February 9, 2022

Interest rates are heading higher.

In normal and efficient markets, a strong economy and steeply rising prices would drive interest rates much higher. But rates have been held down and distorted by the Fed’s hyper-aggressive accommodation.

The Fed dismissed inflation in the early stages as “transitory” and now realizes it missed the boat and inflation is getting out of hand. Behind the curve and embarrassed, the Central Bankers will have to make up for lost time by reversing course, ending its bond buying program and raising the Fed Funds rate.

The main force preventing economic growth and rising prices from pushing interest rates higher is about to be removed, and perhaps quickly. Under the circumstances, it is quite reasonable to expect interest rates to move higher.

In this issue, I highlight an investment in the financial sector. Many companies in the sector benefit from higher rates as they earn higher spreads and profits. This company stands to benefit not only from higher interest rates but a change in consumer behavior as well.

This Month’s Featured Stock

A Stock That Benefits from Rising Rates
Interest rates are heading higher.

Both long- and short-term rates are still well below the average levels of the past several decades. Yet, the economy is booming. GDP growth is the strongest in many decades. Plus, there’s inflation.

Inflation has gotten steadily worse over the past year and has blossomed into a huge problem. Prices have been increasing at more than a 5% annual rate for eight consecutive months. The December number came in at a highest-yet 7%. And it may get worse.

In normal and efficient markets, a strong economy and steeply rising prices would drive interest rates much higher. Demand for money increases as the recovery gains steam and the cost of borrowing rises. As prices rise, investors demand interest compensates for the rising level of prices. But rates have been held down and distorted by the Fed’s hyper-aggressive accommodation.

The Central Bank reduced the benchmark Fed Funds rate to near 0% in the heat of the pandemic, where it remains, and purchased $120 billion of bonds every month, which holds longer-term rates down. But that’s about to change.

The Fed dismissed inflation in the early stages as “transitory” and now realizes it missed the boat and inflation is getting out of hand. Behind the curve and embarrassed, the Central Bankers will have to make up for lost time by reversing course, ending its bond buying program and raising the Fed Funds rate.

The main force preventing economic growth and rising prices from pushing interest rates higher is about to be removed, and perhaps quickly. Under the circumstances, it is quite reasonable to expect interest rates to move higher.

Higher interest rates are bad for most companies. It raises the cost of doing business and lowers margins. It also reduces the anticipated growth rates. But there are certain stocks that thrive with higher interest rates.

In this issue, I highlight an investment in the financial sector. Many companies in the sector benefit from higher rates as they earn higher spreads and profits. This company stands to benefit not only from higher interest rates but a change in consumer behavior as well.

What to Do Now
This is a tough market. And it may remain so for much of this year. There is a good chance that 2022 will be a different animal than what we have seen over much of the past two years.

Overall market valuations are high, and problems are growing. Inflation isn’t going away anytime soon. It’s been over 5% for nine months now and it’s already getting baked into the cake. Employers are raising workers’ salaries and businesses are already factoring higher product prices into their business plans.

The Fed’s more aggressive reversal of accommodation will likely disturb the market. These issues meeting a high-priced market should at least hold back rising prices and will likely cause more volatility. But certain sectors are benefitting and will likely continue to do so.

The energy and financial sectors actually thrive with inflation and rising interest rates. These sectors also offer relatively cheap valuations despite the recent performance. The portfolio positions in those sectors are likely to see more good times ahead in the coming months.

The rest of the market is trickier. Stocks will have to be evaluated on how they navigate this market on an individual basis. And we need to be mindful that this year is likely to be a lot less forgiving than last year. It is prudent to have a short leash on stocks struggling with the current dynamic.

That’s why there have been more sells recently, including AGNC Investment Corp. (AGNC), Compass Diversified (CODI) and this week Spectrum Brands Holdings (SPB).

Monthly Activity
January 12^th
AGNC Investment Corp. (AGNC) – Rating change “BUY” to “SELL ½”
Broadcom (AVGO) – Rating change “BUY” to “HOLD”
Compass Diversified (CODI) – Rating change “BUY” to “SELL”
Purchased Global Ship Lease, Inc. (GSL) - $23.40

January 19^th
AGNC Investment Corp. (AGNC) – SELL

February 8^th
Buy Discover Financial Services (DFS)
Spectrum Brands Holdings – Rating change “HOLD” to “SELL ½”

FEATURED ACTION

Buy Discover Financial Services (DFS)
Discover in the fourth-largest credit card company in the country and one of the largest in the world. The company issues credit and debit cards, offers consumer banking products and provides loans. It operates Discover, Pulse and Diners Club networks. Pulse is one of the country’s largest ATM networks and Diners Club is a popular card internationally.

There are two primary revenue streams, interest income from loans and various fees. But make no mistake about it, the primary revenue generator is interest income, which accounts for about 70% of revenues, primarily from Discover cards. Discover makes money on the difference between the low rates at which they secure funding and the exorbitant rates they charge for credit balances.

Discover grows earnings from both additional customers and higher credit balances. It differs from both Visa (V) and Mastercard (MA) in that it actually lends money, while Visa and Mastercard just collect transaction fees. It also differs from American Express (AXP) in that it permits, indeed encourages, customers to carry balances.

Discover issues unsecured credit to individuals. And that is inherently risky. DFS is not a good stock to own during a recession. When the economy turns south people buy less and there are increasing amounts of customer defaults. But in a strong economy that is likely in the early stages of a recovery, it is a very profitable business. That’s where we are now.

Historical stock performance bears this out. Profits grow as consumers increase spending. And the largest spikes in consumer spending tend to happen in the earlier part of the recovery. DFS provided a total return of 505% over the last ten years, compared to a return of 376% for the S&P 500 over the same period. But most of the outperformance came in the first five years as the economy recovered from the financial crisis recession. From 2011 to 2016, DFS returned 215%, more than double the return of the overall market.

DFS got clobbered in the pandemic bear market. The stock plunged 70% between the middle of January and the middle of March in 2020. But the stock came roaring back and has recovered all those losses and then some. In fact, DFS is now over 40% higher than it was before the bear market,

A person might reasonably conclude that we already missed the boat. But there are several reasons that I believe the outperformance should continue.

For one thing, valuation is a more important gauge than price. DFS currently sells at just seven times earnings, which is just a little more than half of the average valuation over the last five years. It also sells at a cheaper forward price/earnings ratio than the five-year average. And there is reason to believe that profits will accelerate in the quarters ahead.

The consumer has been strong. Savings rates skyrocketed during the pandemic as people were locked down in their homes. Many also received generous unemployment and stimulus benefits. As the lockdowns eased, consumers were flush with cash and pent-up demand. They’ve been spending like crazy.

That should be good for Discover. And the company is benefitting. Management described subscriber growth as “really strong” and sales volume was up 27% over 2019 levels. That shows very solid growth with the whole pandemic anomaly factored out. Earnings were solid in the fourth quarter and grew 41% year over year. But there’s another shoe to drop.

Sure, consumers are spending. But they’re paying with cash and not credit. Repayments on credit card loans have been unusually high. Normally, the current level of spending is accompanied by higher credit card balances. But things will change and Discover will get a growth injection.

Consumers have been flush with cash coming out of the pandemic. But that cash will quickly deplete, and consumers will likely maintain their normal spending habits funded by more credit and less cash. High credit loan repayments are a temporary phenomenon coming out this unusual recession. Habits will quickly revert to normal, and Discover will benefit.

Then there are the interest spreads, which account for most of the profit margins.

The Fed will have to raise the Fed Funds rate much quicker than previously anticipated. But they will likely run into trouble. At a certain point, the market will react negatively. At that point, the central bank may find it counterproductive. There will be limits on how much they can raise short-term rates. But longer rates are a different story.

The Fed can control shorter rates, as it sets the benchmark Fed Funds rate. But market forces determine longer rates. True, the bond buying program has the effect of holding longer rates down, but that’s ending. The market will determine longer-term rates now. And if inflation persists, investors will demand higher rates to keep pace.

The situation is likely to raise the interest rate spread between long-term and short-term rates. And companies like Discover should benefit and see increased profitability.

The yield is a rather modest 1.7% at today’s price. But the dividend is incredibly well supported with just a 15% payout ratio. And it grows like crazy. The payout has been raised by an average of 63% per year for the last five years. In fact, the quarterly payout was just raised 14%.

Discover Financial Services (DFS)
Security type: Common stock
Industry: Financial services, credit card
Price: 118.42
52-week range: 75.88- 135.69
Yield: 1.70%
Profile: Discover is the fourth-largest credit card company in the country and also offers other financial services.

Positives

• Consumers are bound to use more credit as robust cash balances from the pandemic deplete.
• Demand for container ships is the strongest in the industry.
• This is a great point in the economic cycle for credit card companies.
• Earnings estimates are trending higher.

Risks

• The stock has steep downside in recessions and bear markets.
• DFS has already had a huge bear market rebound.

Discover Financial Services (DFS)
Next ex-div date: February 16, 2022

Portfolio At A Glance, Portfolio Updates and Dividend Calendar

Portfolio at a Glance

Portfolio Updates

High Yield Tier

The investments in our High Yield Tier have been chosen for their high current payouts. These investments will often be riskier or have less capital appreciation potential than those in our other two tiers, but they’re appropriate for investors who want to generate maximum income from their portfolios right now.

Blackrock Enhanced Capital and Income Fund (CII – yield 5.8%) – The covered call strategy is a great one. I employ it in Cabot Income Advisor. As a fund, it generally works like a traditional high-dividend stock. The price tends to be relatively stable with a high payout. It will generally underperform the market in good times and outperform it in sideways or down markets. It’s always good to have an investment like that in the portfolio. BUY

Blackrock Enhanced Capital Income Fund (CII)
Next ex-div date: February 11, 2022

Enterprise Product Partners (EPD – yield 7.7%) – The stock has been a laggard. It tends to take a rally in the energy sector to get it moving higher, which has been the case recently, and EPD has some momentum. In addition to the stratospheric and safe payout, EPD still sells at a freakishly low valuation at a time when the market is high and energy stocks look ahead to a promising year.

The stock was particularly impressive during the recent market selloff. The stock price has barely budged and actually moved higher. It looks great over the course of the year and unlikely to take a hit in the near term even if the market volatility continues. (This security generates a K1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: April 28, 2022, est.

Global Ship Lease, Inc. (GSL – yield 5.5%) – The container ship company sold off sharply during the market selloff but has come roaring back with a vengeance. GSL is up over 23% from the low of late January. Business is booming as containership rates remain high with no end in sight. GSL is still cheap after a decade of lousy performance. This stock should have a good year. BUY

Global Ship Lease, Inc. (GSL)
Next ex-div date: February 19, 2022, est.

ONEOK Inc. (OKE – yield 5.9%) – The midstream company stock had been in a funk since a big surge this past fall. In fact, it developed a pronounced downward trend until late December. But it has since been revived by the rally in the energy sector. OKE is now back to within just a few bucks of the 52-week high. It smashed the downtrend and should perform well in the months ahead. Business is good and the price is still below the pre-pandemic high despite higher earnings. BUY

ONEOK Inc. (OKE)
Next ex-div date: April 28, 2022, est.

Realty Income (O – yield 4.3%) – The REIT sector is having a rough year so far, but O is hanging strong and not that far from the recent high. The relative strength is encouraging. O is still well below the pre-pandemic high for no good reason. I like the way the stock is situated going forward as earnings are growing at a better-than-average clip because of the recent acquisition. Also, investors should gravitate toward safer dividend stocks in a more volatile year. HOLD

Realty Income (O)
Next ex-div date: February 28, 2022, est.

STAG Industrial (STAG – yield 3.5%) – This industrial REIT did not hold up that well through the REIT selloff, probably because it had been flying so high before. STAG returned 60% in 2021 and it pulled back about 17% from the high in the peak of the market sell down. But it has been moving sharply again since. I’m sticking with it because industrial properties are in high demand and short supply. HOLD

Stag Industrial Inc. (STAG)
Next ex-div date: February 28, 2022, est.

Dividend Growth Tier

To be chosen for the Dividend Growth tier, investments must have a strong history of dividend increases and indicate both good potential for and high prioritization of continued dividend growth.

AbbVie (ABBV – yield 4.0%) – What crummy market? What bad healthcare sector performance? The biopharmaceutical company stock has been marching to its own drum and continues making new highs. The fantastic pipeline is coming to fruition. Its new drugs are getting approved for more indications. And investors are realizing that AbbVie has the firepower to overcome the Humira competition in 2023. Meanwhile, ABBV is still very cheaply priced with a forward price/earnings ratio of less than 10 and one of the highest dividend yields in the industry. HOLD

AbbVie Inc. (ABBV)
Next ex-div date: April 13, 2022, est.

Broadcom Inc. (AVGO – yield 2.8%) – This legendary technology company stock has been very bouncy. It had a big surge in December and then gave it all back and then some during the tech selloff in January. But it spiked higher again over the past few weeks as tech sector selling abated. But it’s mostly all short-term noise and external pressure because the company itself is still doing great. It’s getting a strong earnings and revenue bump in the near term from 5G, and prospects beyond are rock solid as well. We’ll see where it settles in the near term. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: March 21, 2022, est.

Brookfield Infrastructure Partners (BIP – yield 3.6%) – This infrastructure partnership reported strong earnings last week. Funds from operations (FFOs), the key earnings metric for MLPs, grew 19% from last year’s quarter. The company is benefiting from the new Inter Pipeline acquisition, which helped boost midstream segment earnings growth 70%. It’s also benefitting from indexation, as most of its contracted revenue is automatically adjusted for inflation. I expect good performance going forward. It’s a defensive stock in a volatile market and it benefits from the current inflation. (This security generates a K1 form at tax time). HOLD

Brookfield Infrastructure Partners (BIP)
Next ex-div date: February 28, 2022

Chevron Corp. (CVX – yield 4.2%) – The energy powerhouse stock returned 62% in 2021. It’s up over 18% so far this year. It just made another new high. This is a great time for energy as the sector is up a whopping 26% YTD. The sector is benefiting from strong demand and high prices, the price per barrel of oil hit the highest level since 2014 and appears poised to move still higher. Chevron is highly levered to oil prices. Meanwhile, CVX still sells at a cheap valuation, even by energy sector standards. Hopefully the magnificence continues. HOLD

Chevron Corp. (CVX)
Next ex-div date: February 15, 2022

Eli Lilly and Company (LLY – yield 1.6%) – The big pharma company stock has been very bouncy. The latest bounce has been down as the stock is now over 14% below the December high. Lilly reported earnings last week that soundly beat expectations, but there was a caveat the market didn’t like. It’s Covid treatment drug, which had boosted earning over the past several quarters, is not approved for Omicron, which accounts for almost all the cases now. Lilly will take a bit of hit going forward but the long-term situation is still strong. It still has the likely approval of its potential mega-blockbuster Alzheimer’s drug later this year. Plus, even after the recent downside move, LLY has still returned 20% over the past year and 73% over the past two years. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: February 14, 2022

KKR & Co. Inc. (KKR – yield 0.8%) – This alternative asset investment manager stock fell over 6% early Tuesday as earnings disappointed. Profits decreased over last year’s fourth quarter during the booming Covid recovery. However, KKR bested estimates, and distributable earnings more than doubled and asset under management increased 87% from the year-ago quarter. It seems picky, but the stock had been flying high. I still like the prospects over the next year, but we’ll see if the stock recovers over the next week. HOLD

KKR & Co. (KKR)
Next ex-div date: February 13, 2022, est.

Qualcomm Inc. (QCOM – yield 1.5%) – The chipmaker once again killed it on earnings last week. Qualcomm soundly beat estimates as earnings rose 49% and revenues soared 30% from last year’s quarter. It also raised estimates for the current period and received analyst upgrades. QCOM is up about 10% over the last two weeks.

If there was anything less than stellar in the report it was that auto chip sales and Internet of Things sales slightly missed estimates. But that was because a combination of the chip shortage and Qualcomm’s logical focus on the booming handset business as 5G phone sales continue soar. Qualcomm is in great shape and should move higher again as the pressure in the technology sector abates. HOLD

Qualcomm Inc. (QCOM)
Next ex-div date: March 2, 2022

Rating change “HOLD” to “SELL ½”

Spectrum Brands Holdings, Inc. (SPB – yield 1.9%) – The company reported earnings that weren’t good. Although the company beat revenue estimates, adjusted earnings fell to a per-share loss in the quarter. The company cited “unprecedented inflation” as the cause. Higher costs ate up margins and the company was not yet able to pass those costs on to consumers. The company will make adjustments going forward. But it’s concerning that Spectrum is having difficulty with inflation that is likely to persist throughout the year. We will sell half of the position as an act of caution and watch the shares closely from here. SELL 1/2

Spectrum Brands Holdings (SPB)
Next ex-div date: February 18, 2022

U.S. Bancorp (USB – yield 3.1%) – This regional bank stock caught fire in the first half of January as a steepening yield curve promised to juice profits. But USB gave it all back in the second half of the month and the market turned treacherous. However, rates are continuing to rise, and USB is up sharply over the past couple of weeks. Despite the near-term volatility, USB should be poised for a strong year as business is strong and should get stronger and interest rates rise. HOLD

U.S. Bancorp (USB)
Next ex-div date: March 30, 2022, est.

Valero Energy Corp. (VLO – yield 4.4%) – The indiscriminate selling last month even took VLO down. But VLO has regained traction. In fact, it just made a new 52-week high. The company killed it on earnings as it beat estimates by a lot. EPS grew to $2.47 per share from a loss of $1.06, and revenues more than doubled from the year-ago quarter. As anticipated, Valero is benefitting from much higher volumes and margins, and demand and pricing is strong. Meanwhile, VLO is still well below the pre-pandemic price ahead of a likely strong year. HOLD

Valero Energy Corp. (VLO)
Next ex-div date: February 2, 2022

Visa Inc. (V – yield 0.7%) – The card company got a huge boost from earnings a couple of weeks ago. But it has since leveled off. It reported blowout earnings last week and the stock jumped over 10% on the day of the report and spiked over 16% in a little over a week. As anticipated, international business is picking up, as are the very profitable cross-border transactions as travel returns. The stock should continue to have a good year as the company benefits from a fuller recovery in 2022. BUY

Visa Inc. (V)
Next ex-div date: February 10, 2022

Safe Income Tier

The Safe Income tier of our portfolio holds long-term positions in high-quality stocks and other investments that generate steady income with minimal volatility and low risk. These positions are appropriate for all investors, but are meant to be held for the long term, primarily for income—don’t buy these thinking you’ll double your money in a year.

Invesco Preferred ETF (PGX – yield 4.9%) – The ETF has fallen a bit in price over the past several weeks as rising interest rates and inflation have affected it. Preferred stocks tend to hold up relatively well in those conditions, but they are not immune. We will watch PGX for further weakness going forward. HOLD

Invesco Preferred ETF (PGX)
Next ex-div date: February 22, 2022, est.

NextEra Energy (NEE – yield 2.0%) – This alternative energy utility stock is having a rotten year. It fell over 22% in January but it’s recovering sharply thereafter. The fall was amplified by the earnings report. Earnings were stellar but the company announced management changes that the market didn’t like.

The current CEO is being replaced by a 19-year veteran at the company. But the current CEO guided the company to 9% average earnings growth over the past decade compared to an average of 3% earnings growth for its 10 largest rivals over the same period. The market didn’t want to see him go. But I think it’s a big overreaction as the utility will continue a similar track. The recent selloff is a buying opportunity. BUY

NextEra Energy (NEE)
Next ex-div date: February 24, 2022, est.

Xcel Energy (XEL – yield 2.7%) – This alternative energy utility has been solid and barely budged during the market turmoil of the last week. Utilities have been a solid-performing market sector since things got ugly as investors seek defense and safe havens. It’s a good market to have utilities. But XEL also has the added benefit of being on an uptrend and providing a safe way to play the growth in alternative energy. XEL is strong for now and probably stronger later in the year as investors rediscover clean energy growth. BUY

(XEL) Xcel Energy
Next ex-div date: March 21, 2022, 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 estimated.

The next Cabot Dividend Investor issue will be published on March 9, 2022.