Battleship Balance Sheet Stocks

Dan Wiener: Hello, this is Dan Wiener, chairman and co-founder of Adviser Investments, with another of our “Adviser You Can Talk To” podcasts. Today I’ve got, as my guest, Charlie Toole, who’s co-manager of our Dividend Income strategy and is both a chartered financial analyst and a certified financial planner. So he’s not only well-suited for finding great stocks to invest in, but he also understands the types of investors those stocks are best suited for. Charlie, we refer to the stocks in your portfolio as those of battleship balance sheet companies. What does that mean?

Charlie Toole: Well, Dan, thanks for having me. When we think of or when we look for a battleship balance sheet company, when you think of a battleship, you think of this large, strong, seaworthy vessel that can withstand rough seas and sail smoothly through those rough seas. And what we look for are companies that have strong balance sheets that are able to meet their obligations during good or bad economic times.

Dan Wiener: And when you talk about obligations, what are we talking about? Charlie Toole: We’re talking about servicing their debt or paying back the people that they borrow money from and returning money to the stockholders in the company.

Dan Wiener: And aside from being able to continue to pay the interest on their bonds or pay a dividend, why is a strong balance sheet important? I mean, why is that the driving force behind the stocks you choose for your portfolio?

Charlie Toole: Well, one thing we want is we want companies that are going to survive, companies that will make it through the lows of the business cycle. But we also want companies that are financially strong and that can take advantage of those difficult economic times by taking market share from weaker competitors or even buying a distressed company that might make their business stronger once the economy starts to recover. So we look for companies that are going to survive through different economic cycles, that are going to be around for the long haul, and that can get stronger when other companies get weaker.

Dan Wiener: So run me through this. When you look at a balance sheet, what particular lines on that sheet are you looking at? What are the numbers that are most important to you?

Charlie Toole: So we’re looking at cash and invest, basically, assets that the company owns and then debts that the company has, money that they’ve borrowed, long-term debt. Those are really the two things that we focus on. We want to make sure a company is not over-leveraged and taking on too much debt.

Dan Wiener: So what sort of, we’re talking about a debt-to-equity ratio or debt-to-asset ratio?

Charlie Toole: Debt-to-equity, debt-to-assets.

Dan Wiener: And what are you looking for there?

Charlie Toole: We’re looking for companies that are stronger than their peers, companies that have more debt, I’m sorry, that have more assets than their debt. We look for debt-to-equity less than one. So we want companies that are strong and that have those assets that can pay back those debts or that cover those debts.

Dan Wiener: Now, when you, your strategy, the stocks you pick are something you call a dividend income strategy.

Charlie Toole: Mm-hmm.

Dan Wiener: Talk to me a little bit about that dividend income.

Charlie Toole: Yeah, so the yield or the income that the company pays is important, so that we’re looking for companies that pay or that have a higher dividend yield than the broad market, the S&P 500. We want–

Dan Wiener: Which is about 1.8%, 2%?

Charlie Toole: About 2%. Yeah, a little less than 2%. So we want companies that are paying a good dividend, have a good yield, but are also growing that yield over time and growing it consistently. So we don’t only want to just collect that dividend every year, we want our income to grow year over year.

Dan Wiener: Does the growing dividend necessitate growing sales and growing profits, or can you have a company that’s kind of in stasis but still growing the dividend somehow?

Charlie Toole: There are some companies that grow their dividend, even though their profits or their revenues may be flat, and what they’re doing to accomplish that is they’re taking on more debt. They’re borrowing from the debt markets to be able to pay that dividend. And that is something that we look for. We look for how the companies are growing. One thing we look at is what’s called the payout ratio, and that is the dividend divided by the earnings of the company. And the lower that number is, the more room the company has to raise that dividend over time.

Dan Wiener: So you wouldn’t necessarily be buying into a stock of a company that’s not growing its actual business but still growing the dividend? I mean, that wouldn’t necessarily appeal to you?

Charlie Toole: Correct. Yeah, we want companies, because we don’t think that that’s sustainable. That dividend growth is not sustainable.

Dan Wiener: Can you give me an example of a company that you wouldn’t invest in, that maybe is doing something like that, raising the dividend, using the bond market to provide that extra income?

Charlie Toole: There are a lot of companies, some of the utility companies, their growth hasn’t really been there. Telecom is another one, another sector where the growth really hasn’t been there over the last three or four years, and they’re taking on debt to raise their dividends. And in some cases, those companies have, you’ve seen their dividend grow slow.

Dan Wiener: Mm-hmm.

Charlie Toole: …and even stagnant.

Dan Wiener: So your portfolio tends to hold, I think, around 40 companies. What’s the average dividend yield for the companies in your portfolio?

Charlie Toole: So the overall portfolio, the dividend yields about 2.5%, a little bit more than 2.5%, and it ranges based on the names. We have a couple of names that are lower than the S&P 500. Those are a little bit more growth-oriented stocks, like Nike and Visa. And then we have some other stocks that pay a larger dividend, like Pfizer.
Dan Wiener: Mm-hmm, mm-hmm.

Charlie Toole: So it varies across the portfolio.

Dan Wiener: So let’s talk about the drug stocks. I mean, Pfizer is one of the granddaddies, one of the big drug stocks.

Charlie Toole: Drug stocks used to be big growers. And as they’ve gotten bigger and bigger, and, of course, they went through a lot of mergers at one point, they’ve also become big dividend payers.

Dan Wiener: So is Pfizer, as an example and an example of a battleship balance sheet company, is it a grower, or is it a dividend payer? Or is it both?

Charlie Toole: It’s a little bit of both. They have a high dividend yield, but they’ve been growing that pretty consistently over the last five or six years. So they’ve been returning cash to shareholders. That’s one of their primary, one of the points of emphasis that they have. They’re trying to return cash to shareholders whether it’s through buybacks or dividends.

Dan Wiener: Mm-hmm. And in the portfolio of 30 or 40 stocks, how often do you trade?

Charlie Toole: Our turnover has been about 30 to 50% per year, on average. Some years it’s higher, depending on market conditions. Some years it’s lower. This year we’ve been a little bit lower. We’re below 25 or 20%.

Dan Wiener: So that means your average holding period is two to three years for these stocks? So you’re doing your homework.

Charlie Toole: Correct.

Dan Wiener: Way ahead of time?

Charlie Toole: Yes.

Dan Wiener: You do the research first and do the buying second. So what causes you to sell a stock?

Charlie Toole: We would sell a stock if we see a stock reach our price target, if we see the fundamentals of the company change. We recently just sold CVS. The reason why was they bought Aetna. And as part of that deal, they’re taking on a significant amount of debt. They’re going to raise about $46 billion or so in the debt markets, and they’ve said that they’re going to focus on paying down the debt instead of growing their dividend and buying back stock. So they’re going to spend a lot of time servicing their debt, creating or making their balance sheet, getting their balance sheet in better shape, and less attention paid to raising that dividend. So we owned the stock because it was a dividend grower, and now that’s not going to, the company’s not going to be growing its dividend. So there’s been a change in the fundamentals of the company, and we’re moving on.

Dan Wiener: You mentioned that you have price targets for some of the stocks or probably every one of the stocks in your portfolio. How often does that price target change, and what causes you to change a price target?

Charlie Toole: So the price target, I mean, we’re reviewing the stocks, and we’re watching them on a daily basis. The stocks are reporting earnings on a quarterly basis. And really, what we do or how we derive price targets are through what the dividend yield is and what the price-to-earnings ratio is, what the stock is trading at relative to the earnings that it’s generating. So as earnings are growing, or, in some cases, maybe they’re not growing, we’ll change our price targets based on that. Dan Wiener: So it’s something of a value-oriented strategy of P is or price-to-earnings is a big component of your analysis?

Charlie Toole: Correct.

Dan Wiener: Okay. I guess the next question I’ve got for you has to do with the current environment and whether these large-cap, dividend-paying, battleship balance sheet companies are poised for greater growth going into 2018 or whether we’re going to see a return or a resurgence of smaller companies that maybe don’t pay a lot of dividend yield but are the faster growers typically in the market.

Charlie Toole: Mm-hmm. I think that a lot of that will have to do, surprisingly, on what the bond market does. I think you’ve seen a lot of demand for dividend-paying stocks because interest rates have been so low, and investors are looking for income. And when they’re not getting good income from their fixed-income investments, they’re looking other places, and stocks have been the area where they’ve gone. So if we see interest rates start to rise, that becomes a little bit more of competition for a dividend-paying stock, and you might see some people rotate out of their dividend payers into fixed income.

Dan Wiener: Which would, of course, lower their risk-profile considerably. It strikes me that–

Charlie Toole: It would.

Dan Wiener: –moving from the bond market to the stock market to generate some more income ignores one of the big differences between those two markets, doesn’t it?

Charlie Toole: Yes, and I think a lot of people don’t realize the risk that they’re taking when they make that shift from bonds to dividend-paying stocks. Because they are stocks, there’s more volatility there. Even though it might be kind of the less-volatile or the lower-risk area of the stock market, there’s still stock market risk there. So you’re right, I don’t think people understand what they’re doing or what kind of risk they’re taking on.

Dan Wiener: Right, but this is a long-term strategy and one that really, would you say, could be the core of someone’s stock portfolio?

Charlie Toole: Yes, I think so. We view this as a core holding in a client’s portfolio. It’s large-cap, income-generating stocks.

Dan Wiener: Great. All right, thanks. That was Charlie Toole. He is a co-manager of our dividend income strategy at Adviser Investments. He’s both a chartered financial analyst and this is Dan Wiener, with another one of our “Adviser You Can Talk To” podcasts. Thanks for joining us.