Thursday, February 12, 2009

The Tortoise Wins Again

Barron's has an article by Vito J. Racanelli that profiles Matthew McCormick, portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel. The Tortoise Wins Again

"WE DON'T LIKE SEXY STORIES, BUT WE DO LIKE consistent ones, especially when it comes to the dividend."

That's how Matthew McCormick, a 38-year-old portfolio manager and banking analyst at Bahl & Gaynor Investment Counsel, describes his firm's approach. It has served the Cincinnati-based money manager well over the years -- particularly during bear markets like the one that now has stocks firmly in its grip.

Founded in 1990, Bahl & Gaynor typically invests its $2.5 billion of assets in blue-chip, large-capitalization growth stocks issued by companies that make stuff people need rather than things they want. These would include Procter & Gamble (PG) and Johnson & Johnson (JNJ). Such companies go in and out of market favor -- as the consumer deleverages, they are in vogue again -- but tend to provide market-beating total returns with less volatility over the long haul, due in great part to steady growth and fat dividends, regularly increased.

For Bahl & Gaynor, flashy but short-lived earnings gains don't cut it. "We're the turtle in the growth area, as opposed to the hare," says McCormick. "Capital preservation is our No. 1 objective. Second, we want to grow, and income is third."

The money manager's philosophy is growth at a reasonable price -- with a little value thrown in. "We are from Cincinnati, OK? We aren't going to overpay...[and] we want companies that can double their earnings every five to seven years, regardless of the economic environment," he says.

B&G also seeks companies that have raised their dividends each year for the past five. Such companies tend to be mature, have been seasoned in recessions and bear markets, and have strong free cash flow and balance sheets, offering a cushion in tough times.

Unlike share buybacks, McCormick adds, dividends hold the CEO's feet to the fire, because they must be maintained "or you get whacked. In our quality-growth portfolio, none of our holdings has had a dividend cut."

Out of a universe of 15,000 stocks, there are only about 250 that fit Bahl & Gaynor's basic template. The investment committee whittles that list down to 45 to 50 mostly U.S. names for clients. It is a low-turnover list, and the Sell discipline is straightforward. A reduction in the rate of dividend growth is "a tremendous signal to us," McCormick says.

Nor does B&G care for mergers. "Managing a company is tough, but integrating another one is increasingly difficult. We would rather sit it out and come back after the kinks are worked out," McCormick says. The firm held shares of Rohm & Haas (ROH), for instance, when Dow Chemical (DOW) bid for it, but sold before the deal ran into trouble.

Bahl & Gaynor's largest and oldest position is a hometown stock, household-goods giant P&G. Consensus sees P&G increasing earnings about 12% for the fiscal year ending June 2010, and sports a 3% dividend yield. Procter & Gamble has raised its payout every year for the past 52 years, McCormick notes. It will face margin pressures and tougher competition this year, but people use diapers, detergents and other P&G products every day. P&G also will be able to expand its brands, he says, noting that "the management team is superior, and they have weathered the storm well."

A more recent pick, with the latest purchases made in October 2008, is McDonald's (MCD), the world's biggest fast-food restaurant chain. It has improved its product offerings while many competitors stood still, and could gain in a recession as people trade down in their restaurant choices. Maybe a steak costs too much now, he says, but a burger and Happy Meal for the kids is a nice break. With McDonald's stock yielding 3.5% and 10-year Treasury bonds around 2.9%, "over a 10-year period, I'm willing to bet that McDonald's is going to be a superior investment," McCormick says.
The second-largest holding is Johnson & Johnson, which looks much like a health-care mutual fund without riskier biotechs and health-maintenance organizations in its portfolio, McCormick says. It isn't just a place to hide, but with the U.S.'s aging demographics and product-patent issues at companies such as Merck (MRK) and Pfizer (PFE), which Bahl & Gaynor doesn't own, J&J is a stock that will keep getting better, he predicts. A 3.2% yield doesn't hurt, either.

Another health-care pick is Becton, Dickinson (BDX), which makes basic medical supplies like drug-delivery systems, syringes, and diagnostic-screening products, "the bricks-and-mortar area of the health-care industry." As such, it isn't in the cross-hairs of politicians. The stock, up 12% since Christmas -- a feat few names have managed, as markets have been dragged downward on the bad recent economic news -- has a yield of 2%.

Generally, Bahl & Gaynor eschews consumer-discretionary stocks, and Best Buy (BBY) and Apple (AAPL), where earnings growth is inconsistent, and the company is more dependent on economic growth and new applications. One exception is footwear maker Nike (NKE), whose stock is down 36% and yielding 2.2%. It does well in a recessionary environment, McCormick says, and "has had the ability to grow its earnings. Kids need shoes, and shoes wear out. Its pricing issues aren't as bad as others'. It is the dominant brand." B&G bought the stock at more than 60 (it's now 48) in the last two years.

One key move that helped portfolio performance last year was the sale of many financial stocks, such as Bank of America (BAC) and Cincinnati Financial (CINF), in the late summer of 2007, taking the firm's position in financials down to an 8% weighting from 22%. Stocks such as Northern Trust (NTRS) and US Bancorp (USB) remain.

Some banks are wholly dependent on government life-support to survive, McCormick says: "It is going to take years, not months, to get off that ventilator." The most recent financial sold was Wells Fargo (WFC), amid concerns about integration risk due to its purchase of Wachovia.

In place of Wells, Bahl & Gaynor bought shares of AT&T (T) and Florida utility FPL Group (FPL) -- another stock up since Christmas -- with yields of 6.7% and 3.4%, respectively. B&G's core philosophy explains the switch: Americans won't be taking out so many mortgages in coming months, but they will need to communicate, and will need electricity and natural gas, too. As a result, earnings streams for both types of utilities are consistent. And while traditionally telecoms and utilities are overregulated, McCormick says, these are safe plays now; certainly in the case of AT&T, regulations will be less onerous than coming financial regulations.

In an uncertain future, the focus should be on quality stocks, says the portfolio manager. Even when the bull returns, he argues, odds are investors first will gravitate to big, stable growth stocks like the ones Bahl & Gaynor favors. At some point, "when we come out of this recession, people are going to drop some of these stocks like hot potatoes" to rush into more speculative names, he concedes.

But unlike those sexier shares, Bahl & Gaynor stocks won't have to make up as much ground to outperform again. Then the next bear market will show, as in Aesop's Fables, that the tortoise still beats the hare.

Except that, in Bahl & Gaynor's case, it isn't a fable.

Disclosure: The Div Guy owns shares of PG, JNJ, PFE, BDX, BAC and USB