Income Builder

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Income Builder Model Portfolio

Monthly Portfolio Review: February 2024

Publication date: March 1, 2024

Current portfolio holdings

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Executive summary

Welcome to the Income Builder Model Portfolio!
With the publication of this first report, we are officially initiating the portfolio.
For each position, we provide a summary description of the business and an explanation of the investment thesis.
We then go into a general discussion of the investment approach that drives our Income Builder strategy.
At the end of this report (and all future Monthly Portfolio Reviews), we provide updated tables and charts with important information related to valuation, performance and company earnings expectations.

Business descriptions and investment theses

Blackstone (BX)

Description: Founded by Stephen Schwarzman in 1985, Blackstone provides investment and fund management services. The company operates through four main segments: Real Estate, Private Equity, Credit and Insurance and Hedge Funds Solutions. Blackstone is the largest alternative asset manager in the world with approximately $1 trillion in assets under management.

Thesis: Blackstone is the dominant player in the alternative asset management industry, a structurally growing segment of financial services. Blackstone benefits from scale as well as a reputation for excellence based on historical investment performance, successful asset gathering, and shareholder value creation, which enables the firm to attract and retain the best investment talent available. A highly cash generative business, Blackstone has a flexible dividend policy but has indicated its intention to pay out 85% of distributable earnings on a quarterly basis.

Crown Castle (CCI)

Description: Headquartered in Houston, Texas, Crown Castle is a Real Estate Investment Trust that provides access to wireless infrastructure assets. The company leases space on its portfolio of more than 40,000 towers to all of the major wireless service providers in the United States via long-term contracts. The company’s fiber segment provides customers with small cell network access and other fiber solutions.

Thesis: As one of the two largest owners and operators of mobile phone towers in the United States, CCI plays an indispensable role in the country’s communications infrastructure by supporting the continuously increasing demand for mobile data that is driven by improvements in handset processing power. CCI has delivered exceptional returns for several decades, despite significant underperformance in the past two years as a result of rising rates, customer churn challenges and activist pressure. Despite these risks, the long-term outlook and dividend growth story remain intact, with a compelling valuation.

Digital Realty Trust (DLR)

Description: Headquartered in Austin, Texas, Digital Realty Trust is a Real Estate Investment Trust (REIT) that provides data center, colocation and interconnection solutions and serves a wide range of industries. The company owns and operates more than 300 data centers in over 50 global metropolitan areas, with a majority of Fortune 500 companies as customers.

Thesis: As interest rates rose in 2023, Digital Realty shares suffered along with most REITs but have since pivoted with market differentiation of DLR as a long-term beneficiary of AI trends. With dividend growth that appears sustainable at a mid to high single digit rate for years to come, the shares have the potential to deliver double digit long-term returns and the possibility of more accelerated upside as investors gain conviction around the AI demand story.

Diamondback Energy (FANG)

Description: Founded in 2007 in Midland, Texas, Diamondback Energy is an independent oil and natural gas company that acquires, develops, explores and exploits unconventional, onshore oil and natural gas reserves. The Upstream segment focuses on the Permian Basin in West Texas. The Midstream Services segment operates in the Midland and Delaware Basins.

Thesis: Diamondback Energy is a low-cost, well-managed independent oil and gas exploration and production player that offers leverage to rising energy prices and capital discipline. Diamondback has committed to returning 75% of free cash flow to shareholders as dividends and/or share repurchases. In addition to a strong long-term track record of free cash flow generation and growth, the company has shown an aptitude in M&A, creating value through acquisitions as well as divestitures.

Texas Instruments (TXN)

Description: Founded in 1930, Texas Instruments designs, manufactures, tests and sells analog and embedded semiconductors with a catalog of more than 80,000 products. Analog semiconductors convert real-world signals like sound, temperature and pressure into digital data. Embedded processors handle application-specific tasks such as optimizing power, performance and cost.

Thesis: Texas Instruments is among the few global leaders in the analog chip space, an attractive niche that is both structurally growing due to technological innovation and difficult to penetrate due to the breadth of intellectual property required. The company also stands out historically from a culture, governance and capital allocation perspective. Texas Instruments is focused on reinforcing its competitive advantages and growing free cash flow per share, reflecting a disciplined management approach that has translated into significant outperformance over multiple decades.

VICI Properties (VICI)

Description: VICI Properties is a Real Estate Investment Trust (REIT) that owns, acquires and develops gaming, hospitality and entertainment properties. VICI’s portfolio of experiential real estate includes more than 90 assets in the United States and Canada that comprise approximately 125 million square feet, including several iconic properties on the Las Vegas Strip.

Thesis: VICI is among the largest “triple net lease” REITs (tenants bear almost all costs of premises) and specializes in “experiential” real estate, principally gaming. VICI’s portfolio includes ten trophy properties in Las Vegas, which continues to thrive as a tourism and business destination. With long-term leases that have inflation-protected escalators, VICI offers stable growth alongside a high-quality tenant profile that supports a high current yield. VICI is also able to engineer accretive growth through rights of first refusal with its tenant partners and other acquisitions.

Williams Companies (WMB)

Description: Based in Tulsa, Oklahoma, the Williams Companies is an energy infrastructure company that explores, produces, transports, sells and processes natural gas and petroleum products. Williams handles approximately 30% of U.S. natural gas production and owns and operates more than 30,000 miles of pipeline in 25 states.

Thesis: Williams’ portfolio of pipeline assets is an indispensable element of America’s energy infrastructure, including the Transco pipeline extending from south Texas to New York City which delivers approximately 15% of the nation’s natural gas. Williams has a cash flow profile that is protected on the downside by predominantly fee-based contracts unaffected by commodity prices, with visibility over the next 5-10 years on dozens of potential pipeline expansion opportunities to the transmission network. The business offers generous capital returns, prudent balance sheet management and a platform for accretive growth.

Carlyle Group (CG)

Description: Founded in 1987, Carlyle Group is a multi-product alternative asset manager that is active in corporate private equity, real assets, global credit and investment solutions. The private equity segments focuses on buyouts as well as growth capital investments. The real assets group specializes in real estate, infrastructure and natural resources. The firm is headquartered in Washington, D.C.

Thesis: As a leading player in the alternative asset management space with nearly $400 billion under management, Carlyle is well-positioned to get back on track with fund raising after a period of senior management turmoil. Carlyle maintains a strong reputation in the investment areas in which it specializes. Its current valuation reflects cash flows from embedded client commitments rather than future growth opportunities.

Kinder Morgan (KMI)

Description: Headquartered in Houston, Texas, Kinder Morgan, Inc. is one of the largest energy infrastructure companies in North America, with a focus on energy transportation and storage services. Kinder Morgan owns or operates over 80,000 miles of pipelines, 139 storage terminals and over 700 billion cubic feet of natural gas storage capacity. The company’s pipelines transport natural gas, refined products, crude oil, carbon dioxide and other products, while storage facilities handle gasoline, diesel and jet fuel, and other commodities.

Thesis: Transporting approximately 40% of U.S. natural gas production, which now drives nearly two-third of its cash flows, Kinder Morgan is well-positioned to take advantage of expected growth in U.S. natural gas. The majority of the company’s cash flows are contracted or hedged, providing long-term stability as management pursues a strategy of incremental pipeline expansion, M&A and adjacent strategies, including carbon transport. With significant equity ownership, management is focused on delivering consistent and growing dividends and disciplined value creation.

Mid-America Apartments (MAA)

Description: Headquartered in Germantown, TN, Mid-America Apartment Communities is a Real Estate Investment Trust (REIT) that operates, acquires and develops apartment communities, primarily throughout the southeast, southwest and mid-Atlantic regions of the United States. The company has ownership interests in over 100,000 apartment units across 16 states and the District of Columbia.

Thesis: Mid-America Apartments is a proven multi-family operator with an attractive footprint in sunbelt states, such as Texas, Florida, Georgia and North Carolina, that are likely to benefit from long-term economic and demographic trends. While REITs in general have derated in the wake of higher interest rates, apartment REIT fundamentals remain sound. Since the IPO in 1994, MAA has never suspended or reduced its dividend. Mid-America’s assets are in markets that demonstrate superior population growth, household formation and job creation relative to national averages.

Permian Resources (PR)

Description: Headquartered in Midland, Texas, Permian Resources is an independent oil and natural gas company. The company is now the largest pure-play Delaware Basin exploration and production company with more than 400,000 net acres and approximately 68,000 net royalty acres. Permian Resources is the second largest pure-play E&P operator in the broader Permian Basin.

Thesis: Permian Resources was formed in 2022 through the merger of two E&P peers operating in the Permian Basin, Centennial Development, which was already public, and Colgate Energy Partners III. The company has an attractive asset base with more than 10 years of estimated inventory runway and a financially aligned management team that is focused on free cash flow generation, shareholder returns and value creation. Permian Resources has opportunities as both a consolidator within its territory and as a potential consolidation candidate for a larger player.

Sempra (SRE)

Description: Headquartered in San Diego, California, Sempra is an energy-service holding company that operates regulated utilities in California and Texas and an unregulated energy infrastructure business. In California, Sempra operates through San Diego Gas and Electric Company and Southern California Gas Company. Its Texas operations are held through investments in Oncor Holdings and Sharyland Holdings.

Thesis: Sempra is a well-managed utility and energy infrastructure company that has delivered superior returns for shareholders since its 1998 initial public offering, when the company was formed with the merger of two California utilities. Sempra is differentiated by two key growth drivers, with attractive long-term outlooks. Oncor, the electricity transmission and distribution business based in Texas, should continue to benefit from robust economic growth and a favorable regulatory environment. As its various LNG projects come online over the next decade, this will provide a tailwind to earnings growth.

WEC Energy Group (WEC)

Description: Headquartered in Milwaukee, Wisconsin, WEC Energy Group is a utility holding company that serves nearly 5 million customers in Wisconsin, Illinois, Michigan and Minnesota. The largest subsidiary, We Energies, delivers electricity and natural gas to approximately 2.3 million customers in Wisconsin. The company also holds a majority interest in American Transmission Company, which operates a high-voltage electricity transmission system in the upper Midwest.

Thesis: WEC Energy has a long track record of operational performance and consistent growth. Operating in a favorable geography, in terms of both underlying economic demand and regulatory treatment, the company has visibility on rate base growth that can sustain mid-to-high single digit earnings and dividend growth, which sets the stage for a double-digit total return profile. The regional economy is being solidified by an influx of technology and industrial companies that also have significant energy requirements.

Investing for dividends

How do you live with yourself? – Well-known fund manager

The snarky comment above was allegedly made by well-known fund manager to another fund manager because he specializes in dividend income strategies.

Investing for dividends is actually controversial in the asset management world. This may be somewhat surprising given that dividends are foundational to our current understanding of why stocks have value.

In 1937, John Burr Williams, a Harvard Ph.D. candidate in Economics, submitted a doctoral dissertation on the topic of the “intrinsic value” of a business. The choice of this topic, interestingly, was prompted by the legendary economist and Harvard professor Joseph Schumpeter, who popularized the idea of “creative destruction” to describe how capitalism fuels innovation through disruption.

A year later, John Burr Williams published The Theory of Investment Value. Within this investment classic, Williams laid out the basic framework for understanding the true or intrinsic value of any security. Referring to Williams, Warren Buffett summarized his ideas in Berkshire Hathaway’s 1992 Annual Report.

The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset. - Warren Buffett

Warren Buffett

Williams pioneered discounted cash flow analysis and proposed the “dividend discount model,” which is still used today. The basic premise of the dividend discount model is relatively straightforward.

If we think about the value of a bond as being a function of all the future cash flows it will send back to the owner, a company is no different. A rational person would pay a price for a company (or a portion of a company, i.e. a share of stock) that appropriately reflects the future cash flows that are expected to be received.

Valuation in the dividend discount model is based on the idea of cash distributions that are literally going to be sent to shareholders. Discounted cash flow (DCF) analysis, the primary tool for business and asset valuation today, is a little more abstract.

Rather than dividends, DCF valuation relies on the concept of “free cash flow.” Free cash flow has a few variations, but in essence it is the cash generated by a business after taking into account expenses and other drags to the cash flow of a business (such as working capital increases and capital expenditures). Free cash flow represents the funds generated during a given period that are theoretically available to distribute as dividends without increasing the company’s debt load.

Conceptually, dividends and free cash flow are very similar. Dividends are the actual distributions a company makes, whereas free cash flow measures the potential of a business to support dividends without incurring additional debt.

So, given the central role of dividends in corporate valuation, why is dividend investing at all controversial? Critics of dividend funds and dividend strategies usually make the following points.

5 Common Criticisms of Dividend Investing

“What actually matters is total return (income received plus capital appreciation). It doesn’t matter what form it takes. In fact, receiving dividends is often bad because you may have to pay taxes on them whereas unrealized capital gains are untaxed.”

“Companies that give money back to you are doing so because they have no good way of investing it for you. You want to invest in businesses that can take the cash they generate and reinvest it for higher returns, not just return it to you. Dividends are in fact a sign of weakness, not strength.”

“The board obviously doesn’t think its shares are a good value. Otherwise, they would buy back stock with their extra cash instead of paying dividends.”

“You don’t need the companies to give you the cash. If you want to monetize some of your investment, you can sell down your position and ‘synthetically’ create income.”

“Investors who are chasing dividends are behaving irrationally and just responding psychologically to the positive feeling associated with receiving a dividend check.”

In our view, there are elements of truth in these criticisms but also flaws. We address these below as we explain why it may make sense for investors to prioritize stocks that offer steady and rising dividends as they assemble a long-term portfolio.

5 Reasons to Follow a Dividend Strategy

Actual income versus paper profits‍

As contributors to total return, income and capital appreciation are the same in theory, but we invest in reality. Successful investors tend to have long holding periods, if only to defer realizing capital gains. A stream of dividends as a component of total return alleviates some of the pressure on exit timing as a driver of actual cash on cash investment performance.

Many investors operate with some degree of personal leverage (even if indirectly, by having a home mortgage, for example). Many investors also rely (or want to be able to rely in the future) on investment returns as a source of personal income. In practice, consistent dividend streams represent a valuable source of cash flow that is either needed or potentially needed. By providing actual cash flow, dividend stocks give an investor leeway to have more capital allocated to higher growth equities as opposed to fixed income investments.

Dividends signal capital discipline

Rather than indicate an inability to deploy capital effectively, companies that operate with a clear and meaningful dividend policy demonstrate a disciplined attitude towards capital allocation. Profits are not horded but rather partially returned to shareholders, while only the most promising growth investments (capital projects or acquisitions) are authorized.

Share buybacks are often mistimed

Over the course of our careers, we have observed a tendency for boards of directors to authorize share buyback programs when the outlook seems sunny (and share prices are high) rather than when the company is experiencing turbulence (and share prices are depressed). There is abundant academic research that suggests corporate boards add no discernible value when repurchasing shares versus the alternative of returning cash to shareholders, who can decide for themselves whether to reinvest in the company or the shares of other companies.

Risks with “synthetic income”

Selling down securities to manufacture an income stream introduces a variety of execution risks and implementation burdens. Mechanically selling down positions exposes investors to the possibility of reducing exposure in periods of market stress when holdings are substantially undervalued.

Dividends give us staying power

It may be theoretically correct to equate paper profits to real cash distributions, since one can always sell a liquid security, but receiving a steady stream of cash flow potentially reinforces our psychological commitment to an investment, especially in periods of stress. A supposedly irrational psychological attachment to dividends might offset other irrational temptations, like abandoning investments after a period of disappointing performance. Dividends not only support our actual financial cash flow needs but also sustain a long-term investment mindset and can help avoid short-term trading temptations.

While investors have many valid reasons to emphasize dividends in their investment program, dividend investing, like all forms of investing, needs to be done very carefully. We have significant experience navigating the universe of income investments and have learned a number of things (sometimes the hard way) that are specifically relevant to dividend-paying stocks. When building a portfolio of dividend stocks, investors should be highly aware of the following risks.

5 Pitfalls of Dividend Investing

Conflating dividends with profits

Dividend yield is not really a valuation metric and doesn’t directly signal whether or not a stock is “cheap.” A dividend is for the most part a voluntary cash distribution, determined by a board of directors. The same exact business could have wildly different dividends, or no dividend at all, based on the decisions of the board.

Concepts like free cash flow or cash earnings are more indicative of business value. A company with a high dividend yield may simply be over-distributing cash relative to what it can sustainably support. To make an assessment of value, one has to take a close look at the specific cash flow dynamics of the company.

Over-reaching for yield

Everyone wants high dividends, but the best dividend opportunities are often not the ones offering the highest yields, which may be unsustainable or lack growth potential. Dividend investing should be done in the context of finding good businesses with attractive valuations that also have attractive dividend potential.

Leverage

One way to goose a dividend is by amplifying the cash flow generation of a business with low interest rate debt (which is naturally more common in low interest rate environments). But the more debt a company has, the riskier the equity becomes. REITs, in particular mortgage REITs, are sometimes highly levered yield plays; proceed with extreme caution.

Dividend cuts

Dividend-hungry investors are often lured into seemingly high yields only to watch the dividend get slashed or even eliminated in short order. A dramatic deterioration in the fundamentals of a business could lead to a false perception that a stock trades at a rich dividend yield. In these scenarios, investors look at the most recently declared dividend in relation to a reduced share price. But when a business is threatened financially, boards have a tendency to cut dividends sharply, especially when they are out of whack with peers.

Missing out on growth

Dividend stocks are often clustered in a few industry sectors. Low multiple value stocks are also typically overrepresented within the dividend universe, as opposed to higher multiple growth stocks. Investors should be mindful of diversification when constructing a dividend-oriented portfolio but also look for exposure to good stocks that may lack dividend attributes. Passive approaches that emphasize growth or low dividend sectors (such as technology) are a good complement to a dividend portfolio.

Prioritizing stocks with an attractive dividend profile is a rational stance for many investors. Like any focused investment strategy, investing with a preference for dividends need to be executed carefully and thoughtfully.

With many of years of experience in income-oriented investing, we believe the key to successful dividend investing is to develop a solid understanding of the underlying business fundamentals. Dividend investors should first and foremost consider buying a stock because they believe the business is strong and the valuation is attractive — and not because the yield is high.

The 76research Income Builder Model Portfolio is intended for income-oriented investors and is 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 and may also include ETFs that offer exposure to fixed income instruments. 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.