Morgan Stanley & JP Morgan Expected To Boost Capital Return

One of the reasons we invested in JP Morgan Chase (JPM) and Morgan Stanley (MS) is our belief that they are over capitalized. Their excess capital will eventually be returned to shareholders through buybacks and dividend increases as they continue to pass the Federal Reserve’s Comprehensive Capital and Analysis and Review (CCAR).

Goldman Sachs via Barrons believes that over the next two years we will see the big banks grow their dividends faster than any other group.

These banks will grow their dividends faster than any other sector over the next two years, concludes a recent Goldman Sachs report—once they’re given the green light after the Federal Reserve’s annual Comprehensive Capital and Analysis and Review (CCAR), due shortly.

Richard Ramsden, who heads Goldman’s financials group in global investment research, says: “Banks can grow their dividends by roughly 20% to 25% per year over the next few years, given that both payout ratios and earnings will be growing for the banking system.”

From Barrons. Click image to enlarge.

Source:

Big Banks Expected to Boost Payouts

AMM Dividend Letter Issue 33 ~ Halo, Horns, & Hilton

Download this issue as a PDF

How would you rate this quote?

“You have to be confident as you face the world each day, but you can’t be too cocky. Anyone who thinks he’s going to win them all is going to wind up a huge loser.”

Pretty good, right? It’s no Lincoln.

“Better to remain silent and be thought a fool than to speak and remove all doubt.”

Or Kennedy.

“Ask not what your country can do for you but what you can do for your country.”

What if we told you the first quote came from the 45th President of the United States, Donald Trump. How would you rate the quote now?

Did your rating change for the better? For the worse? If it changed one way or the other, then you have likely fallen for the Halo and Horn effect.

Halo

When you like some aspect of a person you tend to like all other aspects of that person and overate their abilities. Even if you’ve never witnessed these attributes.

You meet Jane at a cocktail party. Jane is personable and easy to talk to. You enjoyed your brief time with Jane. Then later on someone running a charity asks you how generous Jane is and how likely Jane will donate to their charity. You will most likely rate Jane as very generous and very likely to donate to the charity.¹

But how do you know this?

You know nothing about Jane’s generosity. You only really know that Jane was friendly and personable. You overrated Jane’s level of generosity because you liked her.

Horns

The opposite is the horn effect. You tend to underweight someone’s abilities and dislike all other aspects of a person based on one trait.

A perfect example comes from the book Good Advice from Bad People: Selected Wisdom from Murderers, Stock Swindlers, and Lance Armstrong.

“The day you take complete responsibility for yourself, the day you stop making any excuse, that’s the day you start to the top.” — O.J. Simpson

We immediately discount what these people said because of the person who said them.

Tom Brady is an all-time great NFL quarterback. No quarterback has won more Super Bowls than Tom Brady. Go ask a die-hard New York Jets fan what they think about Tom Brady. You’ll likely hear how overrated Tom Brady is. That he isn’t that good and he benefits from the Patriots’ “system”. And you’ll most definitely hear, “He’s a cheater!”

Now, what do you think the comments from Jets fans would be if Tom Brady were on the Jets?

Tom Brady’s only transgression against the Jets is that he plays for a hated rival.

Halo, Horns, Politics, & Your Portfolio

The halo and horn effect happens a lot in politics.

If you like a President’s politics and party affiliation you tend to like the way they dress, how they speak, and how they carry themselves in public. If you don’t like their politics you tend to dislike everything about the President.

Your political affiliation also has an unintended consequence on your portfolio.

From the paper Political Climate, Optimism, and Investment Decision.

In our main empirical analysis, using the Gallup data, we show that Democrats (Republicans) become more optimistic about the stock market and the overall economy when Democrats (Republicans) come to power and there is a decline in optimism when the opposite party comes to power.

Investors tend to increase their exposure to risky, more volatile, assets, when their political party is in power and decrease their exposure when the opposite party is in power. This has the effect of increasing the investors’ returns over time, but not for the reason they think. The casual investor will attribute the performance to their political leader. In reality, increasing their risk exposure simply increases their odds of having higher returns in their portfolio, regardless of which political party is in power.

It’s not just the average investor that falls prey to the Halo and Horn effect. It can happen to us all.

Whitney Tilson runs a small hedge fund but he is a tireless self-promoter and has made a name for himself. You may have seen him on 60 Minutes during their Lumber Liquidators segment. Mr. Tilson spent considerable effort campaigning for Hillary Clinton and spilling a large amount of digital ink deriding “Con Man Don”. After Donald Trump won the election Whitney Tilson sold more of his equity positions into the market rally.

By Wednesday morning, as stocks made a big comeback rally after a near-800-point plunge late Tuesday night in pre-market futures trading on the prospects of a Trump victory, Tilson was busy unloading shares into the rally.

“I was at 60 percent cash coming into today, and I’m selling stocks today,” he told the New York Times.

Mr. Tilson may have let his political affiliation determine his market perception. In Mr. Tilson’s defense, a couple months later he realized he acted on emotion and added equities back to his portfolio.

The Halo and Horns effect is another mental heuristic we use to make quick decisions. It is a form of pattern recognition that often produces irrational and heavily biased decisions.

It is hard for us to tell when we are making an irrational decision based on simple heuristics like the Halo and Horn effect. There is no easy way to counteract this effect. We always advise slowing down your decision making steps and reviewing your process. When truly in doubt, it never hurts to enlist a trusted friend or confidant to play devil’s advocate.

Dividend Stock in Focus

Hilton (HLT): $65.49*
*price as of the close May 24, 2017

We build our dividend growth portfolio on three categories.

  • Dividend Stalwarts: Companies that have paid and grown their dividend over several decades
  • New Dividend Payers: Companies that recently initiated a dividend and can grow their dividend at above average rates for many years.
  • Special Situations: Companies that pay a dividend and are undergoing a corporate restructuring.

Hilton Inc. has been around for a long time. The company started in 1919 when Conrad Hilton bought the Mobley Hotel in Cisco, Texas. In the last few years, Hilton has undergone several ownership changes, corporate restructurings, and Paris’ new DJ career. This is why we classify Hilton as a new dividend payer.

In the fall of 2007 Hilton went private through a leveraged buyout by Blackstone. Then in December 2013 Blackstone took Hilton public again as Hilton Worldwide Holdings (HLT).

In January of 2017 Hilton underwent another corporate restructuring. Hilton Worldwide split into 3 different companies.

  • Hilton Grand Vacations (HGV) is now focused on Hilton’s timeshare business.
  • Park Hotels and Resorts (PK) is a REIT that owns the hotels and other properties.
  • Hilton Inc (HLT) retained the franchise and hotel management business.

It was after the three-way spin-off that we took interest in Hilton Inc. (HLT). As we’ll discuss further below, Hilton is now operating as an asset light business. We expect Hilton’s profit margins to increase and, more importantly, its return on invested capital (ROIC).

Did we mention that Paris Hilton is now a DJ?

Dividend History:

Hilton Worldwide Holdings started paying a dividend of $0.14364 per share a year ago. Post spin-off, the new Hilton Inc. continued to pay the dividend and slightly increased it to $0.15 per share.

We’ll further discuss Hilton’s capital return plans below.

Catalysts for Dividend Growth and Price Appreciation:

Asset Light Management & Franchise Model

By jettisoning the timeshares, hotels, and other properties Hilton became an asset light business. Less assets mean less capital needed to maintain and grow the business. Margins and return on invested capital (ROIC) should both increase. This leads to excess capital available to return to shareholders.

Increasing ROIC

Building hotels requires a lot of capital. Managing hotels and licensing your brand does not. Reducing its capital needs will drive Hilton’s return on capital higher. Increasing returns on invested capital is a key driver to building shareholder value.

Pre-spinoff Hilton’s ROIC reached a high of 9%

Marriott International (MAR) has undergone a similar transformation. In 1992 it spun-off the hotels they owned in to a Real Estate Investment Trust (REIT). 19 years later Marriott International spun-off its time share business, Marriott Vacations Worldwide (VAC). Marriott International retained the franchise and management contract business. Return on invested capital for Marriott International improved greatly since then*.

*The drop in Marriott’s ROIC was due to the completed merger with Starwood Hotels in 2016. Click image to enlarge.

We expect a similar improvement in ROIC for Hilton as they are now in a similar position as Marriott International was in 2011.

Increasing Market Share

The new Hilton generates revenue in two ways. The first is through management contracts with the following set-up:

  • a base fee, which is a percentage of each hotel’s gross revenue
  • Outside of the U.S., fees are often more dependent on hotel profitability measures
  • One-time upfront fees upon execution of certain management contracts
  • A monthly fee based on a percentage of the total gross room revenue that covers the costs of advertising and marketing programs; internet technology and reservation systems expenses; and quality assurance program costs.

The second way Hilton generates revenue is through Franchise agreements.

  • Franchisees pay franchise fees which consist of initial application and initiation fees for new hotels entering the system and monthly royalty fees, generally calculated as a percentage of room revenues
  • Franchisees also pay a monthly program fee based on a percentage of the total gross room revenue that covers the cost of advertising and marketing programs; internet, technology and reservation system expenses; and quality assurance program costs.

Both revenue streams are driven by total rooms available, the average daily rate, and the occupancy rate. Adding more rooms while maintaining the average daily rate and occupancy rate will increase Hilton’s revenues.

Currently, Hilton has a 4.8% global market share of hotel rooms. Of the hotel rooms under construction Hilton has a 21.5% market share. Hilton’s overall room count is growing and its global market share is increasing.

Hilton
From Company Presentation March 1, 2017. Click image to enlarge.

Large Capital Return to Shareholders

An asset light business does not need a lot of capital reinvestment to grow the business. This is a very attractive feature for investors because the company returns excess capital to shareholders through dividend increases and share buybacks.

Hilton Capital Return
From Company Presentation March 1, 2017. Click image to enlarge.

Right after the three-way spin-off transaction, Hilton Inc. announced its first buyback program. Hilton will buy $1 billion worth of shares. At Hilton’s current price, this about 5% of shares outstanding.

Pre-Mortem (Potential Risks to our Thesis):

Cyclical

Travel, both for leisure and business, tends to follow the business cycle. One of the first costs to get reduced during a recession is travel costs. Individuals will take fewer and/or less expensive trips. Companies will look to scale back how many people in their organization will travel and how much they will spend on business travel.

By spinning off its real estate holdings and focusing on franchise fees and the management contract. Hilton has removed some of the cyclicality of its earnings. The restructuring smooths its revenues out over the full business cycle but a portion of Hilton’s revenues is based on the gross dollar volume from each room. Less travelers leads to less gross dollar volume spent and less revenue for Hilton.

The current bull market is in its 8th year along with the current economic expansion. Any upcoming downturn will affect our recent investment in Hilton but a recession will affect all of our positions. If the company is a high-quality business that generates high returns on capital over a full business cycle, then we would likely seek to add to the position during any prolonged downturn.

AirBnb

AirBnb is a platform from which homeowners can rent out a room or a whole house to travelers. The concern and/or the current hype is that AirBnB will disrupt hotel businesses in the same way that Uber and Lyft are disrupting the Taxi business.

There is a big difference between platforms like Uber and Lyft versus AirBnb. The car share platforms are competing against a business, Taxis, with high prices and terrible customer service. The hotel industry, especially companies like Marriott and Hilton, already offer great service and at various price points.

Cities that are tourist destinations make a good portion of their tax revenue from hotels. For example, San Diego’s third largest driver of tax revenue is its Transient Occupancy Tax (TOT). The TOT accounts for 6% of San Diego’s tax revenue.

Taxis have their lobbying groups trying to get cities to push back against Uber and Lyft with limited success. But as soon as you mess with a city’s revenue source then the cities start pushing back. Cities are now passing legislation to limit short-term rentals like AirBnb. Cities and states are also passing laws that AirBnb has to collect taxes on the short term rentals offered on their platform. This is driving up the cost of short-term rentals and making them more in line with the cost of hotel rooms.

Short-term rental owners are trying to maximize their profits too and are pricing their rentals at rates only slightly below average hotel room rates.

AirBnb’s success is from group travelers looking to stay together and with very cost conscious travelers that are willing to stay in someone’s extra bedroom. Business travel is a large part of Hilton’s business and currently AirBnb does not target business travelers. If or when AirBnb does we’ll have to assess the effect on Hilton’s business.

Travel Bans

Hilton’s business is heavily tilted towards travel within and to the U.S. Before the spin-off transaction, the U.S. business represented over 75% of Hilton’s rooms and 60% of Revenue from Owned or leased hotels according to the 2016 10-K.

Hilton U.S. Hotel Rooms
Click image to enlarge.

And 70% of Hilton’s EBITDA comes from its U.S. business.

Hilton EBITDA
Click image to enlarge.

If travel to the U.S. became less attractive and more restrictive then Hilton’s earnings will likely suffer.

A recent travel ban by President Trump is having a spillover effect on potential travel from other countries.

President Donald Trump’s immigration stance has begun to discourage foreign visits to major U.S. cities, threatening to cost billions of dollars and thousands of jobs.

New York, the nation’s most visited city by people overseas, predicts such trips will drop more than 2 percent this year to 12.4 million, the first decline after eight consecutive annual increases. Los Angeles and Miami may also experience decreases.

According to Adam Sacks president of Tourism Economics, Foreigners spent $250 billion in the U.S. last year. If travel drops by 4.3 million visitors as expected by Mr. Sacks then the U.S. travel industry may lose $7.4 billion in revenue.

It is still too early to assess the actual effects of the proposed travel bans (as of this writing the bans are tied up in federal courts). However, given the importance of US hotel traffic to Hilton’s business model, we must include this in our Pre-mortem assessment of risks.

Valuation:

We used an economic profit model to value Hilton Inc. since a main part of our investment thesis is a rising return on invested capital. An economic profit model is driven by Returns on Invested Capital, Invested Capital and the Cost of Capital.

Economic Profit = Invested Capital * (Return on Invested Capital – Weighted Average Cost of Capital)

First, we estimate Hilton’s capital need for the next 10 years. Then we use Hilton’s current capital structure (debt and equity) to derive their Weighted Average Cost of Capital. From here we use our base case estimate of return on invested capital (30%) for Hilton over the next 10 years and calculate each year’s expected economic profit. Finally, we discount back each year’s economic profit and sum it to arrive at a present day value.

We then do a couple balance sheet adjustments, add cash and remove debt, to arrive at a per share equity value.

Using our economic profit model we estimate Hilton’s fair value per share to be $70. This is our base case. If Hilton can increase its ROIC further then Hilton will be worth even more.

All previous letters are archived here.

¹Example from Thinking, Fast and Slow by Daniel Kahneman

THE OPINIONS EXPRESSED IN “THE AMM DIVIDEND LETTER” ARE THOSE OF GABRIEL WISDOM, MICHAEL MOORE AND GLENN BUSCH AND DO NOT NECESSARILY REFLECT THE OPINIONS OF AMERICAN MONEY MANAGEMENT, LLC (AMM), AN SEC REGISTERED INVESTMENT ADVISOR WHO SERVES AS A PORTFOLIO MANAGER TO PRIVATE ACCOUNTS AS WELL AS TO MUTUAL FUNDS. CLIENTS OF AMM, MR. WISDOM, MR. MOORE, MR. BUSCH, EMPLOYEES OF AMM, AND MUTUAL FUNDS AMM MANAGES MAY BUY OR SELL INVESTMENTS MENTIONED WITHOUT PRIOR NOTICE. THIS NEWSLETTER SHOULD NOT BE CONSIDERED INVESTMENT ADVICE AND IS FOR EDUCATIONAL PURPOSES ONLY. THE OPINIONS EXPRESSED DO NOT CONSTITUTE A RECOMMENDATION TO BUY OR SELL SECURITIES. INVESTING INVOLVES RISKS, AND YOU SHOULD CONSULT YOUR OWN INVESTMENT ADVISOR, ATTORNEY, OR ACCOUNTANT BEFORE INVESTING IN ANYTHING. CURRENT STOCK QUOTES ARE OBTAINED AT HTTP://FINANCE.YAHOO.COM. PRICES ARE AS OF THE CLOSE OF THE MARKET ON THE DATE FOR WHICH THE PRICE IS REFERENCED.

AMM Dividend Letter Vol. 30: The “F” Word, Hidden Risks, & Wells Fargo Dividend Growth

Got your attention? The F word we are talking about here is FIDUCIARY.

The Department of Labor (DOL) recently passed the Fiduciary Rule which, among other things, requires that advisors to retirement plans act as fiduciaries. A fiduciary is required by law to act in their clients best interests. This differs from a lesser standard called the Suitability Rule that most stock brokers and financial sales professionals are held to. The suitability standard requires that they recommend suitable investments, however these investments don’t necessarily have to be in the clients best interest.

This may seem like boring minutiae and legalese, but we think a Fiduciary relationship should be the cornerstone of the investment advisor – client relationship. At AMM we act as fiduciaries on all client relationships, and have since the inception of our firm. While the Fiduciary standard doesn’t guarantee great performance, or even any particular level of skill, it does require the person or firm you are dealing with to put your interests first when providing investment advice. An obvious starting point, in our opinion, when hiring an investment advisor.

Hidden Risk

The Fiduciary rule reminds us too, that Risk is much more than just the probability of permanent capital loss. There are other hidden or not readily observable risks that are often overlooked by investors. Using the example above, hiring a non-fiduciary advisor likely increases your risk of being exposed to advice that is not in your best interest. While this may seem self-evident, we have rarely met with a prospective client who asked whether or not we were a fiduciary.

Another common, but hidden risk is inflation. Most of us are aware of the mathematical concept of inflation. A stamp costs 49 cents today vs. 32 cents 20 years ago – representing an increase of more than 2% per year. However when it comes to decision making people often ignore or, at a minimum, don’t fully comprehend the risk of inflation.

In a recent Wall Street Journal article by Jason Zweig he referenced a classic experiment where people were asked who would be happier: someone who got a 2% yearly raise when inflation was zero or someone who got a 5% raise when inflation was 4%. While the person receiving the 2% raise would be better off in real terms, two-thirds of those surveyed said the person with the 5% raise would be happier. Evidently the “bigger raise” provided a psychological happiness benefit that trumped the real increase in wealth.

Some investors may currently be opting for a “conservative return” in bank CDs or short-term government bonds at rates well below inflation instead of investing in more volatile investments with higher return potential. For investors with short term money this is entirely reasonable, but for investors with a long time horizon they are essentially trading a negative real return for the comfort of limited volatility. As we often say, volatility is not risk. Real risk is the likelihood of permanent capital loss, and long-term investors in cash, CDs and money market are nearly guaranteeing this at current interest rate levels.

The investment landscape is riddled with these psychological minefields, and is one of the reasons we focus so heavily on investor psychology in these periodic updates. For a deeper read on the subjects of behavioral finance and investor psychology we strongly recommend Thinking Fast & Slow by Daniel Kahneman and Your Money & Your Brain by Jason Zweig.

Dividend Stock in Focus

Wells Fargo (WFC): $48.30*
*price as of the close July 21, 2016

For most of Civilization’s history, the size of the economy was pretty much fixed. To become wealthy meant someone else became poor.

Then something changed. As Yuval Noah Harari points out in his book Sapiens: A Brief History of Humankind

“In 1500 annual per capita production averaged $550, while today every man, woman and child produces, on the average, $8,800 a year.”

What spurred this immense growth?

CREDIT.

While credit had existed in one form or another since the dawn of civilization, the credit offered was typically small and the rates high. If the economic pie was fixed why lend out large sums of money to bet on future growth?

During the Scientific Revolution, the idea of progress came about. If we invest our resources in research and exploration we will create better technologies and make new discoveries that will increase the sum total of human production. The economic pie can grow and wealth can be created without taking someone else’s slice.

A hopeful outlook on the future allowed people and institutions to believe in and use credit as a means to fund future growth. Credit became more freely available and offered at more reasonable rates.

As much as we love to gripe about banks, they are the institutions that provide the credit to fund our economic dreams.

Wells Fargo started in 1852 to provide banking, financial services, and most importantly credit to one of America’s biggest economic dreams, the westward expansion.

Dividend History:

Like all the major banks, Wells Fargo had to cut its dividend during the financial crisis. The cut was necessary to maintain adequate capital reserve ratios as balance sheet write-offs and loan loss reserves increased during the tumultuous time. Since cutting its quarterly dividend down to $0.05 per share in May 2009, Wells Fargo has increased its quarterly dividend to $0.38, a 39.5% compound annual growth rate. In 2014, Wells Fargo’s total annual dividends paid surpassed its pre-financial crisis high.

Wells Fargo Dividend Growth
Data from S&P Capital IQ. Click image to enlarge.

Catalysts for Dividend Growth and Price Appreciation:

Asset Growth

Wells Fargo recently bought several pieces of General Electric’s (GE) loan portfolio including half of GE’s commercial real estate portfolio and their entire railcar services business. The added efficiency of integrating the portfolio should add around $300 million of net interest income. Well’s Fargo’s efficiency ratio on the new portfolio additions should increase too, as they sell other services to its new customer base of around 160,000 relationships. While these customers had previously only had credit deals with GE, Wells Fargo now has the opportunity to expand the relationships with other commercial banking offerings.

The chart below shows Wells Fargo’s wholesale business loan growth including the recent GE asset purchases.

Wells Fargo Asset Growth
Chart from WFC Presentation May 24, 2016. Click image to enlarge.

Higher Interest Rates

One way a bank makes money off deposits is the spread between the interest a bank pays on a savings account and the interest received from buying short-term US treasury bills. The interest paid by short-term treasury bill is based on the Fed Funds rate which currently sits at 0.25%. The interest rate banks pay on savings accounts are equally as low and the spread between the two has tightened.

Net interest margin measures the amount of income generated by a bank’s assets to the interest it pays out to its lenders including its savings accounts. The spread between interest paid on savings accounts and interest received from treasuries is one component of the net interest margin. As you can see in the chart below Wells Fargo’s Net interest Margin is at its lowest level within the last 10 years.

Wells Fargo Net Interest Margin
Data from S&P Capital IQ. Click image to enlarge.

When or if interest rates rise, Wells Fargo’s Net Interest Margin should rise too increasing its profitability and increasing the excess capital Wells Fargo can return to shareholders.

High Switching Costs

How often do you switch banks? Do you change checking accounts everytime the bank across the street offers a new incentive? We’re going to assume you don’t. It’s highly likely that you’re still with the same bank where you opened up your very first account. That bank may have changed names over the years as banks consolidated but you personally didn’t change where your account was held.

Even though checking and savings accounts are pretty much exactly the same at every bank, we don’t switch banks when one offers a slightly better deal. Once we’ve set up a bank account it’s a hassle to change. We have to get new checks, new debit cards, establish a new bill pay system, etc. The incentives to change banks has to be large enough to make it worth the effort. It usually isn’t. Customers tend to stick with their banks for a very long time.

Product per Person

The more products a bank customer has with their bank – savings account, checking account, credit card, mortgage, car loan – the higher the switching costs become, and the more profitable that relationship is for the bank. This is true for both retail customers and corporate customers.

The efficiency ratio (Non-Interest Expenses/Revenue) is a way to measure this profitability. It is far less costly to generate more revenue per existing customer than to gain new customers. The efficiency ratio is also a good proxy for how well a bank controls costs in general. The lower the number the better.

The chart below compares Wells Fargo’s efficiency ratio (dark blue line)  to the other big banks: Bank of America (BAC), JP Morgan Chase (JPM), Citigroup (C).

Efficiency Ratio comparison
Data from S&P Capital IQ. Click image to enlarge.

Pre-Mortem (Potential Risks to our Thesis):

Continued Low or Negative Interest Rates

The current low-interest rate policy by the Federal Reserve is hurting Wells Fargo’s profitability. After Janet Yellen raised the Fed Funds Rate up to 0.25% from zero in December of 2015, the expectation for more rate increases rose as well. The Federal Reserve had the opportunity to raise rates a few times since then but didn’t.

Now with the fallout of Britain potentially leaving the EU (the referendum is non-binding) hanging over financial markets, the Fed appears unlikely to raise rates anytime soon. Right now markets are expecting that the Federal Reserve won’t raise rates for at least another year.

Fed Fund Rate hike Odds
Odds of a Rate Hike from Bloomberg. Click image to enlarge.

A continued low-interest rate environment means a continued low net interest margin for Wells Fargo. A lower for longer net interest margin means less capital to return to shareholders through dividends and share buybacks.

Regulation

After the 2008 financial crisis and passage of the Dodd-Frank Act, systemically important banks are now required to submit a capital return plan to the Federal Reserve for review. If the Federal Reserve doesn’t think the bank is adequately capitalized or well reserved it can cancel the banks’ capital return plan. Essentially all dividend increases and share buybacks must be approved by a third party. It is no longer up to the discretion of the bank.

Wells Fargo is extremely well reserved and capitalized but that doesn’t mean the Federal Reserve will always think so. Future dividend growth may be hampered by the Federal Reserve’s review. A declined capital return plan doesn’t mean Wells Fargo can not pay a dividend or raise it again in the future. It means the bank will have to submit a revised plan and wait for its approval. It’s possible the new plan will not include a dividend raise. This is a short-term setback because Wells Fargo has to submit its capital plan every year. Missing a dividend raise one year can be “caught-up” in the next review.

Higher Capital Ratio Requirements

Banks create value for their owners by making loans against deposits. All banks, regardless of regulations, should hold some equity reserves to protect against potential losses. The more equity reserves a bank has, the lower their returns on equity, all else being equal. The new higher equity reserve ratios required by the Dodd-Frank Act reduce the overall returns on equity that a bank can deliver.

Wells Fargo’s current Return on Equity is 13.6% which is much lower than during previous economic expansionary periods. Low interest rates and a shrinking Net interest Margin play a part in lower returns on equity too.

Wells Fargo Return on Equity Chart
Data from YCharts. Click image to enlarge.

If the regulators want the systemically significant banks to hold even more equity reserves then the returns Wells Fargo can generate will be lowered further.

Cross Selling Tapped Out

For such a large bank Wells Fargo’s operations and services are pretty basic. It isn’t involved with capital market activities like JP Morgan, Bank of America, or Citigroup. Wells Fargo remains consumer centric. To help reach its level of profitability while staying focused on consumers means Wells Fargo has to sell a lot of extra services and products via cross-selling.

Cross-selling has been a core strategy at Wells Fargo for years. In 2006 their motto for products per customer was, “We’re Over Five! Shooting for Six! Going for Gr-eight!”. In 2016 the average number of products a Wells Fargo customer has is 6.29, however this is down from 6.36 in 2013. While a small decline, if this trend continues or accelerates it will hurt Wells Fargo’s growth and future profitability.

Another issue is that by focusing so hard on cross-selling and incentivizing your employees to sell more you end up with employees engaging in aggressive and borderline illegal activities. The city of Los Angeles filed a civil lawsuit against Wells Fargo last year accusing the company of engaging in “unfair, unlawful, and fraudulent conduct through a pervasive culture of high-pressure sales”. The lawsuit has now attracted the attention of Federal regulators.

Conclusion:

Being the source of credit for economic growth puts banks in a favorable operating position in any capitalistic based economy. A well run bank, a bank that doesn’t take big credit risks and can effectively control costs, can exist for a very long time because their product will always be in demand. The Banca Monte dei Paschi di Siena has been in existence since 1492.

Wells Fargo is comparatively young at 164 years old but it has proven itself as an extremely well-run bank. During its short 164 years, it has survived and grown through many tough economic times. Odds are very good too that it will survive the current low-interest rate, increased regulatory environment currently weighing on its stock price. Even if low-interest rates last for a longer time, as currently expected, there is still tremendous value in Wells Fargo and its banking franchise.

Using 2% per year asset growth, return on assets of 1.3%, share reduction of 1% per year, and a P/E ratio of 11,  We value Wells Fargo at $60 per share. We think Wells Fargo is potentially worth a lot more if/when interest rates increase.

All previous letters are archived here.

THE OPINIONS EXPRESSED IN “THE AMM DIVIDEND LETTER” ARE THOSE OF GABRIEL WISDOM, MICHAEL MOORE AND GLENN BUSCH AND DO NOT NECESSARILY REFLECT THE OPINIONS OF AMERICAN MONEY MANAGEMENT, LLC (AMM), AN SEC REGISTERED INVESTMENT ADVISOR WHO SERVES AS A PORTFOLIO MANAGER TO PRIVATE ACCOUNTS AS WELL AS TO MUTUAL FUNDS. CLIENTS OF AMM, MR. WISDOM, MR. MOORE, MR. BUSCH, EMPLOYEES OF AMM, AND MUTUAL FUNDS AMM MANAGES MAY BUY OR SELL INVESTMENTS MENTIONED WITHOUT PRIOR NOTICE. THIS NEWSLETTER SHOULD NOT BE CONSIDERED INVESTMENT ADVICE AND IS FOR EDUCATIONAL PURPOSES ONLY. THE OPINIONS EXPRESSED DO NOT CONSTITUTE A RECOMMENDATION TO BUY OR SELL SECURITIES. INVESTING INVOLVES RISKS, AND YOU SHOULD CONSULT YOUR OWN INVESTMENT ADVISOR, ATTORNEY, OR ACCOUNTANT BEFORE INVESTING IN ANYTHING. CURRENT STOCK QUOTES ARE OBTAINED AT HTTP://FINANCE.YAHOO.COM. PRICES ARE AS OF THE CLOSE OF THE MARKET ON THE DATE FOR WHICH THE PRICE IS REFERENCED.

Pay Attention to Your Yield on Cost

From Barron’s.

But what matters to long-term investors is the yield based on what you paid for the stock, says Melcher. If the stock appreciates, the current yield may fall – even as the company increases the dividend. But what you’ll actually get paid from your investment will increase handsomely.

That’s why Melcher suggests keeping track of the yield based on your cost basis. Going back to the Apple example, Melcher says his firm purchased Apple stock for a client in 2006, which has gone up more than 1,100% since then. For that client, the yield on the cost basis is 20%.

The article went on to point out a couple of other good examples of yield on cost.

Home Depot (HD) has a current yield of 2.1%, but for someone who bought seven years ago, the yield on cost is 12%.

Altria (MO) has a current yield of 3.6%, but for someone who bought it 13 years ago, the yield on cost is 24%.

I went back and looked at the first handful stocks that we bought and still own for our Dividend Growth Strategy. This only goes back to 2011 but it is worthwhile to see what is our yield on cost for these 5 positions. The 5 companies I found are General Electric (GE), JP Morgan Chase (JPM), Microsoft (MSFT), Pfizer (PFE), and ExxonMobil (XOM).

General Electric (GE) cost basis is $15.07 and today’s yield on cost is 6.10%. GE yielded 3.85% based on TTM dividends when we first bought it.

JP Morgan Chase (JPM) cost basis is $32.04 and today’s yield on cost is 5.49%. JP Morgan yielded 2.5% based on TTM dividends when we first bought it.

Microsoft (MSFT) cost basis is $25.70 and today’s yield on cost is 5.6%. Microsoft yielded 2.49% based on TTM dividends when we fist bought it.

Pfizer (PFE) cost basis is $18.21 and today’s yield on cost is 6.59%. Pfizer yielded 4.4% based on TTM dividends when we first bought it.

ExxonMobil (XOM) cost basis is $70.92 and today’s yield on cost is 4.12%. ExxonMobil yielded 2.57% based on TTM dividends when we first bought it.

Obviously this yield on cost only applies to the accounts that were in our Dividend Growth Strategy from the start in September 2011. Accounts opened later will have much different cost basis for each position and different yields on cost.

JP Morgan’s dividend growth since we first bought it was helped by the fact that the Federal Reserve just started allowing them and other Banks to increase their capital returns to shareholders. One of the TTM (trailing twelve month) dividend payouts was a remnant of the Federal Reserve constrained dividends payout rules for banks.

Even over the short-time period of 4 years, the yield on cost exercise does show the power of not overpaying for a good business combined with strong dividend growth to build a rising income stream.

AMM Dividend Letter Vol. 28: How to Beat a Pigeon at Investing with Pfizer (PFE)

This is from the AMM Dividend Letter released April 7, 2016. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

This is the competition. It’s you versus a pigeon. Both you and the pigeon have two lights in front of you, one red and one green. You have to guess which light, red or green, will flash next. Do you think you can beat the pigeon at this game?

You’re probably thinking, “Of course, I have this big beautiful brain that has put mankind on the moon. I can do better than a bird with a brain a fraction of the size of mine. Don’t we call dumb people ‘bird brains’ for a reason?”

What if I told you the flashing lights will be completely random. Do you still think you could beat the Pigeon?

Don’t worry this game has already been done as an experiment. In the experiment, people were measured against both rats and pigeons. Each subject received a reward after guessing correctly which light flashed next. The flashing lights were completely random but the green light flashed over 80% of the time. The optimal strategy is guessing green every time. You’ll be right 80% of the time.

The rats and pigeons figured out this strategy fairly quickly. The human subjects figured it out quickly too. So it was a tie, right? Wrong.

After a little bit of trial and error, the rats and pigeons guessed green every time and scored an 80% success rate. The people on average scored a 69% accuracy. Why? Because of that big beautiful brain of yours.

Humans are the smartest species and we know it. Because we are so smart, we are overconfident in our ability to predict future events. Maybe the green light flashed several times in a row and the human subjects just “knew” that the red light would flash next. Even though they were told that the flashes would be completely random. On average the human subjects guessed red 1 out of 5 times and this dropped their accuracy to 69%.

The pigeon and the rat do not suffer the same illusions. They just know that if they guess green every time they have a very good chance of getting a reward.

We can’t help ourselves. As humans, we look for patterns and causal relationships in everything. A section in the left hemisphere of our brain drives this. It leads us to believe with just the right amount of data we can figure out the pattern and predict what is going to happen next.

Our desire to find patterns combined with our overconfidence gets us into trouble with complex data like investing.

Investors, professional and amateur, spend a lot of time looking at charts trying to figure out the next wiggle of the stock market. They then trade in and out of the market based on what they think will happen next . What usually happens is they are wrong and they’ve guaranteed themselves a loss of money through excessive trading fees.

Take the beginning of this year, 2016, for example. The stock market had its worse start since at least 1897.

Click image to enlarge.
Click image to enlarge.

Based on past charts and historical patterns it was all but a certainty that the stock market would continue to go down. Nothing was more extreme than the Royal Bank of Scotland’s announcement to “sell everything” and that “2016 will be a cataclysmic year”.

What happened if you listened to RBS on January 12, 2016 and sold everything?

Image courtesy of Stockcharts.com. Click image to enlarge.
Image courtesy of Stockcharts.com. Click image to enlarge.

The S&P 500 is up over 6%. Even after the worse start to any year since 1897 the S&P 500 is flat for 2016. To be fair, we’re only a few months into 2016.

By trying to guess when the stock market will decline next, what RBS and others are doing is guessing when the red light will flash next. We know the red light will eventually flash. We know the stock market will eventually go down but we do not know when. The day-to-day, month-to-month, even year-to-year price fluctuations of the equity market are random. The stock market is a dynamic system with hundreds of interacting variables and overlapping feedback loops. Guessing future moves with near certainty is impossible.

Here’s the good news. Just like in the flashing light experiment above we don’t need to guess the short-term moves of the stock market. We have data on the equity markets that is equivalent to the green light flashing 80% of the time.

The following table is from A Wealth of Common Sense. It shows the percentage chance of having a positive total return given a specific time period.

From A Wealth of Common Sense.
From A Wealth of Common Sense.

The longer we stay invested the better our odds of having positive total returns. According to Ben Carlson, The worst 20 year period for total returns was 54% and the worst 30 year period was 854%.

The objective of investing is the same as the simple light flashing experiment, to maximize our rewards. Trying to guess what equity markets will do tomorrow, next week, or next month and then trading in and out of the stock market to try and catch these moves will only harm our portfolios and ruin our potential to maximize our long-term investing rewards.

We need to focus on what we can control. Finding quality companies and paying a fair price for them.

Dividend Stock in Focus

Pfizer, Inc. (PFE): $32.76*
*price as of the close April 7, 2016

Pfizer is the world’s largest pharmaceutical company based on global sales. But everyone knows it for that little blue pill. You know the one that seems to have a lot of TV ads during golf tournaments for some reason.

We first bought Pfizer in our dividend growth portfolio in September of 2011 because we thought they were extremely cheap and because Pfizer is a dividend stalwart, a company that raises its dividend year-in and year-out.

We’ve continued to add to Pfizer because its intrinsic value has increased over the years and because CEO Ian Read is on a path of restructuring. Mr. Read is streamlining operations by spinning off non-core divisions like Zoetis (ZTS) and acquiring acquisitions for its core businesses like generic drug maker Hospira.

Mr. Read might potentially split Pfizer up even further in order to pursue his ultimate goal of lowering Pfizer’s tax bill by moving out of the U.S.

Dividend History:

Following its purchase of Wyeth, Inc. for $68 billion in 2009, Pfizer cut its dividend so that it could quickly repay the debt issued for the buyout. After cutting its dividend down to a quarterly rate of $0.16 per share, Pfizer now pays $0.30 per share on a quarterly basis. Since February 2009, Pfizer has grown its dividend at a compound annual rate of 9.5%.

From S&P Capital IQ. Click Image to enlarge.
From S&P Capital IQ. Click Image to enlarge.

Catalysts for Dividend Growth and Price Appreciation:

Allergan Merger

Pfizer and Allergan agreed to a $160 billion merger. The deal was structured as a tax inversion. By merging with Allergan, Pfizer would move its country of domicile from the U.S. to Ireland. Ireland’s corporate tax rate is 12.5% versus the 35% U.S. corporate tax rate. The U.S. also taxes U.S. corporations on any profit made overseas that is brought back, “repatriated”, to the U.S. If Pfizer redomiciles in Ireland through a merger with Allergan, Pfizer can reinvest those profits back into its U.S. operations without incurring a tax because it is no longer a U.S. company. Pfizer currently has over $50 billion in cash overseas.

The tax savings alone make a deal like this very attractive but the combined potential of the two companies was even more attractive.

Unfortunately, the deal is no more.

As we were writing this, the Treasury Department released a set of new aggressive anti-tax inversion laws. The new laws specifically target the Pfizer and Allergan merger and because of the new laws Pfizer and Allergan have scrapped the merger.

Pfizer’s CEO Ian Read is set on moving Pfizer out of the U.S. to bring the company’s costs in line with its non-U.S. based competitors. While it won’t be through a merger with Allergan, Mr. Read will likely find a way to redomicile Pfizer out of the U.S. It may take splitting Pfizer up into 3 separate businesses to do so.

Spin-Offs?

Before the Allergan deal was announced, Pfizer told shareholders that at the end of 2016 management would announce whether it was going to split the company up through a series of spin-offs. Expectations for at least one spin-off grew when Pfizer bought Hospira in a bid to boost the value of Pfizer’s generic and biosimilar business. Then the Allergan deal took priority and Pfizer’s management postponed the split up decision until the end of 2018.

Now that the Allergan deal has been canceled. Pfizer is free to continue its spin-off plans unless another merger candidate appears.

The SEC requires 3 years of financial reports broken out by division before a business unit can be spun-off. Pfizer started reporting on its 3 business divisions in 2014. The minimum expectation is for Pfizer to separate its Established Business (generic drugs and drugs soon to be off patent) from its Innovative drug business (recently approved drugs and drugs still in development).

A brief sum of the parts analysis for Pfizer’s three business divisions using Earnings Before Interest and Taxes (EBIT) values Pfizer at $43 per share.

Click image to enlarge.
Click image to enlarge.

Click image to enlarge.

Promising Pipeline & Ibrance

Over the last few years, Pfizer’s revenue has declined due in part to a couple of key drugs losing patent protection. Pfizer lost the patent on Lipitor, on of the most commercially successful drugs ever, in late 2011. The company has been working hard to come up with new drugs to replace the lost revenue. That effort is starting to pay off with some 90 potential new drugs in the pipeline. One of Pfizer’s most promising new drugs is Ibrance.

Ibrance is a specific breast cancer treatment and it is in stage 3/registration phase with the FDA. Estimates of peak sales are $10-15 Billion with Ibrance potentially reaching $4 billion in annual sales by 2020. Ibrance targets metastatic breast cancer and in combination with AstraZeneca’s Faslodex (an estrogen blocker) patients survived on average 9.2 months before their cancer worsened. The control group survived 3.8 months.

Pfizer is working on more indications for Ibrance which could push annual sales well past the estimated $4-5 billion annual sales.

Biotech Buyout

Pfizer could get bigger through a buyout or merger first, before they pursue spinoffs. They have the balance sheet to buy another biotech company in an effort to increase their roster of promising new drugs. Shares in biotech companies are still trading well below their peak last year and the cheaper prices may entice Pfizer to pursue one more buyout before separating the company.

Pre-Mortem (Potential Risks to our Thesis):

More Anti-Inversion Laws

As we were writing this the Treasury Department released a set of new aggressive laws aimed to stop Tax Inversion deals. The wording of the new laws suggests that the authors were targeting the Pfizer and Allergan deal. There are some big questions with these new laws including why is the Treasury Department, part of the Executive Branch, and not Congress writing these new laws? And why are the laws being changed and applied on an ex-post facto basis? The new laws also seem to change the meaning of what constitutes a share, or ownership in a company.

Pfizer is looking for a way to move out of the U.S. The company has now had two deals scuttled because of changing tax laws. Staying in the U.S. does not mean Pfizer will go out of business, however, it does mean Pfizer will have less capital to reinvest into its business versus its foreign-based peers. For an industry built on R&D, every bit of capital reinvestment helps. Over time as Pfizer’s foreign peers reinvest more into their businesses they will slowly out compete Pfizer.

Pipeline Wipeout

Pfizer’s pipeline of new drugs, especially its breast cancer drug, is very attractive. However, we don’t know with certainty what the future will bring. Pfizer’s potential blockbusters may not be blockbusters and the revenue Pfizer has lost from Lipitor may not be regained. For sustained dividend growth, we need business growth.

Conclusion:

With the Allergan deal no longer an option, our base case estimate of fair value for Pfizer using a discounted cash flow model is $40 per share. A sum of the parts estimate of Pfizer’s fair value is around $43 per share. If Pfizer’s pipeline, especially Ibrance, turns out to be as successful as currently estimated then Pfizer is worth more.

Pfizer’s share price had been under pressure as arbitrage funds sold Pfizer shares short and went long allergan shares in anticipation of the deal closing. Now that the deal is off Pfizer’s share price has popped as the arbitrage funds unwind their positions. Pfizer may give back some of its gains from the last few days as the buying pressure subsides, but in the long run we expect the company to offer favorable returns from current levels.

All previous letters are archived here.

THE OPINIONS EXPRESSED IN “THE AMM DIVIDEND LETTER” ARE THOSE OF GABRIEL WISDOM, MICHAEL MOORE AND GLENN BUSCH AND DO NOT NECESSARILY REFLECT THE OPINIONS OF AMERICAN MONEY MANAGEMENT, LLC (AMM), AN SEC REGISTERED INVESTMENT ADVISOR WHO SERVES AS A PORTFOLIO MANAGER TO PRIVATE ACCOUNTS AS WELL AS TO MUTUAL FUNDS. CLIENTS OF AMM, MR. WISDOM, MR. MOORE, MR. BUSCH, EMPLOYEES OF AMM, AND MUTUAL FUNDS AMM MANAGES MAY BUY OR SELL INVESTMENTS MENTIONED WITHOUT PRIOR NOTICE. THIS NEWSLETTER SHOULD NOT BE CONSIDERED INVESTMENT ADVICE AND IS FOR EDUCATIONAL PURPOSES ONLY. THE OPINIONS EXPRESSED DO NOT CONSTITUTE A RECOMMENDATION TO BUY OR SELL SECURITIES. INVESTING INVOLVES RISKS, AND YOU SHOULD CONSULT YOUR OWN INVESTMENT ADVISOR, ATTORNEY, OR ACCOUNTANT BEFORE INVESTING IN ANYTHING. CURRENT STOCK QUOTES ARE OBTAINED AT HTTP://FINANCE.YAHOO.COM. PRICES ARE AS OF THE CLOSE OF THE MARKET ON THE DATE FOR WHICH THE PRICE IS REFERENCED.