Mike Capombassis, President, Bristol Gate Capital

FOCUS: U.S. Dividend Growth Stocks

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MARKET OUTLOOK:

Q1 was the worst quarter this cycle for earnings growth.  The S&P 500 earnings declined 7 percent y/y with revenues down 2 percent.  Consensus for Q2 is much the same with another 7 percent decline year over year in earnings on 1 percent negative top line growth.  Margins in corporate America are also under pressure with continued sluggish productivity gains, tightening labor markets, rising wages and higher credit costs.

But with our portfolio of 22 stocks we can find companies that are growing revenue/earnings organically, provide consistent dividend growth, have healthy balance sheets, low pay out ratios and are run by management teams that want to share in the success of the business with you and me as shareholders.  Our portfolio companies grew their revenue on average by 7 percent and earnings of 13 percent in the first quarter.

I think we need to see a resumption of growth if we are going to have another leg up in the stock market and out of a two year trading range (the S&P 500 first breached the 2000 level in August, 2014). S&P 500 Eps peaked in Q3/Q4 2014 and Revenue growth has been negative since the end of 2014. 

Listening to the financial news outlets and sell side community, the impression given is that with over 66 percent of S&P companies ‘exceeding’ first quarter estimates some to believe it was a healthy quarter. Beating a weak estimate with a slightly better number does not hide the lack of growth in the equity markets. So investors have been patient waiting to see if fundamentals could grow into valuations, but it may not last forever.

We look for U.S. GDP growth of about 2 percent and global growth around 2.5 percent (whatever happened to the BRICS?), nothing to write home about but probably good enough to keep markets range bound. In this kind of environment we will be lucky to realize mid-single digit total returns for the overall market going forward.

Share Buybacks vs Dividends

Buy Backs have stronger short term impact:

Buy backs tend to be expensive and ill timed. Not just at high prices but purchases tend to be pro-cyclical i.e. when companies are flush with cash in stronger portions of earnings cycle and not when stocks are cheap.
Buy backs used to offset option issuance.
Buy backs are often financed by debt (last 3 years $1.4 trillion of debt added vs $1.3 trillion of buybacks).
Buy backs can put a floor under EPS and often used by companies that are likely to miss earnings forecast.
Buy backs have been pushed aggressively by HF’s looking to maximize return in a shorter window.

Dividends have stronger longer term advantages:

Dividends are an actual real return of cash to shareholders.
Companies will not lightly reduce or suspend a dividend. It is a strong signal about management’s commitment to distribute cash to shareholders and its confidence in the future earnings of the business. Companies are very deliberate when it comes to dividends, as opposed to buy backs which should be used more flexibly.
Dividends are typically not financed by debt and most of the time paid out of operating cash flow.

The bottom line is buy backs tend to be expensive, poorly timed, pro cyclical, subject to cancellation without notice and pay shareholders to leave.  Dividends represent a real return of cash to shareholders, are carefully considered, counter cyclical and durable.  A company can’t destroy value by returning cash in form of a dividend but it can surely waste money on a buyback.

We look closely at the Effective Share Repurchase Price.  This is calculated as cash flow paid to repurchase stock less cash flow received from issuance/options and warrants over change in shares outstanding.  If the Effective Share Repurchase Price is at a large premium over the average trading price it may not be an ideal use of capital.

Top Picks:

DISNEY (DIS.N)

17x P/E, div yield 1.4 percent (25 percent PO), last 5 yrs 35c/sh to 1,81/sh, 22 percent Debt/Cap

First EPS/Revenue in FQ2 miss in 5 years but they don’t guide the street. Metrics still very strong and we expect double digit earnings growth, high single digit revenue growth and close to 20 percent dividend growth.

Largest and highest quality media company in the world in our view with massive IP portfolio (Marvel, Pixar and Star Wars). The IP portfolio size and scale is Disney’s key competitive advantage.

Big picture on ESPN is that it is dominant brand in live sports which is less prone to skinny bundles and unlike TV or movies that can be streamed later sports is overwhelmingly watched live. CEO Iger has said that 95 percent of Americans with a multi-channel bundle watched sports.

Diversified business with 11 different properties that each produce at least $1 billion in annual sales. Four operating divisions: media networks, Parks & Resorts, Studio entertainment, and consumer products.

Sales in studio business up 35 percent in first half of F16.

Tractor Supply (TSCO.O)

26xP/E, 1 percent div yield (25 percent PO), last 5 yrs Div 22c/sh to 76c/sh, mkt cap $12b

Not a household name but been around since 1938. Largest specialty retailer to the recreational farming and ranching communities. One of a kind retailer that is 3X the size of its next 6 competitors combined.

Stock is not cheap and for good reason. Business has been built itself to its 1500 store footprint through cash flow. Commitment to add 120 net new stores per year through 2019. The company could add way more but will only grow as fast as they can staff the expansion with qualified managers. LT target is 2500 stores.

Less than 10 percent of its customers live off their land so not affected by agricultural commodity price cycle. Hobby farmers are a core customer and not only do these people earn 2X the national income but they also have considerable assets and low household debt. 

Maintenance of a hobby farm can easily run into the thousands of dollars per year: horses/livestock, pets, fencing, mowing, pest control, hunting, gardening, etc.

15 percent Eps growth and 20 percent dividend growth for years to come, on back of 4-to-5 percent SSS comps, 8 percent sq. footage growth, 25bps annual improvement in Operating Margins and share buy backs.

SNAP-ON Inc. (SNA.N)

19XP/E, 1.4 percent dividend yield (PO 26 percent), last 5 years div 1.22/sh to 1.85/sh, $10b mkt cap

• These tools are tied to the livelihood and productivity of the mechanics so are believed to be critical, non-discretionary items.
• In North America and U.K., mechanics own their own tools, which plays well to Snap-On’s strengths – aspirational brand.
• Dominant network effect (3,500 vans vs. 1,500 for nearest competitor). Their high-touch customer model enables their “customer intelligence” and product innovation cycle, including proprietary database powering their diagnostic tools. This is believed to be a durable advantage.
• The company started building their “van route network” 95 years ago.
• CEO Nick Pinchuk is 68. He has stated a succession plan is in place

• Investment grade debt A-. Balance sheet is good. Debt/cap is reasonable at 27 percent.
• History of paying dividends since 1939 [77yrs of paying dividends] and has never cut dividends.
• Dividend earnings payout ratio is modest at roughly 27.2 percent in line with its five year average.
• The business has and continues to demonstrate the capacity to raise its dividend in the vicinity of ~15 percent coming from earnings growth.
• Top line growth run rate generally in the 4-to-6 percent range, has resulted in EPS growth rate in mid double digits. Expectation is for a continuation of this trend.
• Note, the company underwent a major shift towards lean manufacturing and continuous improvement since 2004 and thus believes in future margin improvement via iteration of existing improvement principles and tasks.
• Strong trend of increasing gross and operating margins since 2006. Gross margins of 50.6 percent and operating margins of 21.1 percent which are higher than the respective five year averages and relatively speaking, quite robust.
• 3 yr ROE and ROIC averaged 17.2 percent and 11.3 percent respectively, which is healthy.
• Operating cash flow compounded at 14.5 percent per annum over the past three years.
• EPS growth has been in the 13.4-to-20.4 percent range over the past 3 years, with growth in DPS in the 12.9-to-18.9 percent in the same period.

• Yes, finance component contributing to earnings, but it’s a high quality financing arm, low history of loan losses
• All the financing arm debt is consolidated on the b/s.
• Even in 2009, financing receivable loan losses where only in the 4 percent range, vs. 3 percent or less normal run rate.
• Crucially, Snap-ON Tools mostly only finances big ticket items $10k+ but the franchisee is involved in the decision.
• Franchise has skin in the game on loan losses.
• Currently the financing business is growing faster than the overall growth in the company, largely because of higher growth in the big ticket

FUND PROFILE:

Bristol Gate U.S. Equity Fund

Performance As of:

April 30. 2016

1 year: Fund 1.9%, Index* 1.2%

3 year: Fund 12.9%, Index* 11.3%

5 year: Fund 14.7%, Index* 11.0% B

Returns provided must be net of fees!

* Index: S&P 500 Total Return

Top 5 holdings of Bristol Gate U.S. Equity Fund

1. Boeing - 5.0%
2. Tractor Supply - 4.9%
3. Amgen - 4.9%
4. United Health - 4.8%
5. Danaher Corp. - 4.8%

A summary of highlights of the Bristol Gate US Equity Strategy:

The Fund is designed to provide investors both income growth and capital appreciation with less market risk over time.  Bristol Gate uses a combination of advanced data analytics and fundamental analysis when building the portfolio.

Ranked in the top 1 percent worldwide of all U.S. Equity large cap core mandates since inception

Invests in companies within the S&P500 Index that are typically leaders in their markets, have solid capital bases, generate strong cash flows and possess the ability to significantly increase their annual dividend.

Strategy encompasses an equally weighted portfolio of 22 highly predictive businesses that exhibit less volatility, better capital preservation and faster recovery in market declines. Our results have been consistent, returning 102 percent of the market upside, while producing only 74 percent of the downside.

The portfolio is actively monitored and immediate action is taken should portfolio companies fail to either meet the strict dividend growth hurdles, or adhere to the associated constraints set by Bristol Gate.

Our active management strategy has been shown to outperform its passive benchmark on both an absolute and risk-adjusted basis over time – providing greater than market returns with less risk.

Website: www.bristolgate.ca