Prudent Yield Hog Focus: Vector Group

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 |  Includes: MO, VGR
by: Marc Gerstein

Vector Group (NYSE:VGR) appeared in the StockScreen123 Prudent Yield Hog model, the more aggressive “pushing-the-envelope” envelope version I wrote about on March 3, and it still appears in the screen today. (See appendix below for details of the model.) This isn’t the highest-yielding stock in the list, but at about 9%, it’s still an eye-opener given current market conditions.

We should start by considering this a tobacco company. So obviously, if you are at all inclined toward what’s known as “socially conscious” investing, this would have to be crossed off the list. (Especially considering that litigation risk, while still present, is not overpowering in light of how easily the company got off in a prior settlement involving most states that spares it the burden of making payments -- a fact that will likely irk many.)

As to mainstream investing, I presume nobody has any illusions about the growth prospects for tobacco, which are, of course, negative. In the U.S., we’ve long understood how bad smoking is for one’s health. I have to assume that such attitudes will eventually spread around the world, although that’s been a slow go.

When thinking of tobacco and income-stock investing, it seems natural to assume we’re dealing with a cash cow (lots of free cash flow and little need for capital spending) that generates more than enough of the green stuff to keep the dividend secure. For a company like Altria (NYSE:MO), that would be a reasonable assumption, although you would have had to stay alert in 2008 to keep track of a restructuring involving the spinoff of Kraft (KFT) and the adjustment of the dividend. But on the whole, the stereotypical cash-cow investment case applies.

But Altria’s yield is closer to 6% than the 9% being offered by Vector. That tells you something’s up, and that the cash-cow story isn’t cutting it here.

For starters, this particular cash cow is regurgitating – big time. Dividend payments amounted to $117.5 million in 2010, but cash from operations was only $67 million. Increased borrowings came to $189.5 million.

So the good news is that we understand where the money to pay dividends came from – debt. (The need for debt support wasn’t as big in prior years, but it has been present.) The bad news is that we usually want to run as far as we can as fast as we can if it looks like a company is in the habit of borrowing to fund dividends, because that’s a strategy that cannot persist for long. Yet the yield on Vector is “only” 9%. That ranks it just ninth out of 15 among the companies passing the screen today. Clearly, the Street, while cognizant of the above-average risk, is not at all in panic mode. So once again, we need to ask: What’s up?

The answer is that Vector is not simply a tobacco company. It’s one that has actually been doing the opposite of what Altria has been doing. The latter has been slimming down. Vector, on the other hand, has been turning itself into a conglomerate of sorts.

Actually, it’s been in real estate for about a decade through its ownership of Douglas Elliman Realty, a pretty big residential real estate brokerage firm in the metropolitan New York area. The details are complicated, given partial stakes and different subsidiaries and acquisitions, and are in the 10-K for those with extreme curiosity or in need of a cure for insomnia. The key, for most of us as prudent yield hogs, is to understand that Vector isn’t simply sitting around waiting for tobacco demand to drop to zero, however far in the future that day may be.

For much of the 2000s, anything connected with real estate seemed like nirvana. That clearly wasn’t the case as the decade drew to a close. But as a broker rather than a lender, Vector got hit mainly by diminishing revenues and profits, rather than viability-threatening vaporization of assets. It wasn’t a builder so it’s not groaning under the weight of unsold inventory. And it wasn’t a heavyweight property manager (aside from a bit of residential management), so it wasn’t wringing its hands over too much commercial space and too few tenants.

But cycles are not one-way streets. Textbook business-and-investment philosophy tells us to get in when the going is bad and nobody wants to do anything, at which time we can get in cheap and position ourselves well. In the real world, many are unable to do that because of the pain they took as the cycle moved down, and just plain fear.

I get it. I get nervous, too. But considering my first boss in the investment business was Arnold Bernhard, the guy who decided to start a stock-market publication (Value Line) in 1932 of all times, I like to think, or hope, something rubbed off.

Vector is playing that game. It wasn’t crushed on the way down and is taking advantage of the textbook opportunities. Mainly through acquisitions, the company has been expanding its brokerage operations and getting involved in relocation services and in mortgage lending. It’s even been picking up some properties on the cheap.

Separately, in October 2008, Vector bought a 10% stake in Castle Brands (NYSEMKT:ROX), a small developer and importer of branded premium spirits.

So what we actually have here is not so much a tobacco company as a fledgling conglomerate. We already see real estate as an important additional business unit, and the Castle Brands stake which, while quite small in the overall context of Vector, potentially signals more diversifying investments to come.

Often, incipient diversification programs scare me. Peter Lynch, afraid such moves would turn out to be duds, coined the phrase “diworsification.” But I’m intrigued here. Those that mess up conglomeration programs often wind up doing so by chasing and paying up to participate in fads. Vector seems to be doing its thing with an eye toward bargain hunting.

Investment bankers, lawyers and accountants who work with Vector are probably overjoyed (they probably can’t help but salivate as they read the 10-K and figure out how much fee income has been generated by all the transactions). But what the heck: Investment bankers, lawyers and accountants have to pay for food, shelter, etc. just like the rest of us. I’m willing to tolerate good times for them so long as shareholders look to be getting treated fairly.

As far as I can see, Vector does seem to have shareholder well-being high on its list of priorities. It raised the quarterly dividend from $0.38 per quarter to $0.40 per quarter, continuing a long-standing pattern. The size of the increase isn’t earth-shaking, but it does seem to signal that management is looking to evolve not just into any old conglomerate but one that takes dividends seriously.

We still have that nasty current situation of a dividend being covered by borrowing, rather than cash flow generated in the ordinary course of business. That, probably, is why the yield is about three percentage points above that of Altria: Mr. Market is not going to hand anyone an extra three percentage points just for the heck of it (notice he can be a lot more rational than Ben Graham, Warren Buffett and the legions of Graham-Buffett fans acknowledge).

Given that Vector’s future is still a work in progress, I wouldn’t want to buy and hold with all or most of my nest egg. But in reality, this stock is just one of 15 presented by the Prudent Yield Hog model, which gets rebalanced every three months. Considering that the model has a hefty sentiment component, which probably means lots of opportunities to exit gracefully if the future starts to look less interesting than I now expect, and the fact that it appears in the more aggressive version of the model (meaning the other 14 stocks are likely to be comparable risky), I’m fine with this.

Appendix

The Prudent Yield Hog model, created on StockScreen123 and introduced in a 3/1/11 Seeking Alpha article, is based on the notion that income-seekers can achieve satisfactory returns by reaching for the highest possible yields if they work with a list that has been pre-qualified to eliminate companies that bear the greatest risk of dividend cut or elimination.

It uses a screen that contains the following rules:

Basic Universe Definitions:

Eliminate OTC stocks, stocks trading below $5, stocks with market capitalization below $250 million, ADRs and companies classified as Miscellaneous Financial Services (most of which are closed-end mutual funds).

Daily volume over the past 60 days must have averaged at least 50,000 shares.

Yield must be equal to or greater than 2/3 of the rate on the 10-year Treasury.

Yield may not exceed five times the rate on the 10-year Treasury.

For this pushing-the-envelope version of the model, the stock must rate 40 or better on a scale of zero to 100 under a ranking system designed to evaluate high-yielding income stocks; under the default version, it would have to rate at least 60.

Here’s a summary of the ranking system referred to in the last screening rule:

Growth Profile (one third of the score)

Dividend growth (60% of sub-category)

EPS growth (30%)

Sales growth (10%)

Dividend Security (one third of the score)

Trailing 12-month dividend payout ratio (lower is better) sorted relative to industry peers

Investor Sentiment (one third of the score)

Price signals (30% of sub-category)

Technical Signals (30%)

Investor Comfort (40%)

For further detail, click here.

From the list of passing companies (i.e., those that have been successfully pre-qualified), select the 15 highest-yielding stocks.

Figure A-1 shows backtested price performance of the strategy from 3/31/01 – 2/28/11 assuming the model is re-run and the list refreshed every three months.

Figure A-1

[Click to enlarge]

Click to enlarge

That’s price performance only. The model faltered during the financial crisis of 2008, as did most other strategies. But the overall start-to-finish capital gain was 106.7%; or 7.6% annualized, which would be added to the yield, which was often in the neighborhood of 9%.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in VGR over the next 72 hours.