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Dividends, Credit, Financials: How to play Value - Weeden Co

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Christopher Harvey
(203) 861-7636
charvey@weedenco.com
March 14, 2012
Dividends, Credit, & Financials: How to play Value
At the beginning of the year, we stated that our enthusiasm for Dividend Yield had waned and expressed
our preference for Dividend Increases as opposed to higher Yields (“Stock Performance after Dividend
Increase Announcement” and “2012 Outlook: US Quants on the Rise, a Quiet Re-Birth” Jan ’12). While
deflating Dividend Yield strategies, we cited relative performance, idiosyncratic risk, credit spreads as
well as the yield curve. Recently, a handful of clients have asked whether we expect the negative YTD
performance for Dividend Yield factors to continue. Further, they’ve inquired about our view on Bookto-Price factors and if we believed the YTD resurgence would continue.
Executive Summary Our analysis suggests that the environment will continue to be hospitable for higher
risk Book-to-Price strategies and we’re anticipating solid factor performance over the coming months /
quarters. Alternatively, the environment remains difficult for lower risk Dividend Yield strategies and
the factor will likely experience meager returns for the balance of 2012. For those investors wanting a
Dividend play, we recommend strategies that try to exploit Dividend Increase Announcements,
especially within the Financial sector (Exhibit 5 & 6).
Liquefying Credit Markets allows firms to source Risk Funding as well as Risk Seeking: Corporate bond
issuance is increasing suggesting investor willingness to provide Risk Funding. Credit spreads are
contracting indicating Risk Funding is becoming cheaper and risky firms are being re-priced. Credit
spreads are above their longer-term average implying room for compression. Historically, the improving
credit environment favors higher risk firms and higher risk factors such as B/P over Dividend Yield.
Solid credit fundamentals suggest further spread compression for Corporate Bonds: Leverage ratios are
still trending down (Exhibit 1), the EPS cycle is in an uptrend and solid balance sheets are liquid.
Improving credit metrics often go hand-in-hand with corporate bond spread compression and corporate
bond spread compression usually fosters equity valuation compression. Over the years, we’ve observed
this dynamic with our Book-to-Price factor as valuation spreads between cheap and expensive B/P
quintiles wax and wane with credit spreads (Exhibit 2). Overall, the credit fundamental picture suggests
Risk Seeking has longevity.
Exhibit 1: Credit fundamentals are favourable as leverage ratios,
balance sheet liquidity and default rates are constructive.
Exhibit 2: Expect further spread compression for Corporate Bonds
and consequently, positive returns to Book-to-Price
Net Debt to EBITDA for the S&P500
1.50
6
B/P Spread btw Cheap & Rich Quintiles (S&P500)
B/P Average Spread
ML Corporate Master Index - OAS
700
600
5
4
500
1.00
400
3
300
2
0.50
200
1
100
0
Dec-99
Dec-01
Dec-03
Source: CapIQ and Weeden & Co
Dec-05
Dec-07
Dec-09
Dec-11
0.00
Dec-99
0
Oct-02
Source: CapIQ and Weeden & Co
Aug-05
Jun-08
Apr-11
Book-to-Price valuation spread has scope for compression: The valuation spread between cheap and
expensive Book-to-Price quintiles (S&P500) is still above average and indicates further compression can
occur driving positive relative performance (Exhibit 2).
Risk Profiles by Factor: When looking at the common characteristics associated with attractive Book-toPrice and Dividend Yield stocks, the metrics paint dissimilar risk profiles. On average, an attractive B/P
name has a higher beta, lower market cap, lower interest coverage and higher volatility than an attractive
Dividend Yield stock (Exhibit 3). These characteristics are generally consistent over time.
Consequently, the risk environment plays an important part in the performance of the factor.
High Yield supportive of Risk Seeking : Within credit, we’ve stated High Yield is an attractive
Risk/Reward. The asset class possesses appealing credit spreads, lower than expected default rates and
favorable credit metrics. In an environment which is favorable to High Yield (Exhibit 4), we would
expect companies sporting higher leverage ratios, lower credit ratings (lower Quality) to outpace higher
Quality names. This dynamic is also benefiting B/P over Dividend Yield as cheap B/P stocks, in general,
possess lower credit ratings, lower interest rate coverage and higher leverage ratios than the average
higher Yielding stock.
Dividend Yield and Serial Correlation with Errors: Many Quants believe and try to exploit serial
correlation with Analysts’ errors. We think this correlation effect will hinder Dividend Yield
performance for material parts of the year. In 2012, Sell-Side Strategists have been very pessimist
regarding Equity Targets. According to Bloomberg, the average Sell-Side Strategist’s Year-End Target
is currently 1357 or 3% below last night’s close – see TNI Strategy Table <go> on Bloomberg. The
positive revisions are already occurring as the Target has moved up 9 point from 1348 on Dec 28, 2012.
As we wrote about in our Quant Strategy Note, “Our Dividend Yield factor is very sensitive to market
direction…” This belief combined with Analyst’s error theory provides another argument against a nearterm revival of the Dividend Yield factor.
Financials, Stress Tests & Dividend Increases: Highlighted in our note “Stock Performance after
Dividend Increase Announcement” was a belief that Dividend Announcements in the Financial sector
pose an interesting opportunity. The average Financial stock displays strong returns relative to the sector
(78bps) post a Dividend Increase Announcement. In addition, we stated that in the coming quarters and
years, the sector may see several waves of Dividend Increase Announcements as the companies meet
Fed requirements and work to restore payout ratios to more traditional levels (Exhibit 5 & 6). With the
Exhibit 3: Attractive B/P stocks generally possess a higher beta
than attractive Dividend Yield stocks
Exhibit 4: High Yield still in an upward trend vs. Investment Grade
Credit, which is supportive of the Risk Seeking
Beta for Median Stock within our attractive Dividend Yield quintile (S&P500)
Return Spread
HYG overbought vs. LQD
Beta for Median Stock within our attractive B/P quintile (S&P500)
1.75
HYG oversold vs. LQD
10%
1.50
5%
1.25
1.00
0%
0.75
-5%
0.50
0.25
0.00
Dec-99
-10%
Dec-09
Dec-01
Dec-03
Source: CapIQ and Weeden & Co
Dec-05
Dec-07
Dec-09
Jun-10
Dec-11
Source: CapIQ and Weeden & Co
Dec-10
Jun-11
Dec-11
Fed stress test results published, we think the number of Dividend Increase Announcements will
increase and provide reasonable opportunity to play Dividend Increase Announcements. Listed below
are the Financial stocks in the S&P500 that have the lowest Payout Ratios. We believe this is a good
place to start when searching for opportunity regarding dividend increase announcements.
Exhibit 5: Financials, Consumer Discretionary and Industrials
accounted for 59% of all the Announcements across the last 10
years (R1000).
Sector
Percent
Financials
Industrials
Con Discretionary
Utilities
Consumer Staples
Materials
Technology
Energy
Healthcare
Telco
Exhibit 6: Stocks within the Energy and Financial displayed solid
performance relative to their sector return but Telcos poor.
(Cumulative excess return to their sector over the 21 trading days)
# of Occurrences
32%
14%
13%
9%
8%
7%
6%
5%
4%
1%
1364
602
562
383
361
313
255
194
190
49
100%
4273
Source: CapIQ and Weeden & Co
Excess Return
vs. Sector (10Yr)
Sector
Energy
Financials
Materials
Technology
Consumer Staples
Industrials
Con Discretionary
Utilities
Healthcare
Telco
1.07%
0.78%
0.59%
0.52%
0.46%
0.31%
0.17%
0.14%
0.03%
-0.11%
Source: CapIQ and Weeden & Co
Financial Stocks with a Payout Ratio less than 25% (S&P500)
Ticker
BRK/B
ICE
CBG
GNW
LUK
ETFC
AIG
NDAQ
C
COF
MA
ZION
DFS
FHN
L
TMK
KEY
STI
MET
BEN
V
LM
Name
BERKSHIRE HATHAWAY INC-CL B
INTERCONTINENTALEXCHANGE INC
CBRE GROUP INC - A
GENWORTH FINANCIAL INC-CL A
LEUCADIA NATIONAL CORP
E*TRADE FINANCIAL CORP
AMERICAN INTERNATIONAL GROUP
NASDAQ OMX GROUP/THE
CITIGROUP INC
CAPITAL ONE FINANCIAL CORP
MASTERCARD INC-CLASS A
ZIONS BANCORPORATION
DISCOVER FINANCIAL SERVICES
FIRST HORIZON NATIONAL CORP
LOEWS CORP
TORCHMARK CORP
KEYCORP
SUNTRUST BANKS INC
METLIFE INC
FRANKLIN RESOURCES INC
VISA INC-CLASS A SHARES
LEGG MASON INC
Price
Payout Ratio
$ 80.60
0.0
$ 140.42
0.0
$ 20.30
0.0
$ 8.94
0.0
$ 27.26
0.0
$ 10.22
0.0
$ 28.35
0.0
$ 26.62
0.0
$ 35.20
0.7
$ 52.47
2.8
$ 422.03
4.0
$ 20.92
4.8
$ 32.03
4.9
$ 10.39
8.4
$ 39.04
9.5
$ 49.51
9.6
$ 8.35
10.2
$ 23.21
11.1
$ 37.75
11.5
$ 122.86
11.5
$ 116.92
11.6
$ 28.69
12.2
Ticker
AIZ
MS
WU
WFC
HBAN
AXP
AMP
STT
PRU
CMA
PNC
USB
AON
CME
JPM
ACE
FITB
LNC
BK
MCO
PGR
Name
ASSURANT INC
MORGAN STANLEY
WESTERN UNION CO
WELLS FARGO & CO
HUNTINGTON BANCSHARES INC
AMERICAN EXPRESS CO
AMERIPRISE FINANCIAL INC
STATE STREET CORP
PRUDENTIAL FINANCIAL INC
COMERICA INC
PNC FINANCIAL SERVICES GROUP
US BANCORP
AON CORP
CME GROUP INC
JPMORGAN CHASE & CO
ACE LTD
FIFTH THIRD BANCORP
LINCOLN NATIONAL CORP
BANK OF NEW YORK MELLON CORP
MOODY'S CORP
PROGRESSIVE CORP
Price
Payout Ratio
$ 42.82
12.4
$ 18.75
15.6
$ 18.16
16.7
$ 32.94
16.9
$ 6.15
16.9
$ 55.90
17.5
$ 57.12
18.7
$ 44.44
18.8
$ 61.97
19.0
$ 31.65
19.1
$ 61.18
20.1
$ 31.18
20.3
$ 48.95
20.5
$ 273.37
20.6
$ 43.46
22.0
$ 72.85
22.3
$ 13.99
23.5
$ 25.97
23.5
$ 23.18
23.8
$ 41.57
23.9
$ 22.65
24.4
Disclaimer: This publication is prepared by a Weeden & Co., LP Market Strategist. The material herein is based on data from sources considered to be reliable, but is not
guaranteed as to accuracy and does not purport to be complete. It is not to be construed as a representation by us or as on offer or the solicitation of an offer to sell or buy any security.
Information contained herein provides insufficient information upon which to base an investment decision. From time to time, this firm, its affiliates, and/or its individual officers and/or
members of their families may have a position in the subject securities which may be consistent with or contrary to the recommendations contained herein; and may make purchases and/or
sales of those securities in the open market or otherwise. Weeden & Co. does not engage in investment banking activities. Use by other than the intended recipients is prohibited.
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