Fear is a funny old thing. I have seen people relish a substantial decline in markets as a great buying opportunity. And I have seen others respond in panic. The questions to ask are:
- Is time to be fearful, while others are not? And
- If I am fearful, what preventative action can I take now (other than panic), to avoid panic later? Will a defensive dividend screen help?
Is time to be fearful, while others are not?
The S&P 500 closed December 27, 2013 at 1,841.40. And markets remain very close to their all-time high. And so the tendency is to view the market as expensive. Is it?
Over the past twenty-one years, at median levels, the market has closed the year at 18.23X operating earnings for the year, having made a low at 14.97X and a high at 19.09X during the year. The average of high, low and close multiples is 17.43X. We can predict that the market will be higher in the long term with near 100% certainty. But what occurs in the short term is utterly unpredictable. If the S&P 500 operating earnings for the year ended 31 December 2014 (FY14) meets expectations of $113, and if we allow history to guide us, over the coming year, we can look for 1,691 as a despair level, 2,158 as the exuberance level, with 2,060 as an expected close value with the three giving an average of 1,970. The markets could reach for exuberance levels if confidence in forward earnings expectations escalates and drives risk aversion down but it's unlikely - exuberance builds with over-confidence and time: we are not there yet. Similarly, the markets could reach for despair levels if confidence in forward earnings expectations falls and drives risk aversion up, but it's unlikely - no more than gentle downward revisions in expectations are likely.
If expectations of a recessionary climate escalate, using median levels less one σ, we can look for high, low, close and average of high/low/close multiples of 13.16X, 11.15X, 13.60X and 12.64X respectively. Such multiples applied to a lowered earnings expectation of $105 would give potential high, low and close targets for the market of 1,428, 1,382 and 1,171 with the three giving an average of 1,327.
With 31 December 2013 (FY13) operating earnings expected to come in at $106 and the market trading at 1,841.40, the S&P 500 is valued at about 17.40X. This is very much in line with the median levels seen during the last couple of decades. But many argue that the market has been expensive these past two decades.
We know the index price. What is the value? What should an investor looking for a very long-term annual return of 9% be willing to pay for very long-term growth of 5% with risk free rates as represented by ten-year government bonds expected to revert to 4.75% over the very long term and with a return of equity similar to the 12.5% we have seen on average since 31 December 1999?
To generate 5% growth with a return on equity of 12.5%, a company would need to re-invest 40% of earnings (40% * 12.5% = 5% Growth). The remaining 60% would be available to shareholders and could be paid out via a dividend, buy backs, or indeed retained by the company to generate growth over and above the 5% expectation. What is the worth of 60% of each $1 in earnings growing in perpetuity at an annualized growth rate of 5% to an investor wanting a long-term return of 9%? Mathematically we calculate it as 60% of Earnings multiplied by (1 + Growth Rate) Divided by (Target Investor Return Expectation minus Growth Rate); that is $1 * 60% * 105 %/( 9%-5%) or 15.75.
Thus 15.75 is the multiple at which the market would be appealing to an investor with the previously discussed economic and return expectations. An investor who sees $106 as the level of earnings, expected to grow at a sustainable 5% very long-term growth rate, would value the market at 1,670.
Another investor who believes that $106 is too high as a base, from which to expect sustainable growth of 5%, might choose to use a lower estimate for sustainable earnings. The average economic cycle lasts for about sixty-six months. The median six-year real operating earnings of about $93 might indicate a sustainable level of earnings from which long-term growth of 5% is reasonably expected. To such a person the market would be rightly valued at 1,465.
Overall, in my mind, the economic cycle appears in the mature phase of expansion. It is not particularly close to a peak or a trough. And in the coming months it is more likely to see an upturn than a further slide. The stock market valuation indicates that the market is more expensive than its value, but not worryingly so, and certainly not to the extent we could call exuberant. Price lies higher than the markets value, but is well within ranges of what has represented normalcy over the past two decades. Trying to predict the unpredictable is foolish but fun. If FY14 earnings expectations of $113 are not unrealistic then a twelve month target of 1,970 is possible: even likely.
On balance, it is time to be fearful, given that current price levels lie over value. But it is never the right time to panic. What should a value investor with a long-term time horizon do?
What preventative action can I take now (other than panic), to avoid panic later? Will a Defensive Dividend Screen help?
Firstly, take advantage of current price levels to return portfolios to our preferred benchmark allocation to equity. Thus, if equity allocations have risen higher than the benchmark, we could reduce allocations back towards the benchmark. The table below displays one of several views on what a standard portfolio allocation could look like.
Secondly, the portfolio bias could be shifted towards dividend yielding stocks, particularly those stocks with low pay-out ratios, which indicate dividend sustainability. When substantial price declines visit the index, dividend yielding stocks tend to outperform. One of the many advantages of a dividend paying stock is that as price declines occur, dividends provide some capital to invest, over and above the capital raised from re-balancing the portfolio back to the benchmark allocation. Dividends add defensive characteristics to a portfolio.
Thirdly, companies employing high levels of leverage tend to decline more substantially compared with unlevered or low levered companies. Thus a focus on balance sheet quality adds defensive characteristics to a portfolio.
Fourthly, we have β. When the index sees substantial price declines, high β companies tend to suffer the greater indignities. A focus on low β companies at a time when there is a risk of a substantial decline, adds defensive characteristics to the portfolio.
Fifthly, when the markets decline, it is common for smaller sized companies to fall more than larger sized ones. In addition, prior to the decline, the valuation of large companies are often more attractive in comparison to small companies. The investor emphasis on growth rewards smaller companies while confidence is high. But when there is fear, the emphasis on growth reduces, as investors seek shelter in value. Thus a bias towards larger capitalization stocks will add defensive characteristics to a portfolio.
Finally, cyclicality in earnings is important. During periods of robust expansion, cyclical sectors tend to out-perform. The earnings of the Financial, Discretionary, Basic Materials, Technology, Industrials, and Energy sectors, tend to fluctuate from year-to-year through the economic cycle. Defensive sectors like Healthcare, Consumer Staples, Utilities and Telecom sectors tend to have earnings less influenced by the economic cycle. When a price decline is anticipated, defensive sectors will out-perform cyclical sectors.
A Defensive Dividend Screener
It is rarely a bad idea to invest in dividend yielding stocks. And with markets priced as they are, it makes good sense to use dividend yield as a screener. In this screen, I am looking for U.S. listed stocks with:
- A dividend yield of over 3%,
- A pay-out ratio of below 60%,
- A market-capitalization over $300 million,
- Return on equity of over 12%,
- Moderate leverage in the context of the industry of operation, and
- β below 1.30.
I eliminate micro-cap stocks with a market capitalization of below $300 million, because liquidity vanishes in the space with substantial declines. Low β, strong return on equity, and moderate leverage levels are criteria which signal quality. And high quality stocks which offer a reasonable dividend yield, with pay-out ratios at a level which indicate that the dividend yield is sustainable, are attractive. I call stocks with these characteristics "Defensive Dividend" stocks.
In the screen you will also see display fields for sectors and size. This allows a reader to make the selection even more defensive by selecting large capitalization companies from defensive sectors. And of course, the option choice to add a bit of aggression to an otherwise defensive selection through selection of smaller capitalization cyclical stocks is always there for readers to consider. I have also left in a growth indicator because I like looking at growth plus yield as a decent indicator of long-term return potential for a stock.
In the above screen, please ignore VFC. VFC has recently been through a stock split and the dividend numbers based on which the yield is calculated has not been adjusted on the system. The split adjusted dividend gives a yield of 1.7%, which falls below the 3% screen criteria. I tried to eliminate VFC off the screen, but the software used will not permit it.
Finally, please do keep in mind, a screen is never a strategy, it's a starting point. A screen is designed to address specific desires or concerns of investors at a point in time. This screen provides a starting point for a person who is fearful at present. This is at best the start of the pre-investment decision due diligence process.