Is Inflation Really Waning? Your Income Shouldn’t Be!

Co-produced with Treading Softly

I often say that half the battle of investing is the actual work of investing – the buying and selling of positions, optimizing your allocations, rebalancing, and overall portfolio management.

So what’s the other half?

It’s keeping abreast of what’s happening globally, what’s occurring economically, and keeping an eye on the horizon. I do this for members by providing them with weekly market outlooks. This, along with weekly top picks and portfolio holding updates, allows them to have the tools to be able to approach the market with knowledge and understanding – enabling them to make good choices from that place of knowledge. For many months, I have been discussing the reality that inflation is slowing down – a stance that was supported in the second half of last year as CPI slowed down considerably.

Everybody “knows” that when inflation is high, you want to own commodities. Everybody “knows” that when inflation is low, you don’t want to own commodities… right?

When “everybody knows” something, you shouldn’t just accept it at face value, be prepared to question such assumptions.

Let’s dive in and look for opportunities in the assumptions of others.

Pick #1: BCX – Yield 5.9%

BlackRock Resources & Commodities Strategy Trust (BCX) is a CEF that invests in commodity stocks. Its holdings fall into three major commodity-sensitive sectors: mining, energy, and agriculture. Source

In these sectors, BCX invests in the largest names, 94% of its holdings have a market capitalization of over $10 billion.

The price of BCX remains below the early 2022 levels. Likely, many investors are thinking that with inflation slowing down, they don’t want exposure to commodities.

Yet the NAV for BCX is only 4% below its 2022 peak.

When a CEF reaches long-term highs with its NAV, we’re used to seeing the discount reduce as the price races to catch up. Instead, BCX continues to trade at an attractive discount. Additionally, BCX hiked its distribution twice last year for a cumulative increase of 29%. With NAV still climbing, we expect there are more distribution hikes in the future.

Why are commodities so strong, even as inflation slows down? The answer lies in a common misperception of inflation. Inflation does not measure prices. High inflation does not mean high prices, and low inflation does not mean low prices. Inflation measures the rate of change in prices.

When we look at several major commodities, we can see that many have come down from their peaks but are still much higher than they were in 2018 and 2019.

Prices are not skyrocketing as they did in early 2022, but even those that have come down are still much higher prices than were seen pre-COVID.

For the companies that engage in mining, oil drilling/refining, or farming, temporary price spikes are not what support their businesses. Sure, a windfall here and there is nice, but the impact is often muted because it’s common for companies to sell futures contracts and hedge.

Sustained higher prices are where real success is at – this is happening throughout commodities as many are facing similar dynamics. The common threads we are seeing are:

• Increasing demand. The post-COVID pop was part of it, but also the population is growing, and developing countries are playing a major role in increasing demand for commodities.
• A lack of capex in recent years caused supply to fail to grow as quickly as demand. In 2020, most companies stopped spending out of uncertainty.
• A lack of government support and sometimes direct blocking of new production. Even as the “Green” energy movement increases the demand for many metals, minerals, and petroleum-based products to produce solar panels, batteries, and windmills, the same movement fights against producing those materials. Rising demand and lower supply create higher prices – a great benefit for those companies that are already producing.
• Cautious producers. From 2014 to 2016, commodity prices across the board collapsed, and as a result, many producers faced bankruptcy and very serious financial issues. That period is recent enough in memory that we have not seen producers push the pedal to the metal. Instead, expansion is being done cautiously.

Even as the rate of rising prices is slowing down, absolute prices remain high and are likely to remain at high prices relative to the past 10 years, this creates an environment for the major producers, like the companies that BCX invests in, to have very strong earnings and high dividends.

Pick #2: AM – Yield 8%

Antero Midstream (AM) hit an important target in Q3 2022 it was cash flow positive after capex and after dividends. This is consistent with its guidance and the long-term goals that were provided to investors when AM reduced its dividend in 2021.

At Q4 2020 earnings, when the dividend cut was announced, management stated:

Due to the upfront acceleration of projects, we expect 2021 and 2022 to be approximately free cash flow breakeven after dividends and then for AM to generate $500 million of cumulative free cash flow after dividends after those projects are placed online through 2025. Importantly, we expect AM to continue to generate peer-leading ROIC in the mid to high teens, enhance leverage profile that declined to three times or less by 2025.

Under the prior $1.23 per share dividend levels, the drilling partnership resulted in outspend in 2029 and leverage in the high three times range. Given these circumstances, we’ve decided to reallocate a portion of dividend payments so that AM does not add any debt or leverage to its balance sheet to fund these attractive opportunities.

The dividend cut was a capital allocation decision to avoid taking on too much debt and having to issue additional equity. True to management’s guidance, 2021 and 2022 were roughly breakeven after dividends. Source

In the Q3 earnings call, management laid out a target of 2024 to achieve its leverage target, while also noting that they are on pace to hit the high end of their 5-year cash flow targets.

In addition, as a result of the acquisition, we’re trending above the high-end of the five-year free cash flow targets. We will look to provide more formal updates to the long-term targets when rollout our 2023 budget.

Importantly, and consistent with our prior expectations, pro forma for the acquisition, we still expect to achieve that three times leverage target in 2024. Once we achieve this target, we will be in a position to evaluate our return of capital strategies.

We appreciate a management team that lays out clear long-term goals and then follows the plan. 2024 will be a meaningful year because, in 2024, the fee rebates for Antero Resources (AR) expire, providing additional growth from their current operations.

So when we look at AM’s dividend, it’s clearly secure. Will it be raised? For 2023 it’s a big “maybe.” As AM does its budget, there could be room for a hike late in the year. In 2024 and 2025, we can be a lot more confident that AM will start increasing its dividend and will likely seek to raise it annually.

With AM, we get a high yield today and the prospect of dividend growth in the future.

Conclusion

We can take advantage of poor inflation assumptions and mistrust of management to lock in high dividend income. With AM, we’re seeing management follow through with what they forecast. With BCX, we can benefit from higher commodity prices, even if inflation is abating and prices are rising slower.

Both allow us to enjoy strong income, with the potential for dividend growth down the road – can we call that dividend inflation?

When it comes to retirement investing, income investing provides a balanced approach between meeting your income needs head on and providing a means by which you are not forced to time the market. When you’re not forced to sell shares to pay your power bill, you don’t have the stress of deciding on the best time to sell to meet that need. You simply get dividends and pay the bill with them!

In the last few months, many have experienced elevated expenses – gas bills and power bills have been higher due to the colder weather. If you were forced to sell shares to pay those bills when the market was down heavily, perhaps it’s time to change how you play the game.

That’s the beauty of our Income Method. It can help your retirement portfolio and outlook.