How to stick to a strategy despite market pressure

Trendy or not, portfolio manager Peter Frost sticks by value investing.

In recent years, when investors were searching for companies with big ideas and high earnings multiples, his focus on steady cash flows and high dividend growth sometimes seemed outmoded.

“I struggle in times where the market really gravitates to companies with high earnings multiples,” he says. The last few years have been especially challenging, he notes, but he stuck to what worked for him.

“I didn’t own Valeant; never really believed in their philosophy, and looked really dumb for quite a while. Now we’ve seen what’s come to fruition on that name.”

Frost, who is portfolio manager and senior vice-president at AGF Investments in Toronto, looks for tangible returns. “If you think of a growth investor, they’re really paying up for the future,” he says, “and I’ve always been of the belief that a bird in the hand is worth two in the bush.”

Now, the business cycle is moving in his favour, he says. “When the future isn’t as rosy as everybody thought, they go back to the companies that are actually producing a lot of cash.”

To find those companies, he screens 5,000 firms globally for dividend growth every month. That includes 600 Canadian and 1,500 U.S. businesses, with the remainder outside North America. He reviews up to 15 years of performance and identifies the top 25% of companies for each year. But that doesn’t mean he rules out new businesses offhand.

“There are a lot of companies that are emerging that have a dividend growth philosophy, which I want to capture,” he says. “What I’m looking for is a company that has a philosophy embedded in their culture of growing their business earnings and cash flow, and along the way rewarding their shareholder base with a rising dividend.”

When his process identifies a company he doesn’t own, he assembles a research report on the company’s history of returns, including return on equity and return on invested capital. He also delves into how a company makes money. Then, he learns about management’s plans, commitment to returning capital to shareholders, and personal share ownership.

“Typically, companies that have this philosophy of growing their dividend have management teams that own fairly large stakes in the company,” he says.

30.7 million

The number of visitors to Macau in 2015, down 2.6% from 2014.

Source: Macau Tourism Authority

Brookfield Infrastructure Partners (TSX: BIP.UN, NYSE: BIP)

Brookfield Infrastructure Partners split from Brookfield Asset Management in 2008. Brookfield AM owns about 30% of BIP. BIP owns large infrastructure projects in North and South America, Australia, Asia and Europe. That includes electricity transmission lines, coal ports, telecommunications infrastructure and toll roads.

Putting it through his process

Brookfield Infrastructure Partners performed well in Frost’s initial dividend growth and cash flow screening.

“They’ve grown their funds from operating cash flow by about 23% over the last eight years,” he says. Average distribution growth for the past five years has been 13.7% a year.

“This company is geared toward increasing its dividends as its cash flows grow,” he adds. He bought in May 2012, when the stock was worth $31. All of Frost’s positions have between a 2% and 3% weight, and Brookfield’s is about 2.3%.

Turning point

As an infrastructure company with 90% of its cash flows set out in long-term contracts or in regulated markets, some investors view Brookfield as interest-rate sensitive. When the Federal Reserve began raising rates in December 2015, the company’s stock came under pressure, says Frost. Further, some investors are worried that the company’s Brazilian ports, toll roads and railroad will lose value as that country deals with political and economic instability.

Frost isn’t worried. As of press time, the Fed hadn’t increased rates this year, so there are likely to be fewer or smaller hikes in 2016 than investors anticipated. Moreover, Brookfield has anticipated the impact of higher rates. Of the firm’s regulated or contractual revenues, 70% are indexed to inflation, says Frost. And 60% of revenues are from take-or-pay contracts, where clients commit to paying Brookfield whether or not they use their services. This protects the firm in economic downturns, when clients may be struggling.

As for Brazil, Frost appreciates that Brookfield’s management is made up of value investors. They look at how a potential asset will generate returns over the long run, and Frost says they try to buy when the rest of the market undervalues assets or regions. He says Brookfield’s management is actually considering expanding in Brazil: “this is the time to invest in Brazil.”

Post-purchase performance

Brookfield’s annual dividend yield is 5.8%—in its goal range of 5% to 9%. At 68%, the company is at the high end of its targeted 60% to 70% payout ratio (the company is paying out 68% of the funds it generates from operation).

Frost says Brookfield can afford to have such a high payout ratio while continuing to reinvest in the business because its cash flows are so stable.

Frost still owns the stock, which was worth $53.37 as of April 21. He adds to or trims his position based on the stock’s dividend yield. Typically, if the yield goes below 4.5%, he’ll trim; if it goes above 5%, he’ll add. Right now it’s at 5.76%. He points out the yield is much more attractive than the 1.29% interest rate for a 10-year Bank of Canada bond.

Las Vegas Sands (NYSE: LVS)

Run by Sheldon Adelson, one of the richest men in the world, Las Vegas Sands went public in 2004. Adelson is chairman and CEO; he and his family own about 54% of the business.

As a shareholder, Adelson has the same priorities as other investors, says Frost. “Almost every quarter after his [conference] call, he says, ‘I love dividends!’ He’s a very interesting character.”

LVS owns four Las Vegas resorts, including the Venetian and the Palazzo, as well as five casinos in Macau, and one in Singapore. In 2015, 56% of its operating earnings came from Macau, 33% from Singapore and 11% from Las Vegas, Frost calculates.

Putting it through his process

Like Brookfield, Frost identified LVS through his dividend screening process. In early 2014, his team compiled a research report on the company but, at the time, the stock was trading around US$80, which he thought was too much.

“We often will do an analysis on a company where we perhaps might like the company, but we might not like the valuation at the time,” he says.

In February 2015, the company’s share price fell to about US$56, and he bought an initial stake. At the time, the dividend was 65 cents per share, quarterly. Over the next six months, he grew his position as the stock fell into the low US$40s. He added to his position again in April when the stock dipped to around US$46, after lower Q1 earnings than expected.

Since the company began paying quarterly dividends in 2012, they’ve increased, on average, 37% a year. In 2014, it issued US$2 per share in quarterly 50-cent installments; in 2015 it gave shareholders US$2.60 a share (65 cents four times). In 2016, it’s paid 72 cents a share so far.

Turning point

In 2014, China’s government cracked down on corruption. Under the new climate, well-off Chinese were afraid of showing their wealth, and fewer high rollers went to Macau. Macau casinos, including the ones owned by LVS, suffered.

When Frost bought the company in 2015, he thought revenues had reached their lowest and would recover. That didn’t happen. LVS’s income was US$2.4 billion in 2015, compared to US$3.6 billion in 2014. Revenues from gambling dropped 24%. The company has now had six straight quarters of declining revenues. Analysts expect revenue to drop another 2.5% in 2016, and for new income to go down another 8.5%, compared to 2015.

Company Stats

Brookfield Infrastructure Partners

Ticker: TSX: BIP.UN, NYSE: BIP HQ: Toronto What: Utilities, transport, energy and communications infrastructure in the Americas, Europe, Australia and Asia Buy: $31 (May 2012) Average price since purchase: $43.35 Low: $30.72 (May 8, 2012) High:$58.10 (April 6, 2015) Current price: $57.55 (June 10, 2016)

Las Vegas Sands

Ticker: NYSE: LVS HQ: Las Vegas, Nevada What: Casino and resort operator Buy:US$56 (February 2015) Average price since purchase: US$49.42 Low: US$36.97 (January 13, 2016) High: US$60.56 (February 18, 2015) Current price: US$46.25 (June 10, 2016)

But as a mass-market brand that attracts people who gamble hundreds—not thousands—of dollars, LVS’s revenues didn’t drop as much as those of casinos that specialize in China’s ultra wealthy, Frost says.

The company’s 2015 earnings per share were US$2.47. With projected distributions of US$2.88 for 2016, it’s possible payouts could exceed earnings per share, warns one analyst.

Frost says past dividend increases have been sustainable, and he’s not concerned yet. He thinks revenues will improve in the second half of 2016. He watches out for companies that are hiding a drop in business by paying out a higher proportion of their earnings as dividends, giving the illusion that business is booming. He also checks earnings per share against EBITDA to see if a company is boosting EPS by buying back shares.

Like Las Vegas, Macau is increasingly being known for more than gambling. The company’s other Macau properties include malls, convention centres and concert venues.

“That’s the reason I like this company,” says Frost. “You may go to Vegas, but you may or may not gamble.”

China’s rising middle class, which Frost says is expected to triple between 2014 and 2023, will also help the company. Las Vegas Sands expects many will go to Macau, a prime tourist destination near Hong Kong.

Post-purchase performance

As gaming revenue has continued to drop, the stock has been volatile, says Frost. In September 2015, as the wider market dipped and Las Vegas Sands replaced its Macau president and COO, the stock went from US$48.71 to US$36.98 in two weeks—then up to US$47.09 in seven days. As of April 21, it was worth US$47.

Frost has a two-year target price of US$65 for the end of 2017. That would be a 38% upside, with two years’ worth of dividends at 6% each year. He expects the company’s fortunes in Asia will turn around later this year. It’s set to open a new Macau casino this September. If that move’s successful, it will boost revenues, but it comes against a backdrop of economic difficulty.

“They’ll continue to grow, not necessarily just in Macau; I think they’ll start to look at other markets,” says Frost.

If the expected recovery doesn’t materialize, he says he’ll assess what’s going wrong before selling. “If it came to the point where we couldn’t see a lot of upside and the Chinese economy was a lot weaker than we expected, I would sell it and move on to something else,” he says.