November 17, 2020 - 6:59pm EST by
2020 2021
Price: 138.00 EPS 0 0
Shares Out. (in M): 374 P/E 20 0
Market Cap (in $M): 51,500 P/FCF 25 0
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0 0

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Note:  I have submitted many idiosyncratic equity ideas over the last decade+ via VIC, but thought today I would propose a macro/thematic idea.  I think it identifies a key problem with the functioning of financial markets we were taught in textbooks and finance courses.  If I am correct, this macro condition may be more important to our collective idea outcomes than our micro analysis of individual securities.  My idea is just one solution, and I hope it spurs some discussion amongst this group for other ideas - hopefully several better than mine.  With that caveat - here goes...



A lot has been written about the death of 60/40 portfolio construction or the end of risk parity over the last year.  And indeed, the logic of strategies relying on a balance of equity and fixed income exposures begins to crumble as bonds approach or break through the zero bound.  There are few good alternatives for investors, but I propose re-allocating a meaningful percentage of a portfolio to invest in the highest quality corporate stocks with meaningful dividends and a history of dividend compounding - an allocation that can generate similar dual objectives of income and growth and still protect capital in times of stress.  VIG - the Vanguard Dividend Appreciation ETF - is a very liquid, ultra low cost, and diverse portfolio of the highest quality US corporates with solid balance sheets, a history of growing dividends, and reasonable valuations.  



My analysis is based on an important assumption - the US has been sucked inescapably into debt monetization and currency debasement as a result of the resulting economic collapse and fiscal and monetary rescue from covid.  The country was likely heading down this path prior to the pandemic as a decade of relatively anemic but consistent economic growth followed the 2008 financial crisis.  The writing seemed to be on the wall.  Japan had already hit excessively high leverage levels and been pinned at the zero bound for many years.  Europe had never fully recovered from its financial crisis.  And bond yields had already been strongly suggesting the path would be the same in the US, but there may have been some small hope of avoiding this destiny before.  Not anymore.


The notion of US fiscal and monetary responsibility have been debated for decades.  Fiscal deficits and their sustainability were a controversial topic.  The financial crisis in 2008 forced a rethink of this debate as deficits ballooned.  We may have been headed for a path to normalcy again, but the pandemic induced pandemic drew deficits to previously unfathomable levels.


The unprecedented monetary stimulus from 6 months of covid response has left the Fed Balance sheet levered as much to date as the cumulative QE1-3 in the decade after the financial crisis.

And the corresponding supply of money in the financial system accelerated at a staggering rate.


It is unclear what the viable path out of the current predicament is.  The US has not generated fiscal surplus in 2 decades.  Debt levels are at extraordinary levels.  Money supply is accelerating at higher rates.  


This leads to the premise stated above - the US is now trapped at the zero bound with debt monetization and currency debasement seemingly inevitable.  And this leads to a need for major adjustments in portfolio and investment decisions.


Bond Markets Broken

Predictably, we have seen the response to the recent crisis in bond yields - with US bond market hitting the zero bound following most other developed markets.  But as described above, this crisis just accelerated us to a conclusion already in process.


To that point above, the notional 10 year US bond yields have been on a descent for decades.


Meanwhile, on a real basis, adjusting for inflation, 10-year bonds have struggled since the financial crisis to generate any yield and are now firmly negative.


And the US is not unique.  We are just the latest advanced economy to enter the fixed income crisis.  In a September 2020 note, JPMorgan calculated that $31 trillion of the $41 trillion of global sovereign debt was trading at negative real yields.  So the problem is global and pervasive.


So think of what this means.  An investment in a 10 year US bond (or 75% of similar sovereigns) is guaranteed to lose real value.  So what is an investor to do?  Invest a sum today, yield virtually no income for a decade, and recover that sum in 10 years to see principal eroded by inflation by approximately 10% over that period?  Awesome…


The reality of notional and real bond yields creates real world headaches.  For the investor - no yield and principal destruction via inflation.  For the issuer - unusually cheap capital to fund and justify nearly any project, no matter how marginal.  And for related markets like equities that index off of risk free yields - ever higher valuations and stock prices driven by ever declining discount rates.


Traditional Balanced Portfolio Theories Broken

When you think about the 60/40 portfolio construct or risk parity or any similar balanced exposure portfolio - the designs were meant to provide stability and income from the bond components, and capital appreciation from the stock portion.  But the construct and logic breaks when bond yields go to 0% (or less).  Near the zero bound, bonds offer virtually no income and far less price stability.  And while real principal destruction is assured at maturity, investors also face the prospect of large mark-to-market losses in bonds on small moves in bond yields.  Meanwhile, stocks now face higher volatility than they have historically as valuations are a) starting from much higher than historical levels and b) have valuations that are inherently more volatile as very low absolute discount rates are highly sensitive to even 10-25bp moves in discount rates.  So fixed income is not providing store of value or yield, and equities are inherently more volatile.

Investors have to adapt.  There will be much dispersion in responses from investors.  The balanced portfolio approaches were easy decisions for most investors to follow - because they combined growth and income very synergistically.  They kept a large portion of the portfolio in stable, decent yielding bond instruments to provide income.  And the construct generally had the advantage of bonds and equities moving in opposite directions at extremes.  So bonds provided capital appreciation in periods where stocks were weak, helping to preserve capital.  

But replacing this efficient construct is tricky as no obvious investments can replace the easy choice of a safe bond with decent yield:  an instrument that is inversely correlated to stocks (generally), is highly liquid, provides decent income, has low transaction costs, and low fees.  Without an obvious solution, investors will have to find hybrid solutions, mixing a wider spectrum of securities that can achieve the desired combination of yield, growth, and capital preservation to match specific needs.  Possible allocation increases would be alternatives like hedge funds and private equity, hard and crypto currencies, higher yielding bonds, among others.  All of the above have some elements of capital preservation, yield, growth, and liquidity for investors.  However, most of the above have high fees or high transaction costs and all of these lack the full mix of traditional bond benefits.

Case for VIG

I propose instead that equity in stable companies with consistently growing dividends can replace a meaningful portion of the historical bond/stock mix, as that is closest to directly replacing the traditional balanced function in the portfolio.

The simplest and lowest cost way (no transaction fee and 6bp management fee) to express this is via the Vanguard Dividend Appreciation Fund.  The current yield is almost 2% today, that dividend yield compounds at a high single digit rate over time (5-10% over decades for the components), and you get inflation protection because most underlying businesses in index have pricing mechanisms for inflation pass through pricing.

Dividends with Growth on a Principal Base that Can Grow - Instead of Flat Interest Rate with High Probability of Real Principal Destruction

Annual dividends for the VIG started in 2007 at $3.33.


Since 2007, the first full year of trading for VIG, consider the following:

We have had 2 major financial crises:

Great Recession/Financial Crisis (2008/2009) 

Coronavirus (2020) 

In addition, we have faced multiple international and domestic crises including:

European bank crisis (2010-2012)

US government shutdown (2011)

China devaluation (2016)

US Federal Reserve 

China trade war (2019)

International tariffs (Trump years)


Through all this tumult, the VIG dividend has more than doubled to $8.69, and is up 2.6x.  That is a CAGR of 7.6%.  During all the above turmoil, the largest fall in sequential LTM dividends was 4%, and the average quarterly sequential increase in LTM dividends was 2%.  Looking a little longer at changes over any 2 year period, the largest LTM dividend decline was 2%, while the average growth rate over 2 years in annual dividend was 16%.  Looking at the chart below, one might think the last decade plus was a pretty benign period.



High quality equity dividend portfolio also provides other benefits besides yield and yield growth.  The most obvious is principal appreciation over time.  This comes in the form of earnings growth - where the components compound earnings over 10% annually over time.  Principal growth is also achieved via valuation expansion.  The analysis of long term yields above would indicate that this expansion should continue as discount rates decline over time.  Finally, the equity constituents in this diversified basket provide inflation protection.  These businesses have ability to price through cost increases over time to prevent value destruction from devalued currency


Why focus on dividend compounders versus VIG versus the S&P500?  The S&P 500 is over-reliant on FAANGM - which comprises 23% of total exposure and 35% of total exposure from internet, software, semis, and related technology.  While this exposure is attractive for its growth, the objective is to use income from large, quality, liquid, underlevered corporates to replace income from traditional bonds.  Also, there is less inherent inflation protection from high multiple no yield stocks.


Makeup of VIG

By industry exposure, VIG offers diversity.


And the individual components are diversified and high quality institutions.


Financial summary

Operating metrics:

Gross margins 44%

EBITDA margin 26%

EBIT margin 20%

ROIC of 14%

WACC of 7%

EPS growth of 10%

Valuation metrics:

Normalized PE (2022 - after covid) of 20x

EV/EBIT of 19x

EV/EBITDA of 15x

FCF yield of 4%

Net debt/EBITDA of 1.4x


Total Returns and Principal Appreciation

Since the start of 2007, through the financial crisis of 2008 and covid in 2020, VIG has compounded 9.3% with reinvestment of dividends.  Principal has increased by 157%, or a 7% compounded rate.  Real principal appreciation.  This exceeds the 60/40 portfolio return of 7.8% compounded over the same period.  But that is looking in the rear view mirror as 10 year yields started 2007 near 5%.  The prospect of continued capital appreciation and safety from a <1% yield world today using the same balanced approach is likely far lower.



The downside risks is that risk free rates rise a lot - but a) unlikely given fed and b) bonds would also be hit in that environment and c) in all likelihood only strong economic recovery would drive yields up and that would obviously be good for names in the index and hence capital appreciation for VIG.

Also, assuming VIG can continue to compound dividends at HSD range (use historical 7.5%), then VIG principal would have to decline by approximately 15% over a decade to achieve the same notional capital as buying treasuries in 10 years.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.



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