This is from the AMM Dividend Letter released February 5, 2015. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.
One of our favorite drawings is the one below by Carl Richards of Behavior Gap.
It is a beautifully simple representation of how our emotions can cause extreme harm in investing. If you flip the word groupings around you also get Warren Buffett’s famous quote, “be fearful when others are greedy and greedy when others are fearful”. Simple advice but very hard to execute. It is extremely difficult to tell when people are being too greedy or too fearful, event at markets extremes, without the benefit of hindsight.
Instead of attempting to sell when everyone is greedy and buy when everyone is fearful, because of the inherent difficulty in timing such things, what if we were able to do something more like this?
Poorly drawn by Glenn Busch
We can’t control other people’s emotional states. We can only focus on controlling ours. The best hope for us to control our emotions is to focus on the one thing we can control, our process.
When others become greedy and the price of the stock we want to buy exceeds our estimate of fair value we will not buy. When emotions change and fear replaces greed the price of the company will come down. When prices fall to levels we are willing to pay, only then will we buy.
This is not to say “buy the dip”. This is a gross oversimplification that also leads to trouble. It means stay focused on the process. It is the process that removes errors caused by emotions.
When we start buying a stock the price could continue to fall and that’s OK. If our valuation remains the same and the underlying business fundamentals remain intact then we’ll try to buy more. It is unlikely that we will buy a stock at the exact bottom. In fact we will often buy too early (stock goes lower after purchase). However if we focus on our process of buying quality companies (highly profitable dividend growers with a defensible market position) at prices at or below fair value then the movement of the stock price over the short run shouldn’t matter all that much. Ultimately, these companies should survive, gain market share, and thrive.
By focusing on our process, buying great companies at or below their fair value, we are trying to build a portfolio that will look more like this over time.
Another masterpiece by Glenn Busch
There will be ups. There will be downs. There will be easily digestible pullbacks and there will shear panic inducing drops. By staying the course and focusing on the process we can navigate the undulating seas of the stock market while keeping our emotions in check. Over the long run this should help us meet our objective of growing your wealth and income.
Sincerely,
Your Portfolio Management Team
Dividend Stock in Focus
General Electric (GE): $24.50*
*price as of the close February 5, 2015
General Electric the business has taken many shapes. Under Thomas Edison General Electric, then known as the Edison Electric Light Company, was the hot new tech company. It created the first incandescent light bulbs, x-ray machines, and the first central power stations.
GE continued to innovate and created many of the modern appliances and conveniences we are all accustomed to today: washing machines, electric ovens, garbage disposals, air conditioning. GE also played a vital role in the development of new industries like radio, TV, aviation, and plastics. General Electric also invented consumer finance, a big innovation for its time.
Thomas Edison and General Electric also played a large role in making Hollywood the film capital of the world not because of them but in spite of them.
When Jack Welch took over as CEO in 1981 GE had become an industrial behemoth with tons of divisions and layers of bureaucracy. The new CEO ushered GE into its next phase. He weeded out weaker divisions, weaker executives, unnecessary layers of bureaucracy, and refocused a giant company towards growth.
One of the biggest things Jack Welch did was build out GE Capital. The division that housed consumer finance expanded into airplane leasing, car loans, and even into sub-prime mortgage lending. GE Capital became so big that General Electric wasn’t so much an industrial company but a diversified finance company.
Then the financial crisis of 2008 hit.
General Electric’s fortune were so tied to finance that, were it not for a $3 billion lifeline from Warren Buffett and Berkshire-Hathaway, the company may not have survived.
After surviving the financial crisis new CEO Jeff Immelt decided to reshape General Electric again by taking the company back to its industrial roots. Jeff Immelt would sell off under-performing industries, focus on growth areas, and greatly reduce GE Capital’s role. Jeff Immelt also made a commitment to restoring GE’s dividend and growing it.
Dividend History:
From 1991 to 2008 General Electric was a classic dividend growth stock, growing its dividend per share at a compound annual growth rate of 11.67%. Then GE had to cut its dividend during the financial crisis. Below is a chart of General Electric’s last nine years of dividend payments.
From S&P Capital IQ. Click to enlarge.
2011 marked General Electric’s return to dividend growth after cutting the payout to a token level in 2010. Since then GE has grown its dividend at a compound annual growth rate of 14.47%. While it has only been 4 years, we expect continued dividend growth for the foreseeable future.
Catalysts for Dividend Growth and Price Appreciation:
Synchrony Financial (SYF) Spin-Off
Synchrony Financial operates in three segments: financing large ticket consumer items like home appliances, payment solutions for elective healthcare procedures, and private label credit cards its largest and most profitable division. Private label credit cards account for about 68% of Synchrony Financial’s revenue.
What are private label credit cards? Look in your wallet. Do you see a Lowe’s credit card? Maybe a credit card to a clothing store like Banana Republic or the Gap? Maybe you have gas credit card to Chevron or Phillips 66? These are private label credit cards.
Synchrony Financial partners up with regional and national retailers and then does all the underwriting and retains all the credit receivables and credit risk. The retailers receive reward payments from Synchrony Financial and they do not have to pay the interchange/exchange fees for in-store purchases, Synchrony Financial covers these costs too. Through Synchrony Financial these retailers can set-up reward programs and drive more sales. Private label credit card users tend to spend 40% more than other customers.
Private label credit cards have higher interest rates than the standard credit cards which generates higher net margins and higher returns on equity. Capital One Financial (COF) is the closest publicly traded company to Synchrony Financial and the chart below compares the net margin as a percentage between the two. Capital One Financial is in red and Synchrony Financial is in Blue.
From S&P Capital IQ. Click to enlarge.
The next chart compares Return on Equity between the two. Same colors.
From S&P Capital IQ. Click to enlarge.
As the economy rebounds and consumer spending continues to climb Synchrony Financial is in the right spot to ride this trend. With its high Returns on Equity and Net Margins it should be a very profitable ride for the company too.
General Electric did an IPO for 15% of its stake in Synchrony Financial in August of 2014. GE still owns the remaining 85% of Synchrony Financial which we value at $2.70 per share of General Electric. By the end of this year GE plans to spin-off the remaining 85% to its existing shareholders.
The question is why own General Electric to get Synchrony Financial when Synchrony Financial is already trading publicly?
Synchrony Financial does not currently pay a dividend. It would ultimately like to pay a dividend but can’t until it is completely separated from General Electric and completes a review by the Federal Reserve (more on this below in the Pre-Mortem).
By owning General Electric we get to collect GE’s dividend while we wait we wait for the spin-off. Post spin-off we’ll end up owning two high quality companies and more than likely two dividend growers.
Refocused on Industrial Growth
The restructured and refocused General Electric operates in the following segments: Power & Water, Oil & Gas, Energy Management, Transportation, Aviation, Healthcare, and Appliance & Lighting. Management’s target is to get 75% of its earnings from industrial activities and 25% from GE Capital.
The bulk of GE’s businesses are focused on infrastructure development which is extremely capital intensive and its very hard for customers to change their entrenched systems. With GE’s strong brand, long-lived customer relationships, and catalog of patents makes GE extremely competitive in these markets. Failure of infrastructure systems are catastrophic. Although 3rd party services exist, having the actual manufacture as the service providers adds a level of comfort that the systems will be maintained effectively. This helps GE secure the 10-20 year long-term and very profitable service contracts on the infrastructure development goods it sells.
The long-term contracts also provide GE with growth. Spending on GE’s industrial goods will track overall economic growth and it is the service contracts that will boost GE’s growth rate slightly higher. The long-term service contracts with 30%+ margins provide GE with stable cash flows and higher returns on capital.
Pre-Mortem (Potential Risks to our Thesis):
Poor Industrial Growth
GE’s continued dividend growth is now based solely on its industrial divisions growing, improving operating margins, and increasing free cash flow. Management decided to focus on: Power & Water, Oil & Gas, Energy Management, Aviation, Healthcare, Transportation, Appliance & Lighting. Excluding its finance division General Electric’s dividend payout ratio is 85% of free cash flow. Management needs to get each business division growing and improving its operations to boost free cash flow in order to continue to grow its dividend each year at a high rate. If management can’t then our expectations for future dividend growth are too optimistic.
Shale Oil Bust
16 percent of General Electric’s revenue is related to Oil and Gas and 25% of Oil & Gas revenue is related to drilling. The decline in oil prices is forcing exploration and production companies to cut back on capital expenditures which will cause GE’s drilling revenues to decline significantly year-over-year. Offsetting the drilling revenue decline is GE’s downstream and compression business divisions that are expected to increase orders due to lower oil prices.
If oil prices remain at current levels for an extended period of time (or go lower), future revenue and earnings growth will be negatively impacted.
Synchrony Not Cleared to Pay Dividend
Even after Synchrony Financial is spun-off and completely free from General Electric it may still not be allowed to pay a dividend. Part of the financial reforms stemming for the 2008 crisis is to have the capital return programs, dividends and buybacks, of large financial institutions reviewed by the Federal Reserve. If the Federal Reserve believes the company to be inadequately covered by its capital base then the Federal Reserve can reject Synchrony Financial’s request to pay a dividend.
If Synchrony Financial is denied its capital return program it doesn’t mean it can never pay a dividend. It just means it will take longer for the company to do so as it revises and resubmits its plan.
Conclusion:
Our fair value for General Electric is $29 per share. $2.70 for GE’s 85% stake in Synchrony Financial and $26.30 per share for GE’s industrial businesses and the remainder of GE Capital. Sticking to our process outlined at the beginning of this letter, at GE’s current price of $24.13 we get to buy both high quality businesses at a discount to our estimate of fair value.
Chart courtesy of Stockcharts.com.Click image to enlarge.
