October 26, 2022

The Bloodbath in Defense is Overdone

The market has been a lot better over the past week. The reason is earnings.

So far, earnings have been better than expected this quarter, although it’s still early. The hope is that a soft landing is still possible, at least as far as corporate profits are concerned. The early better-than-feared results are prompting hope that corporate profits can weather this recession with less damage than has already been priced into stocks.

I hope that optimism comes true but I’m still skeptical that this rally can gain sufficient traction to lead us out of this bear market ahead of still stubbornly high inflation and a likely recession in the months ahead. There remains a strong possibility that the market will hit a new low before the pain is over.

That said, this rotten market is likely closer to the end than the beginning. Markets tend to anticipate six to nine months into the future. At some point in the not-too-distant future, investors will see a turnaround where inflation falls, and the Fed is done hiking rates. Many stocks are at dirt-cheap prices compared to where they will be a year from now or maybe a lot earlier. But I don’t see a turning point quite yet.

While the pain in cyclical stocks may not be over yet, they have more upward traction longer term. But the more near-term opportunity is in the defensive portfolio positions. Most of these stocks plunged in the recent selloff as interest rates soared and fixed-rate alternatives became more attractive. These stocks may have already bottomed.

The selling of defensive dividend payers in likely overdone. Recessions put negative pressure on interest rates as demand for loans decreases and inflation rates fall. Meanwhile, the portfolio positions in utilities are some of the best to own in a recession under normal circumstances, but especially from near the 52-week lows. That’s why NextEra Energy (NEE) and Excel Energy (XEL) were upgraded to BUYs last week and Brookfield Infrastructure Partners (BIP) gets upgraded this week.

High Yield Tier

Enterprise Product Partners (EPD – yield 7.6%) – The midstream energy partnership is having a terrific year compared to the overall market. But it’s still well off the high of June. It seems to have gotten somewhat caught up in a more inclusive market malaise. But with decent price performance and that amazing distribution yield EPD is a huge winner in this environment. I expect the same or better going forward. Maybe next week’s earnings will get investors more excited. (This security generates a K-1 form at tax time). BUY

ONEOK Inc. (OKE – yield 6.6%) – OKE is negative for the year but has still vastly outperformed the overall market, although it is miles from the 52-week high, down 25%. The stock has also underperformed its midstream energy peers this year. This lagging performance is still hard to explain. Earnings in this natural gas arena are resilient and continued to grow through the pandemic. It pays a huge dividend and has automatic inflation adjustments built into its contracts. This midstream energy company also reports earnings next week. BUY

Realty Income (O – yield 5.1%) – This legendary monthly income payer recently hit the 52-week low and remains a long way from the pre-pandemic high, despite having higher earnings. REITs have been under pressure from rising rates at it raises costs for growth projects. But Realty just made a large acquisition and should get strong growth because of that over the next year. Like other defensive dividend-paying stocks.

O had been buoyant until the recent selloff. But now its dirt cheap ahead of a recession that will put downward pressure on interest rates. It has averaged a better than 14% average annual return since its inception in 1994. But that performance is a lot higher when it was purchased near the 52-week low. BUY

The Williams Companies, Inc. (WMB – yield 5.3%) – This midstream energy company in the form of a corporation has been strong so far this month. It also managed to stay above the 52-week low during the selloff. Williams announced that it expected a strong third and fourth quarter and reaffirmed 2022 guidance near the high end of the previous range as the natural gas assets remain strong performers. WMB had great momentum before the recent selloff because it’s ideal for the current environment of inflation and recession. Hopefully, next week’s earnings will trigger a faster move higher. BUY

Medical Properties Trust, Inc. (MPW – yield 11.2%) – This hospital property REIT sells at a fire sale value with a stratospheric dividend yield that should be safe. The stock had been beaten to a pulp and the REIT group had a big selloff as interest rates spiked. Shares are down 53% YTD but the company’s finances haven’t taken a hit. Adjusted funds from operations are up 9.4% year over year in the first six months of the year and the company raised the dividend for the 10th consecutive year. But the stock continues to trend lower as investors seem more keyed on momentum than fundamentals in this market. And yet it’s dirt cheap with a safe dividend. Fundamentals win in the end. HOLD

Dividend Growth Tier

AbbVie (ABBV – yield 3.8%) – Hats off to ABBV. It is one of very few stocks that is actually trading higher since the beginning of August. It also has a positive return YTD, which makes it somewhat of a superstar in this crummy market. But ABBV is still way off the high of last spring and has been sort of floundering since. It may be because of worry about the Humira patent expiration next year.

But those worries are overblown as the company already has two worthy successors to the drug whose sales won’t fall off a cliff after expiration. It also has one of the best pipelines in the business. In addition, Humira worries are already very much baked into the price and overblown. ABBV sells at just 12 times forward earnings. HOLD

Broadcom Inc. (AVGO – yield 3.6%) – While the chip maker and infrastructure software provider continues to deliver on an operational basis, it’s getting creamed by this market. Broadcom once again delivered on earnings with 40% earnings growth and a 25% revenue increase versus last year’s quarter. It also raised guidance for the rest of the year. But that seems to matter very little in a year when the whole technology sector continues to get crushed. But the tech sector will recover. And when it does, AVGO will make up for lost time. HOLD

Rating change “HOLD” to “BUY”

Brookfield Infrastructure Partners (BIP – yield 4.3%) – This once buoyant and positive YTD performer has been clobbered in the latest round of market selling. Interest rates spiked and defensive dividend-paying companies got creamed as fixed-rate alternatives became more attractive. BIP plunged 23% in a month. Therein lies the opportunity.

Interest rates may not stay at current levels when the increasingly expected recession hits. Brookfield should also benefit from recent acquisitions and its exposure to midstream natural gas. There is huge demand for liquified natural gas in Europe and Asia. As a result, North American natural gas production should remain strong even in a recession. BIP pays a solid dividend backed by recession resistant earnings that should be on the rise. BUY

Eli Lilly and Company (LLY – yield 1.2%) – LLY is a superstar. It was the only S&P 500 stock to make a new high last week. It’s up 30% YTD, which means it is outperforming the market to the tune of about 50%. How is it defying gravity like this? In addition to having one of the very best pipelines in the industry at a time when the population is aging at warp speed, it has two potential mega blockbusters pending approval.

Its diabetes drug Mounjaro is pending fast track approval for weight loss. Studies so far have made the drug one of the most promising ever seen in a country where nearly 2 in 5 adults are considered obese. Some analysts estimate the drug could have annual sales of $25 billion. There’s also the Alzheimer’s drug that could be huge. It’s a great time for a great drug company. HOLD

Intel Corporation (INTC – yield 5.3%) – One day in the not-too-distant future the absurdly low valuation and the 5.3% yield in this stock will have been a huge missed opportunity for many investors. The problem is the dream may take a while to realize. These markets require a more long-term orientation to make money. The near-term frustration should be well compensated over time. The stock continues to be under pressure along with the rest of the tech sector in a market where value and fundamentals don’t matter right now. The short term is ugly, but the dividend should continue to be safe with a very low payout ratio. HOLD

Qualcomm Inc. (QCOM – yield 2.7%) – It might take a while longer, but technology will be back. After all, we are in a technological revolution and that sector is where most of the earnings growth is. When that happens, QCOM should be among some of the very first stocks to spike higher. The operational performance has been spectacular. Even with falling smartphone sales, Qualcomm anticipates earnings growth of 23% in the second half of the year. Meanwhile, QCOM is dirt cheap for the growth it offers. HOLD

Visa Inc. (V – yield 0.8%) – V tends to bounce back quickly when the market stabilizes for good reason. Earnings remain strong even in a weakening economy. The reason is that the rebound in international business resulting from the removal of Covid restrictions outweighs the drag of a slowing economy. In addition, Visa should be a huge beneficiary of the eventual market turnaround and the other side of the recession. It’s been a drag along with everything else of late, but V should pay off in the not-too-distant future. HOLD

Safe Income Tier

NextEra Energy (NEE – yield 2.3%) – The alternative energy utility continues to rebound since being upgraded to a BUY last week. This is one of the best utilities on the market with reliable revenues in any economy and growth from its huge clean energy business. The stock was decimated in the recent selloff because of spiking interest rates. But the evolving recession is likely to knock rates down in the months ahead. And NEE should be a stellar relative performer in a recession. BUY

Xcel Energy (XEL – yield 3.2%) – There is probably no bad time for long-term investors to buy this smaller alternative energy utilities. But buying it near the 52-week low is a conspicuously good time. It has the same recession-resistant revenues as NEE as well as growth from clean energy. I expected the stock to perform well in a recession. But from the 52-week low, it may perform very well. BUY

USB Depository Shares (USB-PS – yield 6.1%) – Interest rates have spiked to the highest level in more than a decade. This investment grade fixed rate investment is something that income investors have missed for many years, a sizable yield on a safe income investment that is diversified from the stock market. Interest rates may go higher. But they are less likely to average higher over the next several years as a recession will put negative pressure on rates. BUY

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