Cabot Dividend Investor Issue: May 8, 2024

A High Yield for the Sticky Inflation

The market is thriving in the happy space between inflation and recession. But this nirvana state may prove temporary.

For more than a year, the market indexes rallied as inflation trended sharply lower while the economy remained solid. We appeared to be getting through this rate hiking cycle, the steepest in decades, without the usual economic pain. It seemed inflation was being licked on the cheap. But history says that’s unlikely.

Stickiness has always been a problem with inflation. In fact, anytime in the past when inflation averaged 5% or higher for a year or more it took at least a decade to get rid of it. The Fed knows this and will be reluctant to pursue policies that might enable inflation to be a problem for the rest of the decade, especially since the problem is partly of their own making.

Sure, inflation is way down. The latest CPI (Consumer Price Index) was 3.5%, down from a high of 9.1% in June 2022. But inflation has been rising again this year. The CPI was 3.1% in January. That may seem low compared to the double-digit inflation of the ‘70s. But CPI is measured differently now. Estimates are that it would currently be close to 8% by the old measurement. And that’s with interest rates already at the highest level in decades.

It’s possible that the current rates will drive down this inflation if given more time. But the Fed raised rates to the current level almost a year ago, and inflation has crept higher since. Anything is possible. Maybe inflation will finally come down as the year goes on without higher rates or a recession. But if not, something will have to give. It seems most likely that rates will have to stay near current levels or go higher until they drive the economy down and inflation starts falling again.

It’s been a good year-plus for the overall market. But the dynamic that drove that rally is unlikely to persist. It seems inevitable that the market will have to contend with high interest rates or a faltering economy. Each one is problematic. Of course, there’s still the artificial intelligence catalyst. And defensive stocks are cheap. But the overall market is unlikely to rally as it has recently.

In a flatter market, divdends provide a bigger part of total returns. Let’s get ahead of the curve and get a big fat yield. In this issue, I highlight a stock with a massive dividend yield that has shown good price stability for several years. The company can also thrive amidst inflation and high or rising interest rates and can provide a high income return even if the market struggles through an inflation/recession catch-22.

What to Do Now

The market has shown some renewed strength over the last week, particularly among interest rate-sensitive stocks. The ever-changing interest rate narrative took a turn for the better after last week’s Fed meeting.

The Fed indicated the next rate move is more likely to be lower than higher. Of course, another Fed rate hike wasn’t expected, it was just feared. And the meeting relieved that fear, for now. Also, a slower-than-expected first-quarter GDP report and a low jobs number reinforced the notion that the Fed will be able to cut rates later this year.

While the interest rate narrative has improved and defensive stocks have been rallying, things could reverse after the next inflation report. We probably aren’t out of the woods yet, but the defensive stocks are already beaten down and probably don’t have much more downside even if investors turn negative again. Plus, the utilities and REITs offer better relative performance in the event the economy turns south.

While I’m skeptical that inflation will be licked on the cheap, anything is possible. The market can be nearly impossible to predict in the near term. But certain stocks are more tied to longer and more pronounced trends than Fed decisions or gyrations in the economy. Megatrends like the aging population should be a huge tailwind for healthcare companies over time. Artificial intelligence will likely continue to add a huge growth catalyst for technology companies. And global energy supplies have not kept up with demand.

With that in mind, I offer three current portfolio stocks to “buy first” if you are new to the portfolio. Those include Enterprise Product Partners (EPD) for the high yield and exposure to the energy market. The remarkably steady performing pharmaceutical supply chain company stock McKesson (MCK), for the aging population. And Qualcomm (QCOM), for its exposure to the next wave of AI. QCOM rallied sharply after reporting earnings largely on the hopes that AI will be coming to iPhones and computers next year.

Also in this issue, our long-held position in Xcel Energy (XEL) is being sold. Tremendous uncertainty from the Texas wildfire liability combines with already lackluster performance to diminish prospects for the rest of this year. The position in Realty Income (O) is also being reduced to a “HOLD” because of continuing lackluster performance.

Recent Activity

April 10
SOLD Intel Corporation (INTC) - $37.20

April 17
UnitedHealth Group Inc. (UNH) – Rating change “HOLD” to “BUY”

May 8
Buy FS KKR Capital Corp (FSK)
Realty Income (O) – Rating change “BUY” to “HOLD”
SELL Xcel Energy Inc. (XEL)

Featured Action

Buy FS KKR Capital Corp (FSK) Yield: 14.3%

FS KKR is one of the largest publicly traded business development companies (BDCs). It focuses on loans to upper middle market U.S. companies, primarily in the form of senior secured debt at high rates of interest.

As a BDC, FS KKR operates in the realm of private equity. Private equity is money provided to young and growing businesses that otherwise wouldn’t have access to sufficient capital. This money is typically loaned at very high rates of interest and/or in exchange for equity stakes (a percentage of ownership). The properties of BDCs were discussed more extensively in the recent March issue. I’ll summarize briefly.

Growing businesses with big ambitions need large amounts of capital in order to expand and grow to the next level. But such enterprises often have difficulty getting sizable enough loans from risk-averse banks, and they are too small to access the capital markets by issuing stocks or bonds. Thus, firms with the expertise to evaluate the risks can lend money at very favorable terms for themselves.

Middle market companies are defined as those having annual revenues of between $10 million and $2.5 billion. FSK focuses on more established companies at the higher end of that range.

These smaller companies tend to be very cyclical. That can be good and bad. Smaller companies and BDCs typically do not perform well in an economic downturn. Right now, the economy looks solid and most institutions as well as the Federal Reserve bank have raised their projections for GDP in 2024.

FSK is a BDC with ties to the parent company and wealth management giant KKR & Co. (KKR) from which it can leverage the pseudo-drop-down opportunities. FSK is one of the larger BDCs and scale matters in private equity. BDCs are still a relatively obscure sector, but the biggest ones tend to get a lot more investor attention. It also further diversifies the portfolio and lowers the financing costs.

The BDC mostly makes high interest loans to growing companies. It currently has a portfolio of 204 companies spread across 24 different industries. The concentration in the top 10 companies is 19%. The loans are primarily senior secured debt (66.4% in the first quarter). Rising interest rates don’t bother the business at all because 89.3% of loans are floating rate and only 10.7% are fixed rate. Higher interest rates mean more income. The average loan rate FSK collects from its portfolio is 12.2% as of the end of the first quarter.

The stock performance has been solid even in the tough market for dividend stocks over the last several years. In the last three years, FSK has provided a total return of 38% (with dividends reinvested) compared to a return of 28% for the S&P 500 over the same period. FSK has also provided good price stability, with the price fluctuating between 17.50 and 20.50 per share over the last 20 months. The range has been tighter over the past year. That’s not too much volatility to put up with for a better than 14% yield.

The Dividend

This security is all about the dividend. It pays a massive 14.4% yield at the current price. Therefore, the main question is: How safe is this monstrosity of a payout?

The main reason to buy FSK is the high income it provides. BDCs are tax advantaged securities. Because they provide a desirable function, funding the growth of rising companies, they pay no tax at the corporate level. BDCs typically pay higher dividends because money normally lost to taxes is paid out to shareholders.

It pays a quarterly dividend which has been about $0.64 per share, with one $0.70 payout, which was $2.62, translating to a 13.5% yield at the current price. However, there were also seven supplemental dividends paid for a total of $0.38 per share over the past year. The total payout was $3.00 per share, or a 15.5% yield at the current price. The supplemental dividends are not guaranteed but you will likely receive some going forward.

FSK pays nearly all of its cash flow in dividends and has developed a solid track record of maintaining and raising the payout. The dividend was cut during the pandemic from $0.76 per share to $0.60. That was an extreme situation. But the company may have trouble maintaining that payout in a recession. In the first quarter the dividend was covered 107% with net interest income. It has covered the last four dividends by an average rate of about 111%.

FSK has a good chance to provide a huge dividend income combined with moderate price appreciation in the quarters ahead.

FS KKR Capital Corp. (FSK)

Security type: Business Development Company (BDC)
Industry: Asset Management
Price: $19.42
52-week range: $17.50 - $20.99
Yield: 14.4%
Profile: FS KKR is one of the largest publicly traded BDCs that specializes in high interest secured loans to middle market U.S. companies.

Positives

• The size of the portfolio makes the stock more liquid and desirable to investors.
• It appears to be a good time in the economic cycle for smaller companies and BDCs..
• The massive yield should be maintainable in the year ahead.

Risks

• The stock will not hold up well in an economic downturn.
• Most other BDCs have a poor track record of performance.

FS KKR Capital Corp. (FSK)
Next ex-div date: May 14, 2024

Portfolio Recap

Brookfield Infrastructure Partners (BIP – yield 5.4%) earnings – It was an awful first half of April for the infrastructure company as the stock fell about 20% in the first two weeks. But Brookfield reported strong earnings and the company has rallied over 10% since last week’s report. It’s also up 20% since April 16. Funds from operations grew 11% over last year’s quarter as new assets came online, the transportation segment was strong, and inflation indexation kicked in for a lot of its contracts. The company also raised the next quarterly distribution by 6%. Solid earnings and a distribution raise are indicative of a company that is operationally strong. BIP can be at the mercy of interest rate sentiment in the near term but the longer-term prognosis should be excellent. (This security generates a K-1 form at tax time.) BUY

Brookfield Infrastructure Partners (BIP)
Next ex-div date: May 31, 2024

Enterprise Product Partners (EPD – yield 7.3%) – This midstream energy partnership reported solid earnings last week. Profits per share were in line with estimates and revenues were a lot better as new projects came to fruition. Distributable cash flow was solid with 1.7 times distribution coverage and justified the 5.1% distribution increase. Capital investments were also aligned with strategic initiatives. Overall, the earnings didn’t reflect much change in an already solid story with good stock performance. The massive payout is well-supported, and the energy sector still looks good (This security generates a K-1 form at tax time.) BUY

Enterprise Product Partners (EPD)
Next ex-div date: July 30, 2024, est.

Main Street Capital Corporation (MAIN – yield 5.7%) – The Business Development Company didn’t get hurt at all in early April when other dividend stocks were taking it on the chin. The stock isn’t interest rate sensitive because it has a higher yield, and its companies perform well in a solid economy. The BDC has continued to edge slightly higher since being added to the portfolio. Although MAIN is currently selling near the 52-week high, it is still reasonably priced at less than 1.6 times book value and most valuation measures are below the 5-year average. The safe and high yield pays dividends every single month with a strong possibility of supplemental dividends over the course of the year as well. BUY

Main Street Capital Corp. (MAIN)
Next ex-div date: May 7, 2024

ONEOK Inc. (OKE – yield 5.1%) earnings – The midstream energy company reported earnings last week that missed estimates due to higher costs incurred as a result higher operating costs and capital expenditures. The stock moved slightly lower since but it’s still within 4% of the 52-week high. However, the company also raised guidance for 2024 and analysts still expect 30% revenue growth and 29% earnings growth for this year over last year. The higher costs in the quarter aren’t expected to be a problem that lowers earnings beyond this past quarter. Volumes were higher and the company is still far outpacing its peers in earnings performance. BUY

ONEOK Inc. (OKE)
Next ex-div date: July 30, 2024, est.

Rating change – “BUY” to “HOLD”

Realty Income (O – yield 5.6%) earnings – This legendary REIT reported earnings this week that matched FFO estimates and slightly exceeded revenue forecasts. The report was OK but nothing exciting and the stock moved lower the day of the report. Realty is still floundering after a rough two years. Perhaps O has seen the worst and is finally headed for better days. It looks like O will be stuck in the mud until interest rates really move lower, which may or may not happen later this year.

The monthly dividend is legend and has been raised every year since 1969 but the last two years have been among the worst in this stock’s history. I don’t mind buying out-of-favor stocks, but recent performance has not been encouraging, including compared to other REITs. The stock will be held for now on hopes that the recent improving interest rate narrative can provide some upside. HOLD

Realty Income (O)
Next ex-div date: May 31, 2024, est.

The Williams Companies, Inc. (WMB – yield 4.9%) earnings – The midstream energy company reported strong earnings on Tuesday with 8% adjusted EBITDA growth over last year’s quarter on strong contracted revenue growth. Williams also guided for the top half of the expected range in 2024. The market liked it as the stock was about 2% higher Tuesday morning after the report. The company also has a healthy backlog of expansion projects that should promote solid growth for several years. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: June 7, 2024

AbbVie (ABBV – yield 3.8%) – The biopharmaceutical company reported earnings last week that beat expectations. But the market wasn’t too excited because the company also slightly lowered earnings per share expectations for next year and the stock has dipped slightly since the report. Beyond the short-term noise, the good story is intact. Although Humira sales fell 35.9% after losing patent exclusivity, it was less than expected. Meanwhile, the other immunology drugs, Skyrizi and Rinvoq, grew at torrid paces with revenue of $3.1 billion for the quarter. The company is well on track to replace Humira revenues and return to robust growth in the years ahead. BUY

AbbVie Inc. (ABBV)
Next ex-div date: July 12, 2024, est.

American Tower Corporation (AMT – yield 3.6%) earnings – Help in the form of strong earnings has arrived for this struggling data center REIT. In what has been a pretty awful year so far for REITs and other interest rate-sensitive stocks, AMT had a terrific week when it rallied 7%. American Tower beat estimates on both revenue and earnings with 9.8% adjusted funds from operations per share growth over last year’s quarter. The REIT also raised guidance for 2024. Hopefully, the strong operational performance along with the better interest rate news will last and AMT can muster a sustained rally in the weeks and months ahead. BUY

American Tower Corporation (AMT)
Next ex-div date: July 11, 2024, est.

Broadcom Inc. (AVGO – yield 1.6%) – The stellar performing chip and software infrastructure company stock has leveled off since late February. That behavior is consistent with past performance of the stock since it’s been in the portfolio (and returned 216%). It tends to level off after a big surge, as it did this past June through October before its next surge higher. Earnings could be a catalyst to get the stock moving again but it doesn’t report for another month. Things look good as several technology giants reported increased spending on AI-related products and services in their earnings reports, which should benefit Broadcom. HOLD

Broadcom Inc. (AVGO)
Next ex-div date: June 20, 2024, est.

Digital Realty Trust, Inc. (DLR – yield 3.4%) earnings – The data center REIT reported mixed results from earnings last week as earnings slightly exceeded estimates and revenues lagged somewhat due to higher costs. DLR moved down slightly after the report but is still up 4% so far in May. The report was mostly uneventful except for a statement by management that the REIT is seeing accelerating demand for AI-oriented opportunities. A big reason the stock was added to the portfolio was the additional growth catalyst provided by AI. The statement indicates that is happening. BUY

Digital Realty Trust, Inc. (DLR)
Next ex-div date: June 15, 2024, est.

Eli Lilly and Company (LLY – yield 0.7%) – The pharmaceutical company stock jumped more than 6% after reporting earnings last week. Although the company missed slightly on revenues, earnings per share were much better than expected and, even more importantly, Lilly significantly raised guidance for this year. The main reason is that its weight loss drug revenues obliterated forecasts with $517.4 million in revenue for the quarter versus an expected $373 billion. The company is also aggressively expanding production for future quarters and raised its 2024 revenue projections by $2 billion. The weight loss drug is a monster and looks like a mega blockbuster and the Alzheimer’s drug should get the nod in the next few months. HOLD

Eli Lilly and Company (LLY)
Next ex-div date: May 15, 2024

McKesson Corporation (MCK – yield 0.5%) – MCK made another new all-time high at the end of April and is still in an uptrend that began in early 2023. MCK just continues to forge quietly higher while no one seems to notice. The pharmaceutical supply chain goliath dominates a market that grows all by itself because of the aging population. The main reason MCK was purchased was because of its stellar track record of performance. It has been delivering with a return of 13% YTD and 46% over the past year. McKesson reports earnings this week and could get a further boost. BUY

McKesson Corporation (MCK)
Next ex-div date: June 3, 2024

Marathon Petroleum Corporation (MPC – yield 1.8%) – Energy companies, especially refiners, can be a wild and woolly ride in the near term. MPC had rocketed 45% this year until early April. Since then, it’s down 17%. But the stock is still up 21% YTD. I’m not convinced that the good times are over. The stock just got a little ahead of itself. Although earnings were disappointing because of a record level of shutdowns in the quarter, Marathon is now well positioned for the driving season. Profits are still historically high and the company is loaded with cash. I don’t see a secular decline in energy at this point. The sector still looks good and provides a hedge against escalating tensions around the world. I will continue to hold the stock for now. HOLD

Marathon Petroleum Corporation (MPC)
Next ex-div date: May 15, 2024

Qualcomm Inc. (QCOM – yield 1.9%) earnings – The mobile device chip king reported earnings last week that beat estimates and the company raised earnings guidance for 2024. The market was thrilled and QCOM has risen 12% since the report to a brand new 52-week high. The earnings growth was expected as a still somewhat weak smartphone market is getting better. But the enthusiasm is mostly about the rapid approach of AI-generated smartphones and PCs. One analyst contends that an AI-driven iPhone supercycle is coming next year. Qualcomm is at the leading edge of chips that enable AI for smartphones and PCs and should benefit mightily if such a cycle comes to fruition. BUY

Qualcomm Inc. (QCOM)
Next ex-div date: May 30, 2024

UnitedHealth Group Inc. (UNH – yield 1.5%) – UnitedHealth reported earnings last month that provided some good news for a change. The company soundly beat expectations with an 8.6% revenue rise and a better than 10% increase in adjusted earnings from last year’s quarter. The company also issued strong guidance. It was a relief to the market after recent troubles and the stock has significantly recovered since the report, although the stock has leveled off over the past few weeks. UNH had been reeling after the cyber-attack caused a huge disturbance in the company and the industry. But UnitedHealth appears to have absorbed the costs while maintaining strong growth in the quarter and future quarters. BUY

UnitedHealth Group Inc. (UNH)
Next ex-div date: June 8, 2024, est.

Visa Inc. (V – yield 0.8%) – This payment processing global goliath again reported stellar earnings last month. It reported a 10% jump in revenue and a 20% increase in adjusted earnings per share over last year’s quarter. It is still thriving from cross-border transactions and benefits from the recent better-than-expected economic news. Visa also reported upbeat guidance for this year. Although performance has leveled off over the past few months, V should be solid as long as the economy holds up. HOLD

Visa Inc. (V)
Next ex-div date: May 16, 2024

Alexandria Real Estate Equities, Inc. (ARE – yield 4.2%) – This one-of-a-kind life science property REIT that owns properties in highly sought after innovation clusters throughout the country reported strong earnings that beat expectations. Adjusted funds from operations grew at 7.3% over last year’s quarter and the quarterly dividend was raised by 5%. Occupancy and the rate of acquisitions reflected a solid business and the dividend hike showed confidence. The REIT is somewhat at the mercy of the interest rate narrative in the near term but ARE is a great income stock selling at the low end of historical valuations. BUY

Alexandria Real Estate Equities, Inc. (ARE)
Next ex-div date: June 27, 2024, est.

NextEra Energy (NEE – yield 2.9%) – The combination regulated and alternative energy utility reported earnings last month that slightly missed on revenues but beat significantly on earnings. The stock has continued to move higher since. It was a solid report and NEE is now officially turning things around big time. NEE has been trending higher since the beginning of March and is up 28% in that time. It’s also up 50% from the low in October. NEE had been a superstar performer before inflation and rising interest rates. It provides both safety from its best-in-class regulated utility business and growth from its considerable clean energy business. BUY

NextEra Energy Inc. (NEE)
Next ex-div date: May 25, 2024, est

USB Depository Shares (USB-PS – yield 5.6%) – This preferred stock has weathered a strong interest rate storm and has still returned 17% since being added to the portfolio. I believe it is unlikely that rates eclipse the high of this cycle. Even if they do this security can handle it well. It’s also quite possible that rates fall from here and the stock behaves very well. BUY

U.S. Bancorp Depository Shares (USB-PS)
Next ex-div date: July 15, 2024

Vanguard Long-Term Corp. Bd. Index Fund (VCLT – yield 5.1%) – Ditto for VCLT. It doesn’t like rising rates. But that’s OK unless rates rise to new levels beyond what has been seen in this cycle. I believe that VCLT is still well positioned after the worst two years for fixed income ever. The risk is that interest rates rise to new highs as sticky inflation persists. But the greater chance is still that rates trend lower at this point. BUY

Vanguard Long-Term Corp. Bd. Index Fd. (VCLT)
Next ex-div date: June 1, 2024, est.

Rating change – “HOLD” to “SELL”

Xcel Energy (XEL – yield 4.0%) – It is with a heavy heart that I sell the oldest position in the portfolio. XEL had been a very strong performing utility with above average growth from the clean energy side until the last two years. It has returned -21% over the past two years and -19% over the past year. It has been a tough couple of years for utility stocks amid inflation and rising interest rates. But the benchmark Utilities Select Sector SPDR Fund (XLU) has managed positive returns of 2% and 3% over the same periods, respectively.

Sectors go in and out of favor and utilities will have their day again. But the environment may continue to be tough for a while and XLU has been unable to outperform it. The tipping point is the recent liabilities involved with the Texas wildfires, which Xcel has admitted to being culpable in igniting. The extent of the liability is still a big unknown that will put a drag on stock performance. Despite solid earnings, XLE has floundered even while its peers have rallied in the improving interest rate outlook. It’s a judgement call that it isn’t worth it to wait out the trouble while many other stocks are getting good returns. SELL

Xcel Energy Inc. (XEL)
Next ed-div date: June 14, 2023, 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 June 12, 2024.

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