Best Investment Strategy for Today’s Market

by Levi Folk | October 2, 2006

The United States economy is slowing, led by a sharp correction in the once-booming housing sector — an event that will undoubtedly have repercussions for corporate profitability and returns for equity investors.

The best investment strategy now is to own companies with stable free cash flow that is being directed toward dividends and share buybacks.

Corporate profitability is splashing up on historical high water marks, accounting for the highest share of U.S. GDP since the 1960s. That may seem like a good time to throw money at the stock market, but investors should look forward, not back, when making these decisions. Corporate profitability is cyclical, rising and falling with economic growth. Hence, a slowing U.S. economy suggests the stock market will be challenged by this factor over the next year.

Even with all the strong profitability behind us, investors have been very cautious about buying into these record returns. Prices paid as a multiple of earnings on the S&P 500 have been declining over the past few years from a P/E multiple of over 45 in 2002 based on trailing earnings to a more sober ratio of roughly 16 today. With growth slowing, it is difficult to contemplate how this P/E ratio will rise now, barring a recession.

So with P/E ratios likely stuck and earnings likely to slow, investors should expect that capital gains — those associated with rising P/E multiples — will continue to play a diminished part of total return on investments in U.S. equities, and that could easily apply to Canadian markets, too.

Investors should focus on returns generated from dividends and share buybacks, the sum total defined as shareholder yield (dividends plus share repurchases divided by market capitalization). Jim O’Shaughnessy, manager of the eponymous RBC O’Shaughnessy U.S. Value Fund, utilizes shareholder yield for picking stocks, as does Bill Priest, manager of CI American Value Fund.

Dividend contributions to shareholder returns in any year are obvious, and the importance of those returns is amplified in a market where prices are weak or falling. The dividend yield also provides an automatic stabilizer to the share price because yields rise when prices fall with the weakness therefore creating its own demand.

The caveat, perhaps, is that dividends can be suspended when corporate cash flow is compromised. This risk is obviously more pronounced in periods of economic downturn. So, investors should focus on companies with established track records of dividend increases. The ratio of dividends to earnings should not be excessive, so companies and investors have a cushion in lean times.

Share buybacks are simply another corporate strategy for boosting shareholder value. Fewer shares outstanding equate to higher earnings per share, higher dividends per share, etc. All else being equal, share prices will rise when companies buy back shares, with the expectation being that the market perceives a buyback strategy in opposition to its expectations for corporate reinvestment and growth.

Finding dividend yield data for publicly listed companies in North America is a snap. Share repurchase data is far less publicized, and finding it is a slog. It can often mean rooting through companies’ quarterly earnings reports.

Here are a few large-capitalization companies in the U.S. with steady earnings and compelling yields:

Drug companies are an obvious candidate for high shareholder yield. They generate lots of cash and their share prices have been languishing over the past few years. They are also big, with barriers to entry and steady revenues. Take Pfizer Inc. (PFE/NYSE) for example with an annualized shareholder yield of 5.2%. The company’s share price is well off its five-year peak by roughly 35%.

Merck & Co. (MRK/NYSE) is another candidate for buying based on shareholder yield. The current annualized yield is about 5% based on dividends and share repurchases in the first half of 2006. Here, too, its share price is off roughly 40% from its five-year high.

Rounding out the list is Johnson & Johnson (JNJ/NYSE). Current annualized shareholder yield is roughly 5.4%. Unlike the aforementioned drug companies with issues surrounding drug patents and safety concerns associated with their blockbuster drugs, Johnson & Johnson has sidestepped many of these issues and has profited from its medical services division. As a result, its current share price is just below its five-year high.

Another steady bet is large-cap darling Microsoft Corp. (MSFT/NASDAQ). The company has been going out of its way to return cash to shareholders: In 2005 with a US$32-billion special dividend, and in the first half of this year with more than US$19-billion in share repurchases. Shareholder yield for the first half of 2005 alone clocks in at roughly 8.5%.

Finally, oil companies have lots of cash and low valuations. Take Exxon Mobil Corp. (XOM/NYSE) for example. The current annualized shareholder yield is over 8%. Expect Exxon to continue sending money home so long as it can sell its production for more than US$50 a barrel.

This strategy is premised on the expectation for an economic slowdown in the U.S. Companies with high P/E multiples and low yields tend to suffer in this type of economic environment. On the other hand, those with even modest growth prospects and high yield should fare best.

Levi Folk is president of Generation Capital (www.generation-invest.com), specializing in the creation of structured investment products including principal protected notes. He is also president of the Fund Library www.fundlibrary.com, an investor research Web site.