Equity Income Strategy: Q2 2020 Commentary
The COVID-19 pandemic continued to spread across the globe during the second quarter. By the end of June, the virus had dealt a severe blow to the global economy. Even as many countries that had shut down their economies in March began the delicate task of reopening with varying degrees of success, others were just entering their worst periods of the pandemic. As of quarter-end, over 10.4 million cases of the coronavirus had been detected and close to 510,000 people had lost their lives. Tragically, the United States accounted for 25% of all cases and deaths.
The process of “flattening the curve” of the spread in the U.S. that began with states and municipalities shutting down in various degrees appeared to have achieved its aim by May as daily cases were on the decline. Pressure built to reopen states because of the severe economic damage the shutdown was causing businesses. Sadly, as I write this, cases have seen a resurgence in June and July as it appears some states may have reopened too early and citizens have neglected to follow recommended social distancing and mask guidelines. NIAID Director Anthony Fauci recently stated that he believes we are still in the “first wave” of the coronavirus. Until a vaccine or treatment is widely available it is very likely that we will continue to see flair ups across the country as leaders balance the need to keep the economy going with the need to tamp down the spread of the virus. As U.S. cases increased by 49% (878,000) in June and shutdowns appear unlikely, many people and businesses are increasingly self-regulating and are growing more cautious about resuming pre-COVID activities.
As expected, the impact on both the U.S. and global economy has been severe. The IMF recently reduced its estimate of 2020 growth to -4.9%, the worst since 1946. It also projected a slower recovery in the second half of the year. Every region is projected to have negative growth this year, which would be a first. Conversely, 2021 is expected to be the best (+5.4%) in 56 years. In the U.S., first quarter GDP fell 5% versus the prior quarter and is projected to drop more than 32% in Q2, the worst quarter since the Great Depression. Job losses from the shutdown were also historic, but not as bad as originally forecast. Over twenty-two million jobs were lost in March and April, with unemployment peaking at 14.7%. However, almost 7.5 million jobs returned in May and June as the country reopened. Despite the uptick in jobs, we are still not out of the woods yet. Bankruptcies caused by the pandemic continue to rise, continuing unemployment claims remain at high levels and companies are beginning to announce new rounds of layoffs. The longer it takes to fully reopen the economy, the higher the probability that many of those temporary job losses will become permanent.
Most economic data fell dramatically in March and April and have seen an uptick since, albeit we remain well below levels before the pandemic hit the country. The unprecedented $18 trillion in global monetary and fiscal stimulus was responsible for arresting the fall through financial backstops for individuals and providing liquidity to capital markets to keep them working orderly. Congress has allocated over $2 trillion through the CARES Act and the Fed increased its balance sheet by close to $3 trillion since the crisis began. Congress is discussing an additional $1-3 trillion aid package currently, although passage is not likely to be as quick and easy as before. The Fed announced in June that it would keep buying at the current pace on an open-ended basis. Furthermore, the new projections (“dot plot”) indicated that the Fed Funds Rate would remain zero-bound until 2023.
On the corporate front, the buyback and dividend suspensions that began at the end of March accelerated in in the quarter as companies pared back on cash outlays to shore up balance sheets. Over 100 companies in the S&P 500 have suspended share buybacks and those companies were responsible for 45% of the index’s buyback activity. Recall that buybacks have been the single largest source of stock market inflows since 2010. Companies also increased equity issuance at the highest level in 20 years on top of tapping the debt markets for over $1.2 trillion in additional capital. Companies slashed dividends at a rate last seen during the Great Financial Crisis. Of the 698 companies in the Russell 1000 that paid a dividend at the beginning of the year, 117 companies (17%) have cut or suspended dividends since mid- February. S&P 500 dividend futures now project a 9% decrease in dividends in 2020, although that is much better than the 35% projected cut during the trough.
S&P 500 corporate earnings fell by -15% in the first quarter, which did not represent the full brunt of the coronavirus and subsequent shutdown. Over one-third of companies that usually provide quarterly earnings projections withdrew guidance for Q2. Current street estimates for the second quarter are calling for a 44% drop from the prior year, which would be the worst since Q4 2008. Furthermore, declines are also projected over the subsequent two quarters before we see a rebound in 2021.
Despite the negative economic and corporate data, equity markets continued to recover from their March 23rd lows over the course of the quarter. The Russell 1000 Value index rose 14.3%, its best quarterly performance since late 2009. Despite the 33% rally off the bottom, the index remained 18% below February 19th highs and down 13.7% for the year. Growth stocks (Russell 1000 Growth +27.8) had their best quarter ever and closed the period at new highs (+9.8% YTD). The S&P 500 rose 20.5%, its best quarterly return since 1998 (-3.1% YTD). Small cap stocks (Russell 2000) rose 25% (-13% YTD) and international stocks (MSCI ACWI ex-US) rose 16% (-11% YTD).
As has been the case for the past several years, growth stocks continued to outperform value stocks by a wide margin. We have often written in prior letters that equity markets have become increasingly concentrated among the mega-cap secular growth companies known as the FAAMG stocks (Facebook, Apple, Amazon, Microsoft & Google (Alphabet)). 2020 has been no different as these five companies now represent over 20% of the market cap of the S&P 500 and 37% of the Russell 1000 Growth. Year to date they have returned an average of 24% while the average return of the rest of the S&P is negative 11%. As the world went into shutdown, their services appeared to be more important than ever, which helped them weather the storm better than most. Mainly due to FAAMG, growth stocks have beaten value stocks 22 of the past 28 quarters by a cumulative 313 percent. In fact, the recent outperformance spread of the past 18 months that was exacerbated by the pandemic is reaching levels last seen during the Tech Bubble in 2000.
Portfolio Review and Outlook
The Principal Street Equity Income Strategy returned 14.2% gross of fees (14.0% net) in the second quarter versus 14.3% for the benchmark Russell 1000 Value. All eight sectors represented in the portfolio were positive for the quarter and 36 out of 40 companies were positive. For the year, our strategy is down -25.3% gross (-25.6% net) versus -16.3% for the benchmark.
The Strategy’s financials sector allocation was the top performing sector for the quarter (33%) followed by industrials and information technology. Morgan Stanley (+54%), Goldman Sachs (+37%) and Broadcom (35%) were the best performers. The Strategy’s worst performing sectors were communication services (+8%) and consumer staples (9%). Walgreens Boots Alliance (-6%%), J.M. Smucker (-4%) and Exelon (-0.4%) were the worst performing companies
Three portfolio companies announced dividend increases this quarter, led by PepsiCo (+7%), Johnson & Johnson (+6%) and IBM (1%). The average quarterly increase for the companies that increased dividends was 4.7 percent. Eight portfolio companies paid increased dividends during the quarter, averaging a 4.9% increase. Our portfolio continues to provide above-market dividend growth with a 5-year dividend growth rate of 9.1% compared to 6.6% for Russell 1000 Value. The portfolio’s average dividend yield is 3.9%; in line with our historical average of 3.7% and well above the Russell 1000 Value’s dividend yield of 2.8%.
Last quarter, we shifted to dynamically overweighting sectors in the portfolio versus equally weighting them based on the current environment and to ensure a more robust set of companies that we feel are able to maintain current dividend policies (we still equal weight portfolio positions at 2.5% target). We exited many sectors in March during the market volatility because we wanted to re- underwrite the portfolio’s balance sheet strength and dividend policies. We added four financials sector companies (Goldman Sachs, JP Morgan, Morgan Stanley, and State Street) on the first of April. We then added two companies in the industrials and materials sectors in early May (Emerson Electric, General Dynamics, Eastman Chemical and Steel Dynamics) and two additional industrials companies in mid-June (Cummins and Snap-on). We are currently avoiding the consumer discretionary and energy sectors due to excess volatility and very uncertain dividend policy going forward. We continue to monitor many companies in these sectors to potentially add to the portfolio in the coming months as things become clearer for their specific industries and the economy as a whole.
Some companies and sectors that were in great shape coming into the outbreak are now completely changed for what we believe will be months if not years. Dividend policies have had to be revisited because of either a need to conserve cash. We are thus paying particular attention to the following:
- Leverage multiples – currently 2.3x ex-financials
- Dividend coverage ratios – currently 3.8x
- Management’s past and current comments on the importance of maintaining/growing dividends as a core of that company’s purpose – eight companies are Dividend Aristocrats and all our companies have reiterated their intention to pay a dividend
The core philosophy of our strategy remains intact. Selecting a diversified portfolio of companies with strong balance sheets, above-market dividend policies and that are trading at attractive valuations. Emphasis will be on a company’s ability to continue to support dividends in this difficult environment and tilting toward larger capitalization companies (current median market cap of our portfolio is $63 billion) that tend to be destinations of investor capital in times of market stress.
This year has been an especially difficult period for dividend-paying stocks. As mentioned earlier, 17% of the companies in the Russell 1000 that paid a dividend have cut in some fashion. Two-thirds of those companies suspended dividends entirely due to the pandemic shutdown. The top two quintiles of dividend payers in the Russell 1000 have returned an average of -24% for the year. Typically, in bear market rallies we see investors gravitate to dividend payers as they desire cash flow, safety of margin (value) and more conservative balance sheets. The unique nature of this bear market is that many higher multiple technology-driven companies have seen their services in even higher demand despite many value-oriented sectors experiencing difficulties as a result of the shutdown and shifting consumer behaviors (work from home, reduced travel, telehealth, etc.).
That being said, we cannot stress enough that we view this current environment as a tremendous opportunity for our strategy. Benjamin Graham famously said that in the short run, the market is a voting machine but in the long run it is a weighing machine. Although we recognize and hope that things will continue to improve, we also recognize that the market appears to be pushing all its chips into the middle of the table and betting on a V-shaped recovery despite a very wide set of possible outcomes. Equity markets followed up one of the worst quarters in history with one of the best. It is almost as if 2020 is being thrown out as an anomaly with an expected 2021 recovery almost deemed assured despite not knowing what the long-term effects of the pandemic will have on the economy and company earnings and how long it will take to find a vaccine. We are living in very uncertain times, yet thanks to the FAAMG stocks the S&P 500 at quarter-end was trading only 8% off of its all-time high (the equal-weighted index is 14% off its peak). Interestingly, despite the positive momentum in Q2, volatility remained quite elevated (the VIX averaged 34 for the quarter which is two standard deviations over its historical average).
As mentioned earlier, the gap between growth and value is as wide as it has been in 20 years. We do not discount the potential and market dominance of the FAAMG stocks and others; however, investors are paying a lot for that potential. Growth stocks are trading at close to 30x forward earnings and because of that has increased the S&P 500 P/E to a 22x multiple, more than one standard deviation above its 25-year average. Conversely, large value companies are currently trading at an 18x multiple. We believe the valuation gap between growth and value is even wider because the recent reconstitution of the Russell indexes as the Value index added a lot of “growthier” companies from the Russell 1000 (e.g. Alphabet was added as a 1.4% weighting). Also, defensive sectors like health care, consumer staples and utilities are trading at their lowest valuations in over 10 years.
Our portfolio now trades at less than a 14x forward multiple, which is not the lowest in absolute terms but definitely in relative terms to our benchmark and the broad market. The current rally has been primarily a valuation expansion as forward earnings expectations have dropped. Dividends over the long-term are primarily driven by earnings growth, and we believe that our current portfolio mix will provide that growth to not only continue our current level of income, but also increase that payout over time. Furthermore, the current dividend yield of our portfolio is as attractive as it has ever been. While the current 3.9% yield is in line with our long-term average, the spread between our dividend yield and fixed income yields is at its widest point of our existence (330 basis point versus 10-year Treasury bond). Indeed, because of the Fed’s return to a zero-bound rate and the subsequent flight into fixed income, the S&P 500 dividend yield is trading at its widest premium (2.9x) to the 10-year Treasury in over 65 years.
We are very excited about the quality of our current portfolio companies and the way we are currently positioned. We believe the wide range of potential outcomes from the COVID-19 pandemic require us to proceed with a degree of caution while also playing for an economic rebound that can occur rapidly should a cure be found. We foresee being much more active than in prior years in adding and replacing companies in the portfolio as those potential outcomes become clearer. We thus are maintaining a defensive allocation (overweight consumer staples, health care and utilities) should momentum slow as we expect it may but balancing that with an overweight to the secular growth story in technology. Furthermore, we have opportunistically added back some cyclical sectors (financials, industrials, and materials) to take advantage of reopening momentum as it occurs.
Even though the market is in a much different place today than it was at the end of the first quarter, our closing statement from last quarter’s commentary remains just as timely. Our goal is to generate durable cash flows for our investors while we wait for investors to realize once again the long-term, benefits of investing in high dividend yielding companies. I now add to that statement that those companies are now trading at all-time wide relative valuations for the 11 plus years of our strategy.
This commentary is provided for informational purposes only and contains no investment advice or recommendations to buy or sell any specific securities. The statements contained herein are based upon the opinions of the Portfolio Management team and the data available at the time of publication of this report. Any sectors or securities mentioned are based on newsworthiness and may or may not reflect holdings in any Principal Street portfolio. The reader should not infer that any securities discussed were or will be profitable. Information was obtained from third party source s believed to be reliable, are not necessarily all inclusive, and are not guaranteed as to accuracy. Past performance is no guarantee of future results and there is no assurance that any predicted results will actually occur.