Where’s The Juice?

Financials, despite their drastic dividend cuts after the crash, are still big parts of people’s portfolios. John Schmitz of Bahl & Gaynor in Cincinnati, Ohio, says the banking sector has had a dividend growth resurgence of sorts after its 2008 cuts, but the yields are still below where they were. “You also have more of a regulatory issue with their growth prospects because of capital requirements, payout ratio levels. However, they are better situated than they were 10 years ago. They have better capital, they have better balance sheets, they have better loan quality.”

Besides that, banks will benefit if interest rates go up—as they will, inexorably from the subzero troughs they’re in now.

Ben Kirby, the co-portfolio manager of the Thornburg Investment Income Builder Fund, says dividends around the world are increasing and more companies are paying them, seeing them as an attractive way for companies to boost their stock price, in some cases by using debt to fund it. The Thornburg fund is a global portfolio that buys stocks and bonds to build income, but bonds have fallen from a quarter of the fund to about 9% because of their lower income. That’s put a focus on dividend payers. The fund is looking to companies with ample free cash flow and willingness to return it to shareholders.

“By region, we’re more optimistic on Europe than the U.S. Valuations in the U.S. are relatively high, are relatively stretched.” Emerging markets make up 15% of the fund. (The U.S. makes up 50%.)
 
Different Strokes
Not everyone plays yield the same way.  “There are only two things with certainty that you can value, in our view,” says Mark Eveans, president and CIO of Meritage Portfolio Management. “One is sales. The second thing is dividends. They are a hard cash payment. What we would say is that earnings are kind of a guess. Dividends are a certainty.”

The managers at Meritage, a boutique institutional manager with $1.5 billion, start with finding the best yields for its 12-year-old “Yield Focus” strategy, in which it runs about $300 million. A big component of the view is a company’s free cash flow. The aim of the yield focus strategy is to earn at least 60% to 70% of the expected equity return over 10 to 12 years in cash payments. The minimum yield the firm looks for in a candidate company is 3.5%, which boils down to about 1,000 companies from its 7,000-company database, which then get boiled down further to 45 to 60 portfolio picks.

“About 65% of those exist in United States companies and 35% internationally,” says Eveans. About a third of the portfolio comprises things other than common stocks: REITs, LPs, MLPs, convertible and straight preferreds and business development companies. Though the Yield Focus group is just one of the firm’s value strategies, Eveans says it’s been the best performing.

“We want to earn twice what the S&P pays or any other major market index or for that matter, most of the dividend strategies available on Wall Street; we want to earn twice what they’re paying right up front. That’s a 200 to 300-basis-point advantage that we go into each and every year with in terms of earning return.” Financials, including REITs, make up about 31% of the portfolio, while energy makes up 13% and utilities make up 11%. The company has made a major shift to international within common stocks, where it sees more opportunities with value and yield.

One area he says is starting to look tempting is European banks. Because of regulatory hamstringing, they have been making fewer bad loans and they are overcapitalized, Eveans says. That has led to free cash flow excess. Meanwhile, those banks’ valuations are still good because of the bad economic environment in Europe. He also sees good payers among banks in Canada and Australia, which didn’t have the same financial contretemps the U.S. and Europe did, and which are well capitalized and able to grow their dividends.

National Australia Bank (whose gross dividend yield is 8.83%) and Canadian Imperial Bank of Commerce (with a 4.3% yield) both fall into the top 15 holdings in Meritage’s Yield-Focus Equity fund.

Kirby at Thornburg is circumspect about those stocks that just focus on high yields. Those that pay 5%, 6% over time are probably going to behave more like bonds, he says. “If your companies aren’t growing, the stocks are going to behave and they are going to look very much like bonds. So a stock that’s paying 5% but not growing looks an awful lot like a bond paying 5% and in that case you don’t really have the ability to preserve purchasing power over time.”