SINCE WE OWN AT&T, LET’S TAKE A LOOK AT WHY.

The S&P 500 was up 1.2% on the week to 2834.40, still short of its all-time high of 2940.91 set last fall, but close enough that traders are likely starting to hope for a push to new all-time highs. The immediate target is the 2860 high set just seven days ago. The S&P 500 held support at its 20-day moving average during the recent pullback and is now set to reestablish its uptrend if it can clear 2860. As well, a move above 2860 will clear the way for a test of the old high at 2941. A breakout above the all-time high would be considered bullish and could then set the index up for an extended run, the goal of all those big hedge funds, sovereign funds, and institutional money managers who make far more money when the stock market is rising than they do when it falls. Regardless of the near-term direction of the stock market, the S&P 500 has already risen 13.1% year-to-date, its best start to a year since 1998.

The big money folks are getting an assist from the Federal Reserve, of course, as the central bank continues to signal it’s probably done with interest rate hikes for 2019. There is still the matter of Quantitative Tightening, which is ongoing to the tune of $50 billion per month. The Federal Reserve has indicated it’s looking at its balance sheet shrinking QT program, but so far hasn’t modified or stopped it.

Meanwhile, the bond market continues to signal slower economic growth with the 3-month Treasury bill/10-year Treasury bond curve finishing inverted for a second week. The 10-year ended the week at 2.406 while the 3-month is at 2.418. An inverted yield curve has preceded 10 of the last 10 recessions in the United States. Consumer spending and incomes were weaker than expected and Q4 2018 GDP was just lowered to 2.2% from 2.6%. Corporate earnings are expected to be negative in Q1 and forecasts are dropping for corporate earnings in Q2, with an increased likelihood of negative earnings in the second quarter as well. The bond market has a better track record of forecasting economic slowdowns than does the stock market. All in all, it wouldn’t be surprising if the stock market were to hit a rough patch in the next few months.

I was going to write about Kraft Heinz, a stock we started buying for clients in the high 50s last fall. KHC is currently trading at 32.65 and just set a 52-week low 10 days ago. Not exactly what we were hoping for when we purchased the stock, but also not an infrequent occurrence when you’re looking to buy good companies on sale. After all, they don’t go on sale because the stock is going up, do they?

Instead, we’ll write about KHC and what we plan to do with the stock next week because Barron’s chose to print a cover story about AT&T and Verizon this week. Since we own AT&T, let’s take a look at why.

AT&T pays a 6.6% dividend and it is well covered, despite $171 billion in debt, much of it taken on with the acquisition of Direct/TV in 2015 and the purchase of Time Warner last year. The stock trades at 8.5 times earnings, 4.0x cash flow, and 1.15x sales. The business is worth $40 per share right now, not two years in the future, but right now. How do we know? The market tells us how it’s valued AT&T in the past.

Why is the stock cheap right now? Possibly because investors don’t like the uncertainty of a changing business mix and aren’t comfortable with the debt AT&T has taken on with its acquisitions. It’s also possible that at least some investors rotated out of AT&T and into industries with greater exposure to the economy beginning in 2016 – a time when the conventional wisdom was that the economy was starting to accelerate and investors needed to climb on board by buying tech, industrials, and anything else that might benefit from a faster recovery. After all, AT&T hit a high of almost $44 per share in the middle of 2016, well before the Time Warner acquisition and the $61 billion in debt that came with it.

Regardless, T is cheap and has plenty of cash flow to pay down debt over the next few years. The company has already paid off $9 billion since the Time Warner deal closed, according to Barron’s, and plans on paying off another $18 billion to $20 billion in 2019, which would put its debt to EBITDA ratio back at the company’s five-year average.

(Nerd Note: Modigliani and Miller’s Capital Structure Theory tells us that AT&T’s value isn’t dependent on its capital structure, which means as the company pays down debt the stock price will rise to keep the firm value constant.)

Furthermore, the telecom business is defensive in nature since people don’t stop using their phones or watching TV and movies when the economy falters. Telecom is one of the industries the fast money crowd (pretty much everyone these days) run into when recession fears rise, as they are now.

The investment math goes like this: Assuming AT&T returns to its fair value of $40 per share within three years, the capital gain is 29% from the current $31 per share, while the dividend adds 6.6% annually for a three-year total of 19.8%. The 48.8% total return comes to 16.3% annually. The long run return of the S&P 500 is about 9.5% annually. AT&T is a good company in a defensive industry, highly likely to be doing what it’s currently doing decades from now. Why wouldn’t we want to own it?

Regards,

Christopher R Norwood

Chief Investment Officer