The March of the Losers
These are interesting times, but in a way that’s good for income investors.
In last week’s update, I mentioned the market seemed to be viewing the Georgia Senate runoff elections with some trepidation. After all, the market had rallied after the election on the expectation of dividend government, and a diminished chance of draconian legislation.
A Democrat sweep, some believed, could give Democrats control of the Senate and all three branches of government, threatening the divided government outlook, and the market gains from that anticipation.
What happened? The Democrats swept and the market rallied anyway. Go figure.
It seems that investor sentiment concluded that although Democrats will control the government, the majorities will be so razor thin that we will have divided government anyway. But Democrat control makes more stimulus likely. It’s the same essential result as previously expected, but now with more stimulus. The market loves it.
But the main event is still the vaccine and a full economic recovery later this year. The market is already at least partially pricing in a near full recovery, so it better happen. But an actual recovery is still better than an anticipated full recovery. A booming economy, low interest rates and lots of stimulus should be positive for the market.
More important than the market rally is how it is moving higher. The dogs of yesterday are now on top and driving the market higher. The worst-performing sectors are becoming the best performing as energy and financial sector returns over the past three months and year-to-date are blowing every other sector away.
That’s great news for us. The rally is likely to continue in these formerly loser sectors as the recovery gains traction. Not only are these stocks cheap in an expensive market, but they also tend to pay high yields. The result is high yields and fat call premiums. This advisory will take full advantage.
In this issue I highlight two timely stocks for purchase now.
Buy AGNC Investment Corp. (AGNC) Yield 9.3%
AGNC is a mortgage real estate investment trust (mREIT) that invests predominantly in U.S. government-backed residential mortgages. It pays a high dividend yield, currently 9.3%, and makes dividend payments on a monthly basis.
While typical REITs own actual physical real estate properties, charge rent, and pass that income on to shareholders, mortgage REITs are a different animal. They buy mortgages and generate income from monthly mortgage payments. A mortgage REIT borrows money at low short-term rates and uses that money to buy mortgages that pay a higher interest rate, making a profit on the difference in rates, or the net interest spread.
AGNC invests almost entirely in mortgages backed by Fannie Mae and Freddie Mac, so there is virtually zero credit risk. However, there is certainly interest rate risk. It’s all about the spread. If the difference between the short-term rates at which it borrows money and the mortgage interest paid increases, so do profits. When the spread decreases, profits fall.
Mortgage REITs and AGNC are not good investments to buy and forget about. The long-term total returns tend not to be very good. There are good times and bad times to own these securities. I believe now is a very good time. Here’s why.
Mortgage REITs are coming out of a bad time. Prices fell sharply in the pandemic bear market as interest rates crashed and credit concerns in a recession dragged the sector down. The price of AGNC fell 50% in a little over a month during the tumult. But the situation has vastly improved since. The economy is stable and recovering, and longer-term interest rates are moving higher.
AGNC cut the dividend last year in an abundance of caution, from $0.15 per month to $0.12. But as the environment has rapidly improved, the CFO recently said that the cut was probably not necessary. In the third quarter AGNC earned a net interest spread of $0.81 per share, more than enough to cover the $0.36 in dividends paid during the quarter.
The main story going forward is about interest rates. The Fed has a lot of control over short-term rates, as they set the benchmark Fed funds rate, which is currently near zero. The Central Bank has indicated that short-term rates will remain at current levels for some time. The bank has less control over long-term rates as the economy strengthens.
In fact, the 10-year treasury rate, a benchmark for longer-term rates including mortgages, is already on the rise. It has more than doubled from the low of 0.50% in the midst of the bear market to 1.1% today. It stands to reason that if the more full economic recovery that the market is already pricing in comes to fruition, rates should climb further. And there’s room to run. The 10-year rate was over 3% in 2018.
With longer rates and mortgage rates rising and short-term rates staying the same, the net spreads and profits at AGNC are likely to climb. The stock has also been consistently climbing since the summer, but it is still a long way from pre-pandemic levels.
AGNC pays a massive yield of 9.3%. It pays monthly. And the yield should be safe or even growing as profitability increases. A fat yield with a good prognosis for the stock price should make AGNC a winner for income investors.
Buy Brookfield Infrastructure Partners (BIP) Yield 3.9%
This is the CIA portfolio’s second bite at the apple on BIP within the past year. The stock was originally purchased in late July and called away when shares expired in the money on calls that expired October 16. Between dividends, price appreciation and the call premium, the position resulted in a 13.1% total return in three and a half months.
Bermuda-based Brookfield Infrastructure Partners owns and operates infrastructure assets all over the world. The master limited partnership (MLP) 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.
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.
The stock was called away in October at 45 per share. It is currently priced higher at 50.73. We are buying it again at a higher price because the future looks very bright.
BIP performed on par with the market in 2020, with a 15.5% total return for the year. But despite its highly defensive assets, it was impacted by Covid. The unprecedented shutdown of much of the world diminished revenues in the transportation sector. But Brookfield still generated positive earnings growth in every quarter, including 8% funds from operations (FFOs) growth in the last reported quarter.
The diminished Transportation sector revenue should bounce back this year as the pandemic restrictions recede. The company has also been swapping into more profitable assets. Over the last year it has made a considerable shift into the higher margin cell tower business.
Brookfield is also using its considerable liquidity to buy assets on the cheap as the pandemic is causing cash-strapped governments to unload assets to raise money. It acquired $1 billion in new assets last quarter and should continue to pick up new assets that will boost the bottom line in 2021.
Stock Portfolio Recap
Altria (MO) Yield 8.4%
The cigarette maker stock has shown near-term strength and long-term weakness. The recent rally has not been sufficient so far to break the stock out of the long-term down trend. Such behavior reflects the underlying company. In the near term, MO pays a high and safe dividend, has solid earnings and a dirt cheap valuation in an expensive market. Longer term, the business is in decline as cigarette volumes continue to fall. That will be the case until Altria finds another growth catalyst, which it has failed to do so far. This position is likely to be called away, at a huge return, as options expire on Friday with a 40 strike price, currently 41.03. HOLD
B&G Foods, Inc. (BGS) Yield 7.0%
The packaged food company stock has been bouncing around in a sideways range since the summer. BGS was up over 50% in 2020 as earnings boomed when more people ate at home during the lockdowns. After huge gains for a stodgy stock, some investors see BGS as a pandemic stock whose time is ending. But business will be elevated well above pre-pandemic levels long after the lockdowns as more eating at home is here to stay. As well, when the current headlines inevitably fade, investors will realize that dividend stocks are the only game in town to get a decent income. And BGS pays a super duper dividend that is now safe. BUY
Chevron Corp. (CVX) Yield 5.5%
This best-of-breed oil major is on the march again. It’s up 14% so far in 2021 and 8.5% since being added to this portfolio in late December. CVX, and the energy sector, shot higher after the vaccine announcements in early November but then consolidated after the big move in much of December. The pullback was healthy and to be expected. But the upward move has reignited in 2021. There should be a lot more to go over the next several months. I will look to write a call on this position at the opportune time, so please be sure to keep an eye out for “Special Alerts” in your email. BUY
Enterprise Product Partners (EPD) Yield 8.0%
EPD has been red hot. It’s up 15% already this year and 36% since the vaccine announcement in November. Like CVX, EPD is moving sharply higher after a brief consolidation. Business was always resilient and will bounce back quickly for this midstream energy giant. It never deserved to be as low priced as it was. It’s finally rising as the market anticipates a full recovery. At 22.75, the stock also has a long way to go to just get to the pre-pandemic high of over 30 per share. The calls expire on Friday with a strike price of 20 and EPD shares are likely to be called. But we will lock in a great return and likely get a chance to buy it back in the near future. BUY
U.S. Bancorp (USB) Yield 3.3%
Like energy stocks, bank stocks have rallied since the vaccine announcement on the prospect of a full recovery this year. Banks will benefit as loan demand increases and loan losses decrease and longer-term interest rates rise. They got a further boost when share buyback restrictions were removed and then again when Democrats won in Georgia, as the market anticipates more stimulus as a result.
Although the stock price is up since the portfolio purchase in late November (44.68 purchase price versus the current 49.38 per share), calls were written with a strike price of 45. Shares will be called at options expiration on Friday. That’s okay. We’ll get a 5.4% income return in a short time that will go along with the 8.9% total return captured when this portfolio owned the stock and wrote calls earlier this year. HOLD
Valero Energy (VLO) Yield 7.0%
This refiner has a good chance to be a big star in the months ahead. It is very highly levered to a more full recovery, which I believe is likely to unfold in the quarters ahead. It had a huge move higher after the vaccine announcements but has since consolidated. I believe recent behavior in the stock just marks the end of the beginning with a bigger move ahead. Of course, VLO can always get knocked around in the near term depending on the market. But the prevailing trend going forward should be higher. BUY
Existing Call Trades
Sell EPD Jan 15 20 call at $0.80 or higher
These calls expire on Friday with a 20 strike price. The EPD position is likely dead meat. Shares will be called away unless something drastic happens in the next two days; the stock price is currently 22.66 per share. That’s fine. We purchased an out-of-favor stock with a high yield that no one wanted at the time and made a 20% return in about six months. Although EPD will likely trend higher and has a long way to go to just get back to pre-pandemic levels, it won’t go straight up. We will likely get a chance to buy it back and do this again in the months ahead.
Sell USB Jan 15 45 call at $2.00 or higher
These shares are also highly likely to be called on Friday, as I mentioned above. That will provide a 5.4% income return in less than two months and a total return on this stock of 14.3% from its two tenures in the portfolio in the last seven months.
Sell MO Jan 15 40 call at $1.90 or higher
This one is also likely to be called on Friday at a strike price of 40, with a current price of 41 per share. We win whether it gets called or not with a total return of 16% or 15% either way. This portfolio took a market dog and milked it for a great return in little more than half a year.
Sell BGS February 19 27.50 call at $2.40 or higher
These calls are currently priced well below the $2.40 target at $1.15. It’s looking like this one was played right at this point. We wrote in-the-money calls at a lower strike price with a higher premium. The stock has since moved slightly below the strike price. The calls and the dividend will provide a 10.25% income return if BGS closes below the strike price on expiration and a 13.5% return if it closes higher. But there is still a long way to go before February 19. We’ll see.