Cabot Dividend Investor Issue: June 14, 2023

Play Offense with Defense

WOW! It’s a new bull market. Despite inflation, the Fed, and the risk of recession, stocks are off to the races. The market is proving all the naysayers (including myself) wrong.

I have said repeatedly, in exquisitely crafted monthly issues and updates, that stocks were unlikely to sustain a rally into bull territory until there is more clarity on inflation and recession. The market disagrees. And it’s the boss.

The S&P 500 is up over 12% YTD. And the year isn’t even half over. The index has also rallied more than 20% from the bear market low in October. That’s the definition of a bull market. The market is unpredictable in the near term. The adage applies. No one ever knows in which direction the next 10% move will be, but the next 100% move will surely be higher.

While the market has been surprising and impressive, things aren’t as rosy as the index returns make them seem. This is the thinnest rally I’ve ever seen. Just 10 stocks account for the entire YTD rise in the S&P 500 index. The other 490 stocks have collectively gone nowhere.

Apple (AAPL), Nvidia (NVDA), portfolio position Broadcom (AVGO), Microsoft (MSFT), Amazon (AMZN), Meta Platforms (META), Tesla (TSLA), Advanced Micro Devices (AMD), Alphabet (GOOG), and Salesforce (CRM) account for all the YTD gains. Apple, Nvidia, and Broadcom account for about 40% of the gains alone.

Can these handful of stocks continue to drive the market higher? Sure they can. I’m too embarrassed to make another short-term prediction. But the situation is precarious. Eventually, this rally will have to broaden out or peter out. Either scenario should bode well for defensive stocks.

The market has overwhelmingly favored growth stocks and has not been kind to defensive stocks in the first half of the year. Utilities, Health Care, Consumer Staples, and Energy have been the worst-performing market sectors this year. But that situation is unlikely to persist.

There is still lots of risk. Inflation could be stickier, and the Fed could be more hawkish than currently anticipated. The banking crisis could reignite. Most economists are still predicting a recession later this year or early next year. Even if a recession never happens, it’s reasonable to expect that the economy will slow in the second half of the year. And overall market earnings have already contracted for the last two quarters.

The relative performance of defensive stocks historically thrives in a slowing economy. If the rally broadens in such an environment, it will need participation from the defensive sectors. If the market pulls back, defense should be the best place to be.

The defensive sectors have been the worst performing this year, so far. But this is just a snapshot in time. Things might look a whole lot different in a few months. In the meantime, many of these stocks are undervalued ahead of a period of likely relative outperformance.

In this issue, I highlight three portfolio positions that are some of the best defensive stocks on the market.

What to Do Now

Thank goodness for the technology stocks. Broadcom (AVGO) has been the superstar. But both Qualcomm (QCOM) and red-headed stepchild Intel (INTC) are up over 20% in the last three weeks.

Technology is on its own schedule. Growth in the industry is stupendous. And technology will continue its furious advance even if the world goes to Hell in a handbag.

The tech sector led this market lower last year as rising inflation and interest rates cut into growth projections. But those things are abating this year. An already good year for the sector got a shot of adrenaline from the Nvidia (NVDA) earnings report and its revelations about AI (artificial intelligence) investment.

The technology rally might keep going. It’s tempting to dump the defensive losers in the portfolio and join the party with more tech stocks. Technology is exploding and this portfolio still has over 40% in cash. Perhaps we should put that cash to work in the technology rocket. But I think that would be a mistake. I know because I have made that exact mistake several times in my youth and paid the price.

Sector performance rotates. Things change. All the current good market vibes could reverse with one crummy headline. Even if we avoid recession, the economy is certainly slowing. This inflation/Fed conundrum is far from over. And the market is high again. Things are setting up for defensive stocks which are cheap and underperforming.

Sure, defensive stocks have been dogs in the first half of this year. But that half is about over. The second half is what’s important now. It’s time to embrace the defensive plays, not abandon them.

It’s worth noting that the 100%-plus return stocks currently in the portfolio, including AbbVie Inc. (ABBV), Broadcom (AVGO), Eli Lilly (LLY), and Xcel Energy (XEL), have all spent a considerable amount of time in the doghouse on their journey to market-crushing returns. Wealth building is a marathon, not a race. Don’t give up on defense. Not now.

Featured Action:

Buy NextEra Energy, Inc. (NEE) Yield 2.5%

Utility stocks fill a great niche in any investment portfolio, especially in an economy and market this uncertain. The sector is the most defensive on the market as earnings are virtually immune to economic cycles. Stocks also pay high dividends and typically hold up very well in down markets.

NextEra Energy provides all those advantages plus exposure to the fast-growing and highly sought-after alternative energy market.

NextEra Energy is the world’s largest utility. It’s a monster with over $20 billion in annual revenue and a $158 billion market capitalization.

Ordinarily, when you think of a huge utility you probably think it has lackluster growth and a stable dividend. But that’s not true in this case. Earnings growth and stock returns have well exceeded what is normally expected of a utility.

For the last 15-, 10-, and five-year periods, NEE has not only vastly outperformed the Utility Index. It has also blown away the returns of the overall market. How can that be?

It’s because it isn’t a regular utility. NEE is two companies in one. It owns Florida Power and Light Company, which is one of the very best regulated utilities in the country, accounting for about 55% of revenues. It also owns NextEra Energy Resources, the world’s largest generator of renewable energy from wind and solar and a world leader in battery storage. It accounts for about 45% of earnings and provides a higher level of growth.

Florida Power and Light is the largest regulated utility in the U.S. It has about 6 million customers in Florida. It is one of the very best electrical utilities in the country. There are a few good reasons why Florida is a great place to operate a utility.

The state has a growing population. Utilities have a limited geographical range, and a stagnant population can make it tough to grow. Plus, it is one of the most regulator-friendly areas in the country. That’s huge for getting approvals for periodic expansions and price hikes. It also doesn’t hurt that Floridians run their air conditioners like crazy, and just about all year long.

The alternative energy company, NextEra Energy Resources, is the world’s largest generator of renewable energy from wind and solar. Alternative energy is the future, and this company is the top of the heap. The government and regulators love them for it. It’s also a huge benefit that the cost of clean energy generation constantly gets cheaper as technology advances.

There is also a huge runway for growth projects. NextEra has deployed about $55 billion between 2019 and 2022 on growth expansions and acquisitions. The company is expecting an increase in investments of 1.5 times from year-end 2019 levels between 2021 and 2024.

A key aspect of this recommendation is timing. The stock is a decent bargain after a period of underperformance and ahead of a slowing economy, a period of historic market outperformance.

It’s also an earnings recession already, as average S&P 500 earnings fell over in the last two quarters. Falling earnings are likely to put a premium on companies that can continue to grow profits. And utility stocks typically outperform in such environments.

It’s a good time for a defensive stock like this. The more conservative stocks are still cheap and provide stability in an unpredictable market.

Buy Williams Companies Inc. (WMB) Yield 5.9%

The most resilient and higher-growth midstream companies tend to deal in natural gas and natural gas liquids (NGLs). Natural gas is by far the cleanest burning and fastest-growing fossil fuel source in the world, and the U.S. is the world’s largest producer. It is also viewed more favorably by regulators because it is so much cleaner than oil and coal.

Given the current inflation and energy shortages, even some of the more hardcore climate change activists are increasingly seeing natural gas as the bridge to a lower carbon future. The U.S. and the world currently use fossil fuels for more than 80% of energy needs. It’s unrealistic to expect clean energy sources to replace them any time soon. In the meantime, the U.S. has dramatically lowered its carbon footprint by transitioning to natural gas from coal and oil and will continue to do.

It’s also a similar situation in the rest of the world. The U.S. still has more natural gas than it can use, and other parts of the world are desperate for the stuff. Massive natural gas export facilities have been built in recent years that liquify gas and ship it overseas. That market should remain red hot, especially with Europe looking for other sources after its fallout with Russia.

Williams is an American midstream energy company involved in the transmission, gathering, processing and storage of natural gas. It operates the large Transco and Northwest pipeline systems that transport gas in densely populated areas from the Gulf to the East Coast. Roughly 30% of the natural gas in the U.S. moves through its systems.

The bulk of adjusted EBITDA comes from pipeline transmissions plus a smaller deep-water presence in the Gulf of Mexico (47%) and gathering and processing facilities (38%). The rest is from marketing and NGL (natural gas liquids) services, exploration and production joint ventures, and oil gathering and processing. The company has minimal commodity price exposure, as most revenues are fee-based and secured under long-term contracts with inflation adjustments.

It’s also well worth noting that the company acquired the remaining 26% ownership from its limited partner and is now a regular corporation (not a Master Limited Partnership). Therefore, dividends are taxed at the maximum 15% rate (or 20% in some cases) and the investment doesn’t generate a K-1 form at tax time.

Performance

WMB returned over 30% in 2022 while the market was down more than 19% for the year. But the market neglect of defensive and energy stocks in the early part of this year has reversed things. WMB is down more than 4% YTD (as of June 12).

Natural gas has also been a factor in the recent decline. Prices have fallen largely because of the unusually warm winter temperatures throughout the country and the world. A supply glut has developed and natural gas prices plunged. Although Williams doesn’t have much commodity price exposure, it is still affected by turbulence in the industry. But the price and supply situation is likely temporary for a fuel source that will own the next decade.

And the warm winter isn’t affecting the bottom line. Williams once again delivered on earnings in the first quarter and beat expectations for the fourth straight quarter. Earnings per share grew a whopping 36% over last year’s quarter as natural gas volumes remained strong as recent acquisitions are operational.

Even after the crummy first half of the year, WMD has still averaged better than an 18% per-year return over the last three years. Williams has been able to achieve a higher level of earnings growth than its peers because it is reaping the reward of $8 billion invested in new projects over the last few years. Yet WMB is still priced more than 20% below the 52-week high despite having much higher earnings now.

A huge tailwind is that clear trends are in place for a longer-term secular rise in natural gas demand in all its sectors. There continues to be a growing need for secure and reliable supplies amid geopolitical volatility and climate concerns. In fact, Williams’ earnings continued to rise right through the heart of the pandemic lockdowns, one of the worst periods for the industry ever.

The Dividend

Williams currently pays out $0.4475 per share quarterly, or $1.79 annually, after raising the payout by 5.1%, which translates to a current yield of 5.9%. While the company has paid a quarterly dividend since 1974, it hasn’t always raised or maintained the payout. The company slashed the dividend in the aftermath of the 2014 oil price crash. But it has since restructured in a way that makes the current dividend far safer.

Williams restructured to a regular corporation in 2018. It has since reduced its net debt-to-EBITDA by 21% while investing $8 billion in new projects with an 18.8% return on capital between 2018 and 2021. Operating margins have increased from 57% in 2015 to 70% in 2021. And adjusted earnings per share have increased at a CAGR of 18% since 2018.

The Future

As I mentioned above, the prospects for natural gas volumes going forward are tremendous. And Williams also has the advantage of having a large and well-established network. Regulators tend to be much more lenient for expansions than new projects, favoring established players. Williams has a well-positioned network that allows it to invest in high-return growth projects with minimal regulatory hurdles.

The company currently has $1.5 billion invested in six projects that will boost the bottom line over the next several years. That should keep the growth pump primed.

WMB sells at a reasonable valuation for a company with such solid earnings growth and a high and safe dividend.

Buy Brookfield Infrastructure Partners (BIP) Yield 4.2%

Bermuda-based Brookfield Infrastructure Partners is a Master Limited Partnership (MLP) that owns and operates infrastructure assets all over the world. The company focuses on high-quality, long-life properties that generate stable cash flows, have low maintenance expenses and are virtual monopolies with high barriers to entry.

Infrastructure is defined as the basic physical structures and facilities needed for the operation of a society or enterprise. It includes things like roads, power supplies and water facilities. Not only are these some of the most defensive and reliable income-generating assets on the planet but infrastructure is rapidly becoming a timelier and more popular subsector.

The world is in desperate need of updated infrastructure. The private sector is filling the need as governments don’t have all those trillions lying around. Limited partnerships, giant sovereign-wealth funds, multilateral and development-finance institutions are raising billions of dollars a year for infrastructure investments. It’s almost becoming a new asset class.

As one of the very few tested and tried hands, Brookfield is right there. It’s been successfully acquiring and managing these properties for more than a decade in a way that delivers for shareholders. Since its IPO in 2008, BIP has provided a total return of 842% (with dividends reinvested) compared to a return of 303% for the S&P 500 over the same period. And those returns came with considerably less risk and volatility than the overall market.

Brookfield operates a current portfolio of over 1,000 properties in more than 30 countries on five continents. The company operates four segments: Utilities (30%), Transport (30%), Midstream (30%) and Data (10%).

Assets include:

• Toll roads in South America
• Telecom towers in India and France
• Railroads in Australia and North America
• Utilities in Brazil
• Natural gas pipelines in North America
• Ports in Europe, Australia and North America
• Data centers on five continents.

The dividend is rock solid with a history of steady growth, The payout has grown by a CAGR (compound annual growth rate) of 10% per year since 2009 and the company is targeting 5% to 9% annual growth going forward.

BIP is a good long-term investment anytime, as the above numbers illustrate, but it is particularly attractive now because it’s relatively cheap and can well navigate both inflation and recession.

The infrastructure company reported solid earnings in the first quarter with funds from operations (FFOs) per share growth of 12.5% over last year’s quarter. The company benefited from recent expansions and acquisitions but also showed solid organic growth. Meanwhile, the average S&P 500 stock had negative year-over-year growth in the first quarter of this year.

Roughly 85% of revenues are hedged to inflation with automatic adjustments built into its long-term contracts and its crucial service assets are very recession resistant, and earnings should remain strong even if there is a recession later this year. It also helps that the stock pays a solid and growing dividend.

Recent Activity

May 17
ONEOK, Inc. (OKE) - Rating change “BUY” to “HOLD”

May 23
SOLD ½ Eli Lilly and Company (LLY) - $423.21

May 31
AbbVie Inc. (ABBV) - Rating change “HOLD” to “BUY” and BUY 1/3
SOLD ½ Broadcom Inc. (AVGO) - $807.96

Portfolio Recap

Enterprise Product Partners (EPD – yield 7.5%) – Enterprise is slowly and quietly getting the job of a high-income security done without excitement or fanfare. It returned 15% last year and 12% so far this year. The partnership also increased the quarterly distribution by 5.4%. Business is solid while most company earnings are shrinking. That massive payout is rock solid and growing. The company has just a 75% payout ratio and the distribution is covered 1.8 times by cash flow. That’s sky high for the industry. This one should continue to roll on and hold up well if the market hits the skids. (This security generates a K-1 form at tax time). BUY

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

ONEOK Inc. (OKE – yield 6.4%) – OKE continues to bounce back admirably from the selloff of a couple of weeks ago when the market hated its purchase of Magellan Midstream Partners (MMP). The deal will turn ONEOK from a natural gas operator to a diversified midstream company that services oil and refined products as well. The buyout is a longer-term positive that could hurt performance in the near term. But OKE will remain a solid performer with 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 5.0%) – This year so far has been a tough one for defensive stocks and REITs. Although the YTD return in O is -1.88%, it isn’t time to give up on the stock. This market rally might run out of gas and there is still the possibility of recession later this year or early next year. Defensive stocks could make up for lost time in the next several months. This is a company with safe consumer staple tenants that has raised the dividend through the last three recessions. HOLD

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

The Williams Companies, Inc. (WMB – yield 5.9%) – WMB is down over 4% YTD. This year has not been kind to defensive stocks or energy stocks so far. But there’s also natural gas. Prices have fallen largely because of the unusually warm winter temperatures throughout the country and the world. But it isn’t affecting the bottom line. Williams once again delivered on earnings and beat expectations for the fourth straight quarter. Earnings per share grew a whopping 36% over last year’s quarter as natural gas volumes remained strong and growing. WMB has also had a sharp spike over the past couple of weeks. BUY

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

AbbVie (ABBV – yield 4.3%) – This has not been a good recent phase for the pharma powerhouse. The stock has fallen over 20% from the recent high to a brand-new 52-week low. This is a notoriously bouncy stock and the downward move started with disappointing earnings where its new drugs grew less than projections in the long-awaited Humira patent expiration year. Revenues will shrink this year and next. But that has long been known and the future is bright. Eli Lilly had a similar issue years ago. The company has a phenomenal pipeline capable of replacing lost Humira revenues in the next couple of years. The stock could fly again once investors start looking past this year. BUY

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

Broadcom Inc. (AVGO – yield 2.1%) – This is a great company and stock with a bright future. It may have been a mistake to sell half after the recent runup. Perhaps I was too cute. AVGO does have a historical tendency to pull back after big spikes higher and I wanted to protect profits. But it is continuing to kick butt. Maybe the newfound AI frenzy still has legs. But there are still a lot of risks to this market and if AVGO does pull back, the portfolio will buy back that half because the longer-term trajectory is excellent. HOLD

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

Brookfield Infrastructure Partners (BIP – yield 4.1%) – I like this one. It’s been a dog lately, but the lagging performance shouldn’t last. It’s cheap ahead of a period of likely relative outperformance. The infrastructure company is up about 7% since the beginning of May. The stock got new life after a sluggish period because Brookfield reported a solid earnings quarter with funds from operations (FFOs) per share growth of 12.5% over last year’s quarter. The stock had been suffering from the lull in defensive stocks, but it won’t stay down for long. It is around the top of the recent range, and it’s well positioned for the months ahead. (This security generates a K-1 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%) – This is another star portfolio performer that has returned 50% in the last year and over 200% since being added to the portfolio less than three years ago while the S&P 500 has returned just 34% over the same period. Half of the position was sold after the latest steep spike higher because LLY has a historical tendency to pull back after such moves. But not this time so far. It’s hanging tough around the high because the market still loves it. The pharma superstar has two potential mega-blockbuster drugs up for approval later this year or early next as well as solidly growing earnings for the foreseeable future. HOLD

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

Hess Corporation (HES – yield 1.3%) – This energy exploration and production company has been going sideways since the beginning of May. It’s holding its own while the energy sector languishes. That’s a good sign. This stock can really take off when energy gets hot again. There are a plethora of factors that could pressure oil prices higher in the months ahead. The longer-term supply/demand dynamic favors energy very much and Hess is a special case. It can increase production almost at will with very low-cost production. BUY

Hess Corporation (HES)
Next ex-div date: June 14, 2023

Intel Corporation (INTC – yield 1.5%) – INTC is on a tear. It’s up over 23% in the last three weeks. After Nvidia (NVDA) rocked the market with blowout earnings, Intel appeared to get yet another black eye. INTC fell 7% on the day of the announcement because it doesn’t really have a competitive AI chip. There’s one in the works. But it isn’t expected to launch until 2025. But INTC has since ignited.

The Nvidia CEO expressed interest in using Intel’s production facilities for its chips. Intel has greatly expanded its foundry business and can benefit from the AI frenzy in another way. Institutional ownership in the stock is high as there is a growing sense that INTC will benefit from AI and the stock is very cheap ahead of a bright future. We’ll see if the momentum lasts. HOLD

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

Qualcomm Inc. (QCOM – yield 2.7%) – Staying with these technology stocks through the ugly times is paying off now. Qualcomm is definitely benefitting from the AI excitement. It’s up over 20% in the last three weeks and seems to be surging daily. Qualcomm describes itself as the “on-device AI leader,” as opposed to Nvidia’s data center chips. The company will surely benefit as investment and profits from AI are now likely to soar sooner than previously expected. The company had been reeling from falling smartphone demand. But recent developments indicate that profits are likely to rise sooner. HOLD

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

UnitedHealth Group Inc. (UNH – yield 1.4%) – UnitedHealth has strong predictable revenues in a very defensive business ahead of a possible recession later this year or early next, or at least a slowing economy. UNH has been a terrific stock to own in any market, as its three-, five- and 10-year returns attest. But it is also the epitome of a stock to own during challenging economic times. It hasn’t gone anywhere since being added to the portfolio, but the lagging performance in defensive stocks is likely to correct itself in the months ahead. BUY

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

Visa Inc. (V – yield 0.8%) – V has been hanging so tough near the high end of the recent range. The payments processing company grew earnings per share by 17% and revenues grew double digits versus last year’s quarter. That’s terrific when the average stock is posting lower earnings. Plus, it can really take off in better economic circumstances. This is a great stock in an up market. The resilience in this market is encouraging and makes the stock easy to hold. HOLD

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

NextEra Energy (NEE – yield 2.5%) – 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 that could change in a big way if there is an economic recession or a continued 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. NEE is a great stock and the time is right. BUY

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

Xcel Energy (XEL – yield 3.3%) – Defense isn’t cool this year so far. XEL is out of vogue, don’t you know. This clean energy utility stock has been trending lower since the beginning of April and still flounders. Although this stock tends to be bouncy, the recent weakness doesn’t make much sense. 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: June 14, 2023

USB Depository Shares (USB-PS – yield 5.8%) – After pulling back in unjustified sympathy with the overall bank selloff, this preferred issue is marching right back. 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 resume moving according to interest rates. You can still grab a 5.8% investment grade yield ahead of a slowing economy. That’s a deal. BUY

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

Invesco Preferred ETF (PGX – yield 6.4%) – Longer-term rates are bouncing around again with a bias toward lower since the bank failures increased the risk of a slowing economy. This fund is also vulnerable to fluctuations resulting from banking troubles and many preferred issues are those of banks. The fund is only threatened if things escalate into a more widescale problem. BUY

Invesco Preferred ETF (PGX)
Next ex-div date: June 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 slowing economy in the second half of this year bodes well for the near-term total return of this fund. BUY

Vanguard Long-Term Corp. Bd. Index Fd. (VCLT)
Next ex-div date: July 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 July 12, 2023.