As the COVID-19 crisis has battered global energy demand and oil prices, the midstream energy sector is one area that has remained resilient, thanks in large part to its steady cash flow profile. Valuations in the space, however, remain extremely depressed. We look at those valuations, how they have decoupled from fundamentals, and why we believe midstream may be an attractive space in the current market.
Possibly the most confusing and essential question facing investors in 2020 is what to make of current equity market valuations. Some commentators have called the market a bubble akin to the one that burst in 2001, while others have cited deeply negative real interest rates, an acceleration of a tech-dominated future, and massive Fed liquidity as a justification for sky-high valuations. Whatever the reason, the reality remains that valuations are historically high, and long-term equity returns have consistently been negatively correlated with starting valuations.
The good news for investors is that there are areas of the stock market that continue to show attractive valuation relative to history and the market. While some sectors trade at low multiples for good reason, we believe there are areas of opportunity in today’s market. One area that remains compelling in an otherwise expensive market is midstream energy, or energy infrastructure.
Weak returns have followed expensive market valuations
Source: Bloomberg Finance, L.P., as of August 31, 2020.
Key takeaways
- Investors are faced with extremely high public equity valuations, a reality that has historically resulted in lower long-term forward returns.
- In contrast, valuations in the energy infrastructure space are near record lows.
- Midstream fundamentals remain solid, with Q2 earnings results showing the resiliency of the sector.
- High current income could be supplemented by capital appreciation as valuation improves with greater free cash flow, reduced leverage, and increased shareholder returns.
