Smart Dividend Investing: Beyond Yield
In a zero interest rate world, where liquidity and a newfound (recently rediscovered?) religion that credit defaults will be few and far between, assets with yield have been steadily bid up. The result: just as short-term savings accounts offer almost nothing in the way of interest, risk assets have seen spreads (the difference between their yield and a risk-free proxy) squeezed, so that they look much less attractive.
If you’re a bond manager, the trade-off between yield and safety is fairly apparent; moving up in one requires sacrificing some of the other. But equity investors, for some reason, often overlook that the “free lunch” to be had in dividend investing isn’t as great as it might appear, which is why having a good dividend stock screen is so important to narrow down candidates. Once a starting point is established, here are a few more analytical steps to take:
-Funding the dividend
The dividend culture that exists among investors encourages some management teams to (wrongly) believe that they need to pay a dividend in order to gain some perception of stability or conservatism. But a dividend, like water, is only as good as the source it comes from. Borrowing extra money to continue paying distributions to shareholders is something easily detected by looking at a firm’s Statement of Cash Flows, and a look at the Income Statement can tell if the dividend is an extremely high percentage of earnings. Either situation says that the firm likely is not profitable enough at present to be paying a dividend, which leads us to…
-Distributing excess capital
Some mature firms (many consumer staples come to mind) have limited expansion opportunities but are highly profitable; it makes sense for these companies to distribute such “excess capital” to investors if it would otherwise result in a large cash build-up on the balance sheet. It doesn’t make sense for companies to pay a dividend while simultaneously undergoing an aggressive expansion or trying to maintain certain standards of financial conservativism. Banks are a classic example of the latter; Citigroup (C) and Bank of America (BAC) each paid about $10 billion annually in dividends during the “good times” leading up to the crash. That money, of course, would have been extraordinarily valuable if it were retained. Looking at whether a company is actually giving investors back capital that it can’t make good use of, as opposed to simply increasing leverage (the effective side-effect of dividends), requires more analysis, which should culminate in…
-Estimating a sustainable yield
I’ve seen many people mistake a short-term anomalous yield for a supposedly-good dividend investment. Always check to see if the payout and yield are correct, or if they’re being skewed by a short-term event such as a special payout or variable profits. Common sense reigns here; if something is advertised as having a 15% yield, that should raise eyebrows, since most companies don’t have either the cash flow generating power (#1) or excess capital (#2) to consistently pay out that much.
Exxon (XOM) and XTO: A Bold Vote for… the Status Quo
Exxon Mobil’s (XOM) blockbuster $40+ billion acquisition deal to buy natural gas producer XTO Energy (XTO) immediately raised questions about whether it was a signal nat gas is the future primary energy source for America. Exxon’s management team made it clear that the XTO deal was done with a long-term time horizon and is not meant to be judged on the basis of 2010 earnings accretion or dilution. This perspective is helpful because nat gas producers have many near-term earnings headwinds as their production hedges roll off in 2010; a nearly $2/mcf difference exists between spot prices and where XTO has, on average, hedged half of their scheduled 2010 production. When faced with the reality that future realized prices could be much lower (say, $5.50/mcf vs. $7.50/mcf from lucky hedges), producers needing to show earnings growth will have to produce much greater amounts of nat gas, leading to excess supply and lower prices – a situation that’s tough to break out of.
The sheer size of the transaction lends some weight to the idea that Exxon sees domestic nat gas sources as a valuable transition fuel, perhaps a decade out, but that does not lead to the conclusion that nat gas prices are going to soar. Whatever major sources of energy America uses as a country have always been cheap and readily accessible – something I call “Say’s Law of Natural Gas.” Say’s Law, the idea that supply creates its own demand, means that the over-supply of natural gas at present is keeping prices low, but it will eventually lead to incremental new demand for the fuel, and the friction costs of switching fuel sources will lead to future price inelastic demand for nat gas.
The better comparison than oil vs. nat gas could be the implications for the integrated major business model. Exxon Mobil is proverbially doubling down on that concept with this acquisition, while a company like ConocoPhillips (COP) has stated that the former advantages of the integrated major model are no longer attractive, and it will slowly be shrinking in size. By investing in new reserves rather than buying back its own, Exxon is casting its lot that the status quo – fossil fuels being essential to American energy consumption – will persist for some time.
Other potential nat gas-producing acquisition targets have been fairly well hashed out – Chesapeke (CHK), Devon (DVN), Anadarko (APC), EnCana (ECA), Range Resources (RRC), Petrohawk (HK), Ultra (UPL), and Southwestern (SWN). Funds I co-manage own UPL, as well as XOM.
Dubai, Risk Assets, and the Liquidity Illusion Redux
Is there a way to make money, on the long or short side, from the quasi-sovereign debt issues in Dubai? Because the situation has already broken and isn’t generally accessible to individual investors, there’s a more worthwhile path to consider than trying to short a bank with UAE exposure (which tends to be relatively small in concentration for global banks) – and that’s understanding the signals being sent.
In general, it’s a sharp reminder that credit risk is real, especially unconventional investments in emerging markets. That should give pause to the risk asset rally that has dominated discussion for the majority of 2009, an event that has clouded the perceptions of what safe haven assets are. What bounced on the news? The U.S. dollar (UUP). What “safe haven” sold off? Gold (GLD). I understand the appeal of gold, but am skeptical of its ability to be a true store of value in times of crisis. The “hard sell” many goldbugs, and TV advertisements, give on the usefulness of the metal should be another red flag; good assets are bought and not sold.
The bullet-point story isn’t always accurate – consider liquidity, which is the de facto explanation for the surge in asset prices this year. The last time we heard about an overabundance of liquidity was 2007, when the private equity bubble topped out; one year later we had a liquidity crisis. Liquidity disappears in times of market stress, and the source or cause of stress is not predictable. In other words, liquidity does not create a sustainable rally, it’s a short-term technical factor… and although it might be a significant driver of trading, it is imprudent to rely on liquidity to continue driving prices higher, just as it would be to expect a marginal company to always have access to financing.
The Dubai story, at its heart, is one of uneconomical activity. We are guilty of our fair share of that in America, but Dubai’s existence was predicated on the ability to defy nature through aggressive debt-financed building, and it seems the costs have not been fully considered. I’m not sure what value lies in Dubai, because it has higher structural costs than other locations because of its geography and environment, but combining poor economics with a lack of respect for shareholder rights is a recipe for disaster – understand what you own, and make sure your ownership rights are secure.
Quality Large-Cap Retail is Best Portfolio Stocking Stuffer
Christmas is coming, and that means two sets of flurries are on the horizon – snow and retail news. Now that the aftershocks of the 2008 financial collapse have had time to set in, this year will be a test to see how resilient consumers are in spending for the holidays. Retailers, for their part, have been preparing by slimming down; most are carrying record low levels of inventories to avoid the need for post-rush markdowns. But as the fundamentals are uncertain, retail stocks have been rallying with the rest of the market – the Retail HOLDRs ETF (RTH) is less than 13% off its all-time high in July 2007, led by large allocations to Wal-Mart (WMT), Home Depot (HD), Target (TGT), and Walgreen’s (WAG).
Large-cap, diversified retailers lack the appeal of a growing niche apparel company, for instance, but in many cases they look to be safer bets with decent upside in a market that’s looking increasingly overextended. Wal-Mart and Home Depot attract my attention with relatively stronger moats for the retail industry and a consistent history of posting ROEs in the double-digits, and although they trade at higher earnings multiples than a company like GameStop (GME), I believe the sustainability of earnings favors the stodgier retailers. Earlier this year, investment funds that I co-manage (BCIC) sold GameStop stock on a belief that it is a value trap with illusory single-digit forward earnings multiples, as competition for video game sales increases, and video game makers look to connect directly with consumers and disintermediate brick-and-mortar stores. That stock is down 15% in the last week and is close to its 52-week low, one of the exceptions in a market that is making new 52-week highs.
There will be plenty of news on short-term sales trends involving consumer spending in the month of December, but there might be limited comparability with past years because the paradigm may have shifted in this newly frugal economy. If you’re going to play with retail stocks, then, stay high quality and go with solidly entrenched middlemen. Bed Bath & Beyond (BBBY) is one retailer more off the beaten path that also fits that definition – a differentiated inventory strategy, improved pricing power after the Linens ‘n Things bankruptcy, and a modest valuation – and I’m happy BCIC owns it.
On the apparel front, Goldman Sachs (GS) analysts believe the sweater will be the go-to gift of 2009; while apparel is admittedly not my specialty, BCIC recently established a position in Ralph Lauren (RL).
Over-Analyzing Buffett: Railroads Are Simple
Much has been made of Warren Buffett’s mega-deal for Burlington Northern Sante Fe (BNI). It is the largest deal of his lifetime, and actuarially speaking, unlikely to be surpassed – in other words, it is likely the final significant brush stroke Buffett makes on his portrait that is Berkshire Hathaway (BRK-A, BRK-B). When the greatest investor of our time makes such a statement, it bears watching, but with the caveat that too much can easily be made of a relatively straightforward transaction. Railroads have three major favorable traits:
1. Structural cost advantages compared to other forms of transportation
2. Rail track infrastructure is a network that cannot be duplicated
3. Tax advantaged status
#1 relates directly to the relative cost of transporting goods via rail compared to freight truck. While this is a generally incomplete comparison since the capital expenditures are radically different, it’s true that rail is much more efficient at present energy prices – and that gap only increases as fuel becomes more costly.
#2 is the reason Buffett would buy a company like Burlington Northern, as opposed to a trucking or shipping company – i.e. DryShips (DRYS). Burlington Northern has localized monopolies in areas its track infrastructure reaches, which amounts to a toll on the movement of goods; truckers or shippers only operate the physical transport vessels and have no claim on the medium they move through, making them inherently inferior businesses.
#3 is an overlooked item, in my opinion. Smaller railroads are heavily subsidized with tax credits and the like for investing in their networks, and although this helps Burlington Northern less, it’s one small positive edge they have. The real kicker, though, is that the underlying assets creating value for Burlington Northern (again, track infrastructure) are perpetually carried on the books at a discount to market value, and the appreciation of those assets is not recognized for tax purposes. This creates a permanent carry trade where non-replicable assets (see #2) can grow steadily in value, all tax-free, for an indefinite time period. So although many will point to the seemingly-high (for a “value investor”) earnings multiple Buffett paid, the value of Burlington Northern isn’t in 2010 earnings estimates, it’s in the value of a unique business with a non-replicable asset base.
My largest personal holding is a small-cap railroad stock that I feel is a chronic underperformer, but one with little downside in its present form and significant upside in a turnaround scenario. My bet is that railroads will be a good business that creates value for customers and shareholders, and it’s comforting to have one of the world’s wisest evaluators of businesses betting in the same sector I am.
Bank Bailout Report Card: What Are We Grading?
Earlier this week, I gave a presentation on Merrill Lynch, the differences between it and other investment banks, and why Bank of America’s (BAC) acquisition of the company in its dying days of September 2008 was not necessarily a bad idea. While a tough position to argue on its face, there are actually many reasons justifying such a deal – combining an unstable investment bank with a depository institution is effectively what the Federal Reserve did the next week in allowing Morgan Stanley (MS) and Goldman Sachs (GS) to become bank holding companies, for example. In the short-term, however, a world of rising credit losses will make any deal of that type look to be a poor move, however. Yet basing a decision purely on hindsight-rich outcome is analogous to saying an energy E&P company is poorly run if they start drilling new wells only to see crude prices fall.
Why do I say this? Perspectives can shift quickly, and create unfair comparisons when time horizons or end goals differ. With the bankruptcy filing of CIT Group (CIT), the government is opening itself to questions about the effectiveness of TARP, as the $2.3 billion preferred investment in CIT is in great jeopardy. The purpose of TARP, however, was not to maximize the government’s return on investment; it was to stabilize the financial system (using kind words) or save it from collapse (more bluntly) with a minimum of losses. TARP was a large check the government had to write to buy time, and it definitely succeeded in accomplishing that.
In the last month, I’ve been asked numerous times for thoughts on the financial crisis fallout, having had a year to reflect and see how things have played out. The simple fact that we’re having discussions about the banking system a year later means that TARP achieved its purpose, and the bankruptcy of a relatively smaller financing company like CIT Group doesn’t seem to change that. With the benefit of extra time to assess the choices of the Treasury Department, alternative solutions could surely have been devised that would have rewarded the U.S. government more – but again, that was not the purpose. Though I feel TARP was a good first step toward stemming the crisis of confidence that (rightly or wrongly) gripped the markets in the fall of 2008, the lack of follow-through to reforming the financial system and minimizing future systemic risks is a disappointment. That, however, is a knock against the politicalization of everything Wall Street that came afterwards, not TARP itself.
See here for more discussion on this and other topics.
Why Solar Stocks Are a Long-Term Sell
Amid a number of earnings releases from leading solar companies First Solar (FSLR), Sunpower (SPWRA), and MEMC Electronics (WFR), there is plenty of news to digest on such a dynamic sector. Regardless of how this particular quarter’s numbers pan out, I believe one inevitable truth will eventually assert itself: solar stocks are nothing special.
Solar stocks generally trade at generous multiples to book and EBITDA, and some of them seem to deserve premiums because of high profitability numbers. First Solar, for instance, has operating margins just shy of 40%; MEMC has operating margins of 25%. But such situations rarely persist, and given the industry value chain the solar companies operate within, it will be almost impossible for the great number of competitors to all come out ahead.
Although solar stocks often carry a sexy perception of growth and technology, the reality remains that the companies are beholden to electricity producers – namely regulated utility companies domestically, and either similarly regulated utilities or government-backed enterprises globally. In other words, the customer base for solar companies consist of utilities with limited ability to generate profits or governments with enormous bargaining power. Those are conditions that lead to a vicious price war that undermines profitability for the entire sector, not consistent growth with steady bottom-line results to match.
My view of solar stocks may be different than many market participants, but the interest and amount of capital that has followed the green energy space is a sign in itself that the industry as a whole is not likely to have excellent potential in the near future. In general, a good strategy in these situations is to sell when speculation becomes rampant, but that’s not the case at present – most of the stocks are down significantly from their summer highs, and the recent plunge is only a continuation of that trend.