ELF
Capital Management, LLC
(Endowment
Like Fund Management)
This is the ELF Capital Management, LLC Market Letter
for the month of June 2006. If you
do not wish to be included in our circulation, please reply indicating your
desire to be removed and we will be happy to oblige. Alternatively, any of your friends or colleagues
may receive this on a regular basis by entering their email address on our
list-server via this link. Feel free to forward this to any of your friends!
Thanks for your interest and we hope you enjoy the letter.
Is the party over for the equity markets? Is the
What a difference a month makes! Other than the new Federal Reserve Bank chairman seeking to scare the heck out of the markets, what new macroeconomic trend happened that would explain the sell-off in global markets following the 8th of May? While there are a number of theories, was anything really significant and new?
When markets move dramatically, two things often accompany it. First, markets that trade independently from one another are prone to move similarly, often harmonizing in unison like babies in a nursery joining a comrade in letting the world know someone is seeking immediate attention. Second, both professional investors, and those served by them, will test their beliefs and convictions about how to be invested.
During the month, I was contacted by one of my long standing business relationships who asked me to look into an investment scheme. ML has always possessed a keen eye for ferreting out opportunity and often asks for my advice or perspective. Having followed my career for over 20 years, ML has become comfortable with the breadth of my exposure to various investment types or strategies and always expects me to offer an opinion.
ML’s curiosity was peaked by a 30 page infomercial regarding a supplemental retirement income program. After my review, it became apparent that the advertiser was selling investment advice on how to develop a portfolio of equities that would payout a high yielding stream of income. Basically, it was discussing dividend and like income. As this became painfully evident, I was then able to offer my perspective. It was not a “magic-bullet”…
As readers of our newsletter well know, wealth management is
the ultimate goal of all that we do at ELF
Capital Management. Yes, we promote our
services; yet, you will find that we always seek to present thought provoking
topics that are relevant to our wide audience.
This month’s letter will explore things that you should know
when investing for dividend income. As
well, only those that read through will learn about the GBU. Following this discussion please be sure to spend some time
looking over our market comment and performance at the end of this letter to
find out how we faired against the market’s turbulence. It should be well worth the investment.
In essence,
a dividend is a distribution by a company or business to its owners. As opposed to payments for interest or for
services rendered, this distribution is most commonly paid to those bearing the
risks of ownership out of the operating profits of the business. But not all dividends are paid from operating
profits. Should a company pay out
profits from realized gains on invested assets, the dividend would be
considered a capital gain distribution; and, a distribution other than from
profits would be considered a return of capital. Dividend distributions can come in the form
of cash, stock or payments in-kind.
Regular cash
dividends, also referred to as ordinary dividends, are cash payments that are
paid in regular intervals. Regular
dividends are generally paid from operating profits. Otherwise, a cash dividend made as a one-time
occurrence is referred to as a special dividend. Often, the company’s per share price will be
reduced by the amount of the dividend upon the ex-dividend date which is explained
below.
Stock
dividends are issuances of additional shares of company stock. And, a very large stock dividend is
considered a stock split. After
receiving a stock dividend your ownership percentage remains the same; your
cost basis gets allocated across the total of your old and new shares; and, the
stock per share trading price will often be adjusted downward on a pro-rata
basis. Hence, you have more shares but
your aggregate market value and cost basis remain unchanged. One advantage, however, is that at the
reduced stock price, the shares may now be more affordable to a smaller
investor. Think of the per share price
of Berkshire Hathaway as an example. At
$91,000 per Class A share, how many can you afford to buy?
A payment
in-kind dividend is usually a distribution of company property – other than
cash. The company may distribute some of
its assets or in goods or services. The
most common form of in-kind distribution is a corporate “spin-off”
transaction. A corporate “spin-off”
occurs when a company divests itself of a subsidiary by distributing the
subsidiary’s shares to its own stockholders.
Like a stock dividend, however, your original cost basis and current
market values are allocated over the resulting two independent companies. And, as a result, you will now have two
separate investments to consider.
With
private investments, the process and timing for paying dividends can be quite
informal. In this instance, dividend distributions
are usually made at the end of a fiscal year, may be coincident with a
significant transaction or made at the whim of a majority of owners.
However,
for publicly traded securities, the process is much more formal. The timing of payments is more regimented. And, because ownership can change hands
rapidly, here are some important dates that you should be aware of: The first is the declaration date. This is
the date that the company approves and announces the per share dividend and
records it on the company’s books as a liability. The next two dates, the record date and the ex-dividend
date serve similar purposes in that they determine who the dividend will be
paid to. Purchasers of shares before the
ex-dividend date will be entitled to
the distribution; whereas, purchasers on or after this date will not. And, on the record date, the company’s payment agent will review the registered
owners of record for determining who to pay.
Lastly, it is on the payment date
that the company initiates the dividend payment to the registered owners of
record.
Dividend Investing, the Benefits
Among the
most certain benefits to dividend investing for
For
dividends from operating profits, the Act lowered the rate of tax on
"qualified dividend income" by taxing such income at the reduced
long-term capital gain rate rather than at ordinary income rates. This reduced rate of tax is applicable to
qualified dividend income received on or after
Qualified
dividend income includes certain dividends received from
Qualified
dividend income does not include: (a) dividends paid by tax-exempt organizations;
(b) dividends paid by mutual savings banks and similar institutions; (c),
amounts allowed as a deduction for dividends paid on employer securities held
in an ESOP; or (d). dividends from real estate investment trusts (REIT) or
regulated investment companies (RIC), unless they come from qualifying
dividends that the REIT/RIC received.
A taxpayer
must hold the shares of stock producing the dividend for more than 60 days during
the 120-day period beginning on the date that is 60 days before the date such
shares become ex-dividend. As an
example, assume an individual has owned a share of common stock for 15 days
when the share becomes ex-dividend. The
individual must hold the share for at least 46 more days in order to qualify
for the reduced rate of tax on the dividend. For preferred stock, the required periods are
increased from 60 days to 90 days and from 120 days to 180 days. A dividend is not qualified dividend income to
the extent that the taxpayer is under an obligation (whether resulting from a
short sale or otherwise) to make related payments with respect to positions in
substantially similar or related property.
In addition
to the tax benefits, dividends can provide a significant contribution to
It is
widely touted in the investment industry that investing in dividend paying
companies offers many advantages. Paying
dividends is perceived as a signal to investors that the company is healthy
enough to share its profits. Another
signal, or advantage, is that if a company increases its dividend each year,
it’s generally a good sign that the company has experienced continued growth
and is optimistic about its future which, in turn, could potentially increase
its stock price. It is also believed
that stocks of companies that pay dividends can be expected to exhibit less
market value fluctuation than stocks of companies that don’t pay dividends.
In starting out investing for dividends, you should realize that, at the time of this writing, the average dividend yield on the S&P 500 is 1.68%. The dividend yield is calculated by taking the amount of dividends paid per share over the course of a year and dividing by the stock's price. For example, if a stock pays out $0.84 in dividends over the course of a year and trades at $50, then it has a dividend yield of 1.68%.
That’s not
to say that you couldn’t find higher yielding opportunities to invest in, but
that kind of effort brings its own set of challenges. In fact, some investors focus on doing just
that. Have you ever heard of the “Dogs
of the Dow” strategy? Dogs of the Dow is
a stock picking strategy devoted to selecting among the higher dividend stock
components of the Dow Jones Industrial Average.
So, how
reliable is dividend yield as a predictor of performance?
Dividend Investing, the Considerations
Although
dividends have historically been a large percentage of the S&P 500 total
return, a study performed by Empirical Research Partners, LLC, reveals how
yields have contracted since peaking in 1982. Not only are yields below their historical
average, but the result is that they have also become more expensive. This may not be so bad if you’re able to
select companies with good to great profitability prospects and promising
dividend growth potential.
As
mentioned earlier, dividends are one way companies, usually mature ones, share
their profits with the investors who hold their stock. But unless some of those profits are reserved
for reinvestment back into the business, the probability that management would
achieve continued success in maintaining and growing dividend yield could be
greatly diminished. In fact, without
periodic reinvestment back into the business, one could reasonably expect earnings
and cash flow to decline over time.
Stocks with
declining earnings are usually bad news. For starters, over the long haul, stock prices
tend to track earnings. So a drop in
earnings will probably result in a drop in share price. Further, declining earnings could lead to a
dividend cut, which would not only further pressure the share price, but would
reduce your dividend yield.
As a matter
of fact, when evaluating the growth prospects of a company, securities analysts
will measure the retention rate of net earnings to determine the maximum growth
rate that a firm can sustain without having to increase financial leverage. The retention rate is calculated by
multiplying a firm’s return on equity (ROE) by the difference of 1 minus the
dividend payout rate. Also referred to
as the sustainable growth rate, this measure helps determine how much a firm
can grow without borrowing more money. After
the firm has passed this rate, it must borrow funds from another source to
facilitate growth.
A company's
payout ratio is a measure of the percentage of net earnings paid to shareholders
in the form of dividends. Some companies
strive to increase their dividends on a regular basis, even when their earnings
may actually decrease. That will cause
their payout ratio to jump, if only temporarily. But sometimes, an unusually high ratio over a
longer period of time may be a danger signal that the company will soon have to
cut its dividend. And a dividend cut
usually sends a company's stock tumbling.
Unless a company
is in a regulated industry, like utilities companies, a dividend payout ratio
at or above 40% would be considered fairly high. As such, I would advise that you compare the
payout ratio of a company with others in the same industry to better understand
if it seems out of line. Then, if it is,
you might want to dig a little further to understand why.
Another
good ratio to look at is the dividend coverage ratio. This ratio measures how much cash flow a
company is generating relative to its ability to payout its expected annual
dividend. If this ratio is below 1.00,
this would indicate that the company must sell assets or borrow to pay the
dividend because it is not generating enough cash from operations to meet its
obligation. This would indicate an
increased risk that the dividend may not be “safe” from being reduced or
eliminated. On the other hand, a company
who generates a steady or growing operating cash flow is better able to fund a
dividend than a company that cannot consistently generate cash.
If nothing
else, you should now realize that dividend yield may not be so useful as a
predictor of performance. As well, I
would warn against relying on one measure or indicator for all of your
investment decisions. If you had bought
the five highest dividend yielding shares one year ago, you would have been
buying into many of the companies who had subsequently cut their dividends and
seen their share prices fall substantially.
As an
investor it is important to assess the market environment and the economic
backdrop before deciding on whether the stability of a strong income flow will
be an attractive factor which will help one achieve financial security or encourage
other investors to buy a company's securities.
So, if you
are interested in pursuing a strategy of investing for dividends, the above
provides you the GBU – the good, the bad, and the ugly.
Some Concluding Thoughts
Very often,
I hear clients inquire or discuss with me the merits of investing in a single
asset class or strategy. And, after
experiencing a great many years in the investment industry from the portfolio
management side of the business, I’m of the belief that there simply is no
“magic bullet” to investing. Sound
investing requires a great deal of thought and effort to understand the risks
and how to navigate through them. And,
at the end of the day, we make decisions today that the outcome will not be
known until tomorrow.
ELF Capital Management Investment Performance Update
If you were invested in equities, May was a difficult month;
if you were invested in fixed income, you earned interest only. Volatility increased significantly and all
global equity sectors we track were down except for the S&P 500 utility and
consumer staples industry sectors. With
lackluster performance all year long, the Technology sector was hardest hit,
down 6.5% for the month. In other
markets, after running up better than 25% since the beginning of the year, Gold
Shares (GLD) slid 1.3% and dropped another 5.8% since the beginning of
June. Emerging markets faired worst with
the S&P Latin America 40 Index (ILF) off 13.5% for the month. Wow, what a difference a month makes.
New Fed Chairman Bernanke sounded the alarms about inflation
and traders listened? Did he really say
anything different than what Mr. Greenspan has been saying for his last two
years prior to retiring? Did the markets
sell-off because of distrust in the abilities of Mr. Bernanke? In May, the Fed raised interest rates another
25 basis points (1 basis point equals 1/100 of a percent), at the same measured
rate as has been done for the 16th consecutive time. I, for one, expected that. But, I think traders are becoming afraid that
the Fed will over-shoot efforts to slow down the economy.
As Bernanke
has flexed one of his three monetary policy tools, moral suasion (or, should I
say fear), he impacted global markets.
So much so, that he got a little help from his friends: Following two days of meetings in
For the month ended May
31, 2006, our one-month
performance is down 3.11%, our three-month return is up 0.60% and our one-year
return is up 9.87%.
For
disclosure purposes, past performance is not necessarily indicative of future
results and ELF Capital Management LLC (ELF), formerly Hoffman White &
Kaelber Financial Services LLC, cannot guarantee the success of its
services. There is a chance that
investments managed by ELF may lose a substantial amount of their initial
value.
ELF is an
independent discretionary investment management firm established in February 2003. ELF manages a strategic allocation of
primarily exchange-traded index funds (ETFs), and may invest in other carefully
selected securities. ELF may also employ
hedging techniques, through the use of short positions and options. ELF manages individual portfolio accounts for
both individual and business clients.
The ELF ETF
Strategy returns presented herein represents a composite of actual results from
all client portfolios managed by ELF.
Currently, it is the only composite presented by ELF and separate client
account portfolio positions are substantially similar, except as may be
modified for retirement plan accounts and accounts with net equity of $60,000
or less. There is no minimum account
size for inclusion into ELF’s ETF Strategy composite and accounts with net
equity of $60,000 or less have a tendency to downwardly skew the combined
results.
The
performance data presented herein includes the reinvestment of dividends and
capital gains; as well, ELF’s ETF Strategy composite returns are presented
after deducting actual management fees, transaction costs or other expenses, if
any. ELF charges an annual investment
management fee as follows: 1.25% on the first $250,000; 1.00% on the next
$750,000; 0.95% on the next $4,000,000; and, 0.75% thereafter.