A Mid-Cap Idea With Exceptional Return Possibilities: ONEOK
Summary In searching for exceptional return possibilities, I’m looking for three basic things: low expectations, a high dividend yield and a favorable agreement. ONEOK is a great illustration of all three components, having quite solid long-term prospects coupled with low short-term expectations. This article details this possibility, along with an ending enhancement that could allow for improved gains. The investing world is filled with thousands of securities and a variety of varying assumptions. As such, it can be difficult to pinpoint the “best” potential investment. This is because the business performance and investment performance of a security can be two drastically different items. Even if you succeed in finding an excellent-performing business, it does not guarantee excellent investing results. Investor expectations play an important role. You can have a company humming along at a double-digit rate and yet providing negative returns, as was the case with Wal-Mart (NYSE: WMT ) during the turn of the century. From 1999 through 2005, the business grew by nearly 13% per year, yet each dollar invested would have turned into 70 cents. From 2005 through 2014, the business was growing much slower – at less than 8% per year – yet investors would have seen nearly 9% annual gains. The reasoning for this difference is valuation. In the first period, the company’s valuation went from over 50 times earnings to under 20 times. In the second period, expectations were lower, and thus, the “investment bar” was lower as well. Thus, in searching for potential investment opportunities, I like to look for “low bar” situations. If you need everything to work out perfectly, there isn’t much margin of error – and indeed, could be hazardous to your investing program. On the other hand, if you only need marginal improvements for things to work out, you’re starting from a much better position. I’d like to apply this logic to Seeking Alpha’s current mid-cap contest and searching for the “best” long or short idea. Naturally, the “best” is not yet known. And if it were, more investors would pile in to the idea, increase the current demand for said security, and thus negate the potential for an outsized gain. However, this alone does not preclude you from working through the process. It can be instructive to think about what factors could provide an outsized gain. Personally, there are three basic areas of focus, which all work toward the “low bar” investment idea: Low Expectations High Dividend A Favorable Agreement My pick for a mid-cap company with exceptional return possibilities is ONEOK Inc. (NYSE: OKE ). Actually, as you’re about to see, it’s ONEOK with a bit of a twist, but we’ll get to that. ONEOK, with a market cap around $7.5 billion as I write this, is the general partner of ONEOK Partners (NYSE: OKS ). ONEOK Partners is a large publicly traded master limited partnership, which gathers, processes, stores and transports natural gas and natural gas liquids. ONEOK carries an advantage for investors looking for qualified dividends as opposed to the distributions provided by limited partners. The enterprise as a whole has sold long-term prospects on the horizon. In taking a high level view, natural gas makes a lot of sense. It makes sense that we’ll be using more of this resource in the future. It’s abundant, cleaner, more efficient and cheaper. In fact, we’re already seeing the transition take place: for the first time, natural gas provided more electricity in the U.S. as compared to coal. Moving forward, I would expect this trend to continue rather than retreat. It’s not going to be a linear process, but it seems like a reasonable supposition over the long term. Incidentally, Kinder Morgan’s (NYSE: KMI ) Rich Kinder provided the same type of insight during his company’s most recent earnings call . The thesis for using more natural gas is quite simple, and is something that we’re already seeing, but it helps to be backed up with some market insight. Here are a few tidbits as provided by Mr. Kinder: “McKenzie expects 5% year-over-year growth in demand, and 40% growth by 2025.” “The U.S. Energy Information Administration anticipates that by 2030 39% of electricity will be generated by natural gas, as compared to just 18% from coal.” “More coal and nuclear plants are being retired, creating a need for flexible generation alternatives.” “Natural gas exports to Mexico are expected to be 40% higher this year as compared to 2014.” “The American Chemistry Council counts 243 industrial and petrochemical projects with a cumulative investment of $147 billion from 2010 to 2023, requiring more build out.” “Wood Mack estimates that over 2.5 Bcf a day of additional natural gas will be required by 2018 from 2015 levels to meet industrial demand driven by fertilizer and petrochemical projects.” “The Potential Gas Committee estimates that there are over 100 years of remaining resources relative to current demand.” “The White House’s National Economics Counsel has reported that natural gas ‘is playing a central role in the transition to a clean energy future.” In short, natural gas is expected to play a major (and growing) function in the energy space for years to come, and for good reason. Naturally, this doesn’t mean that every company involved in the sector must benefit, but it follows that collecting “toll booth”-type fees for a growing demand is a desirable place to be. ONEOK stands to benefit greatly in the coming years and decades. You have an industry and business that is set up well for the long term. Which brings us to the first opportunity. Low Expectations Despite the clear thesis for long-term growth, investors tend to focus on the short term. It’s the “shiny object syndrome,” whereby it’s easy to see what’s in front of you, but much harder to contemplate the future. If the short term is bleak, so too are investor expectations. With a long-term time horizon, it doesn’t make much sense to have a penchant for what happens next quarter if you expect to hold for the next 10 or 20 years. Indeed, a bleak current outlook, thereby resulting in lowered expectations, could very well provide an opportunity. In September 2014, shares of ONEOK were trading hands above $70 per share. Since that time, commodities in general have declined mightily. ONEOK is reasonably protected from such declines, but the share price has nonetheless seen commensurate “pains” – trading below $36 as of this writing. That’s effectively a 50% price decline. Now, the question you have to ask yourself is this: “Is the business 50% worse off than it was about a year ago?” I would contend that the answer to this question is “no.” In fact, given a higher payout and more demand, I would contend that the long-term prospects could actually be more apparent today. And therein lies the opportunity. When the share price declines much faster than the business’s outlook, you could very well have an opportunity. At the very least, you’re dealing with a situation where investors’ expectations are sufficiently low such that you don’t need a whole lot to go right in order to make a solid investment. If shares were still trading around $70, I wouldn’t be writing this article. The opportunity lies in the short-term uncertainty. As an example, analysts are presently expecting a future dividend payment around $3.30 in five years’ time, along with a dividend yield around 5.8%. Which, incidentally, more or less lines up with the company’s past guidance during the earlier part of this year. A $3.30 future dividend with a 5.8% yield translates to an anticipated share price of about $57. Over the five years, you would expect to collect $15 or so in dividend payments. This adds up to a total expected value of about $72. Against a share price of $70, this simply isn’t intriguing. No one goes around searching for 0.5% annual gains. On the other hand, the same business prospect with a share price around $36 is exceptionally more compelling. In this instance, the total anticipated value would be the same, but your returns would be greatly enhanced. You would expect to see your capital double over a five-year period, equating to annualized returns of nearly 15% per annum. The low expectations, as communicated via a much lower share price, allow for a much improved value proposition. High Dividend Of course, there is no way to guarantee that low expectations turn more “normal.” Just because you have found an opportunity that offers a “low bar” does not mean that the shares must react as you suspect. As such, a secondary factor that can be useful is an above-average dividend yield. Although a cliché, this allows an investor to “get paid as they wait.” I prefer John Neff’s idea of snacking on ” dividend hors d’oeuvres ” as you wait for the main meal, but the concept is a simple one. The future share price is largely unknown. The dividend can play an important role in your overall return. The more cash flow that you receive from dividend payments, the less focus one might have on everyday price fluctuations. Eventually, things more or less work out, but there is no reason why this must occur on your schedule. ONEOK has been not only paying, but also increasing its dividend since the early 2000s. Recently, the company declared a $0.615 quarterly dividend , or $2.46 on an annualized basis. Based on a share price around $36, this represents a “current” yield of about 6.8%. Without any growth in this payout, reinvestment or capital appreciation, this would indicate an annual return of 6% per year. That’s my idea of a “low bar” investment. Five years without any growth whatsoever, and investors could see still reasonable returns. If a bit of growth does formulate, as the company is set up for in the coming years and decades, the opportunity quickly moves from reasonable to quite impressive. Favorable Agreement The current value proposition for ONEOK is simple: There’s a long-term thesis at play that is currently being discounted by short-term concerns. With a dividend yield near 7%, investors don’t need much to go right in order to see double-digit returns. As a baseline, even expecting 15% annual gains is not an outlandish anticipation. However, there is a further opportunity in regard to this security. At present, the proposition is already agreeable in terms of thinking about longer-term returns. Yet, there is a way to enhance this possibility. At the time of writing, there are November 20th $35 Puts for ONEOK with bids around $1.40. Consider this scenario: You like the prospects of ONEOK and the industry, anticipate, say, 15% annualized returns in the face of lowered expectations and are willing to partner with the company at a price around $36. At the moment, you have this ability. Yet, there is an even more favorable, in my view, opportunity. You could sell the November 20th $35 Put. Let’s see what this does. The price surely will change in the coming days and weeks, but let’s keep it simple. Perhaps you can sell the Put option and receive a $120 premium (after fees, per contract). This is the deal: You agree to buy shares of ONEOK at a price of $35 in the next 28 days (or less). We’ll also suppose the option is cash-secured, such that you would need the capital on hand. You agree to keep $3,500 aside in order to purchase shares at price below what you’re already willing to pay. One of two things happens. First, the Put could go unassigned. Keep in mind that the company has a dividend payment in this period, and is announcing earnings, so the share price could be volatile. Nonetheless, it’s conceivable that the shares do not go below $35 and the option is not assigned. In this case, you would receive $120 upfront for having $3,500 on hand to buy something that you’d be happy to own. The return over those 28 days would be about 3.4%, or over 50% on an annualized basis. Granted, in order to actually see this annual result, you would have to keep finding these types of situations each month, but it nonetheless illustrates a spectacular gain in less than a month. Alternatively, you could be assigned the shares. The difference is that your cost basis would now be lower – call it a $1 lower than the strike price, with assignment fees. So, your cost basis would be around $34 for a security that you were happy to own at $36. Your total return expectation moves from about 15% to 16%, as a baseline. The key is being happy to own shares at the current price and for the long term. Naturally, the actual outcomes could be much better or worse. Yet, I would contend that this is a rather favorable agreement. Either you collect a solid premium representing 50%+ returns on an annual basis, or you get to partner with a company at an even lower cost basis (and dividend yield over 7%) in a security that could very well provide outsized gains anyway. If you’re looking for a mid-cap idea with exceptional return possibilities, this security and scenario could certainly be of interest.