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Comparing Consolidated Edison And American Electric Power

In a previous article I detailed the past history of Consolidated Edison. In detailing this observation, it can be helpful to compare that security to others. This article compares the results of Consolidated Edison and American Electric Power, along with how you might think about the securities moving forward. In a previous article I looked at the past business and investment growth of Consolidated Edison (NYSE: ED ). This is useful for two reasons: it gives you a historical view of the company and it allows you to better think about potential repeatability moving forward. The historical look gives you much more insight than a simple stock price. Instead of seeing a line squiggle about, you can observe how revenues translate to earnings, earnings to earnings-per-share, EPS to share price growth and ultimately to your total return. There are a lot of factors at play that are not adequately captured in a stock chart. Moving forward, this type of information allows you think about the business in the future, with a solid understanding of how it previously got to where it was. If past investment growth was driven by an uptick in the earnings multiple or reduction in the share count, for example, these would be areas that you might want to explore on a forward-looking basis as well. Of course looking at a single security, even through the lens of various return drivers, does have its limitations. Its hard to tell whether revenue growth or investment growth is reasonable or not without also comparing this to other similar firms. As an illustration, let’s compare Consolidated Edison to American Electric Power (NYSE: AEP ), a similar-sized utility, to get a better feel for the company. Here’s a look at both companies historical business and investment growth during the 2005 through 2014 period: ED AEP Revenue Growth 1.1% 3.9% Start Profit Margin 6.2% 8.6% End Profit Margin 8.3% 9.6% Earnings Growth 4.5% 5.2% Yearly Share Count 2.0% 2.4% EPS Growth 2.1% 2.6% Start P/E 15 14 End P/E 18 18 Share Price Growth 4.0% 5.6% % Of Divs Collected 46% 43% Start Payout % 76% 54% End Payout % 70% 61% Dividend Growth 1.1% 4.1% Total Return 7.3% 8.4% From this table we can learn a variety of things. First, note that AEP was able to grow its revenues at a faster rate than Consolidated Edison. AEP also began with a higher net profit margin, and grew this over the period. Interestingly, due to the lower starting base, Consolidated Edison actually made up some growth ground in this area. Total earnings growth for Consolidated Edison came in at 4.5% per year against 5.2% for AEP. Part of the higher growth for AEP was offset on the shareholder level due to having to issue more shares. Once you get to earnings-per-share Consolidated Edison was growing at 2.1% per year against American Electric’s 2.6% annual growth. Allow the companies got there a bit differently, shareholders saw markedly similar growth during the time. Shares of both companies began the period trading around 14 or 15 times earnings and moved up closer to 18 times earnings by the end of the period. The P/E expansion was slightly higher for AEP, resulting in 5.6% annual share price growth versus Consolidated Edison’s 4% annual growth. This is an important point. It’s not just the ending valuation that matters, but also the expectations that lead up to that value. Consolidated Edison started with a higher dividend yield, but grew its payout at a slower rate. Still, an investment in the New York utility would have provided more aggregate income, resulting in closer overall returns. An investment in AEP would have generated 8.4% annual gains, while an investment in Consolidated Edison would have provided 7.3% yearly gains. As a point of reference, based on a $10,000 starting position, that’s the difference between accumulating $18,900 and $20,600. American Electric Power was able to outperform Consolidated Edison in the past due to its slightly faster earnings growth rate and higher valuation uptick. Consolidated Edison provided more dividends per dollar invested, but still trailed slightly. This type of view can illuminate a few things. First, even though the growth rates weren’t spectacular the returns were reasonable. A high starting yield and an uptick in valuation for both companies drove this result. Perhaps just as important, it shows you why one company might have turned in better performance and not just that it happened. Moving forward you could think about an investment in either security in a similar light. Here’s where things get less compelling, in my view. Below I have presented the same table substituting what actually occurred in the past with a hypothetical example for the next decade: ED Forecast AEP Forecast Revenue Growth 1.1% 3.9% Start Profit Margin 8.3% 9.6% End Profit Margin 9.3% 10.6% Earnings Growth 2.3% 4.9% Yearly Share Count 2% 2.4% EPS Growth 0.4% 2.4% Start P/E 18 17 End P/E 15 15 Share Price Growth -1.6% 1.1% % Of Divs Collected 40% 46% Start Payout % 72% 63% End Payout % 72% 63% Dividend Growth 0.4% 2.4% Total Return 2.3% 4.7% On the top line I used the exact same revenue growth, 1.1% per year for Consolidated Edison and 3.9% for AEP. Naturally these could be switched around or any number of different iterations, but the above is used specifically for a demonstration. The next two rows show improvement in the net margin of each company. So you have two companies growing revenue at the same rate as before, and actually keeping more of those profits. Yet the overall growth rate for both companies would still be lower. As a result of coming off a higher base, formulating growth becomes more difficult – it’s not enough to improve, you would need to improve by a greater and greater margin. If the number of shares outstanding also increased at past rates, you would be looking at rather slow earnings-per-share growth rates. Not that the past growth rates weren’t spectacular, but these would be noticeably lower still. With the same business performance, the growth rate is lower off a now higher base. It becomes more and more difficult to offer continued growth. The big difference between 2005 and 2015 is that today you’d likely want to be more cautious in your future multiple anticipation. Its certainly possible that these two companies could trade with P/E ratios of say 20 in the future, but I would contend that this might not be altogether prudent to expect. As such, share price growth could trail the already quite slow earnings growth. In turn, your main total return reliance would rest with dividends. Although the dividend yields are above average – sitting around 4% – they wouldn’t be expected to grow very fast. As such, you might anticipate collecting the dividend yield, seeing it keep pace with or even trail long-term inflation and not much more. A lack of strong growth, coupled with average to above average expectations, makes for a less compelling value proposition. Of course the above assumptions could be too pessimistic. Analysts are presently expecting 3% intermediate-term earnings growth for Consolidated Edison and 5% growth for AEP. Still, these assumptions would only bump the return anticipations up to the mid-single-digits. And to be complete, these higher assumptions can miss share count dilution and the possibility of a lower valuation in the future. In short, both Consolidated Edison and AEP as businesses didn’t grow very fast over the past decade. In spite of this, investors saw reasonable returns due to an uptick in what investors were willing to pay to go along with a solid ongoing dividend. In the future, you likely still wouldn’t expect these companies to grow very fast. However, this time the returns might not be as reasonable. The valuations are higher and consequently dividend benefits a bit lower. As the growth rate of a security slows, the relative expectations and valuation paid become more and more important.

Beating The Market With Profit And Beta: An Exercise

Summary Having established that low-beta stocks outperform, I posited that stocks with returns on invested capital much greater than their cost of capital would also outperform. I further posited that a portfolio comprised of the lowest-beta of these stocks would produce further risk-adjusted outperformance. Using the S&P 1500 as my pool of stocks to choose from, I simulated these strategies over the past 5 years. Here’s what I found. Having recently established in a separate article that low-beta stocks can strongly outperform the market, I wanted to see whether other approaches might outperform the market in an independent fashion, or else add to the alpha of a low-beta approach. I decided to look at whether or not companies with “economic moats” might outperform the broader market as well. The idea is certainly appealing. A company capable of sustaining an economic profit over time would probably benefit from what Morningstar typically contends are moat sources : Network effect, Intangible assets, Efficient scale, Cost advantage, and Switching costs. Certainly, a company imbued with these qualities would be expected to outperform the broader market over a full market cycle, and any discount on such a high-quality firm would be expected to dissipate relatively quickly as the market reestablished a premium reflective of these characteristics. This is the rationale behind certain exchange-traded funds like the Market Vectors Wide Moat ETF (NYSEARCA: MOAT ), and to some degree behind value-based methodologies practiced by Warren Buffett and others of his ilk. The problem, unfortunately, is that moatish qualities are difficult to quantify and may fade over time. A rough guess for the presence of an economic moat for a given firm has been posited by some as the firm being able to post a return on invested capital greater than its weighted average cost of capital, though certainly any given firm in a cyclical industry might be able to do so unreliably. What is probably more predictive is a demonstrated, sustained ability of a firm to generate an economic profit. These might be more readily found in stable industries with predictable dynamics. I posited that a strategy focused on firms with demonstrated sustained economic profits with business models suggestive of stable dynamics would outperform the broader market, and that this strategy would be also prove superior to a low-beta strategy alone. Experimental Method: I gathered 10-year financial data from Morningstar on each of the 1,500 components of the S&P 1500, as well as 10-year price data. I calculated yearly returns on invested capital for each company, and, starting with 2009, calculated a rolling 5-year average ROIC for each company between 2009 to the present. Beta was calculated in rolling 5-year increments using the S&P 500 (NYSEARCA: SPY ) as a benchmark, and a 5-year rolling cost of equity was calculated with the risk-free rate being a rolling average of 10-year treasury interest rates. Weighted average cost of capital was calculated using the normal method, with the cost of debt informally assumed to be either the yearly interest payment over the sum of short and long-term debt versus the interest rate suggested by the company’s interest coverage, whichever was higher. Economic profit was calculated as EVA = ROIC – WACC. From these metrics, the following strategies were simulated: A low-beta strategy, with monthly rebalancing into an equal-weighted portfolio of 12 stocks. On a monthly basis, the entire portfolio would be redistributed into the 12 stocks with the lowest rolling beta values, regardless of valuation. An economic-profit strategy, with monthly rebalancing into an equal-weighted portfolio of 12 stocks. Pre-screens for yearly profitability (e.g., positive yearly EPS) in addition to a positive 5-year rolling EVA were applied. On a monthly basis, the entire portfolio would be redistributed into the 12 stocks with the lowest price to economic-profit ratio (hereafter, “PEVA”). A combined strategy, wherein the top 50 stocks with the lowest PEVA ratios were selected (using the aforementioned pre-screens), and, from these, the 12 with the lowest beta scores would be selected and equal-weighted on a monthly basis; this strategy was repeated using a quarterly rebalancing rule. These 3 strategies were then compared to the S&P 500 and S&P 1500, looking prospectively over the past 5 years. Results: (click to enlarge) As noted previously, a low-beta strategy generated significantly higher annualized returns than the broader market, by a significant amount (26.6% CAGR over the past 5 years versus 15.4% for the SPY and 18.4% for the S&P 1500): (click to enlarge) In comparison, a strategy focused purely on PEVA generated significantly higher returns than even the beta strategy, with a CAGR of 32.76%. (click to enlarge) Returns using a monthly rebalancing rule using a combination of PEVA and beta outperformed a lone beta strategy by nearly 1000 basis points, with a CAGR of 35.3% yearly. (click to enlarge) On a risk-adjusted basis, using a long-term risk-free rate assumption of 4.5%, the PEVA-beta strategy outperformed all other strategies, with a Sharpe ratio of 1.77 (versus 1.64 for low-beta alone). (click to enlarge) Overall, a combined PEVA-low beta strategy offered the strongest risk-adjusted returns over the past five years, and produced the strongest absolute annualized returns over the past 5 years with reasonable compensation for overall risk. Discussion: The results of this exercise suggest that a low-beta strategy may be enhanced by pre-selecting only those firms demonstrating the ability to generate sustained economic profits over time. The success of the PEVA strategy also suggests an underlying valuation component as well, as the strategy focused only on those stocks which had the highest economic profit yield relative to the price. It is worth noting that this strategy did not focus on a single year’s worth of data but rolling 5-year averages; additional study might consider looking at longer rolling averages of ROIC to see if this would affect returns. The astute reader will undoubtedly point out a significant limitation of this study is the relatively low volatility of the overall market during this timeframe, during which time there was virtually no period in which a yearly loss might be recorded. This obviously affects the relative performance of the low-beta or PEVA-beta strategies, though one would probably expect that, if anything, these strategies would be expected to outperform in bear markets. Finally, despite the encouraging results, the PEVA-beta strategy clearly has limitations. Changing the rebalancing period to quarterly shaves off nearly 1000 basis points worth of outperformance and puts the PEVA-beta strategy about on par with the beta strategy alone, reducing the Sharpe ratio to a pedestrian 1.17. Given that an ostensible goal of a focus on sustained economic profits would be to focus on companies capable of outperforming over years at a time, why quarterly rebalancing would diminish returns relative to monthly rebalancing remains a bit unclear. Conclusion: Though generating strong economic profits over time is not necessarily indicative of a stable, high-quality firm, doing so certainly can be suggestive. The success of the PEVA-Beta strategy in this study suggests that focusing on such firms may produce significant outperformance. Though monthly rebalancing costs might be substantial (and capital gains tax burdensome), such a strategy may be worth considering in sideways or downward markets where uncertainty reigns and volatility is high. Current stocks suggested by the PEVA-beta strategy include Coca-Cola (NYSE: KO ), Monster Beverage Corporation (NASDAQ: MNST ), the Brown-Forman Corporation (NYSE: BF.B ) and The Hershey Company (NYSE: HSY ). Other consumer defensive firms make the list, like Altria (NYSE: MO ); trucking firms Knight Transportation (NYSE: KNX ) and Landstar (NASDAQ: LSTR ) are also included.

Finding Bargains Among High Yield Bond CEFs

Summary High yield bond CEFs are selling at historically large discounts. HYT was consistently the best CEF performer on a risk-adjusted basis among the CEFs analyzed. High yield CEFs are not for the fainthearted since their volatility is substantially higher than HYG. As an income-focused investor, I was a fan of high yield bond funds until the Fed crashed the party by discussing plan to increase interest rates. Then the bear market in oil put additional pressure on energy-related high yielding bonds. Figure 1 shows a plot of the iShares iBoxx $ High Yield Corporate Bond (NYSEARCA: HYG ) ETF. This fund has a portfolio of over 1,000 dollar denominated high yielding bonds, with most coming from the following sectors: telecom (23%), energy (14%), consumer discretionary (13%), and consumer staples (13%). The fund has an expense ratio of 0.5% and yields 5.5%. The price of HYG plummeted over 40% during the 2008 bear market but recovered a significantly before heading south again in May, 2013. (click to enlarge) Figure 1. Plot of HYG The recent selloff in high yields has taken an even larger toll on Closed End Funds (CEFs). The discounts associated with high yield CEFs has widened substantially over the past couple of years. This is evidenced by their Z-score, a statistic popularized by Morningstar to measure how far a discount (or premium) is from the average discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A Z-score greater than 2 is a rare event and is worthy of notice. Figure 2 tabulates the high yield CEFs that have a Z-score of 2 or greater. For a particular CEFs, this will occur less than 2.25% of the time. Figure 2. Z-scores of High Yield CEFs. The CEFs in the table also satisfied the following selection criteria: History of at least 5 years Market cap greater than $150 million Average daily trading volume greater than 100,000 shares. Based on the Z-score, these high yield CEFs appear to be bargains but which ones are “best” value. There are many ways to define “best”. Some investors may use total return as a metric, but as a retiree, risk in as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”. I am just saying that this is the definition that works for me. This article will analyze these high yield CEFs in terms of risk versus reward to help you assess which may be right for your portfolio. But before I delve into the analysis, it might be instructive to review the characteristics of high yield bonds, which are popularly referred to as “junk” bonds. From a technical point of view, junk bonds are no different and any other bond. The issuer of junk bonds is a corporation that promises to repay you interest until a specified time in the future, called the maturity date, and at maturity, the corporation will repay you the principal. Default will occur if the corporation, for whatever reason, is unwilling or unable to repay the debt. For example, if the corporation goes bankrupt before the maturity date, the owner of the bond will have to stand in line with other creditors in the hope of receiving some payment. It is therefore critical for bond investors to assess the probability of default. This is not an easy task, especially for retail investors. Therefore rating agencies, such as Moody’s, Standard and Poor’s, and Fitch have come to the rescue by assigning a rating for most bonds. The ratings range from AAA to C (or D depending on the rating agency). The lower the rating, the higher the probability of default. Bonds rated Ba or below by Moody’s (which corresponds to a BB rating by Standard and Poor’s and Fitch) are considered to be “below investment grade” and are called junk bonds. Since it is harder to sell junk bonds to investors, the corporations need to “sweeten” the deal by offering higher interest rates, hence the term high yield. The CEFs listed in Figure 2 are summarized below: Western Asset Managed High Income (NYSE: MHY ). This CEF is selling for a discount of 16.4%, which is a much larger discount than the 5-year average discount of 2.6%. The fund has a portfolio of 349 securities with 85% in high yield bonds and 6% in investment grade bonds. About 75% of the bonds are from companies domiciled within the U.S. The effective duration is 3.8 years. The fund does not use leverage and the expense ratio is 0.9%. The distribution is 8.9% with only a small amount (less than 1%) coming from Return of Capital (ROC). Wells Fargo Advantage Income Opportunity (NYSEMKT: EAD ). This CEF sells at a discount of 14.2%, which is a much larger discount than the 5-year average discount of 1.5%. The fund’s distribution rate is a high 10.5% without any ROC. The portfolio consists of 344 securities, mostly (81%) high yield bonds. About 7% of the portfolio is invested in investment grade bonds and another 7% in senior loans. Most (80%) of the securities are from companies domiciled in the U.S. The effective leveraged duration is 5.1 years. The fund utilizes 25% leverage and has an expense ratio of 1.2%. Western Asset High Income Opportunities (NYSE: HIO ). This CEF sells at a discount of 16.4%, which is a much larger discount than the 5-year average discount of 3.1%. The distribution rate is 8.9% with only a small amount (less than 3%) coming from ROC. The fund has 350 holdings, most of which (84%) are high yield bonds. About 6% are investment grade bonds and 77% of the securities are domiciled within the U.S. This fund does not use leverage and has an expense rate of 0.9%. The effective duration is 3.8 years. Western Asset High Income Fund II (NYSE: HIX ). This CEF sells at a discount of 13.1%, which is unusual since over the past 5-years this fund has averaged a premium of 4.3%. This fund distributes a high 12.2% with only a small amount (less than 1%) from ROC. The fund has 402 holdings, with 83% in high yield bonds. About 23% of the bonds are rated CCC or lower, which is one of the reasons for the high distribution. The fund also has 6% invested in investment grade bonds. About 71% of the securities are domiciled within the U.S. The fund uses leverage of 26% and has an expense ratio of 1.4%. The effective leveraged duration is 4.9 years. Alliance Bernstein Global High Income (NYSE: AWF ). This CEF sells for a discount of 15.2%, which is a larger discount than the 5-year average discount of 3%. The fund has a “go anywhere” strategy and only has 51% of the portfolio’s 1011 securities are invested in high yield bonds. About 27% of portfolio is invested in Government bonds and 9% in asset backed bonds. Overall about 17% of the bonds are investment grade and 72% are domiciled within the US. The fund utilizes 14% leverage and has an expense ratio of 1%. The distribution is 8.6% with no ROC. The effective leveraged duration is 5.5 years. Credit Suisse Asset Management Income (NYSEMKT: CIK ). This CEF sells at a discount of 16.1%, which is a much larger discount than the 5-year average discount of 2.5%. The holdings consists of 209 securities with 69% in high yield bonds and 24% in short term debt. About 78% of the holdings are domiciled within the US. The fund uses 11% leverage and has an expense ratio of 0.7%. The effective leveraged duration is 3.3 years. The distribution is 9% with a small amount (less than 7%) coming from ROC. BlackRock Corporate High Yield (NYSE: HYT ). This CEF sells at a discount of 15.1%, which is a much larger discount than the 5 year average discount of 4.6%. The fund holds 902 securities, with 83% in high yield bonds, 4% in investment grade bonds, 7% in equities, and 5% in preferred stock. About 82% of the holdings are domiciled within the US. The fund uses 31% leverage and has an expense ratio of 1.3%. The effective leveraged duration is 5.3 years. The distribution is 8.4% with only a small amount (less than 2%) coming from ROC. Credit Suisse High Yield Bond (NYSEMKT: DHY ). This CEF sells at a discount of 12.3%, which is unusual since over the past 5 years this fund has averaged a premium of 2.4%. The fund has a portfolio of 223 securities with 80% in high yield bonds and 15% in debt instruments. About 86% of the holdings are domiciled within the US. The fund uses 33% leverage and the expense ratio is 2%. The leveraged effective duration is 2.7 years. The distribution is 12.2% with a small amount (less than 10%) coming from ROC. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years. The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 3. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 3. Risk versus Reward over past 5 years The plot illustrates that the high yield bonds have booked a wide range of returns. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with HYG. If an asset is above the line, it has a higher Sharpe Ratio than HYG. Conversely, if an asset is below the line, the reward-to-risk is worse than HYG. Similarly, the blue line represents the Sharpe Ratio associated with HYT. Some interesting observations are evident from the figure. High yield CEFs are substantially more volatile than HYG. This is not surprising since CEFs can sell at discounts and many use leverage. The only CEF that had a higher absolute return than HYG was HYT. However, HYT was more volatile than HYG so HYG easily outperformed HYT on a risk-adjusted basis. Among the CEFs, HYT was the least volatile and had the highest return. Thus, HYT easily beat the other CEFs on a risk-adjusted basis. One of the reasons for HYT’s outperformance may have been its equity stake. The volatilities of most CEFs (except for HYT and DHY) were tightly bunched but the returns were widely different. The top 3 CEFS in order of risk-adjusted performance were HYT, AWF, and EAD. DHY came in fourth. The worst performer was MHY. That may be one of the reasons it had the largest negative Z-score. Since all the funds were associated with high yield bonds, I wanted to assess how much diversification you might receive by buying multiple funds. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The results are presented in Figure 4. (click to enlarge) Figure 4. Correlation over the past 5 years The figure presents what is called a correlation matrix. The symbols for the funds are listed in the first column on the left side of the figure. The symbols are also listed along the first row at the top. The number in the intersection of the row and column is the correlation between the two assets. For example, if you follow MHY to the right for three columns you will see that the intersection with DHY is 0.453. This indicates that, over the past 5 years, MHY and DHY were only 45% correlated. Note that all assets are 100% correlated with themselves so the values along the diagonal of the matrix are all ones. As shown in the figure, the CEFs are not very correlated with HYG or among themselves. This is a little surprising but indicates that you can obtain diversification by purchasing more than one of these funds. As a final analysis, I looked at the past 3 years. From Figure 1, I knew that this period had not been kind to high yield bonds but I wanted to how the funds held up relative to one another. The results are shown in Figure 5. (click to enlarge) Figure 5. Risk versus Reward over past 3 years What a difference a couple of years made! Over the past 3 years, only HYG and HYT were able to keep above water. AWF and DHY almost broke even but the rest had negative returns. Again, if you wanted to establish a high yield CEF position, HYT would have been your best bet. Bottom Line High yield bond CEFs can have a number of benefits as long as the risks are understood. In a robust economy there is the possibility of capital gains when prospect of companies improve and their bond ratings are upgraded. However, the reverse is also true when there is a recession. Currently, high yield CEFs are selling at historically large discounts and if you believe that neither interest rate hikes nor an economic recession is in the cards, then it may be time to consider these beaten down funds. Based on past performance, HYT clearly offered the best value in this sample of high Z-score CEFs. No one knows the future but in the past, HYT has consistently outperformed its peers on a risk-adjusted basis. But make no mistake, these are highly volatile assets and if you decide to add them to your portfolio, they will need to be managed carefully. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HYT over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.