Cabot Dividend Investor Issue: October 11, 2023

Ride This Megatrend Through an Uncertain Market

The strong rally that led stocks into a new bull market has floundered as “soft landing” euphoria has been replaced with interest rate anxiety.

The inflation rate has stopped falling and interest rates are near the highest level in more than 16 years. High rates are a problem. The average 30-year mortgage rate is now well over 7%. Lending rates across the board are higher than they’ve been in a decade and a half. That makes all things that people borrow money to buy less affordable, and demand will inevitably drop.

Consumption is 70% of GDP. Even if the current interest rates don’t drag the economy down, they might rise still higher until they do. The economy is solid for now. But how long will that last?

Where are we in the market and business cycle? The more than 20% rally from the low implies we are at the beginning of a new bull market and recovery. But if interest rates drive the economy into a recession, we are near the end of a cycle.

It’s a confusing market to say the least. Six months from now we could be in an environment of high rates and sticky inflation, or we could be spiraling toward recession, or anything in between. And stock sector performance is highly dependent on which situation unfolds.

We don’t know where interest rates and inflation or GDP will be in six months, or what the headlines will be. Forget it. Instead, let’s focus on what we know. The future is predictable in some ways. For example, we know for a fact that the weather will trend cooler as we move toward late fall and winter. There’s another thing we know for sure. The population is aging at warp speed.

Baby Boomers are turning 65 at an average rate of 10,000 per day and will continue to do so for years to come. One third of the U.S. population is already over 50 and the fastest growing population segment is 65 and older. The population is older than ever before in history and getting even older still at a rapid pace. The trend is even more pronounced in many other countries.

Markets go up and down. Stock sectors rotate. Business cycles do their thing. That has always been the case. But we are in the midst of a tectonic shift in the human population that will have a profound effect on the market and economy. Companies that benefit from this megatrend will have a huge advantage.

Aging boomers will continue to buy their drugs and pharmaceuticals regardless of what happens with inflation or the stupid Fed or the economy. And the massive market for such products is only getting bigger. As a result, the healthcare industry is having an epic boom. Since 2012, total healthcare expenditures have increased a staggering 75% and now account for 20% of GDP. It’s not an accident that Eli Lilly (LLY) and AbbVie Inc. (ABBV) are the best performing stocks in the portfolio.

In this issue I highlight the stock of a company that serves a vital role in the pharmaceutical supply chain. It operates a near monopoly that grows every year. Performance has been spectacular and there is every reason to believe the good times will continue.

What to do Now

It has been a bloodbath for utility stocks. The sector is down 8% in the last month and is the market’s worst performing sector so far this year, down 18.14%. The portfolio’s utility stocks including NextEra Energy (NEE), Xcel Energy (XEL), and Brookfield Infrastructure Partners (BIP) are all wallowing near the 52-week lows.

But that was the case in last month’s issue when I touted them. They went on to take a huge drubbing in the last couple of weeks, particularly NEE. Things seem to keep getting worse. The main culprit is interest rates. The new surge in rates fueled investor fears about earnings. These companies have high debt levels compared to other sectors and the higher costs will hurt. It’s also true that competing fixed income investments have become more attractive.

But I continue to stand by these stocks and believe the selling has been way overdone. For one thing, interest rates may be at or near the peak. There is a good chance rates will move lower in the quarters ahead. Even if rates don’t fall and go higher from here, a very negative effect is already factored into the stock prices. These companies also have long track records of resiliency and the worst-case scenario the market is pricing will likely not unfold.

The utility stocks, along with battered REIT Realty Income (O), are the best bargains right now. But there are also worthy BUY stocks with good momentum including healthcare insurer UnitedHealth Group (UNH) along with the midstream energy companies Enterprise Product Partners (EPD), ONEOK Inc. (OKE), and Williams Companies (WMB).

Featured Action: Buy McKesson Corporation (MCK)

The pandemic aftermath made us acutely aware of the importance of supply chains. The Oxford Dictionary defines a “supply chain” as the processes involved in the production and distribution of a commodity. It is how stuff gets from the producer into your hands. It involves the pickup and delivery with transportation, storage, distribution centers and networks in the middle.

The pandemic shutdown greatly disrupted these vital supply chains for a while. Many previously abundant products became in short supply. It was tougher to buy a car, get eggs, and many other things. Prices soared as a result. And the previously taken-for-granted supply chains became part of the national vocabulary.

Efficient distribution is what makes this whole consumer economy work. Producers and retailers are not distribution experts. This vital function is mostly done by companies that specialize. Maintaining supply chains is crucial to a functioning economy. In some cases, it is vital to maintaining people’s health and even surviving, such as with the delivery of vital medicines and pharmaceuticals.

McKesson Corporation (MCK) is a leading domestic wholesaler of branded, generic, and specialty pharmaceutical products. The company operates a supply chain that delivers products from 1,300 drug manufacturers to over 180,000 points of dispensation throughout the country. It has a solid base of over 40,000 customers and supplies about one third of the U.S. drug distribution market. It’s a goliath with $284 billion in annual revenues.

The Business
McKesson buys drugs from manufacturers, delivers them, and resells them to retailers at a profit. Established in 1833, the company has been honing the process for nearly two centuries. It delivers from 1,300 producers to over 180,000 retailers by using 29 strategically located distribution centers throughout the country. Naturally, it has strategic partnerships with companies like CVS (CVS), Walmart (WMT), and Rite Aid (RAD).

The extensive distribution network and enormous scale provides tremendous bargaining leverage with suppliers and customers that can’t be easily duplicated by would-be competitors. That’s why the business is an oligopoly. McKesson, Cencora Inc. (COR) and Cardinal Health (CAH) account for 90% of the drug wholesale distribution market in the United States. There are very high switching costs among the providers, so they rarely lose business to the other two companies.

McKesson operates in four business segments: U.S. Pharmaceuticals, Prescription Technology Solutions, Medical-Surgical Solutions, and International. But the U.S. Pharmaceutical segment is by far the main event, accounting for 90% of revenue in fiscal 2023. This segment delivers the spectrum of branded, generic, specialty, biosimilar, and over-the-counter pharmaceuticals.

Results
In this tough earnings environment, McKesson delivered revenue growth of 11% and adjusted earnings per share growth of 25% in the last reported quarter, which was the first fiscal quarter of 2024. The results were helped by solid volume growth in pharmaceuticals. It also raised the quarterly dividend 15% and raised guidance for the rest of fiscal 2024. The company expects earnings growth of 13% to 16% and revenue growth of 13% to 15% for the year.

The dividend is rather lame. It’s only $2.48 per share, which translates to a yield of 0.57% at the current price. The dividend is easily supported by over $4 billion in annual free cash flow and a payout ratio of just 8.05%. But it has grown the payout by an average of about 12% over the last three years. And companies that consistently grow the dividend tend to be the best performing stocks on the market over time.

High performance has certainly been the case with this stock. Here’s how McKesson’s business has translated into stock total returns over the past several years compared to the overall market.

MCK has delivered more than four times the return of the S&P over the last five years and 6.5 times the return over the last three. But this isn’t a high-growth technology stock that’s been clobbering the market. This is a steady defensive stock with highly reliable earnings that has performed so well with far less risk and volatility than the overall market. MCK has a beta of just 0.59, which means the stock is only about 60% as volatile as the market.

The Future
While the past is no guarantee about the future, there are reasons to believe the stock can continue to deliver market-beating performance going forward. For one, the management is very shareholder friendly. The company currently has an $8.9 billion share buyback program over the next few years. It plans to buy back $3.9 billion worth of those shares in fiscal 2024.

McKesson is also focusing on high growth areas in oncology and biopharmaceutical services. In fact, its oncology network already serves 15% of new patients. Management knows the business and where the best opportunities are to deliver pharmaceuticals and services. The company also has plenty of free cash flow it can use to expand and make acquisitions.

That’s all well and good. It has a solid plan to proactively grow its business. But it doesn’t have to go crazy doing that because the main growth catalyst is the growth in existing markets. Pharmaceutical demand continues to rise every year at a solid pace because of the aging population. It has a huge share of a business that will grow all by itself. That’s the advantage of a massive tailwind like the aging population megatrend.

The stock is selling near the high. But despite the recent performance, MCK sells at just 15.5 times forward earnings, which is well below the valuation of the overall market.

McKesson Corporation (MCK)

Security type: Common stock
Sector: Healthcare
Price: $442.00
52-week range: $331.75 - $448.02
Yield: 0.57%
Profile: McKesson is a leading wholesaler of pharmaceuticals that supplies about one third of the U.S. drug distribution market.

Positives

• The market it serves is growing all by itself because of the aging population.
• It operates in an oligopoly with huge barriers to entry and high switching costs.
• The stock has a phenomenal track record with good reasons to believe high returns will continue.

Risks

• MCK sells near the high with a low dividend yield in an uncertain market.
• Drug prices are always under government scrutiny and price pressure could impact profitability.
• The growth of drug distribution through mail could impact growth.

Recent Activity

October 4
SELL Invesco Preferred ETF (PGX)
USB Depository Shares (USB-PS) – Rating change “BUY” to “HOLD”
Vanguard Long-Term Corp. Bd. Index Fund (VCLT) – Rating change “BUY” to “HOLD”

October 11
Buy McKesson Corporation (MCK)
ONEOK, Inc. – Rating change “HOLD” to “BUY”

Portfolio Recap

Enterprise Product Partners (EPD – yield 7.4%) – This midstream energy partnership is holding up remarkably well in this tough market, and better than the other midstream energy companies. EPD continues to trade within pennies of the 52-week high and has returned over 18% YTD after returning over 18% in last year’s bear market. Earnings are resilient in just about any economy and the sky-high distribution yield is very well covered by cash flow. (This security generates a K-1 form at tax time). BUY

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

Rating change – “HOLD” to “BUY”

ONEOK Inc. (OKE – yield 6.0%) – This historically more volatile midstream energy company stock fell sharply in the second half of September, but it is bouncing back strongly this month. OKE fell over 10% but has gotten most of that back. The only news on the company was a series of earnings estimate upgrades. It is also likely that investors realized the resilient business and high and safe yield were a great bargain in this weak market. It may be a good time for this stock and so we upgrade our rating to BUY. BUY

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

Realty Income (O – yield 6.1%) – This rock solid, legendary income REIT has not lived up to its reputation of late. O just hit a brand-new low that is the lowest price for the REIT since the pandemic bear market more than three years ago. Defensive stocks have been poor performers all year. But operational performance has been sound as earnings were solid with a stellar 99% occupancy rate for its properties and an additional $3.1 billion invested in the quarter in 710 properties. O has moved higher from the low. Maybe a great track record and a 6% dividend can perk enough investor interest to drive the stock higher from here. BUY

Realty Income (O)
Next ex-div date: October 31, 2023, est.

The Williams Companies, Inc. (WMB – yield 5.3%) – Midstream energy companies are dividend stocks that have held up relatively well in the market despite rising interest rates. WMB is still trading within about 3% of the 52-week high. It is likely that strength in the more commodity price-sensitive energy stocks is helping the stock while other defensive stocks are struggling. It also operates in an inflation-resistant business and revenues should remain solid even in a slow economy. Earnings were solid and recent expansion and acquisition activity bodes well for growth in 2023 and 2024 beyond what was expected. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: December 8, 2023, est.

AbbVie (ABBV – yield 4.0%) – So far, this cutting-edge biopharmaceutical company stock is getting through this challenging year in decent shape. It has returned -4% YTD. But it has been a lot better over the last two months when it has been up more than 10%. Healthcare is a good sector to be in when the overall market struggles. Shrinking Humira revenues should be overcome with its strong new drugs and pipeline in the future. The recent solid earnings report emboldens the notion that the revenue drop from the Humira patent expiration will be temporary and AbbVie will turn the corner before long. BUY

AbbVie Inc. (ABBV)
Next ex-div date: October 12, 2023

Broadcom Inc. (AVGO – yield 2.2%) – This AI juggernaut looked like it was about to finally have a significant pullback after the huge spring surge but it is hanging tough. True, it has been bouncing around and has gone nowhere since June. But it also seems to have found a more permanent home at this much higher range. It seems to be holding its ground until investors get excited about it again and it has another surge. AVGO has returned 55% YTD and artificial intelligence gives the company a powerful growth catalyst going forward. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: December 20, 2023, est.

Brookfield Infrastructure Partners (BIP – yield 5.5%) – The tough times for safe stocks continue. Despite strong operational performance in a period of shrinking earnings for most companies, BIP continues to make new 52-week lows as investors fear interest rates will limit growth potential. The price hasn’t been this low since the pandemic bear market more than three years ago. But earnings have been solid and growing with remarkably resilient revenue sources ahead of a likely slowing economy. It’s a historically strong market performer, selling at multiyear lows with a safe 5.5% yield. (This security generates a K-1 form at tax time). BUY

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

Digital Realty Trust, Inc. (DLR – yield 4.2%) – This data center REIT has recently given way to the tough market for technology stocks amid rising interest rates. DLR has pulled back about 10% since the end of August as growth rates are being discounted. But the operational performance of the company has been solid. Markets go up and down and sectors rotate. But this is a solid REIT with a good yield and a sizable additional growth catalyst from significantly increasing artificial intelligence spending. BUY

Digital Realty Trust, Inc. (DLR)
Next ex-div date: December 15, 2023, est.

Eli Lilly and Company (LLY – yield 0.8%) – Just when you think this pharmaceutical juggernaut is finally cooling off, it goes higher again. LLY made another new high last month and started pulling back in the second half of September. But it’s up again in October and has made up most of the recent decline. It seems to have found a home in this higher range after returning over 58% YTD. It has two potential mega-blockbuster drugs up for FDA approval this year as well as stellar earnings growth for the next several years. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: November 14, 2023, est.

Hess Corporation (HES – yield 1.2%) – The energy exploration and production company stock hit a new 52-week high last month and then pulled back along with oil prices. The price per barrel of WTI crude oil fell more than $10 from over $93 to under $83 as investors feared high interest rates would slow the economy and energy demand. But HES is busting a move again this week because of fears that the situation in Israel could lead to a wider conflict in the Middle East that could affect oil production. We’ll see if high interest rates or geopolitical turmoil win out in the next couple of weeks. BUY

Hess Corporation (HES)
Next ex-div date: December 15, 2023, est.

Intel Corporation (INTC – yield 1.4%) – After a 15% pullback in September, the bleeding has stopped and INTC has been rallying higher in a tough market. The stock had a huge spike higher in the late summer and a pullback after such a move is normal, especially in a lousy market. The fact that INTC is avoiding falling back into the abyss inspires confidence that the stock is cheap ahead of a brighter future and investors are interested. BUY

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

Qualcomm Inc. (QCOM – yield 2.9%) – The chipmaker stock continues to struggle through this year. It has returned just 2% YTD while the technology sector is up over 30% over the same period. The sector is being driven by stocks with exposure to AI that are benefiting right now. It’s a little soon for Qualcomm. The company is highly dependent on smartphones. And sales have been falling as the 5G cycle comes to an end and the global economy is sputtering. But smartphone sales may have bottomed out. The stock sells at a forward P/E ratio below 11, which is cheap considering the cycle and the growth opportunities in internet of things and other AI applications. BUY

Qualcomm Inc. (QCOM)
Next ex-div date: November 30, 2023, est.

Tractor Supply Company (TSCO – yield 2.0%) – The farm and ranch company stock has been slapped around as investors are worried about the continued resiliency of the consumer. TSCO is near the low for the past year. But Tractor’s rural consumers have already been weak for a while and the company has been successfully compensating with its vast array of staple products. Last quarter, the company delivered 8.5% EPS while average S&P 500 earnings were down. TSCO should be solid in just about any environment with a low beta and a highly resilient product base. BUY

Tractor Supply Company (TSCO)
Next ex-div date: November 25, 2023, est.

UnitedHealth Group Inc. (UNH – yield 1.4%) – The recently underperforming healthcare stalwart has been one of the few bright spots over the past month. UNH is up 8.5% since late September while the S&P is down more than 3% for the same period. Operational performance is stellar and UNH is a superstar that has blown away the returns of the overall market over the past five- and 10-year periods. The stock may be coming alive again as investors are gaining a new appreciation for a dependable healthcare stock in this market. BUY

UnitedHealth Group Inc. (UNH)
Next ex-div date: December 8, 2023, est.

Visa Inc. (V – yield 0.8%) – V did pull back from the high made in September in this tough market. But it has significantly outperformed the market over the past year and is still in a longer-term uptrend. It could take off again if the economic news is good and the consumer stays strong. But it has also shown resiliency in lousy environments. V returned -3.4% in last year’s bear market. It should be a longer-term winner. We’ll see what happens in the next few months. HOLD

Visa Inc. (V)
Next ex-div date: November 10, 2023, est.

NextEra Energy (NEE – yield 3.8%) – These are dark days for NEE that keep getting worse. The stock was already wallowing near the 52-week low when things turned much uglier. The stock has fallen 28% in the last couple of weeks. Utility stocks were struggling as the rising interest rates soured investors on these dividend stocks as fixed rate alternative become more attractive. Then NextEra got bad news. And bad news is disastrous for a stock in a sector that’s already out of favor.

The downturn was triggered by a report from its subsidiary, NextEra Energy Partners, LP (NEP). The MLP announced that it is cutting the projected distribution growth rate from 12% to around 6%. The subsidiary cited higher interest rates for the decision. Investors fear that slower subsidiary growth will negatively affect the parent company’s growth rate. NextEra is sticking with its growth projections for now, but the market doesn’t believe them.

This is a utility that has consistently achieved its projections for more than a decade. Even if the higher interest rates do lower the growth rate, that should be already priced in after a better than 40% fall from the high. The stock now sells near the cheapest valuations ever. We will hold the stock for a bounce back for now. HOLD

NextEra Energy Inc. (NEE)
Next ex-div date: November 29, 2023, est.

USB Depository Shares (USB-PS – yield 5.9%) – This preferred issue has survived a big thrust higher in interest rates in solid fashion. It’s been a tough interest rate environment since this preferred issue was added to the portfolio, with the 10-year Treasury rising from 4% to 4.8%. But the position is only down 4%. If interest rates are near the peak and move lower, the returns should be solid. HOLD

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

Vanguard Long-Term Corp. Bd. Index Fund (VCLT – yield 4.7%) – There could be some near-term turbulence with the price. This long-term bond fund is vulnerable to rising interest rates. It appears rates have stopped rising and have been stabilizing. Even if rates rise further from here, there is a strong chance rates fall lower over the course of the next year. HOLD

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

Xcel Energy (XEL – yield 3.7%) – These days continue to be very ugly for this clean energy utility as well, although not nearly as bad as NEE. XEL has been trending lower since the beginning of April and hit a new 52-week low amid the recent market and sector tumult. This is one of the best utility stocks to own and the recent week’s debauchery may prove to be very temporary. As with NEE, slower growth resulting from higher interest rates is already reflected in the stock price. And rates may be peaking. XEL is now selling close to the pandemic bear market lows of three years ago ahead of a likely slowing economy. BUY

Xcel Energy Inc. (XEL)
Next ed-div date: December 15, 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 November 8, 2023.