In a year like 2016 — in which equity markets plunged and then bounced back to flat all in the first quarter — portfolio managers are often asked where opportunities lie in “up” or “down” markets. For the Invesco Diversified Dividend team, however, that’s simply not the way we look at the world. Performance for a manager may be great in either a bull or a bear market, but it’s the ability to add value over both that we believe is most important.
Our fundamental-based research process is designed to deliver appreciation, income and preservation across a full market cycle by investing in companies with sustainable and growing dividends. With that in mind, I’d like to focus on three sectors where new opportunities are starting to develop: industrials, energy and financials.
Industrials: A bifurcated sector
Within the industrials sector we note the interesting bifurcation among its very diverse subsectors, as evidenced by the large divergence in operating margins (chart 1). Consumer-facing businesses, such as residential and auto, have held up well, and we don’t see much upside from a valuation perspective. In our view, the opportunity in this sector is in the more capital-intensive businesses with end-markets related to energy, construction, mining and other areas. We believe select companies in these areas are not only well-positioned from a balance sheet perspective, but also have great opportunities to unlock value through portfolio restructuring.
In general, industrial companies are experienced at portfolio restructuring — in other words, they transition from broad to narrowly focused in waves over time as they buy and sell assets, and enter and exit various lines of business. Today, many industrial companies are looking to become more specialized and narrower in focus than they historically have been, and we expect to see many of them restructure their businesses over the next three years.
Chart 1: Operating margins have diverged within the industrials sector
Energy: An area of (cautious) interest
Valuations for energy companies have certainly become more attractive over the past few years, but looks can be deceiving. Relative price-to-book ratios are at historic lows, but this is only attractive if the book value remains intact. Invesco Diversified Dividend Fund is currently underweight energy versus its benchmark index1, but we have been adding to our position — opportunistically — over the past 12 months.
A key tenet of our investment process includes downside risk analysis. We strive to understand whether a company’s balance sheet and cash flows can withstand likely impairments to asset values. How do we do that? We consider multiple scenarios of potential impairment and examine whether a company’s book value can sustain further write-downs. This is particularly relevant today as the interest coverage ratio in energy has fallen to 2.7x from 10x just three years ago.2 We also seek to identify companies that can grow profitably and deploy capital in a way that will improve operating metrics when the cycle eventually turns. That’s no easy feat: Many firms that were profitable even in the depths of 2008 and 2009 are not profitable today. Most of our energy investments in the past year have been in the integrated companies where we are highly confident in the strength of their capital structures and ability to manage through an extended downturn.
Financials: Market overreaction undeserved
The financials sector, particularly the bank industry, has corrected a great deal in the past six months. Plunging oil prices led to price weakness for banks with energy market exposure in their loan books, but not all of the reaction was deserved, in our view. Last year we purchased or added to our holdings in companies where a valuation opportunity arose due to the market’s concern over potential energy-related loan losses. In particular, we looked for attractively valued firms whose capital ratios, level of energy-related loan reserves and cash flow testing were supportive of our estimates of their full cycle earnings power.
Learn more about Invesco’s approach to high-conviction investing, and explore Invesco Diversified Dividend Fund. Also, see more from Meggan Walsh as she talks with Bloomberg News’ Tom Keene during our Invesco Interactive webcast.
1 As of March 31, 2016, Invesco Diversified Dividend Fund had 5.81% of total net assets in the energy sector, compared with 12.74% for the Russell 1000 Value Index.
2 Source: Empirical Research Partners, data as of Feb. 28, 2016
Book value is a company’s total assets minus liabilities and intangible assets.
A bank’s capital ratio compares its level of capital with its risk-weighted credit exposure.
An impairment occurs when the market price of a company’s asset falls below the value that’s listed on the company’s balance sheet. When this happens, the company will write-down the asset’s balance sheet value to match the market price.
Integrated oil and gas companies participate in a wide variety of energy activities, from upstream (exploration and production) to downstream (refinement and distribution).
The interest coverage ratio measures how many times over a company could pay its interest payment using its earnings. The lower the number, the higher the company’s debt burden.
Operating margin measures a company’s pricing strategy and operating efficiency.
Price-to-book (P/B) ratio is the market price of a stock divided by the book value per share.
The Russell 1000® Value Index, a trademark/service mark of the Frank Russell Co.®, is an unmanaged index considered representative of large-cap value stocks.
Fluctuations in the price of precious metals may affect the profitability of companies in the mining sector. Changes in the political or economic conditions of countries where companies in the mining sector are located may have a direct effect on the price of precious metals.
The industrials sector can be significantly affected by general economic trends, changes in consumer sentiment and spending, commodity prices, legislation, government regulation and spending, import controls, and worldwide competition, and can be subject to liability for environmental damage, depletion of resources, and mandated expenditures for safety and pollution control.
The profitability of businesses in the financials sector depends on the availability and cost of money and may fluctuate significantly in response to changes in government regulation, interest rates and general economic conditions. These businesses often operate with substantial financial leverage.
Businesses in the energy sector may be adversely affected by foreign, federal or state regulations governing energy production, distribution and sale as well as supply and demand for energy resources.
Common stocks do not assure dividend payments. Dividends are paid only when declared by an issuer’s board of directors, and the amount of any dividend may vary over time.
Risks for Invesco Diversified Dividend Fund
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
The fund is subject to certain other risks. Please see the current prospectus for more information regarding the risks associated with an investment in the fund.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
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