Carnage in energy sector and the hunt for yield

Luckily for the energy sector credit events are the necessary ‘forest fire’ that will restore profitability for the stronger players in the sector when the carnage is over. The energy sector has gone from one of the largest sectors in US equity markets 35 years ago to being one of the smallest. And this is despite energy being a fundamental condition for our modern society – the oxygen for factories and entertainment. Our view is that the energy sector will present investors with a decade worth opportunity on the long side after the ‘forest fire’ has run its course.

Another important event that happened yesterday was the US 10-year yield dropping below 1% for the first time in 150 years closing at 0.95%. Assuming the equity risk premium is unchanged over the coming 10 years at 4.8% then the lower yield is implying significantly lower growth in dividends in the future. Dividends have been growing at 6.2% in the US since 1970 but the bond market is saying 4.7% going forward. With yields being pushed down investors are looking elsewhere to get some yield.

In equities the traditional way of looking at yield was the dividend yield. As buybacks have increased due to its tax effectiveness for a multinational company the dividend yield has been replaced by what is called the shareholder yield, which is essentially the capital returned to shareholders. This yield has three components: dividends, buybacks and debt reduction. The reason why debt reduction is part of the equation is that is a financing activity that could have been used to buy back shares or pay out as dividends – in the case the company is not forced to pay down debt. For financials the changes in debt on the balance sheet is excluded.

Based on current numbers the three sectors with the highest shareholder yield are financials, materials and consumer staples and the sectors offering the lowest shareholder yield are health care, real estate and utilities.