Time is a Friend
I like the company Atmos Energy (ATO). I understand the business model: a natural gas pipeline and storage company with major operations in Texas. The company is a member of the S&P 500 index. The perspective I use with ATO is the way I would evaluate a long-term business partner for me, by looking at the 30-year history of ATO’s financial performance. ATO has a pretty incredible dividend story (both in terms of long-term growth and recent payout ratios), so dividends are an important topic to discuss. I don’t try to predict ATO’s stock price or forecast ATO’s future financial results. I have no special secret knowledge about ATO. Everything I like about ATO is based on information out in the open.
ATO only joined the S&P 500 index in Feb 2019, and as a result it slipped underneath my radar screen this year. I launched the Hardy Stocks Newsletter in Mar 2019, but actually spent many months beforehand preparing the analytics and strategy. The initial ticker screener was based on a list of S&P 500 component companies from Dec 2018, and for the first few months I continued to use the same outdated list of 2018 S&P 500 companies, as a result ATO did not show up on the initial analytics screens. I published an article about a component of the S&P Midcap index in Jun 2019 and the S&P Smallcap index in Jul 2019 … by then ATO did not show up on the new analytics screens either because it was no longer in the Midcap index. Only when I decided to revisit the S&P 500, ATO appeared on the analytics screen out of nowhere this month. If I had noticed ATO when it joined the S&P 500 in Feb 2019 (when the stock was trading around $100 … currently it’s trading around $111), an investment in ATO would have gained 11% in 8 months (vs. 6.5% gain in S&P 500 during same period, for 4.5% of “alpha”) … painful way to learn the lesson to pull fresh data often instead of re-using an old stock screener.
ATO is one of the most consistently improving companies in the S&P 500 based on 30 years of history, especially for the past 14 years from 2004 to 2018. Let’s start by looking at the diluted earnings-per-share (EPS), my favorite metric:
Time is the friend of the wonderful business, the enemy of the mediocre.Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989
I like to start with diluted EPS because it provides a clean look at the earning power of the business from a shareholder perspective. Diluted EPS takes into account the effect of stock options, which may dilute the shares outstanding in the future, while also accounting for the benefits of stock repurchases (shrinking the shares outstanding). Based on the above chart, something significant happened in the 2004-2005 period that transformed the diluted EPS trajectory for ATO. Simply measuring the diluted-EPS compound annual growth rate (CAGR) from 2004 to 2018 shows 10.34%. I found a New York Times article from the 2004 period that explains: in Jun 2004, Atmos acquired the natural gas business from TXU for $1.93 billion, creating one of the largest distributors of natural gas. In particular, a quote from the CEO at that time (in 2004) reveals an amazing backdrop for the current picture of the company (in 2019):
”We’ve raised our dividend 17 years in a row [as of 2004], and I want our investors to know we want to keep on raising it,” Mr. Best said.Quote from June 2004: Robert W. Best, CEO of Atmos Energy, New York Times, “Atmos Buying Gas Operation Of TXU to Expand in Texas”, By Simon Romero
In 2004, Atmos said it raised the dividend 17 years in a row. Now let’s look at a picture of the dividend activity after 2004 to evaluate its dividend growth since then. The CEO Mr. Best wanted investors to know in 2004 that he wants ATO to continue raising the dividend. Let’s see if ATO was able to follow through on that desire.
When a company pays a significant and growing dividend, evaluating the growth in the stock price becomes only part of the total picture, because part of the total return comes from the dividend. The dividend-per-share compound annual growth rate (CAGR) from 2004 to 2018 is 3.37% … not a really great growth rate but the consistency is impressive nonetheless. But the below chart on dividend payout ratio below shows the company is able to reinvest a greater percentage of its earnings back into the business. Last year the dividend payout ratio was 35% in 2018, and two years ago the payout ratio was 48%, where prior to that the payout ratio was above 50%. I actually like to see this situation (growing diluted EPS, growing dividends-per-share, but a shrinking dividend payout ratio), because it’s possible the company has discovered good internal uses of reinvested capital that can grow future earnings.
Buffett Ratio (aka “RORE”)
The Return on Retained Earnings (“RORE”) measures the ability of the management team to reinvest retained earnings into the business. Specifically it compares the cumulative retained earnings over a period of time, with the growth in earnings per share over the same period of time. A long-term investor should avoid mediocre businesses that require constant reinvestment just to stay afloat (i.e. “money pits”); a long-term invest should seek excellent businesses that can payout dividends while also earning a good return on the capital reinvested. All those years in school studying finance and business, I did not understand the importance of this point … until I started studying Warren Buffett carefully via the books of his former daughter-in-law. I also recently discovered the book Buffett and Beyond by Dr. Joseph Belmonte, which gets at the same concept in a slightly different way (focusing on return-on-equity after dividend payouts). For short-hand, I refer to this school of analysis as the “Buffett Ratio” because I don’t know of any other investor incorporating this way of thinking. Since the 2004 period appears to be transformative for ATO, I will run 2 sets of calculations: (1) from as far back as I have data in 1989 to present in 2018, and (2) from 2004 to 2018. Under both periods, ATO generates approximately 23% from retained earnings over a 15-year and 30-year basis. See both calculations below:
- 1989-2018 (30-year period)
- Step 1: Cumulative Basic EPS over time period (1989-2018): $56.29
- Step 2: Cumulative Dividends-Per-Share over time period (1989-2018): $36.17
- Step 3: Cumulative Retained Earnings over time period (1989-2018): $20.12
- (Note: Step 3 = Step 1 – Step 2)
- Step 4: Basic EPS at beginning of time period (1989): $0.89
- Step 5: Basic EPS at end of time period (2018): $5.43
- Step 6: Growth in Basic EPS over time period (1989-2018): $4.54
- (Note: Step 6 = Step 6 – Step 5)
- Step 7: Return on Retained Earnings over time period (1989-2018): 22.56%
- (Note: Step 7 = Step 6 divided by Step 3)
- 2004-2018 (15-year period)
- Step 1: Cumulative Basic EPS over time period (2004-2018): $56.29
- Step 2: Cumulative Dividends-Per-Share over time period (2004-2018): $36.17
- Step 3: Cumulative Retained Earnings over time period (2004-2018): $20.12
- (Note: Step 3 = Step 1 – Step 2)
- Step 4: Basic EPS at beginning of time period (2004): $1.37
- Step 5: Basic EPS at end of time period (2018): $5.43
- Step 6: Growth in Basic EPS over time period (2004-2018): $4.06
- (Note: Step 6 = Step 6 – Step 5)
- Step 7: Return on Retained Earnings over time period (2004-2018): 23.14%
- (Note: Step 7 = Step 6 divided by Step 3)
Buybacks and Share Count
The other way management teams return capital to shareholders (other than dividends) is through stock buybacks. Not all stock buybacks are good, because the management team has to consider the stock valuation for a buyback compared with other investment projects (e.g. internal capital projects, buying another company, research and development, dividends). In the case of ATO, this management only had buybacks in 2 years: 2010 and 2012. This is probably the biggest red flag for me about this management team. The management team spent $100M in 2010 on buybacks, and another $12M in 2012. Generally I evaluate buybacks with a lighter touch for a Midcap or Smallcap company. But now that ATO has joined the S&P 500, I hope that the management team will add a more consistent share buyback program (even if small) to its capital allocation strategy.
The below chart is an ugly chart, showing a steady increasing annual share count over the past 30 years. As the management team expands its capital allocation strategy, ATO should include a regular buyback program as another way to return capital to shareholders, especially if the stock valuation is attractive relative to other investment alternatives.
Long Term Debt as % of Earnings
Many companies finance future growth through debt, so it’s an important step to check the financial stability and resilience of the company by checking the long-term debt as a % of annual earnings. Or stated another way, how many years of profits would be required to payoff the long-term debt? Generally Warren Buffett focuses on conservative balance sheet companies with long-term debt less than 3x to 5x the annual earnings. ATO is showing long-term debt of 4.1x annual earnings in 2018. Although the debt ratio appears manageable, since 2018 was an abnormally high year for earnings, long-term investors should monitor the ATO’s debt ratios going forward.
Current Ratio (Short-Term Liquidity)
As a final check on liquidity and balance sheet management, it is important to examine the current ratio that divides current assets (assets that can be sold within 1 year) with current liabilities (liabilities that come due within 1 year). ATO’s current ratio is around 0.2, which is another red flag from a short term liquidity perspective. A conservatively financed company would have a current ratio greater than 1, which would indicate that it could pay off all of its short-term liabilities with its short-term assets. The chart below shows the ratio has been trending downward since 2010. This might indicate a negative working capital situation where ATO’s customers are delaying payment to the company, while ATO’s supplier require payment upfront. As we saw from the 2007-2009 financial crisis, a company with short-term liquidity risks can quickly become financially insolvent (especially if the commercial paper market dries up). ATO’s long-term investors may want to observe this financial risk carefully.
For fun, I like to look at this website (J3SG) at the top 100 institutional holders of ATO. In particular, I’m curious about the firms that hold this stock as a top 10 position in the portfolio. I wonder if these investors view ATO as being an important investment in the portfolio:
- SFMG, LLC (Plano, TX, $736M in assets). ATO is #1 at 17% of portfolio.
- Maple-Brown Abbott (Sydney, Australia, $1.2B in assets). ATO is #3 at 11% of portfolio.
- Hennessy Advisors (Novato, CA, $2.0B in assets). ATO is #3 at 2% of portfolio.
- Partners Group Holdings AG (Switzerland, $816M in assets). ATO is #5 at 5% of portfolio.
- Seatown Holdings (Singapore, $547M in assets). ATO is #7 at 4% of portfolio.
- Centenus Global Management (New York, NY, $697M in assets). ATO is #8 at 2% of portfolio.
These regulatory filings never capture the full picture, because they don’t include short positions, stock options, and other assets in other investment vehicles. But occasionally an interesting value-oriented investor shows a concentrated position in one of these names.
Interest Rates, Valuation, Yield Curve
The interest rate environment is one of the most important factors when considering investment decisions. Below is a screenshot of the US Treasury Yields for various terms, as of Oct 25, 2019. The most commonly traded term is usually the 10-year US Treasury Bond, currently yielding 1.80%. The US Treasury Bond is considered a “risk-free” investment, because the US Government can raise funds through many sources such as taxation. Question: does the investment under consideration yield at least twice the 10-year US Treasury Bond? Twice the risk-free yield is a proxy for margin-of-safety concept discussed by Benjamin Graham. In other words, the investment yield could be cut in half and still be on par with Treasury yields.
Since the 10-year Treasury yield is 1.80%, a good investment would yield at least 3.60% (twice the yield). Below is a screenshot from the Yahoo Finance quote on ATO. The first 2 things I look: (a) the “earnings yield” (i.e. the reciprocal of the PE-TTM ratio), and (b) the “dividend yield”. ATO has a PE ratio (TTM) of 26.36, which equates to an earnings yield of 3.79% (reciprocal is 1 divided by 26.36). So ATO’s earnings yield (3.79%) is better than twice the 10-year Treasury yield. ATO has a forward dividend yield of 1.85%, which is better than the 10-year Treasury yield of 1.80%. From a valuation perspective, ATO is reasonable given the current interest rate environment.
The below chart shows Treasury rates Year-To-Date (YTD) Oct 2019, and it’s a terrifying picture for people who follow market cycles and interest rates. In a normal market, interest rates are progressively higher for longer terms. The academics call this the Term Structure of Interest Rates. For example in a normal market, the yield on a 2-year Treasury should be higher than a 3-month Treasury; a 5-year Treasury should yield more than a 2-year Treasury; a 10-year Treasury should yield more than a 5-year Treasury; a 30-year Treasury should yield more than a 10-year Treasury. Literally the entire banking industry is dependent on these normal interest rate relationships: a typical bank “borrows short and lends long” … meaning it accepts overnight funds from depositors pays them low interest, and makes long-term loans to businesses for high interest, and pockets the difference. There are entire industries (such as real estate) that depend on the availability of loans from banks. If banks ever decided not to loan money, many industries would become insolvent. When these interest rate relationships get inverted, the situation is called an inverted yield curve. Sophisticated investors know that (a) the inverted yield curve is an early recession predictor because slowing credit growth is a precursor to economic contraction and popping market bubbles, (b) being too early is the same thing as being wrong, (c) different parts of the yield curve invert early, and (d) the long-end of the yield curve matters more than the short-end. In other words, a 2Y-5Y inversion is noteworthy but a 3M-30Y inversion means the “party is over”. For the last 4 days in Aug 2019 and the first day in Sep 2019, the 3M-30Y inverted: 8/27, 8/28, 8/29, 8/30, 9/3.
For a detailed discussion of yield curves as early indicators, please see Deborah Weir’s classic book. I also think “The Agenda” by Bob Woodward explains the power of the bond market. Also worth reading the Fed meeting minutes with Alan Greenspan from the 2006-2007 period.
“You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of fucking bond traders?”President Bill Clinton, “The Agenda” by Bob Woodward. Reference via New York Magazine article “Bonds and Domination by James Surowiecki” published Mar 1, 1999.
For now it appears that the 30-year Treasury bond has returned to its senses, and comfortably yields more than the 3-month. It even appears as though the 10-year has returned from its crazy inverted notions and also yields more than the 3-month. The below chart shows the yields in Oct 2019.
The Aug-Sep 2019 “head-fake” bounce of the inverted 3M-30Y reminds me of the situations in early 2006, as seen in the below graph of the 3M-30Y yield spread going back to 1990. Throughout history, the sharp downward movements reveal mini-crises but the big recessions seem to happen after the graph goes below 0 (i.e. negative spread, or inverted yield curve). There is a mini-crisis in 19991, 1994, 1995, 1998 … but it doesn’t go negative until mid-/late- 2000 … the recession and market crash happens in 2001. Then there is a mini-crisis in 2002 but it doesn’t go negative until 2006 and 2007 … the recession and market crash happens in 2007 and 2008. We see more mini-crises in 2010, 2011, 2012, 2015, 2016 … but it dips below 0 in Aug 2019. Keep an eye on the yield curve.
The SPY chart shows the S&P 500 index since 1993. Sometimes bulls in the current market forget that the stock market highs of 2000 didn’t return until 2007 right before a big crash … we finally returned again to the 1999 highs in 2011. But in particular I see that in 2006, after the 3M-30Y inverted, the S&P still had another 20% run ahead of it. So I see 2 distinct risks from now until the next recession: (a) under-performing the market by 20%, (b) avoiding the major market crash once the major recession arrives.
For professional investors, which I define as people who manage “other people’s money (OPM)”, being early is the same as being wrong. Fortunately for me, I am not a professional investor, so I can “afford to be early in market cycles”. And I can “hedge my investment decisions” by earning a salary in my day job.
Based on feedback from close personal friends and advisors, such as my hedge fund buddy in London and my real estate buddy in Los Angeles, I will start to publish some analytics I developed around tail-risk options (aka “Black Swans”).
Atmos Energy (ATO) is one of my favorite companies in the S&P 500 Index. ATO is the sixth company I have chosen for a monthly article on this new blog. ATO has shown consistent dividend and earnings growth over the past 30 years, although there are some red flags on financial capital allocation (managing share buybacks, long-term debt, short-term debt). ATO’s current valuation is attractive relative to benchmark interest rates, although there are some troubling early indicators that we may be in the later stages in the short-term economic cycle. For long-term-focused investors, ATO is worthy of further study.
Disclosure: I own shares in Atmos Energy (ATO) as of publishing this article (Oct 2019). I have no intention of selling my position in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.