CJ MacDonald, Portfolio Manager at Westwood Management, is out with a note this week covering the history of dividends and an eye toward today’s changing dividend landscape in technology.

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Dividend and Tech Stocks: Happy Days

February 2012

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“The only thing that gives me pleasure is to see my dividends coming in”– John D. Rockefeller (1839‐1937)

 According to Google Books, the use of the word “dividend” peaked in 1922, when the yield on the S&P500 was 6.3%. At the same time the words “Charleston”, “flapper”, and “prohibition” also peaked in usage. In the mid‐1950’s, as dividend yields hit 5.7%, “dividend” had a brief resurgence and the words twist, doody, and hydrogen were also common. In these two disparate decades, following two costly world wars, investors were much less interested in the uncertain potential gains from stock price movements, and much more focused on the certainty that dividend checks appearing in their mailbox provided. Dividends were how “gentlemen” received gains on their stock investments and therefore, their payment was expected by shareholders. Incidentally, the phrase “share repurchase” did not even enter the investing lexicon until the mid‐1970’s. So for most of investing history, there was only one way to share company profits with shareholders: the payment of regular dividends. Dividend payments were thought to ensure capital discipline by management, and provide a valuation floor for the stock. Unfortunately, those good old days changed with the times, and companies found ways other than dividend payments to spend shareholder capital.

 The dividend yield on the S&P averaged 5.4% during the first 50 years of the last century. However, since 1950, the market has averaged a 3.4% dividend yield, and since 1980, investors have received just 2.7% in yield. Even more troubling is the paltry 1.7% yield investors have received over the past 15 years. Corporate managements in recent times have hoarded cash on their balance sheets, and used it for other purposes that were thought to increase shareholder value more than dividends, such as share repurchases, acquisitions, and global expansion. During this period, unfortunately, paying dividends became thought of as stodgy and old‐fashioned. It was considered a silent admission that they could not find a more productive use for the capital, so managements were forced to sheepishly hand it back to shareholders.

 Meanwhile, since 1980, many things have changed. With more than $1 trillion in cash sitting on corporate balance sheets today, corporate America is in terrific financial shape, with profit margins, productivity, and efficiency at historic levels. Corporate debt levels are also extremely low, with the borrowing window open at historically attractive low interest rates. In addition, the yield received on some alternatives to dividend paying stocks are extremely low. The 10‐year government bond yields less than 2.0%, and the latest investing craze, gold, yields nothing. In today’s world of slower global growth, managements are finding fewer avenues in which to grow revenue. Cash is piling up at a record pace and dividend payments are beginning to grow again. Total dividends paid out by S&P 500 companies have actually increased from $196 billion in 2009 to $241 billion in 2011. In 2012, projected dividend payments are expected to be a record $275 billion. However, dividends are not growing at the same rate as cash, and the payout ratio, i.e. the portion of overall earnings that are paid out in dividends, now sits at an historic low. With personal tax rates on dividends at a very favorable 15% rate, we need more dividends!

Many strong companies that have previously shunned paying dividends may have to start yielding to shareholder demands and begin paying out more cash in the form of dividends. Companies like Apple, with $98 billion of net cash, could initiate a 2% dividend payout using only about $9 billion of that cash pile every year. And huge cash flow generators such as IBM, Microsoft, Oracle, and Intel could certainly increase their payouts and still remain in strong financial shape. The time honored maxim that “technology companies do not pay dividends” is slowly fading, as these high‐return companies pile up cash and find internal investment opportunities less attractive than in years past. As a result, dividends in the Technology sector, which have begun to rise, will certainly continue rising in the coming years. 

 1) Demand: Investors are changing their perception of dividends. In this low yield environment, investors do not view dividends as just a nominal payout, but consider them a significant and necessary sharing in the profits of the companies in which they own stock. Corporate managements are hearing a louder call these days from investors for higher dividend payouts, and CEOs are starting to respond. So far in 2012, 61 S&P 500 companies have announced dividend increases and we expect there will be more to come. Managements listen to their largest shareholders, and these influential owners are demanding higher payouts.

2) Visibility: Companies survived the 2008‐09 economic downturn by cutting costs, laying off workers, and doing more with less. Since those dark economic days, business growth has returned, with lower costs and higher margins. Managements have much greater visibility and clarity in their future than they did three years ago. Confidence in future cash flows has returned, and corporate chiefs know that the worst is behind us. Increasing comfort with raising dividends is a reflection of that confidence.

 3) Cash: Cash on corporate balance sheets is at a record high, but at the same time the yield on that cash is at a record low, and is even negative when inflation is factored in. The inefficiency of keeping cash on the balance sheet at negative returns, i.e. negative real yields, is loud and clear, and management is further diluting rates of return on their businesses by continuing to hoard cash for a rainy day that they have already experienced. Investors are not rewarding companies in the form of higher stock prices for keeping a pile of cash on the books that is earning nothing, so management will increasingly choose to pay it out to shareholders.

There are many stocks that have such great underlying business prospects and high dividend yields that they could be considered “Fixed Income Stocks”. Among them are many companies that have raised dividend payouts consistently over many years, and have such steady businesses and high returns on invested capital that they should be able to increase dividends consistently in the future. Some great examples include:

 Abbott Laboratories (ABT, 3.5% yield): Strong cash flows from Abbott’s main drug Humira, which treats rheumatoid arthritis, as well as their vast portfolio of products, from vascular products to infant formula, should allow ABT to increase their dividend at their normal 10% yearly growth rate. A strong new product pipeline, solid earnings growth, and global market reach gives the underlying stock a good shot at share price appreciation as well.

Emerson Electric Co. (EMR, 3.1% yield): Emerson’s broad portfolio of high‐quality industrial businesses have allowed it to gain a reputation for providing consistent returns to investors, both in dividend yield and stock appreciation from growth of the underlying business segments. Emerson has re‐tooled the company over time to focus on higher margin, higher growth business areas around the globe, and the current earnings and cash flow growth is a testament to that focus. Emerson should be able to consistently grow the dividend over time, at their 5‐year clip of 10% a year, and also make strong, sound acquisitions around the world, with great focus on emerging markets.

Intel Corp. (INTC, 3.1% yield): Intel’s 90%+ market share in the $30 billion computer processor market leads to large free cash flows, while still allowing for an unmatched amount of capital to be deployed into research & development to help maintain industry domination. Intel has grown its dividend 15% a year over the last five years, and looks poised to continue to do so, with high barriers to entry in its core business, and a large pile of cash in the bank.

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Since 1962 the S&P dividend yield has averaged less than half of the 10 year Treasury note yield. Given the current low level of bond yields and the demand for higher dividend yields, the S&P dividend yield is actually higher than the Treasury yield today. This margin may increase, given the Fed’s promise to keep interest rates extremely low through 2014, and continued demand by investors for higher corporate dividend payouts. Since its founding in 1983, Westwood has consistently owned high quality, cash flow generating companies on behalf of its clients. Market focus certainly changes over time, but as the market appetite for use of corporate cash comes full circle, and dividends come back in vogue, we believe strategies that invest in high quality dividend paying stocks will be quite attractive over the next few years. Hopefully, we can leave words like “flapper” and “doody” in the past where they belong.

Volume 17, Issue 1

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Market Performance

The year 2011 will be remembered for many things, but investors will likely focus on the market’s volatility. A lack of confidence in political leadership in the US and Europe created extreme levels of volatility, which was the key theme for the year. When coupled with fears about the macro-economic environment, asset prices became highly unpredictable. This crisis of confidence hindered business and consumer spending, and the S&P 500 traded in a volatile 21% range over the year while 10-year Treasury yields fell 200 basis points. Earnings growth, however, remained strong, as S&P 500 corporate profits rose at a consistent double digit rate. Interestingly, despite all the angst felt during the year, stock market indices effectively ended the year unchanged.

The market rebounded in the 4th quarter as strong earnings growth, improved US economic data, and optimism surrounding
the European debt crisis encouraged investors. Better data on housing & employment, and stronger than expected consumer spending convinced investors that the US was not heading into a double dip recession, while S&P 500 earnings posted another double digit year-over-year growth rate during the 4th quarter, confirming a positive outlook for US corporations.

European leaders continued to propose and debate plans to mitigate the risk of a financial crisis precipitated by
default of sovereign debt, and although the details of their plans were largely met with skepticism, the consensus seemed to be that EU leaders were at least on a path that will prevent the situation from deteriorating further over the coming year.

Importantly, despite the many concerns that persisted as the year ended, the improvement in sentiment over the final 3
months of the year was encouraging. Economic data was fairly robust as the year came to a close, and had many believing that 2012 growth could surprise on the upside. Specifically, the four week average of weekly unemployment claims was anchored below the important 400,000 level, housing starts and pending house sales were in an uptrend, and holiday sales were better than expected. Also, home affordability was at an all-time high while the credit card delinquency rate had plunged to a record low.

As a result of moderation in the growth rates of emerging markets, commodity prices were generally well-contained during
the quarter. Crude oil, however, was the notable exception as it rose to $100/bbl. on fears of supply disruption. Gold
prices fell below $1600/oz. as investors began to question the sustainability of the rapid appreciation of the precious metal.

Domestic Equities

In the equity market, fear and volatility led investors to favor sectors with defensive characteristics, specifically Utilities, Consumer Staples, and Health Care during 2011. The best performing sectors during the fourth quarter included Energy, Producer Durables, and Materials & Processing, as economically sensitive stocks with global exposure rebounded nicely due to the renewed optimism about the global economy. Financial Services stocks also performed well, as the announcement of a new stress test for US banks and recapitalization/funding plans for European banks produced hope that a financial crisis will be averted. The worst performing sectors were those that led the market during the previous quarter, specifically the defensive Consumer Staples and Utilities sectors. In addition, although macro fears continued to impact stock price performance, earnings and company fundamentals were much more important factors for investors than during the 3rd quarter.

International

International equity markets were volatile during the fourth quarter, ultimately ending slightly positive for the period. A mix of positive and negative factors buffeted markets. Corporate earnings in 2011 generally met or exceeded expectations, highlighting corporate resilience despite macroeconomic headwinds. Concerns over slowing world growth and sovereign debt problems in Europe were prevalent during the quarter, although the mid-December announcement of a European Central Bank (ECB) plan to provide liquidity to banks heartened markets as it signaled ECB readiness to backstop the banking system. Emerging markets performed well in the quarter due to lessening fears related to Europe’s debt crisis and on China easing monetarily to avoid a hard landing.

During the quarter, sector leadership was mixed as two traditionally defensive sectors, Consumer Staples and Health Care, outperformed as investors sought safety amid market volatility. Among cyclical sectors, Energy was the best performer as it benefitted from the rising price of oil, and Industrials also outperformed. Among the worst performing
sectors were Utilities and Financials. In currency markets, the euro declined against the U.S. dollar as investors remained concerned about the sovereign debt crisis. However, the Australian dollar and the Canadian dollar strengthened relative to the U.S. dollar due to the improved outlook for these resource-based economies.

Fixed Income

During 2011, fixed income investors were not immune to the stock market’s gyrations, and benefitted from a flight to safety trade. Treasuries surged as investors fled the stock market in search of the perceived safety of fixed income securities and as the Federal Reserve maintained its commitment to low interest rates via “Operation Twist” and a continuation of a zero Fed Funds rate. As a result, the 10-year US Treasury produced a 15% return and the 30-year Treasury gained over 35%. The Federal Reserve maintained its commitment to a zero Fed Funds rate at least until mid 2013, but did not embark on a third quantitative easing program, as many had hoped for. However, the turnover on the FOMC in 2012 is likely to result in a membership that is more willing to provide monetary accommodation to the economy if they deem it necessary. Globally, there have been roughly 50 central bank easings since August, including many by governments in emerging market nations. This is a sign that liquidity will not be a problem as we continue to work through the aftermath of the 2008 recession.

In a dramatic change from the extreme volatility experienced over the first three quarters of 2011, interest rates ended the fourth quarter largely unchanged. Events in Europe were once again a constant source of anxiety, but a series of better than expected economic reports, especially on the U.S. laborfront, provided a modest source of relief for investors. At both their November 2nd and December 13th meetings, the Federal Reserve once again reiterated their commitment to keeping short interest rates at 0% for the foreseeable future, and signaled that additional policy responses would be considered as needed. In response, investors sought out duration and once again embraced risk, causing credit spreads to tighten over the final three months of the year.

While more modest than in the third quarter, positive returns were once again the norm in the fourth quarter. After being
the star performer all year, Treasury securities took a back seat to corporate bonds in the fourth quarter as investors sought an alternative to the record low yields offered by government securities. However, with a gain of approximately 2% in the final period and over 35% for the year, the 30-year U.S. Treasury bond easily remained the top performer for all of 2011. Commercial mortgage backed securities, along with long duration corporate bonds from the Industrial and Utility sectors generated the highest returns in the fourth quarter, gaining almost 4%. Floating rate mortgage bonds and short duration Treasuries provided the bottom performers for the period.

This divergence between stock price performance and improving profits highlights the difficulty faced by fundamental stock pickers during 2011. The seemingly strong fundamental attributes of public companies often could not offset the pessimism created by negative macro‐economic headlines. We believe that these positive fundamentals will ultimately be the driver of investor sentiment and stock prices. Equity investors should benefit from a bottom‐up, fundamental approach in 2012, while the search for growth and income will continue, which should provide support for high quality equities and other income‐oriented asset classes outside of traditional fixed income.

Summary of Key Global Events

Markets were buffeted early in the year with the stirrings of unrest in Arab countries. Protests in Tunisia led to the ousting of its longtime President and created the opportunity for a more democratic regime. The success in Tunisia sparked the “Arab Spring”, a wave of protests across Africa and the Middle East. Conflict in Libya and supply disruptions in this oil‐producing country caused a spike in global oil prices from the mid‐$90 range at the beginning of the year to over $125 by April. Other commodity prices also spiked, with cotton, gold, copper and coffee reaching all‐time highs in the first half of the year. In March, the focus shifted to Japan when the island suffered a 9.0‐magnitude earthquake and a tsunami that caused severe damage to residents, businesses and the Fukishima nuclear plant. Success in the war on terror, as the US eliminated Osama bin Laden in early May, was followed by rising concerns over a breach of the US debt ceiling and failure of Congress to agree on a meaningful solution. As a result of Congress’ failure, Standard & Poor’s downgraded the US long‐term federal debt, further pressuring equity markets. In the third quarter, concerns shifted back to Europe and the potential domino effect a default of Greek debt might have on the financial health of the rest of the Eurozone. However, by December, it appeared that the EU and ECB were moving forward with a plan that could delay any serious consequences from the sovereign debt issues faced by the weaker Eurozone nations.

Asset Class Performance

In addition to fixed income, other yield‐oriented asset classes performed well during 2011. Master Limited Partnerships (MLPs) and REITs both generated strong positive returns as investors sought out income in the face of historically low bond yields. This trend can continue in 2012 as bonds trade at very low interest rates and the retirement rate of the Baby Boomer generation expands. Also, despite the fact that foreign asset classes have been in strong demand for the past several years, concerns about Europe and a potential slowdown in Chinese economic growth resulted in the US capital markets outperforming most foreign markets during the year. A continuation of global macro fears in 2012 will likely result in similar outperformance for the “safe haven” US markets.

Growth vs. Value

Growth stocks outperformed Value stocks in 2011. The divergence between the two styles in the large cap indices arose almost entirely from the Financial Services sector. The sector comprises almost a quarter of the Russell 1000 Value index and produced a 19% decline in 2011 as concerns about the health of big banks and insurers drove stock prices lower. In contrast, the Russell 1000 Growth maintained just a 4.4% average weighting in Financial Services companies during the year and was, therefore, much less impacted by the sector. Although there remain concerns about the health of Financial Services companies, especially banks, we believe that valuations reflect an extremely negative scenario that is unlikely to occur due to improvement in the mortgage market and US unemployment as well as the big banks’ solid capital levels and limited exposure to European debt. As such, we view many financial stocks as attractive based on currently depressed valuations.

Large vs. Small

Performance varied widely by market cap. Large companies, as measured by the Russell 1000 index, were up modestly for the year reflecting their strong earnings growth and perceived safety relative to more aggressive asset classes. The small cap universe, as measured by the Russell 2000, underperformed the large cap index predominantly due to declines in Health Care and Producer Durable securities. Importantly, larger firms, which have lagged the smaller, more aggressive stocks for several years, rose in 2011 on their attractive dividend yields, favorable valuations, and stable business models.

2012 Outlook

We believe the economy will generate positive growth in 2012. The broad stock market, as well as other income‐oriented asset classes, has the potential for an attractive return. Several factors support this belief:

Profit growth: Despite the debt crisis in Europe and slowing growth in emerging markets, S&P 500 companies are likely to generate another year of double digit earnings growth. The rising commodity price environment has already begun to reverse itself and should provide a profit tailwind. Specifically, after an initial surge in the spring of 2011, oil prices have modestly declined while natural gas prices have also fallen as new extraction technologies in the United States have increased supply. Other commodities, such as cotton and copper, have likewise backed down from highs reached earlier in the year.

Housing: A turn in housing could also support equity performance. Housing starts have been well below replacement and normal growth levels of approximately 1 million units for several years. Price declines have slowed, and are even positive in some places (see chart at right). With the labor markets slowly improving, home pricing stabilizing, mortgage rates at historic lows, and home affordability at an all‐time high, household balance sheets have stabilized, creating an uptick in the consumer’s confidence in investments and the US economy. A positive development such as this should provide a positive backdrop for increased personal consumption and job creation.

Employment & Spending: Weekly jobless claims have fallen below the important 400,000 level for 4 straight weeks (see chart below), while the unemployment rate has fallen below 9%. Although these are not eye popping numbers, they do indicate that the healing process continues. And, when combined with the strong Christmas season spending data, point to a needed improvement in the health of the consumer.

Low Interest rates and Credit Availability: We anticipate a continuation of low interest rates here in the US, as the Fed employs tools to keep rates across the yield curve at very low levels. We also expect to see a continuation of accommodative monetary policies & rate easing from foreign central banks, including those in the emerging markets. In addition, bank lending has improved, and lending standards have begun to ease, which should lead to greater credit availability.

European risk containment: While policy makers in Europe will continue to struggle with the issues at hand, we believe that the situation will not dramatically change for the worse over the next 12 months. Many details of the recent fiscal agreement still need to be worked out, but EU leaders seem to be progressing toward the tough decisions and actions that must occur to prevent a financial collapse.

Although we don’t expect robust US economic growth in 2012, we do believe that US stocks have the opportunity for doubledigit gains based on their cheap absolute and relative valuations and our outlook for corporate earnings growth. Dividend paying stocks should benefit from investor demand for yield, while the US markets have become the safe haven favorite of global investors.

As always, there are risks to this outlook. Volatility will likely be caused by presidential elections (7 of the G20 nations will hold presidential elections next year), as well as the potential for a failure of EU leaders to contain the debt crisis. However, it’s also possible that too much negativity is priced into markets today. A more robust economic growth rate in 2012, driven by the stimulus of negative real interest rates, would likely drive stocks much higher and be the “good surprise” that very few are expecting. Ultimately, we need an improvement in confidence on the part of consumers, businesses, and investors to see the valuations that we believe US company fundamentals merit today.

Thank you for your continued support. Please contact us if you have any questions or comments.

Volume 16, Issue 10

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Market Performance

Investor tolerance for risk took a sharp nosedive during the third quarter as a number of global events conspired to reduce optimism about future economic growth, both here and abroad. Foremost among these events was the failure of policy makers in the U.S. to put aside partisan bickering and compromise on extending the debt ceiling until the eleventh hour. The debt rating agency, Standard and Poor’s, took that as a sign of further stalemates ahead as Congress attempts to address our untenable debt situation and acted by removing the triple-A rating from U.S.Treasuries. The downgrade was accompanied by heightened concerns about a possible Greek debt default and the potential for a financial crisis in Europe. Finally, weakening economic data, including a lack of job creation during August, prompted more selling by volatility-weary investors. Although stock losses were widespread during the quarter, the market continued to trade in a range following the steep early August sell-off, with rallies occurring following any indication of progress towards a solution to the European debt crisis.

Domestic Markets

During the quarter, defensive stocks, companies with predominately domestic revenue sources, and shares of high quality companies were the best performers. In addition, the flight to quality, coming on the heels of increased investor fears of global slowing, drove capital into other U.S. Dollar-denominated assets and created a tremendous increase in bank deposit balances. The best performing sectors in the third quarter included Consumer Staples and Utilities. The Technology sector also performed relatively well due to the high quality nature of many of the larger stocks in the S&P 500. Energy, Producer Durables, and Materials & Processing, the most economically sensitive sectors, were the worst performers. Despite the continued strong operating results of many companies in these sectors, their shares were driven lower by the extreme macro-economic fears.

The Federal Reserve made two major announcements during the quarter. The first was a commitment to keep the Fed Funds rate near zero until at least mid-2013, while the second, a tactic referred to as “Operation Twist,” is a plan to sell short-term Treasury notes and purchase longer-term Treasury notes. The combination of these two actions is designed to keep interest rates across the yield curve at a very low level for an extended period of time. The goal is to boost economic activity through lower mortgage rates, increased bank lending, and greater risk taking by investors looking to meet certain portfolio return targets. Neither action produced an immediate positive reaction by equity investors, but they have produced
multi-generational lows in interest rates. The real impact on the economy is yet to be seen.

As if the events that roiled the equity markets were not enough to prompt a sharp fall in Treasury rates, U.S. Treasury yields posted one of their sharpest declines in history, with the yield on the 30-year bond finishing the third quarter at 2.91%, a stunning 150 basis points lower than at the end of the second quarter. Fixed income investors were rewarded with positive returns in the third quarter, but the range of performance was exceptionally wide. Without question, the star performer was the 30-year Treasury bond, which gained an astonishing 31% in the third quarter. The 10-year Treasury also posted a return of just over 12%. After proving largely immune to market volatility, credit spreads widened sharply in the third quarter, but most investment grade corporate bonds still managed to generate positive returns. However, issues in the Financial sector proved to be an exception, sharply lagging the broader market.

The third quarter was the worst quarter for the broad High Yield market since the third quarter of 2008, although the trends in underlying corporate fundamentals of most high yield issuers remained generally positive. More highly-rated securities, as well as securities trading to a short maturity date, out-performed the
broad market as investors shunned lower-rated securities that are more susceptible to slower economic growth or generally rising risk premiums. All sectors posted negative returns for the quarter although the Energy, Automotive and Consumer Cyclical sectors out-performed in a sharply negative period. The Financial, Technology and Telecommunications sectors were the worst performers due to their concentration of large, liquid low rated securities that are most sensitive to a market sell-off. Performance for the Short Duration portion of the High Yield market maintained its historical relationship to the broader market, participating in about one-third of the decline. This decline had the effect of pushing yields on the shorter end up in the third quarter. Typical yields for lower volatility, short duration credits moved from 5% to 7.5%. Commodity prices fell in tandem with stocks during the quarter. Crude oil fell from the mid $90s/bbl to the low $80s/bbl, off sharply from a recent high of $113/bbl. Industrial commodities, such as copper, which fell 25% during the quarter, were also under pressure as traders
discounted the slowing pace of global economic activity. Even gold finally lost a bit of its luster, as the bullion price retreated from an all time high of almost $1900/oz. to end the quarter at roughly $1600/oz.

International Markets

International equity markets fell sharply in the third quarter, driven by ongoing macroeconomic concerns. Mounting evidence of slowing growth in both the United States and China was exacerbated by Europe’s failure to address its sovereign debt crisis, raising concern over a potentially more dramatic economic shock. In this environment, cyclical stocks performed poorly, particularly those in the Financial sector, while the defensive sectors generally performed well. Japan outperformed, as their economy is recovering from its earthquake induced slump, and its consumers and corporations are far less leveraged than those in other parts of the world. Emerging Markets performed well initially, but came under pressure toward quarter-end, with some sharp moves in emerging market currencies and in commodities, as funds returned to the U.S. dollar.

Outlook

While macro issues may be the dominating the markets and driving the surge in volatility, it is worth noting that there are more than a few positives to point to today. Many asset classes, including equities, offer attractive opportunities for investing. In addition, there is a tremendous amount of liquidity in the system, including on corporate balance sheets, while interest rates are at a level that is very conducive to fostering economic growth. Falling commodity prices and low mortgage rates are favorable for consumers, and the telltale signs of a recession are just not present today. However, what is lacking is confidence. At Westwood, we will continue to work to earn your confidence each and every day.