Creating income for today, wealth for tomorrow | Issue 49, April 2017

Double-Digit Dividend Growth From an Unlikely (and Uncomfortable) Source


Marc Lichtenfeld

Dear Member,

I’ve always been picky about certain things.

When I was single, I went out on a lot of dates. But I wanted more than a pretty face. I wanted someone smart, fun and ambitious, who didn’t take themselves too seriously.

Then I met my wife, and the search was over.

Slight problem though. She had a boyfriend. But I knew she was the one, so I waited. Luckily, I only had to wait six months.

Twenty-two years and two kids later, I can safely say it was worth the wait.

When I’m picking stocks, it’s often a similar process. I know what I’m looking for, but sometimes I have to wait.

I want yield, dividend growth and an inexpensive valuation. I look for companies that are underfollowed or hated by Wall Street but moving in the right direction.

That’s where Domtar (NYSE: UFS) comes in. And by waiting a few months from when I first discovered it, we can get in at a 25% lower price.

The Fort Mill, South Carolina-based company makes paper products such as those used in religious books, textbooks and envelopes.

As you can imagine, with the world going digital, a papermaker isn’t the most popular idea on Wall Street.

But what everyone’s missing is Domtar’s blossoming personal care line.

Domtar makes fibers for diapers.

It makes and sells its own lines of diapers and, for babies, has the Fisher-Price brand, which it licenses from Compound Income Portfolio member Mattel (Nasdaq: MAT).

It also makes the fibers used in SleepWell and Fitti diapers, as well as other private label brands. But the big growth opportunity is in adult diapers. Seriously.

Between 2015 and 2021, adult diaper sales are expected to soar 57% in the U.S.

Within a decade, adult diapers will outsell infant diapers. In Japan, that’s expected to happen as early as 2020.

According to the Urology Care Foundation, one in three adults has bladder control issues.

Domtar is doubling down on adult diapers. Last October, it acquired Home Delivery Incontinent Supplies Co. (HDIS) for $45 million.

HDIS has annual revenue of about $65 million.

It’s the largest direct-to-consumer provider of incontinence supplies. And it’s been in business for 30 years.

Domtar’s “personal care” segment (what it calls its diaper business) has become an increasingly meaningful part of its overall sales and profitability.

You can see from the chart below that in just five years, personal care has become an important part of Domtar’s revenue and profits.

And those percentages should increase over the coming years.

Diapers Stuffed With Cash

Domtar generates a lot of cash flow. In 2016, cash flow from operations was $465 million. It paid out $102 million in dividends.

However, capital expenditures were sky-high at $347 million, which means free cash flow (cash flow from operations minus capital expenditures) was just $118 million.

Normally, that would concern me. I like to see dividends paid make up only 75% of free cash flow (also called the “payout ratio”). Last year, the payout ratio was 86%.

However, 2016 was not a normal year. The company shut down the largest paper machine in the U.S. and converted an entire facility in Ashdown, Arkansas, from making paper to making fluff pulp, used in diapers.

The conversion is done. That not only will lower capital expenditures but should increase revenue – all of which will add to free cash flow.

Management said capital expenditures should decline to between $210 million and $230 million, a drop of between 34% and 39% from last year’s total.

As a result, in 2017, analysts forecast Domtar’s free cash flow will more than double to $293 million.

The company has raised its dividend every year since 2011. And during those six years, the dividend’s compound annual growth rate was a whopping 22%.

If we assume that the growth rate will be just 10% going forward, the payout ratio will be a low 38% next year.

So it’s quite possible that there will be massive dividend growth in the future if cash flow continues to improve.

The stock currently pays a 4.4% yield, though I expect double-digit annual growth over the next decade.

Additionally, the stock is what the kids might call “crazy cheap.”

It trades at just 12 times forward earnings, 0.5 times sales and – incredibly – below book value at just 0.89. In other words, if the company were liquidated today, you’d be buying the stock for just $0.89 on the dollar.

Unsurprisingly, analysts who wait until stocks are performing well before they recommend them hate Domtar. Nine out of 14 analysts rate the stock a “Hold” or “Sell.”

Domtar reminds me of another company in our Compound Income Portfolio – Meredith Corp. (NYSE: MDP). We first bought the magazine publisher in 2013 when Wall Street didn’t understand that Meredith owned some of the most-visited (by women) sites on the web.

The stock was cheap and had a great dividend that it raised every year.

We made 40% on the stock when it received a buyout offer. A year ago, after the deal fell through and the stock dropped, we bought it again. We’re up 53% since February 2016.

Domtar has many of the same characteristics, and I expect it to do just as well.

A company whose stock is trading below book value, with a solid yield and growing cash flow, and that is a big player in a booming market is worth the wait.

Buy it now before the rest of Wall Street discovers the growth story no one else is talking about yet. You’ll be getting in before the adult diaper trend becomes mainstream news.

Action to Take: Buy Domtar (NYSE: UFS) at the market, and add it to the Instant Income Portfolio and Compound Income Portfolio. Place a trailing stop 25% below your entry point in the Instant Income Portfolio.

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STEVE’S BOND INSIGHTS

Why It Pays to Focus on More Than Just Yield


In my 34 years in the markets, I’ve always been amazed at how the bond and stock markets seem to have the magical ability to take in all the predictions of analysts and experts and then do the exact opposite.

Experts’ predictions about the death of the bond market have been a recurring theme for almost 10 years.

And year after year, those of us on the bond side of the house have had to suffer through calls for sell-offs and bond market disasters that never materialized.

If you play bonds correctly, those will never happen. But that’s a topic for another time...

Recently, the more the so-called “experts” called for a disaster in bonds, the more the market threw it back in their faces.

And, I have to admit, it’s been entertaining to watch.

If the stock market’s activity (since the November presidential election) is any indication, its ability to outsmart the pros is exploding on the equity side of the house, too.

Before the election, virtually every expert in the world – financial and otherwise – didn’t think or wonder but knew “for a fact” that the stock market would crumble in the unlikely event of a Trump victory.

They were wrong on both counts!

And since the election, the number of experts calling for the collapse of the Trump rally has been growing daily.

In my experience, that means we’re nowhere near a top.

But the most convincing evidence of the market’s ability to prove the herd wrong emerged after the Fed increased rates in its March meeting...

Despite weeks of the mainstream financial media calling for another sell-off in bonds and despite the Fed’s rate hike, bond prices actually went up and Treasury yields moved down.

Eventually, though, rising interest rates will cause a drop in the bond market.

And finally, after years of incorrectly predicting a sell-off, the anti-bond experts will be right! Or, at least, sort of...

A Short-Lived Rout

The news behind the news is that consumer confidence is taking off. There are increasing indications of moderately higher inflation, rising to the 2.5% area. And the tax reform and infrastructure spending Trump’s promising is seen as a big growth booster.

If consumer confidence, growth and inflation are showing signs of improvement – and they are – rising bonds yields are not far behind.

If we are to avoid the losses in the bond portion of our income portfolios, it’s time to shift gears. Here’s what you need to do now...

If you’re sitting on gains in any kind of bond fund, cash out now! I’ve written endlessly in my Wealthy Retirement columns about why bond funds will be crushed when the rate shift finally happens.

In today’s environment, if you’re sitting on cash – but want the safety, predictability and reliability that bonds offer – but you’re concerned about an eventual sell-off (which is reasonable), you have to focus on more than just yield.

Keep Your Eye on Duration

Going forward, the name of the game is duration. Duration, unlike other bond concepts, is based on common sense and is actually easy to understand.

It’s a measure of how much a bond’s price will fall when interest rates move up. It’s based on the credit quality of a bond, the number of calls it has and its interest rate.The higher the quality of a bond, the less its price will fall when rates increase.

This makes a lot of sense if you think of it in terms of which bonds you would hold if the market went against you. Investment-grade bonds (rated BBB and higher) have the lowest chances of defaulting.

So most folks hold their higher-rated bonds no matter what the market does.

Your Best Option

The idea here is simple: the less time your money is exposed to the market, the less chance you have of a loss. And the more opportunities you have to reinvest your money in a rising rate market, the greater your average return. Very simple!

Remember, duration (although it’s expressed as a number of years) is not the same thing as maturity. They are two very different things.

A bond with a duration of one year will fall about one point, or $10 in price, with each one-point increase in interest rates. Very bearable.

But duration can be as high as 10 or 15. And 10% to 15% would be a big drop in a bond price for a 1% increase in rates. Plus, that kind of volatility can drive panic-selling, which accounts for almost all bond losses.

Coupon

The higher a bond’s coupon (or annual interest rate), the less likely it is that you’ll sell into a falling market. And panic-selling into a correction is the root of almost all bond losses.

If you’re holding a bond with a 10% coupon versus one with a 3% coupon, common sense says you’re a lot less likely to sell the 10% bond. It pays too much to dump.

Calls

Calls are preplanned opportunities for a company (or municipality) to buy back a bond before maturity at a preset price... usually well above par, $1,000 per bond. As such, the duration of a corporate or municipal bond with multiple calls would be lower than that of a Treasury, which has no calls.

When rates finally move up and bond prices drop, you’ll be very happy if you hold only low-duration bonds. Drops of 5% to 8% are much more bearable than drops of 10%, 15% or more.

Our Blue Chip Bond Portfolio has an average duration of 7.6.

And a 7.6% drop in value is more than tolerable for everyone except the most risk-averse.

If the Fed continues to raise rates at one-quarter of a percent at a time, a 1% increase will take a full year.

In the meantime, keep in mind that bonds with high durations and long maturities are just one element of your income portfolio. If rates don’t rise as much or as quickly as expected (which many believe could happen), these bonds will be fine.

My advice? Turn off the TV, and focus on duration. It’ll limit your downside and help keep you in your bonds... which is where you make money.


Interest Rate Impact

The Death of Dividends?


Editor's Note: In lieu of a regular Infinite Income Strategies column this month, I’m sharing my thoughts on a big topic of conversation at the Club’s 19th Annual Investment U Conference last month. It was the subject of a speech I gave and the heart of countless questions I fielded from conference attendees. If you’re concerned about rising rates eating into your income portfolio, don’t bypass the article below.

What’s going to happen to dividend stocks when rates rise?” my parents’ friend asked me nervously as we chatted during a party.

“The stocks are going to get hurt, right?” he added.

Before I had a chance to answer, my parents walked through the door and we all yelled, “Surprise!”

There’s a perception that when rates rise, dividend stocks fall, especially those of utility companies, given their heavy debt loads. And it kind of makes sense...

If the yield on the 10-year Treasury rose a full percentage point from where it is today, the safest investment on the planet would offer the same yield as a solid dividend payer.

For investors more concerned with income and preservation of capital than growth, the Treasury bond would be more attractive since it’s considered risk-free.

Of course, you probably wouldn’t see any growth from that investment – something that’s important to many investors. But for those who prefer safety over growth, the Treasury would be more appealing.

Could that create less demand for dividend stocks, as many investors think?

Investors who believe this myth will be more surprised than my mother at her birthday party.

You see, there’s simply no evidence backing up that belief.

In fact, just the opposite is true. Dividend payers have consistently beaten the overall market, generally performing well, when rates have moved higher. Especially utilities – companies that, due to their high debt levels, are perceived as vulnerable to rising rates.

For example, Dividend Aristocrats, S&P 500 stocks that have raised their dividends for 25 years in a row or more, were positive the last three times interest rates climbed.

  • From 1994 to 1995, the Dividend Aristocrats Index soared 20%.
  • From June 1999 to December 2000, the index went up 0.7%.
  • From June 2004 to June 2006, the index climbed 19%.

Over all three periods, the index averaged a return of 13.5%.

It’s interesting to note that the dot-com bubble and market peak of March 2000 were right in the middle of the second period when rates rose. Yet the Aristocrats were still positive while the S&P was down more than 2%.

It wasn’t just Aristocrats that performed well. Other segments that paid healthy dividends performed strongly despite rising rates.

Real estate investment trusts were up in two out of the three intervals as measured by the Dow Jones Equity All REIT Index.

When the index was down, during the 1994 to 1995 period, it dipped only 0.4%. It jumped 17.2% and 58.2% in the next two periods.

Master limited partnerships and business development companies have also posted strong gains when rates have climbed.

However, utilities have been the most surprising.

Common wisdom states that you shouldn’t own utilities when rates are rising because utility companies have a lot of debt. Higher interest rates cause their interest expenses to rise, hurting profits and, perhaps, their ability to pay dividends.

But going back 40 years, the Dow Jones Utility Average was up six out of the seven times when interest rates were on the rise.

And it beat the S&P 500’s performance four out of those seven periods.

Even in the period between 1976 and 1980, when the yield on the 10-year Treasury spiked from 7.83% to 12.75%, utilities gained 14%. Meanwhile, the S&P dipped 2%.

I’m sure you’re wondering if this means I’ll add some utilities to our various portfolios.

I’m certainly open to it. However, utilities generally don’t match the requirements of my 10-11-12 System.

Remember, 10-11-12 is all about dividend growth. Meaningful dividend growth.

The dividends have to increase enough each year that we achieve 11% yields within 10 years or 12% average annual total returns over 10 years.

In order to reach those goals at today’s yields, we need to see impressive dividend growth.

Most utilities don’t boost their dividends strongly enough.

For example, Consolidated Edison (NYSE: ED), a New York-based power company, has a decent yield of 3.6%. And it’s raised its dividend every year for 43 years. However, over the past 10 years, it’s averaged an annual increase of only 1.5%.

Northwest Natural Gas (NYSE: NWN) has been raising its dividend every year since 1956. Over the past 10 years, it’s averaged an annual increase of only 3%... and less than 1% over the past three years.

Those kinds of numbers won’t get us where we want to go.

I’ll keep an open mind, and if I can find a utility with a solid track record of large dividend raises and prospects for large increases in the future, I’ll consider it.

But for now, the good news is that even though interest rates will rise for a while, it’s not a death sentence for our dividend stocks.

History has shown that when rates rise, these stocks can not only survive, but thrive.

So don’t be surprised when your dividend stocks continue to perform well regardless of interest rate changes.

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Mailbag

The Oxford Income Mailbag


We believe it's helpful to share questions and clarifications of dividend-investment strategies with all our subscribers. Keep in mind, Marc and Steve can answer your general strategy and service questions, but they cannot give personalized advice.

As always, feel free to send us your questions at mailbag@oxfordclub.com.


Would you please give your thoughts on the financial sector as a whole and as an investment strategy under the Trump administration? Also, please discuss your thoughts on Russian stocks.

- Eric

I like the financial sector.

Interest rates are going up, and that’s generally positive for financials. Additionally, the Trump administration has vowed to cut regulations for many industries, including the financial sector. And we know that banks, insurance companies, investment firms and real estate businesses have to follow lots of rules. Fewer regulations should make it easier for financial institutions to be profitable.

Regarding Russia – I don’t follow Russian stocks too closely anymore, after getting burned on one a few years ago. I learned the hard way that the Russian government can do anything it wants to companies.

I have had Omega Healthcare Investors (NYSE: OHI) in my portfolio since you “first” recommended it back in October 2011 in the predecessor to Oxford Income Letter. I am glad I kept it in my portfolio... it’s yielding 12.26%. Great pick. Thanks!

- Brian N.

Thanks, Brian. This is a perfect example of my 10-11-12 System at work. Five and a half years after buying the stock, you’re enjoying a yield of more than 12%.

Marc, with Mattel’s (Nasdaq: MAT) earnings and free cash flow so negative compared to its dividend payout, aren’t we in danger of a dividend cut? I see in SafetyNet Pro that it’s rated a C. I really would like to get out before a cut if you think one is coming. It looks like it is paying its dividend by borrowing and would need a large increase in free cash flow to prevent a cut. We’ve already taken a large hit on this stock.

- Ray B.

If I’m ever concerned that a dividend cut is coming, rest assured, we will be out of the stock.

You are correct that Mattel’s payout ratio is too high. Its payout ratio is the proportion of dividends paid out of earnings or cash flow.

However, we knew going in that this would be a turnaround story. And while the ship hasn’t turned around yet, it has stopped taking on water. Things are improving at Mattel, which is why I’m willing to give it some more time.

Its Barbie, Fisher-Price and American Girl lines are all improving. And Mattel’s size still makes it an attractive licensing partner. Lastly, its new CEO, who came from Google, should breathe new life into the company with innovative ideas and a fresh corporate culture.

We won’t hold it indefinitely if things don’t continue to improve, but I like the company’s prospects right now.

Can you explain why Brookfield Infrastructure Partners (NYSE: BIP) is considered a good investment when its payout ratio is 183%?

- Reuben A.

I get this type of question all the time. It has to do with how I measure payout ratio versus the way everyone else does.

When you check payout ratio on financial websites like Yahoo Finance, it’s calculated as dividends paid divided by earnings.

However, I calculate it as dividends paid divided by cash flow.

I do this because earnings has all kinds of noncash items, such as depreciation, in its formula. Additionally, companies are allowed to record revenue and earnings on their books even if they haven’t gotten paid on a transaction yet.

Cash flow accounts for only cash that’s come in and gone out the door. Noncash items are not included.

Since dividends are paid with cold hard cash, I want to know how much cash the company generated... Not what its earnings were with all those items that are noncash accounting tricks.

In 2016, Brookfield generated $944 million in funds from operations, a measure of cash flow for partnerships. It paid out $628 million in dividends for a comfortable payout ratio of 66%.

Are REITs best held in a tax-deferred account or another kind?

- G. Arden L.

Tax-deferred.

Unless there’s something unusual about a REIT’s dividend (in which case I’ll point it out), I recommend holding it in a tax-deferred account.

REITs have high yields, and some of them are taxed at ordinary income tax rates, not the lower dividend tax rate. If you can protect that income by holding the stock in a tax-deferred account, that’s usually the best way to go.

I wanted to ask your opinion about a variation of your 10-11-12 System. I have combined your system with my use of trailing stops. If a stock whose dividend I’m collecting as income falls below its trailing stop, I reinvest the dividend. When the stock reverts back above the trailing stop price, I collect the dividends again. This is a long-term strategy that allows occasional reinvestment at a reduced price. Unless a stock really bombs, this seems like a fairly foolproof system.

- Maurice H. (Longtime Oxford subscriber)

Interesting idea. But my concern is, what happens if the stock really bombs? The reason we use stops is to ensure small losses don’t become big ones.

If the stock fell because the entire market was down – and there was no change in the company’s fundamentals or its ability to pay its dividend – I’m fine with it.

In the Compound Income Portfolio, I don’t use stops for precisely that reason – so we can reinvest dividends at a low price in order to generate even more dividends.

So if you’re doing that, just make sure that the stock didn’t drop because it deserved to.



The Compound Income Portfolio

The Oxford Income Letter portfolios fit into the Blue Chip Outperformers level of the Oxford Wealth Pyramid. For more information, go here: www.oxfordclub.com/wealth-pyramid.