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Are These Stocks Tricks or Treats?

Jason Hall, The Motley Fool

With the recent market volatility, many stocks have fallen to near 52-week lows. In this episode of Industry Focus, Nick Sciple is joined by Motley Fool contributor Jason Hall to discuss several of these stocks to determine whether they are a "trick" or a "treat" for your portfolio, and break down whether the market's recent swoon should have you spooked.

A full transcript follows the video.

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This video was recorded on Nov. 1, 2018.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, November 1. In the spirit of Halloween, we're breaking down some energy and industrial stocks near their 52-week lows to decide whether they're a trick or a treat for your portfolio. I'm your host, Nick Sciple. Today, I'm joined by Motley Fool contributor Jason Hall via Skype. How you doing, Jason? 

Jason Hall: Trick or treat, Nick. Trick or treat, buddy.

Sciple: Trick or treat. Jason, I wanted to ask you, just moved from California, across the Atlantic to Ireland. How was it? You have a young son. How was your experience trick or treating for the first time over across the Atlantic?

Hall: Dublin, Ireland. I have to say, it was interesting. We were looking at our calendar before we came over, and saw Halloween and started talking about it. My son's a little under two, so we love dressing up him up in these costumes and that kind of thing. And we were like, "I don't think in Europe, it's that big of a deal." It turns out, Halloween is a huge deal in Ireland. We learned last night -- we were on the seventh floor, which would be the eighth floor in U.S. terms. The eighth floor is where our apartment is. We have balconies on both sides of the building. They set off more fireworks on Halloween night in Dublin than most American cities that I've lived in set off on July 4th. That was a new experience for me, I have to say. It was interesting. 

Sciple: What did your son think about all the fireworks and all that stuff going on?

Hall: He was kind of interested right up until he was ready to go to bed and he was no longer interested. Then he was just mad about it, which is pretty funny, for a 21.5 month old to be mad about fireworks.

Sciple: He didn't plan any of that.

Hall: No, no.

Sciple: We're going to talk about some stocks near their 52-week lows. But with the volatility in the market, I think I'd be remiss if we didn't spend at least a couple minutes talking about what investors should be thinking about this volatility for their portfolio. I pulled some stats earlier this week. Almost half of U.S. stocks are more than 20% off their 52-week highs. We've had a little bit of a bounce-back in the markets over the past couple of days, but that number is still probably holding true. Global stocks sold off nearly $8 trillion in October, which is the most they'd sold off since 2008. We're really seeing the return of volatility to the markets. How should investors think about that when looking at their portfolios? And what kind of decisions should they make in these circumstances?

Hall: Anecdotally, something that's really valuable to share with people, you and I have actually talked about this over the past week as we were planning for the show, about our own personal experiences. At one point when you and I were talking, it was probably toward the end of last week, my portfolio was down like 22% from the peak. I think at that point, the S&P 500 was down 9.4% or something. There are a lot of us that have experienced extreme volatility that's even more than the market itself. But within the greater context, my portfolio, even at that point, at that low, continued, over the long-term, to outgain the S&P 500. I don't get caught up in these short-term things and start planning exit strategies and that kind of thing. My greatest strategy in terms of exit strategy -- I'm 41, I'll be 42 in December. I'm thinking about another 40 years that I'm going to be alive, hopefully, that I have to plan for. It's just like any other asset that I own -- I don't freak out and figure that I've got to sell it just because the market changes. I'm not going to sell my home just because property values fall in my neighborhood. 

The way that I've actually looked at this is, this is a buying opportunity for anybody that has 20 years or more to live. You have to think about growing your assets and growing your value. This just another opportunity to look at that volatility, to use it as a tool to increase the value of your portfolio. I just made a substantial contribution to my 401(k), and over the next few days, I'm planning to invest a fairly substantial amount of money in several different companies that I've been looking pretty closely at. 

Sciple: When we look at stocks, they're one of the only asset classes where the price can go down 20% and people are less willing to buy than they were yesterday. Any other market out there, it goes on a 20% sale and you're rushing out to buy it. Stocks just don't seem to work that way. But if you can get your mindset over the long-term, and really focus on what you're trying to do, building wealth over a lifetime, times like this can really create an opportunity for investors that keep that long-term mindset. 

That's what we're going to talk about today. The first stock we're going to talk about today is Nucor (NYSE: NUE), which is one of the largest steelmakers in the world and the largest in the United States. They were close to their 52-week low at $53.70 this week. Today, they're trading at $59.35. What do you like about Nucor? Is it a trick or treat for investors' portfolios?

Hall: It's interesting. I'll say right off the bat, I think it's a treat. It's a great company. It's absolutely dominant in its industry. It's incredibly well-run. Its management has a great history of capital allocation. And it's in an industry where the most important thing that management can do is allocate capital well and manage the balance sheet across the different cycles. We're going to talk a little bit about, because of the cyclicality of the steel industry, the impact of tariffs, how demand can swing the entire industry from profit to loss in a very short period of time, there are some risks. But in general, I'm a big fan of Nucor. I really am.

Sciple: Talking about how Nucor has been able to manage their balance sheet, Nucor is a dividend aristocrat. They've raised their dividend for 45 consecutive years, every year. They're almost to a dividend king. That would be raising their dividend 50 years in a row. They've really, as you mentioned, done a great job of maintaining their balance sheet, both when the steel market is at its cyclical peak and when it's at its cyclical bottom. Particularly at the bottom, that's where Nucor really shines. Having that strong balance sheet, they're able to pick up some inexpensive assets at the bottom of the market. Do you want to talk a little bit about what Nucor has been able to do there, and what opportunities it's given the business over the long-term? 

Hall: Over the past ten years, the company has invested something like $8 billion, primarily in acquisitions, but also in some internal investments, also in some share repurchases, to add value, to add per-share returns. The key thing about these investments is, management knows the industry really well. Their CEO has been with the company for multiple decades at this point, knows the steel industry incredibly well. The company has been able to leverage its balance sheet. We're talking about an investment-grade credit rating. I don't think there's any other steel company that comes close to having that kind of credit rating. It's able to get access to capital really cheaply, and then it can deploy that capital at the bottom of the market. 

Steel is an industry where, when the market's down, companies are selling off assets at fire sale prices a lot of times just to keep the doors open. They might be selling off an acquisition that they bought at a high premium at the peak of the market a decade before. Nucor is able to swoop in and add these bolt-on parts to its business that add leverage. It's not just about adding scale or volume. It's about adding the right kind of additional capacity. Maybe growing in a segment of the market that it doesn't really have enough strength in, or a place that it knows that the market is going to be growing demand. The company's been really good at doing that, and it's been able to use those acquisitions to get really quick accretive returns.

One of the nice things about acquisitions, if you do them well, as Nucor has, is that it can turn those investments into per-share extra earnings within a year or so. That's been a good thing that it's been able to do, and it's been able to push its earnings per share back up to its pre-financial crisis peak here over the past few quarters. 

Sciple: I'll say, just personally, I've had a little bit of a relationship with Nucor acquisitions. My girlfriend worked at a subsidiary that was acquired by Nucor a little over a year ago. I got to watch how they put in their company culture. They really tightened up ship. It had been a family run business prior to that. Once Nucor came in, they put their culture in place, did some reforms in the front office to bring things in. It's really a well-run business. It was remarkable to see how quickly they were able to change the culture of that business and get efficiency up and going.

Let's talk a little bit about the cycle again, Jason, for our listeners. We're at a five-year high in cold rolled sheet and strip steel. We're at a five-year high in iron and steel, that was reached in August. We're also at a five-year high in steel pipe and tubing. So, we're really looking like we're at a cyclical top. Part of that is going to have to do with tariffs that were put in place earlier this year. President Trump put in place 25% tariffs on foreign steel. That has led steel prices to increase more than they would have otherwise.

Hall: No doubt about it. 

Sciple: Looking forward, how should we think about these tariffs with respect to Nucor? How does it affect the thesis over the long-term for the business?

Hall: I'm actually going to rewind back four or five years ago. North American steel demand has been above pre-financial crisis peak -- we can go back to probably four years ago, actual demand was at those super high peaks. But because imports were consuming well over a third of the domestic market, the domestic steelmakers were just not getting the big benefit of that high point of the cycle that we had seen in prior years. We can even go back to under the Obama Administration. There were duties and tariffs and trade actions that were being put into place that were much more surgical, targeting very specific kinds of steel out of very specific places, that were having some impacts on that. But, they were pretty narrow, and the impact would only last for a few quarters, and then these guys would figure out how to skirt it again.

So, I think in general, these tariffs have been very good for somebody like Nucor because they're so dominant and they're so big. I think the bigger concern is, now that we've seen these massive surges across the board, the question is, how much of that impact is going to start affecting demand? It could be another couple quarters, it could be another couple years. It's really hard to predict. I think that's the crux. As an investor, if you're thinking about the steel industry, this why Nucor and maybe Steel Dynamics -- another one that I like -- are really the only ones that are worth considering as long-term investments. So many of the other steelmakers, like U.S. Steel, AK Steel, their cost structures and manufacturing structures are not set up to do well over the cycles. They don't have the balance sheets to bounce back like Nucor does when the steel market does get weak.

Sciple: Right, Jason! Nucor's management has proven over previous cycles that they know how to allocate their capital in a way that other steelmakers really have not been able to do. You can really trust, as an investor, that they're going to be good stewards of your investment, regardless of what the steel market looks like one year to the next.

Hall: We're already starting to see that with the shift in their focus over the past few quarters. They've started shifting away from targeting external acquisitions. They've started announcing these internal investments, adding capacity, adding certain kinds of production in certain areas. These projects, they're internal investments, so there's going to be some difference in the payoff. They announce an expansion of a steel mill or a certain facility, it's going to take a few years to build that out, and they're going to spend a few hundred million dollars over that period that they're not going to get any return on that invested capital. Over the next few years, as they prioritize these internal capital expenditure projects, we could actually see a few years where the return on invested capital actually gets squeezed a little bit. But, again, that's more an indication that management is starting to do the right thing, and they're not overpaying to acquire an asset when they can take that same money and they develop something in-house that's going to pay off over the long-term with better returns.

Sciple: Right, Jason. I think that's an important thing to remember in any cyclical industry -- having a management that can really navigate those cyclical peaks and valleys. 

Jason, on the second half of the show, the second stock we're going to talk about is Beazer Homes (NYSE: BZH), ticker BZH. Beazer Homes is down 59% from its highs on the year and it's trading at $8.90 versus its $8.16 52-week low. Is it a trick or a treat for our listeners' portfolios?

Hall: I have to say, when we first started looking at this, I was really tempted to say that Beazer was a treat. But I just keep coming back to their model and where they focus, in terms of the houses that they build and the market they focus on, and I'm going to say it's a trick. And that's for a company that's saying that they're going to generate $2.50 in earnings per share next year. So, it trades for around 4X next year's earnings. But I don't think they're going to make that. I don't think they're going to get that number. I don't I don't think their model supports it, based on everything that we know about where the housing industry is right now. So, I'm going to say it's a trick.

Sciple: To pull the thread on where you're going there, Beazer focuses on homes that are a little bit above entry level. Their average selling price is $365,000, which is up 7% year over year. That the price is ticking up. Compare that to, according to Zillow, the median U.S. home value is $220,000. Beazer is selling homes that are, on average, 50% higher than the market. 

What we're seeing now is, the age of repeat homebuyers -- the buyers that would be inclined to not buy starter homes, to buy their second home -- has been trending up for about 20 years. However, the age for entry homebuyers has been stagnant at about 32 going back to 1997. As we're seeing interest rates rise, it seems to be the case that repeat home buying age will continue to tick up. Those first-time homebuyers, those millennials, they're getting ready to get in their first home at age 32 on average, they're going to be where the demand is coming from in this market going forward. What are your thoughts?

Hall: Absolutely. I think, to a certain extent, Beazer is setting itself up to really miss that market opportunity. I know the company has made some progress, they've made some steps. Their balance sheet continues to be a concern. At the end of their last quarter, the company had around $1.3 billion in total debt. That's about the same amount of debt as Meritage Homes, which does around 60% more revenue per year. And, Meritage is also focusing on the entry-level market. 

Homebuilders are very leveraged companies in general. They buy a lot of property that sits on their books for a couple years at a time as they're developing it before they sell it, so they're paying all this interest on it. They carry a lot of debt. They're pretty leveraged. They're also more at risk because of that. Just like steelmakers, homebuilding is a cyclical industry. When the cycle goes down, the tide goes out, the guys that are swimming naked that we find out about. They're the ones that continue to add property and add debt to add that property that they now have on their books. And now, all of the sudden, they're not selling the homes at the same levels they were. Then, that debt really becomes a problem. 

They've taken steps to ameliorate that sum. They say they're going to pay off another tranche before the end of the year. But they're still going to have one of the most leveraged balance sheets in the industry, in terms of debt to EBITDA. And they're not shifting their portfolio enough to really meet where I think the market's going to go.

Sciple: I touched on this earlier -- as rates increase, folks who don't have to buy a home are probably going to avoid making those choices. People who want to have a family and have to buy a home for their life stage choices, they're going to be where the demand really comes from over the next three years or so as the market peaks. 

Hall: I think so. If you are really interested in, because this is a very cyclical industry, I think anybody that's looking to get a pop return, to buy it and get a big return in six months or a year, despite all the obvious unpredictable things, like, who knows what the economy does, some surprise that nobody expects out of nowhere that hits the market, all these things that we can't predict. The things that we can definitely look at are rising interest rates. The big demand is from entry-level buyers. Before I would ever consider buying Beazer, I would certainly look at Meritage Homes. About 85% of the property that they buy is targeting entry-level homes. Their average selling price is actually falling, which sounds backwards, that that would be a good thing. But it's good. It indicates that their strategy to shift away from step-up homes into more entry-level is starting to pay off, and they're selling more of these entry-level homes. That should set Meritage up much better in the near-term, and certainly better over the long-term, as the better investment here.

Sciple: Let's go to our last stock we're going to talk about today, which is Pattern Energy Group (NASDAQ: PEGI), ticker PEGI. Pattern Energy is down about 21% off its highs. It's primarily a wind and solar energy company. Do you think Pattern Energy is a trick or a treat for our listeners' portfolios?

Hall: I'm going to say it's a treat, but I could get tricked. I'll be honest about that. I'll be blunt about that. If you think about the industry that it's in, it's a renewable energy producer, primarily wind. They're looking to invest in other assets like distribution, storage. They're looking at solar assets. The reason that it could be a trick is, it already pays basically all of its cash flows out in dividends right now. The end of last year, the end of 2017, it froze its dividend, stopped increasing its dividend, to maintain cash flows. There have been some things that were a product of federal tax reform that have actually been bad for renewable energy companies in terms of investments, getting access to capital. That's weighing on it.

But I like the management a lot. I really do. It has a privately held company, Pattern Energy LLC, that's a big project developer that backs it and shares the same CEO. Their CEO has a 25-year history of developing renewable assets. And I think his skills and the skills of the people around him of riding out these different markets should pay off. Today, you're looking at a 9.5% yield. If you're an income investor and you need that yield, I wouldn't recommend it. But I think DRIP-ing that yield back into new shares is going to pay off over time. Once the funding situation clears up, I think this is going to be a market-beating stock.

Sciple: I'm going to zoom out and talk about the history of Pattern Energy, and how it's gotten to where it is. It IPO-ed in 2013. Since that date, they've tripled the size of their energy portfolio. Their cash flow is up 135% since their IPO. Their dividend's up 35%. All that sounds great. But the other side of the coin is, how did they finance that growth? 

Hall: Shares and debt, baby. Shares and debt.

Sciple: [laughs] Yeah. The share count is up 92% since IPO, and they've borrowed $2.3 billion since IPO. Over half of its enterprise value is now put in place in debt. As you mentioned, they're paying almost 100% of their distributable cash in dividends. This is a company that has had incredibly growth, but the way they've financed that growth has really left equity investors holding the bag a little bit. Even if you count in the dividend, since IPO, they're only up 10%.

But, with that growth, they have opportunities to grow going forward. What are your thoughts on their ability to delever that balance sheet and their growth opportunities for the next five years? Do you think they're going to have to use as much debt and equity financing to get the growth that they need going forward? 

Hall: I think to a certain extent, management has learned a little bit of a lesson here, in terms of operating on the public side as opposed to private in the past. I think they've learned that you can't completely rely on equity, selling stock, to fund a substantial amount of your growth. I think that's one of the reasons they decided to go ahead and freeze the dividend and let things play out a little bit, let market calm down. They also sold off one of their facilities in Chile, and they sold it at a higher premium than they paid for it. That's a very good thing. Ideally, they'll be able to use the proceeds of that to make another investment somewhere else that's a little closer geographically to some of their other facilities. That would help with other operational costs, which would yield bigger returns. I expect that they'll be able to be savvy doing that thing. 

I think the big thing that's going to drive it is going to be demand growth. Renewables continue to become more cost effective, cost efficient, in terms of producing power. They're very competitive in most of the world with coal and natural gas. That cost benefit alone is enough that they will find access to capital to be able to grow. Over time, even adding debt and still issuing some shares, they will start to give per-share cash flow growth, the dividend will start to grow again, and over time, the dividend growth will make this a good, solid investment.

Sciple: Talking about these risks for Pattern Energy, why should investors look at Pattern Energy over some other opportunities in the renewables space, like TerraForm Power or Brookfield Renewable, which might not have the same risk profile we're looking at with Pattern Energy?

Hall: If you're an investor that's willing to take on a little bit more risk, the market has been so down on Pattern for so long, that yield -- for example, TerraForm Power, which I love and also own, pays about a 6.7% yield right now. Pattern Energy's yield is about 40% higher. That's a substantial boost in returns over time, even with the fact that TerraForm Power should be able to increase its dividend 5-10% per year over the next few years, while Pattern's dividend is probably not going to grow for the next two to three years at all. 

Again, if you're willing to take on more risk. If things don't get better for Pattern, it may have to cut the dividend a little bit to generate excess cash flow to strengthen its balance sheet. That's the big risk there. But if you're a little more risk-averse and you're really looking for something that you can buy and hold and not have to worry about, and that you can pretty regularly count on your dividend going up, I do like TerraForm Power a lot. That might be the better investment for a lot of people simply for peace of mind. TerraForm Power is also a regular S corp, so you can buy it in your retirement accounts and it's easy to deal with.

Brookfield Renewable, on the other hand, is a master limited partnership. There's unrelated taxable business income, UBTI, that some of these master limited partnerships pay out that can make you have to pay taxes even in your retirement account. Brookfield Renewable doesn't pay that. But, some brokers still won't let you own it inside retirement accounts. So, if you're looking for retirement account stocks, TerraForm Power just might be the safer investment. 

Brookfield Renewable is really interesting because it owns like 30% of TerraForm Power. That should tell you a lot about its view, in terms of TerraForm Power's prospects. They're both controlled by Brookfield Asset Management. It's one of the biggest, most well-known infrastructure asset management companies in the world. You can't beat them all. 

For me, the higher yield that Pattern is paying today, how beaten down its stock is, if you're willing to stomach the risk, I think you're going to get a better return, with the risk that things could turn south.

Sciple: One follow-up there. What would you say to investors that say, "I know renewable is something that's going to grow over the long-term. I've seen estimates that, to switch over our carbon-based power plants, we're going to have to put a lot of investment into that." What would you say to an investor that said, "I'm just going to do a basket approach with these guys, buy a little bit of everything and get exposure to the space?"

Hall: If you're looking at these yieldcos, these independent power producers, I think that's a reasonable approach. A lot has shaken out in that space over the past two or three years. 8point3 Energy, which was SunPower and First Solar, that was their shared yieldco, a lot of investors lost money there. TerraForm Power was a terrible investment until Brookfield Asset Management took it over. Now, it's turned into what looks like is going to be a great company.

I think now, it's a pretty reasonable way to look at these yieldcos. I wouldn't do that with the entire renewable energy space. Look at solar panel makers, for example. That's still a scary space. It's kind of the wild west. There are a lot of low-cost Chinese solar panel makers where I wouldn't pay a dime for a dollars' worth of their stock. So, I think with this space, it's a reasonable approach.

Sciple: Awesome, Jason. I know renewables is something we're going to follow over the next few years. I'm sure I'll have you on later to break it down once again. We gave investors a couple treats and one trick to watch out for in their portfolio. If there's any other businesses y'all want us to cover, tweet us @MFIndustryFocus and we'll be happy to answer whatever questions you have. Great to have you on the podcast, Jason. Looking forward to having you on again in the future. 

Hall: Always fun to be on. Cheers, take care! 

Sciple: Thanks so much! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any of the stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Steve Broido for his work behind the glass. For Jason Hall, I'm Nick Sciple. Thanks for listening and Fool on!

Jason Hall owns shares of First Solar, Meritage Homes, Nucor, Pattern Energy Group, SunPower, TerraForm Power, Zillow Group (A shares), and Zillow Group (C shares). Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Zillow Group (A shares) and Zillow Group (C shares). The Motley Fool recommends First Solar, Meritage Homes, and Nucor. The Motley Fool has a disclosure policy.