Monday, August 15, 2016

Hidden Profits: Stock Pick Trifecta

Economy and Markets

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ECONOMY & MARKETS | August 15, 2016

Dividends, Buybacks and Low Interest Debt. Oh my.

By John Del Vecchio, Editor, Forensic Investor

When I'm on the hunt for an investment opportunity, I want a company that pays ME first!

In my last two pieces in Economy & Markets, I talked about the importance of dividends and quality share buy backs. Both are key indicators of quality shareholder yield.

Dividends may not be sexy, but companies that grow their dividends over time can be. This is what Johnson & Johnson (JNJ) did every year for 38 years between 1966 and 2008.

If you'd bought the stock in the early 1970s, the dividend yield that you would have earned between then and now on your initial shares would've grown approximately 12% annually. By 2004, your earnings from dividends alone would have given a 48% annual return on your initial shares!

These companies, like Johnson & Johnson, that grow their dividends over time, vastly out-perform those that don't.

Buy backs can also be a source of returning cash to shareholders (although they can also be tools that executives use to manipulate the bottom line and fund their own compensation schemes).

We prefer the former to the latter, of course.

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But the third way to create shareholder yield is to pay down high-interest debt. A company that does that essentially "pays" us well to own it. By paying down debt it saves cash because it's not paying interest.

If a company has a huge debt load, it has big payments. There's always a risk it won't make the payments in a credit or economic crunch.

But a company with a diminished debt load is a different story. It's balance sheet strengthens with each high-interest debt paid down and it can survive the storms that plague all companies.

Plus, it can refinance remaining debt at lower rates because lenders will compete for the now-better borrower – just like snaring better mortgage rates with a higher credit score!

Best of all, the company paying down its debt can use that cash to pay us in those two other ways: buying back cheap stock and starting or increasing dividends.

Let's look at a couple of examples!

Cincinnati Bell (CBB)

The market is just now catching on to the debt pay down, and growing cash pile, at this boring telecom.

Because I look more closely than the general market does, let me tell you, the stock is far from boring. In fact, it's a thrill-a-minute.

By spinning off a fast-growing but cash-guzzling division, Cincinnati Bell created cash out of thin air because the market awarded a great stock price to the new separate company.

Then, it sold off stock in the new company a bit at a time using the influx of cash to pay down debt – and, last quarter, the company used additional cash to buy back cheap shares.

Because telecoms typically need some debt to finance investment in high-speed Internet communications and the now-familiar triple play of fiber optic TV, Internet and phone, we don't want the company to pay down all its debt – it does get tax deductions for the interest payments – but we want the debt to have low interest rates.

Fortunately, Cincinnati Bell is refinancing to save even more because lenders offer better interest rates as the company strengthens.

It's a quiet little story where forensic accounting shows the way, before it winds up on every finance blog in the country.

Xerox (XRX)

The 914 was a key driver of Xerox's revenues in the mid-1960s – two thirds revenue in 1965, with $243M income. The first commercial plain paper copier, in 1959, revolutionized the document-copying industry.

The old Xerox has evolved into a very financially sound company and a large part of that is slicing away 42% – almost half! – of its long-term debt in the last five years. In addition, Xerox freed-up 50% of its short-term obligations in the last four years. This is phenomenal. It provided cash for the company to buy back a third of its cheap shares.

So what has the former copier giant, now services provider, done to pay us even more? Since the time it began mega-buybacks, Xerox has boosted the dividend every year for an 82% overall bump.

With a 3% yield and only a 30% payout ratio today, there is much more room to pay down debt, buy back more cheap shares – they are cheap – and hike the dividend.

The market hasn't rewarded the stock yet – it's watching numbers that don't matter – but I see the future.

Use this shareholder yield trifecta to identify stocks that pay you first. Your investment portfolio will benefit!

John Del Vecchio
Editor, Forensic Investor

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