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Monday, March 14, 2005
Value in Dividends
How a bottom-up strategy targets energy, metals, big pharma and some banks
By SANDRA WARD
AN INTERVIEW WITH BEN FISCHER AND CLIFF HOOVER -- Deep value. Absolute returns. Contrary opinion. High-yielding dividend stocks. These are the hallmarks of the investing style practiced at NFJ Investment Group, a 16-year-old investment boutique based in Dallas and, since 2000, a unit of Allianz Global Investors. Through meticulous research and unbending adherence to a time-tested philosophy, the group has delivered outstanding returns for the $12 billion in assets it manages on behalf of institutions, individuals and separately managed accounts. It also offers mutual funds, including the NFJ Dividend Value, and is also part of a team managing the just launched NFJ Dividend, Interest and Premium Strategy, a closed-end fund.
For why a dividend-value approach matters more than ever, please listen to a conversation we had with Fischer, a founder of the firm, and Hoover, the next generation.
Hoover, left, and Fischer, who sees investors still "thinking in terms of the past. They are all looking for the next high-tech period. They want to do what they did in the 'Nineties."
Barron's: I know you're bottom-up stock pickers, but what's your view on the market at this juncture?
Hoover: We try not to let a top-down view invade our bottom-up stock selection too much. But I can make a plausible case that oil is going to go to $100 a barrel by 2010. On a bottom-up basis, some of the energy stocks are already discounting that. If all the energy stocks were selling at 10 times cash flow as Exxon Mobil is, then we really wouldn't be interested. We own companies such as Marathon Oil, Kerr-McGee and Occidental Petroleum selling at about six times cash flow. So it is not enough to know the fundamentals of a company or an industry. You also have to realize what is already discounted in the price.
And that's how we apply a top-down view to our stock selection. As for our view on the market, though, the peak-to-peak P/E on the S&P 500 is about 20 times.
That points to a fairly rich market here. Earnings have grown substantially over the last couple of years, but that was from a trough.
The Value Line median P/E is a good snapshot of what the average stock is selling at. In 2000, the Nasdaq and cap-weighted S&P 500 were at very high valuation levels, yet the Value Line median P/E was only 12½, and it suggested small-cap and mid-cap companies were very cheap. Today the Value Line median P/E is 19. The average stock in the U.S. is not cheap. The overall market is relatively expensive, rates are going back up and we have a very conservative outlook. The last couple of years we had pretty good runs; 2003 was a low-quality, high-beta market, and 2004 was a post-election melt-up.
But we probably cannibalized some future returns from the next couple of years. One of the remaining pockets of inefficiencies in the market today are dividend-paying value stocks. A lot of money hasn't spilled into these Russell 1000 dividend-paying companies yet. But for the most part, you have to be careful.
Fischer: I started in the business in 1966 and from then until 1982, the market didn't go anywhere. It was a pretty difficult period if you were a buy-and-hold or S&P 500-index-fund investor. At the same time, it was a very exciting period for stock picking. From 1982 through 1999, we went through a long-term buy-and-hold bull market when everything worked.
Interest rates went down, inflation went down, P/E ratios went up, earnings did OK and it was a great John Bogle market when you could just buy an S&P 500 index fund and do well, although in the end it was dominated by high technology.
When you get up to P/Es that we are up to now, with a dividend yield less than 2%, the market has to go flat for a period of time. Eventually, we'll get back to reasonable P/E multiples and the S&P will trade at 12-14 times earnings and it will have a nice 3% or 4% yield.
There are two ways to get there: Either the market goes down a lot, which I don't anticipate and nobody can predict, or what is more probable, as earnings increase and dividends increase, the S&P will remain somewhat flat over a long period of time until the valuation problem is corrected. It is reminiscent of previous periods, particularly 1966-1982, when inflation was rising and interest rates gradually rose. And it is going to be volatile.
Hoover: But active stock pickers actually made a lot of money in 1975 through 1982, and that is what we expect to see now. The big indices are going to be fairly flat while active stock pickers will add value.
Q: You're focusing on dividend-paying stocks, but investors haven't seemed to care much about them despite their tax advantages. Why is that?
Fischer: They still are thinking in terms of the past. They are all looking for the next high-tech period. They want to do what they did in the 'Nineties, and it will take a long time for investor psychology to realize those days are over.
Hoover: The intoxication of the QQQ culture still lingers. Historically, it takes the second or third leg down in a secular bear market to fully cure that intoxication, and we're not there yet. Today, instead of WorldCom there is Google.
Google is priced so that it discounts the next 2000 years worth of earnings. Google is worth about $25 a share. eBay is trading at 17 times sales, which assumes a gigantic earnings growth rate for a million years into the future.
The average investor doesn't realize that, and they still want to play these highly speculative vehicles.
Fischer: We don't invest in dividend payers just to generate yield, and we don't concentrate in any one particular industry. If all the yields are in utilities, that doesn't mean we are buying only utilities.
We are very diversified. Dividends are a very good statement on the part of the management and tell you they are willing to pay real cash to the shareholders or they have a commitment to make investments wisely for a good rate of return. Dividends provide great discipline. Also, the future rate of return of stocks probably will not come mainly from capital gains as they have the past 20 years but a larger percentage will come from dividends. Go back to the 'Seventies: The S&P was up about 5.9% annualized, and if you break that down, 4.3% came from dividends. We have a 3.4% yield on our dividend value portfolio, and if the S&P returns are going to be in that 5% or 6% range, a large chunk of that return is already booked. There is more empirical data now, too, showing that companies that pay out more dividends actually have higher return on equity (ROE) and those with lower payout ratios retain more earnings but have lower ROEs. That's because many corporate management teams have a propensity to destroy capital at the margin. IBM buying back its stock at 10 times book value in 1999 was a complete obliteration of capital. Companies that pay a healthy dividend are perhaps prevented from making marginal investments.
Q: What's an example?
Fischer: Freeport-McMoRan Copper & Gold. They mine copper and gold in Indonesia. There is a lot of political risk with this stock, but the environment has changed for commodities, and raw materials are in demand in China and throughout Asia and are rising in price. Here is a company that is benefiting from a rising commodity environment and has very, very rich reserves and a very good production outlook. The main thing is they are generating cash flow, about $1.1 billion in cash flow is projected this year. Their capital expenditure is only about $180 million and their dividend is $1 a share, or about $180 million. Of $1.1 billion in cash flow, $360 million is used for capital expenditures and dividends. Some of that will be used to pay down debt. But they also declared a special dividend in February, a 50-cent special common-stock dividend payable on March 31 in addition to the 25-cent quarterly. That's $1.50 annually, which is approximately a 4% yield. This is a mining company, and you wouldn't expect a mining company to be able to increase dividends. As time goes by they might increase the dividend to a 50-cent-a-share quarterly payout for a $2 dividend yield. They won't do it all at once, but they'll continue to declare special dividends. Much depends on the economy and the world outlook, but with that kind of cash flow, part of it will go to higher dividends. As they increase the dividend, the stock should benefit, and that doesn't even take into account what could happen if we had a worldwide economic boom. Ten years from now, China is going to be absorbing a lot more copper, and new supply will be constrained.
Q: The commodity boom is sustainable, then?
Hoover: Absolutely. China could cool off at some point and for a short period you could have a rain delay. But we are fairly convinced we're in a 10-15-year new secular trend. In any great secular trend, historically, there's likely to be a 50% correction along the way. But that should be viewed as an accumulation period.
Q: Others are recognizing the same trend because Freeport has had a good run.
Fischer: People are expecting it is going to earn $3.50 in 2005, and it is trading only a bit over 10 times earnings even though it has run up from the 20s. Earnings will grow as the demand for commodities grows, and that's the beauty of it. This is not the ninth inning. It is more like the second. Also, take a look at the materials weighting in the S&P 500. It is around 3%. There aren't that many companies, and their capitalizations are minute compared to companies in, say, the Internet space. From where we are to where we can go, there is enormous potential.
Hoover: Look at the energy space. Look at Kerr-McGee or Occidental Petroleum, a couple of our current holdings, and read the analyst reports from the last couple of weeks. Analysts are recommending investors hold Occidental and Kerr-McGee because they are up a lot this year and are selling at six times cash flow, while five years ago they sold at 3½ times cash flow. The past is irrelevant now that China has awakened and six times cash is still very attractive. They are trying to use history to say the stocks are expensive, and we're saying, hey, these stocks are just getting going. A while back I compared Exxon Mobil to Occidental: Occidental trades at six times its cash flow and Exxon trades at 10. Why the difference? It is the indexers and the Bogles of the world. Of every dollar that comes through the door, 3% goes to Exxon Mobil. They have to buy it. In Occidental, we own the better value. Most people don't realize that in the past five years, even though Exxon's stock price has been going up, Occidental compounded at a 33% annualized return while Exxon compounded at a 12%.
Fischer and Hoover's Picks
Company Ticker Recent Price
Freeport-McMoRan FCX $40.92
Kerr-McGee KMG 77.99
Occidental Petroleum OXY 70.51
Dow Chemical DOW 54.92
Merck MRK 32.16
Pfizer PFE 26.75
Washington Mutual WM 41.36
Bank of America BAC 45.86
J.P. Morgan Chase JPM 36.36
Q: How do you like investing alongside Carl Icahn now that he's taken an interest in Kerr-McGee?
Hoover: We owned Kerr-McGee pre-Icahn, but we don't mind somebody coming in and stirring things up a bit.
Fischer: The larger implication of Icahn's interest is that people are now starting to realize there is a shortage of cheap commodity reserves and cheap energy reserves.
It is a lot cheaper to find oil on the New York Stock Exchange than it is to go out and explore for it. That is what Icahn is recognizing. In time, we will see a shrinkage of the number of energy companies traded on the exchange as it becomes better understood that the huge reserves that could be found 20 years ago are no longer easy to find.
Q: What else have you put in the portfolio more recently?
Fischer: In August we bought Dow Chemical at around 40-41 when the P/E ratio was a little bit less than 13 times earnings and it was yielding 3.3%-3.4%. We bought it in a less mature stage of the economic cycle and as raw-material prices were rising. At first we thought the reason this stock was selling at such a cheap P/E was because they were going to see their profit margins squeezed. But after investigating, we realized, holy cow, nobody had invested very much money in the chemical industry in the last five to 10 years. Dow Chemical is operating at high levels of capacity and they can pass their raw-material costs on. Their profit margins are actually quite healthy. We figured its exposure to asbestos liability would be resolved. In the end, we came up with a company with good finances, a strong balance sheet and high-quality management that was underpriced relative to its true value. Annual average earnings growth over the next several years is going to be above that of the past. The stock is just now starting to break out. And with their free cash flow they should be able to pay higher dividends.
Q: All the examples you have given are energy or raw-materials beneficiaries. Are you finding values across the board?
Hoover: We will always have representation in around 35 industries out of about 53. We spread the money around. We like the big pharmas. We like Merck, a very controversial stock, very much. We think Merck is worth $40 a share worst case and probably 50 on a more normalized basis.
Q: When did you start buying Merck? Were you holders through its difficulties?
Hoover: Yes, and we have been adding to it.
When the stock reached a low of 25.60 or so, I calculated the market was discounting about $70 billion in litigation reserves, while the company's market cap was $55 billion at the time. The range for litigation reserves is more like $4 billion to $18 billion. Mr. Market is very skittish and still remembers Enron and WorldCom, and we think Merck's problems are nothing like that. We own Pfizer.
And we are tickled. We are pinching ourselves that we can buy a stock that normally has a high P/E for 12½ times earnings and a triple A-rated balance sheet. The market is focusing on their final-stage drug pipeline, but their early- and mid-stage pipelines are pretty good. We sold Bristol-Myers Squibb to buy Pfizer, and felt it was a good quality trade going a tier up. We also own GlaxoSmithKline. These stocks are not going to move tomorrow, but over the next two to three years, investors will come back to these stocks. They are very inexpensive and the market has overdiscounted their future prospects.
Q: What about financials?
Fischer: Bill Gross is a manager of one of our sister companies and we follow what he says on the interest-rate and bond picture reasonably closely. We are hearing it is not likely we are going to have sharp increases in long-term rates over the next six to 12 months. That's a reasonable expectation, and if it's true, there is not that much downside risk in the financials. We have stocks like Washington Mutual and Bank of America and J.P. Morgan Chase and they all pay good dividends.
Q: They are also not without controversy.
Fischer: Everything we own is controversial.
Hoover: There has to be something wrong with it for it to be cheap, right? Washington Mutual is an example of a company where the market is focusing only on the mortgage side of the business.
The market hasn't realized it is a very efficient and very innovative retail bank that somebody would be interested in paying about $65 a share for, in our opinion, and it's trading in the low 40s now.
Fischer: Don't get the wrong idea. We do everything from a bottom-up standpoint. But our attitude on some of these financials is there is still a lot of inefficiency on an interest-rate basis.
Q: So why are you underweight the financials?
Fischer: Our macro point of view and our focus on dividend growth takes us in a different area. We are more focused on materials and commodities and the energy area, and so the shifts will have to come from some area, and that will probably be the finance sector. There is nothing wrong with financials short term; it is just that as we see this new era develop, we are reevaluating what our sector weightings are.
Hoover: I would also make the observation that in the small-cap and mid-cap arena, a lot of the banks and S&Ls are not cheap. They're selling at 15 times earnings and three times book. The companies we own sell at 10 or 11 times earnings. If Bank of America were selling at 15 times earnings, we wouldn't be interested in it.
Q: How do you make a decision to sell?
Hoover: Our most important parameter is valuation. Secondly, we use a price-momentum model. Most growth managers use that type of model to buy high-momentum stocks. But because we are always buying laggard stocks, if we have a company in the portfolio that starts exhibiting weak price momentum, it signals something could be wrong with the company. It looks cheap but the market might know something we don't. If a stock falls into a very weak price-momentum state, we'll do more fundamental work on the company and many times we'll sell the company. We sold Fannie Mae when it was at 66 based on that, and it is now in the mid-50s. There are a lot of moving parts to it that you really can't get your hands around. Its 10K and 10Q filings border on hieroglyphics.
Q: Do you think the run in small-caps can continue?
Hoover: The sweet spot in dividend value investing is in the larger caps; that's where the most inefficiency is. A lot of money has gone into the small-cap and mid-cap arena the last five years, and our small-cap product has annualized returns of 20%.
With that kind of positive momentum trend, a lot of stocks have become more fully priced in that small-cap and mid-cap space.
Q: OK, gentlemen, thank you very much for this. |
