Tag Archives: management

American Electric Power Raises Dividend 5.7%… What Now?

Summary For a utility, AEP’s record of dividend hikes is impressive. However, I suspect growth will be smaller in coming years as the ‘shale boom’ comes to a screeching end. At this time, I believe it’s best to stay on the sidelines on AEP. As a dividend investor, I tend to like utilities. But ‘climate change legislation’ has kept me away from most utilities. Solar and wind energy are expensive relative to fossil fuels. While utilities may ultimately pass those costs on to consumers, utility companies will have to invest a lot of money into new transmission and generation infrastructure. That means lots of new debt, with no significant demand growth: A very bad combination. When I look for utility companies, I look for ones that operate in states which have minimal or no ‘renewable energy mandates.’ I therefore tend to stick with US-based utilities because the US has some of the most reasonable energy policies of the developed world. I also tend to stick with select states where mandates are the lowest. American Electric Power (NYSE: AEP ) is one of the utilities I like. It operates mostly in Ohio, West Virginia, Texas and Oklahoma. While AEP has been increasing its renewable share of power, the numbers remain quite reasonable. Have a look. (click to enlarge) Courtesy of AEP Investor Relations. Even by 2026, only 15% of AEP’s total generation will be from ‘renewable’ energy sources. That’s pretty good. Of all the country’s utility providers, AEP’s generation is among the most economical. Back on November 6th, AEP paid a dividend of 56 cents, which is 5.7% higher than the previous quarterly dividend. For a utility, that’s quite an impressive growth record. That dividend growth has been mirrored by earnings growth. Between last year, this year and next year, AEP expects 4%-6% earnings growth, and the company is making good on that promise thus far. (click to enlarge) Courtesy of AEP Investor Relations. Where is that growth coming from? Well, it’s coming from capital investment, ‘rate recovery’ from investment in fully-regulated assets, and also cost savings. Each account for a good part of AEP’s earnings growth. Courtesy of AEP Investor Relations. A big advantage that AEP has lies in its location. AEP operates in the Eagle Ford, Permian, Marcellus and Utica shales. These territories have been hot-spots for growth over the last few years. Have a look. Courtesy of AEP investor relations. As you can see, industrial load growth in shale areas has far outpaced the rest of the company’s industrial base (and, indeed, the rest of the country in general), even though crude prices have fallen by 60% and rig counts have dropped by over half. This juxtaposition exists because the number of wells drilled per rig has increased dramatically, and the build out of midstream infrastructure has lagged behind the drop in activity. So, does the ‘shale boom’ live on? I don’t think so. Judging from both the comments and actions of OPEC kingpin Saudi Arabia, it really looks as if crude oil prices are going to stay low. But will production in these regions continue to remain stubbornly high? I really don’t think so. In 2016, the hedges of most shale-based E&Ps will roll off. This will ultimately lead to smaller lines of credit, and much less access to capital for these E&Ps (junk bond yields have risen sharply). With credit markets squeezed, I believe that small-sized and even medium-sized shale drillers will find it difficult to continue drilling at some point next year. Energy activity is lagging behind the oil price, but that drop is already coming. Therefore, I really believe that AEP will find it shale-area industrial growth coming to a halt next year. There’s a good chance it could even go negative. Courtesy of AEP Investor Relations. In fact, we can already see that industrial sales growth in shale regions has already pulled back significantly over the last few quarters. Expect much more of this. All things considered, earnings growth is probably going to slow down as a result of this. By how much is difficult to estimate. However, as the energy crisis deepens and takes a bite out of the economies of Texas, Ohio and Oklahoma, overall employment and GDP numbers in AEP’s service areas will underperform the rest of the country. In fact, that’s already begun to happen. (click to enlarge) Courtesy of AEP Investor Relations. Overall, AEP’s total electricity sales are scheduled to increase 0.6% in 2015, and that should translate to 4%-6% earnings growth. Next year, and indeed the years after, will be more challenging as long as crude oil prices remain low. While low oil prices are good for the country as a whole, they do effect AEP’s service areas. That is apparent when looking at the above right chart, where ‘AEP West’ represents both Texas and Oklahoma. Going forward I expect to see considerably slower EPS growth; perhaps something more like 2% or even less, because AEP’s operating territory is about to be hit hard, especially Texas. Overall, AEP will be fine because it is a diversified, regulated utility, but the company’s engine of growth is going to peter out soon. Therefore, I expect tamer dividend growth going forward. Is AEP a buy? Is AEP worth buying here? I would be cautious on this. According to data from FAST Graphs, AEP’s ten-year average price-to-earnings ratio is 13.7 times, but right now the company trades at 15.8 times. As a utility, AEP is also somewhat exposed to higher interest rates. If bonds trade lower, chances are AEP will follow. Right now, as with many stocks, caution is warranted with AEP. Those wanting to pick up a utility should instead look at Entergy Corp (NYSE: ETR ), which is benefiting from the petchem boom along the Louisiana and Texas coasts. That growth story is still somewhat intact.

XLF: The Heavy Financial Sector Exposure Doesn’t Appeal To Me

Summary The fund offers a reasonable expense ratio and incorporates more than banks. One of the challenges for investors is the combination of REITs and other stocks in a single ETF. Looking into the REIT holdings, I’d rather not see such a huge focus on the biggest companies. The historical volatility on the fund demonstrates the risk of going so heavy on the sector. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Financial Select Sector SPDR Fund (NYSEARCA: XLF ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Index XLF attempts to track the total return (before fees and expenses) of the Financial Select Sector Index. Substantially all of the assets (at least 95%) are invested in funds included in this index. XLF falls under the category of “Financial”. It sounds like the ETF would be very highly concentrated, but it includes everything from diversified financial services to REITs and banks. When I was first reading about the holdings, I was expecting more diversification than I found. You’ll see what I mean when I get to the holdings section. Expense Ratio The expense ratio is .14%. It could be a little better, but it isn’t too bad. Industry The allocation by industry is interesting. Investors that are new to the fund may simply assume that it allocates everything to “financials”, but the fund’s website goes much deeper in explaining which parts of the financial sector is going to get the weights. The allocation to banks is heavy, but it is also well below 100%. The fund also uses heavy allocations to insurance and REITs. I certainly prefer this strategy to going exceptionally heavy on the banking sector, but I find the holdings somewhat problematic as I prefer to run my REIT exposure through tax advantaged accounts. This is a challenge for any ETF that wants the diversification benefits of incorporating REITs. There isn’t much an ETF can do to get around this other than simply not holding REITs. Holdings Since I’m primarily a REIT analyst, the REIT exposure is the first part of the portfolio that my eyes are drawn to. The heaviest REIT allocation here is Simon Property Group (NYSE: SPG ) which I find a little disappointing. I find the REIT sector attractive for investing, but REITs should be divided between types the same way that banks and insurance companies were split up into different sectors. SPG is an absolutely enormous REIT, but I’d rather see exposure to Realty Income Corporation (NYSE: O ) or the fairly new STORE Capital (NYSE: STOR ). I simply prefer triple net lease REITs like O and STOR to most other types of REITs. Realty Income Corporation is included in the portfolio, but it is only .43% of the total portfolio. Since I prefer keeping REIT exposure inside tax advantaged accounts, there was already one challenge with the REIT allocation. I’m not thrilled with the allocation strategy for choosing REITs, which creates another challenge. Return History Historical returns shouldn’t be used to predict future returns, however the historical values for factors like correlation and volatility over a long time period can provide investors with a base line for setting expectations on whether the asset would fit in their portfolio. I ran the returns since January of 2000 through Investspy.com and came up with the following charts: (click to enlarge) Since 2000 the ETF has a total return of about 45% compared to the S&P 500, represented by SPY , having a return of 90.3%. The underperformance isn’t so much of an issue as the risk level. The fund had an annualized volatility of 33% compared to 20% for SPY. There were two market crashes during that period which leads to much higher volatility numbers, but the general premise remains. The fund is substantially more volatile. Since the holdings are also more concentrated, that makes sense. Unfortunately, when we switch to using beta as our measurement of risk the problem remains. The sector allocation simply lends itself to too much volatility for my portfolio. Conclusion XLF is a huge ETF for exposure to the financial sector. There are some bright spots for the fund, but the overall product is a little lacking for my tastes. The combination of other financial sectors with REITs may be acceptable for investors that have plenty of room in their tax advantaged accounts or investors that aren’t concerned with tax planning. Even moving past that, I’m not thrilled with the methodology for selecting REITs as it results in prioritizing enormous REITs. That is an area where I’d rather be adding individual stocks or using REIT specific ETFs with lower expense ratios. Seeing the enormous volatility reinforces my concerns about overweighting this particular sector. The fund may do very well in a continued bull market, but I’d rather keep a more defensive allocation. I just don’t like the risk of facing a third correction before the decade is over. I’ll keep most of my portfolio in equity, but I’ll stick to the more defensive companies and sectors.

No Pain, No Gain: The Only Cure For Low Bond Returns Is Rising Rates

Summary High on the list of investor fears heading into 2016 is a “rising rate” environment. Over longer-term time frames, it is the level of interest rates, not their direction, that is the most important driver of returns. The low yields of today portend lower long-term returns. The only way out of this situation is pain, with rising rates leading to short-term losses but the promise of higher. High on the list of investor fears heading into 2016 is a “rising rate” environment. Déjà vu indeed. This has been a concern among investors for years now. With the Federal Reserve increasing interest rates this month for the first time since 2006, these fears have only been exacerbated. When it comes to investing in bonds, are these fears warranted? At first blush, they would seem to be. As bond prices move in the opposite direction to interest rates, rising rates can be a short-term headwind for bond returns. As we will soon see, though, the key to this sentence is short-term. Over longer-term time frames, it is the level of interest rates, not their direction, that is the most important driver of returns. We have total return data on the Barclays Aggregate US Bond Index going back to 1976. Since then, bonds have experienced only 3 down years: 1994, 1999, and 2013. In each of these years interest rates rose: 239 basis points (2.39%) in 1994, 151 basis points in 1999, and 74 basis points in 2013. (Note: the worst year for bonds was -2.92%, incredible when you consider that the fear of bonds today exceeds the fear of stocks). While certainly a factor over a 1-year time frame, when we look at longer-term returns the direction of interest rates becomes less and less important. The most important driver of long-term bond returns is the beginning yield. Why? Simply stated: when bonds approach maturity, they move closer to their par value and the short-term gains or losses from interest rate moves disappear. What you are left with, then, is the compounded return from the starting yield and reinvestment of interest. The relationship is immediately clear when viewing the chart below which displays starting yields by decile (lowest decile = lowest starting yield) and actual forward returns. The higher the starting yield, the higher the forward return and vice versa. (click to enlarge) The close relationship between beginning yield and future return has persisted throughout time. While rising rates can be challenging for bond holders over short-term periods, they are a positive for investors over longer periods as interest payments and maturing bonds are reinvested at higher yields. (click to enlarge) From 1977 through 1981, the yield on the Barclays Aggregate Bond Index rose each and every year, moving from 6.99% at the beginning of 1977 to 14.64% at the end of 1981. Over this 5-year period, bonds were still positive every year though performance was subpar. How was this possible? Again, the starting yield of 6.99% provided a cushion for returns as did the reinvestment of interest/principal at higher yields. The short-term pain from the rise in yields from 1977-1981 would lead to long-term gains for bond investors. The next five years would witness the highest 5-year annualized return in history at nearly 20%. This was achieved due to high starting yields and a decline in rates over that subsequent period, with the beginning yield again being the most important factor. No Pain, No Gain As I wrote back in May (see “Bond Math and the Elephant in the Room”), bond investors today are faced with their most challenging environment in history. The low yields of today portend lower long-term returns. The only way out of this situation is pain, with rising rates leading to short-term losses but the promise of higher future returns. If investors were objective and rational, then, the greatest fear would not be “rising rates” but a continuation of the lowest yield environment in history. Or worse still, “falling rates” from here which would provide a short-term boost to returns only to guarantee even lower long-term performance. This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing. CHARLIE BILELLO, CMT Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts. He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms. Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant certificate.