Do you think the market has recently hit a turning point where dividend-paying and other quality stocks are likely to do better in 2013 than they did in 2010 and 2011?
I'm not convinced that's the case, though I think that stocks in general can continue to do well in 2013. As long as interest rates remain at or close to zero—which is likely to be the case at least through the end of this year—and the economy does not slip back into recession, which seems probable, then I think the market should do pretty well.
The key questions, then, are: Will the market discriminate? Will quality stocks continue to distinguish themselves through the end of 2013 and beyond? My own view is that quality has been on a good run since the fourth quarter of 2012 and into the beginning of this year. I think that this has allowed many high-quality companies—those with strong balance sheets, high returns on capital, and solid earnings—to catch up with lower-quality businesses. So the overall valuation picture has shifted a bit.
Quality small-caps don't look as attractively cheap as they did six months ago. The underperformance arbitrage opportunity has diminished. As we came out of the downturn in March 2009, lower-quality stocks led, as we would expect them to, given the market's history. As long as rates remain historically low and the economy keeps growing, I think that we are in a period where stocks as a whole should do well, but I don't see a huge advantage for quality going forward.
Why do you think dividend-paying small-caps did well in the second half of 2012?
I think investors began waking up to the fact that dividends represent a solid source of income, which was sort of forgotten for a little while. There's been a heightened search for sources of income among investors since the 2008 financial crisis.
First, a lot of money moved away from stocks and into bonds and bond funds over the last few years. More recently, investors have started to realize the potential downside risk to fixed income investments first because of the possibility of interest rates eventually rising—which is bound to happen at some point in the next couple of years—and second because of the inflation risk inherent in owning individual bonds.
All of this led to searches for alternatives. People invested in REITs and MLPs, which some view as bond proxies but which I see as no-growth stocks that offer a yield. Their growth is dependent on capital markets. So the alternative can be dividend-paying stocks.
What is the ongoing thesis for investing in dividend-paying small-cap stocks?
If you buy a 10-year Treasury, you receive a small yield but also run the risk of losing purchasing power if there's any inflation in the economy, which I don't see as a great trade. If you want to go out further and buy a long-term bond or 30-year Treasury, the yield is higher so there's a bit more inflation protection, but there's still the risk that your purchasing power will erode because there's no growth.
An investor can do a little better in terms of yield by buying credit—one can buy corporate debt or junk bonds, but with the latter there's a lot of downside risk for very little growth on the upside because junk bonds have done very well over the last couple of years and have likely peaked.
This leaves an investor with the option of looking for income in the equity markets where someone can buy dividend-paying stocks in healthy, growing businesses. In many cases you can receive a dividend that is as good as or better than what Treasuries are currently paying with the added prospect that the dividend will grow over time and /or that the underlying business will grow in value. There is obviously the risk of stock price volatility.
However, there's always the possibility that equities will recover nicely from a down market.
Today, I don't see that same degree of recovery potential for fixed income securities if the bond market turns bearish. Looking out long term over the next decade or so, equities—especially dividend-paying equities—simply look better to me than the alternatives.
Do you expect M&A activity to pick up in 2013?
I do. My view on this has not really changed. I am still surprised that more of our companies were not acquired and that M&A activity was relatively subdued in 2012.
All of the conditions for a dynamic M&A market remain present—companies are cash rich, capital is cheap, profits are at or close to peak levels for many firms, and revenue growth is harder and harder to come by.
In addition, many of our holdings possess qualities that have been highly attractive to companies looking to make acquisitions—well-managed businesses with strong balance sheets and positive cash flow. So I think that 2013 could be a good year for M&A.
Where have you been seeing attractive valuations recently?
No industry or sector really stands out. After a strong year such as 2012, that's not surprising. In fact, I've been doing more selling than buying of late. However, every day I find something that's worth buying. The difference is that several months ago it was easy to find really attractive bargains.
Today, I'm seeing more discrete opportunities—it's been much more of a stock-picker's market recently. The areas that I've been most active in would include industrial businesses, tech companies, and retailers.
I'm not convinced that's the case, though I think that stocks in general can continue to do well in 2013. As long as interest rates remain at or close to zero—which is likely to be the case at least through the end of this year—and the economy does not slip back into recession, which seems probable, then I think the market should do pretty well.
The key questions, then, are: Will the market discriminate? Will quality stocks continue to distinguish themselves through the end of 2013 and beyond? My own view is that quality has been on a good run since the fourth quarter of 2012 and into the beginning of this year. I think that this has allowed many high-quality companies—those with strong balance sheets, high returns on capital, and solid earnings—to catch up with lower-quality businesses. So the overall valuation picture has shifted a bit.
Quality small-caps don't look as attractively cheap as they did six months ago. The underperformance arbitrage opportunity has diminished. As we came out of the downturn in March 2009, lower-quality stocks led, as we would expect them to, given the market's history. As long as rates remain historically low and the economy keeps growing, I think that we are in a period where stocks as a whole should do well, but I don't see a huge advantage for quality going forward.
Why do you think dividend-paying small-caps did well in the second half of 2012?
I think investors began waking up to the fact that dividends represent a solid source of income, which was sort of forgotten for a little while. There's been a heightened search for sources of income among investors since the 2008 financial crisis.
First, a lot of money moved away from stocks and into bonds and bond funds over the last few years. More recently, investors have started to realize the potential downside risk to fixed income investments first because of the possibility of interest rates eventually rising—which is bound to happen at some point in the next couple of years—and second because of the inflation risk inherent in owning individual bonds.
All of this led to searches for alternatives. People invested in REITs and MLPs, which some view as bond proxies but which I see as no-growth stocks that offer a yield. Their growth is dependent on capital markets. So the alternative can be dividend-paying stocks.
What is the ongoing thesis for investing in dividend-paying small-cap stocks?
If you buy a 10-year Treasury, you receive a small yield but also run the risk of losing purchasing power if there's any inflation in the economy, which I don't see as a great trade. If you want to go out further and buy a long-term bond or 30-year Treasury, the yield is higher so there's a bit more inflation protection, but there's still the risk that your purchasing power will erode because there's no growth.
An investor can do a little better in terms of yield by buying credit—one can buy corporate debt or junk bonds, but with the latter there's a lot of downside risk for very little growth on the upside because junk bonds have done very well over the last couple of years and have likely peaked.
This leaves an investor with the option of looking for income in the equity markets where someone can buy dividend-paying stocks in healthy, growing businesses. In many cases you can receive a dividend that is as good as or better than what Treasuries are currently paying with the added prospect that the dividend will grow over time and /or that the underlying business will grow in value. There is obviously the risk of stock price volatility.
However, there's always the possibility that equities will recover nicely from a down market.
Today, I don't see that same degree of recovery potential for fixed income securities if the bond market turns bearish. Looking out long term over the next decade or so, equities—especially dividend-paying equities—simply look better to me than the alternatives.
Do you expect M&A activity to pick up in 2013?
I do. My view on this has not really changed. I am still surprised that more of our companies were not acquired and that M&A activity was relatively subdued in 2012.
All of the conditions for a dynamic M&A market remain present—companies are cash rich, capital is cheap, profits are at or close to peak levels for many firms, and revenue growth is harder and harder to come by.
In addition, many of our holdings possess qualities that have been highly attractive to companies looking to make acquisitions—well-managed businesses with strong balance sheets and positive cash flow. So I think that 2013 could be a good year for M&A.
Where have you been seeing attractive valuations recently?
No industry or sector really stands out. After a strong year such as 2012, that's not surprising. In fact, I've been doing more selling than buying of late. However, every day I find something that's worth buying. The difference is that several months ago it was easy to find really attractive bargains.
Today, I'm seeing more discrete opportunities—it's been much more of a stock-picker's market recently. The areas that I've been most active in would include industrial businesses, tech companies, and retailers.
