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 | Income Builder Model Portfolio |
| Monthly Portfolio Review: October 2024Publication date: November 4, 2024 |
| | | Current portfolio holdings |
|  | | FOR SUBSCRIBER USE ONLY. DO NOT FORWARD OR SHARE. |
| | | The Income Builder portfolio generated a total return of 3.4% in October, significantly ahead of the S&P 500 Index, which declined by 0.9%. Five stocks within the portfolio produced a double digit return, with Carlyle Group (CG), Williams (WMB) and Kinder Morgan (KMI) leading the way. The portfolio was negatively impacted by the sharp upward move in long-term interest rates, which affected REITs like Crown Castle (CCI) and VICI Properties (VICI). Data center REIT Digital Realty Trust (DLR) performed quite well, despite the move in rates, after a highly encouraging earnings report. We include our recent discussion of DLR below. We share our thoughts as Election Day approaches, but our focus remains on identifying income-generative stocks that will create value over the long-term regardless of political outcomes.
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| | | In October, the Income Builder portfolio delivered a total return of 3.4% and significantly outperformed the S&P 500 Index, which return -0.9%. For the three months ending October 31, 2024, the Income Builder generated a total return of 7.2%, versus the S&P 500 Index at 3.7%.
The top performing stocks in the portfolio were Carlyle Group (CG), which returned 16%; Williams (WMB), which returned 15%; and Kinder Morgan (KMI), which returned 12%. The worst performing stocks in October were Crown Castle (CCI), which returned -9%, and VICI Properties (VICI), which returned -5%. |
| The month of October was, broadly speaking, a flat to down month for stocks. The S&P 500 did, however, reach an all-time high toward the middle of the month, only to give up most of this progress in the final days.
Stocks have seen strong momentum since early August, when weak jobs numbers, along with downward revisions of prior jobs reports, generated concern that the economy was finally choking from the pressure of high interest rates.
Since then, the Fed has pivoted. This began with Powell’s announcement in late August at Jackson Hole that the “time has come” to cut interest rates. In mid-September, the Fed followed through with its 50 basis point cut.
With interest rates coming down and corporate earnings generally good, especially in the index-dominating tech sector, stocks have enjoyed a decent tailwind. Momentum in stocks was further supported in October as investors began to price in a higher probability of a Trump victory in November.
In early October, for the first time in months, Trump pulled materially ahead of Harris in the widely followed Polymarket prediction site. Notwithstanding some concerns around the potential impact of Trump’s tariffs, investors generally view Trump’s tax proposals and growth-oriented policy agenda as preferable for stock prices. |
|  | It is worth noting that the weakness in stocks that we witnessed at the very end of October, with the S&P 500 falling more than 2% in the final two trading days of the month, coincided with a decline in the implied odds of victory for Trump in Polymarket.
While the election weighed heavily on investors’ minds in October, the other important—and related—variable was long-term interest rates. The yield on 10-year Treasuries rose from 3.8% at the end of September to 4.3% at the end of October, a significant move.
Our interpretation is that bond investors are signaling a mismatch between the dovish monetary policy shift, initiated by the Fed in August and September, and an economic growth outlook that is supported by relatively robust corporate earnings along with the prospect of a Trump victory.
Put differently, the Fed may now be on a rate-cutting path just as the private sector is potentially about to get an injection of animal spirits from a pro-growth administration.
Gold reached all-time highs towards the end of October, which supports the idea that monetary policy is overly accommodative. Gold closed just shy of $2,800 per ounce on October 30. Gold is up 33% year-to-date as of October 31. |
|  | Gold is influenced by a number of factors, including geopolitical tensions, especially in the Middle East, and central bank buying patterns, as emerging market countries persistently add to their reserves. This makes interpreting gold price fluctuations difficult.
The inflationary signal provided by the gold price, however, is reinforced by the rise in bond yields. Bond investors are now demanding more compensation in the form of higher long-term interest rates to offset inflation risk.
Private sector job creation remains weak, as indicated by the most recent Bureau of Labor Statistics report for October. As a result, the Fed will likely be under pressure to cut rates to stimulate employment growth even though the economy overall may not really need it (especially if Trump wins). Both gold and Treasury investors seem to have taken note of this inflationary dynamic.
Rising long-term rates weighed on stocks in October. This was visible in the relative performance of the various industry sectors. |
|  | The financial sector, which is dominated by banks, generally does well in rising rate environments because financial institutions are able to earn higher spreads off customer deposits. Within the S&P 500, Financials led the way in October, with a 3% total return.
The worst performing sectors in the S&P 500 in October were Health Care, down 5%; Consumer Staples, down 3%; and Real Estate, down 3%. Stocks within these sectors tend to be more defensive and characterized by stable long-term cash flows. Like bonds, their valuations are adversely affected by upward movements in long-term rates.
Election Day is almost here
As we write, the election is only two full trading days away. We may know by Wednesday, November 6 who will be the next President.
Depending on how close the results are in swing states, we also may not know the winner, which presents a wide range of potentially risky scenarios. An argument could be made that recent strength in gold somewhat reflects investor positioning for the tail risk of civil unrest in the U.S. that could be associated with an inconclusive or questionable outcome. Such a scenario could be very destabilizing for markets.
Given that the stock market has responded favorably in response to improved perceptions of a Trump victory, it stands to reason that the market would continue to react favorably if he were to emerge the winner.
Conversely, a Harris victory would likely be interpreted as signaling a slower growth trajectory and more difficult operating environment for many companies.
Because a Harris victory would be seen as worse from a growth perspective, long-term bonds may rally if she wins as interest rates come down. The defensive sectors that underperformed in October as rates rose may outperform in this scenario.
Who will win?
Despite the recent reversal, Trump generally remains favored in prediction markets and polls. Early voting results in swing states seem to indicate a better relative showing of Republicans than Democrats versus 2020.
One important caveat is that Republicans have been more focused this time around on generating early votes. To some extent, the better relative performance could just represent a “pull forward” of votes that otherwise would have been cast on Election Day.
As we analyze the map along with state level prediction market indicators, the so-called “blue wall” states are clearly pivotal. These also seem to be the closest swing state races, with Trump likely to prevail in North Carolina, Arizona, Georgia and even Nevada.
Assuming Trump wins in the four sunbelt states mentioned above, he just needs to win one of the three blue wall states to clear 270 electoral college votes. (Trump can actually afford to lose Nevada if he wins in Pennsylvania, Michigan or Wisconsin, which renders Nevada irrelevant in most scenarios.)
Even if we concede Michigan to Harris, if we assume Harris and Trump each have an approximately 50% chance of victory in Pennsylvania and Wisconsin, the odds of Harris winning both states are only 25%. This (perhaps oversimplified) math implies a 75% chance of victory for Trump.
Of course, anything is possible, including upset victories in any of the states mentioned. Perceptions around the candidates’ chances in any given state are largely driven by polling, which is of uncertain value. That being said, we tend to concur with prediction markets that the overall odds favor a Trump win.
As we recently communicated to subscribers, long-term investors should not get too distracted by the ebb and flow of the political cycle. Our Model Portfolio selections are not predicated on any particular political outcome. The focus should be on staying invested in strong businesses that will succeed—independent of the political backdrop. |
| | | In October, performance in the Income Builder portfolio was led by Carlyle Group (CG), which delivered a total return of 16%; Williams (WMB), which delivered a total return of 15%; and Kinder Morgan (KMI), which delivered a total return of 12%. The largest performance detractors in October were Crown Castle (CCI), which returned -9%, and VICI Properties (VICI), which returned -4%.
After experiencing notable weakness in August and early September, CG has recovered and reached its highest trading levels since 2022. Conditions in the private equity industry are favorable, as evidenced by CG peer Blackstone (BX), which reported impressive earnings results in October.
Shares of BX themselves returned 10% in October, as analysts upgraded their numbers after the results. Fundraising was notably strong, a trend that likely applies across the industry. We continue to like BX and CG as leading platforms within alternative asset management.
WMB shares advanced partly in response to firming natural gas prices. The strength also reflects growing conviction in the critical importance of WMB’s natural gas pipeline network to the national electric grid. Investors continue to come to terms with growing demand for electrical power generation, which is being driven to a large degree by the AI data center buildout.
A Trump victory would also be helpful for WMB given Trump’s intention to support the development of Liquefied Natural Gas (LNG) export facilities.
KMI, another energy infrastructure player, is also predominantly exposed to natural gas pipelines. KMI reported strong earnings results in mid-October, which involved a more challenged outlook for oil-related products but positive indications for natural gas transport. KMI shares rose following these results, with WMB benefiting as well from the read across.
While the Income Builder portfolio as a whole performed well this month, rising interest rates were a headwind. REITs, which tend to underperform in rising rate environments because they compete for capital with bonds, were generally challenged. The weakness in CCI and VICI reflected the adverse interest rate move.
All things being equal, data center REIT Digital Realty Trust (DLR) would have probably traded down on higher rates but for its extremely encouraging earnings results and outlook. Despite rising rates, DLR shares delivered a 10% total return for the month.
On October 29, we provided an update on DLR in the 76report. We include that discussion below as well. |
| | |  | | |  | | |  | | Digital Realty (DLR) see record-setting AI demand |
| Investing in well-managed companies with strong market positions and nice growth prospects is a great starting point for long-term investors in stocks. It may sound simple, but buying into solid, high quality businesses tends to work out pretty well over time.
The only drawback to putting your money into “good” companies is that, at any given time, you are probably not the only investor out there who recognizes a good company’s strengths. The risk is that a stock’s valuation already reflects these positive attributes. In other words, it’s priced in.
When investors become overly enthusiastic about any particular business, the shares can become overvalued. The result may ultimately be sub-par (or negative) returns even if the company delivers good (but not great) financial results.
The best investment scenario arises when a good company is underappreciated or misunderstood by other investors—like a valuable antique foolishly being sold for $5 at a garage sale. At 76research, we are continuously on the hunt for good companies that, for one reason or another, are trading at discounted prices.
When you find a high quality, well-positioned business that the market is pricing as if it were a challenged one, the return potential can be very high.
Even when a good company is properly priced, you can still do quite well as the company delivers on its value creation strategy. But when a good company is underpriced, you can benefit from additional share price appreciation as the market comes to recognize its mistake.
Digital Realty Trust (DLR) is a prime example of a good company that was also severely underpriced when we first presented it to subscribers.
While the share price has risen significantly since then and outperformed, DLR remains a top holding within our Income Builder Model Portfolio. We still view DLR as a compelling long-term opportunity as the company capitalizes on a global AI data center buildout that remains in early stages.
On the heels of a truly impressive third quarter earnings report, DLR is displaying excellent momentum across all areas of its business. This recent success solidifies its financial position, de-risks the growth outlook, and bolsters the overall investment case.
We initially profiled DLR, our very first stock pick, back in June 2023, in the inaugural version of the newsletter sent to pilot subscribers. This original memo has been made available on our website since our launch.
We chose DLR as our first focus investment because we saw a disconnect between the market perception of the company and profound shifts that were clearly underway in the data center space.
What the market got wrong
Shares of DLR were depressed at the time for two major reasons.
First, DLR is a Real Estate Investment Trust (REIT), and the REIT sector was generally weak because of the high interest rate environment.
Second, certain short-sellers, most notably Jim Chanos, were promoting a (highly flawed) bearish thesis on data center REITs like DLR. This short thesis centered around the idea that they would be rendered obsolete as enterprises shifted their data storage to the cloud via hyperscalers like Microsoft Azure and Amazon Web Services.
What investors were failing to appreciate at the time was a major inflection point in demand for data center capacity. Interestingly, this inflection was not a well-kept secret.
NVIDIA (NVDA) shares were surging on the back of extraordinarily strong financial performance. NVIDIA’s CEO Jensen Huang was effectively shouting this from the hilltop, which we noted in our initial report. |
| | In the future, it's fairly clear now with generative AI becoming the primary workload of most of the world's data centers generating information…. We're going through that moment right now as we speak while the world's data center cap ex budget is limited, but at the same time, we're seeing incredible orders to retool the world's data centers. So I think you're seeing the beginning of, call it a 10-year transition, to basically recycle or reclaim the world's data centers and build it out as accelerated computing. - Jensen Huang (5/24/2023) |
| | Just over a year later, we are pleased to note that our belief that DLR would benefit from the AI transition was entirely justified. On October 24, 2024, DLR reported third quarter earnings. While the financial results were generally at or above expectations, what really caught the market’s attention was the jump in bookings, which refer to new leases that were signed during the quarter. |
|  | Source: Digital Realty Trust |
| As tech giants plead with government officials to invest in our electrical infrastructure to meet their AI power needs, we are witnessing a wall of demand for data center capacity. Being one of the largest owners and developers of data center capacity in the world, DLR is a natural beneficiary.
DLR shares have advanced approximately 11% since the third quarter earnings release, as analysts have revised upward their long-term expectations. Since we initiated DLR as a top holding within the Income Builder Model Portfolio on March 1, 2024, shares of DLR have now delivered a total return of 24% versus 14% for the S&P 500.
Since we first published our memo on DLR on June 22, 2023, DLR shares have returned 81% versus 33% for the S&P 500. |
|  | On the conference call following the earnings release, DLR management attributed approximately 50% of the new business to AI-related demand, especially among large customers. These customers include major hyperscalers, which in some cases operate their own data center facilities and in other cases lease space from independent data center operators like DLR.
It is important to note that customer demand was robust across the board. Smaller data center bookings also saw record growth, suggesting AI-related demand is having a positive knock-on effect on traditional computing requirements.
The favorable supply/demand imbalance is benefiting DLR in other ways as well.
Pricing is strong. As leases with existing tenants expire, DLR is able to charge more for renewals. Guidance for the year was lifted from a midpoint of 6% on cash rental renewal growth to 9%.
New leases are also being signed with higher automatic annual escalators, which are now around 4%. This enables DLR to lock in a high level of rental growth on data center leases that are typically five to ten years long.
While DLR’s existing footprint of some 300 data centers is becoming more profitable as customers scramble for space, it is important to remember DLR also grows through development.
With substantial land holdings in key locations, proprietary opportunities to expand existing facilities and a strong development team, DLR is a leading developer of new data centers. DLR also has strategic partnerships with some of the most important players in AI, including NVDA and Oracle (ORCL). These relationships are helping to fuel its growth.
On October 23, NVDA founder Jensen Huang joined the King of Denmark to launch the country’s first AI supercomputer, Gefion (named after the Norse Goddess of agriculture). The supercomputer is hosted at a DLR data center in Copenhagen. |
|  | Jensen with the King of Denmark |
| Surging demand is improving the economics of new data center development for DLR. In the most recent earnings call, management noted a 50% sequential quarterly increase in its development pipeline.
DLR now anticipates an impressive 12.0% yield on new development (versus a reported 10.4% in the prior quarter). This means customers are paying DLR more to develop new data center capacity for them, which improves DLR’s return on investment.
Is DLR still worth owning?
DLR shares have returned approximately 39% year to date, versus 22% for the S&P 500 Index. Whenever there is sharp price appreciation, it is essential to question if the higher valuation is justified and if it is time to sell.
The “easy money” in DLR may be gone. A year ago, DLR was arguably perceived by the market as a potential victim of technological change. Now it is clearly a beneficiary. Much of the performance over the past 12 to 15 months represents a reversal of sentiment on that subject.
The long-term growth outlook for DLR has improved substantially, however. The outlook has also been de-risked by a flow of new business on favorable terms. Looking across financial metrics, the current valuation strikes us as justified.
It was just over a year ago that the stock market was essentially giving DLR almost no credit for the long-term AI opportunity. Now that AI-related spending is manifesting itself in the financial results, we have seen some nice movement in the share price.
We are still, however, in very early stages of the AI data center buildout. DLR has a premier global data center asset base and development platform. There is ample room for growth in the years, if not decades, ahead as data centers come to play an increasingly important role in the future of computing, as Jensen Huang has described.
Investment lessons
Whether an investment works or fails, it is good practice to reflect on the experience and the decision-making process. We can identify a few important takeaways from the recent success of DLR.
(1) Pay attention to other companies.
Last year, NVDA management was providing extremely clear signals regarding future AI-driven data center demand. It is possible that many REIT investors were too siloed and failed to pay sufficient attention to broader technology trends.
(2) Don’t be intimidated by short-sellers and hedge funds.
Many investors were probably spooked by the bearish calls of prominent short-sellers like Jim Chanos, who articulated negative views on the data center sector. Notwithstanding their billions under management and Hamptons mansions, short-sellers and hedge funds frequently misinterpret industry trends. In our experience, they are at their best when they are identifying financial frauds; pay close attention when those are flagged.
(3) Get the big picture right.
Investors, especially professional investors, often get bogged down in details, but the most important thing is to be directionally correct on the key points. To justify an investment in DLR a year or so ago, one really only had to recognize that we were on the cusp of a meaningful uptick in data center demand. Sometimes investing can be easy. |
| | | |  |  | | |  |  | | Digital Realty Trust (DLR) |
|  |  | | Diamondback Energy (FANG) |
|  |  | | |  |  | | |  |  | | |  |  | | |  |  | | |  |  | | Mid-America Apartment (MAA) |
|  |  | | |  |  | | |  |  | | |  |  | | 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. |
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