The oil price is going up; there are growing expectations of higher interest rates. When markets value a company, they are supposed to estimate future earnings and discount the earnings to derive a net current value. So, if interest rates rise, the discount of future earnings increases. In such times you would expect shares in companies with significant future potential to fall and shares in high dividend-paying companies to rise. In other words, by the above reasoning, this is a time for investing in mature companies that pay high dividends — at least it is if you believe interest rates are indeed about to rise.
This all begs the question, which dividend-paying mature companies — also called defensive stocks — should you consider?
Obvious candidates include the banks, which we have covered recently; see Are HSBC shares now a bargain? and Five reasons why a Lloyds Bank dividend bonanza is close
A superficial analysis might suggest oil companies as good investment prospects — after all, high dividend-paying companies like BP and Royal Dutch Shell might especially benefit from the high oil price.
But I worry about oil companies — the oil cycle twists and turns over the years, but in hindsight, we can say it follows a predictable pattern. Oil peaked in 2008, crashed, surged again earlier last decade and then crashed again; now, once more, it is moving up. But I think that as fears over climate change grow and the renewables revolution gathers pace, the oil cycle might be in its last throws; sure, we are in an upswing phase, but I suspect that this might be the last such occasion. Later this decade, I think oil will be far less important to the global economy. Indeed, I think Saudi understands this, which is why it floated Aramco when it did and why OPEC recently elected not to increase oil supply. Instead, I believe oil exporters are trying to squeeze as much money as possible out of the oil cash cow before it runs dry.
However, I think a consequence of higher energy prices will be an acceleration of alternative energy sources such as renewables.
Maybe then, an investor wishing to benefit from rising energy costs whilst simultaneously investing in high dividend-paying companies may want to look at companies like Drax, SSE or National Grid. These three companies pay reasonable dividends, with the DRAX dividend the lowest of the trio last year.
SSE is a major investor in renewables, and Drax have pivoted away from coal, although I worry about the Drax emphasis on biomass, but its investment into carbon capture is worth watching.
SSE may also see an influx of new customers as smaller rivals go bust.
But forgive me for not jumping up and down with excitement.
Acceleration toward EVs and heat pumps
Thanks to rising oil and gas prices, we are also likely to accelerate electric vehicles. So far, I say nothing new; the EV market is well documented. But I also see an acceleration towards electric heat pumps replacing gas boilers. Electric heat pumps provide energy cost-effectively but entail high up-front costs, the transition from gas boilers will be gradual at first, but I expect it to accelerate, especially as heat pump costs fall as the market scales up.
One company in this space with exciting technology is The Kensa Group. The company says it is “the UK’s only manufacturer of ground source heat pumps.” Unfortunately, you can’t buy shares in Kensa yet, but there is a way to indirectly secure a stake in the company, which I will explain shortly.
The dream stock
Investors really need to find a solid defensive company that pays good dividends and somehow provides exposure to the new energy opportunity.
And I have found the most unlikely of candidates. Financial services company Legal & General is a classic example of a defensive stock. Shares have risen sharply over the last 18 months or so, but then they fell sharply in March last year, so I don’t read too much into recent increases. Indeed, the Legal & General share price is still below the February 2020 price. But its dividend yield at around six per cent is good; its P/E at around 7.5 is modest, and although it took a hit last year, profits are now rising. Barclays recently said: “The macroeconomic and investor landscapes are changing as demand for green assets rapidly increases. We believe that Legal & General is fast becoming a group driven not only by the supply of life liabilities but increasingly also by demand for its unique asset generation abilities in L&G Capital.”
Legal & General Capital (LON: LGEN)
It is the last few words from the Barclays quote that I especially agree with it because Legal & General Capital has just invested in Kensa, grabbing itself a 36 per cent stake.
I think the L&G investment in Kensa tells us something positive about the vision behind its venture capital arm, which tallies with Barclays’ comments.
As a solid dividend stock, at a time when markets look vulnerable from rising rates, Legal & General is an obvious investment candidate. But I think Legal & General Capital gives the group good growth prospects too, and right now, the combination of solid dividends and growth prospects feels pretty compelling to me.