The Investment Committee has been discussing the outlook for the energy sector and has lowered our view on its prospects. We have concerns with the supply and demand dynamics for both oil as a commodity and oil company stocks. The producers of oil are desperate for revenue, be they petrostates such as Saudi Arabia, Russia, or Venezuela, whose government budgets assume oil prices that now seem unrealistic, or Permian Basin frackers needing to service high-cost debt. All are highly incentivized to continue pumping oil at what seem to be uneconomic prices.

A price war and fight for market share between Saudi Arabia and Russia, where each has ramped up production, is aggravating the problem of excess supply. On the demand side, growth has come from emerging market countries (primarily China and India) as Western nations seek to wean themselves from fossil fuels. This picture of slowing growth has been impacted by the global economic downturn brought on by the coronavirus (COVID-19) pandemic. This surge in supply and sharp drop in demand have combined to cause a plunge in the price of oil and growing fears of running out of storage. A recent deal reached between the price-war antagonists will not change the unfavorable long-term supply/demand dynamic for oil.

Demand for energy stocks is also diminishing. The rise of Environmental, Social & Governance (ESG) investing has led many large institutional investors such as BlackRock to announce plans to shun the sector, while active managers flee a sector with such poor fundamental prospects and years of terrible investment performance. What was once the largest sector of the S&P 500 Index has shrunk to less than 3% of the benchmark. The Investment Committee decided to move to an underweight stance on the sector.

Recently, we sold our position in Total (TOT), the French petrochemical giant, in the Defensive Portfolio. In the Core Portfolio, we sold our position in Chevron (CVX), leaving for now a position in Valero (VLO), a leading refiner/marketer that should eventually benefit from low oil prices. Based on future developments, we may return to an overweight stance in energy or exit the sector entirely given its rather small allocation at this point.

Core Portfolio

In late March we added a position in Akamai Technologies (AKAM), a leader in the content delivery network space—think of it as the plumbing behind Netflix—that has added a rapidly growing offering in cybersecurity. This past weekend, Barron’s Magazine named AKAM as the top idea to take advantage of the work-from-home movement, given the explosion in use of videoconferencing services such as Zoom, Slack, and Microsoft Teams.

April 3 was the culmination of the long-awaited and complicated merger/demerger involving Core Portfolio holding conglomerate United Technologies (UTX). UTX simultaneously merged with defense contractor Raytheon while spinning out its Carrier and Otis divisions. As a result, the Core Portfolio now has positions in Raytheon Technologies (RTX), a giant in aerospace and defense; Carrier Global (CARR), a leader in HVAC; and Otis Worldwide (OTIS), a dominant player in elevators. For now, we are planning on hanging on to all three positions as we evaluate the business prospects for each independently while seeing how the market treats the now pure-play stocks. Greg Hayes, CEO of RTX, noted that while the challenges in commercial aerospace may linger for a year or two, the defense business has a record backlog of $70 billion with military customers, highlighting the foresight of this merger.

We sold Dow Chemical (DOW) and replaced it with Nucor (NUE). DOW has struggled since spinning out from Dow Dupont last year, often trading in tandem with the price of oil (a major input to its commodity chemicals business). NUE is the largest mini-mill steelmaker in the U.S., employing scrap metal and electric arc furnaces rather than smelting steel from iron ore in huge blast furnaces. NUE’s stock has been battered by the trade war (steel tariffs meant to help NUE backfired) and recent worries about recession. It is a high-quality company with a strong balance sheet and a cost advantage over its competitors that should help it prosper when the economy rebounds. In the meantime, the stock yields 4.5% with a long history of annual dividend increases.

We sold Citigroup (C) and replaced it with Cisco Systems (CSCO), a leader in networking hardware and software. We have been seeking to both reduce exposure to financials and increase exposure to high-quality information technology stocks. The current crisis, with many forced to work from home utilizing videoconferencing, along with the rapid growth in cloud computing will lead telecom service providers to invest more heavily in networking infrastructure in order to handle demand. CSCO exhibits steady growth in earnings per share, has a P/E ratio around 14, and has a steadily rising dividend currently yielding 3.5%.

We sold PPL (PPL) and replaced it with Dominion Energy (D). D is a fully integrated gas and electric holding company; it is the parent company of Virginia Power and South Carolina’s SCANA. D has very steady earnings growth, a dividend yield of 5.3%, and a history of annual dividend increases.

Defensive Portfolio

In late March we added a position in Sysco (SYY). SYY is the leading food distribution company in the country, with double the market share of the next biggest player, and likely to grow larger through acquisition as smaller players suffer during the current economic downturn.

We sold Darden Restaurants (DRI) and replaced it with Apple (AAPL). As the owner of Olive Garden restaurants, DRI faces an extended period of uncertainty (as we don’t know when lockdowns will end or how quickly casual dining customers will feel comfortable returning). The Defensive Portfolio has been significantly underweight on technology stocks, and AAPL displays many defensive characteristics, including a dominant market share of smartphone profits, a healthy dividend that steadily increases, a wide economic moat, and a fortress-like balance sheet with more than $200 billion in cash and equivalents.

We sold Lincoln Financial (LNC) and replaced it with Prudential Financial (PRU). Vanishing interest rates have crushed stocks in the financial sector, but PRU is not going away. Recall that it was designated as a systemically important financial institution (SIFI) during the financial crisis a decade ago. But investors fleeing the sector have driven PRU’s stock to a P/E ratio under 5 while sporting a dividend yield of more than 7%. We are being paid well to wait until the coast clears.

We sold PPL (PPL) and replaced it with NextEra Energy (NEE). NEE is the parent company of Florida Power & Light and a leader in renewable energy (with a huge investment in solar power).

Last week we parted ways with both Clorox (CLX) and Royal Dutch Shell (RDS.A). CLX goes in the win column, having performed very well recently thanks to the pandemic—but to such a degree that the stock was getting very expensive at 30 times earnings. We began to fear that all the good news might already be in the stock price, so we decided to take our chips off the table. Unfortunately, we cannot put Royal Dutch Shell in the win column. As I discussed earlier, the Investment Committee lowered its outlook on the energy sector, and we felt the potential risks in Royal Dutch Shell outweighed the possible future returns; thus, we felt that it didn’t belong in the Defensive Portfolio. With the sale of Royal Dutch Shell, the Defensive Portfolio now has no exposure to the energy sector.

We have been seeking to boost our exposure to the consumer staples sector, so we added two leading companies: Coca-Cola (KO) and Conagra (CAG). KO had pulled back recently, offering us a more compelling entry point for this mega-cap stalwart with a current yield of 3.4%. Lesser-known CAG is a major food company with such brands as Healthy Choice, Banquet, Hunt’s, and Peter Pan. The stock is trading at a modest P/E ratio of only 14 and currently yields 2.6%. Both names are the kind of steady performer that we like to see in the Defensive Portfolio.

This week we sold our position in Bank of Montreal (BMO) and replaced it with Dentsply Sirona (XRAY). We have been looking to lower our exposure to financials and increase our exposure to healthcare. The Canadian economy is highly dependent upon oil, whose price is plunging to new lows today. It is highly unlikely that high-cost Canadian tar sands oil will be economically viable any time soon. XRAY is a designer, developer, manufacturer, and marketer of a broad range of products for the dental market. The stock price has pulled back during the pandemic, probably due to fears about a drop in elective dental procedures during the lockdown. As life returns to something approaching normal, demand for this company’s products should recover, and with it the stock price.

We will continue to search for opportunities to upgrade the quality of holdings in our portfolios on your behalf. Again, we are always here for you; please don’t hesitate to contact us if you have any questions or concerns.

 

Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments and/or investment strategies recommended and/or undertaken by Reilly Financial Advisors (“RFA”), or any non-investment related services will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.

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