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Consolidated Edison – An Unsettling Look At Shareholder Yield

In a prior commentary I looked at the “shareholder yield,” that is dividends and share repurchases, for Coca-Cola and Exxon Mobil. In both instances the shareholder yield was greater than the dividend yield. Alternatively, a company like Consolidated Edison has a shareholder yield that has been routinely lower than its dividend yield. In a previous article I compared the “shareholder yield” of both Coca-Cola (NYSE: KO ) and Exxon Mobil (NYSE: XOM ). The idea was to take it a step further than simply looking at dividend yield, and instead focus on funds used for both dividends and share repurchases. As a part owner, share repurchases are commonplace. Yet if you owned the entire business, there would be no need to repurchase shares and thus these funds could be diverted elsewhere. For Coca-Cola and Exxon Mobil, this meant that the “shareholder yield” – dividends plus buybacks – was reasonably higher than the ordinary dividend yield that you commonly see quoted. Exxon Mobil turned out to have a higher shareholder yield than Coca-Cola (it’s share repurchase program has more room and a lower valuation of purchased shares) but the takeaway was that both companies had the ability to send away more cash without impairing the business. Which brings us to a company like Consolidated Edison (NYSE: ED ). Unlike Coca-Cola or Exxon Mobil or any number of well-known dividend paying companies, Consolidated Edison’s share count has been increasing over the years rather than decreasing. Thus conversely the shareholder yield tends to be lower than the quoted dividend yield. Let’s look at the past decade to see what I mean: Year Divs Sh Re Shares Total / Sh Price Sh Yield 2005 $518 -$78 245 $1.79 $46.33 3.9% 2006 $533 -$510 257 $0.09 $48.07 0.2% 2007 $582 -$685 272 -$0.38 $48.85 -0.8% 2008 $618 -$51 274 $2.07 $38.93 5.3% 2009 $612 -$257 281 $1.26 $45.43 2.8% 2010 $640 -$439 292 $0.69 $49.57 1.4% 2011 $704 -$31 293 $2.30 $62.03 3.7% 2012 $712 $0 293 $2.43 $55.54 4.4% 2013 $721 $0 293 $2.46 $55.28 4.5% 2014 $739 $0 293 $2.52 $66.01 3.8% The first three numerical columns are in millions, while the next two represent a per share basis. On the dividend front we can see that Consolidated Edison has been paying more and more total dividends, as to be expected from a company with a long history of regularly increasing its payout . What’s not readily obvious until you take a closer look is that the company had been issuing a good amount shares during the 2005 through 2011 period. This makes sense when think about it – the business is inherently capital intensive – but it might not be something that you would instantly notice. As such, the share count has been increasing. The company had 245 million shares outstanding in 2005, which has now become 293 million. This makes a difference when you’re thinking like an owner rather than a small shareholder. Here’s a comparison of the shareholder yield and the dividend yield over the years: Year Div Yield Sh Yield Difference 2005 4.6% 3.9% 0.7% 2006 4.3% 0.2% 4.1% 2007 4.4% -0.8% 5.2% 2008 5.8% 5.3% 0.5% 2009 4.8% 2.8% 2.0% 2010 4.4% 1.4% 3.0% 2011 3.9% 3.7% 0.2% 2012 4.4% 4.4% 0.0% 2013 4.5% 4.5% 0.0% 2014 3.8% 3.8% 0.0% The first number is what you’re accustomed to seeing quoted on any financial website – a dividend yield in the 3.5% to 5% range. The next column – shareholder yield – illustrates what magnitude of cash is actually being returned to shareholders. Consolidated Edison was indeed paying the full dividend, but it was also receiving cash back from shareholders to increase the share count. If you owned Coca-Cola or Exxon Mobil or any number of other firms in their entirety, the amount of cash that would be available to you would likely be greater than the current dividend yield. When a company both pays a dividend and buys back shares, the shareholder yield is greater than the dividend yield. With Consolidated Edison you have the opposite effect take place. The amount of cash that can be extracted from utility-like business models (without impairment) is lessened when you think about owning the entire thing. Issuing shares is common practice in the utility world (and other worlds for that matter) but it likely wouldn’t be occurring if there was just one owner. (You wouldn’t buy more shares yourself, or you could, but that would simply be inputting more capital). Thus you have a couple other options: issue more debt or reduce the dividend payment. The second option is what is being illustrated in a “shareholder yield” way, but the first one is much more common. Incidentally, whether you own all of it or not, this is exactly what we have seen with Consolidated Edison in the past decade. Notice the difference in the 2005 through 2011 period and the 2012 through 2014 timeframe. In the first period you had an increasing dividend to go along with a good deal of shares being issued. In 2007 shareholders received $582 million in dividend payments, but gave back $685 million to add to the share count. You can call the dividend payment yield, but in the aggregate the company was actually a net beneficiary of cash received. The amount of funds available had been quite a bit lower than what the dividend yield alone would indicate. Notably, Consolidated Edison did not issue shares in 2012, 2013 or 2014. Which means that the shareholder yield was equal to the dividend yield in those periods. Yet there was still impairment during this time. The company had net debt issuances of $1.1 billion, $1.4 billion and $1.1 billion during those years. Instead of issuing shares, debt was used – much like what might be required if you owned the business in its entirety. The shareholder yield gives a reasonable gauge as to the type of cash flow that could be extracted from the business, but naturally it’s just a first step in the process. In this instance, it shows that while the dividend has been above average and increasing, the amount of cash than can be taken out of the business without impairment has been consistently lower than this yield. Warren Buffett had a particularly revealing commentary related to this concept (and incidentally Consolidated Edison itself) back in the 1970’s: “In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn’t have the money to pay the dividend. Candor was rewarded with calamity in the marketplace.” “The more sophisticated utility maintains – perhaps increases – the quarterly dividend and then ask shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in good spirits (particularly the underwriters).” Naturally today you can make a bevy of arguments (rock bottom interest rates, for one) that did not qualify back then. However, the concept is similar: the amount of money that can be taken out from owning the entire business is apt to be lower, not higher, than the stated dividend yield. Ideally you’d like to think in “owner’s earnings” terms, but the shareholder yield provides a short cut to get you started. Whereas a company that regularly repurchases shares has a bit of wiggle room (those repurchase funds could be diverted toward sustaining the dividend in dire times) a company issuing shares has the opposite effect occurring. A company that regularly issues shares has “negative” wiggle room. Now I’m not suggesting that Consolidated Edison is a poor business or that it’s bound for doom – far from it. Utilities tend to exist out of necessity and have been churning out cash for decades. However, looking at shareholder yield (and ultimately owner earnings) is a bit of a different way to think about it. If you owned all of Exxon Mobil you could pay yourself a 5% or 8% dividend in regular times and not put an added burden on the business. That is, the quoted dividend yield understates the amount of cash that could be extracted without impairing the company. With Consolidated Edison, this likely isn’t the case. If you owned all of Consolidated Edison, you’d be more likely to see a lower not higher percentage of cash being paid out. No longer would you be issuing shares and thus the focus would turn to added debt or a reduced payout. The debt could go on indefinitely, but the capital necessities are such that the current dividend payment coexists with other pressing requirements. When they say that you’re “buying it for the dividend” this could be even more applicable than it first appears.

The Time To Hedge Is Now! December 2015 Update

Summary Overview of strategy series and why I hedge. Short summary of how the strategy has worked so far. Some new positions I want to consider. Discussion of risk involved in this hedge strategy. Back to Do Not Rely On Gold Strategy Overview If you are new to this series, you will likely find it useful to refer back to the original articles, all of which are listed with links in this instablog . It may be more difficult to follow the logic without reading Parts I, II and IV. In Part I of this series, I provided an overview of a strategy to protect an equity portfolio from heavy losses in a market crash. In Part II, I provided more explanation of how the strategy works and gave the first two candidate companies to choose from as part of a diversified basket using put option contracts. I also provided an explanation of the candidate selection process and an example of how it can help grow both capital and income over the long term. Part III provided a basic tutorial on options. Part IV explained my process for selecting options and Part V explained why I prefer to not use ETFs for hedging. Parts VI through IX primarily provide additional candidates for use in the strategy. Part X explains my rules that guide my exit strategy. All of the articles in this series include varying views that I consider to be worthy of contemplation regarding possible triggers that could lead to another sizeable market correction. I want to make it very clear that I am NOT predicting a market crash. I merely like to take some of the pain out of the downside to make it easier to stick to my investing plan: select superior companies that have sustainable advantages, consistently rising dividends and excellent long-term growth prospects. Then I like to hold onto those investments unless the fundamental reasons for which I bought them in the first place changes. Investing long term works! If you are interested in a more detailed explanation of my investment philosophy, please consider reading ” How I Created My Own Portfolio Over a Lifetime .” Why I Hedge If the market (and your portfolio) drops by 50 percent, you will need to double your assets from the new lower level just to get back to even. I prefer to avoid such pain, both financial and emotional. If the market drops by 50 percent and I only lose 20 percent (but keep collecting my dividends all the while), I only need a gain of 25 percent to get back to even. That is much easier to accomplish than doubling a portfolio and takes less time. Trust me, I have done it both ways, and losing less puts me way ahead of the crowd when the dust settles. I view insurance, like hedging, as a necessary evil to avoid significant financial setbacks. From my point of view, those who do not hedge are trying to time the market, in my humble opinion. They intend to sell when the market turns but always buy the dips. While buying the dips is a sound strategy, it does not work well when the “dip” evolves into a full-blown bear market. At that point, the eternal bull finds himself catching the proverbial rain of falling knives as his/her portfolio tanks. Then panic sets in and the typical investor sells when they should be getting ready to buy. A short summary of how the strategy has worked so far I have been hedged since April 2014. In 2014, our only significant candidate win was Terex (NYSE: TEX ) which provided gains of over 600 percent to help offset some of my cost. I missed taking some profits in October of 2014 that could have put me in the black for the year, but by doing so, I would have left my portfolio too exposed, so I let most of those positions expire worthless. It is insurance, after all. The results for 2015 have been stellar! I like it when the market gives me a gain in early December because the likelihood of a year-end (Santa Claus) rally is very high and will usually give me an opportunity to redeploy the profits before the rest of my positions expire. I could have taken more gains but decided to leave some on the table in case the rally did not materialize to keep my portfolio mostly protected. I explained all my moves in the last article of the series linked at the top. My biggest winners in 2015 were Men’s Wearhouse (NYSE: MW ) with gains of over 2,700 percent, Micron Technologies (NASDAQ: MU ) with gains of up to 1,012 percent, Sotheby’s (NYSE: BID ) with gains of up to 1,500 percent, Seagate Technologies (NASDAQ: STX ) gaining over 570 percent, and Williams-Sonoma (NYSE: WSM ) with a gain of 527 percent. The gains realized on sold positions now puts me in a position of needing to add some hedges going into 2016, but with plenty of available cash. I will only deploy enough of those gains to protect my portfolio through the end of June 2016 and hold onto the rest to be deployed into new positions to provide a hedge through January 2017. Some new positions I want to consider Do not forget that I usually buy multiple positions in each candidate that I use and you should, too, unless you get in at a particularly good premium and strike. I add positions as I find I can do better than what I already own in order to improve my overall hedge. Sometimes I may buy only half or a third of the position I intend to own in the first purchase. As we get deeper into this bull market (if it still is a bull), I try to stay closer to fully hedged as much as possible. I will be hedging most of my portfolio again over the next month or so since most of my remaining positions are set to expire in mid-January of 2016. I cannot emphasize this enough: buy put options on strong rally days! Here is the list of what I would buy next and the premiums at which I would make the purchases. I may get in if the premium gets down close to my buy price and you will need to make such decisions for yourself. This is a different format from what I have used prior to this month. I will be placing good until cancelled orders at or just below my target premiums to get the positions I want when available without my having to watch daily. I list the candidates in the order of my preference. I will explain how many contracts per $100,000 of portfolio value will be needed and list the expiration months below the table. Symbol Current Price Target Price Strike Price Ask Prem Buy At Prem Poss. % Gain Tot. Est. $ Hedge % Cost of Portfolio RCL $99.92 $22 $75 $1.85 $1.80 2,844 $5,120 0.180% GT $32.79 $8 $28 $1.25 $1.25 1,500 $3,750 0.250% ADSK $61.85 $24 $50 $2.03 $1.80 1,344 $4,840 0.360% SIX $54.63 $20 $45 $1.30 $1.20 1,983 $4,760 0.240% LB $96.82 $30 $85 $2.65 $2.50 2,100 $5,250 0.250% LVLT $54.40 $20 $48 $2.20 $1.90 1,374 $2,610 0.190% TPX $71.64 $20 $60 $2.85 $2.50 1,500 $3,750 0.250% UAL $59.78 $18 $50 $2.29 $2.00 1,500 $3,000 0.200% MAS $28.44 $10 $25 $1.25 $0.85 1,665 $4,245 0.255% ETFC $29.71 $7 $27 $1.87 $1.25 1,500 $3,750 0.250% I will need only one June 2016 RCL put option contract to provide the coverage indicated in the above table. Remember that this is one of eight positions, each designed to hedge one-eighth of a $100,000 portfolio against a 30 percent drop in the S&P 500 Index. I will need eight positions from the table above to protect each $100,000 of equity portfolio value. To protect a $500,000 portfolio, I would need to multiply the number of contracts in each of my five positions by five to be fully protected. Below is a list of the expiration month (all expire in 2016) and number contracts needed for each position I use. Royal Caribbean Cruises Ltd. (NYSE: RCL ) June One Goodyear Tire (NASDAQ: GT ) July Two Autodesk (NASDAQ: ADSK ) July Two Six Flags (NYSE: SIX ) June Two L Brands (NYSE: LB ) May One Level 3 Communications (NYSE: LVLT ) June One Tempur Sealy (NYSE: TPX ) June One United Continental (NYSE: UAL ) June One Masco (NYSE: MAS ) July Three E – Trade Financial (NASDAQ: ETFC ) June Two If I use only the first eight positions listed above, I would protect each $100,000 of equity portfolio value against a drop of approximately $33,080 for a cost of $1,920 (plus commissions). What this means is that if the market falls by 30 percent, my hedge positions should more than offset the losses to my portfolio. This coverage only provides about six months of additional protection, but I have more than double that from my gains taken this year. Hopefully, there will more gains available to further offset future losses come summer and I will roll my positions again (and again, if necessary) until we finally have a recession. Both MAS and ETFC “Buy at Premiums” listed above are below the range of the current bid and ask premiums. That was the case with all of the premiums I used in the last article and most of those have been achieved already. Patience often pays off in lower costs. All of the other premiums listed are within the current range and should be available either immediately or with a small additional rally. I do not intend to chase these premiums and will try to get lower premiums when available. I expect that the current rally could extend into year-end giving me a better entry point on some of these candidates and possibly some others that just do not work at this level. I will provide another update if that opportunity occurs. But I am not ready to take that possibility to the bank, so I will place some orders Monday morning. I do not try to hedge the bond portion of my portfolio with equity options. For those who would like to hedge against a rout in high-yield bonds, I use options on JNK and may add HYG as a candidate for that purpose. If that seems interesting, please consider my recent article on the subject. Discussion of risk involved in this hedge strategy If an investor decides to employ this hedge strategy, each individual needs to do some additional due diligence to identify which candidates they wish to use and which contracts are best suited for their respective risk tolerance. I do not always choose the option contract with the highest possible gain or the lowest cost. I should also point out that in many cases I will own several different contracts with different strikes on one company. I do so because as the strike rises, the hedge kicks in sooner, but I buy a mix to keep the overall cost down. To accomplish this, I generally add new positions at the new strikes over time, especially when the stock is near its recent high. My goal is to commit approximately two percent (but up to three percent, if necessary) of my portfolio value to this hedge per year. If we need to roll positions before expiration there may be additional costs involved, so I try to hold down costs for each round that is necessary. My expectation is that this represents the last time we should need to roll positions before we see the benefit of this strategy work more fully. We have been fortunate enough this past year to have ample gains to cover our hedge costs for the next year. The previous year, we were able to reduce the cost to below one percent due to gains taken. Thus, over the full 20 months since I began writing this series, our total cost to hedge has turned out to be less than one percent. I want to discuss risk for a moment now. Obviously, if the market continues higher beyond January 2016, all of our old January expiration option contracts that we have open could expire worthless. I have never found insurance offered for free. We could lose all of our initial premiums paid plus commissions, except for those gains we have already collected. If I expected that to happen, I would not be using the strategy myself. But it is one of the potential outcomes and readers should be aware of it. I have already begun to initiate another round of put options for expiration beyond January 2016, using up to two percent of my portfolio (fully offset this year by realized gains) to hedge for another year. The longer the bulls maintain control of the market the more the insurance is likely to cost me. But I will not be worrying about the next crash. Peace of mind has a cost. I just like to keep it as low as possible. Because of the uncertainty in terms of how much longer this bull market can be sustained and the potential risk versus reward potential of hedging versus not hedging, it is my preference to risk a small percentage of my principal (perhaps as much as two percent per year) to insure against losing a much larger portion of my capital (30 to 50 percent). But this is a decision that each investor needs to make for themselves. I do not commit more than three percent of my portfolio value to an initial hedge strategy position and have never committed more than ten percent to such a strategy in total before a major market downturn has occurred. The ten percent rule may come into play when a bull market continues much longer than expected (like five years instead of 18 months). And when the bull continues for longer than is supported by the fundamentals, the bear that follows is usually deeper than it otherwise would have been. In other words, at this point, I would expect the next bear market to be more like the last two, especially if the market continues higher through all of 2016. Anything is possible but if I am right, protecting a portfolio becomes ever more important as the bull market continues. As always, I welcome comments and will try to address any concerns or questions either in the comments section or in a future article as soon as I can. The great thing about Seeking Alpha is that we can agree to disagree and, through respectful discussion, learn from each other’s experience and knowledge.

ETFs: Passing Marks For Liquidity, But What About Performance?

By Alliance Bernstein Proponents of credit exchange traded funds (ETFs) claim the last week of market turmoil was a test for these instruments-and that they passed. We think this takes grading on a curve to a new level. The cheerleaders say ETFs succeeded because they traded regularly after a high-yield mutual fund failed and barred investor withdrawals. Here’s what they’re not telling you: in exchange for this liquidity, investors ended up with instruments that have woefully underperformed active mutual funds-recently and over many years. For long-term investors who are saving to pay for college or retirement, that’s an awfully steep price to pay for something they don’t really need. The numbers speak for themselves: Over the first 11 months of this year, the two largest ETFs – HYG and JNK – have sharply underperformed the average active manager, not to mention their own benchmarks. They’ve also trailed the average active manager so far in the fourth quarter ( Display ) and since the start of December, one of the year’s most volatile months so far. ETFs’ longer-term performance falls short, too. In fact, not only have active managers outpaced ETFs over the long run, they’ve done it with lower volatility, as measured by risk-adjusted returns. The Sharpe ratio, which measures return per unit of risk, was 0.45 for JNK and 0.51 for HYG between February 2008, shortly after they began trading, and November of this year. For the top 20% of active high-yield managers, it was 0.71. How Much Liquidity Is Enough? Is the ability to get in or out of an ETF at any point in the day worth the underperformance? For asset managers and traders who need to trade frequently to hedge positions, maybe. After all, they’re not investing in these instruments as long-term income generators. But a large share of the people who own high-yield ETFs aren’t traders. They’re regular folks saving for college, or to buy a new home, or for retirement. In other words, they’re investors, not traders. Most probably aren’t doing any intraday trading at all. If they’re buying ETFs for the liquidity, they’re paying-dearly-for something they don’t need. In our view, an actively managed mutual fund is likely to offer higher potential returns over the long run – and give investors a better chance of meeting their goals. In fact, the data suggest that investors who want long-term exposure to high yield would do better to pick an active manager out of a hat than invest in an ETF. With Mutual Funds, Diversification Is Key All well and good, some investors are no doubt thinking. But what happens when mutual funds fail? That’s a fair question. Liquidity is important for everyone, as the failure of Third Avenue Management’s Focused Credit Fund illustrates. But it’s important to remember that this mutual fund was not a typical high-yield fund. It focused almost exclusively on risky distressed debt issued by highly leveraged companies. These types of assets are relatively illiquid, and that became a problem when large number of investors wanted to sell their shares. In other words, investors were promised “daily liquidity”-the ability to buy or sell shares in the mutual fund at the end of each trading day-but the assets the mutual fund owned could not be bought or sold on a daily basis. These types of strategies are bound to fail eventually. Most high-yield managers follow more diversified strategies that focus on a wide array of higher-quality assets. Of course, investors should still make sure their investment managers have a dynamic, multi-sector approach and are managing their liquidity risk effectively . Those who do a good job will be in position to meet redemptions during downturns and seize opportunities as they arise . That’s something Third Avenue couldn’t do. High-yield ETFs can’t do it, either . The recent turbulence in the high-yield market probably isn’t over. But we don’t think that should concern long-term investors too much. In our view, the best approach at this point is probably to ride out the storm. The intraday liquidity ETFs offer comes at a high price-and if you’re a long-term investor in high yield, you shouldn’t be paying it. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Disclosure: None