October 22, 2015
The Right Direction
After enduring 4 straight months of declines, it appears the market, and our accounts, are moving back in The Right Direction. The S&P 500 has posted a 5.5% gain so far in the month of October and our average accounts are registering gains close to that as well.
We are relieved to see some of the losses erased, but are still concerned about our near-term future. Morningstar points to 3 lingering areas of concern: lumpy and sluggish economic growth (GDP) in the US of around 2%, inflation so low that the threat of deflation (much more scary) still lurks in the shadows, and the slumps, if not outright recessions, taking place around the world.
These are not meant to be projections of future market moves, but serve as reminders of how challenging the economic and financial landscape still is. The bottom line is no matter what the reason, a recession is coming at some point, and our portfolios need to be prepared when it strikes.
Overly Generous
In the last letter we talked about using dividends to monitor the strength of the companies to ensure our portfolios are prepared for the next downturn. We’d like to take it one step further this time and discuss the Payout Ratio. This refers to the amount of earnings (or something comparable) that a company pays out to its shareholders in dividends. Another way to think of the Payout Ratio is as a Generosity Ratio. It shows how generous the companies are to their shareholders in terms of percentages.
Let me give you an example, 10 years ago we had a client who received a significant lump sum in a divorce. She was a wonderful lady and was incredibly generous. On one occasion she decided to take the entire extended family on a trip to Disney and made the decision to pay for absolutely everything! As you can imagine the family was ecstatic, however, we cautioned her about this decision because we felt like she was jeopardizing her retirement.
She disregarded our advice and went on giving her money away until she had nothing left. Ultimately she had to begin working again to make ends meet. This is an example of being overly generous. She gave away more than 100% of what she was earning, and that can’t continue forever.
Are some corporations too generous? Companies that are overly generous have payout ratios over 100%. As you can see in the image only one company in Morningstar’s portfolio has a payout ratio that high. Chevron CVX had earnings drop significantly in the last 18 months. Because their dividend remained the same this raised the ratio to its current level of 131%. Morningstar analyzed their situation and believes CVX has until 2017 for earnings (driven by oil prices) to rise again before the dividend would be in jeopardy.
The rest of the companies on the list have payout ratios below 100% and this will help our portfolios stand up to the inevitable next downturn.
If you’d like more information about the Payout Ratio or anything else, please don’t hesitate to contact us.