Tuesday, April 21, 2015

The Value of Royal Blue Chip Stocks

How do you gain the benefits of investing in stocks while minimizing the inherent risk of investing?  Enter Royal Blue chip stocks. 

Royal Blue chip stocks are one of the pillars of our Cornerstone portfolio.  They are the AA and AAA-rated companies that make products the world cannot function without.  Many of them produce billions in cash flow, which they use to consistently grow their dividends year-after-year.

Royal Blue chip stocks are not particularly exciting.  When the overall market is up 15-20% per year, we might expect the average Royal Blue chip stock to be up more like 8-10%.  In other words, owning Royal Blue chip stocks will drag down performance in a bull market like the one we’ve seen over the past 6 years.   

So why own these stocks?

Less Price Volatility

Royal Blue chip stock prices are far less volatile than the average stock.  In a bull market, this low volatility means underperforming the index.  Take Procter & Gamble (PG), for example. Since the beginning of 2013, PG's price is up 23% compared to 50% for the S&P 500.  In a bear market, however, Royal Blue chip stocks act like parachutes.  In the second half of 2008, the S&P 500 was down by over 35%.  PG, on the other hand, was down by less than 7%.

Royal Blue chip stocks are the reason our Cornerstone portfolio was down by far less than the S&P 500 in the 2008-09 financial crisis.  They aren’t exciting in bull markets, but when the inevitable bad spell hits - you are glad that you own them.

Low Business Risk

The chances that a Royal Blue chip company could go out of business is extremely slim.   Not only are they some of the most financially secure companies on Earth, but their products are staple to our lives.  These companies aren’t going away anytime soon.

Steady Dividends

Most Royal Blue chip stocks have paid and grown their dividends every year for decades.  When your portfolio contains Royal Blue chip dividend growth stocks, your portfolio continues to produce a growing stream of dividend income, regardless of what happens in the markets.

Stock prices have always been volatile. Our priorities for our clients’ portfolios are: security, income and growth - in that order.  Royal Blue chips may drag down performance in bull markets, but they will always be a pillar of our Cornerstone portfolio.  History shows us that when the next bear market comes, Royal Blue chips should outperform the broader market.

Monday, April 13, 2015

Downshifting The Industrials

In today’s Investment Policy Committee (IPC) meeting, we focused on the sector weightings in our portfolio.  Industrial stocks were of particular interest.  The industrial sector faces several headwinds at this time.

1. Interest Rates

How can low interest rates be a headwind?  Our research shows that the relative performance of the Industrial sector is positively correlated to interest rates.  The chart below shows this relationship.

As you can see, 10-Year Interest Rate Yield (blue line) and Industrials Index relative to S&P 500 (orange line) move closely together.  This may not be immediately intuitive, but the relationship does make sense. 

When interest rates rise, that generally means the economic outlook is improving.  The Industrial sector is particularly sensitive to economic movements.  Therefore, an increase in interest rates indicates an improving economy, which is positive for industrials.

We believe interest rates will remain muted.  The industrial sector could underperform over the near-term, as a result.

2. Emerging markets

Many industrial companies have made huge investments in foreign economies, particularly emerging markets.  The decline in oil prices has really put a hurt on several foreign nations, particularly Brazil.  China’s economy has also slowed, which has not been favorable for the outlook of many industrials.

3. Energy prices

Low commodity prices represent another headwind.  Oil prices do not directly impact industrials, however, many of them manufacture supplies for the energy producers.  As the investment budgets for energy companies dry up, it means less demand for their suppliers.  If oil prices remain low, the energy divisions of many industrials will also suffer.

4. Competitiveness

Currency issues impact the industrial stocks in two ways:

1. Earnings translated back into U.S. dollars are worth 20% less than they were 6 months ago.  The market can overlook that, as we will explain more in coming weeks.  

2. Industrial companies who sell to foreign nations are much less competitive when the dollar strengthens.  That hurts competitiveness of U.S. suppliers.

What does it mean for you?

We continue to like the industrial sector for the long-term, but these headwinds will not go away in the near-term.  As a result, we have decided that it is prudent to cut back your exposure to the Industrial sector until these headwinds subside.

Wednesday, April 01, 2015

Why Are Stocks So Volatile?

Stock market volatility has increased dramatically over the last six months. Many commentators are saying the increased volatility is a negative sign for stock performance through the remainder of the year and perhaps beyond.  As usual they might be right, and they might be wrong.  Before we give you our view, let’s look at what we believe are the three main drivers of the increased volatility and see how they are trending.

1. Uncertainty about the timing of the Fed rate hike
2. Earnings worries
3. Valuation concerns

The Fed: Don’t fight the Fed, don’t fight the Fed, don’t fight the Fed.  As any seasoned investor knows, these are the first three rules of investing.  The Fed has incredible power to impose its will on the markets.  Back in the days prior to the Tech wreck, commentators were saying that the Fed’s power to rein in the technology stocks was dramatically reduced because most of these companies used very little debt.  The Fed raised its Fed Funds rate seven times before Tech stocks crumbled, but crumble they did.  Again in 2009, the chorus of naysayers was deafening in its assertion that the subprime crisis was too big for the Fed.  Today the S&P 500 is approximately 300% higher than its low in March of 2009.  In our judgement, the Fed can do what it wants.  So the single most important question facing investors is, “What does the Fed want?”

We believe the Fed has no intentions of causing a big sell off in stocks. Indeed, Quantitative Easing was all about pushing investors out of riskless securities and into riskier assets, including stocks.  Why would the Fed have moved heaven and earth over the last six years to avoid a deflationary mindset from setting in with banks and investors, to toss it all away and send stocks into a tailspin?  That is an absolute recipe for recession, and they know it.   

The Fed wants to keep a lid on inflation and stimulate job growth, yet it also wants to avoid both another 1995-1999 stock market melt-up and a 2000-2002 meltdown.  Our Macro Team believes that the lessons of the 1990s are still very much alive in the minds of the Fed.  To accomplish their purposes, they are likely to do a lot of talking but very little acting.  We believe Fed Chair Janet Yellen said as much in her speech last Friday.  The uncertainty about what the Fed will do is not going away, yet we believe the odds of the Fed slamming on the brakes are extremely low.  They will increase rates modestly at some point, but we do not forecast a long string of hikes that would freeze the markets or cause a big sell off.

Earnings: Earnings growth for the S&P 500 over the last 12 months has been a paltry 4.3%.  During this same time, stock prices have risen nearly 13%.  At the beginning of 2014, we said that stocks were about fairly valued, so the returns for the year would likely be about the same as earnings and dividend growth.  A 13% price return on earnings growth of about one-third of that is front and center in the minds of every investment firm we know of.  The market has given the weak earnings a pass so far because of two unusual events:

1. The dollar has risen by as much as 20% versus the currencies of other developed countries.  Since S&P 500 companies generate nearly 50% of their revenues outside the U.S, they have had to absorb currency losses for the last four quarters.  These currency translation losses have significantly reduced reported earnings.  This trend cannot continue indefinitely.

2. The entire Energy sector took a huge earnings hit in the fourth quarter of 2014 and will again in the first quarter of 2015.   Since the Energy sector represents nearly 10% of the S&P 500, it has also produced a drag on corporate earnings.  Once oil prices reach a bottom, this too will cease to be a headwind.

The good news here, which gets almost no attention in the media, is that S&P 500 dividends increased by over 13% during the last 12 months.  We consider that an important signal that corporate America believes the two headwinds hurting earnings are temporary.

Valuation:  If prices rose in 2014 by 13% and earnings grew by only 4.3%, then the price-to-earnings (P/E) multiple expanded.  Indeed, the P/E multiple now stands at nearly 18 times earnings, which is the highest level since 2007. Stocks are not cheap from a P/E perspective, which worries a lot of investors. We have modeled P/Es going back to the 1920s and we find there is no such thing as a “normal” P/E ratio.  

Our research shows that P/Es are inversely correlated with inflation.  In high inflation periods, P/E ratios have almost always been low and high in low inflation eras.  Think of it this way:  If we divide earnings by price, we produce something called Earnings Yield.  Earnings Yield is stated as a percentage.  It is essentially a computation that shows how much a company’s earnings produce as a percentage of it price.  This percentage can then be compared to bonds, inflation, or other stocks to determine how good of a deal you are getting.  This is how an investor like Warren Buffett determines if Heinz or Kraft is a good deal.

As we said before, the S&P 500 is currently selling for about 18 times earnings.  To convert this into an Earnings Yield, we divide 18 into 1 to see that the current level is 5.5%.  That means if Warren Buffet was interested in buying the whole S&P 500, he would earn a 5.5% total annual return based on the current earnings.  5.5% does not seem like a great return, but there are two important considerations.

1. How does that return compare to my other alternatives?

While 5.5% may not seem like much, it is terrific when compared to a short list of alternatives.  A five-year U.S. Treasury bond yields 1.3%, and a ten-year U.S. Treasury bond yields about 1.9%.  Thus, not counting any earnings growth that we may receive in the future, stocks would seem to be a good deal with an earnings yield much higher than bond yields.  

As we said earlier, our work has shown that Earnings Yields or P/Es are most highly correlated with inflation.  Today, the inflation figure that the Fed uses, the Personal Consumption Expenditure Deflator (PCE) stands at 1.1%.  We have found that the spread between Earnings Yield and the PCD over the last 50 years has averaged 3.4%.  By adding the current level of inflation of 1.1% to the average spread of 3.4%, we find that the model would suggest that the right level of Earnings Yield for today’s inflation level is 4.4%.  

So we can get back to how we normally talk about earnings and prices, let’s re-convert the predicted 4.4% Earnings Yield back to a P/E ratio.  A 4.4% Earnings Yield would equate to a P/E ratio of 22.7.  With stocks currently selling at 18 times earnings, our P/E finder model would say they are  cheap.

2. Is that return all we are likely to get?

The current earnings yield of 5.5% does not factor in any future earnings growth.  If the long-term growth of earnings approximates nominal GDP growth of 5% or 6%, the effective earnings yield for today’s investor would double once every 12-14 years.

In addition to P/E, we have another way of looking at market valuations.  As we have discussed over the years, we have a S&P 500 valuation model.  This is a statistical model that calculates the relationship between various factors including dividends, earnings, inflation, and interest rates.  According to that model, we are currently selling about 7% under where year-end 2015 data for the variables are now predicted to be.

Bottom Line

Uncertainties about many different factors have caused stocks to become more volatile.  We believe we will know a lot more about Fed actions and the outlook for future earnings beginning in August once the impact of big changes in currencies and oil prices are better understood.  Furthermore, valuation is not a problem according to both our P/E finder model and statistical S&P 500 model.  

The current market’s volatility will ultimately pass.  Based upon what we see, the path of least resistance for stocks is still up.  However, it will take a few more months before many of investor concerns will subside.  The best course for investors is to ignore market volatility and remain committed to building a stream of growing dividend income.