The Valuentum analyst team explains the difference between the adjusted Dividend Cushion ratio and its unadjusted counterpart. The success of the Dividend Growth Newsletter portfolio is covered, and Valuentum’s top 3 dividend growth ideas are unveiled. ~13 minutes.
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Kris Rosemann:
Hello and welcome to the Valuentum Securities podcast. My name is Kris Rosemann and with me today is Chris Araos and Brian Nelson, the president of equity research and ETF analysis here at Valuentum, and today we’re going to be discussing the Dividend Cushion ratio, the Dividend Growth Newsletter portfolio, and some of our favorite dividend ideas on the market today.
So Brian, if you could, let’s start by discussing the different Dividend Cushion ratio measurements we have on the Valuentum website. We have the raw, unadjusted Dividend Cushion ratio, and we have the adjusted Dividend Cushion ratio, and I think it can be confusing sometimes for investors to really understand the difference where we choose to distinguish between the two and why we choose to distinguish between the two for certain companies.
Brian Nelson, CFA:
That’s a great question, and I think it speaks to the dynamic nature of our research depending on various credit market and financial market decisions (conditions). The Dividend Cushion ratio has been a fantastic ratio for predicting dividend cuts, and its track record over the past 12 months alone, it is predicted a dividend cut at Kinder Morgan (KMI), Potash (POT), ConocoPhillips (COP), BHP (BHP), and the list goes on and on. Those are just a few bellwethers.
The Dividend Cushion ratio’s success emanates from its forward-looking nature and basis of free cash flow, and mapping that to a company’s cash dividends paid. We tend to be relatively debt-averse when it comes to identifying ideas, and companies that are financially-leveraged with a lot of debt tend to be weaker dividend payers than those that tend to have a lot of (net) cash — and that just makes sense. The more cash you have the more flexibility you have in paying (dividends), so this is a simple concept of the Dividend Cushion ratio embraces.
In terms of the difference between an (raw) unadjusted and an adjusted Dividend Cushion ratio — really what we’re after is the essence of capital-market access. Business models such as MLPs and real estate investment trusts tend to be revolving doors of capital-market access, meaning they’re issuing equity, raising debt pretty frequently for necessary reasons, and because of that, the adjusted Dividend Cushion ratio factors in our team’s assessment of whether that capital market access will continue into the future.
That’s a unique perspective that overlays the raw, unadjusted Dividend Cushion ratio for all other sectors and business models in our coverage, so the REITs and MLPs tend to have two different Dividend Cushion ratios — one being our assessment of the marketplace of credit markets tend to be open and the other based on whether capital-market access is tight, and you’ll see that there are two, often two, different answers to that question (for each REIT and MLP).
What we saw during the energy market collapse during 2015 was that when credit markets tightened, we saw a lot of dividend cuts in the energy space so that’s (in part) helps explain why we have two different Dividend Cushion ratios — to help identify risks under two different and unique market conditions for the same company.
Kris:
Wow, great. Very, very interesting stuff there Brian. Next, could you talk for a minute about our Dividend Growth Newsletter portfolio, how our returns have stacked up against our expectations, and maybe some of the considerations that go into how we manage the portfolio.
Brian:
Absolutely, that’s a great question. So the Dividend Growth Newsletter portfolio is a portfolio that is housed within the monthly Dividend Growth Newsletter that we deliver to members each month on the first of the month. The Dividend Growth Newsletter portfolio’s goal is to generate a high-single-digit annual return over rolling three to five-year periods. So far, the annualized returns have been well in excess of our target.
Part of that has been due to the strength of dividend-paying entities and them coming into favor, but also we think that a very in-depth cash-flow based valuation focus has allowed us to identify significantly undervalued companies — companies that have performed incredibly well from a capital appreciation standpoint. But most relevantly, the Dividend Cushion ratio has allowed us to avoid dividend cuts, holding companies that have cut their dividends while they’ve been in our portfolio.
So, for example, we held at ConocoPhillips in 2012, and when the Dividend Cushion ratio for ConocoPhillips fell significantly, flashing a warning of it having to cut its dividend…three years later when ConocoPhillips cut its dividend, its shares were substantially lower than when we removed it a number of years ago. The same story rings true with Rio Tinto (RIO) where the Dividend Cushion ratio flashed a very serious risk flag of the company, and we removed it well in advance its dividend cut.
We have had zero dividend cuts in the Dividend Growth Newsletter portfolio. Part of that is attributed to the talent of our team at Valuentum, but also how the methodology really focuses on what matters for dividends — and that’s the (net) cash of a company’s business and the leverage that it has on the books.
Chris Araos:
Post-recession, fixed-income investors have invested a significant amount of money into consistent dividend payers. This has resulted in a distinct difference in valuation between what an analyst would price the company and what the company’s stock is actually selling at — what is to prevent the bottom from falling out of this market?
Brian:
Mr. Araos, that’s a great question, and you’re speaking to the asset-flight dynamic of assets flowing out of fixed income due to the ultra-low interest rate environment into relatively higher-yielding, dividend-paying stocks. When I say higher-yielding, I’m talking about dividend-paying stocks that are paying 2%-3% relative to a 10-year Treasury that’s under 2% (at the time of this podcast), and so what has happened is a lot of asset flight from fixed income to capture that dividend (growth) yield.
A lot of great research centers on the benefits of dividend growth investing, and I think that has been the cause surrounding the asset flow into that strategy. I think there are a lot of concerns regarding the tipping point of when dividend-paying stocks, which are risky assets, when they start yielding below that of a risk-less asset like a Treasury bond. When that tipping point happens, I believe that we are going to see some significant selling pressure within dividend-paying equities. But remember these are good, strong companies, too, companies like Coca Cola (KO) and Clorox (CLX) and Procter & Gamble (PG).
So we’re not going to see, you know, a dot-com bust (equivalent); we’re not going to see a Financial Crisis, but we will see, in my view, a reversion to what I think are intrinsic values. Right now, the consumer staples sector is trading at nearly 20 times its forward earnings. It wouldn’t be surprising to me to see that revert back to 15 times, which doesn’t sound like a lot, but in the context of that kind of an adjustment, that could be a 25% adjustment. I think a lot of income investors may be really surprised if they saw their portfolios impaired by 25% on a normalized basis, and we know that the markets overshoot all the time.
Kris:
Great thanks. Can you speak to some of the holdings in our Dividend Growth Newsletter portfolio that you think present investors with the best opportunity to generate safe income that might not be as exposed to the dividend growth, the dividend cliff that you hinted at?
Brian:
Sure, well one thing I want to emphasize is that safe is a relative word. Nothing is safe when it comes to equity investing. There are just degrees of risk, so what we like to focus on is on the lower level degree of risk, and really…I think in assessing that (risk) comes from a good assessment of the balance sheet. One stock, in particular, that I wanted to emphasize as having one of the strongest balance sheets out there, and yes Apple (AAPL) does have a strong balance sheet, but one company that I think is equally strong is Microsoft (MSFT) — and while it has purchased LinkedIn (LNKD) and utilized a large portion of that cash position on its balance sheet, we think that its dividend growth years have a long runway of growth, and we continue to be optimistic about Microsoft’s dividend-paying years.
Another company that I think flies under the radar due to its questionable industry, and I think it catches a lot of flak because tobacco has been under attack more recently than decades past, but Altria (MO) is still one of our favorite income-oriented ideas and not only does the company cover its dividend with earnings–its payout ratio is 80% consistently on a non-GAAP basis–but it has significant pricing strength with respect to its product, and it has the ace-in-the-hole with its ownership stake AB-Inbev-SABMiller, which just recently tied the knot. That (stake) gives Altria significant financial flexibility; if it ever were to liquidate that position, the catalyst its dividend growth would be substantial.
Those are a couple ideas that have been staples of our Dividend Growth Newsletter portfolio, and I think have attributed to its significant strong performance, but you know I’d like to maybe ask the same question to you Kris — what might be you one of your favorite ideas in our Dividend Growth Newsletter portfolio?
Kris:
Sure, I think that Hasbro (HAS), the toy giant, is really an interesting consideration, and it has continued to transition to a licensing business model, as opposed to a physical toy maker, and in doing so, it has an asset-light business model that allows it to generate a high return on invested capital, and therefore its free cash flow conversion rate is very high, allowing it to cover its dividend payments relatively easily.
Its business continues to experience strong momentum its relationship with Disney (DIS), specifically with the Frozen franchise, and coming into the holiday season, it’s already showing some great momentum in its business this year, and we love its free-cash-flow coverage of its dividends, as I mentioned, its asset-light, high-ROIC licensing business model that it continues to transition to really sets it apart from some of the other more traditional operators in our coverage universe.
Hasbro is also a good example of something that we’ve encountered in this (currently) overheated market to a degree as its share price continues to run near the upper bound of our fair value range of the company. Many may question whether or not we’re going to remove our position, or a portion of the position in the company, as it grows closer and closer to that upper bound of our fair value range. Our reasoning at this point is that we want to retain equity exposure to as many high-quality names as we possibly can in this current market environment — as our cash position in the Dividend Growth Newsletter portfolio is already at 30% (at the time of this podcast) — and we view Hasbro as a high-quality equity name that we will continue to retain exposure to.
Brian:
That’s just a really, really great point. Hasbro is starting to get a little bit pricey, but when you look across the dividend-paying universe, there are a lot more companies that are far more expensive. If we had removed companies when they reached fair value (in this market), we would have lost significant potential outperformance from what we describe to be “letting our winners run,” and that has proven to be a core component of the Valuentum strategy, and that has worked out wonderfully both in the Dividend Growth Newsletter portfolio, as well as in the Best Ideas Newsletter portfolio.
Kris:
Great. Thanks for your time Brian, and please stay tuned for more updates on our Dividend Growth Newsletter portfolio and future podcasts.
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The Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio are not real money portfolios. Any performance, including that in the Nelson Exclusive publication, is hypothetical and does not represent actual trading. Past performance is not a guarantee of future results. Valuentum is an investment research publishing company.