In anticipation of a booming economy in the months and quarters ahead, the stock market has rallied within a whisker of all time highs. But certain individual stocks and sectors are still languishing despite the index performance. It is among these stocks where great value and high yield can still be found.
In this issue I highlight one of the best banks in the country at a historically low price as the sector struggles. But the bank has remained solidly profitable through the horrible economy in the second quarter, and the stock will benefit as the recovery gains traction. It currently offers a great income opportunity with a high yield and getting high call premiums as the market anticipates better days ahead.
Cabot Income Advisor 720
[premium_html_toc post_id="210706"]
Earn High Income from an Out-of-Favor Titan
This is a wild market environment, the likes of which I have never seen. A self-induced economic crash to defend against a pandemic is a new one on me, and everybody else. I strongly believe in the U.S. economy and that it will roar back with a fury beyond what economists expect. But I still remain cautious on the market given the unprecedented nature of the current situation.
The indexes have come almost all the way back from the recent carnage. The S&P 500 is now within just 4% of the all-time high and in positive territory year-to-date. The technology-laden Nasdaq has recently made a series of new all time highs and is up nearly 20% for the year so far, after returning over 30% last year.
This bizarre economic situation is treating companies and sectors unequally. Technology companies are booming as people rely on them more than ever during the lockdown. Other sectors, like Energy and Finance, are still suffering as the economic contraction is killing demand for their products and services.
The technology sector is pulling up the Indexes while many stocks are still languishing. If the booming economy that the market currently expects comes to fruition it should revive the cyclical stocks and sectors. There is still great opportunity out there despite the indexes being high.
However, I still remain cautious because the market has moved up awfully far and awfully fast considering the risks that are still floating around out there. There is still the unpredictable course of the coronavirus and the possibility of a second wave later this year. Then there’s the election in November. The political discourse is rancid and there could be big trouble if this election is close.
For those reasons, I have not embraced the riskier and more aggressive plays so far in this newsletter. The objective is not only to provide you with strategies that provide a high current income but to keep your principle safe as well. All the stocks currently in the portfolio sell at compelling values and are companies that can endure another downturn and come back strong.
In this issue, I highlight one of the best run and most conservative banks in the country that is selling at a deep discount in the current environment. Although the second quarter was the low point of the pandemic recession, this bank easily endured the worst of it and conditions should rapidly improve going forward.
Monthly Recap
June 24th
Purchase - Enterprise Product Partners (EPD) – 18
Purchase - Brookfield Infrastructure Partners (BIP) – 42
Purchase - Qualcomm Inc. (QCOM) - 89
Sold - QCOM September 18 $95 call at $4.30 or higher
July 8th
Removed pending trade - Sell EPD August 21 $21 call at $0.65 or higher
July 15th
Removed pending trade - Sell BIP September 18 $45 call at $2.10 or higher
Sold - ABBV September 18 $100 call at $4.60 or higher
The June issue included recommendations to buy EPD, BIP and QCOM as well as recommendations to sell covered calls on all three stocks at targeted prices. The market was down significantly on the day of the issue and the only call to hold its target price was QCOM. That call was written and the other two were not. As time expired and call premiums decreased, the trades for calls on EPD and BIP were removed.
Last week’s update included a “Special Alert” to sell a call on the ABBV position that was initiated in the June 2nd inaugural issue. That target price was reached and the trade is pending.
The call trades currently still pending include:
MO July 31 $42 call at $1.60
QCOM September 18 $95 call at $4.30
ABBV September 18 $100 call at $4.60
On July 17th, the call written for IIPR at the $95 strike price expired. The price was not reached and the stock is kept, along with the $3 call premium.
What to Do Now
Although the prices of all the portfolio positions are higher than when originally purchased, they all still represent good value at current prices and are BUY rated. The market is still trending higher and has shown strong resilience in the face of bad virus news. The trend is good but things can change.
The positions were all chosen with the possibility that the market turns south in the weeks and months ahead. All the positions have safe dividends and businesses that will remain strong even under the most difficult circumstances.
High call premiums are more difficult to find than in months past. However, there are special cases where high premiums can still be found. In this issue I highlight another stock to buy while simultaneously writing a call to maximize income. As well, a new call is targeted to sell on IIPR. It is the second call written on that stock.
It is the first of many positions on which we can write multiple calls. I try to target strike prices that have a good chance of not being reached in hopes that the calls will expire and we can keep the stock for more call and dividends. This is how we can continue to ring the register and generate income on the same stocks.
In the event that the strike price is reached at the expiration date, the stock will be called away, but you will get capital appreciation, in addition to call premium and dividends, for your trouble. And we’ll find more stocks.
Featured Action
Buy U.S. Bancorp (USB)
U.S. Bancorp (USB) is the fifth largest bank in the United States and the country’s largest regional bank with over 3000 bank branches in 25 states in the Western and Northern U.S. The Minneapolis bank was founded in 1863 and now has more than 70,000 employees and $543 billion in assets.
The bank offers a wide range of services. There are four main divisions including consumer and business real estate banking, corporate and commercial banking, wealth management services and payment services. That probably sounds more complicated than it is. Most revenue is generated from net interest income (NII), which is the rate spread between the cost of money and the loan interest charged to customers. Half of the loan volume is to businesses with the rest primarily from residential mortgages and personal loans. The rest of the revenue is derived from banking fees.
This is a horrible environment for banks. They make money on economic activity and loan demand as well as the interest rate spread earned on loans. Well, this is one of the worst environments for banks ever. Loan demand has dried up during the lockdowns and interest rates have fallen to all time low levels.
Economists expect a 30% to 40% contraction in GDP for the second quarter. That would be the worst economic quarter ever recorded. How did U.S. Bancorp fare in this worst ever quarter? The bank has remained profitable and is proving to be incredibly resilient.
The bank beat estimates on both earnings and revenues. Revenues were actually up a slight 0.3% from last year’s quarter. Earnings of $0.41 per share bested estimates of $0.22 but represented a 62% year-over-year decrease. However, that loss was due to a $1.7 billion provision for loan losses not yet realized. On an operational basis, the bank did quite well under the circumstances. Operating income fell less than 6% from last year’s quarter. The stock rallied 3.2% on the day of the announcement.
The bank actually grew deposits, loans and fee income in this pandemic depression of a quarter. And this is as bad as it gets. The bank is still profitable and growing the business. Conditions should most certainly improve in future quarters. Economic growth in the quarters ahead is likely to be torrid, and loan demand will surely increase. As well, the economic activity will likely put upward pressure on interest rates, increasing net interest income.
The stock is dirt cheap. It’s down 40% from the December high and selling at just 11 times earnings, half the current price/earnings ratio of the S&P 500. As a result of the lower price, the dividend yield is up to 4.7%. The dividend should be safe as the bank has a manageable 52% payout ratio.
This is one of the best run banks in the country. It is one of the very few that remained profitable through the financial crisis. It has industry leading operating margins and profitability and is actually a favorite of Warren Buffet’s.
This is a contrarian play. But U.S. Bancorp is one of the very best banks in the country selling at a seven-year-low price. The banking industry is in much better shape than it was in the financial crisis. The sector was at the center of the problem and never really fared well during the recovery. The bull market should be much kinder to banks. And it is only just beginning.
It’s worth noting that the call premiums for the stock are high, which reflects investor confidence in the near term price movement.
U.S. Bancorp (USB)
Security type: Common stock
Industry: Banking
Price: $36.50
52-week range: $28.36 - $61.11
Yield: 4.7%
Profile: USB is a massive US regional operator and the fifth largest bank in the country.
Positives
- All signs point to a strong economic recovery in the quarters ahead.
- Bank operations have been remarkably resilient through the pandemic.
- It is one of the best banks selling at a cheap price in an out-of-favor industry.
Risks
- Large loan losses could continue to be written off in the quarters ahead.
- The recovery could get derailed in a second wave of the pandemic.
- Election uncertainty may limit stock price gains.
Covered Calls
Sell USB September 18 $37.50 call at $2.00 or higher
Expiration date: September 18
Strike price: $37.50
Call price: $2.00 or higher
Return possibilities at current 36.50 purchase price
- The stock goes above $37.50
Call premium: $5.00
Appreciation: $1.00 (37.50 strike price minus 36.50 purchase price)
Total: $3.00 (total return will be 8.2% in less than 2 months) - The stock price stays the same
Call premium: $2.00
Total: $2.00 (total return will be 5.5% in less than 2 months) - The stock price declines
You will be down by however much the stock is down less the $2.00 from the call.
Sell IIPR September 18 $100 call at $5.00 or higher
Expiration date: September 18
Strike price: $100
Call price: $5.00 or higher
Return possibilities at current 95 purchase price and original 87.82 purchase price
- The stock goes above $100
Current 95 price
Call premium: $5.00
Appreciation: $5.00 (100 strike price minus 95 purchase price)
Total: $10.00 (total return will be 10.5% in less than 2 months)
Original 87.82 price
Call premium: $5.00
Appreciation: $12.18 (100 strike price minus 87.82 purchase price)
Total: $17.18 (total return will be 19.6% in three and a half months) - The stock price stays the same
Call premium: $5.00
Total: $5.00 (total return will be 5.3% in less than 2 months 5.7% on original purchase price) - The stock price declines
You will be down by however much the stock is down less the $5.00 from the call.
Note: This is the second call written on the same position. The first call was $3 (at least) plus a $1.06 per share dividend paid. If you purchased the stock when recommended and wrote the last call as well as this one you will get $9.06 in income between the dividend and the calls for a 10.3% income in about three and a half months if the stock doesn’t reach the strike price by expiration in September.
If the stock does reach or exceed the $100 strike price and the stock is called, your total return will be 24% from the original purchase price (12.18 appreciation plus the two calls, $8, plus the dividend, $1.06).
Portfolio Updates
AbbVie Inc. (ABBV)
Yield 4.7%
This Biopharmaceutical stock just hit a new 52-week high, surpassing the previous high hit in February after a strong run. ABBV has returned over 20% in the past three months and over 50% in the past year. But the stock is still reasonably valued at just 10 times forward earnings and more than 20% below the 2018 high. And it’s paying a strong 4.7% yield.
It also helps that biotechnology stocks are red hot. The iShares Nasdaq Biotechnology ETF (IBB) just hit a brand new all time high. Investors seem to be gaining increasing confidence that AbbVie can overcome increasing competition for Humira with its strong performing newly launched drugs, best-in-class pipeline and the merger with Allergan. The stock seems to have everything going for it right now but the company will announce earnings at the end of the month. That adds some uncertainty. BUY
Altria (MO)
Yield 8.3%
The stock of this cigarette maker has been trending higher of late. It’s moved about 8% higher in the last three weeks. There hasn’t been any major news on the stock and the recent move may be from anticipation of second quarter earnings which come out next week. Altria has beaten expectations the past two quarters. An important issue to watch in the upcoming report is sales and market share of the company’s Marlboro brand. There has been some speculation that Altria is losing sales of its expensive brand to cheaper competitors as smokers tighten their belts during the pandemic. We’ll see what they report. I don’t see too much risk because the stock is already beaten to a pulp. Plus, if the news isn’t good that means the stock will likely not reach the $42 strike price by expiration in July 31st and we can write more calls in the future. BUY
Brookfield Infrastructure Partners (BIP)
Yield 4.5%
The stock of this infrastructure partnership broke the recent sideways pattern and moved up over 5% this past week. It may be benefitting from a rotation away from some of the big tech names. But the market isn’t really buying into the near term upward trend yet as the stock is at the same price where the original September call was targeted, but the call price is still a lot lower. There may be an opportunity for higher call premiums in the weeks ahead. In the meantime, BIP is still a solid holding in the uncertain economy with 95% of earnings contracted or regulated. BUY
Enterprise Product Partners (EPD)
Yield 9.8%
I’m looking forward to the second quarter earnings report on July 30th. This stock has been unreasonably punished along with the rest of the beleaguered energy sector despite the fact that it has much less volatile earnings. Although higher over the past week, this reliable energy infrastructure stock continues to wallow in undervalued oblivion. The company collects fees for storage, piping and processing of oil and gas and doesn’t rely on volatile commodity prices. There is a strong chance that the next report proves its resilience and the market appreciates it a little more. It may offer a good opportunity to write a call. If not, that massive dividend yield should be safe. BUY
Innovative Industrial Properties (IIPR)
Yield 4.4%
IIPR has return over 27% YTD and almost 8% since being added to the portfolio on June 2nd. However, it failed to hit the strike price of 95 on expiration day last Friday and, therefore, was not called away. That means we can write another call and continue to ring the register on income. In this issue, I target another call to sell on the stock.
This marijuana farm REIT is growing at fast clip as demand for legal marijuana continues to increase. Analysts are expecting 150% earnings growth in the second quarter as the company now has 59 properties, up by 13 so far this year. At 94.66, the stock is still well below the 2019 high of 130. The prognosis remains very good for the company and the stock. But it can be volatile with the market. It has had a nice move recently which creates a great opportunity to write a call at a good premium. BUY
Qualcomm inc. (QCOM)
Yield 2.8%
The chip maker stands to benefit greatly as 5G smart phones hit the market later this year and next year. It makes the only good 5G chip for smart phones, including for Apple (AAPL). Although the release of the new 5G enabled phones got pushed back because of the pandemic, the company is looking ahead to a strong earnings boost as 5G enabled phones start selling and paying royalties to Qualcomm. The calls written don’t expire until September at a strike price of 95, versus the current 93.17. It seems likely at this point that the stock will reach that price and be called, but it’s difficult to know what kind of mood the market will be in by the middle of September. BUY
MLP Alternatives
This newsletter recently purchased two securities that are Master Limited Partnerships (MLPs), Brookfield Infrastructure Partners (BIP) and Enterprise Product Partners (EPD). These are securities with special tax status granted to encourage investment in certain areas. But I understand they can be a problem for some of you.
MLPs pay no income tax at the corporate level provided they pay out the bulk of their earnings in the form of distributions. For this reason they generally pay a higher level of income than ordinary corporations because they can pay out money not lost to taxes. The distributions themselves have different tax properties, as a large portion are treated as return of capital. But they also require filing a special tax form, K-1, with your taxes.
I get it. It’s a pain in the tweasle. Who needs another piece of minutia to deal with at tax time? There is also a risk that you could owe taxes in a tax deferred account if the investment is large enough. Unrelated business taxable income (UBTI) can be generated on income over $1000 per year in a retirement account. I’ve also seen cases where people living abroad cannot own MLPs.
I sometimes choose MLPs despite these issues when they offer a unique investment opportunity that isn’t available anywhere else. Such is the case with the two recent portfolio additions.
In the case of EPD, there are similar alternatives available that aren’t MLPs, namely Kinder Morgan Inc. (KMI) and The Williams Companies (WMB). These are also large U.S. oil and gas infrastructure companies that pay large dividends. In fact, they are former MLPs that converted to regular corporations. But this is a highly unusual environment and I’m only comfortable investing in the space with EPD right now.
Midstream energy companies haven’t reported earnings yet and I don’t know the full extent of the carnage from the pandemic, or precisely what the financial fallout will be for some of these companies. I know that EPD has qualities and finances that make it extremely unlikely that they cut the distribution. I can’t say the same for the other companies. And as long as EPD pays that massive 10% yield the stock should hold its own from here until business recovers.
The situation is changing rapidly as the recovery continues to gain traction. As the economic fallout from the business disruption becomes clear, I will likely offer one of these alternatives, or another one, in the future for those of you that don’t want MLPs.
There are also other infrastructure plays besides BIP. In fact, Brookfield spun off shares of an identical business in the form of a regular corporation for investors and institutions that can’t by MLPs. The stock trades under the symbol BIPC. The only problem is that there are no options traded on that stock at this point. There are no other high dividend infrastructure investments that offer an acceptable range of options on the stock. But things change and I will keep my eye out for a non MLP infrastructure investment in the future.
Income 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 Income Advisor for an explanation of how dates are estimated.
The next Cabot Income Advisor issue will be published on August 26, 2020.
Cabot Wealth Network
Publishing independent investment advice since 1970.
CEO & Chief Investment Strategist: Timothy Lutts
President & Publisher: Ed Coburn
176 North Street, PO Box 2049, Salem, MA 01970 USA
800-326-8826 | support@cabotwealth.com | CabotWealth.com
Copyright © 2020. All rights reserved. Copying or electronic transmission of this information is a violation of copyright law. For the protection of our subscribers, copyright violations will result in immediate termination of all subscriptions without refund. No Conflicts: Cabot Wealth Network exists to serve you, our readers. We derive 100% of our revenue, or close to it, from selling subscriptions to its publications. Neither Cabot Wealth Network nor our employees are compensated in any way by the companies whose stocks we recommend or providers of associated financial services. Disclaimer: Sources of information are believed to be reliable but they are not guaranteed to be complete or error-free. Recommendations, opinions or suggestions are given with the understanding that subscribers acting on information assume all risks involved. Buy/Sell Recommendations: All recommendations are made in regular issues or email alerts or updates and posted on the private subscriber web page. Performance: The performance of this portfolio is determined using the midpoint of the high and low on the day following the recommendation. Cabot’s policy is to sell any stock that shows a loss of 20% in a bull market or 15% in a bear market from the original purchase price, calculated using the current closing price. Subscribers should apply loss limits based on their own personal purchase prices.