Clare Hart is vice president and co-portfolio manager of JPM Equity Income fund. She recently answered our questions on the importance of dividend yields for investors seeking income in today's market. She also discussed good buying opportunities in the investment management industry and U.S. consumer sector as well as the prospects for dividend hikes in the financials sector.
1. With the Federal Reserve signalling that rates will stay in the basement for at least two more years, how do you think investors can use equities as a source of yield and income?
With interest rates unlikely to rise anytime soon, stocks with healthy dividend yields will continue to be an attractive option to investors seeking income. Some large-cap stocks have dividend yields approaching or even exceeding the company's bond yield, effectively giving you an income stream similar to that of the bond with an equity kicker on top. For example, Merck (MRK) currently has a dividend yield of 4.57% and a 2011 free cash flow yield of 12.10%, while its debt only pays at a rate of 4.34%. Even though equities clearly have downside risk, the attractive free cash flow yields of many companies offer investors comfort that they are paying a reasonable price for those companies' future cash flows.
It is also important to remember that bonds are not without capital risk. Once interest rates eventually start to rise, many investors might find that bonds are not the safe haven they expected. In fact, in a moderate inflation environment, stocks often hold up much better than do bonds.
2. Has the continuing sovereign debt saga in Europe had a major impact on your holdings or strategy?
Our research process is designed to identify companies with predictable and durable business models deemed capable of paying consistent dividends while also achieving sustainable growth. Our philosophy emphasises high-quality, lower-beta stocks that offer steady performance across a range of macroeconomic environments. Thus, we typically have a much longer holding period than many portfolios that employ shorter-term, more tactical strategies.
Europe's debt saga has not made a major impact to the holdings. In direct response to the crisis in Europe we have made adjustments to earnings where we think appropriate given a slowdown in European economies. Our approach to the strategy has not changed; we like high-quality companies that pay a healthy dividend.
We have also sought to minimise our exposure to global banks for fundamental reasons, though they could also be affected by the European debt crisis. Many of these banks fail to meet our dividend-yield requirement of 2% and are probably years away from normalised earnings levels. Instead, we have sought to focus our financial exposure on high-quality regional banks, investment managers, and insurance companies, many of which are trading at or below their book values. As a result, financials are the portfolio's biggest current underweight, a position that we arrived at through our bottom-up work but that we also feel very comfortable with on a macro level.
3. Many firms are sitting on big cash piles. What will convince boards to increase dividends during the next year? What is your outlook for growth during the next 12 months?
Given the severity of the financial crisis, it is probably not surprising that companies are hesitant to part with their cash piles. We have already seen a number of companies increasing their dividend payments. In fact, the number of S&P 500 companies that have increased dividends thus far in 2011 exceeds pre-financial-crisis levels. However, companies clearly have a lot more room to increase their dividends going forward. Payout ratios are still at historical lows (26% versus an average of 37% during the last 20 years) while cash on corporate balance sheets is exceptionally high. As companies gain confidence in the macroeconomic backdrop, and as we get more clarity around regulatory and tax changes, they will increase their dividends in greater numbers.
Of course, an exception to this will be the banking sector. Given the need that many of these companies have to meet increased capital requirements and regulatory oversight that dictates how they return capital to shareholders, it could be a long time before some of these companies are allowed to restore their dividends to normal levels.
4. What companies look attractive to you today on a total-return basis? Why?
We have found a lot of good buying opportunities in the investment management industry, for example T. Rowe Price (TROW). T. Rowe Price has a dominant mutual fund franchise with above-average investment performance and inflows, resulting in a steadily increasing market share. Although T. Rowe Price is not subject to capital charges or Tier 1 ratios as other financials are, the firm often trades with the overall financials sector despite a business model that is not predicated on spread lending or availability of capital. The company also has an exceptionally strong balance sheet that allows it to weather market dislocations without raising equity or forcing massive layoffs. Its stock's valuation is near historically low levels, currently offering a 2.4% dividend yield.
We also find a lot of the variables we look for, such as durable franchises, strong cash flow, steady earnings patterns, in the consumer sector. In particular, Hershey (HSY) is one of the higher-conviction names in the portfolio. Hershey is the largest domestic chocolate manufacturer, with an estimated 42% share of the U.S. chocolate confectionery market, offering industry-leading brands such as Reese's, Hershey's Kisses, York Peppermint Patty, Almond Joy, and Twizzlers. We believe that the domestic chocolate confectionery industry has among the most attractive category dynamics within consumer staples as a result of its significant consolidation, high customer loyalty, lower absolute price points, and minimal private-label penetration. This backdrop, in conjunction with Hershey's significant advertising and innovation investments, will enable Hershey to see a material earnings benefit from its recently announced 10% price increase, which will be phased in through 2011 and 2012. The stock currently has a dividend yield of 2.3%.
5. Before 2008, financials stocks were the tent pole of many income portfolios. Do you think banks will be able to raise their dividends appreciably in the coming years?
We have already seen some of the stronger banks, such as Wells Fargo (WFC), raise their dividends, as the Fed has allowed those banks with adequate capital to work toward a more reasonable dividend payout. However, for some of the weaker banks, it may take years before they are able to restore their dividends to precrisis levels. Our portfolio has always emphasised the higher-quality, better-capitalised companies, currently making many banks unsuitable candidates for our portfolio before even considering the attractiveness of their dividends. As banks rebuild their capital positions, and as an improving economy presents more opportunities for them to expand their loan portfolios, we would expect income portfolios' exposure to these companies to increase. However, it may take years for their exposure to get back to precrisis levels.
