How To Find Yield In Today’s Tenuous Markets

From Invesco: As dividend value investors, my team is focused on sustainability of profit margins over a full profit cycle.

I believe that we are in the later stages of the profit cycle, with corporate profit margins at about 1%1 below their peak levels in late 2014. What does that mean for us as high-conviction, bottom-up investors?

First and foremost, we are not macro investors. However, our fundamental research process does offer insights, particularly with respect to the profit cycle. We want to understand how companies are over- or under-earning over time.

A key focus for us is knowing how much of the operating improvement has come from structural versus cyclical factors. We want to identify the parts of a company’s operating profit recovery that stem from structural changes, such as supply chain improvements or fixed-cost management, compared with more cyclical factors, such as decreased funding costs due to low interest rates.

These structural and cyclical factors have come together to create a robust profit cycle, particularly in the US. Understanding this is an important element of our research process.

Cyclical vs. structural drivers

A change that I believe is more permanent in nature is better supply-chain-management functionality. We are seeing increased focus on improved cost-structure initiatives, particularly in the US with initiatives like zero-based budgeting2 being embraced by many companies within the more stable growth sectors of the economy.

Conversely, cyclically low interest rates are unlikely to be sustainable longer term, in our view. Interest rate changes are important to both the cost and capital structure of a company, which are reflected in a company’s interest-coverage ratios.3 We do think some of these changes are adequately reflected by sell-side analysts, but not all. Our process normalizes these key inputs of a firm’s cost structure to understand its potential profitability over a full cycle. Today, some of our models are indicating that companies are over-earning relative to their full market-cycle potential. This is an area, in my opinion, where we differ from other investors in today’s market.

Investing in today’s environment

There are many policy unknowns on the table right now around the globe — central bank policy, leadership changes and potential changes to the US tax code. These are all significant. For example, if the US tax code changes are realized, it would be a shift we haven’t seen in 30 years. One such change being discussed is eliminating the ability for corporations to deduct interest expense. Companies optimize their balance sheets to leverage debt, so this potential change would have a real impact on how companies view their capital structure. We’re not political strategists, and we don’t make calls on the policy initiatives in Washington. However, we do monitor them closely because expectations around these various policy unknowns are discounted in advance of policy certainty and often embedded in stock prices.

We seek to find companies with strong balance sheets and attractive cash flow generation that are returning capital to shareholders. As mentioned above, I believe that we are currently in the later stages of the profit cycle; sales growth has slowed, productivity remains weak and the labor market is tightening. In this environment, we are focusing on companies that can use self-help initiatives, including productivity initiatives or changes to their business mix, to offset these headwinds.

Learn more about Invesco Diversified Dividend Fund and Invesco Dividend Income Fund.

The PowerShares S&P 500® High Dividend Low Volatility Portfolio (NYSE:SPHD) was unchanged in premarket trading Wednesday. Year-to-date, SPHD has gained 3.22%, versus a 4.63% rise in the benchmark S&P 500 index during the same period.

SPHD currently has an ETF Daily News SMART Grade of A (Strong Buy), and is ranked #14 of 74 ETFs in the Large Cap Value ETFs category.

1 Source: Cornerstone Macro as of Sept. 30, 2016. Latest data available.

2 Zero-based budgeting is a method of budgeting in which all expenses must be justified for each new period.

3 The interest coverage ratio is used to determine how easily a company can pay interest expenses on outstanding debt. The ratio is calculated by dividing a company’s earnings before interest and taxes by the company’s interest expenses for the same period.

Important information

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The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.

A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.

Stocks of small and mid-sized companies tend to be more vulnerable to adverse developments, may be more volatile, and may be illiquid or restricted as to resale.

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This article is brought to you courtesy of Invesco.

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