Cabot Dividend Investor Issue: December 14, 2022

Hope for the Best, but Prepare for the Worst

It’s been an awful year for the market. Next year should be better.

2022 has been a bear market. While the index returns have been bad, most individual stocks have fared far worse. The average S&P 500 stock is down 30%. The average Nasdaq stock is 50% lower. As this abysmal year comes to an end and we look ahead to 2023, there are reasons for both optimism and caution.

Let’s take the optimistic view first.

Inflation has been moving lower and has likely peaked. In response, the Fed has already raised the Fed Funds rate to the highest level in 15 years. The twin catalysts of ever-rising inflation and a hyper-aggressive Fed that caused this bear market are likely to abate in 2023.

Markets tend to anticipate six to nine months into the future. The average bear market since 1980 has lasted 15.2 months (minus the very short-lived and bizarre pandemic bear market in 2020). In those six bear markets, only one lasted as long as two years. This bear market is almost a year old.

In the 42 years since 1979 (1980 through 2021), there have been seven calendar years of negative market returns. Five of those years were followed by years of market returns of at least 20%.

But there’s also good reason for caution in the near term.

Inflation has gone down a little. But it’s still way too high. No one really knows how easily it will fall or how sticky it will be. It could continue to recede without much more pain, or it could take a deep recession to tame it. Plus, there is great uncertainty about how much damage the Fed has done already.

It takes a while for the effects of interest rate hikes to filter through the economy. This has been the steepest, or fastest, rate hiking cycle in the last 30 years. It will be several months from now before we know how the economy reacts. The economy may fall into a deeper recession than currently expected. It’s also possible that the economy endures the rate hikes well, but inflation remains, and more rate hikes will be necessary.

In short, it is reasonable to expect a significant market turnaround sometime next year. But it’s difficult to see how the market will generate lasting upside traction ahead of the current uncertainties. Things should get a lot better in 2023. But there is a strong chance they get worse first. The market could hit new lows before it recovers.

Of course, a recovery and new bull market should reward the short-term pain handsomely over time. As a longer-term investor, which dividend investors should be, it should just be short-term noise on the way to long-term profits. But we can do better than just riding out the storm. We can exploit another possible market downturn to our advantage.

It’s a fact that many stocks that get hurt the worst in a bear market are the first to recover when the market turns. In this issue, I highlight a phenomenal cyclical stock that had been a market superstar but has been clobbered in this bear market. The stock is targeted at a low, low price that may be reached if the market falls to a new low. It could provide incredible upside leverage ahead of a market recovery.

Sure, the stock may never hit that price. Things could go well, and the market could continue to recover from here. It’s possible. But that’s OK. Let’s hope for the best but prepare for the worst in a way that could make you richer over time.

What to Do now

The safe stocks are working. Healthcare, utilities, and consumer staples have been the top-performing S&P 500 sectors over the past month. The reason for the strong performance is twofold: the stocks steeply sold off as interest rates spiked in the fall selloff, and we are looking ahead to a likely recession in 2023.

Dividend payers got clobbered as the 10-year Treasury rates spiked to a 15-year high in October. But falling inflation and a slowing economy have since dragged rates lower. A recession next year would apply more downward pressure. The impetuous fall trade got undone. It’s also worth owning these defensive stocks ahead of a souring economy, where their historic relative performance is best.

NextEra Energy (NEE) and Xcel Energy (XEL) are both up over 20% from the October lows. Meanwhile, Eli Lilly (LLY) recently made a new all-time high and AbbVie (ABBV) is at the highest level since the spring and may be poised to make a run at the high. Those stocks along with Brookfield Infrastructure Partners (BIP) and the three midstream energy stocks, Enterprise Product Partners (EPD), ONEOK Inc. (OKE), The Williams Companies (WMB,) are all currently BUY-rated.

The more cyclical stocks remain a HOLD as the view is still cautious going into 2023.

Featured Action: Target KKR & Co. Inc. (KKR) below the current market price

Alternative assets are basically those that do not fall within the realm of traditional stock and bond market investments. In the world of high finance, these assets include areas such as private equity and hedge funds, among other things. Private equity includes investments of debt and equity stakes in companies that are not publicly traded or available to most investors. Alternative assets are a growth business for good reasons.

Consider your own investment situation. This year is a bear market for stocks and things could get worse as we head towards a likely recession. At the same time, it has been one of the worst years for bonds on record as interest rates have spiked to the highest level in 15 years. Traditional investing has suddenly become a much more risky endeavor.

This is an even bigger problem for high-net-worth individuals, and most especially for institutions like pension and endowment funds with fiduciary responsibility. They need to manage risk and diversify away from the market and get a decent return at the same time. Alternative assets are just what the doctor ordered.

KKR & Co. (KKR), Formerly Kohlberg Kravis Roberts Co., is a leading global alternative asset manager. The firm manages multiple alternative asset classes including private equity, energy, infrastructure, real estate, credit, as well as hedge funds through strategic partners. It generates revenues from management fees, performance income and investment income with a global reach on five continents. It also has a sizable presence in insurance with annuities, life insurance and reinsurance.

As with any product that satisfies an otherwise unmet demand, alternative investments have been growing like crazy. The assets class has gone from the periphery in the early part of last decade to a major player in the investment industry.

It is estimated that alternative assets worldwide will continue to grow, from $14 trillion in 2020 to more than $21 trillion by 2025. Estimates vary, of course. But all estimates show rapid growth. There are several major publicly traded players in the alternative asset arena. Industry powerhouses include The Blackstone Group (BX), The Carlyle Group (CG) and Apollo Global Management (APO). Why pick KKR?

One reason is superior stock performance. Before this year, KKR had blown away the performance of its peers in just about every measurable period over the past five years. Since its IPO on July 15, 2010, KKR has delivered an average annual return of about 19% (with dividends reinvested). In 2021, KKR delivered a total return of 90%.

The superior performance is well justified with a look under the hood. Assets under management (AUM), a hugely important determinant of revenues, grew at a compound annual growth rate (CAGR) of 22% since 2011. Annual fee business, which adds predictability, has grown at a CAGR of 15% since 2016. Earnings per share grew at an average rate of more than 14% per year over the past five years.

But KKR is a very cyclical stock as earnings are highly dependent on investment performance in the near term. The stock fell nearly 50% from the 2021 high before recovering somewhat in the last rally. Third-quarter earnings fell $0.11 per share compared to a profit of $1.94 per share in last year’s quarter as the decline in the value of investments decreases fees. But that’s the opportunity.

The stock has been crushed in this bear market. And it will almost certainly fall further if the market turns south again. We can target the stock at a price below the current market price, under 35 per share versus the current 49.80. We can potentially pick up a great cyclical stock at a new low ahead of the recovery. And the company should thrive once this bear market abates.

It’s one of the largest companies that focuses on high-growth alternative investments. KKR has $496.3 billion in assets under management (AUM) and $397.6 billion is in fee-earning assets. In fact, even in this bear market, AUM has grown 11.3%. That’s the main gauge as these assets will most certainly produce skyrocketing fees when the market turns. The company also has plenty of dry powder in cash to pounce when the market turns.

KKR does a considerable amount of business in Asia, which is expected to account for 60% of global growth through 2027. That increases the growth trajectory going forward as Asia only has about a quarter of the amount of its investments in alternative assets as North America.

KKR also made a huge $4.4 billion investment in Global Atlantic Financial Group (GA), a huge player in the insurance industry last year. It further diversifies KKR into this timely industry and Global’s growth has been even more impressive than KKR’s in recent years. It grew assets from $17 billion to $90 billion between 2013 and 2019, a CAGR of 29%. It also grew adjusted operating earnings by a 17% CAGR and book value by 16% over the same period. The acquisition could be a needle-mover going forward.

KKR also pays a quarterly dividend with a current 1.2% yield. That’s not much. But with a payout ratio of just around 20%, there is plenty of room for payout growth going forward.

It presents a great opportunity to possibly grab a great cyclical stock at a dirt-cheap price near the bear market low and get great upside leverage when the market inevitably turns around.

KKR & Co. Inc. (KKR)

Security type: Common stock
Industry: Finance, Asset Management
Price: $49.80
Price target: $35
52-week range: $41.77- $78.40
Yield: 1.3%
Profile: KKR is a leading global alternative asset firm that manages multiple asset classes, including private equity, credit and real estate assets, and hedge funds managed with strategic partners.

Positives
· Cyclical stocks that take the brunt of bear market selling are usually the first to soar when the market turns.
· KKR has consistently and significantly outperformed its peers in the industry.
· Alternative assets management is a rapidly growing industry.

Risks
· The bear market could drag on for a longer time than usual.
· This is not a good down-market stock or asset class.

Portfolio at a Glance

Enterprise Product Partners (EPD – yield 8.0%) – On the surface, EPD doesn’t appear to be doing anything. It’s around the middle of the 52-week trading range and the same price it was back in March. But EPD has returned about 20% YTD in an abysmal year. This stock is designed to bore you to tears while providing a high income and positive traction in a bear market. Earnings should remain strong in a recession. The stratospheric distribution is safe. And the stock is reasonably priced. The market is likely in for more trouble ahead and more outperformance from EPD. (This security generates a K-1 form at tax time). BUY

Enterprise Product Partners (EPD)
Next ex-div date: January 28, 2023, est.

Medical Properties Trust, Inc. (MPW – yield 9.8%) – This hospital property REIT had been trending nicely higher but has sputtered of late. Hopefully, MPW has already hit bottom and will trend higher from here. The company delivered terrific earnings for the recent quarter with profits up 30% over last year. That was pretty good for a stock that was trading down 50% YTD. Results strongly indicate that the stratospheric dividend should be safe. It’s in a recession-resistant business and performance should improve, especially on a relative basis. HOLD

Medical Properties Trust, Inc. (MPW)

Next ex-div date: March 7, 2023, est.

ONEOK Inc. (OKE – yield 5.7%) – This midstream energy stock has leveled off recently since trending sharply higher following the September market selloff. It was one of those defensive dividend stocks that got hit as interest rates soared in the late summer but has since regained traction as interest rates have fallen and investors realize that defensive stocks are attractive ahead of a likely recession in 2023. This is a cheap stock with a high and safe dividend with a business that is well equipped to endure both recession and inflation. BUY

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

Realty Income (O – yield 4.6%) – This legendary monthly income REIT tends to trend high and then get choppy for a while. But O still has the right stuff for this market. It’s recession-resistant and a great source of income. Again, defensive stocks tend to outperform in weaker economies and recession. O should provide a steady income and relative strong performance during likely turbulence in the first half of 2023. It will still likely continue to trend higher, but perhaps in a choppier fashion than we’ve seen recently. BUY

Realty Income (O)
Next ex-div date: December 30, 2022, est.

The Williams Companies, Inc. (WMB – yield 5.1%) – This midstream energy company stock is a similar recent story to OKE. It has moved up strongly since late September. However, WMB tends to be more resilient in choppy markets and is less than 10% from the all-time high. The stock is still very much in an uptrend ahead of a period of strong relative performance. The company posted strong earnings because of resilient natural gas demand, something that is likely to endure through the recession based on shortages overseas. BUY

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

AbbVie (ABBV – yield 3.6%) – This great healthcare company is at the highest level since topping out in April and appears poised to make a run at a new high. Although ABBV has traded well below the 52-week high for most of the year, it has quietly returned over 26% YTD in a bear market. The market loves the defensive business as a recession looms. Plus, AbbVie has 11 other drugs besides Humira that are on track to top $1 billion in net revenue this year. It’s a great company meeting a friendly market environment for the sector. HOLD

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

Broadcom Inc. (AVGO – yield 3.3%) – This technology stalwart once again topped Wall Street’s earnings estimates last week with 21% revenue growth and a 34% earnings increase over last year’s quarter. Broadcom also topped estimates for the next quarter. The stock hit the highest price level since August and may continue to move higher in the weeks ahead. AVGO is still a long way from the 52-week high and still has a negative-14% return YTD. But it is in a beleaguered sector and should move up fast when the overall tech environment improves. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: December 19, 2022

Brookfield Infrastructure Partners (BIP – yield 4.1%) – This seems like the perfect stock for the current environment. Its crucial assets are highly defensive as recession looms. It’s also well set up for above-trend growth in the quarters ahead and recent acquisitions hit the bottom line. But recent performance has been lousy. BIP is down 17% over the last three months and 7% over the last month. It’s likely because of turbulence in China and/or a stronger dollar. But it should be a temporary blip as the company’s crucial assets will continue to deliver steady earnings through a recession, it has inflation adjustments built into its contracts, the dividend is solid, and the stock is cheap now. (This security generates a K-1 form at tax time). BUY

Brookfield Infrastructure Partners (BIP)
Next ex-div date: February 28, 2023, est.

Eli Lilly and Company (LLY – yield 1.1%) – LLY just keeps on rolling. In a bear market it’s up well over 30% YTD. The stock may be poised to break out to new levels. Not only is Lilly expected to deliver annual earnings growth of 19% over the next five years, but it also has two incredible drugs in the pipeline that are potential future mega-blockbusters. In addition, they just raised the dividend by 15%. HOLD

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

Intel Corporation (INTC – yield 5.1%) – The environment has been improving for technology. It has been one of the better-performing S&P 500 sectors over the last month as inflation looks to have peaked and longer-term interest rates have moved lower. The situation will surely improve for technology. Hopefully, the big turnaround isn’t that far off. Intel’s individual prospects should significantly improve as growth investments come to fruition. It’s been a painful slog. But it could prove to be worth the pain over time. BUY

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

Qualcomm Inc. (QCOM – yield 2.5%) – After a stellar performance in 2021, QCOM is down 30% YTD in 2022. That’s about the same as the overall semiconductor sector this year. That’s the bad news. The good news is that technology stocks can turn around fast and make up for lost time as the environment changes, and it likely will in the new year. Qualcomm just announced a profit slowdown for the quarters ahead. But the market has been pricing that in all year, even when current profits were still booming. Before long, the market may start sniffing out a recovery. HOLD

Qualcomm Inc. (QCOM)
Next ex-div date: February 28, 2023, est.

Visa Inc. (V – yield 0.9%) – V has been a decent performer considering the bear market circumstances. The market has not been kind to financial stocks as the sector is down double digits for the year. But V is even YTD. Even isn’t bad for a stock like this in a bear market. Plus, V should move higher quickly when the market eventually recovers. The company once again killed it on earnings. The payments processing giant continues to benefit from the end of Covid restrictions despite the slower economy. HOLD

Visa Inc. (V)
Next ex-div date: February 9, 2023, est.

NextEra Energy (NEE – yield 2.0%) – This combination utility and clean energy powerhouse has been trending sharply higher since the recent low in October. Even if the overall market hits a new bottom again, I believe NEE has already seen the bottom and will continue to recover. The interest rate spike that sent utility stocks reeling is reversing as we head towards recession. NEE has already regained most of what it lost in the fall selloff. And it’s probably not done yet. BUY

NextEra Energy NEE
Next ex-div date: February 9, 2023, est.

Xcel Energy (XEL – yield 2.7%) – This clean energy utility was oversold in the September market plunge and has had a recovery very similar to NEE. It was upgraded to BUY because it was timely after a huge selloff that is proving to have been unjustified. XEL has had a 25% move higher since the October low. The near term is shaping up well and the longer-term prognosis is also excellent. It should also benefit from new legislation from Washington that will reduce costs of its considerable clean energy production. The stock should be solid in a recession. BUY

Xcel Energy XEL
Next ex-div date: February 23, 2023, est.

USB Depository Shares (USB-PS – yield 5.7%) – The high-paying, investment-grade preferred stock is certainly working so far. It was added to the portfolio after interest rates spiked to a 15-year high. Rates have since been plunging as inflation cools and we barrel toward recession. Hopefully, you got the stock last month when the yield was over 6% but you can still buy it now if you didn’t. BUY

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

Invesco Preferred ETF (PGX – yield 6.2%) – Ditto what I said about USB-PS. Longer-term rates have fallen significantly since this preferred stock ETF was added to the portfolio early last month. Although interest rates may have peaked for the foreseeable future, it’s still a good time to lock in this high yield as a recession is likely to pressure rates lower. BUY

Invesco Preferred ETF (PGX)
Next ex-div date: December 19, 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 are estimated.

The next Cabot Dividend Investor issue will be published on January 11, 2023.