TRP:CC - Why Warren Buffett Is Doubling Down On Energy: Our Top Picks

2023-07-28 14:00:00 ET

Summary

• After already allocating billions of dollars to energy investments, Warren Buffett's Berkshire Hathaway has poured billions more dollars into the sector in recent weeks.
• We discuss why Warren Buffett loves energy investments so much.
• We also discuss our top picks in the sector.

Warren Buffett has made no secret of his thirst for energy stocks ( XLE ) and has been buying up shares of Occidental Petroleum ( OXY ) through his conglomerate Berkshire Hathaway ( BRK.A )( BRK.B ) hand over fist.

However, he is not stopping there and recently bought 2.1 million shares of OXY stock to bring his stake to over 25%. On top of that, he reportedly poured a whopping $3.3 billion into acquiring a 50% stake in the Cove Point liquefied natural gas facility.

In this article, we will look at why Warren Buffett is buying energy stocks so aggressively and then share some of our top picks in the sector.

Why Warren Buffett Likes Energy

The reason why Warren Buffett's Berkshire Hathaway is investing in energy so aggressively right now is because:

1. It is still relatively undervalued compared to the rest of the market.
2. Business fundamentals are quite strong at the moment as the recent boom in energy prices and slashed capital expenditures of recent years has left energy company balance sheets in excellent shape while the businesses continue to generate a lot of free cash flow.
3. Returns on invested capital - a favored metric of Buffett's - in the sector tend to be quite favorable.
4. Berkshire's view is that energy assets will become more valuable over time due to global growth, significant underinvestment in the sector in recent years, and inflationary forces .

As Bill Stone, chief investment officer at Glenview Trust and a Berkshire shareholder, stated of Buffett and his team's recent energy investment:

It builds on their long-term theme of energy resources becoming more valuable and ownership of one of only a few US LNG exporters...Buffett has liked pipelines for a long time, given their toll bridge-type revenues rather than pure commodity exposure, and this is likely similar. Natural gas prices are down a ton, but I think most of these exporters work on long-term take or pay contracts.

Our Top Picks

We agree with Buffett's thesis on energy and we especially like his affinity for the commodity price resistant nature of long-term midstream contracts. As a result, we are primarily invested in midstream infrastructure businesses ( AMLP ) for hydrocarbon energy exposure in our portfolio. Here are two of our favorite picks of the moment:

#1. Energy Transfer Stock ( ET )

First and foremost, we like ET because its distribution yield is close to 10% on a forward looking basis. With an expected 2023 DCF coverage ratio of ~2x, the distribution is not only very attractive but also extremely safe for the foreseeable future.

Another reason we like ET so much is that it has aggressively deleveraged over the past few years, bringing its leverage ratio to the low end of its target range. When combined with the fairly stable cash flows that it generates from one of the largest and highest quality portfolios in the industry, ET is positioned for a credit rating upgrade and increasingly looks like a low risk investment.

Last, but not least, ET is also quite attractive for the simple reason that its valuation is between 1.5 and 2 turns lower than its investment grade peers on an EV/EBITDA basis. This makes it materially undervalued. When combining the near 10% forward yield, the expected 3-5% distribution per unit CAGR for the foreseeable future, the significantly discounted EV/EBITDA valuation multiple, and the potential credit rating upgrade catalyst, ET appears highly likely to outperform its sector and the broader stock market ( SPY ) in the coming years.

#2. TC Energy Stock ( TRP )

While TRP has badly underperformed its sector recently, this will likely change moving forward given that TRP is now materially undervalued, has a solid balance sheet, and has a high quality asset portfolio with attractive growth potential.

Nearly all of its EBITDA comes from either regulated or long-term contracted assets that are in very strategic locations. Moreover, its BBB credit rating, 20-year weighted average term to maturity on its debt, significant liquidity, and recently completed multi-billion dollar sale of a stake in some of its pipeline assets puts it on a clear path to deleveraging its balance sheet significantly and position itself for sustainable growth for the long-term.

Most attractive of all is the fact that TRP offers investors a 7.7% forward dividend yield (that is covered 1.8x by distributable cash flow) alongside an expected 3-5% dividend per share CAGR, an expected 5-7% EBITDA CAGR, and an EV/EBITDA multiple that stands at a steep discount to its 10-year average (10.71x compared to 12.23x). When combining the yield plus growth, investors have a clear path to low to mid-teens annualized total returns and if TRP can re-expand its valuation multiple closer to historical levels, the annualized total returns could end up being even higher.

Investor Takeaway

Warren Buffett has built a phenomenal track record of picking winning stocks by focusing on fundamental analysis to identify great companies and taking advantage of gyrating market emotions and misunderstandings to buy them at fair or even great prices.

We agree with his thesis that energy is a fundamentally attractive industry to be buying right now and believe that we have found some very attractive opportunities from a risk-reward perspective. Between TRP and ET, we are generating very attractive and very sustainable current income along with long-term growth potential that should outpace inflation. Moreover, both stocks are deeply undervalued and have strong balance sheets, meaning that we should enjoy double-digit annualized total returns along with fairly low long-term risk from these investments. At High Yield Investor, we are buying ET, TRP, and several other high yielding, low risk, and undervalued energy investments.

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