess, that's the way it's usually worked in the past.

While all this is true, instead of running for the hills, we continue to find pockets of opportunity in the high yield space. In particular, these two sectors look particularly attractive to us right now:

#1. Investment Grade Materials ( XME )

There has been a greater than 20% pullback in miner and materials stocks over the past several months:

While the pullback is somewhat justified in the short-term as commodity prices have also fallen, we believe this provides investors a golden opportunity to build overweight positions in quality investment grade producers in this sector with an eye towards very favorable long-term trends for the sector. These include:

1. Strong demand for new infrastructure across the developed and developing economies of the world, which has led Goldman Sachs ( GS ) to predict a 10-year commodity super cycle.
2. The massive projected electrification in the coming decade will generate such overwhelming demand for copper that supply will be overwhelmed. As a result, the price of copper should soar in the coming years.
3. Continued rapid growth in developing economies should lead to very strong demand for commodities.
4. The expectation that inflation will likely remain on the higher side due to continued low interest rates and significant government deficit spending, is a major tailwind for commodities.
5. Furthermore, rising geopolitical risks could also serve as a major tailwind for commodities as they can serve as a safe haven (especially precious metals like silver ( SLV ) and gold ( GLD )) and also can end up in short supply if a major producer is impacted by the geopolitical event. A current example of this is the disruption in agricultural and energy exports from Russia and Ukraine in the wake of sanctions and other disruptions due to the ongoing war between those two countries.

On top of these bullish macro trends, investment grade materials companies are in phenomenal financial shape, with their balance sheets flush with cash and their cash flow statements showing billions of dollars of free cash flow pouring into their coffers. This in turn is leading to historically high capital returns to shareholders in the form of dividends and share repurchases. Some of our top high yield investment grade picks of the moment that we expect to generate outsized returns over the next 5-10 years include Rio Tinto ( RIO ), Southern Copper Co ( SCCO ), LyondellBasell Industries ( LYB ), Newmont ( NEM ), and Barrick Gold ( GOLD ).

#2. Investment Grade Midstream ( AMLP )

Midstream energy - particularly our top picks in the sector - have massively outperformed the market year-to-date:

However, we believe that there remains compelling value in the sector for the following reasons:

1. Energy prices remain elevated relative to historical levels, which bodes well for midstream given that their upstream clients become stronger and additional energy production is incentivized (which results in greater demand for midstream infrastructure).
2. The war in Ukraine shows no sign of ending anytime soon. The longer this war drags on, the worse the energy crisis in Europe grows. This leads to ever-greater demand for North American energy to replace reliance on Russian energy. This should prove to be a boon to North American midstream businesses which have exposure to the energy export markets.
3. The growing probability of a prolonged stagflationary environment makes midstream an attractive place to invest. Midstream businesses generate stable and defensive cash flows that are largely linked to various inflation-related escalators, making them an ideal pick in an environment with elevated inflation and weak economic growth.
4. Midstream businesses have largely completed their major capital projects, meaning that they have minimal exposure to inflationary pressures on the cost side even as their inflation-linked contracted cash flows should see a bump from high inflation.

Our top picks of the moment include: Energy Transfer ( ET ), Plains All American ( PAA ), Western Midstream ( WES ), and Enterprise Products Partners ( EPD ). Each of these businesses is gushing free cash flow, paying out a hefty and very safe distribution, and has a strong investment grade balance sheet.

Investor Takeaway

The stock market is a scary place to invest these days given the still lofty valuations, the negative macroeconomic outlook, and the rising geopolitical risks. However, for long-term income-oriented investors, there are still plenty of attractive opportunities for allocating capital at steep discounts to intrinsic value while also positioning a portfolio to outperform in the current stagflationary environment and benefit from long-term macro trends. By investing in investment grade, high yielding materials and midstream stocks, we believe we are well positioned to continue delivering alpha in our Core Portfolio at High Yield Investor.

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