Past performance is not an indicator of future results. How many times have you seen that disclaimer during your investing research? I cannot disagree with the phrase one bit - just because something did well yesterday, that does mean it will do well today. However, it is a very odd phrase because while you are researching an investment, what else do you have to work with? Future financial projections are critical, but at the end of the day, those are simply theories waiting to be (in)validated as results are released. I believe there is much to learn from reviewing the past as it relates to building a thesis for a future investment - and I would like to share a story with you.
In 2008, I fancied the idea of building a nest egg for my daughters and relying on the power of dividend reinvesting to accomplish this objective. I turned to direct stock purchase plans and after some research, decided that Pfizer, Inc. (NYSE:PFE) was a good place to periodically park some cash and build some dividend reinvesting momentum. I read about some of the long-term concerns of the company and its ability to achieve huge levels of growth going forward as some of their more profitable patents were going to expire and it was uncertain they would be able to replace the growth. However, PFE had lots of cash, liked to buy back shares, sported a history of raising its dividend, was yielding over 5% and had lots of and lots of products in the market. The shares were also trading in the $25 range - about 30% down from its trading range from just a few years prior. From a boring, long-term investing strategy, PFE fit the bill. So, I started building a position - my investment thesis was not looking for the stock price to explode to record heights but to achieve an increasing stream of dividend income by periodically accumulating shares and watching the dividend methodically increase year after year. Well, nothing is ever that simple.
Shortly after buying my first shares at around $25, rumors started to swirl about a dividend reduction. This was a big deal considering PFE had a decades-long steak of consistent dividend hikes. Over the coming weeks and months, the stock continued to experience weakness. The dividend remained at $1.28/year. The poor economic and marketplace environment made matters worse. The stock declined down to $20. I was a little upset but recalled my investment thesis - this was not for 1 year or even 5 but perhaps for 20 or more. I was more focused on PFE's ability to produce an attractive dividend income stream versus appreciation. I mustered my intestinal fortitude and continued to acquire shares - if I liked the 5% yield, 6% or 7% yields were even better. The stock continued to drift lower and below $20 and late in 2008, it became a foregone conclusion that at some point, PFE was going to reduce its dividend. In early 2009, those fears were realized and PFE slashed its dividend in half to $0.64 cents and the stock traded into the $14s. As a dividend investor, I was not a big fan of this and I was faced with a decision - sell and take loss or re-evaluate the environment.
I re-evaluated and determined that the same underlying principles that brought me to PFE for this particular investment remained intact. Yes, the shares I bought at $25 were now producing a 2.5% yield instead of 5% - but that was still better than a savings account. Even at $15, the yield was over 4%. I continued to accumulate shares in a regimented fashion. My theory remained the same and PFE would be able to resume dividend increases in the future - shares bought today at $15 yielding 4% would be yielding 8% once the dividend got back to its $1.28 rate. I was not certain when and if this would happen, if ever, but I felt committed to the approach based on my deeper research and due diligence. In terms of a trading range, PFE never traded much lower than the $14 range - a price level reached prior to official dividend reduction announcement. It is never this simple, but it almost appeared that the market was anticipating the dividend reduction. That was certainly a catalyst behind the stock's decline and once the announcement was made, a potential floor on the stock price was set. One of the questions we asked during our analysis: why did the stock not continue to decline once the dividend reduction was made official?
Let's fast forward to today. PFE stock is trading in the $31-$32 range and the dividend has been increased each year since the 50% haircut and is now at $1.04 per year. Analysts also believe further increases are likely and I agree with them. I am glad for the shares I bought at $15, $16, $18 along the way - reducing my cost basis and driving up my annual yield on my position, especially as the dividends have increased.
This by no means is an apples to apples comparison - but could a similar thesis be formed for FirstEnergy Corporation (NYSE:FE)? My interest in FE is similar to that of PFE - to supplement a portfolio with some consistent, predictable income. One thing I have learned about studying some successful managers is their interest in income producing securities and common stocks in addition to their strategy of finding truly outstanding growth opportunities.
We began building a position in FE in the $35-$38 range in 2010. The stock was down roughly 50% from its all-time highs and was paying a very generous 6% dividend at these levels. For the next 2 years, we continued to build a position and we looked pretty smart for a while as the stock returned to the high $40s price range. However, once the yield crossed below 5% (around $43 range), we stopped our new purchases. From a yield and risk management perspective, for this particular investment, we felt 5% was the minimum yield we would accept. We acknowledged that a dividend cut was likely and so the forward yield was somewhat artificial.
Regardless, there was not much secrecy surrounding some of FE's challenges in the marketplace. Their stock floundered in 2013 compared to many of its utility peers. As the stock dipped back under $40, we resumed our automatic purchases. We were aware of some of the financial weakness showing up in FE's balance sheet and like PFE, rumblings of the dividend being cut started to circulate. We certainly acknowledged the high-likelihood of this event but we remained confident in FE's long-term ability to produce a steady stream of income as a regulated utility. Again, our investment thesis in FE is a long-term, multi-year time horizon and a stable flow of income we can count on to supplement our core portfolio strategy.
Earlier this year, FE reduced their dividend to $1.44 per year from $2.20 per year. I do not think this came as any surprise to myself or anyone else following the stock. It does save FE about $320 million of annual cash, which is still a drop in the bucket compared to their debt load, but certainly a component of shoring up their financials. The stock certainly looked like it wanted to trade below $30 in the weeks following the news, but never broke that mark. Since then, FE has rallied about 9%. We certainly are not calling a bottom on FE stock, but we find ourselves asking similar questions that we did when PFE cut their dividend. Why did FE stock not continue its decline on the dividend reduction news? Was all of the negative price action in the months leading up to the announcement potentially pricing in the dividend reduction prior to the announcement? Will the excess cash from a dividend reduction better enable FE to carry out is strategic business objectives? Will these objectives yield more efficient financial performance over the long term? Will successful execution of these efforts lead to higher dividend payments?
Certainly, the challenges faced by PFE are much different than what FE is facing. The market and landscape of 2014 is much different than 2009. PFE and FE are completely different businesses. We are not here to conclude that the start of PFE's 100%+ total return from 2009 (measured from when they actually reduced the dividend) means we are on the cusp of a 100% rally in FE stock over the next 3-4 years just because FE bit the bullet and cut their dividend.
However, we do believe that is an important history lesson to draw insight. When PFE cut the dividend, the decision to do so was based on a wide variety of complex factors - factors that nearly all retail investors and most analysts do not have full exposure or awareness. The shareholders count on management to make strategic decisions thinking about what is in the best interests of the company and shareholders today, tomorrow and many years from now. FE has taken a similar step - it certainly feels like a loss when a dividend is reduced, especially for funds and investors that were counting on that quarterly cash flow as part of their income. However, FE absolutely wants to find itself in a better financial position and make investments in the business that will allow it to pay their employees, service their debt and provide a stable, increasing stream of income to common shareholders.
In addition to sharing a PFE success story, I hope this discussion provides insight into future investment decisions. Specifically, before simply bailing on FE stock because they cut their dividend and their stock is trading at levels not seen since the late 1990s and early 2000s, it may be worth re-evaluating why you first became interested in FE stock in the first place. Is it because you thought the stock would be a candidate to double in price in a very short-time frame or because you felt better about earning 4%+ income return rather than buying a CD or parking money in a sub 1% interest rate money market? If you are looking at FE as a contrarian play, it may be comforting to hear a story of another large capitalization, established company that had to make the painful decision to reduce payments to its owners - and the subsequent performance. For us, we are confident in FE's ability to maintain its dividend, we are looking at attractive current and future valuations and that in the future, FE will be able to steadily increase its dividend.
Of course, there is no guarantee that FE stock will follow a similar path of dividend increases or stock appreciation compared to PFE, but it is not out of the question. This is where looking at the past can be helpful in formulating an introductory investment thesis. From there, I encourage further research to understand the financial standing of the business, the proposed strategic direction of the company, management's ability to execute on that plan and what marketplace factors and trends the company may have to deal with during its execution. For the record, by our estimates, FE is trading at roughly 11 times next year's earnings and roughly at 7x forward Enterprise Value to EBITDA, a 4.5% yield is in line with most of its utility peers and FE seems to be re-establishing business focus. Most importantly, I would like to stress that there are quite a few companies that sported attractive yields, declined in price, reduced their dividend to conserve cash only to see their stock price resume a downward price trend in the weeks and months following the dividend reduction announcement.
We are long PFE - but are not accumulating additional shares at this time. We are long FE and we have accelerated our accumulation of shares on the January, 2014 official news of the dividend reduction. The latter suggests we are confident FE will be able to handle its challenges and return to financial performance that, given time, will aid in driving dividend increases and stock appreciation. As with most investments, time will tell if our thesis proves (in)correct. However, without reflecting on some history, we may never have considered taking the actions that we did.
Disclosure: I am long FE, PFE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: We are actively accumulating shares of FE. Currently, we are not adding to our PFE position and have no plans to do in the near-term.