Bear markets often cause substantial losses for US equity investors particularly in highly volatile technology and biotechnology stocks.
Jeremy A. Ellis, CFA, a Portfolio Manager/Analyst at Campbell Newman Asset Management, emphasizes dividend growth stocks.
Jeremy A. Ellis, CFA, Portfolio Manager/Analyst at Campbell Newman Asset Management,
“…Our investment philosophy is that a company’s dividend policy is tangible evidence of management’s confidence in future earnings growth.
Our focus there is really on the policy, not necessarily the yield.
We view this as a total return strategy, where we view that dividend policy as a signal from management that is more insightful than their verbal or written commentary, because it involves a non-retrievable cash payment to shareholders.
When we are doing our research, we’re really looking for companies with growing earnings.
We believe that the payment of a dividend, along with the expectation that it needs to be increased every year, imposes an important discipline on management, and that makes them better allocators of shareholders’ capital and ultimately promotes more consistent and predictable earnings over time.
Ultimately, what we’re trying to do is deliver a strategy that participates strongly in up markets and protects in down markets and outperforms our benchmark, which is the S&P 500, over a market cycle. ”
Bear market protection is built into the Jeremy Ellis investing philosophy.
“The research that was done by the team on dividend growth found that when a company initiates a dividend, fewer increase it the next year, and fewer increase it the third year after that.
But by the time you get to five years, it really starts to become institutionalized in the company philosophy, and imposes an important discipline on management that makes them a better allocator of shareholder capital and promotes that consistency in earnings growth that we’re looking for.
So, that’s how we break down the universe, with that dividend factor really being the most limiting and differentiated factor for us.
From there, we do have a valuation overlay, where we look at a company’s price-to-earnings ratio on next year’s earnings, and we look back over 20 years, so we can get some different market cycles in there.
We’re looking to buy companies at 70% or less of that 20-year peak, so we’re making sure we’re not paying peak earnings and we have room to grow over the market cycle.
Ultimately, we’re building a concentrated portfolio of 25 to 35 high-quality stocks that have delivered consistent growing earnings and a consistent growing dividend.
We build that on a bottom-up stock picking basis. We want this to be a best ideas portfolio. We’re letting the high-quality stocks drive where we go in terms of the portfolio construction.”
Bear market dividends provide a downside cushion, and this has led Jeremy Ellis recently to financial stocks.
“…One area that has become built up over the last two years is the financial sector, where we’re carrying an overweight position relative to the benchmark, and that’s through the collection of a number of high-quality businesses.
What we’re looking for there is high-quality recurring business models that can deliver strong growth with consistency, and we tend to avoid areas that have strong macroeconomic sensitivities or significant credit risk.
If you look at our holdings there, our largest position has been Arthur J. Gallagher (NYSE:AJG), that’s one of the leading insurance brokers in the industry.
They help clients understand the risks that they have as a business and help place insurance.
Importantly, they aren’t taking the underwriting risk themselves, and instead are taking a commission on the insurance placed.
They’ve been benefiting from being in a high-risk insurance market and overall insurance premiums going up.
We’ve obviously seen property levels going up, we’ve seen overall for corporates a lot of excess risk needing to be placed, and they benefit from that.
So, that’s our largest holdings, but if you look across our financial sector, we have a number of businesses that fit the profile I discussed.
We have both MasterCard (NYSE:MA) and Visa (NYSE:V) in the payment space, who continue to benefit from strong consumer payments over time globally.
But they continue to diversify their businesses into not only going after the commercial opportunity as that becomes more of a digital card-based business, as well as adding more services to their businesses.
And so, you’re seeing them be very strong, consistent growers.
We also have both S&P Global (NYSE:SPGI) and Moody’s (NYSE:MCO).
The first thought for many is that those are the rating agencies.
They are the two largest rating agencies, but both of them have diversified their businesses greatly over the last number of years into different data and subscription services type business models, where now over half their business for both companies come from those diversified recurring sources.
We also have both Nasdaq (NASDAQ:NDAQ) and Intercontinental Exchange (NYSE:ICE), which owns the NYSE.
Similarly there, I think the first reaction by many is those are exchange trading businesses, but similar to S&P Global and Moody’s, both have diversified greatly over the last number of years, and similarly have greater than half their business models coming from recurring nature type businesses.”
Bear market protection also leads Jeffrey D. Lent, a Partner at Torray Investment Partners and the Portfolio Manager for the Torray Equity Income strategy, to stocks with growing dividends.
Jeffrey Lent is also the Co-Portfolio Manager of the Torray Fund (TORYX) and the firm’s concentrated growth strategies.
“We’re looking for recurring, non-cyclical revenue. I think everyone says that, but we solve for the recurring by running that regression analysis on the revenues, earnings and cash flows, to find companies that are producing positively sloped but consistent outcomes.
When a company’s data plots are all over the place, we question the quality of the business model.
I don’t want to say we’re dogmatic, but we’re very much guided by that process, and that’s very key to understanding our firm and our three different products, which all have a track record of outperforming when markets get dicey, as the time period we’re in now.
That’s when we really shine, and you really see the value of our process and insistence on these robust but steady fundamental outcomes.
Sticking to that process — and I think you see it across the portfolios — that’s really our differentiating factor.”
The bear market stock picks from Jeffrey Lent are idiosyncratic.
Jeffrey Lent, Partner, Torray Investment Partners, Portfolio Manager, Torray Equity Income.
“One is a non-traditional piece of paper, it’s a preferred, and it is not owned for any of the things that I just described — steady, robust, recurring, non-cyclical revenue — it is owned simply as an incredible hedge against the likely largest risk of an equity income or a fixed income stream, which is higher interest rates.
The company is Sallie Mae, and they issued probably 25, 26 years ago now a preferred stock (NASDAQ:SLMBP).
I own it for its terms.
I don’t own it for the business, I don’t own it for the name, I’m not trying to have a credit quality upgrade to get paid.
This piece of paper is priced at three months SOFR, plus 170 basis points.
That’s the coupon, and your coupon will clearly rise as three-month interest rates rise.
It trades at a discount, it’s $75 on $100 par, so you’re getting it at $0.75 on the dollar.
And that math, that SOFR plus 170 basis points right now at a $75 price, is getting you a 9% or 10% yield.
In this world, with all of the concerns that we have right now, straight up higher interest rates based on inflation are probably the biggest threat to future income streams.
I’ve owned that paper for a long time.
It has never really produced the capital appreciation I would have expected, but the coupon has gone straight up the last three years, since 2022.
We all had that miserable year of 2022 when the Fed was raising interest rates every meeting.
So, its coupon went from $1.84 at the end of 2021 to $6.40 in March of 2023.
It was the perfect hedge in the biggest threat dynamic that I can think of for the portfolio.
I own that simply as an anchor to windward.
If higher interest rates are going to threaten the economy and cash flows, I want to own this paper for that time period and for that possible downside outcome.
So, I’ve owned it for a long time.
I do somewhat ignore the credit rating, but I feel very comforted because the common is doing well, the company is buying back stock and raising their dividends, so I feel somewhat insulated being in the preferred.
But I own it simply for those straight math terms that are on the paper; that’s the reason we have this in this portfolio.”
Bear market insurance is also provided by another lesser known dividend growth stock.
“This one is Royalty Pharma (NASDAQ:RPRX), and it’s very much like a private equity company.
They make investments in future pharmaceutical royalty streams, so they will partner with biotech and pharmaceutical companies on a certain product or molecule and invest in the probability of a positive outcome from the development of that drug, and then they will participate in the future royalties that it produces.
The founder has a background in investment banking.
His team has the biomedical research backgrounds.
What we need them to do is pick the right molecule, pick the right drug program, and then price it correctly.
Innovation and R&D are expensive and very risky. Different stakeholders — academics, foundations, biotech and pharmaceutical companies — approach RPRX looking for capital in exchange for royalties on either existing or future products.
Stakeholders prefer to partner with RPRX because it is non-dilutive and does not leverage their balance sheet.
RPRX evaluates and selects deals based on their due diligence.
So, there are two things that Royalty has to get right: Pick the right molecule, and pay the right price for that future royalty stream.
The CEO has a long, very successful track record of doing just that, paying the right price.
He was an investment banker at Lazard, and so he gets the future cash flow discounting pricing correct, and his team guides him to the different drug development opportunities.
The real unspoken attraction here is, these guys get to legally use non-public information, inside information, and as shareholders of RPRX we get to benefit from that — because behind the protection of an NDA, they get to go in with their drug company partner and look at all of the data that isn’t publicly available to public pharma or biotech investors.
So, they get to see all of that while they make their offer of Royalty capital.
They can’t then go buy the stock or do anything like that.
There’s nothing nefarious going on.
But they get to see a lot of things that a public investor in that same company doesn’t get to see as they make their capital commitment, and that’s really unique, very private equity like, but with the overlay of a very specific biotech specialty.
Private equity has high returns, number one.
Biotech has high returns, number two.
But with the added knowledge and experience and capability of pricing these things, they have a very high success rate.
It’s a $15 billion-ish market cap company, and there are less than 100 people working there, so it’s a highly lever-able business model.
They don’t use leverage, that’s not my point, but it’s highly scalable.
They can do this over and over and over again, as long as they have capital, and they have a very good track record of doing this.
And the dividend is growing at a very nice clip right now.
It’s just under 3%, but they’ve raised it several times, and they’re buying back stock.
That’s another attribute that’s quite prevalent in the Equity Income portfolio — buybacks. I like businesses and management teams that are understanding of and capable of paying the owners of the business, paying the shareholders either by retiring shares or paying and raising their dividend.
I like that mindset.”
Find out all the bear market stock picks from these two highly efficient portfolio managers by reading both interviews, exclusively in the Wall Street Transcript.
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