November 10, 2021

Inflation is back. And it might be for real this time.

Inflation has taken off since the end of the lockdowns this past spring. In September, the inflation rate rose to 5.4%, the highest monthly reading in 30 years. Inflation over the last twelve months is also the highest such measure in 30 years.

This inflation may prove to be a temporary side effect of the pandemic recovery that will fade away over the next year. But maybe not. Once that inflation genie gets out of the bottle it can be hard to put back. There are powerfull reasons why it could be worse than most expect.

This Month’s Featured Stocks

Inflation Is Back
A new and powerful issue has arisen in the wake of this pandemic recovery. It’s called inflation. It hasn’t been a real problem in ages. But it used to be a huge problem.

It’s a time warp. Inflation is an issue that transports us back to the world of the 1970s. If you’re old enough to remember, inflation was as much a part of that decade as ugly clothes and lax morals.

Inflation was in the news all the time. It never went away and always got worse. Every President in that decade declared war on inflation and lost every single war. It seemed like an insurmountable problem that could never be fixed, any sooner than you could fix bad taste.

It finally faded in the 1980’s and has never really been a big problem since. But now, inflation is rearing its tacky head again. Is it for real?

Inflation has taken off since the end of the lockdowns this past spring. In September, the inflation rate rose to 5.4%, the highest monthly reading in 30 years. Inflation over the last twelve months is also the highest such measure in 30 years.

The cause is primarily the rapid shut down and startup of the economy in the pandemic. Supply chains, many of which originate overseas, are delicate. They got broken in the global shutdown and haven’t recovered yet. But the consumer has. Flush with savings and pent-up demand, consumers are on a buying spree. High demand and limited supplies are a recipe for rising prices.

But this inflation is still widely considered to be a temporary situation. As supply chains eventually recover, and the consumer becomes less rich, the supply/demand dynamic will come back into balance. And prices will come back down.

That will probably be the case. But inflation is already proving to be a much stickier problem than originally thought. Supply chains are still getting worse. Consensus opinion is evolving into the view that inflation will last a while. Even the Fed is backtracking on that “transitory” stuff and acknowledges that it will last well into next year at least.

The pundits might be right, and this inflation will prove to be a temporary side effect of the pandemic recovery that will fade away over the next year. But maybe not.

Rising prices can be a psychological phenomenon as well as an economic one. The longer prices continue to rise, the more people expect it. Once that inflation genie gets out of the bottle, it can be hard to get back in.

There’s also the matter of the $6 trillion the government printed and spread into the economy during the pandemic, as well as trillions more likely on the way. Inflation is defined as “too much money chasing too few goods.” Even if the “too few goods” part gets fixed, won’t there still be too much money?

We’ll see what happens. But whether inflation lasts for several years or just a year, it’s worth defending your portfolio against the effects. In this issue, I highlight two portfolio positions that are ideally suited for rising prices and should thrive in an inflationary environment.

Monthly Activity
October 13
Valero Energy (VLO) – Rating change “HOLD” to “BUY”Chevron (CVX) – Rating change “HOLD” to “BUY”Purchased Compass Diversified (CODI) - $31.10

October 20
Eli Lilly & Co. (LLY) – Rating change “HOLD” to “BUY 1/3”

October 27
BlackRock Enhanced Capital Income Fund (CII) – Rating change “HOLD” to “BUY”ONEOK Inc. (OKE) – Rating change “BUY” to “HOLD”Spectrum Brands Holdings, Inc. – Rating change “BUY” to “HOLD”

November 3
KKR & Co. (KKR) – Rating change “BUY” to “HOLD”

November 10
KKR & Co. (KKR) – Rating change “HOLD” to “SELL 1/2”

What to Do Now
Times are good. After a rough September, the market soared 8% higher to a new all-time high. Earnings have been spectacular, and the bull market is back.

There are nine portfolio positions that are at or near the 52-weeks high. This is typically a good time to pull back on the throttle and take some profits. However, most of these positions still have strong momentum and the market looks bullish over the rest of the year.

Along with the energy stocks, which have consolidated since the October surge, several positions have been on fire. These include Qualcomm (QCOM), KKR & Co. (KKR) and Eli Lilly (LLY). QCOM is up 23% in the past week after reporting blow-out earnings and receiving several analyst upgrades.

Most of the stocks near highs still have good momentum, and it doesn’t seem like the time to pull the plug and take profits. QCOM and LLY are still below the 52-week high. Other stocks haven’t shown signs of weakness yet. However, I believe it’s a prudent time to take a profit in KKR. That stock had a huge run and has already pulled back over 5% from the recent highs. In that particular case, it seems prudent to take some money off the table while the going is still so good.

FEATURED STOCKS

One area that is especially suited for inflation is commodities. Hard asset prices tend to rise disproportionality with inflation. Dollars buy less and it takes more of them to buy the same assets. Materials and commodities also tend to get steeper price rises than the overall economy.

Oil and gas are essential commodities. And energy companies tend to thrive during times of inflation as the price of oil and gas tends to rise a lot more than the costs of extracting it and bringing it to market. The Energy Select Sector SPDR Fund (XLE), which tracks stock in the S&P 500 energy sector, soared 23% from late September to late October. XLE is also up over 100% for the past year.

Energy stocks got creamed during the pandemic and a big part of the high returns over the past year was a recovery from absurd lows as the lockdowns ended and demand returned. But the latest surge is directly attributable to inflation and rising energy prices. Prices should continue to skyrocket on strong demand and supply constraints with no end in sight.

It’s worth noting that midstream energy portfolio positions Enterprise Product Partners (EPD) and ONEOK Inc. (OKE) should hold up well while we have inflation for two reasons. One, because the high yields provide a good chunk of total return and in these cases outpace the inflation rate. And two, they both have inflation adjustments built into their service contracts. But they aren’t levered to commodity prices and don’t benefit as directly from inflation as the stocks highlighted below.

Valero Energy (VLO)
Valero is the largest petroleum refiner in the U.S. It has 15 petroleum refineries and markets products in 43 states, Canada and the U.K. It is also one of the largest producers of ethanol and has a rapidly growing renewable diesel business.

It is the best refiner because it is the most technologically advanced and has some of highest and most resilient profit margins in the business. But none of that is the main story for this stock right now. It’s all about the recovery. Refiners are extremely cyclical. And Valero is a high-leverage play on the continued recovery in energy stocks.

As demand for gasoline and diesel crashed during the pandemic, VLO got crushed. In late October, VLO was down 50% from the pre-pandemic high and 70% from the all-time high. But things are reversing in a big way. VLO has more than doubled over the past year.

Third-quarter revenue soared 87% from the year-ago quarter and profits flipped from a negative $464 million to a positive $463 million over the same period. Sure, crude oil is a cost and the price per barrel is way up. But so is the price of gasoline, which has more than doubled over the past year. Valero is good at making sure the margins are still high. And the robust demand and prices of refined products should stay strong in the quarters ahead.

But you haven’t missed the boat. VLO still sells at nearly 10% from the 52-week high, 23% below the pre-pandemic high, and 37% below the all-time high. This refiner should have a lot more room to run.

Chevron (CVX)
Much of what I said about the cyclicality and pricing of VLO is true for CVX as well, except to a lesser extent. Chevron is the best-run oil major with high margins and can more quickly turn a profit as things improve. It didn’t go down as much as VLO and has gone up less too. But the gist of the move is the same.

Chevron started the pandemic in much better shape than it peers and weathered the storm better. The company has done a stellar job of getting leaner and meaner over the last several years. Chevron’s cost per dollar of BOE produced has fallen from $18 in 2014 to under $10 today. Chevron has lower costs and higher margins than its peers.

The oil giant also hit this recession right. It completed several large projects in the past several years and had already wound down capital expenditures.

There’s an important thing to realize about Chevron. It is skewed more heavily toward oil exploration and production and is more leveraged to oil prices than the other energy majors. It’s loving the current environment. Third-quarter earnings skyrocketed to $6.1 billion, the highest since 2013. Cash flow of $6.7 billion for the quarter was the highest ever.

Yet, despite the stellar performance, CVX is still below the pre-pandemic price. The good times should continue to roll for CVX which received a slew of analyst upgrades after the third-quarter report.

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.

AGNC Investment Corp. (AGNC – yield 8.9%) – After trending higher through October amidst rising interest rates, AGNC took a hit after the earnings report. Although earnings came in better than expected, AGNC was downgraded by JPMorgan to “market perform” citing the lack of a catalyst for a move higher. I disagree. Inflation and rising interest rates will do just fine as a catalyst. We’ll see. The stock seems to have stabilized. BUY

Blackrock Enhanced Capital and Income Fund (CII – yield 5.5%) – This covered call ETF is a solid performer and a way to get a solid income at the same time. It lags when the market is hot but relative performance increases when the market rises slowly or goes sideways. It tends to move roughly in the direction of the overall market. It was lowered to a HOLD during the September turbulence but has since been raised back to a BUY as the market found its mojo again. BUY

Compass Diversified (CODI – yield 4.7%) – This holding company for small businesses reported strong earnings that beat estimates at the end of October and has rallied over 6% since. The huge growth over last year is because of new acquisitions as well as the economic recovery. Small businesses tend to thrive disproportionately in a recovering economy. I expect the uptrend to continue. BUY

Enterprise Product Partners (EPD – yield 8.0%) – This slow-moving (buy very high-yielding) midstream energy partnership had really started moving higher again in October during the energy sector rally. But earnings failed to impress, and the stock gave up most of those recent gains. Volumes were higher pretty much across the board. Most measures of income, including operating income and free cash flow, were higher over last year’s quarter. But not by that much.

Of course, earnings didn’t suffer much in the pandemic. For 2020, distributable cash flow only fell 3% from the prior year. There is no robust recovery because there was no robust bust. Enterprise is being perceived as failing to deliver on the excitement of the energy sector revival. But business is still solid and improving. The stock has been moving higher again and that huge distribution is rock solid. BUY

ONEOK Inc. (OKE – yield 5.8%) – This midstream energy company also had a big move higher in October. But it has leveled off and not pulled back like EPD. ONEOK announced earnings that showed strong growth and soundly beat expectations. Although business didn’t falter much in 2020, ONEOK posted year-over-year 26% earnings per share growth. It deals in the high-growth natural gas and NGL segments that are seeing a strong rebound in recovery. Business is booming and OKE is still priced below pre-pandemic levels despite having higher earnings. HOLD

Realty Income (O – yield 3.9%) – This legendary income REIT completed a merger with similar company VEREIT (VER). The market has reacted positively to the deal as it will be immediately accretive to the bottom line and give the stock another positive catalyst in the near term. The deal also includes the receipt of shares of a spinoff company which includes all the office properties of Realty Income and VEREIT. The new company will be called Orion Office REIT and trade under the symbol (ONL).

Shareholders of O on the record date November 1 will receive one share of ONL for every 10 shares of O on the spinoff date November 12. Office properties are not the best place to be as the work-from-home trend is here to stay and the supply/demand dynamic of office properties is not in a healthy state, that’s why the properties are being spun off. But the shares are a freebee, and an extra and unexpected distribution. The position of this newsletter is to sell the shares upon receipt and consider the proceeds an extra cash distribution. HOLD

STAG Industrial (STAG – yield 3.4%) – This industrial REIT reported solid earnings that beat estimates last month. It grew earnings per share by 15% over last year’s quarter as acquisition and strong demand for industrial properties in the recovery powered results. STAG has pulled back about 5% from the high after a strong surge earlier this year and in October. But that’s consistent with the pattern over the past year and STAG could again move higher. Until the stock shows some significant weakness, there’s no reason to abandon it. HOLD

Verizon Communications (VZ – yield 4.9%) – I would say that these big telecom companies have become like utilities, with a high dividend and little growth. But that would be an insult to utilities. That sector has performed much better. Recently, Verizon announced a delay in the 5G rollout, which the market didn’t like. VZ is at the low point of the recent range, and we’ll see if it at least gravitates to the higher end in the months ahead. HOLD

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 4.8%) – Earnings revived this recently floundering biopharmaceutical giant. AbbVie soundly beat earnings estimates last month with 18% earnings growth and 11% revenue growth for the quarter. AbbVie also raised full-year guidance and raised the dividend 8.5% to $1.41 per quarter. Results were helped by a rebound in cosmetic treatments as Botox sales grew 49% as well as stronger than expected performance for its blockbuster drug Humira and its recently launched immunology drugs.

The stock had been wallowing since late August after the FDA announced a requirement for the company to put a nasty warning label on one of its most promising new drugs. LLY is up about 6.5% since the report and looks like it may make a run at the recent high. BUY

Broadcom Inc. (AVGO – yield 2.6%) – This chip and software infrastructure icon has really found its legs since the beginning of October. It had gone sideways since February but now AVGO is up over 17% in just a little over a month and has been making a series of new all-time highs. The stock started to gain traction after impressive earnings last September. It reports third-quarter earnings again in December. The company is growing earnings better than expected and will likely continue to do so. BUY

Brookfield Infrastructure Partners (BIP – yield 3.3%) – This infrastructure partnership is breaking out. It had been a very slow mover, but BIP is up 14% since late September, a big move for this stock. It’s now at a new all-time high. Last week’s earnings grew a solid 12.6% over last year’s quarter and it raised the dividend 5%. Brookfield also completed the acquisition of Inter Pipeline last month, which should boost earnings going forward. It may also be getting a boost from the passage of the new infrastructure bill and it increased investor awareness of the sector. HOLD

Chevron Corp. (CVX – yield 4.7%) – This best-in-class energy major is at a 52-week high. It has returned 70% over the past year. Yet, the stock price remains below the pre-pandemic price despite a much better environment now. It’s a simple story right now.

Chevron is more levered to the price of oil than any other major and oil prices are skyrocketing and unlikely to come down anytime soon. Chevron reported earnings in late September that had the highest profits since 2013 and the highest free cash flow ever. The stock is also a great inflation hedge and should have more room to run. BUY

Eli Lilly and Company (LLY – yield 1.3%) – The biopharmaceutical giant bounces around a lot. It had a huge surge over the summer on the likelihood of an approval of its Alzheimer’s drug next year. It then pulled back 25% for no good reason. But after getting the obligatory dip after the surge out of its system, LLY has turned back up with a vengeance. LLY soared 20% in a month and came within a whisker of the all-time high again. Look, this is a fantastic drug company and stock that should serve you very well over time. But it’s going to bounce around a lot in the process. HOLD

Rating change “HOLD” to “SELL ½”
KKR & Co. Inc. (KKR – yield 0.7%) – This alternative investment asset manager has cooled off over the past week. That was to be expected, which is why the rating was lowered to a HOLD last week. KKR had run up 40% in a month on blow-out earnings and the fading of Chinese contagion fears. It has since pulled back about 6% from last week’s high. The stock has returned 96% for 2021 and about 70% since being added to the portfolio in March. It’s a big move in a short time and some consolidation can be expected. Let’s take some profits off the table while the going is so good. SELL ½

Qualcomm Inc. (QCOM – yield 1.7%) – Holy cow! It looks like the QCOM ship we’ve been waiting for has finally come in. After floundering since February after a big surge, the stock is up 25% in the last week. The price rises every day and is now near a new high. We’ve been patient with this stock on the assumption that when it moves it can make up for lost time. Here it is.

Qualcomm reported blow-out earnings that shattered expectations and the company also raised guidance for next year. The chipmaker grew earnings over 100% for the past year and forecast continued growth of 20% in fiscal 2022. Along with red-hot, 5G-chip phone royalties, the company’s other businesses with great prospects over the longer term are killing it too. There were also a slew of analyst upgrades after the report as earning projections for next year are rising. BUY

Spectrum Brands Holdings, Inc. (SPB – yield 1.8%) – There is some caution here. The company reports earnings next week. Although earnings in general have been able to successfully navigate the supply and inflation issues so far, Spectrum’s last earnings report was negatively impacted by inflation. There could be a disappointment in the works. That’s why this seller of home products was downgraded to a HOLD a few weeks ago. HOLD

U.S. Bancorp (USB – yield 3.0%) – The regional bank stock had a nice move between the middle of September and mid-October. But it has since been bouncing around near the high point of the recent range. Earnings disappointed the market as the bank didn’t realize higher net interest income in the quarter because rates didn’t move higher until the very end. It may go sideways for a while, but I like the bank’s prospects over the intermediate term. Business is solid in every area except net interest income. But that should rise with interest rates in the quarters ahead. HOLD

Valero Energy Corp. (VLO – yield 5.0%) – The economy is recovering, and energy demand is soaring. Oil prices are the highest in seven years. Gasoline prices have doubled over the past year. The refiner reported an 86.73% revenue increase over last year’s quarter. And profits flipped from a loss of $464 million to a profit of $463 over the same period. That’s why VLO is up over 100% for the last year.

The stock recently soared near the 52-week high but has since pulled back along with the energy sector after a big October. I don’t see prices going lower soon. At the same time, demand should remain strong for gasoline and diesel. Meanwhile, VLO still trades below the pre-pandemic level. I think the rally has more to go. BUY

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%) – This unusual, fixed income investment is delivering as advertised. You don’t get any real price appreciation, aside from recovering from the pandemic bear market. But the yield is solid, and it’s dependable, and it’s paid monthly. PGX is also a good way to diversify as preferred stocks are not highly correlated to the stock or bond markets. HOLD

NextEra Energy (NEE – yield 1.8%) – It’s tough to figure out this regulated/alternative utility stock recently. It just sort of bounces around like a high quality utility stock, going in and out of favor. But it used to be more and will be again. It should mainly be a fantastic way for conservative investors to play the growth in clean energy. But investors seem to have forgotten all about clean energy for the time being as conventional energy has gotten red hot in the recovery. But NEE should be back to its old ways when the market normalizes. BUY

Xcel Energy (XEL – yield 2.9%) – This alternative energy utility is still floundering near the low point of the recent crummy range. Investors seems to be ignoring the growth in alternative energy while conventional energy is hot. But alternative energy still owns the future, and nothing has changed for XEL since it was a darling of investors before the pandemic. In the near term, XEL should at least gravitate to the higher point of its range. Longer term, it should regain its rightful place as a sought-after conservative play on alternative energy. BUY

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 December 8, 2021.