#$sdy

[valuentumbrian]

A New Measure of Leverage for Dividend-Growth and Income-Oriented Shareholders, One That Is Dividend-Adjusted

As more and more investors rely on company dividends for income, dividends, in our view, have become more debt-like commitments in nature, especially from the perspective of dividend-growth or income-oriented shareholders. We plan to roll out a new measure of financial leverage that considers both the company’s debt and the present value of its future expected cash dividend obligations, which, in the eyes of die-hard dividend-growth or income-oriented shareholders, may be implicitly assumed to be debt-like commitments in substance. We think this leverage ratio can be used in conjunction with the Dividend Cushion ratio to gain additional insight into the dividend-paying financial health of an entity.

Note: There is often great confusion with respect to published measures of financial leverage, and our intent with the creation of this leverage ratio is not to add to the confusion, but to help dividend growth and income-oriented investors think about what is implied in terms of leverage by their expectations that a company’s dividend is secure (and is anticipated to grow), as in the case of the dividend essentially being viewed as a cash commitment to shareholders/unitholders, which may often be the case for many dividend growth and income-oriented investors. Typically, most reporting uses the credit-rating agencies’ leverage metrics or measures of leverage that are provided by the company. Depending on the stakeholder, however, the application of various measures of leverage may be helpful in painting a better picture of the risk to the dividend. Said plainly, this tool is to help the equity investor evaluate the financial risks of more-speculative dividend payers and raise awareness of what their views regarding the dividend imply with respect to leverage.

By Brian Nelson, CFA

Financial leverage is a very subjective consideration and can be measured in a variety of different ways depending on its relevance to a particular stakeholder, whether it be an equity holder or debt holder. Some measures of leverage include assets-to-equity as in the third product of the DuPont equation, for example, or total debt-to-EBITDA, or net debt-to-EBTIDA, or total debt-to-equity, among many others. Most leverage metrics, however, tend to focus more on assessing credit quality, as in evaluating the ability of a company to repay its debtholders, or in measuring and ranking the probability of default.

The credit rating agencies, for example, employ a wide variety of adjusted financial metrics that have myriad “subjective judgments” embedded within them. Moody’s, for example, uses debt-to-equity and debt-to-book-capitalization, as well as a unique measure called retained cash flow to net debt (RCF/net debt). The definitions for many credit metrics can be relatively complex, in some cases. For example, according to Moody’s, RCF/net debt decomposes into the following: (FFO-preferred dividends-common dividends-minority dividends) / (short-term debt + long-term debt, gross – cash and cash equivalents).

The ratio RCF/net debt is a rare credit metric, in our view, that may be applicable to that of the dividend growth or income investor. Where a bond holder may implicitly assume that dividends can be cut/reduced in order to shore up cash flow to service debt repayment, from the perspective of the equity investor (one that is counting on that dividend for income), the view is quite different. In the eyes of many die-hard dividend growth or income investors, for example, the dividend payment is often viewed, in great substance, as the equivalent of a debt-like cash commitment. RCF/net debt provides some context in how much cash flow is left over after paying dividends or distributions to service the debt, but it may not be a pure measure of dividend-adjusted leverage, as in the traditional sense (where EBITDA may be in the denominator, for example, as in net debt-to-adjusted EBITDA).

In any case, what we like about the RCF/net debt ratio is that it does not assume that dividends are not going to be paid, as in the case of other traditional credit metrics that effectively ignore the dividend or distribution as an important cash outflow (and an implicit reduction to credit quality). The RCF/net debt ratio assumes that the dividend is an debt-like cash commitment reducing funds from operations, something we believe is very relevant to the dividend growth or income-oriented shareholder that is depending heavily on that dividend or distribution payment. What RCF/net debt also considers is that the same money distributed to shareholders or unitholders is not also used twice as same money that can be used to service the debt (double counting). In our view, it should be generally assumed that such capital can only be used once; if it’s paid out as a dividend/distribution, it generally should not be assumed that it is also capital that can be used for debt repayment.

The idea of a new measure of leverage for dividend growth and income-oriented shareholders/unitholders that considers dividend/distribution obligations originated in the 2015 analysis of Kinder Morgan (KMI) when we explained how a dividend-growth or income-oriented investor that, if they are truly counting on the dividend/distribution to be paid in the future for their income stream, they should evaluate the company’s financial leverage in the context of both its net debt and the present value of those dividends/distributions to shareholders/unitholders. Once the capital corresponding to dividend payments is released to shareholders/unitholders, that same capital shouldn’t also be considered as a means to repay debt as well. Here’s what we said in that 2015 piece:

One of the dual and perhaps lesser-known benefits of the dividend discount model is that it seconds as a calculation of the present value of future cash dividend obligations. For example, the higher the “perceived” equity value that is supported by the dividend discount model, the more the present value of cash obligations the company has to shareholders, and by extension, the lower implicit credit quality of the organization, assuming a company continues to pay and increase its dividend...

In any case, what matters most is not the absolute level of the debt on Kinder Morgan’s books, which is striking by itself, but whether Kinder Morgan can service all of its debt-like, cash obligations with its own organically-generated EBITDA, which pays no mind to capital spending in any form. Kinder Morgan currently has $42.8 billion in debt, net of cash, on the balance sheet, and implicitly, on the basis of the price targets of some brokerage houses that employ a dividend discount model, it has another ~$100 billion in “mandatory” obligations to shareholders in the form of dividends (though if you ask a shareholder, the dividend payment is as contractual as it gets).

We think that, as the credit rating agencies evaluate the firm’s die-hard commitment to shareholders and its unwavering backing of an explosive future dividend growth plan, the implied leverage of cash, debt-like commitments at Kinder Morgan should approach $140 billion. The company’s reported Debt-to-EBITDA is 5.8 times, already a consideration for junk-rated credit status, but its implied Debt-to-EBITDA is closer to 19 times ($140 billion/$7.35 billion) after factoring in all cash, debt-like commitments…

What we’re proposing is that the concept of financial leverage should be viewed differently as it relates to the perspective of either the debt holder or the dividend-growth and income-oriented equity holder. In the case of Kinder Morgan in 2015, for example, many holders of its stock were die-hard dividend growth investors, and they were counting on the company’s dividend no matter what. This assumption should be an important part of leverage analysis of that of the dividend growth and income investor. Looking at financial leverage from the perspective of that of a bold holder, or as one that assumes the company will cut its dividend to repay debt, may not be an accurate representation of actual cash, debt-like obligations in the eyes of dividend-growth or income-oriented shareholders, which are counting on the dividend to be paid through thick and thin.

Where RCF/net debt effectively reduces the numerator by dividends paid as a way to explain just how much cash is left over to service the debt, an implied measure of leverage that views dividends as cash, debt-like commitments may be of equal usefulness. We believe it makes little sense from the perspective of a dividend-growth or income-oriented shareholder to evaluate a company’s financial leverage as if one is never going to get paid a dividend or distribution! Financial leverage from the perspective of the dividend-growth or income-oriented shareholder should consider all net debt and the present value of all future expected dividend obligations. Much like rent can be capitalized to arrive at a present value of debt equivalent (as if a retailer were to finance a building instead of paying rent), dividends can be capitalized in much of the same way through either the construct of a dividend-discount model or through a growing perpetuity function with a reasonable discount rate.

The dividend-adjusted measure of leverage, or financial leverage as we think it should be viewed in the eyes of the dividend-growth and income-oriented investor, is as follows:

Valuentum will start to roll out this new dividend-adjusted leverage ratio in the fourth-quarter Data Screener, due for release October 1, 2018. We think this ratio used in conjunction with the Dividend Cushion ratio will provide even more insight into the dividend-paying financial health of the entity.

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Valuentum members have access to our 16-page stock reports, Valuentum Buying Index ratings, Dividend Cushion ratios, fair value estimates and ranges, dividend reports and more. Not a member? Subscribe today. The first 14 days are free.

Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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The High Yield Dividend Newsletter, Best Ideas Newsletter, Dividend Growth Newsletter, Nelson Exclusive publication, and any reports and content found on this website are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of its newsletters, reports, commentary, or publications and accepts no liability for how readers may choose to utilize the content. Valuentum is not a money manager, is not a registered investment advisor, and does not offer brokerage or investment banking services. The sources of the data used on this website and reports are believed by Valuentum to be reliable, but the data’s accuracy, completeness or interpretation cannot be guaranteed. Valuentum, its employees, independent contractors and affiliates may have long, short or derivative positions in the securities mentioned on this website. The High Yield Dividend Newsletter portfolio, Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Performance, including that in the Nelson Exclusive publication, is hypothetical and does not represent actual trading. Actual results may differ from simulated information, results, or performance being presented. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[factorinvestor]

Five points of caution for dividend investors

At a time when demand for income generating assets is at an all-time high, the yields on income generating assets are at, or near, all-time lows. While the headlines often speak to the number of Baby Boomers entering retirement, the more important statistic is actually the amount of wealth entering retirement. According to the U.S. Census Bureau, of the 125 million households in the U.S., 32% fall between the ages of 55 and 70. That group also represents a disproportionate 57% of median household net worth. Assuming these retirees and near-retirees started saving around age 30, that would place the beginning of their “investment memory” somewhere between 1976 and 1991 and continuing to the present. That entire span was encapsulated by arguably the greatest bond bull market ever, and some of the most robust equity returns in history.

As this cache of wealth is in or approaches the distribution phase of the investment lifecycle, the thirst for income generating assets will be unquenchable. Most retirement models are predicated on a 4% annual withdrawal from retirement assets. In a world of sub-2% equity and bond yields, such a large annual withdrawal seems optimistic and susceptible to substantial sequence-of-return risk.

Though this cohort lived through a golden age of financial asset return, they have also experienced the most dramatic bear markets since the Great Depression. The tech bubble in the early 2000’s and financial crisis of the late 2000’s marks the first time two greater-than 40% downturns occurred in a ten year span, again since the Great Depression. An adaptation of the old adage, twice bitten thrice shy, may appropriately describe many investors.

McKinsey captured the outcome of this phenomenon in a recent report, which suggested that investors are laser focused on: 1) protecting principal, 2) hedging against severe downside risks, 3) minimizing volatility and 4) generating income. While the active management industry has been toiling to identify yet uncovered sources of alpha, investors seem to just want a reliable combination of principal protection and income generation at a reasonable fee. Investor sentiment has shifted, for now, from performance to solutions-focused objectives.

ETF assets confirm the popularity of at least two of these preferences (chart below). The most popular ETF categories, outside of the broad shift to market-cap weighted passive vehicles, are low volatility and dividend-focused.

While equity income could never be a substitute for the principal stability of fixed income, it does offer compelling long-term income generating potential. With equity yields at or higher than yields on most 10-year government bonds, they are no doubt becoming an increasingly popular component of retirees portfolios.

Five considerations for seeking dividend income

Dividend investing requires great care, particularly in the current environment. The combination of poor recent performance, elevated stock valuations, and uncertainty as to the path of interest rates are enough to perplex most investors. In speaking with advisors and clients across the country, we have identified five key considerations for equity income investors.

Dividends performed terribly in the years preceding 2016; that’s a good thing

We have just emerged from a period when stocks with strong dividend yield have struggled. As an investment theme, dividend yield found itself at the epicenter of three major events that conspired to drive lackluster performance—oil, the US dollar, and US outperformance. The crash in the price of oil in late 2014 took its toll on Energy firms. As oil recovered from its 2008 lows, profitability at large oil and gas exploration and production firms increased. They expanded their dividend programs and dividend investors found solace in the strong dividend yields offered. As oil declined in 2014, these previous darlings of the dividend space sold off. Because oil and the US dollar tend to be inversely related, the US dollar strengthened during this period. For global dividend investors, the strengthening of the US dollar served as an additional headwind to performance. Further compounding the performance issues for globally-oriented investors, persistent geopolitical concerns have resulted in dramatic underperformance of developed international and emerging markets. As of October month end, the S&P 500 was beating its developed and emerging counterparts by around 10% annualized over the trailing three years (even with the recent bounce in emerging markets).

Below is a snapshot of calendar year excess returns for stocks with strong dividend yield and dividend growth. Whether you favored dividend yield or dividend growth from 2012-2015, domestically or abroad, chances are high that performance has been challenged.

It would be easy to cast dividend payers aside for that reason, but know that historically it is very common for investment factors to come in and out of favor. So far in 2016, dividend yield has experienced a solid recovery. The chart below shows the rolling five year excess performance of stocks in the top quintile of dividend yield back to the 1970's. Notice that periods of underperformance are followed by prolonged and/or significant periods of outperformance. If history serves as a guide, its possible the recovery of dividend yield experienced so far this year may continue for years to come.

Certain dividend payers historically buck the rising rate performance headwind

The fear of rising interest rates has been particularly alarming for some investors, most notably back in 2015 as the Fed wavered on when rates would increase. For the most part, the pain inflicted there was psychosomatic. The Fed had actually started tightening as far back as 2013 with the announcement of "taper" (when the Fed started reducing its monthly bond purchases). With some positive recent economic data, rates have again moved higher in anticipation of a hike. The concern now is that interest rate sensitive assets—Utilities in particular—will get torpedoed if the Fed starts raising in earnest.

When we looked at the 12 environments where the 10 year US Treasury rose by 1.0% or greater over a 12 month period, we found evidence to support that suspicion. The Utilities sector underperformed in ten of the 12 environments and had an average underperformance of -8.5% on an annualized basis. Real Estate (REITs) underperformed, but robust data only covers three of the rising rate environments so it’s challenging to draw inference. Beyond REITs, Financials are the second worst performer with banks underperforming by 5% on average across all the periods. On the positive side, Energy and Info Tech did exceptionally well, outperforming by 6.1% and 7.4% on average, respectively. Energy outperformed in eight of the 12 environments while Info Tech outperformed in nine. It’s important to note that these are averages across some very unique periods in market history—from the inflationary death spiral of the 1970’s to the tech bubble of the late 1990’s.

Be wary of dividend ETF’s; they offer less diversification than investors are led to believe

Financial innovation is a wonderful thing. ETF's are a wonderful thing. But, investor assets are becoming more and more concentrated in specific investment themes, and specific investment vehicles. While I have my own thoughts on the concentration in passive investment vehicles, I've found a few assessments to be particularly provoking, such as the one below which discusses the implications of passive investing on corporate competitive behavior.

The dividend theme may be particularly susceptible to this phenomenon of concentration into investment vehicles. In a recent analysis, we analyzed the four most popular dividend ETFs to see what names they hold in common. The results are summed up in the graphic below. The largest circles represent an ETF. Each of the spokes is an individual stock holding and is scaled to its weight across the ETFs. The spokes connect each stock to the ETFs in which it is held. For the sake of simplification, only underlying holdings with a greater than 3% weight receive a ticker label.

Notice that the largest names tend to be those that are held in common between all of the ETF's—those stocks in the middle of the map. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. We found it quite surprising how similar the ETF's are; only 20% of the total weight across the 4 ETF's is unique. 80% of the assets have at least one holding in common with the other three ETF's. 30% have two holdings in common. And 9% of the assets are held in common across all four ETF's.

Here’s why that matters. Individual investors should realize that when owning the most popular investment products, their fate is tied to the whims of the masses. These vehicles provide near instant liquidity, which can result in massive and rapid flows out of the ETFs and their underlying stocks. Because the ETF's have similar underlying holdings, sales out of one ETF can result in price declines for holdings in the other ETF's, creating a downward spiral in a panic scenario. When the Fed did raise rates in December 2015, fearful investors withdrew $30 billion in assets from dividend ETF's in the two months following the hike.

Yet, short-term trigger-happy speculators often tend to be wrong. From December 15, 2015 when the Fed raised rates through 9/30/2016, stocks with strong dividend yield delivered an 18% total return. Many a crisis negotiator will impart the advice of “slow it down” in times of stress. We may have gotten to the point where financial innovation, ETF’s, have made it a little too easy to hit the sell button. Let's slow it down a notch.

Dividend growth on its own is not an effective strategy

As valuations have risen on the highest yielding stocks, dividend managers are seeking dividend stocks with modest valuations. As an alternative to pure yield, dividend growers provide ready access to income and the perception of safety. Unfortunately, they fall short on performance. Quite simply, stocks with the best dividend growth have actually underperformed the market since the mid 1970's on average. There are bright spots in that nearly five decade span, but since the credit crisis, dividend growth has muddled along.

The chart above looks at the total annualized excess return of various dividend growth metrics—1, 3, 5 and 10 year annualized dividend growth. What we found was that stocks with high dividend growth really don’t offer much on the performance front. Take, for example, stocks with high 10 year dividend growth, they actually underperform the market by 0.7%, while stocks with low 10 year dividend growth outperform. Further, stocks with low 5 year dividend growth counter-intuitively outperform the market and those stocks with high dividend growth. Dividend growth may expand the opportunity set for income investors, but it is not a panacea. 

Valuation trumps dividends

Valuations are rising across the board. The market is nowhere near the single digit price to earnings ratio we saw in mid-2009. Today, it is not uncommon to find investment strategies that aspire to a "value-based" investment philosophy carrying a PE ratio greater than 20x. Unfortunately, a lot of those strategies also fall in the dividend space. A byproduct of the massive flows (about $90 billion since 2009) into dividend focused strategies is that valuations have been pushed higher. In the analysis of popular dividend ETFs above, we found that stocks receiving a disproportionate amount of those flows—stocks with the greatest weights in the ETFs—were more expensive than the lower weighted holdings. Underlying stocks with a greater than 1% weight were more expensive than stocks with less than a 1% weight on average by between 17% and 37% depending on the value metric used—price to sales, price to earnings, price to cash flow, or price to book.

This positioning runs contrary to what we know from the historical record. From 1975-2016, a focus on discounted valuation within the dividend yield theme meant the difference between outperforming the market and underperforming. Below, we narrow the investment universe to dividend stocks falling in the highest-yielding third and then subdividing further to create three high-yielding portfolios differentiated by valuation. These portfolios share one thing in common, high dividend yield, but are differentiated by another—valuation. High yield and discounted valuation outperform high yield and expensive valuation by 5.4% annualized. The price you pay is an all important constant in investment success. 

A few suggestions

Thinking about the five considerations outlined above, we have outlined some suggestions for seeking equity income allocations.

Flows into equity income are not likely to stop anytime soon. There is too much demographic demand for income producing assets. It is important to recognize, however, that there are only so many large high-quality dividend paying firms. The trends towards ETF’s has concentrated flows into a relatively small swath of the overall market. At some point, even the best companies can become bad investments due to high valuations. Be cognizant of the price you are paying for dividend income, and seek discounted pricing even if you have to sacrifice yield.

Ensure that there is low overlap across dividend-focused portfolios you hold. This means diving into individual ETF’s and mutual funds to make sure they don’t hold the same investments. One way to do this is to hold strategies with different objectives within the dividend space: US dividends, global dividends, small cap dividends, etc.

As we move into a rising interest rate cycle, it may be prudent to consider shying away from the sectors (Utilities and REITs) that have done poorly in those environments. However, as evidenced by the performance of yield after the December 2015 rate hike, don’t underestimate the total return potential of the dividend theme. Sometimes markets become too pessimistic, which breeds opportunity, as was the case late last year.

Recognize that dividend yield and dividend growth on their own are not the most effective stock selection factors. Dividend yield does better than dividend growth, but valuation reigns supreme historically. Pair yield and valuation with quality considerations like balance sheet strength and cash-based earnings to insure the dividend is sustainable.

Calculated based on the number of households by age cohort and their share of the weighted median net worth for households across age cohorts.

“The $64 trillion question: Convergence in asset management”. Pooneh Baghai, Onur Erzan, and Ju-Hon Kwek. Feb 2015.

OSAM calculations, top quintile of dividend yield for global large capitalization stocks.

[factorinvestor]

The illusion of choice in ETF's

“Learning to choose is hard. Learning to choose well is harder. And learning to choose well in a world of unlimited possibilities is harder still, perhaps too hard.”

— Barry Schwartz, The Paradox of Choice: Why More Is Less

A search for all equity ETF's available to U.S. investors in Bloomberg leads to a list of 969 candidates, a surprisingly large number of options for a relatively new investment vehicle. Given that most focus on large capitalization stocks here in the U.S. (not all, but most), this means that there has to be overlap in the underlying stock holdings...in some cases a lot of overlap.

The unfortunate result is that investors are lured into believing that 1) their exists choice within ETF categories, and 2) building portfolios of ETF's represent a diversified set of exposures. This is generally not the case.

A distinction without a difference

When I wrote about my concerns with Low Volatility ETF's here, here, and here, I noticed that the turnover in those ETF's was very low, which suggested that the billions of dollars flowing into the low volatility theme were being channeled into a relatively concentrated group of stocks. It turns out, dividend ETF's are more popular by a factor of five, and there tends to be a lot of overlap in the underlying holdings.

As you can tell from the chart below, dividend ETF's are by far the largest "Smart Beta" ETF category, having amassed $126 billion in assets as of the third quarter of 2016.

The challenge with dividends as an investment factor, as opposed to Value, Momentum, or Quality, is that only so many companies pay dividends. As buybacks have become more popular in the U.S., the share of stocks paying high dividend yields has declined. The chart below breaks down dividend payers listed on the S&P 500 by their level of yield. While the share of companies paying small yields of less than 1% has decreased, the share of companies paying greater than 4% has also declined. Historically, about 12% of S&P 500 stocks offer a yield of 4% or greater. As of the third quarter, the tally is half that at 6%.

So, as a generation of Baby Boomers seeks alternative solutions for income generation in the face of low fixed income yields, the dividend opportunity set is also shrinking. Even still, with average dividend yields in excess of most fixed income, you can bet dividend ETF's will continue to be recipients of investment dollars.

Circling back on the point of overlap, let's take for example, four of the most popular dividend ETF's by assets:

Vanguard Dividend Appreciation ETF ($VIG)

iShares Select Dividend ($DVY)

Vanguard High Dividend Yield ETF ($VYM)

SPDR S&P Dividend ETF ($SDY)

After pulling the holdings as of 1Q 2016, I used some fancy programming pyrotechnics to generate a map of their holdings. The graphic below illustrates the overlap between these ETF's. The large circles represent an ETF ticker. Each of the spokes is an individual stock holding and is scaled to its weight across the ETF's. The spokes connect each stock to the ETFs in which it is held. For the sake of simplification, only underlying holdings with a greater than 3% weight receive a label.

A few observations. The largest names tend to be those that are held in common between all of the ETF's--those stocks in the middle of the map. The stocks that are unique to an ETF tend to be the smallest weights and line the periphery. It's surprising how similar the ETF's are; only 20% of the total weight across the 4 ETF's is unique. 80% of the assets have at least one holding in common with the other three ETF's. 30% have two holdings in common. And 9% of the assets are held in common across all four ETF's.

Self-perpetuating momentum

Here's why this matters. I mentioned earlier that $126 billion resides in dividend ETF's. If the stocks occupying the largest weights are the ones that are most commonly held across dividend ETF's, then the massive flows we have seen over the last few years have disproportionately gone into these stocks.

The characteristics of the most highly-weighted names across these popular ETF's betray exactly this point. Flows have pushed up valuations of the stocks holding the greatest weights, and those with the greatest weights have substantially better momentum (momentum being the average of 12 month trailing total return).

The table below takes all of the stocks held in the four popular dividend ETF's and treats them as one super portfolio. It then segregates the super portfolio into stocks that occupy weights greater than and less than 1%. I then calculate average characteristics on the two groups of stocks.

The <1% group is cheaper by 37%, 17%, 28%, and 32% relative to sales, earnings, cash flows and book value than the >1% group, and their dividend yield is 10% higher. Given the choice between these two groups of stocks, any competent investor would choose the <1% group! Unfortunately, the <1% group represents a disproportionately small amount of the ETF's holdings, just 19%. The more expensive and lower-yielding group represents a whopping 81% share.

Why?

In a word...scale. ETF's prefer stocks with large market capitalizations because they are designed to accommodate large amounts of assets that are not limited by capacity constraints. Some of the highest yields are offered by lower capitalization stocks that are beyond the reach of the Vanguards, iShares and SPDR's of the world. This creates opportunities for smart investors willing to go against the grain.

[valuentumbrian]

General Mills a Reminder of the Dividend Growth Bubble

Recent developments surrounding consumer staples giant General Mills have reminded us that it is important to keep perspective in today’s market.

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By Kris Rosemann

We have not been shy about our concerns with the current overheated state of the market, “A Kleenex? Consumer Staples Trading At Nosebleed Levels (August 2016)”:

“At arguably no time in the history of the stock market have investors been willing to pay so much for each unit of earnings to capture a dividend yield of just a few percentage points. Negative interest rates across much of the world have created this scenario. In many ways, the strongest business models have become some of the most risky stocks, to no fault of their own. What do the bulls say though -- as long as everybody keeps buying these steady-eddy companies to capture yield, share prices will continue to go up. Why not?”

General Mills (GIS) has been a beneficiary of the ongoing dividend growth bubble as its shares are now changing hands at more than 20 times fiscal 2017 earnings per share guidance, even after a material pullback following the release of its fiscal 2017 guidance in early September. Additional pressure has come since the company reported rather pedestrian fiscal first quarter results September 21, as top-line weakness persists in its 'Foundation' businesses.

Such performance was not necessarily unexpected, and management reminded investors that it is working to drive efficiency by reducing the number of SKUs it carries and optimizing spending, which will inevitably reduce volume. For fiscal 2017, the firm is expecting organic sales to be flat to down 2% from fiscal 2016, while operating profit and adjusted diluted earnings per share are expected to grow 6%-8% on a constant currency basis from the prior year.

Upon the recent updating of the food products (large/mid-cap) industry, General Mills registered a 1 on the Valuentum Buying Index, the lowest possible rating, as a result of the combination of it being overvalued on both a discounted cash flow basis and a relative valuation basis and its bearish technicals. Could this be the VBI foreshadowing an impending decline in our overheated market, likely to be led by the very stocks that did a large part of the bubble inflating?

Image Source: Valuentum 

We’re not going to make such a claim, though it is certainly an interesting development. In fact, it will take some time for price-to-fair value convergence takes place in the stock, the catalyst for which may very well end up being the bursting of the dividend growth bubble. Speculation as to when this will happen could be an exercise in futility, though the Fed’s decisions regarding interest rate increases will play a factor as its recent inactivity has only further fueled the overheated, yield-hungry market. Shares of General Mills currently yield ~3%.

It is important to note that General Mills registering a 1 on the VBI is not an indictment of its business, brands, or staying power, but is instead an assessment of a combination of factors that make it an unattractive investment consideration, in our opinion. It does not indicate that we are anticipating a catastrophic development to unfold in its operation. We are using this instance as a reminder that it is imperative to always keep valuation in mind when making an investment decision. As our loyal readers know, there is much more to consider in a stock than its dividend yield, which accounts for but a portion of shareholder return in a high quality investment consideration.

Food Products (Large/Mid-Cap): ADM, BG, CPB, CAG, GIS, HSY, K, KHC, MDLZ, MJN, NSRGY, UL, UN

Related tickers: XLP, SDY, VIG

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This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[valuentumbrian]

Valuentum’s Nelson’s Warning to the Board Rooms of America

Image Source: Robert Lyle Bolton

“In some ways, a cash dividend is like paying shareholders with their own money, and making a big deal about it!” -- Brian Nelson, CFA

To the Board Rooms of America:

We learn a lot from the culture we live in, the education system we promote, and the games we play. Who hasn’t played Monopoly, the age-old game that Hasbro scooped up from Parker Brothers, first published in 1935? For more than 80 years now, men and women of all ages have been collecting $50 from the “bank” after pulling one of the more-fortuitous Chance cards. Ingrained in society has become the belief that a “dividend” is incremental, that something is “given” to shareholders that otherwise was not there. After all, the Monopoly player now has $50 when prior to pulling the Chance card, he or she didn’t.

But unlike the “make-believe” Monopoly game, a stock’s dividend is nothing like this. A stock’s dividend is “already owned” by the shareholder.  Stockholders own everything about the company, all of its assets, including the cash used to pay the dividend prior to it being paid. How can I know this for sure? Well, because I am a business owner myself. If the board of Valuentum, for example, wants to pay a dividend, Valuentum’s cash balance would be reduced by the amount of the dividend payment. Valuentum’s owners already owned that cash balance on its books prior to the dividend payment, and now they would own the cash outright after the dividend is paid--it’s a wash for the stockholder, tax implications aside. The dividend is neither a source of value nor a transfer of value. Value is created by the future earnings and cash flows of the business--not in the dividend payment.

Today, with most of the world muddling through a negative interest rate environment, I believe we’re in the early stages of a “dividend” bubble, and I am writing this note because the future consequences are unknown. I am concerned. I believe that most shareholders do not know that when they receive a dividend, they are being paid with their own money. One might argue that most of the “value” of the dividend payment, whether a monthly or quarterly one, is just the structure and timing of the income “payment” to the investor. That it keeps excess capital out of the hands of management may be another reason, but I’d like to think that the owners like management—after all, they vote them in.

Here is the deal: shouldn’t the focus of investing be on the company, not on the company’s arbitrary dividend policy? Shouldn’t management teams do a better job of explaining what a cash dividend is and what it is not? Can’t financial advisors structure income payments in other ways to meet their clients’ requests without stretching needlessly for “getting paid with their own money (i.e. the dividend)?” Is the tail (the ease of income policy with dividend payments) wagging the dog (the decisions in setting prudent investment policies for retirees)? Wasn’t the tulip bulb arbitrary? Wasn’t valuing companies on the basis of “eyeballs” arbitrary during the dot-com bubble? Dividend policies are arbitrary. You see what I’m getting at?

Partly because the dividend is fueled by future earnings and free cash flow, I’d never go so far as to say that picking a stock on the basis of its dividend is like following the advice of Evangeline Adams, an astrologer in the 1920s, but estimating the value of a company on the basis of dividend policy or liking a company "because of its dividend" is an arbitrary practice. The value of a company is based on its net cash position on the books and the present value of its future enterprise free cash flows. I don’t want to see investors hurt, and I think management teams would perform a great service by working with their owners in explaining the concept of a dividend--that the value of the company is reduced once the dividend is paid, that they own the company, including the balance sheet, or the source of the dividend payment.

It is an honor and a privilege to identify some of the strongest dividend payers via Valuentum’s Dividend Cushion ratio and publish some of our best ideas in Valuentum’s Dividend Growth Newsletter portfolio, but we always emphasize the importance of business analysis and valuation at Valuentum, independent of a company’s dividend policy. I believe there are thousands (maybe millions) of investors out there today that do not understand what a dividend truly is, and I ask the board rooms of America to aid in the continued education of their owners. It is often the most trusting investors that get hurt the most in “bubbles,” and I do not want this to happen.

Thank you for your consideration.

Kind regards,

Brian Nelson, CFA President, Investment Research & Analysis [email protected]

Related tickers: SDY, NOBL, VIG, DVY, TDIV, DGRW, SCHD, QDEF, DIA, SPY

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This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice. For more information about Valuentum and the products and services it offers, please contact us at [email protected].

[mitchzacks]

Should You Sell in May and Go Away?

New York, New York asks…

Mitch, there’s an old investing adage “Sell in May and Go Away,” that’s based on notoriously weak summer returns. I think about doing this every year—does it make sense?

The “Sell in May” adage makes its way into the equities market narrative every year, so I’m not surprised you’re hearing about it again. Looking at historical statistics, I will concede that there’s a decent, but by no means strong, argument for ditching stocks for a six-month period starting in May. Since 1928, the S&P 500 has pretty widely outperformed during the November–April period relative to the May–October months, producing a +5.1% average return versus the meager +1.9%.

But the fallacy of the “Sell in May” strategy is also apparent as the May–October period is still positive on average. Since 1928, the actual month of May has been positive 49 times and negative 39 times, meaning if you took this approach the odds of being correct are already stacked against you.

The last two years prove as much. In 2014, the “Sell in May and Go Away” strategy would have crimped portfolio returns since the S&P 500 rose some 7% during the May–November period. Trying the strategy in 2015 would have also been largely ineffective, since it would have meant buying into the S&P 500 at essentially the same level you sold. An investor would have avoided the steep summer correction last year but would have also missed the compelling “v-shaped” bounce off the bottom. There are too many examples of the strategy not working to take it seriously.

The May–October period may not be the strongest six-month period historically, but it’s still positive on average. If there’s any adage you should follow, I’d recommend, “It’s time in the market, not timing the market.”

FREE Download – Zacks Economic Outlook: May, 2016

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss. Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Zacks Investment Management, Inc. is not engaged in rendering legal, tax, accounting or other professional services. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney- client relationship. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel.

.

[mitchzacks]

Will ‘Sentiment’ Turn This Bull into a Bear?

I have used this space many times to discuss how fundamentals drive stock prices over the long run. Additionally, in the midst of (sometimes severe) volatility and rising uncertainties that come with it, I’ve often made the point to stay focused on what really matters in terms of equity prices these days including:

U.S. GDP expected to expand at a roughly 2% rate in 2016

Earnings weakness in the first half of the year with an expected recovery of double digit growth in the second half of 2016

Europe poised to gain growth momentum with an expected full-year growth of around 1%

U.S. inflation could pick up to a comfortable 1%-1.5% as the year progresses and crude prices stabilize further

Interest rates remain low globally. In the U.S., the Fed raises overnight rates more gradually than expected, and pressure on the 10-year eases (making for an upward sloping yield curve—good for growth)

Global GDP expected to post in the ~3% range—modest but healthy

In Zacks Investment Management’s view, each of these fundamental factors makes a strong case for expansion in 2016, not recession. And, as I’ve said many times, only very rarely have we seen a bear market without a recession.

But, there’s the sentiment factor. We just saw how sentiment can drive markets in the first three months of this year. In the first six weeks, as fears mounted over China’s slowdown and government intervention, the S&P 500 fell some -10%. But, as pessimism continued to grow, this eventually paved the way for the market to climb the proverbial ‘wall of worry,’ and markets love climbing that wall. Indeed, by the end of the first quarter, the S&P 500 was already back in positive territory.

Can Sentiment Derail a Bull Market?

The short answer is ‘yes.’ But, in my experience, market ‘derailment’ is more likely to occur when sentiment becomes too positive (and not the other way around).

Legendary investor John Templeton famously said, “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” In the short term, when pessimism builds on false or overblown fears, we would usually expect the market to power through it—like we saw in the first three months of the year.

This can, and does, happen often during bull markets. That’s why you often see me ‘raise an eyebrow’ when rapid-onset downside volatility is accompanied by negative news stories that aren’t likely to be impactful (the fiscal cliff, European sovereign debt crisis, Greece leaving the European Union, Ebola, China slowdown, etc.…).

In my view, what we really need to look for in the current market is growing optimism, which may emerge as complacency (versus outright optimism or euphoria).

Many times, we’ve seen Templeton’s quote play-out nearly perfectly. For example, the late 1920’s euphoria that erupted as Americans migrated to cities seeking a slice of industrial sector riches, resulted in the banking sector boom. Similarly, in 2000, the tech bubble saw investors pouring money into start-ups with billion dollar valuations and negative earnings. In both cases, euphoria caused equity prices to balloon and overly positive sentiment killed the bull.  

Today, with modest growth rates likely here to stay, I’m not convinced that we’ll see outright euphoria this late in the cycle. There isn’t enough artificial wealth being created for investors to grow euphoric over. But, we could see complacency seep into the markets. Complacent investors tend to ignore risk, meaning they could be more likely to pay too much for already overvalued stocks. And, when that happens the market could easily move from fairly-valued to over-valued. If fundamentals quietly start to break down as that’s happening, I think that could trigger the next bear market.  

Bottom Line for Investors

While fundamentals remain strong, I still think plenty of pessimism remains. In my view, that’s a recipe for a market that can, and should, grind higher. The things to watch out for, from a sentiment point of view, are:

Geopolitical tensions in the Middle East eased

Oil prices stabilize and fade as a news story

Europe and China post convincing growth

U.S. earnings turn out much better than expected.

If all of these things happen, which is possible, then sentiment could improve dramatically to the point of supporting complacency. And, that’s when I’d start becoming more cautious.

FREE Download – Zacks Economic Outlook: May, 2016

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Zacks Investment Management, Inc. is not engaged in rendering legal, tax, accounting or other professional services. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney- client relationship. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel.