Down Market, Good Stocks, Southern Company, PepsiCo, Caterpillar (Episode 49)

At this moment in time, knowing that we're only maybe even halfway through this interest rate hike cycle, so there's at least another a hundred basis points to go this year, maybe another 25 to 50 basis points in increased rates next year. We're really just looking at these types of companies that have earnings, durability that will be able to survive the higher cost of capital. Really what's gonna separate, we think some of the leaders and laggards is the ability to invest in your own future growth. And so looking at utilities where they have really strong and durable earnings kind of sometimes because they have a captive audience, if you will, but also some favorable, you know, treatment in terms of a stronger dollar does help them in some of their pricing power and that kind of stuff. And so Southern Company is a stock that we like because they have probably about double the earnings growth projected over the s and p 500 and they have a very certain amount of revenue that's coming through and and that could even grow as they are able to pass along higher expenses to their customers as well. So we feel like there's just a feel of durability in this type of a name.

Well, I mean I really, it was just having made some really good investments in their own infrastructure. They've actually come a long way in 20 years pivoting from a base of power generation that used to be 80% coal and now it's only 20% coal. So now they're 80% in other areas, mainly natural gas, but the renewable inventory is coming online nicely as well. And so they've benefited from really good smart investments in their own infrastructure that's giving them a lot more pricing power in today and we believe going into the future.

I think so, and that's a question really about the type of market cycle that we're in. As rates are going up, we've already seen basically the destruction of the really high multiple PE stocks that's already happen and now we're starting to see at least some of the cyclical sectors start to be affected again by the higher cost of capital and lowering demand and things of that nature. And so there really is a picture here where you should consider, obviously it's a great dividend, it's about 3.7%. That's a healthy dividend. That's a good place to drive income. We certainly acknowledge that and we own it for some of those reasons ourselves. But also if you're looking at a company that has doubled a projected earnings growth than the broader index and like you said, revenue growth in the way that they've been able to sustain it over the last couple of years as well, this is not a stock that we would expect to double in share price, but when the market's down 22%, this is a great way to avoid some of that volatility.

And the answer is probably no. In that type of an environment then it does become a little bit less of a conservative type of a allocation period. And so we would certainly understand people wanting to to adjust how their portfolio is invested at that point in time. One of the things that we know about higher interest rates is that it makes the value of future earnings worth less. And so one piece of that dividend conversation is you get paid in today's dollars also when a high inflation environment you have, you know, money coming in now that you can use to offset higher costs. That's again conversation about where we are in this moment in the market cycle. As that changes, we would absolutely expect people to change their allocation models as well and so would we, but we think that that period of time is probably two years away in terms of when we get back to that more of a risk on environment.

At the end of the day when we have rates finally level off and right now we're seeing, you know, that terminal rate being priced in somewhere between four and a half and 4.7% and the grand scheme of things, that's not a really, really big number and the market will adjust to that, but it's the frame of time that we've seen from zero to that 4.5% that the market is having to adjust. And during that period of time we're gonna continue to see volatility in valuations. And again, this is a great way to store capital, making sure that you're not going down as much as the market that way you have a higher starting point when you do get to that rally or that new bull market when it starts.

No question. I just look at mortgages now, you know, we're getting to that point where it's two and a half times where we started in March and well, that means if you're a business that has to have some type of leverage or borrowing in your model, the cost of capital is usually up two and a half times as well. It's a hit directly to your profitability and that has to be absorbed in the short one and, and we're starting to see that be priced in by these markets as part of why we've seen some of the downside volatility recently, but it will normalize over time. We're confident of

Well, I mean, you know, they're dependent on a couple of things. One is their ability to negotiate basically that capital audience and Southern Company has three states that they service and they're the exclusive service provider for those three states. So that's one way they don't have really any internal competition because they know who they're servicing and where the second piece of it would be if the population were to change in those particular states and the states that Southern Company services happen to have had some really good population growth lately and that does help generate the better revenue picture that we've been talking about. Now, is that sustainable over a really long period of time? No, there's migratory patterns that definitely come into play here and there. There's also, you know, some policy decisions that affect where people want to live and and how their own pocket books are treated and that kind of stuff. But what we are saying is we can obviously recognize that places like Georgia and Alabama and Mississippi where they service have actually seen net population growth and that's better for their bottom

Another one of those earnings durability conversations, given again all the financial conditions that we've already been talking about prior to the Celsius acquisition, which has been genius by the way you drive by any high school or college campus right now. And it it's absolutely full of Celsius cancer, I guarantee it. That's

Before that, they bought FritoLay and Quaker Oats, and again, these are brand names that have loyalty, which leads to pricing power, meaning they can raise costs on their product to consumers a few cents here or there and they'll still complete the sale. They're not pivoting away from these, they're certainly not looked at as luxury brands, if you will. They're daily staples that people will consume in terms of cereals, potato chips, sodas, and then let's not forget, they also own the Mountain Dew and Gatorade franchises, which have been adding new brands and new flavors significantly over the last three years. So even during Covid we're starting to see different things come out. And one thing in particular that's been very popular in addition to the Celsius energy drink is the protein line of Gatorade supplements that have been very popular now that gyms are back open, sporting events at the youth level and competitive level, college level are back around. That's really where Gatorade has made its bones, if you will, with all of that brand loyalty. And now they're coming out with more innovative products that are higher margin products that they're able to actually profit more from. So they've really, PepsiCo as a complete brand has grown their footprint with consumers significantly even through the Covid shutdown.

I really think that there is, and obviously that is, you know, part of the marketing genius of what they have been able to do and connect with that next generation of consumers constantly. And that really is, if you drive by any little field ballpark, whether it's you know, soccer games or whatever, if you're near youth sports, you're seeing that Gatorade logo everywhere you go and now it goes into preparation with protein. They have electrolyte heavy drinks for recovery afterwards. They're really giving you the full cycle of what they think are the best possible supplements to make you a better athlete. Everybody wants to be Tiger Woods or Michael Jordan or Roger Feder, whatever it is. And if I can have the access to this type of a supplement that will help me perform at that level, they've done a great job of painting that picture for a couple of generations now and making people feel like they need this in order to be performing at their best level. It creates that type of loyalty where they really will spend a little bit more for these premium beverages and maybe not have as much Pepsi or Diet Pepsi, but that's one of the genius things of the company overall is they're not really cannibalizing their own profits, they're simply growing their margin through different brands.

Well, yeah, I mean, and I think that's why they've obviously made these types of acquisitions in investments in that, you know, soda by itself, if you will, is boring. And especially, you know, some of the lower calorie, you know, you have some of the Pepsi Zero and those types of things that are out there and for specific dietary needs and those people that are wanting to watch both sugars and carbs and things of that nature, they have a solution for that. But it's a, it is a declining portion of their portfolio, which is why we think we've seen some of these key acquisitions over this period of time to stay in touch where there's, it feels like there's a little bit more of a value add. I'm bringing you this caffeine in a Celsius can really is what it comes down to. But there's also a couple of other, you know, vitamins in there to help with your, your daily vitamin intake in that kind of stuff.

And so they've done a really good job of providing that value add that feel that I'm not just drinking a Coke because I like the sugar in the caffeine, I'm getting something else from it as well, whether it's athletic performance or a little energy for myself before I go into a big meeting or to, you know, this big long class while I'm on my college campus and things of that nature. So they've really paid attention to what the market wants and then providing a solution that they can obviously get on the shelves, which I think is another piece of this particular company that we really like is that they've, in this period of supply chain disruptions, Pepsi has spent a lot of time and effort closing that logistical loop to make sure that they've had no slowdown in production and they've had no slowdown in delivery.

And that's one of the reasons that we see a lot of growth in their earnings as well as some of the profitability because they're on the shelves where some other manufacturers have fallen short of supply and they're not selling as much as before. In fact, Pepsi is investing in a brand new distribution facility here in Denver, Colorado where it's gonna be the largest bottler in the country, essentially located. You've got access to rail air or really good highway systems. So they're gonna be able to maintain that edge in the supply chain where some other manufacturers have kind of fallen short. And so combining their skill set by being excellent marketers like we've been talking about, with the ability to logistically get products from A to B and close the sale, that's an really important part of the business cycle. You can have all the inventory in the world, but if you can't get it to your customers, you're not closing that sale. And that's what Pepsi I think has also done better than some of its peer group.

Yeah, no question. There's a really steep learning curve in what happened and we're starting to see these types of solutions come where rather than relying on just the coast, one coast or the other as a main hub of distribution, you're starting to see these larger global companies move to the interior of the United States for a hub where they can onshore productivity if you will, and have a better sense of that supply chain and its integrity at any moment in time. There's much less disruption. What we did see from a lot of these companies is the willingness to innovate when it became much too costly to use shipping containers. We started to see these companies use airplanes and fly cargo in because the cost difference really was negligible. It was about how can we get the product here so that we can close the sale and generate that revenue that comes into our balance sheet. If not, it's just dead cargo sitting somewhere and it's losing money for us no matter what. And so that key innovation, the ability to be responsive to some of these problems, I think will absolutely pay dividends for these companies going forward.

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Yeah, absolutely. And you know, manufacturing and durables has been kind of a hard hit sector by the supply chain. The lack of available chips has obviously impacted the auto manufacturers. We heard that Ford last week came out telling us they've got 45,000 cars sitting somewhere that can't be completed because they're missing components. Caterpillar has been able to negotiate those contracts, just like we were talking about with Pepsi. They were able to go back and find out what were the critical components they have to have in order to finish the manufacturing of these machines because they're gonna be in really high demand. We feel really good about Caterpillar. It's actually one of the larger earnings per share growers that we see in this current environment because you have the confluence of both the inflation reduction act as well as the infrastructure spending that is going to be advantageous to construction spending in our personal opinions.

So we've seen what we believe is about 12% earnings per share growth projected along with that 3% dividend yield, you're looking at probably expected annualized returns over the next three to five years of somewhere around 14 or 15%. That's double what we're seeing in terms of annualized returns for the s and p 500. So again, it's a relative conversation. It's not going to be a Tesla in your portfolio where it's gonna double in share price every three years, but relative to where we are now in this market cycle, if I could bring to you an idea that looks like it's gonna earn even somewhere between 10 and 15% as a range, then that seems to be a very attractive place again to start building back in your portfolio until we do get to more of that full growth on type of an allocation a couple of years from now.

Yeah, no question and I certainly agree with that. It would definitely fall more in a cyclical category, but if you take a look at where we are at the moment, it's got a PE under 13 and a price to book of around five and a half. And so in terms of its actual value right now, and given everything I've just laid out in terms of their expected returns, this is a particular company that is well positioned to take advantage of the environment that we're currently sitting in. There are other large manufacturing, you know, producer, durable type companies that definitely are not in the same posture that Caterpillar is. They are having trouble with their supply chains, they are not able to finish the farm implements that some of the other peer group people are in this particular category where there's short of the raw components and materials that they need to finish their products. Caterpillar has, I think, overcome those hurdles in a way that they're uniquely positioned to benefit from a large investment in government spending at the same time, but that we're seeing some commercial building booms regionally that they'll be able to take advantage of as well.

Yes, I hear you. I understand you. And welcome to the world of government permitting and here we are now, I think almost two full years from the passage of that particular piece of legislation. And what we're now seeing is down at this state and county and city level projects have been approved, bids have gone out, permits have been issued, and we believe that in the next 12 to 18 months you'll see a significant pickup in the actual activity in terms of breaking ground and projects moving forward. It does take that long, unfortunately, in this process to apply for the grants cuz this is a federal program. If you're a state or a local municipality, you have to apply for that money through a process. Then once it's approved, it has to be permitted. You have to hire the contractors. Those contractors are gonna hire Caterpillar for the earth movers and the bulldozers. And that's where we see this ripple effect going on. So there's no question there's been a lag in that money going to work, but we feel like we're at the point now that it rolls over and the projects will begin in the next 12 to 18 months.

Well, I certainly appreciate that. Thank you so much. You can always go to our website, which is www dot zach's im.com, that's for Zach's investment Management, and there's a tab at the top that says blog. All of our research reports and our weekly commentaries are there. They're filed by time. So you'll see the most recent stuff first. But we're more than happy to be transparent and share all of our thinking about what we believe in terms of what's going on economically, but also where we see opportunities in the investment world as well. So we definitely appreciate the opportunity to be with you today. Thank you so much for having