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Commentary

Dividend Strategy

Fourth Quarter 2016

Key Takeaways
  • Financial markets are projecting that tax reform, less regulation and greater federal spending will lead to higher corporate earnings and much stronger growth.
  • A spike in bond yields has begun to negate the low interest rate environment that has supported stocks since the Great Recession.
  • Holding a diversified portfolio of high-quality dividend growers should help us navigate a market at elevated valuation levels.
Market Overview and Outlook

Our last commentary glibly stated that the more things change, the more they stay the same. Well, the election and the markets surely proved that wrong! In our year-end commentary last December, we predicted a very modest gain at best for 2016. We said that in order for the market to move sharply higher, two things needed to happen. First, oil had to reverse its drastic decline, as it was hurting too many industries. Second, we needed to see meaningful rises in corporate earnings, whereas we were expecting only modest increases.

The overall market was pretty much on course for what we had thought, with our group of dividend payers tacking on solid gains, until the election of Donald Trump caused a new belief system to set in – that large fiscal stimulus (government spending) and tax reform would ignite growth. Many stocks exploded to the upside, while more conservative stocks that had been used by many as bond proxies lagged. At the same time, rates on the 10-year Treasury note, which had been the main prop for the markets, shot up.

The topic that seems to be on most investors’ minds, as well as the general population, is what will President Trump mean for the markets and the economy? In truth, the answer is that no one knows. Because Trump is unpredictable, one can make only guesses. Clearly, the financial markets have bought into the scenario that corporate tax cuts and reform, together with fewer regulations and more federal spending, will lead to higher corporate earnings and much stronger growth. From skepticism and despair last January, the markets are now reflecting a great deal of optimism. Whether such optimism is warranted will play out over the next year.

If corporate tax cuts take hold, earnings will rise much more than previously anticipated. Repatriation of overseas earnings will provide a boost to cash available for corporate uses such as reinvestment, dividends and share repurchases. These factors will provide support for stock prices and might not send interest rates much higher.

However, there are a few caution signs. First, our overall bullish thesis since 2009 for stocks, and dividend payers in particular, was based on the fact that for the first time in 60 years, the yield on stocks was materially higher than the yield on bonds – a low risk alternative. While interest rates are still low, the recent spike in yields on the 10-year Treasury note to 2.50%, coupled with advancing stock prices, has negated that startling advantage. With the economy having a tepid recovery since the Great Recession, we attribute much of the advance in stocks over the past eight years to ultra-low interest rates and the advantage of stock valuations. As recently as September, we wrote that the main support for stocks was ultra-low rates which left returns on alternative investments comparatively lean.

We continue to advocate holding and buying dividend growers. Yet whereas three years ago, we proclaimed a “Golden Age” of dividends, we now believe that dividend growth in most companies will slow from the teens to mid-single digits – still worthy but less compelling. After dividend payout ratios declined in the 1990s, the past few years have been characterized by strong increases – enough to bring back the percentage of profits paid out to pre-1990 levels. More normal increases are in store as dividend increases will track only earnings gains.

Manufacturing jobs in the U.S. have been in decline since World War II. The difficulty in blaming our domestic companies for shipping jobs overseas is that the biggest job killers in this economy are applications from technology. The huge job growth from the computer and communications industries in the 1990s has given way to those amazing technologies doing the work by a few that used to require many. Automation and artificial intelligence are difficult foes on which to declare war. Regrettably, there are no easy answers to the manufacturing issues.

 

"Repatriation of overseas earnings will provide a boost to cash available for corporate uses such as reinvestment, dividends and share repurchases."

 

Things to worry about that could bite the market include import tariffs – a disaster waiting to happen. Also, why pick a fight with China, whose backing we need in world affairs, who is a huge trade partner and holds massive sums of our Treasury paper? A strong dollar due to rising interest rates will negatively affect profits. Companies that export will face stiffer competition and fewer orders. Companies that import will benefit, as will consumers.

It would be great if the shake-up in politics actually led to better and more plentiful jobs. Clearly, enough of the country wanted change and our cliché about the more things change, the more they stay the same is likely to be rattled. For the sake of the U.S. economy and for our country, let’s hope the changes are for the better.

Currently, the financial markets have chosen to focus on potential upside, with a seeming lack of interest in risks. There are reasons to hope that the economy will see large benefits from taxes and stimulus, but with markets at hefty valuation levels, we have trouble buying into the hype. We will stick with our policy of holding a diversified portfolio that emphasizes excellent business models and friendly shareholder actions.

Portfolio Highlights

The Dividend Strategy portfolio outperformed its S&P 500 Index benchmark during the fourth quarter. On an absolute basis, the Strategy had gains in seven of the sectors in which it was invested for the quarter (out of 11 sectors total). The main contributors to Strategy performance came from the financials sector while the main detractors came from the consumer staples sector.

On a relative basis, overall sector allocation contributed to performance but was partially offset by stock selection decisions. In particular, underweights in the health care and information technology (IT) sectors, an overweight in financials and stock selection in the consumer discretionary and IT sectors drove results. On the negative side, stock selection in the financials, consumer staples and energy sector and an overweight in consumer staples hurt relative performance.

On an individual stock basis, positions in Time Warner in the consumer discretionary sector as well as Wells Fargo, JPMorgan Chase, Berkshire Hathaway and MetLife in the financials sector were the greatest contributors to absolute returns in the fourth quarter. The largest detractors included Nestle, Anheuser-Busch InBev and Kimberly-Clark in the consumer staples sector, Astrazeneca in the health care sector and American Tower in the real estate sector.

During the fourth quarter we established new positions in Bank of America and BlackRock in the financials sector, IBM in the IT sector and Lamb Weston Holdings in the consumer staples sector. We also sold positions in C.H. Robinson Worldwide in the industrials sector and Astrazeneca in the health care sector.

The Strategy has never had much exposure to the money center banks, but rising interest rates, the prospect for easing regulatory burdens under the Trump administration and reasonable valuations make the sector more attractive. Bank of America, in particular, is the most rate-sensitive money center bank and trades at a lower multiple than rivals. BlackRock is the largest asset manager in the world, with a well-diversified set of products across equity and fixed income asset classes and active and passive investment approaches. It runs a high-margin, high-return business and we were able to purchase shares on short-term weakness.

IBM has a strong balance sheet that it has used in the past several years to fund acquisitions in emerging growth areas. The company generates ample free cash flow, which is improving as it realizes higher cost savings from recent restructurings. In our view, the company is on solid financial footing and the stock offers an attractive current yield with the potential to see dividend growth over time. Lamb Weston is a leading player in the frozen potato market that was spun off from ConAgra Foods in November. The company has a strong track record of delivering strong top-line growth and solid margins and we were able to purchase shares at a discount to peers.

We sold shares of Astrazeneca as the health care sector has come under pressure. The company, a leading player in the area of immunotherapy, has fallen in sympathy after a negative Phase III trial for a competitor offering a similar treatment and disappointing third-quarter earnings. C.H. Robinson maintains a leadership position in matching truck drivers with freight clients, however the fundamentals of the trucking business remain challenging and we believe other areas of the market offer better opportunities.

Hersh Cohen

Co-Chief Investment Officer, Portfolio Manager
48 Years experience
48 Years at ClearBridge

Michael Clarfeld, CFA

Portfolio Manager
17 Years experience
11 Years at ClearBridge

Peter Vanderlee, CFA

Portfolio Manager
18 Years experience
18 Years at ClearBridge

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  • All opinions and data included in this commentary are as of December 31, 2016 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information. 

  • Past performance is no guarantee of future results.