- After a multi-year bull run for stocks that has created relatively rich valuations, we would not be surprised to see a pullback in the near term.
- Failure to pass a health care bill has created uncertainty in the market over whether tax reform will be passed or infrastructure spending approved.
- Though the rate of dividend increases has slowed recently, we are confident in continued dividend growth for our portfolio companies.
Market Overview and Outlook
When we began working in portfolio management, we were excited by the idea that everything happening in the world was reflected in the prices that went by on the ticker tape - economic data, war, peace, elections, and the anticipation of an almost infinite number of factors. The past several months have been astonishing to watch. Beginning with a major surprise in the presidential election and a massive rally in the stock market, we have tried to understand the behavior of participants. We think it is fair to say the country has seen events unfold in ways that would have previously been hard to imagine.
Can this market really be factoring in all of the things that have occurred - possible Russian meddling in the election, charges of wiretapping of the president, North Korea, border walls, threats of trade disputes, intemperate tweets? Or have emotions overtaken logic? This grand bull market began during the depths of despair in the economy. With an economic recovery seemingly improving, it is fair to wonder whether a market that is, at best, fully valued can continue its rapid advance.
Prior to the election, economic recovery and stock market gains were aided, and maybe even caused, by ultra-low interest rates and easy credit. From 2009-2015, dividend yields on stocks exceeded the interest rates available on low risk bonds for the first time since the 1950s.
Then came the election and an abrupt turnaround in the mindset of investors, as the focus turned to the prospects for much stronger economic growth and higher corporate earnings. The thinking became that the combination of fewer regulations, sharply lower taxes, repatriation of foreign profits, and massive infrastructure spending would justify the higher valuations being placed on stocks.
In a rather bizarre turn of events, the attempt to repeal and replace the Affordable Care Act was beaten down. A program that few understand fully was being offered to replace a program that while equally confusing, had put more people under health care coverage.
The question now becomes what happens to factors that kept the markets bubbling?
Over the past eight years, price-to-earnings (P/E) ratios have almost doubled from the nadir of 2009. Just since the election, P/E ratios have expanded by several percentage points. Though economic activity had begun to improve, the bet by participants has been that the factors listed above would give a huge boost to earnings that would be more than enough to offset the likely rise in interest rates.
With the collapse of the health care bill, a huge question mark will hang over an expensive market. No one can be sure now that promised tax reform will be passed, or infrastructure spending will be approved. The large Republican majority clearly is not going to be bullied by the president. While Congressional gridlock was favored by many over the past decade, expectations for movement on tax cuts and reform have gotten very high.
Valuations for most stocks seem rich compared to historical levels. Very low interest rates have abetted those valuations. We simply don’t know how long investors will drink the Kool-Aid of the grand benefits of potential changes in entrenched political positions. If stocks were trading at depressed levels it would be a non-issue. But the bull market that fed on easy money is likely to demand proof now that a potential smooth ride through Congress has turned bumpy.
In the meantime, the dividend train keeps rolling, as so many companies have continued to do right by investors. Exhibit 1 lists the dividend increases announced by portfolio companies in the first quarter. Though the rate of dividend increases has slowed a bit, we are confident in continued increases going forward.
Exhibit 1: First Quarter Dividend Increases
|Company||Amount of Increase|
|United Parcel Service||6.4%|
|Brookfield Renewable Partners||5.1%|
|Brookfield Renewable Partners (Canada)||5.1%|
|Brookfield Infrastructure Partners||10.7%|
We are trying to make sense of the astounding events occurring almost daily. Thus far, investors have not shown an interest in aggressive stock selling. We will continue to hold our best companies, understanding that the results of the first three months of the year are unlikely to be translated into an annual rate of return. It has been a great run in the market for several years; a rest or pullback would not be surprising. Interest rates, though up from pre-election levels, remain at rates that are not likely to draw money from stocks, or threaten economic recovery. We have lived through multiple stock cycles and believe firmly that patience, balanced by good research, is a winning formula. In the current rapidly changing environment, we continue our preference for those companies providing a measure of stability in cash flows and dividends.
The Dividend Strategy portfolio underperformed its S&P 500 Index benchmark during the first quarter. On an absolute basis, the Strategy had gains in nine 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 information technology (IT) and consumer staples sectors while the main detractors came from the energy sector.
On a relative basis, overall stock selection and sector allocation detracted from performance for the quarter. In particular, an underweight in the IT sector as well as stock selection in the IT, industrials and consumer discretionary sectors hurt relative results. On the positive side, an underweight in the energy sector and stock selection in the real estate sector aided relative performance.
On an individual stock basis, positions in Apple, Brookfield Infrastructure Partners, American Tower, Kimberly-Clark and Home Depot were the greatest contributors to absolute returns in the first quarter. The largest detractors included Schlumberger, General Electric, Verizon, Exxon Mobil and United Parcel Service.
During the first quarter we established new positions in Williams Companies in the energy sector, Visa and Mastercard in the IT sector, General Motors in the consumer discretionary sector and Pentair in the industrials sector. The Strategy also received shares of Enbridge in the energy sector following the completion of its acquisition of existing holding Spectra Energy. We sold positions in General Electric in the industrials sector, CenterPoint Energy in the utilities sector and IBM in the IT sector.
"It is fair to wonder whether a market that is, at best, fully valued can continue its rapid advance."
Visa and Mastercard are high-quality franchises that command dominant positions in the oligopolistic electronic payments market. Both maintain solid organic revenue growth and very high incremental margins and returns on capital, leading to outstanding long-term profitability. Dividends of both companies are growing consistently with earnings. General Motors, meanwhile, offers an attractive 4% dividend yield and trades at a low multiple of earnings. While large changes are affecting the auto industry - electric cars, autonomous cars, ride-sharing - we think the current share price reflects much of those uncertainties. Over the last many years, GM has righted its ship operationally and financially and is a far stronger company than in the past. The company is aggressively buying back its stock and maintains a low payout ratio, giving it room to continue to grow its dividend.
Williams is a high-quality energy infrastructure company well positioned to support natural gas production. The company’s recent corporate simplification has reduced its cost of capital and set it up for long-term success. The combination of Spectra and Enbridge creates the largest energy infrastructure firm in North America, with a leadership position in oil transport in Canada and natural gas transport in the U.S. We are confident in holding shares of Enbridge as it is a well-capitalized company with a strong, stable growth outlook. Pentair provides filtration, equipment protection and heat tracing technologies for the energy, industrial, construction and food and beverage markets. The company recently announced the sale of its valves and controls business, which should lead to an increased focus on its core competencies and allow it to fortify its balance sheet and buy back stock. Pentair is attractively valued and should also benefit from the involvement of an activist investor in the stock.
We sold shares of General Electric following recent results that failed to meet our expectations as we believe the valuation is no longer attractive compared to other opportunities. IBM shares appreciated significantly in a short period, making the risk-reward less compelling. Texas-based utility CenterPoint Energy has also enjoyed a strong run, causing its earnings multiple to expand and making it less attractive going forward.