View this email in your browser

Income Builder Model Portfolio

Monthly Portfolio Review: August 2024

Publication date: September 4, 2024

Current portfolio holdings

FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE.

Executive summary

• The Income Builder portfolio returned 2.3% in August, essentially in-line with the S&P 500 Index, which returned 2.4%.

• While stocks ultimately posted modest gains in August, it was a very volatile journey.

• Recession fears brought stocks down early in the month, while hopes for a Fed pivot on interest rates drove their recovery by the end of August.

• The Income Builder portfolio is well-suited for a falling interest rate environment and should continue to benefit as the Fed shifts its focus from price stability to maximum employment.

• We highlight tech holding TXN as a rare opportunity to invest in a dividend growth stock that also stands to benefit from long-term innovation in AI.

Performance review

The Income Builder portfolio returned 2.3% in August, roughly in line with the S&P 500, which returned 2.4%. Individual positions ranged from -19% for Carlyle Group (CG) to 16% for Mid-America Apartment Communities (MAA).

Although the portfolio and the broader market produced a positive return for the month, the journey was quite erratic. Stocks sold off hard at the beginning of the month, following a weak jobs report, which was exacerbated by selling pressure related to the unwind of the Japanese yen carry trade.

Investors in the first week of August were panicking to an extent that the economy was quickly losing momentum and potentially dipping into recession, following two years of restrictive monetary policy.

Stocks would soon recover, however, as the Bureau of Labor Statistics issued a severe downward revision of its job creation estimates. This fueled anticipation of a Fed pivot towards interest rate cuts, which was confirmed by Jerome Powell when he spoke at the Fed’s summer symposium at Jackson Hole on August 23.

Today, the labor market has cooled considerably from its formerly overheated state…. The upside risks to inflation have diminished. And the downside risks to employment have increased….  The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks. - Fed Chair Jerome Powell (8/23/2024)

Last month, and elsewhere, we discussed the profound impact that the Mag 7 technology platform stocks, especially NVIDIA (NVDA), have had on markets. These seven stocks now represent about one-third of the S&P 500.

The high representation of tech stocks within the index affects not only performance but also volatility. Tech stocks in general tend to have higher volatility and are typically “high beta,” meaning their fluctuations tend to be directionally consistent with market movements but are more extreme.

As markets weakened in early August, NVDA (which now has an approximately 6% weighting within the S&P 500) led the way down. NVDA fell more than 15% from the end of July through August 7—only to rally more than 30% from that low point by the time Powell spoke approximately two weeks later.

The unusually high volatility that we saw over the course of the month was reflected by a surge in the VIX Index early in the month. The VIX is perhaps the most widely referenced measure of market volatility—the more wildly the market fluctuates, up or down, the higher the VIX Index goes. The VIX spiked above 35 in early August—a level not seen since the market meltdown of 2022.

In August, higher volatility tech stocks underperformed as investors grew concerned over the health of the economy, which prompted a rotation into more defensive areas, such as Consumer Staples, Real Estate, Health Care and Utilities. Expectations of falling interest rates also provided support for these defensive sectors, which in many cases are viewed as “bond proxies” (stocks that are underpinned by stable long-term cash flows).

The Income Builder portfolio benefited from its exposure to some of the sectors that outperformed in August. These included our positions in Real Estate and Utilities. Energy sector exposure created a modest headwind.

In comparison with the broader market, which is now heavily skewed towards technology, dividend-paying stocks tend to be found in relatively interest rate sensitive sectors (with some exceptions, like oil and gas producers). As a result, dividend stocks tend to perform well as interest rates come down.

The Income Builder portfolio has benefited from the decline in long-term interest rates from peak levels that were struck earlier this year. The yield on 10-year Treasuries hit their 2024 peak in late-April, reaching approximately 4.7%. Yields on 10-year Treasuries are currently around 3.8%.

Many of the stocks held within the Income Builder have performed well over the past several months as the world transitions into a lower interest rate scenario. It is worth noting, however, that many of these stocks had become heavily discounted as we entered the Fed tightening cycle in 2022. In many cases, they remain well below previous highs or are still trading on much lower valuation metrics.

Despite the fact that inflation remains above the 2% target level, with the most recent CPI report at 2.9%, the Fed is clearly shifting focus towards its “maximum employment” mandate, potentially at the expense of price stability. With labor markets in a fragile state, we expect the Fed’s bias to remain towards rate-cutting, while tolerating inflation rates above target levels.

Stable or falling interest rates should continue to provide a performance tailwind for the Income Builder portfolio.

Portfolio highlights

Within the Income Builder portfolio, performance was led by Mid-America Apartment Communities (MAA), which returned 16%. WEC Energy (WEC) returned 9%, followed by VICI Properties (VICI), which returned 7%. The most significant detractors to performance were Carlyle Group (CG), which returned -19%, and Permian Resources (PR), which returned -6%.

The shares of apartment landlord and developer MAA continue to perform well. Softness in supply/demand dynamics in the company’s core southeastern markets appears to be dissipating. In its early August earnings report, MAA reported very encouraging trends and an improved financial outlook.

Despite the strong performance over the last three to six months, MAA shares are still down some 30% from year-end 2021 levels. While most of MAA’s outperformance can be attributed to improving fundamentals, falling interest rates have been helpful as well.

WEC and VICI are somewhat similar stories to MAA. Both are high quality, stable cash flow businesses with steady growth profiles that are benefiting from renewed investor interest as the interest rate environment shifts. This is a good opportunity to remind readers of our late April discussion of the VICI investment case.

CG shares returned -19% in August, after having returned 24% in July. Investor expectations appeared to get ahead of themselves heading into second quarter earnings, which came out the first week of August. CG is a relatively volatile position within the portfolio, which informs our 5% position weighting, but we like its long-term prospects as a leading platform within alternative asset management.

PR participated in the modest downside that affected the Energy sector, which was generally weak amidst concerns over a growth slowdown. We continue to favor PR as a long-term consolidation candidate with a very attractive footprint in the Delaware Basin.

An AI Dividend Play?

With the rise of the NVDA and the now massive representation of the Mag 7 within the U.S. stock market, Artificial Intelligence (AI) has become one of the most important subjects facing all investors. (For those especially interested, we have addressed this topic in a number segments on our @76research YouTube channel, which can be conveniently found in our recently created and rapidly growing Tech Trends playlist.)

From an investment perspective, we are excited about the potential of AI for many reasons, from opening new market opportunities to driving efficiencies to improving the overall real growth of the economy. But as with any technological transformation, there are risks—valuations can become excessive, over-investment can take place, and first mover profitability can erode.

In this context, it is worth returning to our favorite Income Builder tech stock, Texas Instruments (TXN).

TXN has many commendable attributes, which we have described. Specifically when it comes to AI, we see TXN as an excellent downstream beneficiary of the massive investment in AI computing capacity and the ongoing deployment of AI technologies across multiple industries.

As the global leader in analog semiconductors, TXN is well-positioned to supply the analog chips that will be required as AI technology is implemented in automobiles and across other real world industrial applications.

From a valuation perspective, TXN appears to be on the cusp of a very significant recovery in free cash flow generation. This follows a temporary free cash flow squeeze, which hurt the share price, that was brought about by the confluence of pandemic-related inventory surpluses and planned long-term investment in advanced manufacturing capacity (strategically located within the borders of the United States).

An important step forward in the free cash flow story took place on August 20, when TXN announced on its capital management conference call that it would take a more flexible approach to 2026 capital spending. Previously, the company had signaled $5 billion; now, TXN is targeting $2 to $5 billion, based on demand.

The more cautious approach to capital spending likely reflects the pressure recently applied by one of its largest shareholders, hedge fund Elliott Management, which has been nudging TXN to exhibit more capital discipline. As free cash flow recovers, we believe there is a strong likelihood that TXN shares will benefit from earnings multiple expansion, consistent with historical patterns.

A free cash flow recovery will also support dividend growth at TXN. While TXN’s 2.4% dividend yield is on the low side for the Income Builder portfolio, it is approximately double the market average. We view TXN as a unique opportunity to pair a meaningful and growing dividend with participation in the long-term AI trend.

Key metrics

Valuation detail

Performance detail

Company snapshots

Blackstone (BX)

Crown Castle (CCI)

Digital Realty Trust (DLR)

Diamondback Energy (FANG)

Texas Instruments (TXN)

VICI Properties (VICI)

Williams (WMB)

Carlyle Group (CG)

Kinder Morgan (KMI)

Mid-America Apartment (MAA)

Permian Resources (PR)

Sempra (SRE)

WEC Energy Group (WEC)

The 76research Income Builder Model Portfolio is intended for income-oriented investors and managed to generate an overall yield that is materially higher than broad equity indices. The portfolio primarily includes stocks with above average dividend yields from a cross section of industries. While investments are screened for their income and income growth characteristics, specific holdings are chosen based on valuation and general business quality, growth and risk considerations.

Disclaimer

FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE.