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By David Falkof | 03-04-2011 11:29 AM

Highly Cyclical Firms May Have Already Hit Peak Margins

Invesco's Meggan Walsh says an impressively rapid rise in corporate profitability has greatly reduced the number of attractively priced stocks.

David Falkof: I'm David Falkof, mutual fund analyst at Morningstar. I'm joined today by Meggan Walsh, Manager of the Invesco Diversified Dividend Fund.

Thanks for joining us Meggan.

Meggan Walsh: Thanks for having us.

Falkof: So, I wanted to ask you first off about margin cycles. A lot of businesses, we're seeing above average margins. A lot of the companies have produced strong earnings on modest revenue growth. What are some sectors that you see as vulnerable to lower margins going forward?

Walsh: Sure. So, as you pointed out both the speed and magnitude of the margin recovery has been very impressive, and it's taken a lot of investors by surprise. It has allowed the earnings cycle to occur much faster than I think many investors imagined. So, where we sit today is we do believe in the durability of the margin cycle; we are believers in that. But the opportunity set that we see today versus two years ago is much narrower.

So, some of the areas that we're focusing on today are what we'd call less cyclical areas, more the stable growth areas like consumer staples. The one exception to that would be within financials. We still see an opportunity there, which would be a highly cyclical area of the economy. But away from financials, we think the more highly cyclical areas, such as early-cycle names of industrial machinery stocks, technology stocks, and early retail consumer discretionary, have probably seen their peak or close to peak level in margins.

Falkof: So, two of the names in your top holdings are General Mills and Kraft. With rising commodity prices, how do you see those stocks maintaining their margins going forward with rising input costs?

Walsh: Sure. So, David, we have the luxury to be long-term investors. Every investment we analyze is over a two-year investment horizon. So, to your point on the very real issue of rising commodity prices impacting food stocks, we view the highly myopic view that Wall Street tends to take as an opportunity for us.

So, yes these companies will have short-term pressures on their margins, but we do believe that over time, they are able to take pricing. The evidence so far has been that they have price realization of about 1% to 3% over and above commodity pressures, and there always is a lag for them to pass on these price increases. Coupled with innovation that we're seeing across their product lines, as well as productivity initiatives, we think they'll be able to hold their margins.

Falkof: Let's switch over to the dividend cycle. The fund owns a fair amount of financials. How do see in the financial sector how those businesses are poised for dividend payouts?

Walsh: Sure. Within financials, we have a large exposure to banks. So within the financial section of our portfolio, we do have a very offensive positioning. This is very different than the transitions we've been making in the remainder of the portfolios, as I mentioned, to more of a mid- and late-cycle area.

The reason for that is, to your point, the dividend cycle. Very shortly here within the next couple of weeks we will get the final analysis on the capital plans that have been submitted and the resumptions of dividends are likely to occur.

We do think that the resumption of dividend payouts will not immediately go back to the 50% rate that we witnessed pre- the credit crisis. The banks are likely to raise dividends more slowly, probably up to 20% to 30% payout ratios over the next two years. But we do think the effective payout ratio will probably be higher than that because they will use buybacks instead, until both the regulators and the corporate management teams have more confidence in the durability and sustainability of the recovery.

Falkof: As far as valuation goes, are you seeing differences in the valuation between banks that are several years away from normalized earnings compared to the big money centers that are closer to reaching normalized dividend payouts?

Walsh: We do see a differential in the valuation between regional banks that will have a lag to resumption of dividend payouts versus some of the large money center banks. It's not a large differential, but more importantly for us we focus on a normalized earnings power over our full investment horizon, which is two years. And so if you look at the total return approach that we incorporate into our process, we see more upside in those regional names over our investment period. So, a one- or two-quarter lag for resumption of dividends is not the deciding factor in our valuation framework.

Falkof: As far as energy holdings go, there aren't very many energy holdings in the top of the portfolio, and yet a lot of the energy companies have decent dividends. What are you seeing that you're steering clear while that other investors are missing on these energy names?

Walsh: We've seen a nice resumption in dividends, particularly in the more stable areas of energy. We do think that the large international oil companies are still an area where we'll see nice dividend growth. But the more highly cyclical areas of energy to a point we spoke about earlier, which was the margin degradation risk, we think there's been a peaking there. In fact, if you look over the past two quarters, we've seen a number of companies that actually haven't missed on margins. So we've seen a higher resumption in capex spend in the more cyclical areas within energy, and we think those areas are more at risk.

Falkof: Well, thank you Meggan for joining us today.

Walsh: Thanks, David. Appreciate you having us.

Falkof: I am David Falkof for Morningstar. Thanks for watching.

 

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