This Energy Stock Could Double By 2021

Three reasons annual reports are becoming irrelevant... A look at why one company's shares recently imploded... The best source of new and timely investor information... This energy stock could double by 2021... Another high-upside investment opportunity...

1903 was a year of historic firsts...

The newly established Ford Motor Company (F) took the first order of its brand-new Model A car. And the board of directors for the newly formed U.S. Steel Corporation (X) – a group that included industry titans John D. Rockefeller, J.P. Morgan, and Charles Schwab – published the company's first-ever annual report to shareholders.

Given the arc of automotive innovation since the eight-horsepower Model A rolled off the assembly line, you might assume the same is also true for corporate annual reports... But you'd be wrong.

Today – 116 years later – U.S. Steel investors get a balance sheet and income statement in a similar format. Corporate financial reporting has essentially remained frozen in time.

In their 2016 book titled The End of Accounting, authors Baruch Lev and Feng Gu explain that failing to keep pace with the evolution of American business has produced a startling result for investors: The basic financial report that publicly traded companies crank out every quarter has been growing less and less relevant for decades.

By their estimation, financial reports comprise just 5% of what investors really need to make informed decisions. They attribute most of this growing irrelevance to three factors...

1. The inexplicable accounting treatment of intangible assets

2. The rise of subjective managerial judgment

3. Delays in recognizing important business events

In today's Digest, I (Mike Barrett) will take a closer look at each...

We'll start with the treatment of intangible assets – things you can't hold and touch, like Allergan's (AGN) Botox brand or Google's search algorithms.

Intangible assets have tremendous value because they give their owners special rights and privileges. But archaic rules implemented decades ago prevent accountants from recognizing these internally developed intangibles for what they really are: assets that deserve to be on the balance sheet.

Consider Facebook (FB), one of the most recognizable brands on the planet. Billions of customers use its social media services daily.

As of December 31, 2018, the net value of Facebook's tangible assets – primarily cash, marketable securities, data centers, and networking equipment – was about $23 per share. Intangible assets (mostly related to the acquisition of customers, technology, and patents) totaled $7 per share.

Meanwhile, shares currently trade more than five times higher, around $173. Most of that extra $143 is attributable to the value of Facebook's internally developed tangible assets. In other words, more than 80% of Facebook's corporate value doesn't show up on the balance sheet.

It's no wonder financial reporting has lost relevance over time.

Just last month, investing legend Warren Buffett notified his Berkshire Hathaway (BRK-B) shareholders that he's ditching book value, an investment metric he has relied on for almost three decades. The reason? As Buffett put it...

Accounting rules require our collection of operating companies to be included in book value at an amount far below their current value, a mismark that has grown in recent years.

The second reason financial reports are becoming irrelevant is the rise of subjective managerial judgment...

Lev and Gu like to say accounting is no longer just about facts... and is becoming increasingly reliant on judgments, estimates, and projections.

Virtually every income statement item and balance sheet value incorporates some level of estimation. Even revenue isn't immune.

Look at the 2017 annual report for industrial conglomerate General Electric (GE), for instance... You'll find the word "estimate" five times in the description of how sales of goods and services are recorded. Unfortunately, no one outside the company knows just how much of the revenue line is an estimate, because no such disclosure is required.

The third and final reason is due to delays in recognizing important business events...

Accounting involves meticulously recording transactional items like sales to customers, purchases from suppliers, and interest paid on loans each quarter.

The problem is, many business events – like the loss of an important customer or key executive, disruption of a lucrative product, or the failure of a clinical trial – are non-transactional and can't be captured so cleanly in real time.

The accounting recognition of such events is often delayed until they directly impact asset values, expenses, or revenues... But they often have dramatic and immediate impacts on corporate value.

A prime example of this is Stamps.com (STMP)...

After the market closed on February 21, the Internet-based provider of mailing and shipping solutions reported its fiscal fourth-quarter results. A few minutes earlier, the stock had closed around $198.

Then, about 15 minutes into the conference call with analysts, CEO Ken McBride dropped this nuke on listeners: "We decided to discontinue our shipping partnership with the [U.S. Postal Service] so that we can fully embrace partnerships with other carriers."

STMP shares imploded, closing the following day around $84... a single-day plunge of 58%.

In the February 1 Digest, I explained that a company's share price is really the present value of the free cash flow ("FCF") it's expected to generate in the future. With Stamps management lowering 2019 estimates for customized postage revenue 30% to 40% and increasing operating expenses 9% to 14%, the company's future FCF will be materially lower – hence, the draconian share-price adjustment.

In short, while the dissolution of this key partnership will play out in the company's financials over the next year or two, its impact on corporate value was felt immediately.

So... if company reports aren't the best source of new and timely investment information, what is?

When Stamps management decided it was time to share the bad news about terminating the partnership with the U.S. Postal Service, it didn't issue a press release. It didn't say anything specific about it in its fourth-quarter earnings release. Instead, it delivered the news during the regularly scheduled quarterly conference call.

This underscores a key point I'd like to make today: Quarterly conference calls are an important source of new and timely information for investors.

For our Extreme Value models, sometimes they are the only source of critical information – like guidance on the effective tax rate, or the breakdown in revenue by product line or customer type.

Public companies typically only report what they're required to in their annual and quarterly reports. To really understand the business, you need more information. That's why JPMorgan analysts recently reviewed some 25,000 conference calls, presentations, and Q&A sessions.

Links to the latest conference-call transcripts for widely held stocks can often be found for free on Yahoo Finance. Other subscription-based websites provide access to several years' worth of transcripts for thousands of companies.

To make the most of my research time, I focus on three questions whenever I evaluate a company...

1. What are the competitive advantages, and how is the company sustaining them?

2. How will the benefits of those competitive advantages (and the costs associated with them) affect future cash flows?

3. Am I paying a price for those future cash flows that put the odds in my favor?

Answering these three questions can often be done without ever laying an eye on the annual report.

Take energy-infrastructure giant Kinder Morgan (KMI), for instance...

Dan and I recommended shares to Extreme Value subscribers in September. In this particular case, I relied primarily on presentations and earnings releases available from Kinder Morgan's website. Conference call transcripts were helpful as well.

Earlier this month, Kinder Morgan executives presented at the Barclays Investment Grade Energy & Pipeline Conference (which you can view here).

Not many companies can illustrate their core competitive advantage on a single PowerPoint slide, but Kinder Morgan does on the sixth slide of its presentation. It's a map of North America, depicting the location of its key assets – the largest collection of energy infrastructure owned by a single company anywhere in the world.

Kinder Morgan's 70,000 miles of natural gas pipelines are the company's crown jewel. They move roughly 40% of the natural gas consumed in the U.S. They're like a giant toll bridge across America that delivers essential energy products from every major fossil-fuel-producing basin to several major metropolitan markets.

Kinder Morgan has a distinct competitive advantage in that its assets are a critical part of North America's energy backbone. If they disappeared tomorrow, Americans everywhere would feel serious pain. It took decades to acquire, build, and integrate these assets. It would be impossible for a competitor to replicate them and generate Kinder Morgan's returns.

The company is sustaining its competitive advantage by adding new, high-demand incremental assets that make the entire system even more valuable than it was before (like new pipelines in the Permian Basin).

The second question is how the benefits of those competitive advantages (and the costs associated with them) will affect Kinder Morgan's future cash flows.

Ideally, a pipeline operator consistently generates enough cash flow to both pay a growing dividend and internally fund all (or most) of its growth projects. Doing so means it doesn't have to add debt or dilute shareholders by issuing more shares.

This is where Kinder Morgan really shines... It's one of the few companies in its sector to have demonstrated this ability over the past couple of years. Even more important, through 2021, we estimate the company will generate all the cash it needs to pay for around $6 billion in expansion projects – after paying dividends growing at 25% per year.

Most pipeline companies aren't likely to self-fund their expansion capital needs over the next three years and hike their dividend that fast. Kinder Morgan can because of its tremendous scale of irreplaceable, in-demand assets.

Finally, we must consider whether we're paying a price for those future cash flows that stacks the odds of investment success in our favor.

To find out if investors are optimistic or pessimistic about a company's future, we like to put its current valuation multiples in historical perspective. Incredibly, Kinder Morgan's price-to-earnings (P/E) ratio and the ratio of its enterprise value to earnings before interest, taxes, depreciation, and amortization (EV/EBITDA) are near five-year lows.

In other words, investors aren't expecting much of Kinder Morgan going forward.

Low expectations combined with a well-informed, contrarian outlook are the hallmarks of value investing. Buying when expectations are low means you can enjoy the ride higher as investors become more optimistic.

Alternatively, consider that KMI shares are currently trading near $20 and paying an $0.80 annual dividend – or 4%.

Kinder Morgan management is committed to paying a $1.25 dividend in 2020. We think another 25% increase to $1.56 is likely in 2021. If shares continue to trade near a yield of 4% in 2021, shares would have to rise to $39... meaning Kinder Morgan's stock has the potential to almost double over the next three years.

In short, investors who buy KMI shares at today's levels have the odds stacked in their favor in a big way.

Meanwhile, in Extreme Value, we've also published research on another stock with massive upside...

It's a small-cap stock you likely aren't familiar with. My colleague Dan Ferris calls it his No. 1 recommendation.

Like Kinder Morgan, it's a high-quality, dividend-paying business with a dominant market position and toll bridge-like features. It's rare to find a business with this little downside and this much upside. That's why Dan recently sat down on camera to explain this incredible opportunity. To watch his interview, click here.

(The stock is currently trading just pennies above Dan's maximum "buy" price. But he believes patient investors who wait for it to dip back into buy range will be rewarded handsomely.)

New 52-week highs (as of 3/12/19): Equity Commonwealth (EQC), Essex Property Trust (ESS), Franco-Nevada (FNV), Ionis Pharmaceuticals (IONS), Nestlé (NSRGY), New York Times (NYT), and Vanguard Real Estate Fund (VNQ).

Today, a subscriber shares his thoughts on "Tom and Kate" from Monday's Digest. Keep sending your comments, questions, and concerns to feedback@stansberryresearch.com.

"Regarding the March 11 Digest article – it happens that my father's parents were named Tom and Kate, and I remember hearing that Tom clipped coupons from their bond investments. Born in 1884, he lived into his 90's and to my knowledge never ran out of money. (Frugality Rules!) But I digress...

"Your article mentions CPI. Now and then I come across pieces of hardware my father or I purchased years ago (I'm in my 70's) and am both amused and saddened by the price tags on them. Example: A pair of hacksaw blades was marked as eighty cents. Nowadays they go for $7 or $8. When I retired I looked up U.S. inflation data and found prices had risen by a factor of seven times from when I'd started working in 1963 – at $1.15/hour. (And we know the official figures lie.)

"I often ask myself 'Why is there inflation at all? What's wrong with zero?' and conclude that it's purposely created by government to their benefit. My concern about it is that someday soon my Social Security and/or Medicare coverage, or my state pension, will – not just could – decline because of government mismanagement. That will put me in the same boat as Tom and Kate, but it won't be my fault.

"My savings won't then cover my expenses forever, but with Stansberry's continued advice I hope to stretch that for many more years and still have something to pass on to my children (along with my subscriptions!)." – Paid-up subscriber Roger A.

Regards,

Mike Barrett
Orlando, Florida
March 13, 2019