“Bond Proxies” 2.0 – Dressing up for Income

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Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

July 21st, 2016

“Bond Proxies” 2.0 – Dressing up for Income

  • The following could turn their stocks into “bond-proxies” by raising dividends, thereby attracting more attention in a low interest rates/slow growth World (Exhibit 1):
    • SNA – organic growth has markedly slowed
    • PPG – long time automotive tailwind appears to have ended – 15 consecutive quarters of auto OEM coatings outpacing production ended in Q1 ’16
    • SWK – organic growth expected to slow but return to M&A market could impact availability of funds – M&A history of success is mixed
    • APD – paying down debt a more immediate priority – ample cash flows to reduce debt and increase dividend
  • Earlier this month we identified several of the stocks in our universe as potential beneficiaries of yield seeking behavior
    • DD, DOW, ETN, EMR, et al display characteristics of other sectors (staples, utilities) that have benefitted from this dynamic – high yield, sufficient cash coverage, (relatively) low price volatility
    • This group of unconventional Industrial & Material bond proxies has outperformed the S&P year to date by 4% on average – results are significantly better excluding CF which has been challenged by weak fertilizer fundamentals and rising natural gas prices
  • With growth constrained and global interest rates low to negative, companies may have an easier and more direct impact on their stock prices by raising their payouts and returning cash to shareholders rather than chasing projects with marginal returns or deals with uncertainty of execution
    • In our prior work, we looked for companies with low price volatility, cash flow coverage of dividends, and a yield over 2.5%
    • Here we look at companies yielding below 2.5% and identify those who could most easily raise payouts without much of a strategy trade-off
  • The opportunity for shareholders is to pressure management teams to raise dividends

Exhibit 1

Source: Capital IQ and SSR Analysis

“Price Volatility” is the standard deviation of historical premiums/discounts to fair value based on normal earnings

Overview

The low rate environment that has persisted since the global financial crisis of 2008-2009 has steadily driven up the value of traditional “bond-proxy” sectors such as consumer staples and utilities – Exhibit 2. In recent research, we filtered the typically cyclical Industrial & Material space for companies with similar profiles to the usual bond proxies – high-yielding stocks with (relatively) low volatility of price swings. The twelve stocks that fell out of this analysis have outperformed the S&P year to date – Exhibit 3. Eight of the twelve have driven this result and looking at those eight in isolation, the performance gap triples (DOW and DD have been subdued, CF – the major laggard – and UFS have endured market challenges).

In this piece we look for companies that have the potential to join the list of unconventional bond proxies. We use the same price volatility and cash flow criterion but restrict the analysis to those companies that do not currently have a plus market yield – i.e., those with dividend yields of less than 2.5% (the current estimate for the S&P 500 yield is roughly 2%).

Exhibit 2

Source: Bloomberg and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

I&M Bond Proxies: DD, DOW, CF, EMR, ETN, UTX, UPS, NSC, BRC, PKG, SON, UFS

Potential Proxies

Volume growth has been slowing for many companies as the economic environment remains constrained in developed economies (not helped by the Brexit) and continues to decelerate in emerging markets. The IMF took its estimates for global GDP growth down another notch in the latest update – Exhibit 4 – with the Brexit partially to blame.

Exhibit 4

Source: IMF and SSR Analysis

With organic growth prospects diminishing (and reflected in reported corporate figures), we have seen M&A activity heat up over the past year. Yet the uncertainty associated with large deals (exemplified by the ongoing MON-Bayer negotiations) can have the opposite of the intended effect on stock prices.

If the benefits from M&A are longer term and uncertain from the perspective of the shareholder, a dividend increase is immediate and definite. Share buybacks have become popular for their flexibility and bottom line impacts but our prior research has shown higher dividends to be more associated with stock outperformance than higher levels of stock repurchases.

A number of companies clearly have the ability to increase dividends without really compromising on strategy and in the small-mid cap space there are some obvious names – Exhibit 5.

Exhibit 5

Source: Capital IQ and SSR Analysis

The more obvious opportunities in the larger cap universe are SWK, ECL, ITW, DHR and FDX. If we look at uncommitted cash versus leverage the group to the right in Exhibit 6 stand out.

Exhibit 6

Source: Capital IQ and SSR Analysis

SNA

Exhibit 7



Source: Capital IQ and SSR Analysis

PPG

Exhibit 8



Source: Capital IQ and SSR Analysis

SWK

Exhibit 9



Source: Capital IQ and SSR Analysis

APD

Exhibit 10



Source: Capital IQ and SSR Analysis

©2016, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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