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Fixed Returns from Fixed Assets

The Wall Street Journal ran a front page article this week detailing the troubles facing many American companies. For about a third of the S&P 500 companies both profits and revenue had fallen for the first time in six years. Analysts expect overall earnings for the index components to fall 2.8% in the quarter, with revenue down by 4%.

That’s not good news, but it wasn’t entirely unexpected either. If you follow U.S. economic indicators, you already know that just 142,000 new jobs were created in September, following the addition of 173,000 jobs in August, both well below the average 200,000 jobs a month we’d seen over the prior year and a half. And this morning the Commerce Department announced that our gross domestic product growth slowed to just 1.5% in the third quarter, down from 3.9% in the second. While still up 2% year-over-year, this is the slowest growth since the first quarter of last year.

The confluence of slowing revenue and earnings growth, weakening jobs growth and a modest economic expansion at best is probably why the Federal Reserve choose to stand pat on interest rates following its meeting this week. It did strongly hint that it could make a move following its December meeting of policy makers, though dropping references to the fragile global economy.

While that is about the clearest indication we’ve had yet on the Fed’s thinking on rates, and it never pays to buck the Fed, it seems counterintuitive that it would finally raise rates when most signs point to the economy weakening. We’re also not sure how the markets will react to the Fed finally making a move, no matter how clearly it broadcasts its intentions ahead of time, giving the taper tantrum we saw in the summer of 2013. So for now, it is probably best to play things safe.

While we don’t think a recession is necessarily imminent, we are worried about the recent spate of data. When earnings contract for two consecutive quarters, which isn’t currently expected but is a possibility, a broader recession is often close behind. At the same time, the U.S. economy has been expanding since July 2009, a total of 75 months. While that’s neither the shortest nor the longest period of expansion in the post-World War II era – that honor goes to the March 1991 to March 2001 period (otherwise known as the run up to the DotCom bust) – it is longer than the 63 month average.

That’s a major reason why our Global Income Edge Conservative Portfolio has a heavy weighting towards companies with a lot of fixed infrastructure, like utilities. Utilities aren’t exactly recession-proof, since their share prices will slide up and down like pretty much everything else, but they have the benefit of selling an essential service in what are typically well-regulated markets. So share prices don’t move as much as, say, a company selling mid-market clothing or other purely discretionary items. They also don’t typically see dramatic dips in earnings so, most importantly to us, dividends tend to hold steady or even grow in downturns.

For instance, Southern Co experienced a dip in earnings during the recession, falling from $2.29 per share in 2007 to $2.26 in 2008 and $2.07 in 2009. But being a regulated utility, its rates are set to allow it to recoup its costs plus a profit margin on top of that; giving it room to grow its dividend even when sales and earnings take a temporary dip. In the case of Southern (NYSE: SO), its dividend grew from a pre-recession total annual payout of $1.60 to $1.73 in 2009.

While telecoms are virtually unregulated these days following the breakup of Ma Bell in the early 1980s, they are similarly heavy on infrastructure. Regardless of whether they are predominantly mobile service providers or fixed-line, they have to make fairly predictable investments in their infrastructure to maintain and upgrade services. They also provide an essential service – really, who could live without their telephone or internet connection, even in a recession – which lends a consistency to their revenue and earnings.

Both Verizon and AT&T maintained fairly consistent revenue during the recession and resumed growing along with the economy, but both also saw their margins and earnings drop in the post-recession years as they resumed investing in their infrastructures. But since those costs are pretty predictable, they’ve been able to consistently grow their dividends and reward their investors well.

So while there really isn’t such a thing as a recession-proof company, our holdings are recession-resistant enough that we’ll continue collecting steady dividend checks regardless of a slowdown in the economy or an ill-timed rate decision from the Fed.


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