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Commentary

Dividend Strategy

Second Quarter 2017

Key Takeaways
  • Better earnings, a weaker dollar and healthy merger & acquisition activity are currently driving stock performance.
  • The shale revolution has altered the dynamics of the energy industry, with the U.S. as a swing producer creating large excess supplies that have led to the latest decline in oil prices.
  • Political wrangling over health care reform seems to have created too many obstacles to fulfill prior hopes for meaningful tax and policy change. 
Market Overview and Outlook

We prefer to have a strong conviction on stocks and the markets.  However, we view this environment as one of very conflicting factors.  Stocks are highly priced on an absolute basis, but are likely the best available asset class in a world where nothing seems inexpensive.  Because interest rates are still very low, investors remain reluctant either to sell stocks or buy more bonds.  Indeed, flows to equities have picked up this year.  The question on our minds:  is the rising stock market correct about profits and economic growth, or are low interest rates and falling oil prices better barometers?

The list of factors with current or potential impact on financial markets can be summed up in a short list. Once again, oil is near the top of the list.  Are declining oil prices a symptom of problems for the economy?  Instead of conforming to consensus expectations of rising prices, crude oil has again taken a downturn.  As we noted a year and a half ago, predicting the correct price for oil is elusive, as it is determined by supply and demand, as opposed to having some intrinsic value. While not yet as severe as 2015-2016, the current decline triggers fears of credit losses and diminished profits for oil-related industries.  Additionally, overall capital expenditures from manufacturing companies will fall.  Employment in oil-producing states will be hurt.  High yield bonds connected to exploration companies have been hit.  We have pointed out that in past years, we would cheer lower prices, as they would diminish the money flowing to OPEC.  Inflationary pressures would abate and consumers would have more discretionary income.  The shale revolution has altered the dynamics.  The U.S. is now the “swing” producer, creating large excess supplies. For the time being, the negatives seem to be outweighing the benefits.  Another job creation area has been clean energy – solar, wind, geothermal.  Sharply lower energy prices create fewer incentives for development and use of alternatives.

So why are consumers not showing the benefits of lower gasoline and heating costs?  Two things come to mind: higher health care costs and a step up in savings rates.  Consumers received a wake-up call from the recession and where possible, seem to have increased the percentage of income saved for the future. As we see the U.S. savings rate continue to tick higher, there is an impact on discretionary spending. One exception is in home improvement sales, where homeowners add value to their primary asset. Savings still have room to climb though as over half of Americans say they could not afford $500 in unexpected expenses. Although the number of people saving more has improved over the last seven years, it is still off a very low base.  Evidence points to one third of the country that has only enough to cover six months of expenses.  Years of stagnant wages for most workers has exacerbated the problem.

 

"With the rising payouts we have seen, we believe that future dividend growth will more closely follow earnings growth."

 

The second factor impacting markets is the string of problems from retailers.  Jobs are being lost as stores close.  E-commerce has given shoppers reasons to not travel to malls and other stores.  The impact is still being evaluated by the markets.  Commercial real estate is being impacted as stores go vacant.

Third, the markets are hanging on to the hope of tax reform and tax cuts.  In our opinion, the same thing that torpedoed many of President Obama’s programs is impacting the current administration.  The first thing both presidents did was attempt a huge overhaul of health care.  It seems apparent that success has been elusive and indeed current wrangling is likely to worsen the health insurance issue.  Furthermore, the antagonisms that have surfaced seem to us to make it unlikely that tax reform will be accomplished anytime soon.  There is still arguing going on about trade and whether tax cuts have to be offset with spending cuts.  The issue of a border tax is still being debated.  We remain skeptical of measures that would impact trade.  It seems to us that too many obstacles have been created to fulfill prior hopes for meaningful change. 

We have a slow, tired and mixed economic recovery. Auto sales have peaked.  Fights over immigration are affecting the supply of labor in some industries.  The Federal Reserve is looking at low unemployment but seemingly ignoring signs of deflation.  Politics are divisive and at a near standstill.  But corporate earnings have been rising slowly. Millennials might soon decide to look at homes and continue the housing lift.  The weakness in the dollar is helping companies with large foreign revenues.  More than ample monetary liquidity has kept merger and acquisition activity at very high levels.  With real revenue increases hard to achieve in this low growth environment, more companies are exploring acquisitions or mergers to enhance earnings.

Our dividend growers continue to execute according to our expectations.  In an environment where income is hard to achieve, we remain constructive on the portfolios.  We do think dividend increases can continue, albeit at a slower pace. Dividend increases have surpassed earnings growth over the last several years, a trend that cannot continue indefinitely. With the rising payouts we have seen, we do believe that future dividend growth will more closely follow earnings growth, holding payout ratios more constant. And, as we did a year ago, we want to manage expectations for capital appreciation given the strong gains we have seen since the financial recession. Despite these more moderate growth expectations, we continue to feel good about the companies we own and believe that holding a portfolio of high-quality companies remains an attractive investment proposition in today's climate. 

Portfolio Highlights

The Dividend Strategy portfolio outperformed its S&P 500 Index benchmark during the second 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 financials and consumer staples sectors while the main detractors came from the energy sector.

On a relative basis, overall stock selection contributed to performance for the quarter. In particular, stock selection in the consumer staples, financials, utilities and consumer discretionary sectors drove relative results. On the negative side, stock selection in the information technology sector and an underweight in the health care sector detracted from relative performance.

On an individual stock basis, positions in Nestle, Blackstone Group, Alphabet, American Tower and McDonald’s were the greatest contributors to absolute returns in the second quarter. The largest detractors included Schlumberger, AT&T, Verizon, Enbridge and Texas Instruments.

During the second quarter we closed a position in CVS Health in the consumer staples sector.

Michael Clarfeld, CFA

Portfolio Manager
17 Years experience
11 Years at ClearBridge

Hersh Cohen

Co-Chief Investment Officer, Portfolio Manager
48 Years experience
48 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 June 30, 2017 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 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.