Selling Karoon Energy (ASX:KAR) and adding to Steadfast Group (ASX:SDF)

I have no business owning O&G stocks

I sold my shares in Karoon Energy following a phone call with an informed friend. I originally bought the shares because the stock is cheap (2x forward PE according to Stockopedia) and I wanted some exposure to energy as a hedge in light of Middle East tensions.

However, I now think that a potential peace deal in Ukraine creates downside risk for the oil price. Meanwhile, the Arab states and Iran are totally dependent on oil and gas these days so a major supply crunch like we saw in the 1970s is unlikely, even if Trump does turn Gaza into a real estate project.

I still think Karoon is cheap, but I am not a fan of the capital allocation on display here. In particular, the company issued a $350 million bond last year with a coupon of 10.5% despite already having plenty of cash and being highly cash flow generative. This followed a major Gulf of America Mexico (GoM) acquisition in 2023 accompanied by a A$480 million equity raise.

I want capital returns not expansion given the risks inherent in acquiring projects as has been born out in the GoM where production has not met initial expectations. To be fair, capital returns have improved following pressure from investors and a $75 million buyback is currently underway, but the strategy remains unclear.

In truth, I was aware (or should have been) of most of the above prior to buying the stock, although my friend did provide further colour which I will not go into here. And the stock is very cheap which probably more than compensates for these issues. Ultimately though, the average O&G stock destroys shareholder value over time and I am no sector expert, nor have any intention of being one. I am bearish on the longterm outlook for oil and have no business owning energy stocks.

Topping up Steadfast

Steadfast is a compounding machine that I have owned on and off for some years and I allocated the Karoon proceeds here because I felt the portfolio was underweight the stock.

The Four Corners report into Steadfast’s strata business looks to be blowing over over with an ongoing internal review so far finding no evidence of wrongdoing. In any case, strata represents just 10% of Steadfast Network’s GWP.

The recently enacted Treasury Laws Amendment (Mergers & Acquisitions Reform) Act 2024 will likely impact Steadfast going forward. The group has successfully rolled up many small brokers over the years and this has turbocharged growth. This new legislation will probably restrict the pace of further acquisitions and in some cases halt such deals altogether given Steadfast’s market dominance.

However, Steadfast has now turned its attention to overseas markets in Europe and the US and so I don’t expect the new bill to stifle growth much, if at all. Obviously, there is extra risk in entering new markets and this is something I need to watch carefully. I note that the board has approved an increase in maximum gearing from 30% to 35% and I wonder if this is to fuel a final spree in Australia prior to the new M&A rules coming into force.

A remaining point of uncertainty relates to an investigation into two employees trading Steadfast securities between 30 August and 2 September. From what I can tell, these employees are not directors based on publicly released 3Y appendices. Again, I expect this to pass without longterm damage to the business.

Aside from new ventures overseas, I don’t think anything much has changed here. Sure, the insurance cycle might soften in the near term, but climate change guarantees longterm rate inflation which plays into Steadfast’s hands.

Could AI be a risk? Possibly, but it is hard to see how it can disrupt Steadfast’s established network of brokers, underwriters, insurers and funders, and it may even strengthen it if the technology can be harnessed internally.

For more than ten years Steadfast has provided investors with strong, low volatility returns. Five year dividend per share CAGR is 15% and the forward yield is 3.6% and management reconfirmed full-year guidance of 12% to 16% in underlying EPS growth in the recent interim results. I feel comfortable with a sizeable position here.