Cabot Dividend Investor 619

So far, the market has had a fantastic year with the S&P up 16.38% at the halfway point. It’s also been a stellar June as the index has climbed 7.3% this month alone. Now, the market is perched near all-time record highs. In this issue, I highlight a stock that is cheap in an expensive market that has a great chance of moving higher in the quarters ahead. It is the best run American refiner that has been knocked back because of temporary conditions in an environment otherwise ideal for American refiners.

Cabot Dividend Investor 619

A Cautious View at the Midpoint of the Year

We’ve reached the midpoint of 2019, which means it’s a good time to take some stock of where we are and where we might be headed for the rest of the year.

In several ways, things look pretty good. The S&P 500 is already up 16.38% for the year, and the year is only half over. In fact, the index has rallied 7.3% this month alone and is now within a whisker of new all-time highs. The strong performance this year comes with much-better-than-expected economic growth in the first quarter and an end to the near-term recession fears that spooked the market at the end of last year.

But a deeper look at the numbers paints a less rosy picture. Sure, market performance has been strong this year. But much of the move has been a rebound from the oversold conditions late last year when the market sold off 20%. Over the past year, the S&P 500 is only up 7.14%. And while there have been some dramatic ups and downs, the market is just a few percentage points higher than it was at the beginning of 2018.

The market advance petered out a year and a half ago. It could be a healthy consolidation from overbought conditions after a euphoric 2017. It may be that after the tax cuts investors haven’t found enough to get excited about to drive stock prices through the old highs and into new bull market territory. It needs a catalyst. What might that be?

A strong economy is always good. But, then again, that would lower the probability of more rate cuts, and the market wouldn’t like that. The most obvious catalyst would be a trade deal with China. After all, the trade war is having a negative effect on the market, curbing global growth and hurting business confidence here. It also gets conveniently blamed for everything but the kitchen sink.

The market looks poised to rally today on a statement by Treasury Secretary Steve Mnuchin that he believes a trade deal with China is 90% done ahead of crucial negotiations and the upcoming G-20 meeting. I hope a deal gets done. But I’m skeptical. The deal was 90% done three months ago. That other 10% is mostly about making sure China actually complies with the agreement, and that’s always been the sticking point.

Near all-time highs with an uncertain catalyst for further advancement, I’m cautious here. Of course, I fully acknowledge that the market could move higher even without a catalyst in a confounding manner that is not unusual. But I prefer to err on the side of caution and play it a little safer right now.

Specifically, I don’t want to pay a high price for the more cyclical stocks in the current dynamic. Defensive stocks are in favor and continue to perform well, but most are getting expensive. I prefer to find cheaply valued stocks, which are in dwindling supply. Besides, most cheap stocks are cheap for a reason, with the market at all-time highs. But certain select opportunities have a different ebb and flow than the overall market. And an even more select group is poised to move higher because of industry-specific reasons that are less dependent on the performance of the overall market.

I found such a stock in this month’s “Featured Buy.”

[highlight_box]What To Do Now: There are two rating changes this week. Pharmaceutical company AbbVie (ABBV) is reduced from a BUY to a HOLD as the market digests its purchase of Allergan (AGN). There is a more in depth explanation regarding that in today’s Special Bulletin. Also, spice maker McCormick and Company (MKC) is lowered from a HOLD to SELL HALF ahead of tomorrow’s earnings announcement.

The defensive oriented stocks in the portfolio continue to perform well. In this uncertain environment, investors continue to have a strong appetite for non-cyclical, dividend-paying stocks with less headline exposure. Most of these stocks are rated HOLD and not BUY because of high valuations. However, they are not SELLS either because of continued strong momentum.

The portfolio positions I like best right now and would consider “buy-first” stocks are Enterprise Product Partners (EPD), Brookfield Infrastructure Partners (BIP) and Crown Castle International (CCI).

EPD has great operational performance, solid growth prospects and sells at a bargain price. It also could be poised near a breakout level. BIP is an ideal stock for this market. It is in a defensive business with reliable cash flows and is also reasonably valued. Both stocks also pay monster dividends that should be quite safe and will likely continue to grow.

CCI a little different than the other two. It pays a lower dividend and isn’t particularly cheap. But the dynamics surrounding the 5G build out are so strong that a higher price is justified. I also consider it a defensive stock as 5G infrastructure will be in demand regardless of the state of the economy or the market.[/highlight_box]

Featured Buy

Valero Energy (VLO)

Valero Energy (VLO) is the largest petroleum refiner in the U.S. The San Antonio-based refiner operates 15 petroleum refineries in the U.S., Canada and the U.K. with a capacity of about 3.1 million barrels per day (MMbpd). It markets products in 43 states, Canada, the UK, Ireland and Latin America and has over $100 billion in annual revenues.

In addition to the petroleum refineries the company also operates 14 ethanol refineries and is one of the largest U.S. producers, accounting for more than 20% of all U.S. exports. Valero also has a rapidly growing renewable diesel business that is now a whole segment of the company. It also owns midstream piping and storage assets from the recent buyout of its Midstream MLP. But the main event is still petroleum products.

Refining is a tough and unpredictable business.

In petroleum refineries, refiners use crude oil as a feedstock to make transportation fuels (gasoline, diesel, jet fuel) and petro chemicals (asphalt, propane, natural gas liquids, Vaseline, etc.). Profits are primarily determined by volume and “crack spreads,” the difference between the cost of producing a barrel of refined product and the price at which it is sold. Consequently, profits are always at the mercy of various commodity prices and their relationship with each other as well as the ever-fluctuating supply/demand dynamic.

Even during prosperous times for refiners, profits can always plunge in any given quarter as certain factors shift the wrong way. While the short term is always hard to predict, the longer trend provides a more accurate read. And the broader trend is still strong for American refiners.

A big reason is the American energy boom. So much oil is being produced that there are bottlenecks because of insufficient infrastructure to transport it. The abundant supply makes U.S. crude oil prices, as represented by the U.S. benchmark West Texas Intermediate (WTI), cheaper than the international benchmark, Brent Crude. Right now the spread between the two is $7 per barrel, $57.79 for WTI and $64.86 for Brent.

Refined products are priced by the international benchmark, even in the U.S., giving American refiners a distinct advantage of cheaper crude oil feedstock. Lower costs make higher margins. In addition, this country provides the latest technology to hone the processes and lower costs, as well as efficient capital markets to hedge against commodity risk.

I like Valero the best of the American refiners right now for several reasons.

• Technological Sophistication
Valero refineries are the most complex and efficient in the sector. The company has flexibility that others don’t, like the ability to refine cheap heavy crude from Canada or light, sweet U.S. crude depending on which offers the higher margins at the time. Valero can also produce more climate-conscious products in growing demand like renewable diesel, NGLs, ethanol, and new lower sulfur fuels required by the International Maritime Organization (IMO) starting in 2020. Valero is also the lowest cost producer in the space and operates profitably even in lousy conditions.

• Shareholder Friendliness
VLO pays the largest dividend of the refining majors, with a current yield of 4.5%. The dividend is well supported with a low target payout ratio of 40% to 50% and a solid balance sheet with debt levels well below the industry average and a 52% debt/equity ratio. The company has a stated goal of returning 40% to 50% of earnings to shareholders in the form of dividend and buybacks. Since 2014, shares outstanding have been reduced from 550 million to 425 million and the annual dividend has grown from $1.05 to $3.20 per share.

• Future Growth
It’s not just a matter of waiting around until commodity prices and other factors swing into favor. Valero invests heavily in new growth projects that will grow profits to a new level. It invests 40% of capex into growth projects, the highest among its peers. In fact, there is high margin new capacity coming on line this year and next that will boost revenue and profits.

But the best reason to buy it now is timing. It’s cheap. The stock is coming off a bad stint, down over 25% the past year and 34% off the 2018 high. It was down because of a litany of temporary issues. Gasoline inventories spiked to record highs and crack spreads were at record lows. Canadian oil prices spiked and recent planned maintenance shutdowns were heavy.

Consider the longer trend. Over the past five years, a period that included the oil price crash and havoc in the industry, VLO returned 74% compared to a negative 26% return over the period for the Energy Select Sector SPDR Fund (ETF). The stock also outperformed the overall market over that period, and that’s after being down 25% over the past year.

Now, the stock is selling at valuations that are cheap relative to its peers and the market and there is a good chance that business conditions improve in the quarters ahead. Gasoline inventories tend to work themselves out and there are new pipelines coming online this year that will deliver cheaper Permian Basin crude oil to the refineries. The stock can move too. The stock price nearly doubled between May 2017 and August 2018 when conditions lined up well. But now the stock price is more aligned with the longer-term trend line.

Profits and stock performance will wax and wane in the near term amid an industry environment with growth prospects above the historical norm. Global energy demand continues to grow and Valero is better than the competition, with a distinct American advantage that should last a while. We will thus add the stock to the Dividend Growth Tier with a “BUY” rating.

Valero Energy Corp. (VLO)

Valero Energy Corp. (VLO)

Security type: Common stock
Industry: Energy (refining)
Price: $81.85
52-week range: $68.81 - $122.42
Yield: 4.4%
Profile: Valero is the largest petroleum product refiner in the U.S.

Positives
• Cheaper U.S. crude prices give U.S. refiners a huge advantage.
• The company’s cutting-edge refineries enable it to operate profitably in almost any environment.
• New projects are coming online that should boost earnings in the quarters ahead.
• Management remains committed to rewarding shareholders with stock buybacks and dividend hikes.

Risks
• Refiners are not recession proof and not good in a bear market.
• An uncertain global economy amidst the U.S./China trade war could negatively impact demand.
• Short-term business conditions are highly unpredictable.

Portfolio at a Glance

Portfolio Updates

High Yield Tier

The investments in our High Yield tier have been chosen for their high current payouts. These ?investments will often be riskier or have less capital appreciation potential than those in our other ?two tiers, but they’re appropriate for investors who want to generate maximum income from their? portfolios right now.

BUY – Brookfield Infrastructure Partners (BIP 42 – yield 4.7%) – Assets of this global infrastructure company include cell towers, data centers and natural gas pipelines and storage facilities, similar to Crown Castle and Enterprise Product Partners. It also owns heating plants, ports, toll roads and railroads. All these assets are reliable cash generators that operate near monopolies. After a rare stumble last year the company is back in business, growing earnings and boasting a 25% year-to-date return. The stock is still reasonably priced and should have strong upside over the rest of the year.

HOLD – Community Health Trust (CHCT 38 – yield 4.3%) – This small healthcare REIT has absolutely blown away the performance of other healthcare REITs and the overall market over the past three years. The stock has returned about 40% so far this year and averaged a 30% return over the past three years. It offers a high dividend and much stronger growth than its peers. The one gripe I have is that it’s getting a little pricey as it continues to make new highs. But I won’t fight the momentum for now.

BUY – Enterprise Product Partners (EPD 29 – yield 6.1%) – A monster 6% dividend is a beautiful thing, though it normally raises justified concerns over whether it is sustainable. But that’s not a worry with EPD. It has growing earnings, one of the lowest payout ratios of its peers, a stellar balance sheet and it has raised the payout for 20 consecutive years. Earnings revisions have consistently trended higher and the company beat earnings estimates for the last three quarters. But while the stock has outperformed the market year to date, it has underperformed over the past couple of months. The reason is likely energy industry worries including the China trade war and trouble in Iran and Venezuela. These issues haven’t affected business but the market tends to punish the whole sector in the short term. But the stock is still perched near recent highs, ready to breakout on good news.

HOLD – STAG Industrial (STAG 30 – 4.6%) – This industrial REIT continues to look strong. It broke out to new highs in June and has pulled back slightly over the past week. It’s a high dividend payer with a great niche in a strong REIT sector. Industrial REITs enjoy a high demand that outstrips current supply. The market loves this monthly dividend payer right now and, although it has gotten somewhat expensive, it still has great momentum and is worth holding.

Dividend Growth Tier

To be chosen for the Dividend Growth tier, investments must have a strong history of dividend increases and indicate both good potential for and high prioritization of continued dividend growth.

Rating change “BUY” to “HOLD”
HOLD – AbbVie (ABBV 68 – 5.5%) – The stock took a huge 16% hit yesterday on the announced purchase of Allegan plc (see my Special Bulletin). Clearly the market isn’t fond of the deal. The reason is that Allergan has not been growing earnings and doesn’t have strong growth drugs or a promising pipeline. For $63 billion, investors want better. I don’t believe the deal was necessary and AbbVie did it to please the market. On that front, they failed miserably. That said, AbbVie has plenty of future growth in its newly launched drugs and industry-leading pipeline. What they need is more revenue right away and diversification away from Humira. It looks like they got that. We’ll have to see how the story unfolds as the market digests the news. Until there is more clarity, the rating is reduced to HOLD.

BUY – Altria (MO 48 – 6.4%) – The stock has been under pressure this week. The problem is a focus on regulatory issues for E-cigarettes. Earlier this year, Altria purchased a 35% stake in E-cigarette company JUUL in the hopes of offsetting cigarette volume slippage with E-cigarette revenues. A recent ruling pushed the date by which E-cigarette manufacturers have to file for FDA approval of their products to 10 months. The former FDA commissioner expressed skepticism on a CNBC appearance that these companies would be able to get approved because of youth use. But while this could be a big problem for JUUL, Altria should be fine. If E-cigarettes are banned, Altria will sell more regular cigarettes. It seems like every time the stock moves higher it gets knocked back by some regulatory concern. Hopefully it can get some momentum going.

HOLD – American Express (AXP 124 – yield 1.3%) – The credit card business is a great place to be as the world moves to increasingly cashless transactions. AXP has been one of the best-performing Dow stocks in 2019, up 31% so far this year. The stock soared to new highs in April after first-quarter earnings beat expectations and several analyst upgrades followed in May and June. The stock is now matching the upside of rivals Visa (V) and MasterCard (MA). Unless the economy sputters or the global economy sinks, the stock is likely to continue moving higher.

BUY – Crown Castle International (CCI 131 – yield 3.3%) – The growth dynamics surrounding the 5G infrastructure buildout are outstanding. This is a REIT that offers both defense and growth in an uncertain market. The stock continues to outperform both the overall market and its peers by significant margins. The stock is a perfect fit for the current market and in excellent shape if things change. It should hold up relatively well if the market turns south and if it meets or exceeds its 20% per-year expected earnings growth.

Safe Income Tier

The Safe Income tier of our portfolio holds long-term positions in high-quality stocks and other investments that generate steady income with minimal volatility and low risk. These positions are appropriate for all investors, but are meant to be held for the long term, primarily for income—don’t buy these thinking you’ll double your money in a year.

BUY – Invesco BulletShares 2019 Corporate Bond ETF (BSCJ 21 – yield 2.2%)
BUY – Invesco BulletShares 2021 Corporate Bond ETF (BSCL 21 – yield 2.7%)
In a good market these safe short-term bond ETFs give you the comfort of being diversified. In a down market you’re happy you have something that won’t go down. You get a stable price and a steady yield no matter what.

HOLD – Consolidated Edison (ED 88 – yield 3.4%) – This is a great time for utilities with the market uncertainty and interest rates likely to fall. Utilities have been the number one performing sector of the market over the past year. Even so far this year, with the S&P up 16.38%, ED has matched the return. The stock has had a great run recently and may have gotten a little ahead of itself but the momentum still has shown no signs of faltering. It could go higher in the weeks and months ahead.

BUY – Invesco Preferred ETF (PGX 15 – yield 5.6%) – The high yield and lack of correlation to the stock and bond markets make this a nice portfolio holding and income generator. The stock price has barely budged for this entire year so far and that’s exactly what investors sign up for with this ETF. Enjoy the juicy yield and stable price in this uncertain market.

Rating change from “HOLD” to “SELL HALF”
SELL HALF – McCormick & Co (MKC 150 - yield 1.5%) – The spice maker announces its fiscal second-quarter earnings on Thursday. That makes me nervous considering the near 50% return on the stock over the past year. The stock now sells at a rather lofty 29.6 times 2019 projected earnings, and growth is expected to moderate this quarter as the company deals with a higher effective tax rate. The company performance still looks solid and profit margins are growing but I can see a pullback in the stock after earnings. In a measure of caution I am selling half of the position from the portfolio and encouraging you to do the same to protect profits.

HOLD – NextEra Energy (NEE 204 – yield 2.4%) – The stock just continues its slow and unabated journey ever higher. It’s making new highs every week with no signs of stopping. Utility stock have been performing well but NextEra offers significantly more growth than its peers by virtue of its alternative energy business. You get the steady, reliable cash flow of a utility without missing out on growth, and the market loves it. At some point the stock will have to pull back somewhat but I don’t see any signs of it yet.

HOLD – Xcel Energy (XEL 60 – yield 2.7%) – This is a fantastic utility that offers dependable income and growth from its alternative energy business. It’s returned over 46% for the past year and 26% so far this year. Valuations are getting stretched but the stock still has great momentum. It seems to make new highs every week. I may pull back on the position ahead of earnings next month but for now let it ride.

Prices as of late morning June 26, 2019

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 estimated.

The Rate Cut Game

The market has enjoyed a marvelous month of June as the S&P 500 has rallied over 7% in the month so far. Most of the rally has been induced by speculation that the Fed will start cutting the Fed Funds rate after a market pullback in May and concerns about the negative effects of the continuing trade war with China.

While the Fed seems likely to cut the rate by 0.25% in July, I’m not so sure there will be more rate cuts before the end of the year. But the market seems to be pricing them in anyway. The current situation occurs at least once every cycle. It’s a weird dynamic where bad news is good news and good news is bad news.

Certain market sectors react negatively to good economic news because it lowers the probability of further rate cuts. Certain stocks actually rally on bad news as it increases the possibility of more rate cuts. Sometimes we get to a situation where economic growth that is too strong is greeted negatively by the market because it prefers a little less growth, plus a rate cut.

The biggest driver of market performance can often be the Fed in times like this. Heavy speculation surrounds the Fed every time it meets.

It’s also true that the market loves this rate cut talk because the Fed gives the market a put. If the economy booms, that’s great. Stocks can rally on that good news. But in the event it falters, the Fed will come to the rescue. Either scenario is good for stocks.

I mention this because, as a dividend investor, you should be aware of the shifting dynamics as interest rates have a big effect on dividend stocks. Higher interest rates are often bad for dividend stocks as competing investments in fixed income become more attractive and the relative value of the dividend yield decreases. Falling rates can have the opposite effect.

Many safe dividend payers have been given new life and further upside as interest rates fall. Going forward, speculation surrounding the Fed could have a bigger relative effect on dividend stocks. I will be commenting on the state of this dynamic in future updates and monthly issues.

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Cabot Dividend Investor 619