Avi Morris'  Instablog

High yield sectors have had a truly outstanding year in 2009.  Junk (high yield) bond funds are up over 50%, from a time when their yields were at record levels (above 25%).  Then risk was being punished, risk averse became the driving force for investors.  The subsequent rally has reduced yields from dividends paid by junk bond funds to 10-12%, not too far above the 9% area they have yielded in the best of times.  Last week, Bill Gross, head of PIMCO, the world's largest owner of debt, said junk bonds had peaked.  Junk bond funds sold off but have bounced back partially this week.

The Dow Jones REIT Index plunged from the 250s prior to the financial crisis last year to 82 early this year.  When the financial crisis hit full force, some REITs were forced to cut or eliminate dividends under financial pressure, including the largest REIT - Simon Property (SPG).  Then REITs had a strong recovery around midyear.  After more than doubling from their lows, REIT gains have been limited by choppy trading in the last 3 months.  The index has waffled around 160 or 10% below its peak 6 weeks ago.  Worries grow that vacancy rates on properties will rise if economic recovery is slow. 

MLPs suffered a similar decline.  The Alerian MLP Index had already fallen to 270 by September of last year, then it plunged below 155 (a 6 year low) in the extreme market sell-off.  Early this year, the yield on the index soared to over 15% (never seen before).  Since then MLPs rallied, many have doubled from depressed levels.  Their businesses continue strong, moving more oil and gas through pipelines.  MLPs have not had trouble selling more equity units and borrowing more money.  Raising capital is critical for their their investment programs, pipelines and terminals.  They have just announced Q3 earnings and distributions for Q4.  Many of their distributions showed quarter over quarter distribution increases.

While near their yearly highs, high yield securities are feeling selling pressures after their best year in history.  Their future is tied to a rapidly improving economy.  Greater concerns about a sluggish rebound are encouraging successful investors to take some money off the table.  A faster recovery will solve many problems associated with high yield securities.  Stretching out the recovery will aggravate problems - higher default rates on junk bonds, higher vacancy rates on properties, etc. I worry that high unemployment rates (including under-employed workers) and soggy levels for housing, autos & retail sales into 2010 will bring higher yields and correspondingly lower prices for these securities.

Disclosure: long SPG

Dividends and capital gains are the 2 ways for earning money when investing in stocks.  With stocks experiencing one of their best years in history, dividends are being ignored even though they can be helpful earning a steady rate of return.  The S&P 500 Dividend Aristocrats are members of the group required to have a minimum track record of 25 consecutive years of paying higher annual dividends.  Only about 10% qualify.  Below are 2 excellent companies, one which everybody knows & a second which is not as well known.  Each has an outstanding and consistent record of dividend growth, a valuable tool in earning high rates of return.

Coca Cola (KO), founded in 1886, has the best known brand names in the world.   They sell Coca Cola and related cola syrups to their bottlers which are in turn sold to retail businesses around the world.  Coca Cola claims to be in more countries than the UN.  Additional drinks include Minute Maid, A&W Root Beer, Glaceau, Dasani and brands specific to foreign countries.  In the last 2 decades, the stock had a run from 20 to over 80 in the middle of the first decade.  Then it pulled back to the 40s where it has largely traded since then.  In the last 10 years sales doubled to $32 billion, EPS and dividends have more than doubled.  Their finances are quite strong, allowing them to purchase more than 1.2 billion shares of treasury stock. Coca Cola has increased the annual dividends for more than 40 consecutive years.  At 53, Coca Cola still yields over 3% (far above yields on short term instruments).  With aggressive expansion overseas, i.e. China, Russia, etc., revenues and profits should keep growing so they can continue their streak of higher annual dividends.

Automatic Data Processing (ADP) does not have a well known brand name, but it has an outstanding track record of growth.  They were founded 60 years ago to provide business services (many are payroll related) and this has been a growth business.  In the prior decade the stock went from 6 into the 40s as markets reached record highs in 2000.  Even though the current decade has been a tough time for the stock, earnings per share have doubled (aided by treasury stock purchases) while the stock has mostly traded in the 40s.  Increasing the yearly dividends raised the yield from 1% to over 3%.  A month ago, in the annual report, their president talked about the strength of their business models and said, "I remain optimistic about out longer-term objective to achieve high single-digit annual organic revenue growth, supplemented by acquisitions, with at least 15% earnings per share growth."  He also mentioned that ADP is one of a handful of companies with AAA credit ratings.  At 41, the stock yields a respectable 3.3% which should continue to increase going forward.

Dividend Aristocrats are high quality companies (like these).  They have outstanding track records, especially when measured by consistent growth of dividends, as rewarding investments over the long run.  With a yield of 2-3% (or more), earning an annual rate of return of 10% becomes easier.  Steady annual dividend increases helped with reinvested dividends provide even more help.  One word of caution.  There are a number of Dividend Aristocrat lists posted and by definition they have to be at least 1 year old.  I estimate about 10 companies have been removed from the list in the last 2 years.  When evaluating any company, it is important to verify that dividends have been increased particularly in the last 2 years (a time when quite a few have not continued their streak of higher annual dividends).  Gains from dividends deserve more respect.

Disclosure:  Long K

MLPs keep roaring ahead taking them to new yearly highs.  It seems like we're in a new world when remembering last October.  I had just written a primer article on MLPs, introducing many investors to a new type of investment.  That was at the start of September, after MLPs had already fallen 20% from their peaks in the prior year (along with other market averages).  Then they plunged and by October it looked liked they were heading for zero.  Risk averse was the driving force in investment thinking, all securities with high yields were being thrown away without regard to their investment value.  The collapse of Lehman in September made matters worse for MLPs because they had been a big believer (and investor) in MLPs.  MLPs went through an awful 6 months as yields shot up to over 15%.  But believers were rewarded.

From their lows, MLPs have rebounded sharply.  The Alerian MLP Index (AMZ) at 265, is up a dazzling 100+ points from the lows in March.  Aside from a modest setback in June and settling into a trading range during August-September, the rise has been about as steady as could be hoped for.  In October, the index is up 10% from the low of the latest trading range. 

The reasons for this optimism are simple.  MLPs have gotten through the credit crisis in excellent shape.  They continued to sell units to boost equity, allowing more borrowings to finance expansion of pipelines and terminals (long term assets).  Kinder Morgan (KMP) is the largest MLP.  They've raised over $750 million in 2009 (75% of their goal for 2009) by selling units which allowed them to increase borrowings.  Last month Enterprise Products Partners (EPD) sold $250 million in units and arranged to borrow an additional $1.1 billion.  In addition, a merger with TEPPCO Partners (TPP) was just approved by TEPPCO unit holders at a special meeting.  This will create the country's largest MLP with a value of approximately $30 billion.  Other MLPs are buying additional assets (terminals, etc.), those transactions are part of their large capital expansion programs.  These stories are common among MLPs, they have been able to finance expansion during the credit crisis.

OK, it has not all been smooth.  A couple of smaller MLPs, such as Constellation Energy (CEP) and Breitburn Energy Partners (BBEP), have had to eliminate distributions so they could concentrate on reducing debt.  But they are making progress and their units have more than doubled from the 2009 lows.  Quarterly updates will be released next week.

For those new to MLPs, a little extra explanation may be helpful.  Investors buy units (not shares) in master limited partnerships (MLP).  MLPs pay distributions which are typically 80-90% tax free and their yields are high.  But tax free brings tax hassle.  A yearly K-1 tax statement is sent around early March with terms like depletion and amortization that have to be dealt with.  However I've been told that tax preparation programs help with tax preparation.  In addition, records have to be kept since the cost basis of the investment is reduced. 

Risk premium, the spread of the yield on the Alerian MLP index over the yield on the 10-year Treasury bond, is very important.  The rule of thumb had been that a 200 basis point spread was to be expected.  A narrowed spread indicated a good time to sell.  MLPs peaked in July 2007 with a spread near zero when the yield on the Treasury bond had risen to 5¼%.  That was the time to sell.  A few months ago the premium shot up to well over 1000 basis points, signaling a good time to buy MLPs at low prices.  The yield on the Alerian MLP Index is currently 7.8%, down sharply from 15% earlier this year, with a spread of more than 400 basis points.  Bulls would say this spread still gives a buy signal (based on the 200 point basis point standard).  Bears would say the risk is higher now, justifying a larger spread.

There are ways to invest in MLPs by buying stock.  A tracking new ETF (AMJ) is priced at 10% of the Alerian MLP Index value.  It rises and falls along with the Alerian Index and provides a dividend from net distribution income.  2 of the largest MLPs have stock equivalents in addition to their units:

Kinder Morgan (KMR)
Enbridge Energy (EEQ)

These are called management corporations, each share has one unit backing it and generally sells at a small discount to the unit value.  When distributions are paid, shareholders receive an equivalent stock dividend.  Being corporations, they are retirement account friendly and tax efficient for individual accounts since there is no need to issue a 1099 tax form.  The stock dividends make for a very efficient automatic dividend reinvestment program. 

The astounding rise this year comes from greater recognition that MLPs have gotten through the credit crisis without significant problems.  They have high yields which are largely tax-free, units have low beta price movements and their track record of growth is excellent at a time when shaggy long term track records are common.  The Alerian Index has grown 2.7 times in 15 years.  With reinvested income included, that index has grown 6.9 times.  MLPs are overbought short term, but a pullback by MLPs should provide a better time to invest for term growth and income.

Disclosure: no positions

Stock markets are having one of their best years in history.  Most averages are up over 50% from their lows in March. As usual, the gains have not been spread around equally.  Some of the Dividend Aristocrats have been left behind and represent superior opportunities for value investors.

Dividend Aristocrats are companies in the S&P 500 which have minimum track records of 25 consecutive annual increases for their dividends.  However, this elite group has shrunk in the last year.  All banks are being removed after dividend cuts.  This year, General Electric (GE), Pfizer (PFE) and Masco (MAS) have cut dividends which will take them off the list by next year.  But those remaining in the group represent excellent values, many have been left behind in the market surge this year.  These were the kind of stocks recommended by top analysts when the markets were at their lows (so much for listening to the "experts" for investment advice) last March.  Now many of these companies represent good values.

Eli Lilly (LLY) is a stock I have owned for many years.  The last decade was an excellent period for their stock but followed by a terrible time in this decade.  Early in this decade the stock was over 100, today it has fallen to 35.  Meanwhile their dividend has consistently been raised.  Next year's increase should be announced early in 2010 which could take it over $2.  At the beginning of this decade, their Prozac lost patent protection but Lilly went forward.  Zyprexa, their top selling drug today, will lose patent protection in a few years.  However, they've acquired ImClone to become a bio tech and cancer powerhouse.  They have many drugs working their way through the pipeline.  EPS is forecasted at $4.30 this year and is expected to rise to $4.65 next year.  Selling near their low price in this decade, with a 6% yield and a long time Dividend Aristocrat should make Lilly an investment candidate for value investors.

Exxon Mobil (XOM), a Dow stock and new Dividend Aristocrat, is the largest oil company in the world.  It's made up of Exxon and Mobil, the 2 largest companies spun off after Standard Oil was broken up in 1911.  The stock has roughly doubled in the this decade, but has not performed well in recent years.  The price of 73 is where it was 3 years ago.  Their successful 100 year track record along with prospects for future growth should make Exxon a good investment for the long run.  EPS is depressed this year after the large decline in oil prices, but next year Exxon is forecasted to earn $5.87.  The $1.68 dividend is well covered.

Wal-Mart (WMT), another Dow stock, is one more company so large that everybody knows their business.  The stock has been flat in the last decade, trading in the 45-60 zone.  Their growth keeps Wal-Mart moving forward allowing them to raise dividends yearly.  Growth from expanding their chain of stores, especially in China, should enable them to keep increasing dividends.  The stock trades at 52 with a $1.09 dividend.  Earnings are forecasted at $3.59 in 2009 and $3.90 next year.

These are just 3 Dividend Aristocrats.  The remainder generally have excellent tracks records which have let them continue increasing dividends even through the credit crises.  Dividend Aristocrats deserve more attention for value investors. 
Disclosure: Long LLY

The last 12 months have been an unusually volatile time for MLPs.  Traditionally they are low beta securities, but in September 2008 stocks fell off the cliff and MLPs joined in the massive sell-off.  It looked like the end of the world, there were even requests to get Chicken Little's phone number.  MLPs had a very rough 5 months but then they came roaring back from the lows in March 2009.  The Alerian MLP Index shot up from under 160 to just above 250.  Then for 2 months the index traded sideways in the 240s, no advance while the rest of the markets kept going higher.  Yesterday (October 7) it was at its new 2009 high of 252.  Because the index did not break through the ceiling with conviction, it's too early to tell if MLP buyers can take the index to new highs.

MLPs pipelines kept moving oil and gas in 2009.  They have been able to secure large sums of outside financing for capital expansion (their main business).  A few MLPs had to eliminate distributions to get their finances squared away.  BreitBurn Energy Partners (BBEP) just reaffirmed their borrowing base of $732 million.  Translation is they reduced borrowings by $150 million and gave the impression that distributions may return fairly soon.  The units gained and have more than doubled from the depressed lows earlier in 2009.  Constellation Energy Partners (CEP) also eliminated its distribution in 2009 and will probably make an announcement soon about improving their finances.  MLPs announce results and distributions for Q4 later in October. 

The 2 largest MLPs, Kinder Morgan (KMP) and Enterprise Products Partners (EPD), have continued to attract billions for their capital expansion programs.  Kinder Morgan said they have already raised over 75% of the $1 billion in equity funds they expected to raise (by selling units) in 2009.  Increased equity allowed them to increase borrowing with attractive rates at a time when loans have been difficult to obtain.  Enterprise Products Partners (EPD) just borrowed another $1+ billion after selling more than 8 million units.  They are also completing a merger with TEPPCO Partners (TPP) which will make them the largest MLP.

Overall, MLPs have gotten through the credit crisis in good shape.  Many have maintained or increased distributions, only a few have cut or reduced theirs and it looks like they will survive.  The very brave might want to buy MLPs which have eliminated distributions hoping to benefit from higher prices if distributions are restored (or partially restored).  The biggest worry is if the economy pulls back again, how will that affect MLPs?  Their results are fuzzier than for other companies since distributions are paid from distributable cash flow, not EPS, and few really understand distributable cash flow.

Disclosure: no positions

Junk (high yield) bonds are having their best year in history.  At the start of 2009, risk averse was the popular theme in plunging stock markets.  Junk bond prices plummeted sending their yields over 25%.  Since early March, stocks roared back (popular stock averages are typically up 50%) and the rebound in junk bonds has been even more dramatic.  Risk is being embraced and rewarded.

However Treasuries rallied when risk averse behavior became the motivating force in the markets early in 2009.  That rally cut the yield on the 10-year Treasury to only 2%.  Then junk bonds rallied and Treasuries sold off sharply.  The yield on the 10-year Treasury soared, touching 4% two months ago.  In the last 2 months, Treasuries rallied again taking their yield back below 3¼%.  Meanwhile in the last 2 months junk bonds extended their rally, bringing their yields even lower to around 11-13%.  But the junk bond rally has flatten remaining at or near 2009 highs in the last 2 weeks.  This could be signal for the end of the 2009 rally in junk bonds.

Yields on junk bond funds are not too much higher than their lowest yields in the best of times, around 9%. I recently met with 2 money managers for junk bond funds.  One was very optimistic about the outlook for junk bonds primarily based on an expected strong rebound for the US economy next year (with a growth rate of 3+%).  A high growth rate  would take care of many bond default problems.  The other manager was much less optimistic about the future.  He is concerned about current high default rates on junk bonds, worried that high default rates may continue or even rise. 

The disconnect between the recent rise in prices for Treasuries (quality bonds) and junk bonds is significant and can not last.  I worry about a sluggish recovery for the economy keeping default rates high for junk bonds, requiring higher interest rates than current (which are only slightly above the lowest rates in the best of times).  Higher interest rates will require lower junk bond prices.