The Driving Force of Dividends

This may be a new era of investing -- one in which the long-term buy-and-hold strategy may not the best choice. So says Jeffrey N. Kleintop, chief investment strategist for PNC Advisors.

"The returns in the capital markets are likely to be lower than they've been in the last few years," Kleintop thinks, and as a result, "a more tactical approach to investing might be required to generate superior results. That means that active investors may be able to outperform the indexes for the first time in a long time."

For the rest of this year, Kleintop sees at least three positive signs: the fact that many investors are still on the sideline, the amount of merger and acquisition activity, and the strong trend in dividend growth. Asked to recommend a good dividend-paying stock, Kleintop names Bank of America (BAC), with a yield just under 5%.

Among the stock sectors, he is overweight in information technology, and within that sector his favorite is semiconductors, partly because of the dividend payout. "Five years ago, only 2 of the top 10 semiconductor companies paid dividends -- now only two don't," he explains.

These were a few of the points Kleintop made in an investing chat presented Aug. 11 by BusinessWeek Online on America Online, in response to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a full transcript at

Q: Jeff, with the year more than half over, what's your broad view of the stock market?

A: Well, I think it's both unusual and a positive sign that after a three-month rally, measures of investor sentiment remain much lower than in prior rallies, like in late 2004 and 2003. This means investors have yet to embrace this rally. The range in M&A activity is outstanding, both in its size and because of the low premiums being paid this time around -- 20% premiums, vs. 30% to 40% in the '80s and '90s.

Another key driver that will lift the market in the latter part of the year is the strong trend in the growth of dividends per year. Double-digit growth here will inspire investors to put more money into the stock market. The bond market probably isn't growing much this year -- it will remain flat, but we're currently overweight in equities.

Q: What about the spike in oil prices (today it touched $66)?

A: Oil is a risk to the economy and the stock market, but what we have to keep in mind is that consumers have seen their aftertax income grow by $500 billion over the last 12 months, and over that same period of time, consumer expenditures on energy are up only $50 billion. So there's still a lot of room for people to spend money and grow the economy in spite of the rise in energy prices.

There will be a critical point, but I believe that will be more around the $100-per-barrel price area -- so not yet a dramatic negative for the consumer. In terms of impact on business, we currently spend about twice as much on legal expenditures as we do on energy....

Q: Do you like energy stocks in this environment?

A: In general, we have a market weighting on the energy sector. The sector has tended to move in line with crude oil prices. Despite the recent price spikes, however, we believe that oil prices will fall over the next few years to average $35 to $40 a barrel a few years from now. If we see a steady decline in the next year or two, it's unlikely that energy stocks will boom.

We find that most of the integrated energy companies have not kept up in the recent rally, so the companies that have done well lately are in the service side and drilling. Statoil certainly has exposure to crude oil, as well as natural gas. have exposure to the sector through Exxon Mobil (XOM) and Schlumberger (SLB).

Q: Is eBay (EBAY) a buy now?

A: We currently do not own eBay, though it's certainly an impressive business model. They own their space, so to speak. Lately there's been some concern about slowing auction volumes, but there's still a lot of room for growth.

It's an expensive stock, trading around 50 times earnings, so a lot depends on whether this company is able to generate the earnings necessary to justify that premium valuation. We're of the opinion that there are probably more attractive risk/reward possibilities in the electronics and consumer area than eBay.

Q: What's your opinion of EMC (EMC)?

A: There's always demand for storage technology, so they're benefiting from a demand for increasing amounts of data to be stored, whether it's related to entertainment, finance, etc. We do currently recommend EMC, but the stock isn't cheap. It's had its ups and downs, but we do think they're one of the better-positioned companies in the sector, given their ability to benefit from a broad number of trends.

Q: Beyond EMC, what's your take on tech?

A: We recommend an overweight in the IT [information technology] sector. Telecommunications equipment providers such as Cisco Systems (CSCO) are likely to benefit from increased spending by telecom companies as they transition to all-Internet-protocol networks to deliver new services. They want to deliver television to your house in competition with cable companies, but that will require money.

Security spending is another imperative. Interactive Data, which tracks worldwide tech trends, predicts a large rise in security spending every year through 2007. VeriSign (VRSN) is a company that will benefit from that.

The most attractive area, however, is the semiconductor area. Order growth is still down on a year-over-year basis, but it's nearing a trough. Like most commodities, changes in supply are far more important to profit than demand. Order growth is just now starting to stabilize following a year-over-year decline of 40%. We expect this to pick up in the latter portion of the year. IDC has also ramped up its chip sales forecast. This shows the potential for some strong performance in semis -- Intel (INTC) especially comes to mind.

The trend of embracing dividends is key in the semiconductor industry. Five years ago, only 2 of the top 10 semiconductor companies paid dividends -- now only 2 don't.

The tech sector has had the fastest dividend growth rate of any sector in the past few years. Cash balances are high, and more companies are favoring dividends over share buybacks as we shift to executive compensation being satisfied by share grants, vs. options grants. This is a positive backdrop for the technology sector.

Q: Looking for high dividend stocks -- any ideas?

A: Yes. I focus on the idea of high dividend growth vs. high yield. But one stock that stands out, where you can have your dividend and grow it, too, is Bank of America (BAC). The yield is just under 5%, with a dividend growth rate of 13%. So not only is there a high yield in this low-return environment, but there's tremendous opportunity for growth.

People are worried about the diminished capability of banks to generate profits, but banks have evolved and can manage a rising cost of funds through hedging, as well as exposure to fee-based lines of business. The sensitivity of banks to financial trends has been reduced. So in Bank of America we have a solid company with a very, very attractive yield.

Q: Back on energy, do you have any concerns with the regime in Venezuela and its effect on the oil market?

A: Yes, I do. Today's comments from Chavez highlight the antagonistic tone toward the U.S. that's prevalent in Venezuela. However, the primary source of economic growth in that nation remains oil. So despite the strikes, protests, and complications regarding oil in that nation, we have not seen a pullback in their supply to us. In fact, we've seen it grow. So while it's a worry, it's in nobody's benefit to see those supplies get cut off.

Proven oil reserves have actually grown faster than oil consumption in the last 10 years, and at the price of $35 a barrel, it's economical to extract oil from nonconventional sources, such as the oil sands in Canada.

U.S. investment is up about 30% year over year in extraction equipment, so we're investing in supplies. Oil-demand growth has also been in line, in the last few years, with the 35-year average, despite the cries about India and China. Inventories have actually increased, which provides a nicer buffer than ever in case of disruption.

Q: What about Target (TGT)? I think they will take down Wal-Mart (WMT) in the long haul.

A: We currently don't own Target, but it's not a bad choice. There had been a lot of concern about the consumer, given high energy prices and the potential for a sharp rise in interest rates. But these concerns have clearly been ill founded, and consumers have driven ahead with strong results for both luxury retailers and their economy brethren as well.

What Target has done, vs. Wal-Mart, is target the consumer who desires more fashionable goods. Wal-Mart can't easily take on Target -- it's easier for Target to switch to the lower end if the market dictates, but harder for Wal-Mart to move up.

The luxury retailers are the ones that have been posting incredible returns -- companies like Coach (COH) -- which means that a company like Target that can move up if necessary is well positioned.

In our portfolio, however, we've moved straight to the high end, like the aforementioned Coach. These luxury retailers have an added advantage that they don't supply to the consumers who could potentially be impacted by high energy prices. So they're certainly an important part of our portfolio.

Q: What do you think about the pharmaceutical stocks, and which one (or ones) do you recommend?

A: Great question. I think that pharmaceuticals have not offered investors the defensiveness they used to.... They still face challenges like patent expirations, patent challenges, and political dynamics. Given the last two years of underperformance in drug stocks, and weak sentiment in the sector, however, we believe the tide could turn.

Revenue growth has been soft in the area for the last few years, but the new Medicare drug benefits and the aging population will benefit these companies. The risks will never go away, but the fact that these companies trade in line with valuations of their European and Asian counterparts (where the industry is, for the most part, socialized) reflects the worst-case scenarios priced in. This year, we got some clarity regarding the tort liability that these companies face, and the sector's performed better since the FDA advisory panel that ruled on the Cox-2 inhibitors weighed in on their views regarding liability...we like the sector.

A standout is Wyeth (WYE). They have much less near-term generic exposure vs. their peers. The company has exceeded expectations and will continue to do so as margins exceed expectations. The company is also adequately reserved for remaining liabilities with regard to diet drugs, after recent legislation clarified limits.

Q: Jeff, how would you sum up the strategy a long-term investor should

follow now?

A: We're embarking on a new stage in the evolution of the capital markets. The strategies that worked well over the last 10 to 20 years might not be successful in the years ahead. The returns in the capital markets are likely to be lower than they've been in the last few years, given the decline in interest rates is behind us.

A long-term buy-and-hold mentality that worked so well in the '90s might not work as well in the 2000s. A more tactical approach to investing might be required to generate superior results. That means that active investors may be able to outperform the indexes for the first time in a long time. On behalf of the industry of professional money mangers, we're certainly looking forward to that.

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