Cabot Dividend Investor Issue: July 12, 2023

Profit Ahead of a Powerful Artificial Intelligence Tailwind

Artificial Intelligence (AI) is defined in the Oxford dictionary as “the theory and development of computer systems able to perform tasks that normally require human intelligence, such as visual perception, speech recognition, and translation between languages.”

It is essentially the next level of technological development whereby computers can think for themselves. The possibilities are massive in business and real-world applications. It is also a game-changer that will have a dramatic positive impact on certain stock prices for years to come.

AI technology is already here to a limited extent. It’s in the GPS system in your car and phone, face recognition, shopping preferences online, and voice assistance. Sure, that stuff is quaint, but the staggering potential is mind-blowing.

Computers can now analyze data. It has enormous potential in virtually every field. Accurate medical information can be obtained immediately, financial firms can more easily detect fraud, industry can hone production processes. And cost-saving potential among businesses is enormous, and organizations can’t afford to ignore it.

It’s also the crucial technology bringing about autonomous cars and robot technology that can lead to real robots, like we used to see in the old science fiction movies, and much more. We may not realize it now, but AI will change our lives like the Internet, smartphones, and social media.

If the technology doesn’t capture your imagination, consider the investment implications. According to a recent CxO Pulse Survey, 67% of U.S. organizations plan to increase their spending on technology and are prioritizing investments in data and AI. A whopping 95% of organizations are increasing their investments as a percentage of revenue. And 97% of executives say AI will be transformative to their company and industry.

Growth estimates vary of course, but I haven’t seen any estimates of less than 20% annual growth for the AI market until 2030. Research firm Grand View Research estimates the AI market will grow by a staggering 37.3% per year from 2023 to 2030. Another study estimates that the AI industry’s value will grow by 13 times over the next seven years.

AI has been around and talked about in investment circles for a while. But the phenomenon got a huge shot of adrenaline when Nvidia (NVDA) blew away earnings estimates, citing greater demand for AI technology far sooner than expected. It’s like the opening gun has sounded for the new craze.

The efficiency and cost-saving potential for businesses are massive. Technology moves very fast. Companies can’t afford to fall behind. For many businesses, rapid AI adaptation is a matter of survival. There is a stampede to apply cutting-edge AI technology to businesses before the competition. Companies that provide AI-enabling products and services will benefit mightily for years to come.

This market is unpredictable. It surprised almost everyone with a 16% gain in the first half. Maybe the rally continues in the second half. But it’s possible that inflation, or the Fed, or a recession catches up to stocks and the market has trouble in the second half. Nobody ever really knows in which direction the next 10% move in the market will be, but the next 100% move will surely be higher. That 100% move probably got a whole lot sooner with AI.

The best thing in investing is a massive tailwind. It makes success so much easier. You only have to be partially right about a stock. A megatrend like AI can make a mediocre stock a great stock, and a good stock one of your best investments ever.

In this issue, I highlight the great income stock of a company that will surely benefit from the race to adopt AI. The price is still very reasonable, and it pays a high dividend yield. There is a window of opportunity after the first wave of price surges levels off before the longer-term price appreciation sets in.

What to Do Now

The portfolio currently has three stock positions in technology, not including the stock added this issue. They are Broadcom (AVGO), Qualcomm (QCOM) and Intel (INTC).

AVGO has been one of the huge beneficiaries of the initial wave of the AI frenzy because it benefits more directly and immediately than the other two companies. The stock has returned 59% YTD. It’s up 112% from the October low and 40% since the Nvidia report in May. Half of the position was sold on the strong possibility of a pullback after that massive surge. So far, AVGO is hanging tough near the high.

INTC and QCOM benefit less directly and immediately from AI. Both stocks got a sizable boost since the Nvidia announcement. But the AI frenzy will make both stocks better and the technology inevitably lifts profits in the years ahead.

It’s only the beginning and AI excitement will find its way to these stocks eventually. As the future has gotten brighter, both INTC and QCOM have been upgraded from a “HOLD” to a “BUY” rating. Even if they languish in the near term, they can make up for lost time very quickly when they move. The next few years should be very good for these stocks, and it isn’t worth risking missing any of the move higher by getting too cute with the timing.

The three technology stocks along with the one added this month plus Visa (V) and Hess (HES) should benefit if the soft landing plays out and the market rallies in the second half. The midstream energy companies Enterprise Product Partners (EPD), ONEOK (OKE), and The Williams Companies (WMB) should also benefit.

In the event of a sideways or down market in the second half, the portfolio has many defensive positions in utilities and healthcare. All these stocks, with the exception of Eli Lilly (LLY), are cheap right now and should benefit as the rally either broadens out or fades.

Featured Action:

Buy Digital Realty Trust, Inc. (DLR)

Digital Realty is a Real Estate Investment Trust (REIT) specializing in data center properties. It is the second largest data center REIT by market cap and the largest owner of data center space globally with 314 properties serving 5,000 customers in more than 50 metropolitan areas on five continents.

A data center is a specialized facility used to house computer systems and related components, servers and network equipment. It has sophisticated temperature control systems, integrated fire suppression. It also has redundant data communications connections and multiple backup power systems. Large data centers are industrial-scale operations that can use as much electricity as a small town.

The torrid pace of technological advancement and the staggering growth of the digital age has necessitated a new type of real estate property. The dependable operation of systems and information is crucial to the operational integrity of companies large and small. A computer outage can be a disastrous occurrence for a company that relies on smooth technological operation to deliver promised services.

If Amazon can’t fulfill orders, people can’t post on Meta, or if ADP can’t process payrolls, there are disastrous consequences. You can’t just stuff computer systems and associated components in some basement anymore. The complexity of the equipment and the vitality of seamless operation require highly specialized facilities.

Of course, these properties aren’t that new anymore. DLR first traded on the market in 2004 and has experienced torrid growth ever since. It has been one of the best-performing REITs on the market. From the November 2004 IPO until the beginning of last year, DLR returned a whopping 2,865% with an average annual return of 21.85%. The returns over the period were more than five times the S&P 500 returns of 464%.

But since 2022 it has been a different story. DLR has returned -31% since the beginning of last year, greatly exceeding the overall market contraction of -5% over the same period. There are good reasons for the REIT’s underperformance.

The tech sector had an abysmal year in 2022 as inflation and rising interest rates cut into growth projections, although the sector is strong again this year as those things are abating. As a REIT, Digital must pay out the bulk of earnings in dividends. It must fund growth and acquisitions with either debt or share offerings. Higher interest rates increased the cost of borrowing, and the REIT was also forced to offer additional shares at a crummy price, thus diluting shareholdings.

The already-significant debt burden has been rising. Net debt/EBITDA has risen from 6.2 times in 2018 to 7.1 times as of the last quarter. It suggests the company might be cash-strapped and the dividend could be threatened. DLR had raised the dividend every year since the IPO in 2004. But it has failed to raise the payout for six straight quarters and counting. There was also a management shakeup that didn’t inspire confidence.

The recent price decline has created a compelling valuation and a high yield of 4.36%. Superstar stocks don’t often go on sale. When they do, it is usually for a good reason. But I believe Digital is capable of overcoming the current problems and it operates in a subsector with incredibly powerful and compelling tailwinds. The low valuation combined with the strong growth potential and history of outperformance could provide the basis for powerful upside in the quarters ahead.

To counter the higher debt levels, the company has a plan to unload $2 billion worth of joint venture assets and use the money to pay down the debt. The debt reduction would reduce net debt/EBITDA to around 6 times, even lower than the 2018 level. It’s also worth noting that Digital has investment-grade ratings on its debt from all the major credit rating agencies. The dividend is also well covered with a 73% payout ratio, which is low for a REIT.

There also seems to be a sense among investors that the party is over with the torrid data center growth. But it isn’t. The digital age is only just beginning and the need to house computers and related components continues to soar every year. Research firm Allied Market Research estimates that the data center market will grow from $187.4 billion in 2020 to over $500 billion in 2030.

A REIT with the size and scale of Digital is in an ideal position to benefit from this growth. With more properties and space than any other industry players, Digital can capitalize on the growing need for co-location services as cloud computing companies need to be connected to customers. It’s also true that Digital’s size gives it tremendous cost advantages. Digital gets significant discounts as one of the largest consumers of generators, air conditioning equipment, and electrical power.

But the growth projections above don’t include the burgeoning AI phenomenon. Businesses desperately scrambling to not fall behind in the game-changing technology will necessitate much more space and equipment that needs to be housed. According to one recent estimate, the global economy will need to invest $1 trillion over the next five years to upgrade data infrastructure.

Digital should benefit enormously and is already benefiting. Companies most likely to expand their AI capabilities are already tenants. Also, the technology often requires co-location with the company’s customers, which Digital is in a great position to provide. It should be easily doable for Digital to right the financial ship amid such overwhelming tailwinds.

These are confusing times in the market. It looks like a soft landing for the economy is more likely. But that’s no guarantee. We could still have a recession next year. The bull market could rage on or pull back. Instead of betting on the economic cycle, it’s a time to focus on individual stocks. Companies cannot afford to fall behind in crucial emerging technologies regardless of the temporary state of the market or economy.

Digital has consistent revenues backed by long-term contracts. It’s worth pointing out that the DLR stock price barely budged in the pandemic crash of 2020. DLR will surely benefit as AI proliferates. The market also agrees. The stock got a nearly 30% boost since the Nvidia report.

Digital Realty Trust, Inc. (DLR)

Security type: Real Estate Investment Trust
Sector: Technology
Price: $113.80
52-week range: $85.76 - $138.09
Yield: 4.3%
Profile: Digital is the world’s second-largest data center REIT with 314 properties spanning five continents.

Positives

• Data center demand is forecasted to quadruple this decade.
• The AI craze will provide even more growth to the already rapidly expanding demand.
• Despite the strong tailwinds, DLR sells 35% below the high.

Risks

• The company has a high level of debt that has increased.
• Rising interest rates have led to financial stumbles.

Recent Activity

June 21^st
ONEOK Inc. – Rating change “HOLD” to “BUY”

June 28^th
Realty Income – Rating change “HOLD” to “BUY”

July 12^th
Buy Digital Realty Trust, Inc. (DLR)
Qualcomm (QCOM) – Rating change “HOLD” to “BUY”
Intel (INTC) – Rating change “HOLD” to “BUY”

Portfolio Recap

Enterprise Product Partners (EPD – yield 7.4%) – Enterprise is a defensive midstream energy partnership with a high and safe dividend. EPD has returned over 14% YTD despite being in a sector that hasn’t participated in this market rally. It’s also not far from the 52-week high and may be headed for a breakout. The partnership also increased the quarterly distribution by 5.4%. Business is solid while most company earnings are shrinking and will likely continue to do so in this quarter. Enterprise should be a solid holding in a broadening or changing rally. (This security generates a K1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: July 27, 2023, est.

ONEOK Inc. (OKE – yield 6.1%) – After getting clobbered in May when the market hated its purchase of Magellan Midstream Partners (MMP), OKE has been coming right back and has regained nearly all those losses. It’s up 10% since the beginning of June. The deal will turn ONEOK from a natural gas operator to a diversified midstream company that services oil and refined products as well. The deal is a longer-term positive that could hurt performance in the near term. But this will remain a solid performer with a high and safe dividend and reliable earnings in an environment where overall market earnings are contracting. HOLD

ONEOK Inc. (OKE)
Next ex-div date: July 28, 2023, est.

Realty Income (O – yield 5.1%) – This legendary monthly income stock is part of two underperforming sectors in the first half, real estate, and consumer staples. It currently sells well below the pre-pandemic high, despite having higher earnings, and the stock is now near the lowest point since last summer. But income and safety may be at a premium in the second half of the year. Either investors will crave defense again or the rally will broaden out to include this year’s lagging sectors. BUY

Realty Income (O)
Next ex-div date: July 30, 2023, est.

The Williams Companies, Inc. (WMB – yield 5.5%) – This midstream energy company has reliable earnings that should even remain solid in a slowing economy. Earnings per share grew a whopping 36% over last year’s quarter as natural gas volumes remained strong and growing. But growth is expected to slow as year-over-year comparisons include recent acquisitions. At the same time, Williams is also investing heavily for future growth. Selling at just 8 times earnings, it is a cheap and defensive stock with a high and reliable dividend ahead of an uncertain second half of the year. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: September 9, 2023, est.

AbbVie (ABBV – yield 4.4%) – This long-feared Humira U.S. patent expiration year has been hard for the drug maker. It’s down 14% YTD in an up market and wallowing near the 52-week low as revenues and earnings have dipped from the loss of Humira sales. But the company has a phenomenal pipeline of more than 50 drugs in mid- or late-stage development. Plus, its two new immunology drugs, Skyrizi and Rinvoq, can together replace all the lost Humira revenues in the next couple of years. I purchased Eli Lilly about 11 years ago in a similar predicament, and it’s up over 1,400% since. BUY

AbbVie Inc. (ABBV)
Next ex-div date: July 13, 2023

Broadcom Inc. (AVGO – yield 2.1%) – Few companies have gotten a bigger boast from AI than AVGO. It’s up over 50% YTD, 100% since the October low, and over 100% since being added to the portfolio. The stock is benefiting because it makes generative AI chips. These chips don’t provide AI functions per se but rather the technology that enables AI to connect to all other systems, which it must to be of any use. The sheer volume increases from the new technology as well as soaring demand for the next generations of its chips should enable Broadcom to achieve a much higher level of profit growth for years to come.

I expected this stalwart and big AI beneficiary to pull back after the massive surge in May as this phase of the AI frenzy wore off. But AVGO had another surge higher in June and it is hanging tough near the high point of the recent much higher range. A pullback is still very possible and healthy, but momentum is winning out so far. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: September 21, 2023, est.

Brookfield Infrastructure Partners (BIP – yield 4.3%) – The infrastructure company stock looks rock solid going forward. The company estimates earnings (as measured by funds from operations) will grow over 10% for 2023. Despite the market’s rise this year, BIPC still sells about 9% below the 52-week high, largely due to the lull in defensive stocks in the first half of the year. The market rally is broadening out and the economy is likely to slow in the second half, two things that should bode well for the relative performance of BIPC. (This security generates a K1 form at tax time). BUY

Brookfield Infrastructure Partners (BIP)
Next ex-div date: August 30, 2023, est.

Eli Lilly and Company (LLY – yield 1.0%) – A pullback after the huge surge higher this spring would be historically normal behavior for this stock. But it isn’t happening. LLY has trended slowly higher instead of pulling back. LLY has now returned over 200% since being added to the portfolio a little less than three years ago. The market has refused to cool on LLY because it has two potential mega-blockbuster drugs up for approval later this year or early next as well as better than 20% annual earnings growth for the next several years. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: August 12, 2023, est.

Hess Corporation (HES – yield 1.3%) – HES is up a little since being added to the portfolio in May. But it really hasn’t gone anywhere. It has bounced around on positive and negative news about energy prices. The more resilient economy is a plus, as are a plethora of factors likely to put upward pressure on prices in the intermediate term. The longer-term supply/demand dynamic favors energy and Hess is a special case. It can increase production almost at will with very low-cost production. It should be stellar if energy stocks move higher again. It reports earnings later this month and that report could get the stock moving. BUY

Hess Corporation (HES)
Next ex-div date: September 14, 2023, est.

Rating change “HOLD” to “BUY”

Intel Corporation (INTC – yield 1.5%) – INTC got a huge 30% bump with confidence in its chip production ability and the indirect benefits from the soaring demand for AI-related products and services. We’ll see if Intel can slay the competition with its new plan and its new chips down the road. But a surge in technology demand across the board provided by the magnitude of the AI frenzy will lift all boats. Intel’s future got a lot better with the recent AI bump. It might increasingly be seen as a cheap stock with a brighter future. BUY

Intel Corporation (INTC)
Next ex-div date: August 4, 2023, est.

Rating change “HOLD” to “BUY”

Qualcomm Inc. (QCOM – yield 2.7%) – QCOM has leveled off since the big rise in late May and early June from the AI craze. Qualcomm has cutting-edge chips with AI capabilities and describes itself as the “on-device AI leader,” and the company should benefit mightily from the increasing shift towards AI and profits are now likely to soar sooner than previously expected. Although Qualcomm doesn’t benefit as directly and immediately from AI as some other companies, eventually the AI boost will find its way to mobile devices and QCOM will be in a great position. BUY

Qualcomm Inc. (QCOM)
Next ex-div date: August 31, 2023, est.

UnitedHealth Group Inc. (UNH – yield 1.5%) – It’s been a rough patch for UnitedHealth. The main problem was last month when the healthcare insurer reported rising costs as elective procedures are surging from pent-up pandemic era demand. It’s a blip that will likely put a dent in earnings for the next couple of quarters. But it shouldn’t change the positive longer-term story. Plus, the rise in procedures may peter out if the economy slows down. UnitedHealth reports earnings on Friday and a positive report could get the stock moving in the right direction. BUY

UnitedHealth Group Inc. (UNH)
Next ex-div date: September 15, 2023, est.

Visa Inc. (V – yield 0.8%) – V loves the surprisingly strong economy and increasing soft-landing talk. Inflation is down, GDP was revised higher, and the consumer is still strong. In addition, Visa just purchased a Brazilian fintech company that rival MasterCard (MA) also wanted and beat them out. As a result, V soared to a new 52-week high and is very near the highest price in about two years. The stock has broken out to a new level and may have further to run. HOLD

Visa Inc. (V)
Next ex-div date: August 11, 2023, est.

NextEra Energy (NEE – yield 2.6%) – This combination regulated, and clean energy utility stock is currently at the lower end of that range. It is still more than 20% below the 52-week high. It has not been a good year for defensive stocks and the price is reflecting that. But the rally has broadened in the last month and there is an earnings recession. This company is targeting earnings per share growth of 6% to 8% annually through 2026 and 10% per year dividend growth through at least 2024. Perhaps investors will realize the value and potential when NextEra reports earnings next week. BUY

NextEra Energy Inc. (NEE)
Next ex-div date: August 26, 2023, est.

Xcel Energy (XEL – yield 3.3%) – This clean energy utility stock is also languishing. It has been trending lower since the beginning of April and still flounders, although it has shown some life in the past few weeks in the broader market rally. XEL tends to be bouncy and it is near the low point of the recent range. Defensive stocks are still a safe and promising place to be as the economy slows and overall market earnings continue to fall. This stock has become cheap ahead of a period of likely market outperformance. BUY

Xcel Energy Inc. (XEL)
Next ed-div date: September 14, 2023, est.

USB Depository Shares (USB-PS – yield 5.9%) – After pulling back in sympathy with the overall bank selloff, this preferred issue has trended higher. This is a preferred stock of one of the country’s largest banks that has rising deposits. The bank is rock solid, and this security should continue to move according to interest rates. Rates moved near the high point again but should fall if and when the economy slows. BUY

U.S. Bancorp Depository Shares (USB-PS)
Next ex-div date: July 15, 2023

Invesco Preferred ETF (PGX – yield 6.4%) – Longer-term rates are bouncing around with an upward bias lately. But rates should fall in the event of a slowing economy and this fund should provide a good offset when the stock market stumbles. BUY

Invesco Preferred ETF (PGX)
Next ex-div date: July 24, 2023, est.

Vanguard Long-Term Corp. Bd. Index Fund (VCLT – yield 4.5%) – There could be some near-term turbulence with the price on the way to solid longer-term returns and diversification. The increased risk of a recession down the road bodes well for falling interest rates and the near-term total return of this fund. BUY

Vanguard Long-Term Corp. Bd. Index Fd. (VCLT)
Next ex-div date: August 1, 2023, est.

Dividend Calendar

Ex-Dividend Dates are in RED and italics. Dividend Payments Dates are in GREEN. Confirmed dates are in bold, all other dates are estimated. See the Guide to Cabot Dividend Investor for an explanation of how dates are estimated.

The next Cabot Dividend Investor issue will be published on August 9, 2023.