Cabot Dividend Investor Issue: September 11, 2024

Cash In on the Changing Cycle

With fall comes change, not only in the weather but in the market. For most of the last two years it has been a market of high interest rates and technology sector dominance. That dynamic is changing.

The economy began to show signs of slowing this summer, possibly toward recession. It became clear that the Fed would begin lowering rates in September. Longer-term rates started to decline as well. The previously beleaguered interest rate-sensitive stocks and defensive stocks ignited and began to lead the overall market higher as technology pulled back.

The environment is changing from one of high inflation and high interest rates to one of falling inflation and interest rates in a weakening economy. After the summer malaise, this new trend is being unambiguously confirmed. And it is unlikely to be a mere short-term gyration but rather the beginning of a new environment that should last for some time. It is a whole new part of the cycle.

While this cycle change has been in the works for some time, it just hit critical mass, and the market must catch up.

The Fed Funds rate, which was raised from 0% to 5.5% from February of 2022 to July of 2023, will start to be lowered for the first time in years later this month. While there is speculation whether it will be a 0.25% or 0.50% cut, it will be just the beginning of a rate reducing process that will bring the rate far lower in the months and years ahead. Longer rates are already falling. The benchmark 10-year Treasury rate has fallen from about 5% a little less than a year ago to 3.7%.

Interest rates may fall quickly or more slowly depending on whether the economy remains buoyant or slips towards recession. But rates will fall much more significantly than they have in years.

The cycle reversal will create new winners and losers. Certain interest rate-sensitive stocks have been laggards for a long time and have a lot of catching up to do. They are still cheap, high yielding, and now have momentum.

In this issue, I highlight a great monthly income stock. The yield is massive, and it provides a high income in an uncertain market. The stock also can provide great price performance when the interest rate cycle goes its way. This point in the cycle provides a great opportunity to get a high income and total return on the right side of a pronounced market shift ahead.

What to Do Now

Welcome to September. The first holiday-shortened week after Labor Day was the worst week for the market in about two years. In just four trading days the Dow, S&P 500, and the Nasdaq fell 3%, 4% and 6%, respectively. I guess people are grouchy when the summer ends.

The indexes did recover somewhat on Monday. But we’ll see if this is just a temporary pullback like we saw in the early parts of April and August or something more.

After the initial recession fears in early August after the bad jobs report, investors seemed to conclude that the fears of recession talk were overblown and interest rates are coming down. But they came back to business as usual after Labor Day with a more skeptical attitude. The worse-than-expected August jobs report exacerbated the mood.

Sure, interest rates are coming down and the economy is still OK for now. But even if a recession isn’t imminent, it’s on the radar. A lousy economic number could send stocks reeling at any point. And there is headline risk with the election heating up and two wars continuing.

The economy has been resilient and it is quite possible, if not likely, that there will be no looming recession any time soon. But with inflation way down and interest rates moving lower, recession is the main risk that investors will fret over for the rest of the year. Even if a recession never comes, there will likely be some head fakes and volatility.

We’ll see what happens. But it seems clear at this point that the economy is at least slowing, and interest rates are surely coming down. There are existing portfolio positions that should benefit from the changing environment including Brookfield Infrastructure Partners (BIP), NextEra Energy (NEE), Alexandria Real Estate Equities (ARE), and American Tower (AMT).

These are all stocks that have suffered for much of the last couple of years as interest rates rose to multidecade highs. But things have already started changing in a big way.

These stocks have rallied for the past several months. But they are mostly well below the all-time high and are paying higher yields and sell at a lower valuation than usual. The stocks are also defensive ahead of a slowing economy. They have all the right stuff right now, including momentum.

Meanwhile, certain portfolio positions that have been thriving and are selling at high prices have been reduced to a HOLD rating while other stocks trading well below the high have been raised to a BUY rating.

Recent Activity

August 14
Purchased Constellation Energy Corporation (CEG) - $182

August 28
Qualcomm (QCOM) – added 2/3rds to position

September 11
Buy AGNC Investment Corp. (AGNC)
Broadcom Inc. (AVGO) – Rating Change “HOLD” to “BUY” and add ½ position
ONEOK Inc. (OKE) – Rating change “BUY” to “HOLD”
AbbVie (ABBV) – Rating change “BUY” to “SELL 1/2”
NextEra Energy (NEE) – Rating Change “HOLD” to “BUY”

Featured Action

Buy AGNC Investment Corp. (AGNC) 

Yield: 14.1%

AGNC Investment Corp. is a Real Estate Investment Trust (REIT) that invests in U.S. government agency mortgaged-backed securities. It’s a mortgage REIT that, unlike most REITs which invest in various real estate properties, owns a portfolio of mortgage securities. 

The $66 billion portfolio is invested primarily (90.5%) in fixed-rate mortgage-backed securities (MBS) from The Federal National Mortgage Association (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac). These securities have the backing of the U.S. government and have an implied zero credit risk. The rest of the portfolio is invested in adjustable-rate and non-agency mortgages. 

Most of these MBS (96%) are 30-year fixed-rate mortgages with an overage interest rate of 5.87%. The REIT uses leverage to borrow money at short-term interest rates and buy longer-term securities that pay a higher rate.  AGNC makes profits based on the difference between what the MBS portfolio pays and what it costs to borrow, or the spread. 

The performance of the REIT has been pretty good since its IPO on May 15, 2008. Since that date, AGNC’s total return (with dividends reinvested) has been 447%, which translates to about an 11% average annual return over that 16-year period. That’s a slightly better return than the S&P 500 over the same time frame. But AGNC is not being purchased in the portfolio for its performance over the long term. 

There are good times to buy AGNC and bad times to buy AGNC. The security is being targeted now because it is cheap coming off a very bad time ahead of what should be a good time. 

Because of the U.S. government agency securities, AGNC has little credit risk. If a buyer defaults, the mortgage is guaranteed by the government. However, there is considerable interest rate risk. 

AGNC got clobbered in recent years as inflation and interest rates soared to multi-decade highs. As the Fed raised the short-term interest benchmark, the Fed Funds rate, from 0% to 5.25% to 5.50% in less than a year and a half, AGNC’s borrowing costs soared and profits fell. Mortgage rates rose also but not proportionally as much as the inverted yield curve (short-term rates rise above long-term rates). 

From the beginning of 2022 to the end of June 2024, income from the MBS portfolio increased $2 billion but borrowing costs increased $2.3 billion. In the June quarter of this year, AGNC reported net interest income (NII) of -$246 million. That was down from NII of $965 million in 2022 and $1.3 billion in 2021. 

The rapidly rising rates also wreaked havoc on the REIT’s book value. As interest rates rise, the value of existing fixed-rate securities falls, because the price is discounted to reflect the new higher interest rates. In 2022 and 2023, AGNC’s book value crashed 45%, from $15.75 per share to $8.70. The stock price tends to be highly correlated to the book value, as the chart below illustrates. 

An environment of rising interest rates and yield curve inversion is clearly a bad time to be invested in AGNC. The REIT price plunged from over 18 per share in 2021 to just over 10 per share today. But AGNC has since regained some traction. The total return is positive in 2024, and the stock is also trading above its 50-day moving average, a bullish sign. But more importantly, the situation that caused the bad stock performance is reversing. 

The Fed has begun cutting rates. Projections from CME Group are that the Fed will cut the Fed Funds rate by 1.75% in the next year. The benchmark 10-year Treasury rate is already falling, and interest rates appear highly likely at this point to continue trending lower in the years ahead.  

AGNC’s spread should increase with lower short-term rates and an established portfolio of higher-paying mortgages. The book value should increase as longer-term rates trend lower. The horrible direction of the past few years is going into reverse.

It’s also worth noting that even after the recent 45% price plunge, the long-term returns for AGNC are still a little better than the overall market. That’s because good times tend to offset the bad times. 

The biggest attribute of AGNC is the massive dividend yield, currently over 14%. The REIT also pays a dividend every single month. With that high of a payout, and profits looking wobbly of late, is that dividend safe?  

Profits have been up and down over the last several quarters, but the changing circumstances are likely to fix that for the better. In the meantime, AGNC pays out about $266.4 million per quarter in dividends and has roughly $5.3 billion in cash. The REIT can easily ride out another crummy quarter on the way to far better times in the very near future. 

AGNC is a great way to get a high monthly income in an uncertain market. AGNC only needs a little bit of appreciation to combine with the 14% dividend to provide a great total return. And appreciation should be likely as the book value rises. It’s worthwhile having a stock in the portfolio that greatly benefits from the imminent phase of the rate cycle. 

AGNC Investment Corporation (AGNC) 
Security type: Real Estate Investment Trust (REIT) 
Sector: Mortgage 
Price:  $10.20 
52-week range:  $6.81 - $10.57 
Yield:  14.05% 
Profile: AGNC is a mortgage REIT with a portfolio a U.S. government agency mortgage-backed securities. 

Positives 

• AGNC benefits during Fed rate cutting cycles. 
• The stock is cheap because of factors that are reversing. 
• It pays a huge yield that should be safe, and the stock should appreciate as long-term rates decline. 

Risks 

• Inflation could come back, and interest rates may remain high. 
• The stock price is in a longer-term downward trend. 

AGNC Investment Corp. (AGNC)
Next ex-div date: November 30, 2024, est.

Portfolio Recap

Brookfield Infrastructure Partners (BIP – yield 5.1%) – This previous market outperformer had a terrible time of it until April of this year. It’s up 30% since. It didn’t like the high interest rates because it raised costs and investors opted for fixed-rate alternatives. BIP leveled off after late August but is still near the 52-week high. Brookfield reported solid earnings with 10% funds from operations growth over last year’s quarter. BIP had been a stellar performer for many years prior to inflation and rising interest rates. But now interest rates are moving significantly lower, and the main threat is now a recession. That’s in Brookfield’s wheelhouse as its crucial assets are highly recession-resistant. (This security generates a K-1 form at tax time.) BUY

Brookfield Infrastructure Partners (BIP)
Next ex-div date: November 30, 2024, est.

Enterprise Product Partners (EPD – yield 7.3%) – This steady midstream energy partnership bent a little but didn’t break in the recent market turbulence. EPD did pull back after making a new high in late July but has since recovered most of the decline and leveled off, even in the recent ugly market. It’s still only about a dollar per share below the high. EPD tends to be very solid in turbulent markets and should trend higher as more investors opt for dependable income in the increasing volatility. The distribution is 5% higher than a year ago and there is still an industry standout 1.6 times distribution coverage with cash flow. (This security generates a K-1 form at tax time.) BUY

Enterprise Product Partners (EPD)
Next ex-div date: October 31, 2024, est.

FS KKR Capital Corp. (FSK – yield 14.0%) – This ultra-high-yielding Business Development Company has been holding up quite well. The price did slip in early August after the initial recession fears hit. But FSK has slowly crept back and regained just about all that loss. But the stock goes ex-dividend later this week. Expect a price drop. When a dividend is this massive it almost always declines after the ex-date. While a recession is still on the radar, it might be a long way off and that huge payout from FSK should be highly desirable in a more sideways market over the next few months. HOLD

FS KKR Capital Corp. (FSK)
Next ex-div date: September 11, 2024

Main Street Capital Corporation (MAIN – yield 5.9%) – This BDC confirmed the monthly dividend of $0.245 per share for the rest of the year and announced an additional $0.30 per share supplemental dividend payable in September. The BDC also has a lot of small business exposure, which is problematic during recessions. The stock got knocked back with the recession scare last month when it was downgraded to a HOLD. But it has been creeping back higher. A recession would certainly change the dynamics. However, solid earnings and reduced recession expectations are resulting in the stock regaining lost ground. HOLD

Main Street Capital Corp. (MAIN)
Next ex-div date: September 20, 2024

Rating change – “BUY” to “HOLD”

ONEOK Inc. (OKE – yield 4.3%) – This midstream energy stud is right back to within pennies of the all-time high after barely budging in last week’s tumult. The recent acquisitions have changed the math for the better. ONEOK announced $5.9 billion in acquisitions of two companies, pipeline company Enlink Midstream (ENLC) and Medallion Midstream. The deals are expected to close in the fourth quarter and be accretive to earnings immediately. The company conservatively expects a 5% jump in earnings and a 15% increase in cash flow through 2028. It greatly adds presence in the high-growth Permian Basin and adds predictable fee-based business.

The market loves the deal, and the stock is hot when practically nothing else is. OKE is now up 17% since early August and 35% YTD. I still like the stock, and the momentum could take it still higher in the weeks ahead. But it has moved beyond the ideal buy range and is downgraded to a HOLD based on price. HOLD

ONEOK Inc. (OKE)
Next ex-div date: November 1, 2024, est.

The Williams Companies, Inc. (WMB – yield 4.3%) – Not bad at all. WMB pulled back a little bit last week but not much and is still within about a buck of the high. WMB is proving to be stable during market selloffs. That’s a good thing with all the headline risk floating around. And WMB has returned over 28% YTD. The stock can be vulnerable to shocks in the energy sector in the short term but tends to be the first of its peers to recover. It also should remain solid even in a slowing economy and natural gas demand tends to remain quite steady. WMB is still in an uptrend that began in the middle of February. BUY

Williams Companies, Inc. (WMB)
Next ex-div date: September 13, 2024

Rating change – “BUY” to “SELL 1/2”

AbbVie (ABBV – yield 3.2%) – The cutting-edge Pharma company stock got hot over the summer. It has leveled off since late August but has hung mighty tough in the recent down market and is still only about 1% below the high. ABBV is up 27% YTD. That’s impressive considering this was supposed to be a tough year with falling revenues from the Humira patent expiration. But investors are impressed that newer drugs Rinvoq and Skyrizi are killing it with a combined $4 billion in revenue for the last quarter and are increasingly confident of the company’s ability to replace the lost Humira revenue.

ABBV is getting through this year in spades ahead of greener pasters next year when management expects the company to return to “robust growth.” But ABBV has a long track record of pulling back after surges like it just had, up 28% since the end of May. It’s a good time to take a profit of a half position and perhaps add it back after a dip. SELL 1/2

AbbVie Inc. (ABBV)
Next ex-div date: October 15, 2024, est.

American Tower Corporation (AMT – yield 2.7%) – After a bad start to this year, this cell tower REIT is really stepping on the gas. AMT is up a whopping 38% since April. The REIT did pull back in August but has moved back to a new high while the overall market flounders. Earnings were solid and the stock is now at the highest level in about two years. The prognosis looks bright as customers are being added to existing towers and the properties continue to expand in the U.S. and overseas. It also raised guidance for 2024. BUY

American Tower Corporation (AMT)
Next ex-div date: September 13, 2024, est.

Rating Change “HOLD” to “BUY” and add ½ position

Broadcom Inc. (AVGO – yield 1.3%) – For the first time in a long time performance for AVGO has gotten ugly. The tech giant and AI superstar reported earnings last week that the market hated. AVGO fell over 10% on the day of the report and is now down 24% from the high made in mid-June. Earnings beat expectations but the market was disappointed with next quarter’s guidance. The AI part of the business is booming beyond previous expectations and the VMware acquisition continues to benefit the company. But the performance of the other business segments is lackluster.

The AI story is still alive and well. But the market of last week was itching to punish AI stocks that have been thriving. It was a very bad time for a hiccup. Even after the dip AVGO is still up over 30% YTD and 67% over the past year. The company still grew EPS 18% and revenue 47% over last year’s quarter. The fledgling parts of business are cyclical and at a low point in the cycle and should come back when it changes. The story remains the same as it was when AVGO was soaring and now the stock is a lot cheaper. And it still sells at just 23 times forward earnings. The prognosis is still excellent. It’s an opportunity to add back the half position. BUY

Broadcom Inc. (AVGO)
Next ex-div date: September 19, 2024

Cheniere Energy, Inc. (LNG – yield 1.0%) – The stock has been somewhat choppy after a surge earlier this summer. Natural gas prices have declined because of expected warmer weather and a declining global economy. The stock gets held up when the overall sector struggles. Plus, last week was ugly for just about everything. But lower natural gas prices at home should actually increase margins when sold overseas. And the price is still hanging near the high. The slowing global economy is more concerning, but natural gas demand should remain steady. The world still needs U.S. natural gas. BUY

Cheniere Energy. Inc. (LNG)
Next ex-div date: November 9, 2024, est.

Constellation Energy Corporation (CEG – yield 0.8%) – This nuclear power provider took a beating last week, down 12% in the four trading days. Most utilities held up well, but Constellation is a much more aggressive, unregulated company that returned 35% YTD. It is also related to technology, as it should be a primary beneficiary of increased electricity demand from AI. I suppose the combination of strong performance and association with AI caused the drop. But the fundamental story remains intact. Constellation should be a high-growth electricity producer, positioned in the wheelhouse of growing electricity demand. BUY

Constellation Energy Corporation (CEG)
Next ex-div date: November 12, 2024, est.

Digital Realty Trust, Inc. (DLR – yield 3.3%) – The data center REIT has pulled back from the high in July after a big surge. It leveled off and moved slowly higher since, but it’s having a big surge in the market recovery this week. It’s also still in an uptrend that began in April. DLR was going strong when other REITs were struggling and now the sector is in a much better position as interest rates are likely to move lower. But the main story is the data center properties that are a high growth business. Tech companies are forecast to invest $1 trillion in data centers over the next five years to accommodate AI. BUY

Digital Realty Trust, Inc. (DLR)
Next ex-div date: September 13, 2024

Eli Lilly and Company (LLY – yield 0.6%) – The pharma superstar stock is down over 6% so far in September. But it’s down for a dumb reason. Novo Nordisk A/S (NVO) is experiencing supply shortages for its weight loss drug. Ozempic is the biggest competitor for Lilly’s new weight loss drug and there is fear that Lilly may have supply problems too. But Lilly is reporting an easing of supply constraints. Novo had supply problems last quarter and Lilly didn’t. There’s no reason to assume these problems will apply to Lilly. Plus, competitor stumbles are a good thing. It’s also a good thing when a drug is in such demand the main challenge is making enough of it. BUY

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

McKesson Corporation (MCK – yield 0.6%) – Unfortunately, the Novo supply issues mentioned above are a bigger problem for this pharmaceutical supply chain company. Earnings disappointed with lower-than-expected revenues last quarter and the company cited weight loss drug supplies not keeping up with demand as the main cause. The recent report indicates that it could be more of the same for McKesson in this quarter. The stock is down 9.6% so far in September and 20% from the high. I’m not sure how this issue will get sorted out in the near term. But it’s a temporary problem and the longer-term prognosis for MCK is excellent. This is a good buying opportunity if you don’t already own the stock. BUY

McKesson Corporation (MCK)
Next ex-div date: November 30, 2024, est.

Qualcomm Inc. (QCOM – yield 2.1%) – This semiconductor giant has certainly taken some lumps in recent months. It has pulled back again so far in September and is now down 30% from the high made in mid-June. Technology has been getting crushed in the recent market and the AI trade has been losing a lot of its luster. The AI juggernaut may weaken further but it is not going away. Qualcomm is still very well positioned ahead of the next wave of AI, which should be in mobile devices. Analysts are forecasting a strong upgrade cycle for smartphones sometime next year and QCOM can easily make up for lost time when it gets hot. BUY

Qualcomm Inc. (QCOM)
Next ex-div date: December 5, 2024, est.

UnitedHealth Group Inc. (UNH – yield 1.4%) – This healthcare insurer stock is looking strong. It’s been hot stuff for two months now and just made another new high in September while the rest of the world was going to Hell in a handbag. UNH soared over 20% since early July. It leveled off for a while but has regained the initiative. Earnings reinvigorated the stock. UnitedHealth beat earnings forecasts as it added more patients and pharmaceutical customers despite a continuing negative effect on profits from the February cyber-attack. UnitedHealth also reaffirmed previous guidance for 2024. It’s well positioned in a slowing economy as a highly defensive stock. BUY

UnitedHealth Group Inc. (UNH)
Next ex-div date: September 16, 2024

Alexandria Real Estate Equities, Inc. (ARE – yield 4.4%) – I was losing my patience with this niche innovation center property REIT, but I’m encouraged by the recent behavior. After hitting a 52-week low in mid-August, ARE had a strong move higher over the rest of the month. It has moved down in the past couple of weeks along with most other stocks, but the uptrend is likely to last as interest rates trend lower. ARE stumbled after the earnings report, but earnings were still solid and should be strong going forward. The defensive characteristics may serve ARE well going forward with the increased recession fears. BUY

Alexandria Real Estate Equities, Inc. (ARE)
Next ex-div date: September 30, 2024

Rating Change – “HOLD” to “BUY”

NextEra Energy (NEE – yield 2.5%) – NEE is another stock making new highs this month. NEE has predated the overall utility recovery and has been strong since March. It is a highly defensive utility, and the recession fears make NEE more desirable. NextEra forecasts revenue growth of 8.3% per year over the next three years, compared to average growth of 4.7% for the electric utility group. There is also growing anticipation of a steep acceleration in electricity demand in the years ahead prompted by onshoring of manufacturing, electric vehicle growth, and increasing data center electricity demand because of AI. Renewable demand is expected to grow the most.

Although NEE has rallied strongly recently, it is still well below the all-time high after an abysmal year in 2023. The stock never deserved to be that pummeled and investors are waking up to a stock that blew away the returns of the overall market for years prior to rising interest rates. NEE could get an added boost from the rise in electricity demand that will be skewed toward clean energy. BUY

NextEra Energy Inc. (NEE)
Next ex-div date: November 30, 2024, est.

USB Depository Shares (USB-PS – yield 5.3%) – This preferred stock had a tepid reaction initially as recession fears grew in August. But fears have faded, and this security has been reveling in the falling interest rates. The position has returned 27% in less than two years in a fixed income market that has been bad most of that time. BUY

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

Vanguard Long-Term Corp. Bd. Index Fund (VCLT – yield 4.9%) – Ditto for VCLT. The long-term corporate bond ETF loves falling interest rates. There could be some default issues in the event of a recession, but the fund is highly diversified and will benefit greatly from lower rates as well. There should be more good times ahead as the main risk for the market has changed from rising rates to a slowing economy (and likely falling interest rates). BUY

Vanguard Long-Term Corp. Bd. Index Fd. (VCLT)
Next ex-div date: October 1, 2024, 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 October 9, 2024.

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