Investors should consider special situation stocks for their ability to create growth and income opportunities
Most investing is sector-driven. Even the S&P 500 is divided into 11 neat sectors, and most of Wall Street is preoccupied with which sectors they think investors should underweight and overweight at any given time.
Overweight energy stocks when oil prices are rising. Underweight consumer discretionary when inflation is afoot. Overweight technology when a transformational shift is at hand, such as artificial intelligence (AI) technology.
But not all stocks can fit into such neat categories. Some that don’t are known as special situation stocks.
What are special situation stocks?
Many special situations are event-driven: a merger, acquisition or spinoff, for example. It could also be a change in a market that plays into a company’s unique skill set. For example, the Inflation Reduction Act of 2022 which allocates $370 billion for energy security and climate change initiatives plays into the strengths of infrastructure solutions provider Quantas Services (PWR) detailed below.
Special situations can also arise from some sort of dislocation on a balance sheet. For instance companies can own real estate that is likely to be worth much more than its carry value on the books, and this has implications for their dividends.
And special situation stocks can get a boost from world events, such as the impact of the Russian invasions on shipping rates for crude oil carriers or a potato shortage driving the price of french fries.
Sector investing is popular for a reason. It works and provides opportunities for strategic diversification. But for investors looking for growth or wanting to earn outsized dividends, special situation stocks merit consideration as well.
The question investors need to ask themselves is whether the transformation of CVS Health (CVS, $68.68) from a retailer to a healthcare company will continue – and whether it will be able to keep paying and growing its hefty 3.5% dividend.
CVS paid about $3 billion in dividends last year, and repurchased about $3.5 billion of its own shares. The company’s capital expenditures, about $2.7 billion, are modest, and will continue to be so, especially if it makes good on its commitment to close 900 stores between 2022 and 2025. Adding all that together, CVS Health’s core commitments are about $9 billion and cash flow from operations is about $16 billion.
Should cash flow dip, CVS and its shareholders have a safety net of sorts in the form of real estate. The company is carrying nearly $7 billion of property on its balance sheet, and this figure is net of depreciation. The current value of the real estate, though unknown, could be much higher, since this asset class tends to appreciate in the real world, even though it depreciates on corporate balance sheets.
While a look at the cash flows inspires confidence, a look at CVS’s income statement is a little more perilous. 2022 earnings of $4.1 billion were about half of earnings for 2021, thanks in part to opioid litigation charges to the tune of nearly $6 billion.
In the process, the dividend payout ratio – the percentage of net income that gets paid out in dividends – grew from a safe and modest 33% to a less safe and less modest 70%. Presumably, CVS’s opioid liabilities are behind it – the 10K reports that 2022 agreements “resolve substantially all opioid claims against the Company” and that profitability to historical averages will return.
The challenge for investors is that the averages are just that: average. Shares of the special situation stock are trading today just about where they were in November of 2018, when CVS Health acquired giant healthcare insurer Aetna for a whopping $69 billion.
This year will provide some comfort, or discomfort, that growth is at hand. The consensus 2023 forecast is $7.28 per share, a big jump from the 2022 opioid-laden earnings per share of $3.14.
Original Article: https://www.kiplinger.com/investing/stocks/special-situation-stocks
