VALUATION DIVIDEND
QUARTERLY REPORT: Q4 2019
Valuation Dividend™ returned 6.52% in 19Q4, vs. 7.41% for its benchmark Russell 1000 Value, on a total return basis. In 2019, the Valuation Dividend returned 24.92%, below the R1000 Value by 162 bps.
In the 4th quarter, the overall large cap. US equity market posted strong returns, driven by optimism of the US and China signing a “phase one” deal, potentially better global economic growth trajectory in 2020, and the US Fed in December holding fund rates steady while signaling no desire to raise rates in the foreseeable future. While the memories are still fresh of inverted yields of the 2 year and 10 year US Treasury bonds in mid-August, the first time since May 2007, and the 10 Yr US Treasury yield collapsed to 1.5%, near its 5 year low, the 10 Yr yield has since recovered to end 2019 at 1.9%, as confidence resumed that the US economy will continue expanding. In the quarter, value stocks underperformed growth /momentum stocks, with IWD (iShare R1000 Value) lagging IWF (iShare R1000 Growth) by nearly 320 bps. The Technology sector managed to post best performance, while high dividend yielding sectors such as REITs, Utilities, and Consumer Staples performed the worst. Dividend yield as a factor didn’t contribute to alpha generation, with the bottom 20% ranked stocks in the R1000 outperforming the rest of the index.
The following are the best and worst performing stocks in the Valuation Dividend in 19Q4.
Target (TGT) delivered another outstanding quarter in Q4, thanks to another beat and raise quarter. What is particularly exciting as reflected in Target’s 19Q3 results is that e-commerce sales rose 31% year over year, with most of the growth driven by same-day delivery or pickup, validating the company’s strategic focus to provide ultra convenience and a seamless omnichannel experience to satisfy customer needs. While executing this focus, Target made more pronounced progress in shipping orders from nearby stores rather than from distribution centers, which made e-commerce more profitable in the quarter. Separately, the company is gaining market share in the apparel, home and beauty categories, which command higher margins and helped Target’s operating margin expand 80 bps y-o-y. Target’s strong Q3 performance and confidence towards the future further convinced us its business model is durable and its competitiveness in the retail arena will continue and improve.
JP Morgan (JPM) started Q4 by reporting robust 19Q3 results, which handily exceeded expectations. Despite fears of an economic slowdown, the company delivered strong growth in consumer banking, bond trading, and record investment banking fees. During the rest of the quarter, the bank’s common stocks rode the tide of a rising US equity market and improved sentiments towards the global economic outlook as the US and China had agreed to sign a phase one deal.
Eli Lilly (LLY) in October posted stronger-than-expected Q3 earnings, and boosted its full-year profit guidance, thanks in part to strong sales growth in the drug maker’s newer medicines such as Trulicity, a diabetes treatment, and its severe plaque psoriasis drug Talz. In December, Lilly shares received another boost after management provided upbeat FY20 guidance. The company expects 2020 adjusted net earnings per share of $6.70 to $6.80, compared with the consensus of $6.62, and revenue of $23.6 to $24.1 billion, vs. the consensus of $23.5 billion. Management expressed optimism about the company’s long term future, citing the company’s “attractive commercial portfolio and limited patent exposure through the latter half of the upcoming decade”. We concur Lilly is well positioned to deliver sustainable volume-based revenue growth and drive further operating margin expansion.
On the detracting side, Hasbro (HAS) was the worst performer. After posting a strong 19Q2, Hasbro’s 19Q3 profit and revenue badly missed expectations. Adjusted net income fell to $233.8 million from $264 million a year ago, or $1.84 cents a share, well below the consensus estimates of $2.21. Revenue edged up to $1.58 billion from $1.57 billion, missing the consensus forecast of $1.72 billion. Management attributed the entire shortfall in performance to the disruption caused by the volatile global trade environment, which propelled retailers to cancel major direct import program orders (retailers take ownership of inventory in China), and rewrote many of those orders as domestic shipments (retailers take ownership of inventory in the US). Hasbro ultimately was unable to rewrite all of the orders from direct import to domestic orders in one single quarter. The company was also unable to ship all orders, many of which came late in September. It is important to know there didn’t seem to be weakness in demand as products such as STAR WARS Triple Force Friday, FROZEN II, and NERF Ultra, had very strong sales in line with or ahead of plans, as the company prioritized those critically important launches. The tariff environment and shipment timing gap Hasbro experienced in Q3 are short term in nature and are largely resolved as the company moves into the new year. Management maintained its view that 2019 will deliver profitable growth, and the company is on track in the long term to deliver mid-single digit revenue growth and double-digit earnings growth on annualized basis.
UGI Corp (UGI) in mid-November provided 2020 guidance which is well below analyst forecasts. On an adjusted basis, the firm forecasts adjusted earnings per share of $2.60-$2.90 in 2020, vs. analyst estimates of $3.04. Management cited reduced pipeline capacity as one of the reasons for the soft guidance, a lagging issue in their Midstream & Marketing segment for 2019. Management expects capacity to improve in 2020, but still be lower than recent years. Additionally, UGI sees a longer time horizon for acquisition returns to have meaningful impact on its operations, and during the conference call, management repeatedly spoke of 2021-2023 as the period of visible returns from the two recent acquisitions. Despite the worse than expected guidance, we believe UGI offers a great valuation. Future expectations for the firm appear quite negative, and a recent increase in the dividend helps provide UGI a strong yield.
Looking at 2019, the Valuation Dividend returned 24.92%, underperforming the R1000 Value by 162 bps. Among the worst performers, Walgreen (WBA) is battling with sometimes uneven script growth quarter over quarter, continued reimbursement pressure, and negative front store sales trend, among others. The company is focused on driving traffic and script volume growth by establishing partnerships with a variety of service providers and signing exclusive, preferred contracts with certain health plans. In addition, the company is investing heavily to accelerate digitalization of the company, while rolling out transformational cost management program with targeted annual savings of $1.8 billion to be realized by 2022. Separately, Kohl’s (KSS) had a challenging year with quarter after quarter misses of its operational target. The company will likely see its 2019 sales decline in single digit while EPS drop in double digit, when compared to 2018. In the year, the company experienced a wide range of executional issues, from product offering, to marketing effectiveness, to operational consistency. We believe Kohl’s can do better, however, and as recently as in 2018, the company grew comparable store sales by 1.7% and grew EPS by 34% from the prior year. The company also has a strong balance sheet and has been actively reducing debt. With free cash flow of approximately $1 billion a year, Kohl’s can afford investing for the future. Kohl’s has the work cut out for them to build a durable business model, which delivers consistent results, but its valuation is quite compelling.
Though we are disappointed the Valuation Dividend™ slightly underperformed its benchmark in 2019, our principle and process remain the same. For 2019, high yielding dividend stocks underperformed the low yielding stocks in the R1000. As we pick from the high dividend yielding universe, it is not surprising such headwinds were hard to overcome. However, the Valuation Dividend™ strategy again outperformed the popular VYM and SDY ETFs handily, continuing to prove the value of skillful active management. As a summary of our investment beliefs, we aim for the strategy to maintain strong income generation ability with broad sector exposure through companies with attractive valuation, robust balance sheet strength, and sustainable business model. Valuation Dividend currently enjoys an average dividend yield of 3.2%.
