Written by Sam Kovacs.
There’s less than two weeks until the Fed’s next interest rate decision.
While the consensus remains that the Fed will keep their target rates stable at 5.25%-5.5%, there is some uneasiness in the market with an 8% (non-zero) probability that rates will be increased.
Futures markets this morning signaled an uneasy market, as conflicting data continues to come our way, which has all market participants second-guessing themselves.
Last week’s employment figures initially seemed to alleviate tension, pointing to a more relaxed labor market. However, the narrative flipped with Wednesday’s ISM report, which had quite the opposite effect-prompting the market to recalibrate its expectations around a potentially prolonged period of elevated interest rates.
Yet the markets’ performance continues to tell another story.
Consider below the sector performance year to date.
And consider the relative performance of each sector next to Fidelity’s archetype of sector performance throughout the business cycle.
With the exception of real estate and financials (until now), and energy being an outlier, all the sectors are behaving as if we were in an early rebound.
Take 2022, and the archetype looked a lot like a recessionary environment.
Remember that the market is usually a leading economic factor. The market is signaling to us that we might be in an early rebound phase of the stock market.
But this feels so wrong: rates are high, we’re waiting for the economy to collapse, inflation is persistent.
How does one invest in a way where they act on what the market is telling them, all while protecting their downside if things don’t turn out as planned?
It’s simple, although not easy.
First, you pick sectors which you believe should outperform if what the market is telling us about the business cycle is accurate.
Right now it is telling us that we are in an early rebound, which can only coincide with the idea that the Fed is successfully pulling off a soft landing.
So let’s give this outcome some merit.
If the soft landing were to be pulled off, what sectors would we be looking at right now?
The answer is:
- Real Estate.
- Consumer Discretionary.
The next step in determining good stock picks would be to pick some of the best stocks in each of these sectors, what Robert & I would refer to as “All Weather” stocks.
We cover about 120 stocks at the Dividend Freedom Tribe, of which the majority are “All Weather” picks.
All Weather dividend stocks might see their price go up and down, but their businesses are insulated by large moats, which provides them with the ability to pay growing dividends for the foreseeable future.
And to further protect your downside, you’d want to pick the best of breed stocks from each of these sectors which also happen to be undervalued.
Does this reduce the number of picks drastically?
Yes it does.
At the same time, it gives a short list of high quality names to pick from which you can buy and sleep well at night.
Below are 2 such picks:
SWAN Real Estate Pick: Realty Income
The latest earnings release once again highlights how Realty Income Corporation’s (O) superior business model leads to it being a superior income stock.
The real estate investment trust, or REIT, slightly adjusted up its guidance for funds from operation, or FFO, and reported positive results, in line with analyst expectations.
What makes O the best triple net REIT?
It all starts with focusing on high quality tenants, and mission-critical properties.
The benefit of this is further compounded by high quality diversification, whereby no client represents more than 4% of rent, no industry represents more than 10% of rent, and no state represents more than 10% of the portfolio’s rent.
This has historically led to consistent cashflows.
The pandemic was the perfect stress test of this, where O still collected 97.9% of rent. This year it is back up to over 99%.
The consequence, is that the high occupancy of high quality tenants, leads to superior dividend growth, credit rating, and ultimately higher total returns.
The one negative from the earnings call, was that there continued to be some short-term AFFO headwinds due to increasing short-term rates.
This is a very short-term issue, which actually provides O with long-term opportunities.
As highlighted in the slide below, it usually takes 12 months for cap rates to adjust to changing rates.
This lag can pressure AFFO when rates are on the rise. When rates ultimately decline again, the lag will cause higher short-term spreads, suggesting that when you take a long-term approach, it is something which will be normalized and spread out to a net 0 effect.
But recessionary environments also provide O with acquisition opportunities at very attractive cap rates relative to interest rates.
As a superior business with a great credit rating, O can capitalize on this, and has historically done so with discipline.
The company prides itself in being very shareholder-friendly, and the 635 monthly dividends which the company has paid without interruption should convince investors of this.
As I said, I believe O can continue to find sufficient opportunities to continue growing the dividend at 3% per annum, which given its 5.5% yield, gives it very good income potential.
O currently trades at $55 and yields nearly a whole 1% more than its 10-year median yield of 4.6%.
If you were to invest $10K in O at the current price, and reinvest dividends at the current yield, while assuming a 3% increase in dividends each year, then 10 years from now, you’ll expect over $1,400 in annual income, or 14% of your original investment.
This is an extremely attractive income profile, from an extremely stable company.
I believe that O should be a staple of most dividend portfolios, and is an All Weather position which should only be sold when overvalued.
SWAN Consumer Discretionary Pick: Best Buy
Best Buy Co., Inc. (BBY) might raise a few eyebrows when mentioned as an All Weather pick, given that the stock has seen two years of constant revenue declines.
Yet this is a superficial outlook in my opinion.
In August 2022, when I wrote about BBY, I warned that while:
Relative to its dividend, it is not far from as cheap as it has ever been.
If it were to hit its valuation lows of 2012, it would go all the way down to $60.
At the time the stock was trading at $75. Today, the stock is back at $75, which suggests that in a year, it has been flat, with only the dividend driving performance.
Following a 4.5% increase in dividend this year, BBY now yields 4.9%.
There was some positivity in BBY’s latest earnings, as management have started to map out an overall inflection point in demand for their products.
But first, it is important to understand: Why have BBY’s revenues declined for the past 2 years?
According to management:
Our industry continues to experience lower consumer demand due to the pandemic pull-forward of tech purchases and the shift back into services spend outside the home like travel and entertainment. In addition, of course, persistent inflation has impacted spending decisions for a substantial part of the population.
So on one side of the equation, we have inflation weighing down on consumer decisions. Fair enough, but every retailer faces this problem.
The other, bigger, more significant issue, is the idea that demand was pulled forward during the pandemic, that in 2021 and 2022, consumers made purchases they otherwise would have made later. They bought a new TV, a new phone, a new laptop, a new fridge, earlier than planned.
Given that people change phones every 2-3 years and laptops every 3 to 5 years, it makes sense that purchases of new tech which peaked in 2021, are going to start to see their replacements take place in late 2023 and 2024.
When you know that laptops and phones are 40-45% of BBY’s revenue, their product cycle is an important contributor.
Management are seeing strong stabilization factors across all of their verticals.
Our full-year guidance implies a wide range for Q4 comparable sales of down 3% to slightly positive. There are a number of factors supporting our belief that our Q4 year-over-year comparable sales will improve and could potentially turn positive. We expect growth in-home theater as we expect to be better-positioned with inventory across all price points and budget spends last year. We are starting to see signs of stabilization in our home theater business.
For example, TV sales trends improved in Q2 and units returned to growth. We expect performance in our computing category to improve as we build on our position of strength in the premium assortment will not exactly linear. We are also starting to see signs of stabilization in this category as Q2 laptop sales trends improved materially and units were flat to last year. We expect to see continued growth in the gaming category as inventory is more readily available and there is a promising slate of new software titles expected to be released in the back half of the year.
So the trough is pretty much in for Best Buy, as Q1 next year will likely lap the low bar set this current year.
The dividend takes up just 45% of FCF, and management bought back another 3% of shares in the past year.
This means that even after seeing sales pull back significantly, BBY’s dividend is still very well covered, and thus very safe. Like Brad Thomas likes to say: the safest dividend is the one that’s just been raised.
Management has used this downturn to optimize its services, product availability, improve its workforce’s training.
Best Buy can compete with Amazon thanks to its pre-sale and post-sale services. It continues to see very good satisfaction metrics, and to drive new members to its subscription programs. Its hybrid model of online/offline is a unique value proposition which has meant that they’ve remained competitive.
The market isn’t giving them any credit.
The current price doesn’t make sense, BBY should be a $100 stock.
I believe this will likely come to pass in 2024.
The 4.9% yield remains a bargain. Last year I said it would take patience for a turnaround in sentiment. This is still the case, but the turning point is getting closer.
When in doubt, it makes sense to find investment opportunities which will give you a great outcome no matter what happens:
- If the market unfolds as expected: you’ll get large capital gains from a reversion to mean valuations.
- If the market goes in another direction: you’ll enjoy a growing dividend which should supply you with plenty of income, until the market turns and gives you a capital gain.
Buying high quality stocks is the most “foolproof” approach to investing. Provided you have the right timeline, and don’t buy “quality traps” then you stand a great chance of doing well. Buy them at basement prices, and it is not a question of “if” these stocks will go up, only of “when.”