INSIGHTS

On May 05, 2014

Viewpoints from AAM - Crossroads: Which Way Will Investors Go?

Many rock fans erroneously believe Eric Clapton wrote and originally performed “Crossroads.” Some will say the band “Cream” was responsible. True aficionados already knew blues legend Robert Johnson penned “Cross Road Blues” in 1936 and his virtuoso-like guitar skills inspired countless musicians for years to come.

Johnson had a short, troubled life. He died of unknown (yet, murky) circumstances at age 27 – and his grave site is unverified. Details about him are sketchy and full of rumors. Namely, Johnson supposedly sold his soul to the devil to obtain mastery of the guitar and become famous. Johnson supposedly made a “Faustian” bargain where an individual surrenders their integrity (or their soul) for short-term power or success. Faust was a German scholar who supposedly traded his soul for unlimited knowledge and worldly pleasures for 24 years.

To many, some investors have made a similar deal as a resilient stock market seems to only go up and continuously reward risk. Those who believe valuations, fundamentals and dividends matter shake their heads in bewilderment as little known apps get over $20 billion in a takeover or have an initial public offering.

“I went down to the crossroads, tried to flag a ride.

I went down to the crossroads, tried to flag a ride.

Nobody seemed to know me, everybody passed me by.”

We believe investors are at a crossroads and face a choice; desperately seek outperformance via hot, glamorous, expensive story stocks that seem to offer tremendous upside in the short term. Or, focus on the proverbially boring “blue chip” equities for the longer term.

This latter approach has been mostly shunned by the “cool kids” since January 2012. “Everyone passed it by” though it may offer stronger fundamentals, better dividend growth opportunities and more reasonable valuations. Many have enjoyed the stock market’s considerable rise. However, they may now want to consider a more conservative outlook. They also forget the sage advice of Lou Mannheim (Hal Holbrook) to Bud Fox (Charlie Sheen) in the 1987 movie “Wall Street.”

“Kid, you're on a roll. Enjoy it while it lasts, 'cause it never does.” (Fox made a Faustian bargain with Gordon Gekko, played by Michael Douglas. He engaged in insider trading, enjoyed the fruits of his ill-gotten gains and ultimately lost everything.)

We believe a speculative approach seems quixotic as economic growth, earnings and revenues are improving. However, these metrics are mostly “just ok” - not great, in our opinion. Management guidance is especially cautious. According to FactSet’s John Butters, the first quarter of 2014 saw the “second highest number of companies issuing negative EPS (earnings per share) guidance and the third lowest number of companies issuing positive EPS guidance for a quarter since FactSet began tracking the data in 2006.” It appears corporate executives (insiders who best know their company’s EPS prospects) are becoming increasingly pessimistic. Yet, paradoxically, the stock market keeps advancing higher. Investors apparently are listening to the devil on one shoulder and ignoring the angel on the other.

Case in point: concerns like Putin’s aggressiveness in Ukraine, emerging market weakness, Federal Reserve tapering uncertainties, potential hard landing in China, weakness in Japan, nasty U.S. weather and other geopolitical issues are disregarded. Previously, any one of these troubles would have typically caused a 10% to 15% correction. Instead these issues are amazingly (and quickly) forgotten as many aggressive investors stampede into risk – and are somehow rewarded – while more conservative investors are openly mocked.

We believe investors should take profits from their existing low-quality, non-dividend stocks that are perversely outperforming in an increasingly volatile market environment. In our view, rotation into higher quality stocks - with better fundamentals, business models and strong dividend yields makes logical sense in a market increasingly becoming illogical. Being aggressive could be counterproductive as the “low-quality/non-dividend” trade should eventually cool and profit talking will likely occur. The precise date or catalyst is unknown – but it should happen.

The only question would be “when?” When this shift takes place, low-quality/non-dividend stocks will likely fall from grace as investors who forgot valuations, fundamentals, quality and dividends will likely seek them out, en masse, as they did in 2008 and 2011.

Alarmingly, the valuations for non-dividend-paying stocks within the S&P 500 Index¹ appear sky high. According to FactSet, the average trailing price-earnings ratio (P/E) for non-dividend stocks (just 80 companies or 13.54% of the index) within the S&P 500 Index as of 3/31/2014 is 28.4x (cap-weighted). The S&P 500’s trailing P/E is 17.0x and Price/Book is 2.6x. As the chart shows below, these valuations are on par – or now surpass – 3Q 2007!

Source: FactSet                                                                                  Cap-weighted

Though non-dividend stocks within the S&P 500 Index outperformed in 2012 and 2013, few would disagree they are extremely expensive. Eventually, they must have more earnings to justify excessive valuations, or share prices must come back to reality. Non-dividend stocks are also showing signs of wear. Thus, “doubling down” on non-dividend stocks could be a risky bargain going forward as prudence is still warranted. Many believe the stock market appears ripe for a pause, profit taking and/or correction.

Though recommending caution, we feel optimism is justified in the higher quality dividend growth space. Technology looks quite compelling and many argue we are entering a secular bull market, especially if some froth is removed.

Again, we believe investors are facing a crossroads centered upon two choices.

1)    They can ignore reality, chase greed and believe the empty promises of short-term pleasure (e.g., performance), without consequence.

2)    Or, keep the faith, avoid temptation and invest for the long term.

Bahl & Gaynor is nowhere near perfect. Investors should understand our approach will move in and out of favor – and so will our performance. But, the second option appears (to us), to be the best decision.

Robert Johnson allegedly sold his soul for short-lived gains. He may have paid a steep and long-lasting price for his hubris. Rest assured, we won’t “sell out” and change our discipline for such an ephemeral bargain. Why should you?

“And I’m standing at the crossroads, believe I’m sinking down.”

Bottom line: The market has been very resilient and rewarded risk. Investors are paying massive premiums for a very narrow portion of the market in order to get returns. We all know this “risk-on” trade will eventually end in tears as valuations, fundamentals, quality and dividends will sooner or later become paramount to investors. The only question for us is when?

CRN: 2014-0501-4197 R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at www.aamlive.com/blog/about/disclosures. For additional commentary or financial resources, please visit www.aamlive.com

The information contained herein is obtained from Bahl & Gaynor and believed to be reliable. The information is not warranted as to completeness and accuracy and is subject to change without notice. The foregoing has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security.

The views expressed in this commentary are not necessarily that of AAM.

¹The S&P 500 Index is an unmanaged capitalization-weighted index (weighted by the market value of the companies) of 500 stocks listed on various exchanges. It is not possible to invest directly in an index.