The rebounding economy has buoyed equities throughout the year, but investors toggled between growth and value stocks depending on COVID-19 headlines. Investors shifted towards value stocks late in 2020 with the vaccine announcements offering hope for a sharp economic recovery. Value’s outperformance continued during the first part of 2021, but the emergence of the Delta variant raised the specter of a more prolonged pandemic, boosting growth stocks.

Investors Toggled between Growth and Value Stocks

As of December 31, 2021. Sources: Bloomberg; Google Trends.
Total returns of the Russell 1000 Value Index and the Russell 1000 Growth Index.

The Omicron variant made headlines starting in mid-November, and the new variant quickly spread around the world. Prior to Omicron, there was hope that we were rapidly getting to the point where the vast majority of Americans would have immunity, either by vaccination, previous infection, or both.

The Omicron variant has upended this calculus given the widespread incidence of repeat cases and breakthrough infections. Omicron is so infectious that it looks like it will work through the population rapidly. Indeed, as of this writing, cases in South Africa—where Omicron was first reported—have already peaked, and hospitalizations and deaths are running below the levels seen in prior waves.

COVID-19 in South Africa
% of Delta Variant Peak

As of December 25, 2021. Sources: Johns Hopkins; Our World in Data.
Delta variant cases and hospitalizations peaked the week ended 7/10/21.
Deaths peaked the week ended 7/24/21

Experts have long expected COVID-19 to become endemic, meaning that the population has enough immunity through vaccinations and natural infection to keep the number of cases low, akin to the flu. Omicron may have restarted the clock, but its high transmissibility should shorten the course. In the meantime, physicians are much more knowledgeable about how to treat the disease, mitigating some of the worst consequences. In addition, both Pfizer and Merck have developed therapeutics that reduce the probability of severe disease if taken in the first few days following the onset of symptoms. Despite the daily barrage of negative headlines, we still believe that we are months, rather than years, away from the end of the pandemic dominating daily behavior.

Despite concerns regarding COVID-19, most economic activity has returned to normal. Looking at the use of trains, planes, and automobiles to move people and goods, we see that railroad usage never really dropped. Both miles driven and number of airport travelers fell dramatically during the early days of the pandemic, but now have largely returned to 2019 levels. Overall US Gross Domestic Product (GDP) is up, running 8% above 2019.

Trains, Planes, and Automobiles

As of December 31, 2021. Sources: Bloomberg; US Department of Transportation; Association of American Railroads; Transportation & Security Administration. 12/31/19=100.
TSA Checkpoint Traveler Volume is the month-end 7-day rolling average of airline passenger throughput.
Rail Car and TSA Checkpoint data as of 12/31/2021. Vehicle Miles Traveled data as of 10/31/21.

Many parts of the economy continue to lag, reflecting the reality that the pandemic is still with us. Soft demand can be seen in low attendance at sporting events, half-empty restaurants and cinemas, and the continued struggle to sell passages on cruises. As the pandemic fades, we expect demand for experiences to rebound.

Kastle Back to Work Barometer*
Weekly

As of December 29, 2021. Source: Bloomberg.
* Displays commercial property occupancy rate based on entries in Kastle-secured buildings.

The one aspect of the economy that could be permanently changed is office work. On average, less than half of US office workers are back in the office. Results have varied by city, with office attendance typically highest in Austin and lowest in San Francisco. Even in Austin, the commercial property occupancy rate did not reach 60% of pre-pandemic levels before plummeting just ahead of the holiday season to under 25%.

Almost two years into the pandemic, this is remarkable especially considering how many other activities have returned to normal. Work from home seems to be here to stay. The shift to remote work has contributed to the tremendous growth in new business formation, more than ever witnessed in the United States.

US Business Formation Statistics:
Monthly Business Applications

As of November 30, 2021. Sources: Bloomberg; US Census Bureau.

Our conclusion is that the US economy has proven to be remarkably resilient. GDP growth has jumped back and unemployment continues to drop. Work from home is expected to unleash productivity gains, and the remaining pockets of demand weakness will provide opportunities for growth in a post-pandemic world.

The economy’s strong performance has translated into superb sales and profits. At the beginning of the year, Wall Street analysts were in a grim mood, forecasting S&P 500 Index earnings per share of $170 for 2021. This forecast proved to be overly pessimistic, with earnings for the almost-complete 2021 now expected to come in at almost $210 per share. Early forecasts were also wildly off for S&P 500 sales per share, now on track to be about 8% higher than initial estimates. Analysts are expecting 2022 to be only average in terms of sales and earnings per share growth, despite the strong starting point for both businesses and consumers (see Miller/Howard’s 3Q 2021 Quarterly Report). We believe 2022 forecasts will, again, prove to be overly pessimistic.

S&P 500: Earnings & Sales per Share
Since 1995

As of December 31, 2021. Source: Bloomberg.

Earnings expansion was the principal driver of stock market returns in 2021. The increase in earnings estimates was largest for value stocks, but the impact was somewhat offset by a fairly large contraction in price-to-earnings multiples (P/E). Despite outstanding returns in 2021, stocks in the Russell 1000 Value Index are entering 2022 with substantially lower P/E multiples—a good set up for the coming year, in our view. In contrast, Russell 1000 Growth Index earnings estimates increased less than those of value stocks over the year, yet growth stocks outperformed because their P/E multiples contracted minimally compared to value stocks.

2021 Total Return Composition

As of December 31, 2021. Sources: Bloomberg; Miller/Howard Research & Analysis.

The battle between growth and value will hinge mainly on inflation, both how it evolves and how the Federal Reserve reacts. The ideal environment for value stocks, in our view, would be a growing economy accompanied by moderate inflation with higher interest rates, both at the short and long end of the yield curve. This would cause investors to put a greater discount on distant earnings, placing more emphasis on near-term earnings—to the benefit of value stocks. Higher interest rates would also give a substantial boost to financial stocks which are far more prevalent in the value benchmark.

The most likely scenarios in which growth stocks outperform would be a material extension in the pandemic or a policy error by the Fed that pushes the economy into a recession. Since so much of the uncertainty hinges on inflation, let’s take a closer look at the recent spike.

Inflation Spiked in 4Q 2021
Jan 1970–Nov 2021

As of November 30, 2021.
Source: Bloomberg; Bureau of Labor Statistics.
CPI = Consumer Price Index.

Inflation spiked to 6.8% in November, the highest reading since the early 1980s. The core Consumer Price Index (CPI), meaning excluding food and energy, also increased to a level not seen since the early 1990s. The persistent and widespread inflation has caused the Fed to stop using “transitory” as a descriptor.

Contribution to Inflation
Year-Over-Year CPI Growth: 6.8%

As of November 30, 2021.
Sources: US Bureau of Labor Statistics; Federal Reserve Economic Data (FRED), created and maintained by the Research Department at the Federal Reserve Bank of St. Louis; Miller/Howard Research & Analysis.
* Auto combines categories New Vehicles, Used Cars and Trucks, Motor Vehicle Maintenance and Repair, and Motor Vehicle Parts and equipment as provided by the US Bureau of Labor Statistics.
** Other is all remaining CPI categories after removing categories Housing, Energy, Auto*, and Food & Beverage as provided by the US Bureau of Labor Statistics.

The largest contributor to the recent run-up in inflation has been the cost of housing. For owner-occupied units, the CPI is based on a survey question on what owners think they could get in rent for their homes. The Zillow Rent Index is constructed using actual rent data and is probably a more accurate measure of housing inflation, suggesting that the CPI is understating this important category. Given that it will take a substantial amount of time for housing supply to catch up with demand, we expect this component of inflation to be with us for a while.

Housing Cost Inflation
Housing CPI vs Zillow Rent Index

As of November 30, 2021.
Sources: Bloomberg; US Bureau of Labor Statistics.
CPI Rent Index definition: For an owner-occupied unit, the cost of shelter is the implicit rent that owner occupants would have to pay if they were renting their homes. Owner Equivalent Rent, or OER, is based on the following question that the Consumer Expenditure Survey asks of consumers who own their primary residence: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?”

We feel that the other major contributors—energy, automobiles, and food & beverage—are more likely to be transitory. Energy prices are notoriously volatile, and higher prices historically bring on more supply, particularly from US shale basins that require short lead times.

We believe that some of the inflation we are seeing today has been caused by supply disruptions in the economy. Some of these can be traced directly to the pandemic—for example, many semiconductor plants had to be closed temporarily following outbreaks of COVID-19. Other bottlenecks are indirect but nonetheless significant. COVID-19 shifted consumer spending from services to hard goods, much of which come from Asia. Bottlenecks in both shipping and trucking have led to shortages at retailers. As a result, the normal mechanism of supply and demand has pushed prices up, but we should expect this aspect of inflation to reverse as supply bounces back.

Container Ships Waiting
at the Ports of Los Angeles and Long Beach

Data from January 1, 2021 to December 31, 2021. Source: Marine Exchange of Southern California.

Parts shortages have caused auto production to plunge, leading to extremely low inventories on dealer lots. Customers have bid up the prices of both new and used vehicles, with the spike in used car prices being the largest ever. The increase in both new and used auto prices has been an important part of the inflation spike. We expect this to prove transitory once supply conditions normalize.

Domestic US Auto Production & YoY Change in Used Vehicle Value

Manheim Index as of 12/31/21. Auto Production as of 11/30/21.
Sources: Bloomberg; US Bureau of Economic Analysis.
Domestic auto production is defined as all autos assembled within the US on a monthly basis.

Inventory/Sales Ratio for the Domestic US Auto Industry

As of November 30, 2021. Sources: Bloomberg; US Bureau of Economic Analysis.
Inventory is defined as the domestic US unit inventory of new vehicles assembled in the US, Canada, or Mexico. Sales is defined as domestic US unit sales of new vehicles assembled in the US, Canada, and Mexico on a monthly basis. Excludes vehicles produced elsewhere and exports.

The best argument for a portion of inflation being more than merely transitory is the unprecedented monetary and fiscal stimulus that has been used to offset the economic impact of the pandemic. Critics argue that this stimulus will overheat the economy, resulting in inflation.

Federal COVID-19 Stimulus and Relief Packages

As of December 31, 2021. Source: Miller/Howard Research & Analysis. Cumulative aid is displayed as a % of 2020 GDP.

There is no debating that the stimulus was massive. The Fed dropped the federal funds rate in two steps in March 2020, going from a target range of 1.50-1.75% to 0-0.25% in total, representing a dramatic decrease in the cost of bank funding. The purpose of the decrease was to encourage bank lending. The Fed also rapidly grew its balance sheet by increasing bond purchases and upping its repo program. Combined, these moves reduced interest rates and increased liquidity. The Fed also engaged in direct lending through several programs, with the Paycheck Protection Program (PPP) loans being the most prominent.

Fiscal stimulus to address the fallout from the pandemic was also massive, with additional spending totaling more than a quarter of a 2020’s GDP. Bills passed in 2020 and 2021 provided a panoply of programs including direct cash payments, expanded unemployment benefits, mortgage and student loan forbearance, interest moratoriums, and grants to state and local governments, hospital, universities, transportation systems, and so on. It’s worth pointing out that inflation hawks have been warning for decades that deficit spending would result in a return of 1970s inflation. These predictions have been dead wrong up until now, but the hawks may be right this time given the unprecedented fiscal and monetary stimulus.

Monetary Stimulus during the COVID-19 Pandemic

As of December 31, 2021. Sources: Bloomberg; Federal Reserve Bank of NY.
The grey bar represents a recessionary period as designated by the Federal Reserve.

Higher inflation is a real possibility, so we must ask, “How will it affect our investments?”

Clients tend to worry that the companies in our portfolios will be unable to pass along cost inflation. The truth is that any well-diversified portfolio will have some companies that benefit from inflation and others that are hurt—one firm’s product is another firm’s cost. We looked at year-over-year changes in gross margins for sectors in the S&P 500 to see how well firms passed along cost inflation in the third quarter. While there were some sectors that faced difficulties, S&P 500 companies (excluding financials, real estate, and utilities) grew gross margins in 3Q 2021, meaning revenues grew faster than the cost of goods sold. Despite occasional variation, firms will generally raise prices in line with inflation. Even firms in highly competitive industries will see prices go up as inflation drives costs up for all competitors.

Change in Gross Margin by Industry

As of December 2021. Sources: Bloomberg; Miller/Howard Research & Analysis.
* Industry excludes members of GICS Sector Classifications Financials, Real Estate, and Utilities as gross margin is less meaningful for these sectors. Industry members are based on members of the S&P 500 Index as of the comparison dates. Industry clasification is based on GICS. Members with missing data have been excluded from totals.

In contrast to equities, most bonds cannot adjust for inflation. A bond promises a fixed coupon. Outside of the inflation-indexed niche, bonds will continue to yield a fixed return even when inflation is eroding away the coupon’s value.

The best equity valuation metric to compare to bond yields is the earnings yield, or the inverse of a price/earnings multiple. This represents the return a company earns relative to the price of the stock. We prefer companies that pay out a healthy portion of their earnings as dividends, but retained earnings are also valuable as they can be reinvested to grow future earnings and dividends.

Currently, the S&P 500 has a forward earnings yield of roughly 4.7%, well above the 1.5% yield on the 10-year Treasury. Looking back at all rolling 10-year investment periods starting in 1955, the S&P 500 has grown earnings 100% of the time. Equities offer a higher earnings yield plus a strong probability of growth in earnings over long investment periods. The threat of inflation only improves the case for equities, as companies serve as pass-through vehicles for higher prices, while bond investors are stuck clipping coupons that are declining in real value.

The stock market is still dominated by growth companies selling at high P/Es—multiples that can only be justified by forecasts for rapid earnings growth far into the future. At Miller/Howard, we prefer stocks with lower valuations than the broad market combined with a healthy portion of earnings being returned to investors in the form of dividends. Focusing on higher earnings now with higher dividends now makes our portfolios much less dependent on earnings forecasted for 2030 and beyond. If the pandemic and the resulting spike in inflation have taught us anything, it’s that forecasting is difficult. Our approach for navigating this uncertainty is to focus on companies with strong balance sheets, good dividend yields, and an outlook for dividend growth that is not dependent on overly aggressive forecasts.

Read the 4Q 2021 Quarterly Report ►

   

Inflation eats away at your ability to afford your current life style. Even at an annual inflation rate of 5%, prices double in 14 years. This 5% assumption is well under the most recent reading of 6.8% for consumer inflation and 9.6% for raw materials and manufacturing inputs (future inflation?). If current trends persist, prices could double sooner. Put another way, when prices double, it would be like trying to live now on half of your income. What expenses would you need to cut to survive on half of your current income? What pleasures would you need to eliminate from your life?

We view dividend-paying stocks as a potential solution—with a focus on companies that have the potential to raise their dividends consistently over the long term. As prices rise, so too should corporate profits, allowing some companies to increase their dividends in-line with inflation. We call this “unfixed income”. These “unfixed income” investments could allow your income to keep pace with inflation and help you maintain the same standard of living that you enjoy now well into the future.

Over time, dividend growth has broadly kept up during periods of high inflation, as can be seen during the 1970s and 1980s, the last time the US experienced a prolonged period of high inflation. (Inflation has been generally muted over the past several decades, so we need to look back in history to find a comparison.) In the ten years ending December 31, 1980, when prices rose at an annualized +8.1%, dividends for the S&P 500 Index grew +7.1% per year. Dividends didn’t quite keep up with the more than doubling of prices during that decade, but they did help to protect purchasing power much better than a bond, where interest payments remained unchanged.

Over the subsequent ten years ending December 31, 1990, price inflation moderated to “only” +4.5% per year, but this time dividend growth outpaced inflation to grow +6.9%. For the combined twenty-year period, inflation was an annualized +6.3% while dividends grew at a comparable +7.0%. Dividends helped investors maintain their inflation adjusted or “real” income levels. Of course, a “fixed income” bond did not provide any income growth over that time.

Given today’s potential for an increase in US inflation and low current interest rates, it may be time for investors to rethink their portfolio strategy and look to increase their investment portfolio’s exposure to dividends for both current income and inflation protection.

   

At Miller/Howard, we ask these questions of the companies we invest in, and of ourselves:

• How does a company identify its risks?
• What are its blind spots?
• What are its strategies for the short and long term?

We are committed to managing the risks we see to ensure that our portfolios’ risk exposures suit our clients’ risk appetites.

We strive to provide Sustainable Income Opportunities®  using our Guiding Values as our compass.

Just as we push companies to be better—positioning for long-term profitability and accountability to their investors—we constantly assess our own process. To this end, in 2021, we updated our Guiding Values to include 'responsible climate change approach' as a fourth pillar. Previously, we considered a company's climate change strategy within the context of resource management, disclosure, environmental risks, and sustainability. However, we feel the time has come to prioritize this commitment and recognize it as a unique pillar.

The Miller/Howard Climate Change Working Group launched in 2020

In recognition of the systemic risks posed by climate change, Miller/Howard launched an internal Climate Change Working Group (CCWG) in 2020. CCWG is a cross-departmental initiative that reports directly to Miller/Howard’s president, and is comprised of representatives from all departments. The group considers physical and transition risks associated with climate change, takes an expansive and critical look at Miller/Howard’s existing policies and practices, and provides forward-looking insights that can support us in our goals.

Miller/Howard’s multi-decade commitment to ESG provided a solid foundation, from which we could refine a more fulsome program and build on existing capacities, successes, and talents. We chose to distinguish “climate change” as a unique consideration that, while closely tied to environment, is not equivalent in concept or implications.

Additionally, the CCWG has worked to:

• Consolidate existing policies and practices that relate to climate change into one cogent, clear strategy, to reduce redundancies and increase the efficiency and efficacy.
• Look for gaps, opportunities, and blind spots.
• Support greater risk assessment as well as new insights, ideas, and adaptations.

We encourage all to use this information to reflect on your own strategy and preparation, whether it’s in service of your clients or your own investments and financial goals. Miller/Howard stands at the ready to partner with those seeking our Sustainable Income Opportunities®.

Read Miller/Howard’s full Climate Change Risk Management Strategy ►

   

How many times have you heard Wall Street gurus claim that the stock market is in a bubble? To paraphrase the old saw about economists, market pundits have identified ten of the last two stock market bubbles. But we must acknowledge that the recent run in US equities has been spectacular. An investment in the S&P 500 Index in the past 12 months generated an astounding 30% return—well above its longer-term average of 11%. No one argues that returns can continue at this torrid pace, but what is the case for the market turning down for an extended period?

The best bearish arguments focus on valuation and Fed policy. The forward price-to-earnings (P/E) ratio is now at 20x for the broad market (based on the S&P 500), well above the average of 17x we have seen since 1990. But if high P/Es were a reliable sign of a market top, 2021 should have been a down year. Instead, we have seen earnings estimates rise during the year, suggesting that market participants saw a recovery in earnings sooner than Wall Street analysts. High P/Es make returns from multiple expansion less likely going forward, but earnings growth and dividends can still push the market to new highs in our view.

A better bear argument hinges on the Fed tightening monetary policy to fight inflation, either by directly raising the federal funds rate or by tapering its bond-buying program. Inflation numbers have increased recently, and so far, the Fed has viewed this as a temporary phenomenon. Even if inflation does persist, causing the Fed to begin tightening, higher interest rates will not necessarily lead to a prolonged drop in the stock market. Yes, multiples on expensive stocks would likely fall with higher interest rates as earnings in distant years become more discounted. We expect this impact would be offset by the continual payment of dividends and the upward trend in earnings for the broad market driven by economic growth. Earnings in the financial sector would also get a specific boost from higher interest rates. Inflation poses a legitimate threat to P/E multiples, but we believe that earnings growth and dividends should continue to drive healthy market returns, particularly for stocks with moderate valuations.

No one can entirely dismiss bear cases for the market, but what is the case for optimism? When the pandemic finally fades, are we set up for a strong recovery?

As of September 30, 2021. Source: Morningstar Direct. *1/31/1990 - 9/30/2021 **As of 9/30/2021

As of September 30, 2021. Source: Bloomberg. *** Forward Estimate

The Consumer is Strong

When it comes to the consumer, it really is different this time, at least relative to the 2008 bubble. The consumer drives almost 70% of the US economy and has never been in better shape. Consumer net worth is higher than ever, currently $405,000 per person. A fair pushback would be that this reflects a run-up in home prices. But even cash per capita is at an all-time high at $50,000 per person. Rising asset prices combined with generous government support has left the average consumer with plenty of spending power.

US Household Net Worth and Cash Equivalents per Capita

Thousands of Inflation-Adjusted Dollars

As of June 30, 2021. Sources: Federal Reserve, Bureau of Labor Statistics; Bloomberg.
4Q20 Consumer Price Index = 1. Cash & Cash Equivalents is defined as financial assets that are liquid household deposits.

The consumer is also remarkably unencumbered by debt. Looking at the ratio of debt to disposable income, we see that the average consumer has de-levered extensively since 2008. Yet this understates the case because interest rates on consumer debt have also come down significantly. The debt service ratio measures the percentage of disposable income that goes to interest on mortgages and other debt. The graph of the debt service ratio shows how dramatically interest payments have fallen relative to disposable income.

Total Consumer Debt as a Percent of Disposable Income

As of June 30, 2021. Source: The Federal Reserve; Bloomberg.

US Household Debt Service Ratio*

As of March 31, 2021. Source: The Federal Reserve; Bloomberg.
*The household debt service ratio (DSR) is the ratio of total required household debt payments to total disposable income, reported quarterly.

Some argue that statistics on the average consumer are overly influenced by wealthy people and that there is a substantial fraction of consumers in dire straits. We have examined this issue from multiple perspectives and still conclude that even the lower-income consumers are better off than normal. One interesting metric is the percent of consumers with bills at third-party collection agencies. Seven percent of US consumers have bills in collection, typically medical and utility bills. Seven percent still sounds high, but it is roughly half of what it was at the peak in 2013. Many of these bills can be for small amounts. Serious debt problems are best measured by bankruptcies and foreclosures, both of which are at record lows.

But are problems for the consumer just around the corner? A good forward-looking metric is the percent of consumer debt that is 30 days or more delinquent. Thirty days is often just a missed payment but clearly could be the start of a serious downward slide. As the graphs below show, consumer debt delinquency is also at an all-time low.

Percent of US Consumers with Third Party Collections

As of June 30, 2021. Source: New York Fed Consumer Credit Panel/Equifax.

Number of US Consumers with New Foreclosures or Bankruptcies

As of June 30, 2021. Source: New York Fed Consumer Credit Panel/Equifax.

Total US Consumer Credit Card Delinquency Rate

As of June 30, 2021. Source: The Federal Reserve

In addition to improvements in consumer balance sheets, the labor market is also steadily getting better. Unemployment dropped to 4.8% in September, continuing the march lower that began in May 2020. Job openings as measured by the Bureau of Labor & Statistics are at an all-time high.

Every way we look at it, we conclude that the consumer is poised to spend in a recovery.

How’s Business?

Earnings announcements have been complicated this year, with many companies reporting strong demand for their products but frequently complaining about supply chain disruptions. Our focus here, however, is on the overall health of the business sector. Are companies well-situated for a recovery?

Business was impacted by the pandemic, arguably more than the consumer. The Bloomberg Bankruptcy Index rose substantially last year, but it was nowhere close to what we witnessed following 2008. Bankruptcies in 2021 have dropped to one of lowest levels ever, suggesting that the shakeout is over.

Bloomberg Corporate Bankruptcy Index

Source: Bloomberg, last updated September 24, 2021.
The Bloomberg Corporate Bankruptcy Index measures both the occurrence and severity of current and recent US bankruptcy activity for corporations with at least $50 million in reported liabilities. The index is a barometer of bankruptcy activity that equally considers the number of bankruptcies and the US dollar amount of liabilities relative to their 2000 to 2012 medians which are set at 100. Each known bankruptcy observation is discounted daily from a full weighting to zero over the following year.

Positive indications also come from the performance of commercial and industrial loans at US banks. Both delinquencies and defaults are at low levels. Overall, it appears that US business has the financial strength to shift into high gear as normal life returns.

Commercial and Industrial Loans

Delinquency and Default Rates(%)

As of June 30, 2021. Source: The Federal Reserve. Commercial and industrial loans exclude leases and real estate.

COVID-19 Headwinds Should Abate

Both the consumer and the business sector are well-positioned for a recovery, but the economy will continue to be choppy as long as COVID-19 restricts normal activity. While some parts of the economy have returned to normal, the pandemic continues to disrupt domestic industries such as healthcare, retail, travel, and hospitality, as well as creating havoc with global supply chains. The spread of the virus has been difficult to predict, but evidence suggests we are approaching the final stage.

First, the vaccine has been very effective. One way to see that is to examine the current case rates for all 50 states versus the percent of the population that is vaccinated. Higher vaccination rates are clearly associated with lower new case rates. Other factors, however, are also at work. Sending children back to school is arguably our most decisive move towards normalization. Despite best efforts, children will contract COVID-19 and bring it home. We have seen spikes in cases following the first day of school in many places across the country. States with later school starts, such as those in the Northeast, may have a new wave of COVID-19 cases despite higher vaccination rates.

September Daily Average New COVID-19 Cases

Versus Vaccination Rate by State

As of September 30, 2021. Source: Centers for Disease Control and Prevention (CDC); Miller/Howard Research & Analysis.

The good news is that effect seems to be waning for the states with the earliest starting dates. Looking at new case rates over time for Alabama, Indiana, Hawaii, and Arizona, new case rates have already fallen off their peaks.

Daily New COVID-19 Cases for States with Earliest School Starts

As of September 30, 2021. Source: Centers for Disease Control and Prevention (CDC); Miller/Howard Research & Analysis.
Seven-day moving average. School starts were researched using state and municipal school district public resources as well as the Public Holidays Global website.

The main reason why we believe the end of the pandemic is on the horizon is that the virus is running out of people to infect. At quarter-end, 56% of Americans were fully vaccinated and this number continues to grow. Vaccinated people can be infected, but the rate is very low, particularly for severe cases. People can also gain immunity by contracting the virus. Reinfections have been reported but are still rare. Estimating the cumulative number of cases is difficult because many people either have no symptoms or a mild enough case that they never get tested. The Center for Disease Control estimates that only 1 in 4.2 cases is reported. This implies that 55% of Americans have already had COVID-19. Adjusting for people who contracted the virus and then were vaccinated, we estimate that 83% of the US population may now have reasonably good immunity, either through vaccination, infection, or both.

Estimated COVID-19 Immunity Status of the US Population

As of September 30, 2021. Source: Centers for Disease Control and Prevention (CDC); Miller/Howard Research & Analysis.

Everyday, more Americans get vaccinated or contract COVID-19. At current rates, another 1% of Americans gain some level of immunity every two weeks. Given that we estimate that only 17% of Americans were at high risk (no vaccine and no prior case) at the end of the quarter, we are approaching the point at which the virus will struggle to find victims who are easy to infect. Once case rates drop in earnest, most people will view the risk of infection as tolerable, analogous to the flu or the common cold. At that point, we believe economic activity should normalize.

The biggest caveat to this conclusion is that it depends on the virus not mutating in a way that undermines the effectiveness of vaccines or prior infections. We continue to monitor this issue, but currently, our view is that we are months rather than years away from the end of the pandemic.

But Markets are Already Up!

A reasonable rebuttal to our optimism would be that broad market returns have been well above average, even during the worst pandemic in 100 years. How crazy is that? At Miller/Howard, we view earnings growth and dividends as the high-quality sources of stock market returns. Fluctuations in P/E multiples can significantly impact returns in a particular year, but as we have written (see Miller/Howard Quarterly 1Q 2021), P/E multiples are fickle and unlikely to be a sustainable source of investment returns over the long term.

Keeping this framework in mind, returns in 2021 have been driven by the sustainable factors—earnings growth and dividends. Earnings have grown tremendously off an admittedly weak 2020. P/E multiples have actually contracted this year as earnings have grown faster than stock prices. Valuations are more palatable now than at the beginning of the year.

Year-to-Date Total Return Composition

As of September 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

The case for optimism centers on the remarkable strength of both the consumer and business sectors. Factors such as the Delta variant or supply chain disruptions may cause short-term delays in the recovery, but once the recovery comes, the economy is primed to be strong.

Given this setup, are equities a good buy at current prices?

Let’s start by comparing stocks and bonds, the two large, liquid asset classes on the investor menu. Bonds are easy to value – the interest rate is the buy-and-hold return. One simple way to compare the return on equities to bonds is to look at the dividend yield on equities. Currently, the dividend yield on the broad market is roughly the same as the interest rate on the 10-year Treasury. Thirty years ago, the interest rate on the 10-year Treasury was substantially higher than the S&P 500’s dividend yield. Put simply, bond investors required the higher interest rates to compensate for the lack of growth. Now, markets have evolved to the point where the interest rate on the 10-year Treasury is roughly the same as the dividend yield on the broad stock market, even though bonds still do not offer any income growth. Through the dividend lens, even the modest yield of the S&P 500 looks attractive.

S&P 500 Earnings & Dividend Yield vs. 10-Year Treasury Yield

As of September 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

A better valuation metric for comparing equities to bonds is the earnings yield, or the inverse of the P/E multiple. Some might argue that dividends should be the metric to compare to bond coupons. After all, dividends and bond coupons are both “money in your pocket.” As much as we like dividends at Miller/Howard, we view earnings as the right comparison. The portion of earnings not paid as dividends provide companies with the capital to grow earnings and dividends in the future. Thirty years ago, the earnings yield on the S&P 500 was roughly the same as the 10-year Treasury interest rate, suggesting investors thought that the growth prospects for equities offset the risks involved. Now, the spread between the equity earnings yield and Treasury rate has ballooned out, offering investors substantially more earnings in equities relative to bond interest, again leading to the conclusion that equities are attractive relative to bonds.

This is just the defense of equities as an asset class. The favorable points above can be dialed up with the right portfolio exposures. Miller/Howard strategies have substantially higher earnings yields and dividend yields relative to the broad market, making them, in our view, a good place to put money to work in a recovery.

Worries about the broad equity market are understandable, but fixed income alternatives suffer in a low interest rate environment. Buy-and-hold investors in high dividend yield stocks have done better over 10-year holding periods than the S&P 500 and bond alternatives. (See our 2021 Q2 Quarterly, page 6.) In our view, today’s entry point for dividend investors is particularly attractive given the setup for a recovery and current valuations.

Read the 2021 Q3 Quarterly Report ►

   

Do Unprofitable Companies Belong in Your Portfolio?

Most investors saving for retirement would answer, “Surely not!” And yet, turn on any business channel and you will hear experts lauding the shining future of various growth and small-cap stocks. Many of these stocks have positive and growing earnings, but a surprising number are currently losing money. In the Russell 1000 Growth Index, 23% lost money last year. In the small-cap Russell 2000 Index, fully 47% were unprofitable in 2020. Even 16% of the S&P 500 Index names were unprofitable last year. Unprofitable companies are so ubiquitous that they can be found in virtually all retirement accounts, particularly for investors using passive funds or ETFs.

This is not just an artifact of the pandemic. The chart below shows the fraction of unprofitable companies in the S&P 500, Russell 1000 Growth, and Russell 2000 indices over the last 25 years. As you can see, unprofitability rises in times of stress such as the end of the Internet Bubble, the Global Financial Crisis, and the COVID-19 pandemic. But the fraction of companies losing money in the broad market (as represented by the S&P 500) is persistently high. Among small-cap stocks, the percent of unprofitable companies has been trending up, reaching almost half of the Russell 2000 Index by weight. It seems unlikely that the average saver would be comfortable investing in unprofitable companies to this extent.

Many investors will try to comfort themselves with the notion that GAAP accounting is inherently conservative and includes many one-time, non-cash charges. At Miller/Howard, we are sympathetic to this viewpoint and focus mainly on free cash flow (FCF) as our profit metric. Free cash flow is defined as operating cash flow less capital expenditure. It’s the ultimate “show me the money” metric in that it reflects the actual cash a company generates that can be used for dividends, share buybacks, strengthening the balance sheet, or acquisitions.

Percent of Members that are Unprofitable

Negative TTM EPS — Market Cap Weighted*

As of December 31, 2020. Source: Bloomberg.
*TTM = Twelve Trailing Months; EPS = Earnings Per Share The universes are defined as members of the listed indexes
(Russell 2000, Russell 1000 Growth, S&P 500) as of each calendar year end and are market-cap weighted.
GAAP = Generally Accepted Accounting Principles

Percent of Members with Negative Free Cash Flow Yield

Market Cap Weighted

As of December 31, 2020. Source: Bloomberg. Free cash flow is defined as operating cash flow less capital expenditure.
The universes are defined as members of the listed indexes (Russell 2000, Russell 1000 Growth, S&P 500) as of each calendar year end and are market-cap weighted.

As the chart above shows, a significant percentage of stocks in the broad market have negative free cash flow. For small-cap stocks, roughly one-third of companies are investing more capital than operations generate. Even for the S&P 500, over 10% of the companies in the index have been free cash flow negative in recent years. For one unique sector of the economy, regulated utilities, negative free cash flow is not a significant concern. Utilities can invest more than their operating cash flow knowing that regulators will ensure that investment returns will indeed follow. In contrast, the vast majority of companies invest without guaranteed returns. Running with negative free cash flow means that executives are “betting the firm” with capital expenditures, depending on either good returns or the continued willingness of investors to inject new equity or debt capital.

Our view at Miller/Howard has always been that people saving for retirement are best served by investing in mature, self-sustaining companies—companies with enough free cash flow to fund a large and growing dividend. We would argue that venture capitalists are the right investors for young, money-losing enterprises. These sophisticated investors have greater access to management and detailed company information—much more access than any equity investor in a public company. Ideally, companies become profitable and then go public, but the rush to “cash out” has pushed moneylosing companies into the public markets and thus into investors’ portfolios. Is this a good thing?

Succeeding with Business Startups

Many people become wealthy by starting their own business, which, no doubt, has an unprofitable phase. Others do well by investing in small businesses started by friends or family members. But if your favorite niece or nephew is not destined to start the next mega-cap growth company, can you reliably buy stocks to replicate that type of opportunity? Is investing in unprofitable public companies a good investment strategy?

Annual Performance of Russell 2000 Index
Unprofitable Companies vs Profitable Companies

*As of June 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

To answer these questions, we first looked at investing in small-cap stocks—surely this is where money-losing acorns may grow to mighty oaks. The chart above shows the results of investing in unprofitable companies versus profitable small-cap companies in the Russell 2000 Index. As you can see, investing in unprofitable companies worked well just as the Internet/New Economy Bubble was coming to an end, then did well again in the market recovery years of 2003 and 2009, and then had an excellent 2020. But the chart below shows that on a cumulative basis, there is no contest—investing in profitable small-cap companies has generated much higher cumulative returns.

Cumulative Performance of Russell 2000 Index
Unprofitable Companies vs Profitable Companies

*As of June 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.
Note for charts on this page: Unprofitable is defined as members of the Russell 2000 Index with negative trailing earnings per share as of each calendar year end. Profitable is defined as members of the Russell 2000 Index with positive trailing earnings per share as of each calendar year end. Both Unprofitable and Profitable are market capitalization weighted and rebalanced at year-end.

A skeptic might argue that a broad market index of small-cap stocks is not the right place to look for the next big thing. The two charts below show the results of investing in profitable versus unprofitable companies within the Russell 1000 Growth Index. Investing in unprofitable growth companies during 1995-2019 would have led to significant underperformance relative to owning profitable growth companies. Before 2020, the conclusion was clear: Within the growth stock universe, investing in profitable companies would be a better strategy. Results for 2020 were radically different—unprofitable growth companies outperformed profitable ones by such a magnitude that the cumulative returns for unprofitable companies are now above the returns for profitable growth companies. This year unprofitable companies are once again underperforming, and our view is that investing in money-losing public companies will ultimately prove to be unwise, regardless of recent results to the contrary.

Annual Performance of Russell 1000 Growth Index
Unprofitable Companies vs Profitable Companies

*As of June 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

Cumulative Performance of Russell 1000 Growth Index
Unprofitable Companies vs Profitable Companies

*As of June 30, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.
Note for charts on this page: Unprofitable is defined as members of the Russell 1000 Growth Index with negative trailing earnings per share as of each calendar year end. Profitable is defined as members of the Russell 1000 Growth Index with positive trailing earnings per share as of each calendar year end. Both Unprofitable and Profitable are market capitalization weighted and rebalanced at year-end.

The Year of Speculation

As of June 4, 2021. Source: Wolfe Research; Standard & Poor’s.
SPAC = Special purpose acquistion company; IPO = Initial public offering

The high returns for money-losing stocks in 2020 was just one more sign of the recent rise in speculation gripping the investment world. If you think this is just young people buying meme stocks based on social media posts, think again. Capital raised for Special Purpose Acquisition Companies (SPACs) soared last year, and the first half of 2021 has already surpassed the 2020 total. So far in 2021, more money has been raised for SPACs than regular IPOs. SPACs used to be called “blank check” companies, because capital was raised so that company executives could go shopping for acquisitions. Regulations have been tightened, but SPACs remain the exact opposite of investing in a known business with consistent cash flows.

But at least SPAC investors can hope that their investments might one day generate income. Cryptocurrency offers no such hope. Investors are lured into buying an asset that gyrates on investor moods and celebrity tweets. Is it more useful than currency for transactions? Probably not, after we set aside criminal activity. Is it a good store of value? The chart below says “no.” But like other popular speculative vehicles, it has made a lot of people rich recently. The time frame says it all—too many investors focus on what has worked recently, dismissing traditional wealth strategies with catch phrases such as, “You don’t get it” or its latest rendition, the pithy “Okay boomer.”

Bitcoin: Store of Value?

Growth of $100 USD Invested in Bitcoin Currency

As of June 30, 2021. Source: Bloomberg

The Dividend Investor

Average Rolling 10-Year Total Returns by Decade

(January 1, 1951 - December 31, 2019)

Data are through December 31, 2019. Based on the rolling 10-year annualized total returns, ending each calendar year, averaged by decade.
Source: Miller/Howard Research & Analysis; 2019 Stocks, Bonds, Bills and Inflation (“SBBI Yearbook”) and S&P 500 Index data as reported to Morningstar Direct. High Yield Stocks data are provided by the Fama/French Research data library (value weighted deciles); Long-term government and corporate bond returns are based on the SBBI Yearbook.

We have seen a move in the markets back towards value and income stocks, but the wide interest in SPACs, cryptocurrency, and meme stocks suggests that the speculative fever has not yet broken. When it does, we will no doubt hear stories of the winners. But what of the average saver who belatedly turns to the latest faddish asset just after its peak?

At Miller/Howard, we have long advocated high-yield dividend stocks for long-term investors. The stocks we choose for our portfolios tend to have reasonable price-to-earnings (P/E) multiples, good free cash flow, and relatively low debt levels. Studying unprofitable companies may seem odd given our investment discipline, but clients are always asking about our thoughts on the general market. We have written extensively about the outperformance of high P/E stocks prior to Pfizer’s vaccine announcement (see page 6 of our 1Q 2021 Quarterly Report). Unmentioned was the rocket-ship performance of companies that were not merely expensive on a P/E basis but actually losing money.

Using data going back to the 1950s, we have established that high-yield stocks have produced excellent returns for 10-year holding periods in every decade, better on average than the S&P 500 and better than bonds. (Please see Miller/Howard’s 2Q 2020 Quarterly Report for details.) Income investing works for the long term because, typically, companies must have durable, sustainable earnings to commit to a dividend.

Investing always involves risks, but good cash flow and earnings seems to be a logical place to start when researching a potential stock investment. In contrast, investing in unprofitable companies requires fairly heroic assumptions about the future. Income investing does involve having general views on the future, but ultimate success is much more dependent on the power of compounding than 20/20 foresight.

Better Earnings Outlook Driving Stocks Higher

Market returns last year were driven largely by price-to-earnings (P/E) multiple expansion, as discussed in Miller/Howard’s 1Q 2021 Quarterly Report. The tenor of the market is changing this year, with the increase in earnings estimates becoming more important. This quarter, we witnessed very large increases in earnings estimates for both 2021 and 2022. Earnings estimates are up the most for cyclically-tilted value stocks. Consistent with the higher earnings estimates, value stocks have outperformed both the broad market and growth stocks year-to-date.

During the second quarter, growth stocks led value as many investors worried over the possibility of higher inflation and a potential reemergence of COVID-19 linked to new variants. Growth stocks are viewed as less dependent on economic growth and therefore more defensive. Growth stocks are now up 13% year-to-date, despite their 2021 earnings estimates being up only 5% in the same period. In contrast, value stocks are up 17%, close to the 15% increase in their 2021 estimates.

For the broad market, estimates for 2022 have risen 24% since the beginning of the year. There is a myth that “earnings estimates are always too high,” and this was clearly contradicted by the increases this year, with analysts scrambling to catch up with the improving economy. The estimates for 2022 may prove to be optimistic, but so far, they appear to reflect the vigorous reopening that many expect. If forecasted earnings growth materializes, it will provide a rationale for continued positive stock market returns without relying on multiple expansion.

Increasing Earnings Estimates vs Total Returns

Source: Bloomberg; Miller/Howard Research & Analysis.
*First Quarter of 2021: As of March 31, 2021; % Change in earnings estimates is between estimates as of 12/31/2020 vs. 3/31/2021.
**First Half of 2021: As of June 30, 2021; % Change in earnings estimates is between estimates as of 12/31/2020 vs. 6/30/2021.

   

In one remarkable recent example, you may have read about a contested election at ExxonMobil, a major energy company. Shareholders largely supported some director nominees that the company opposed, sending a strong message of investor dissatisfaction with the current board and company strategy, particularly as it relates to climate.

Corporate watchers and many stakeholders know that the annual meeting format provides an opportunity for investors. Investors can send a message of support or opposition by voting on management proposals and bring concerns or new issues to the attention of the company and other shareholders by filing and voting on shareholder proposals.

Roughly speaking, for most public companies: shareholders oversee the Board, the Board oversees the CEO, and the CEO oversees the company. We believe that investors have an important role to play with companies in creating a sustainable, equitable, and profitable market. That is why Miller/Howard takes the active voting of proxy ballots so seriously. We look at each proposal and vote based on our ESG-aligned Proxy Voting Policy, which intends to prioritize the interests of our clients.

ExxonMobil (XOM) was not held in any Miller/Howard strategies as of May 31, 2021.

   

Midstream energy companies are yielding over four-times the S&P 500’s yield, a wide spread relative to most of history.

The yield in midstream is also higher than its own history, although it has come in since the volatile 2020 period, which is to be expected. Given trends towards financial discipline in the sector, we believe today’s high yield is well supported. We also view midstream energy’s high yield as diversifying within a client’s income portfolio.

In the recent webcast, Midstream Marvels: An ETF Strategy for the Low-Rate Landscape, John Cusick, Portfolio Manager and Research Analyst, discusses:

• What is midstream energy?
• How does midstream’s high current income compare to other asset classes?
• How is midstream benefiting from financial discipline and better alignment with shareholder interests?
• How can Miller/Howard be an ESG manager in the energy sector?
• What is the outlook and opportunity in midstream energy?

Watch: Midstream Marvels: An ETF Strategy for the Low-Rate Landscape ►

   

Large US Banks:

Source: Executive Summary of the Fed’s December 2020 Dodd-Frank Act Stress Test, page 2. The common equity tier 1 capital ratio is the primary metric the Fed uses to judge bank capital adequacy.

What’s more, bank balance sheets continue to be strong, even in the additional December 2020 stress test using COVID-19 recession scenarios. As a group, despite doubling the reserves set aside for potential (but not realized) loan losses, banks actually improved their capital metrics during 2020, as earnings were substantially more than dividends paid. The money is literally “in the bank,” meaning that excess capital has accumulated.

Importantly for us, the Fed recently announced that it will once again allow banks to increase their dividends, provided they pass the June 2021 stress test.

Until then, buybacks in the first half of 2021 reduce shares outstanding, making dividend increases more affordable.

Read the 1Q 2021 Quarterly Report  ►

   

Value Outperformed Growth Post-Vaccine Announcement
Performance Pre- & Post-COVID Vaccine Announcement (S&P 500 Index Forward P/E Quintiles)

As of March 31, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

As we noted last quarter, announcement of Pfizer’s successful development of a COVID-19 vaccine caused investors to lose some of their infatuation with expensive stocks and move towards the value side of the market. When we made that observation, we were admittedly commenting on a short period of time, roughly seven weeks. Now that 20 weeks have passed, we can say with more confidence that the market has indeed changed course.

The chart above shows the performance of stocks split into price/earnings (P/E) quintiles at the beginning of 2020. Prior to the vaccine announcement in November 2020, the more expensive the quintile, the better the performance. Our interpretation is that investors, prior to any proof that a vaccine would work, were more willing to pay for the growth stories of expensive stocks rather than the cheaper earnings and dividends of value stocks. Essentially, investors thought there was no “bird in the hand” option given the uncertainties of the pandemic, so they might as well pay up for mega-cap growth stocks.

Following Pfizer’s vaccine news, the market did a full reversal—the cheaper the quintile, the higher the investment returns. The vaccine news gave investors confidence that they could rely on the near-term earnings forecasts and dividends that make value stocks attractive. Of course, we have seen continuing good news since November 9th that helped keep the value rally alive, including additional vaccines authorized in the US and globally. After a sluggish start, US vaccination numbers began to surge in February, and it was announced that all American adults would be eligible for vaccines by April 19th. We also have seen COVID-19 cases drop from 2020 highs and the unemployment rate continue to fall. These are still not the best of times, but enough is going right for confidence to rebound.

Performance Pre- & Post-Vaccine Announcement

As of March 31, 2021. Source: Bloomberg; Miller/Howard Research & Analysis. High-Dividend-Yield Stocks consists of Decile 7, 8, & 9 of a universe of US dividend paying common stocks with a market capitalization or greater than $4 billion. FAANG + MSFT= Facebook, Apple, Amazon, Netflix, Alphabet (Google), & Microsoft.

Vaccine news did more than shift the market towards value. The graph above shows other indications of investors shifting away from mega-cap growth stocks towards equity categories that have struggled in recent years. Stocks dubbed the Super Six, Facebook, Apple, Amazon, Netflix, Alphabet, and Microsoft, outperformed the market massively during 2020 prior to the vaccine news. The Super Six somehow morphed from stocks with exciting long-term growth stories to places to hide your money when it seemed like the pandemic would never end. Since the vaccine news, the Super Six have trailed the broader market.

Value, Dividend Yield, and Small Cap Rotation Continues

Since the vaccine news, the S&P 500 Index has continued to perform well, but the drivers of market performance are now value stocks and high-yield stocks. The recovery of small-cap stocks has been the most dramatic with the Russell 2000 Index up over 35% since the vaccine news.

The story on small-caps is a bit complicated:

• The small-cap universe is tilted towards cyclicals, so the value shift we saw in large-caps benefitted small-caps even more.
• We also saw growth investors move away from the mega-cap growth stocks towards small-cap growth stocks.

The rebound in small-caps is a good sign for both value and active management. Portfolio managers can, once again, be rewarded for sifting through long lists of potential investments from a wide range of market capitalizations, including stocks with good earnings and dividends that have been underappreciated by the market.

High-Dividend-Yield Stocks Are Trading at a Valuation Discount While Offering a Significant Yield Advantage Relative to History

As of March 31, 2021. Source: Bloomberg; Miller/Howard Research & Analysis. High-Dividend-Yield Stocks consists of Decile 7, 8, & 9 of a universe of US dividend paying common stocks with a market capitalization equal to or greater than $4 billion.

Despite the recent rally, the universe of high-dividend-yield stocks remains attractive relative to both long-term bonds and the broad stock market, in our view. The graph above shows how P/E multiples and yields have varied over time, using a wide-range of market capitalizations for the high-dividend-yield universe. The spread in both yields and valuations of high-dividend-yield equities versus both the S&P 500 and long-term bonds remains high, suggesting a good entry point for investors considering high-dividend-paying stocks.

Read the 1Q 2021 Quarterly Report  ►

   

The graph below shows the annual investment returns of the S&P 500 Index going back to 1993. We have decomposed returns into dividends, growth in expected earnings, and the change in the forward price-to-earnings (P/E) multiple.

Observations:

• Dividends are always positive, and the yield on the broad market is steady.
• Earnings increase in most years, consistent with a growing economy. Earnings growth does, however, vary much more than dividend returns.
• P/E multiples soar and plunge, causing much of the variation in stock market returns.

Stock market investors are so used to fluctuations in P/E multiples driving variations in returns that they rarely pause to consider how remarkable the concept is. Suppose you are considering buying a small business—how would you calculate your potential return? The first consideration would be the annual income the business would provide you. Second, you would want to forecast how fast earnings will grow—clearly a critical element of investment returns. Lastly, you may think about any change in how much other investors might be willing to pay for a dollar of earnings. The last point sounds like an afterthought until you realize that this is the P/E ratio, the primary fuel for stock market debates.

Contribution to Returns: Dividends and Earnings Growth Have Been More Reliable
S&P 500 Index Calendar Year Total Returns and Composition

As of December 31, 2020. Source: Bloomberg.

The good news for long-term investors is that while changes in P/E multiples are important in the short term, they have not dominated long-term returns. The chart below shows the annualized decomposition of the S&P 500 returns over 1993-2020, the same years shown in the calendar year graph on the first page. Despite the drama that P/E changes cause year-to-year, the impact on S&P 500 returns during the entire period has been less than the dividend yield and less than a quarter of earnings growth.

Historic Mix of Stock Market Returns
S&P 500 Index Total Returns and Composition

Data: 12/31/1992-12/31/2020, annualized.
Source: Miller/Howard Research & Analysis. High-dividend-yield stocks are defined as members of the S&P 500 Index that fall within deciles 7 thru 9 by dividend yield (with 1 being lowest; 10 highest). Members without an available historical estimated forward P/E have been excluded from the group.

In summary, the broad market has offered good but volatile returns with roughly a fifth of return coming from dividends, a seventh from multiple expansion, and fully two-thirds from earnings growth. We will argue that the future will look quite different, but let’s first look at the historic decomposition of returns for high-dividend-yield stocks. As you can see, the overall return for high-dividend-yield S&P 500 stocks is a tad higher than the S&P 500 for this period. This should not be a surprise—in Miller/Howard’s Q3 2020 Quarterly Report (on page 5), we showed that high-dividend-yield stocks have had better long-term returns over many decades compared to the S&P 500. The important point here is that the mix of return factors for high-dividend-yield stocks has been substantially different. As expected, dividend yield is a larger component of return, but what may be surprising is that multiple expansion has been a larger component for high-dividend-yield stocks than for the market as a whole.

This is only surprising because it runs counter to recent history. The chart below shows how the average P/E for the broad market has soared in the past two years, driven by significantly greater multiple expansion for the most expensive quintile of stocks.

Similar to the Tech Bubble, Today’s High Valuation Is Driven by the Most Expensive Stocks
S&P 500 Index: Forward P/E

As of March 31, 2021. Source: Bloomberg; Miller/Howard Research & Analysis.

Time will tell how this plays out, but the graph looks suspiciously like the P/E expansion that occurred during the Internet/New Economy Bubble in the late 1990s. The P/E graph for high-yield stocks is less dramatic but has grown over time simply because interest rates have trended down. At Miller/Howard, we favor high-yielding stocks with the potential for significant earnings growth, but a material number of high-dividend payers can be considered bond proxies—companies with little earnings growth but steady dividends. As bond prices have inflated over the long term, it follows that the prices of bond proxies would keep pace. As evidence, the graph on the left shows that the P/E of the two sectors with the most bond proxies, utilities and consumer staples, have indeed inflated over time.

As of March 31, 2021.
Sources: Bloomberg; Federal Reserve Bank of St. Louis (FRED); Miller/Howard Research & Analysis. Bond proxies are represented by utilities and consumer staples. High-dividend-yield stocks are defined as members of the S&P 500 Index that fall within deciles 7 thru 9 by dividend yield (with 1 being lowest; 10 highest).

The Tide May Be Turning for P/E Expansion

Historic returns are interesting, but what we really care about is future returns. Looking out over the coming decades, we expect dividends and earnings growth to remain important for investment returns, but we expect the returns from P/E multiple expansion to be zero at best.

Naturally, P/E expansion and contraction will continue to cause year-to-year fluctuations, but we expect zero or even negative returns from P/E multiple changes over the longer term. Why? First, higher P/Es come from ascribing more value to earnings in distant years. When considering a single stock, clearly investors can become more optimistic about earnings in the outer years, but is that plausible for the market as a whole? A much simpler explanation for higher average P/Es is the long-term downward trend in interest rates, causing distant earnings to be less discounted. This implies that ever-higher market multiples would require even lower long-term interest rates–an unlikely prospect given their low starting point today.

No doubt you can find an experienced equity investor who says something like, “I don’t link stock prices and interest rates. Things get better over time. I’ve been doing this for forty years and have developed intuition.” But forty years is not enough! We’ve been in a bond bull market for forty years. The entire career of most equity investors has taken place while long-term interest rates have trended down. How can you trust your intuition on multiple expansion when it has been trained in a largely one-way market?

Despite the recent run-up in interest rates, bond prices are volatile enough that no one can say for sure that the 40-year bond bull market is over. There are strong indications, however, that we may be at a turning point. Last August Federal Reserve Chairman Jerome Powell announced that the Fed would target an average of 2% inflation, allowing inflation to run over 2% for periods of time without policy adjustments. This could prove to be a big change from treating the 2% inflation target as effectively a third rail—tightening before touching it. Another reason to be bearish on long-term bonds is the significant increase in spending in response to the pandemic. This will require a large increase in bond supply, much of it at the long end. The market will likely require higher rates to absorb the new issuance.

The second reason investors should not depend on returns from multiple expansion is that we are beginning from an already high P/E. As a point of reference, the forward P/E for the S&P 500 at the end of 2020 was higher than at the end of either 1998 or 1999. Gray-haired investors remember the late 1990s well, and will recall many similarities. Many large-cap companies, such as Microsoft and Cisco, were going to change the world, and arguably did, but proved to be poor investments for years following their peaks. Today we have many equally exciting companies, but investors have always reached a limit on the P/E multiples they are willing to pay. Combining this argument with the nascent trend towards higher long-term interest rates, it seems much more likely that the S&P 500’s P/E will average below recent highs, not above.

But market P/E multiple compression does not necessarily portend poor investment results—it just means that investors need a plan with regards to all three return factors. The chart below shows the sources of investment return for the S&P 500 and high-dividend-yield S&P 500 stocks over time. At first blush, you might be pessimistic, thinking that dividend yields are low relative to your total return expectations, earnings growth is volatile, and P/E changes are even more volatile and likely to be negative going forward. We view it differently.

Miller/Howard’s View on the Sources of Investment Returns

As of December 31, 2020.
Source: Bloomberg; Miller/Howard Research &Analysis. High-dividend-yield stocks are defined as members of the S&P 500 Index that fall within deciles 7 thru 9 by dividend yield (with 1 being lowest; 10 highest). Members without an available historical estimated forward P/E have been excluded from the group.

The graph below shows the distribution of forward P/Es across the stocks in the S&P 500 weighted by market cap. Remarkably, 8% are trading at a multiple above 50x. Cumulatively, 24% of the value of the S&P 500 is currently in stocks that trade at more than 30x this year’s expected earnings—a historically high number. These are the stocks that we think are most at risk of multiple compression, as rising interest rates reduce the value of their decade-out earnings projections, even if those often-rosy assumptions are realized. But also note the other end of the graph. There are plenty of stocks with P/Es well below the market average of 27x. We believe that the best defense against multiple contraction is constructing portfolios of stocks with high dividend yields and earnings growth potential that are trading at reasonable valuations.

Percent of S&P 500 Index Stocks with Expensive Valuations at a Historic High
Market Cap Weighted

As of March 31, 2021. Based on forward P/E. Source: Bloomberg; Miller/Howard Research & Analysis.

Overall, we continue to be optimistic that the stock market will remain a good source of both income and total returns. Returns in the last couple of years have been dominated by P/E multiple expansion. It’s easy to get caught up in the stampede towards expensive stocks. But bear in mind that multiple expansion has not been the principal driver of long-term investment returns over the last few decades, and it is quite likely to be negative for the overall market going forward.

Timing the drop in the market multiple is tricky, but we are confident that portfolios focusing on dividends and earnings growth can navigate these difficult waters, generating both dependable high-and-growing income and total returns.

Read the 1Q 2021 Quarterly Report  ►

   

• Miller/Howard’s goal is to serve the interests of our clients and to work with energy and utility companies, pushing them to be better corporate citizens and sustainable businesses.
• Engagement moves industry to better practices, increased disclosure, and heightened transparency.

Miller/Howard welcomes this conversation, buoyed by conviction and decades of experience in the engagement space. We focus on engagement, an effective mechanism of change through which we encourage companies to be better corporate citizens.

We speak from the perspective of realists who understand that, at such a critical time in our economy and world, we need all hands on deck.

We effect change now by engaging companies on difficult questions—moving the industry to better practices, increasing disclosure, and heightening transparency faster than regulators can. That happens with engagement.

Miller/Howard has learned that investor voices are powerful in dialogues with companies and in dialogues with regulators.

We ask companies to adhere to identified best practices, look at the long-term picture, utilize resources appropriately (including energy, water, and people), and be efficient and innovative. We work to foster working—not adversarial—relationships with company management, having found through experience and research that such an approach is best, even if the conversations can be difficult and the asks, tough.

Miller/Howard’s goal is to serve the interests of our clients and to work with companies, pushing them to be better corporate citizens and sustainable businesses. We see it less as a question of “How can we be an ESG manager in the energy sector?” and more a question of “How can we not be?”

Shareholder Advocacy & Engagements: Analysis Becomes Action in the Energy Sector

By means of letters, conversations, comparisons to peers, and submitting and/or supporting shareholder proposals, our work over the last year encompassed a variety of environmental, social, and governance issues.

Recent Engagements

Highlighted Initiatives:

• More disclosure on environmental management, including policies, practices, and metrics
• Action supporting increased board gender diversity and improved governance
• Improved disclosure, management, and/or structure of executive compensation plans
• Other ESG issues, such as:
  • Disclosure of lobbying & political spending policies
  • Policy requiring an independent chairperson
  • Public support of reasonable methane regulations

Engaged Companies:

• AES
• Black Hills
• CenterPoint Energy
• CF Industries Holdings
• Cheniere Energy
• Concho Resources
• Continental Resources
• Devon Energy
• Dominion Energy
• Eaton Corporation
• EOG Resources
• ExxonMobil
• Kinder Morgan
• Marathon Petroleum
• National Fuel Gas
• Occidental Petroleum
• Oneok
• Pioneer Natural Resources
• PPL
• Tallgrass Energy

We also work as part of Climate Action 100+, “an investor-led initiative to ensure the world’s largest corporate greenhouse gas emitters take necessary action on climate change.”ⁱ

Read more about these efforts in our Annual Engagement Report on our website.

i Climate Action 100+ website

  

Large US Banks: Dividend Changes

* As of December 22, 2020.
Source: Bloomberg; Miller/Howard Research & Analysis. Large US Banks are defined as those that currently participate in Fed stress testing. The Federal Reserve halted dividend increases in June 2020.

At the outset of the pandemic, strong voices called for the elimination of bank dividends. The argument was that banks would need as much capital as possible to cover credit losses caused by COVID-19. The Fed took a more moderate view, halting dividend increases but allowing dividends to continue as long as they were covered by earnings over the trailing four quarters. In contrast, the Fed stopped all share repurchases. Banks had been spending more than double on share repurchases relative to dividends, so the prohibition on buybacks did much to bolster balance sheets.

Following the annual bank stress test in June, the Fed announced that banks would be put through an additional stress test in the fall using Coronavirus-driven recession scenarios. Based on this analysis, the Fed announced on December 18th that the largest banks have more than enough capital to continue lending even if the economy deteriorates significantly from here. Dividend increases are still on hold, but the Fed is once again allowing share repurchases.

The key point in the Fed’s analysis is just how strong bank balance sheets are now. As a group, despite doubling the reserves set aside for potential (but not realized) loan losses, banks actually improved their capital metrics during 2020, as earnings were substantially more than dividends paid. The Fed’s stamp of approval on bank credit metrics should build investor confidence, based on the Fed’s unique ability to peer into non-public details of each bank’s financial health.

Capital Metrics Improved in 2020

* Source: Executive Summary of the Fed’s December 2020. The common equity tier 1 capital ratio is the primary metric the Fed uses to judge bank capital adequacy.

What does all this mean for income investors? Out of the 22 large US banks, only Wells Fargo and Capital One (neither is owned by Miller/Howard) cut dividends during 2020. Banks proved to be a reliable source of dividends, even during a difficult period. It is true that the Fed has not yet allowed the dividend increases that we seek, but the money is literally “in the bank,” meaning that excess capital has accumulated. We expect regulators to allow dividend increases once we get closer to the end of the pandemic, provided credit losses are not substantially above expectations. In the meantime, buybacks reduce shares outstanding, making dividend increases more affordable.

Link to the 4Q20 Quarterly Report  ►

  

Pfizer Vaccine: Cumulative Incidence Curves for the First COVID-19 Occurrence After Dose 1

* Source: FDA/Pfizer-BioNTech COVID-19 Vaccine VRBPAC Briefing Document,page 58. Pfizer Vaccine: BNT162b2 (30mg). As of November 17, 2020. As of December 31, 2020, Pfizer was held in Miller/Howard’s Income-Equity Strategy; Moderna was not held in any Miller/Howard strategies.

Pfizer’s clinical results were indeed excellent, first described as “over 90%” effective and then shown to be 95% effective when the results were formally presented to the FDA. Pfizer was quickly joined by Moderna with its own vaccine, based on the same messenger-RNA technology, also with roughly 95% effectiveness. In a year of unrelenting bad news, the success of these clinical trials gave the market some visibility into how the pandemic would end.

In past quarterlies, we have shown how uncertainty created by COVID-19 combined with associated low interest rates pushed the market to favor large-cap growth stocks. Essentially the market looked at the next year and shrugged—why buy stocks based on near-term earnings and dividends when the short-term felt so uncertain? The mega-cap growth stocks seemed to offer earnings growth “forever” without any hard thinking about how the pandemic would be resolved. Investors view earnings far into the future as worth less than earnings now, but extremely low interest rates meant that forecasts of earnings and dividends in the 2030s did not require much discounting. The stampede into mega-cap growth stocks created a headwind for both value stocks and small- and mid-cap stocks. Income stocks were collateral damage, as the expensive mega-cap growth stocks do not pay good dividends, if they pay at all.

Performance of Expensive Stocks Was Highly Unusual in 2020
S&P 500 Index Forward P/E: Quintile 1 vs Quintile 5

* As of December 31, 2020.
Source: Bloomberg; Miller/Howard Research & Analysis. Quintile 1 is cheapest; Quintile 5 is most expensive.

The market turned sharply, beginning the day Pfizer announced the positive news. Let’s first look at the performance of value stocks. The chart above shows the long-term performance of the cheapest quintile versus the most expensive using forward P/Es (price to earnings ratio) as our value metric. In most years, the cheapest quintile of stocks has outperformed the most expensive. For 2020 as a whole, expensive stocks outperformed by a magnitude not seen since 1999. The chart below breaks 2020 into two parts: before and after the vaccine news. Prior to November 9th, the more expensive the quintile, the better the total return. Following the vaccine news, the results reversed in favor of value with cheaper quintiles doing progressively better.

Value Outperformed Growth Post-Vaccine Announcement
S&P Performance Pre- & Post-COVID Vaccine Announcement (S&P 500 Index Forward P/E Quintiles)

* As of December 31, 2020.
Source: Bloomberg; Miller/Howard Research & Analysis.

Will the value rally continue into the new year?

This year has taught us all how difficult it can be to forecast the future, but the set-up remains good, in our opinion. Value rallies typically begin when the spread between expensive and cheap stocks is wide. Comparing forward P/Es for the Russell 1000 Growth Index versus the Russell 1000 Value Index, the spread remains wide despite the market’s recent turn towards value (see chart below).

The Valuation Spread Between Growth and Value Remains Wide
Russell 1000 Value and Growth Indices, Forward Price/Earnings

* As of December 29, 2020. Source: Bloomberg.

Another trend this year has been the outperformance of large-cap stocks. The Super Six (Microsoft, Apple, Amazon, Google, Facebook, and Netflix) accounted for about 60% of the total return of the S&P 500 Index. Weighting by market capitalization has been important to the returns of the S&P 500 (see chart below). The unweighted version of the index trailed for the year, but this relationship reversed significantly following the release of the vaccine news. As with value stocks, the partial lifting of the fog of uncertainty surrounding the pandemic has prompted more investors to look beyond the mega-cap growth stocks.

Vaccine Announcement Reversed Cap-Weighted Leadership

* As of December 31, 2020.
Source: Morningstar; S&P; Miller/Howard Research & Analysis. Based on the total returns of the S&P 500 Index and the S&P 500 Equal-Weighted Index.

Value, mid/small capitalization, and income investing are three distinct disciplines, but their fates have been intertwined recently given the run-up in mega-cap growth stocks. We’ve seen that value and mid/small capitalization returns improved significantly following Pfizer’s vaccine news, but what about income stocks? We define high-dividend stocks as those with yields in deciles 7-9 when dividend payers are sorted from highest to lowest, with the riskier highest-yielding stocks in decile 10 not included. The chart below, the returns of these high yield stocks versus the S&P 500 and the Super Six, both before and after the announcement of the vaccine results. As you can see, high yield stocks have begun to outperform the broader market while the mega-cap growth stocks have slowed.

High Yield Stocks: 2020 Performance

* As of December 31, 2020.
Source: Bloomberg; Miller/Howard Research & Analysis. High-Dividend Yield Stocks consists of Decile 7, 8, and 9 of a universe of US dividend paying common stocks with a market capitalization or greater than $4 billion. FAANG + MSFT= Facebook, Apple, Amazon, Netflix, Alphabet (Google), and Microsoft.

Looking Forward

We continue to view this as a good entry point for dividend stocks. The charts below show that dividend stocks remain cheap relative to the broader market and offer superior yields relative to both the S&P 500 and Treasury bonds.

What can go wrong? From a multitude of risks, we’ll focus on three we are monitoring. Regarding the vaccines, there will be production and logistical challenges, but those problems should be resolved given the high stakes. Not so easily set aside is the risk of the virus mutating in such a way that it is no longer prevented by available vaccines. Scientists should be able to respond with an updated vaccine, but time is critical, and we would hate to see this turn into the biological equivalent of “whack a mole.”

High-Dividend Yield Stocks are Trading at a Valuation Discount While Offering a Significant Yield Advantage Relative to History

* As of December 31, 2020.
Source: Bloomberg; Miller/Howard Research & Analysis. High-Dividend Yield Stocks consists of Decile 7, 8, & 9 of a universe of US dividend paying common stocks with a market capitalization equal to or greater than $1 billion.

The vaccine will be supply-constrained early in its rollout, but at some point during 2021, we will learn about the impact of our second major risk: reluctance to take the vaccine. Combining the Pfizer and Moderna clinical trials, the scientific results are based on double-blinded studies including more than 60,000 people. Yet some individuals will have qualms about the vaccine—some may decline while others delay—and this may reduce the number inoculated below the threshold required for a return to normal life.

A significant increase in long-term interest rates is the third major risk we will be monitoring. If all goes well and the economy comes roaring back, long-term interest rates would likely rise. For the reason why, just ask yourself why anyone would tie up their money in a good economy to earn 1%. But higher rates come with their own risks. The high multiples on many growth stocks can only be justified by placing high value on earnings expected more than a decade from now. These far-off earnings will be worth less if rates rise. Conversely, financials should do better given higher interest rates and many cyclicals would benefit from a strong economy. But mega-cap growth stocks form a large chunk of broad indices, so the overall market is vulnerable to higher rates. Just as we saw pundits wonder why the market was up in a terrible 2020 (answer: interest rates), we may very well see pundits asking why the market is falling once the economy truly rebounds.

We continue to see dividend stocks as sound investments. The stocks in our income strategies proved to be reliable dividend payers, even in a difficult year. We seek to invest in companies that have the earnings power to pay dividends now, keeping us away from risky stocks with frothy valuations.

Link to the 4Q20 Quarterly Report  ►

  

Utilities offer attractive "unfixed" income—high dividend yields, with prospects for growth.

With renewed volatility in the markets, it may be a good time to think about an allocation to utilities.

What may come as a surprise to investors is that the traditionally-defensive utilities sector has significantly lagged S&P 500 Index year-to-date*. Utilities have underperformed by over -11% as a handful of mega-cap stocks have driven the broad market higher.

As of August 31, 2020
Source: Bloomberg; S&P; Miller/Howard Research & Analysis

We view today’s environment as a unique valuation opportunity in utilities.

The dividend yield for utilities stocks relative to the US 10-year Treasury yield peaked on March 23, 2020 during the COVID-19 market panic. The spread remains near historic highs, even six months later. Today’s spread between the utility sector dividend yield versus 10-year Treasury yield remains in the 99th percentile relative to the past 25 years.

As of August 31, 2020
Source: Federal Reserve Bank of St. Louis

This is largely driven by one half of the equation: the 10-year Treasury is near historic lows. To frame it from an income-perspective, a client with $1 million in savings invested in the 10-year Treasury can expect an annual income of roughly $7,000.** Looking at the Miller/Howard Utilities Plus portfolio, with a current dividend yield of 3.6%, that same $1 million could hypothetically produce an annual income of $36,000 in year one.***

Utilities are, traditionally, a more stable source of income for bond investors who are tired of meager income. With a high current yield—5-times the 10-year Treasury yield—and a strong track record of income growth, utilities can be a powerful alternative to fixed income.***

Sources: Bloomberg, S&P 500 Utilities Index, S&P 500 Index, Federal Reserve Bank of St. Louis, Miller/Howard Research & Analysis
* As of September 21, 2020
** Source: Federal Reserve Bank of St. Louis Economic Research - 10-Year Treasury Constant Maturity Rate (DGS10), as of August 31, 2020
*** Based on the Miller/Howard Utilities Plus portfolio dividend yield as of August 31, 2020

  

More than 200 US companies announced dividend cuts in the first half of 2020, greater than double what we typically see in a full year. Many of the cutters were well-known companies such as General Motors, Disney, and Boeing. Miller/Howard strategies largely avoided dividend cuts. We had no cuts in our Income-Equity Strategies with one possible exception of Coca-Cola European Partners, a twice-yearly payer, delaying its second quarter dividend until they have better visibility.

As of June 30, 2020.
Source: The Wall Street Journal; S&P Capital IQ; Eikon; FactSet; StreetAccount; Miller/Howard Research & Analysis. Based on US companies and public investment funds (REITs, etc). Year-to-date 2020 dividend data are based on stocks with market capitalizations >$1B, as tracked by Miller/Howard Investments. Data prior to 2020 are sourced from the Wall Street Journal and S&P Capital IQ.
As of June 30, 2020, GM, F, DAL, M, DIS, BA were not held in Miller/Howard's Income-Equity Strategies.

Our success in largely eluding dividend cuts comes principally from avoiding stocks with high leverage. The chart below shows the cumulative distribution of leverage, measured by Net Debt/Trailing EBITDA, for the entire dividend-paying universe (excluding financials). As the chart shows, median leverage for the universe was 2.5x, a half-turn higher than our Income-Equity Strategy at the end of Q1. Over the course of the second quarter, we moved our Income-Equity holdings towards firms with less leverage, ending the quarter with a weighted average of 1.6x.

In contrast, dividend cutters on average had much more debt, averaging 3.3x. The dividend cuts in 2020 have confirmed Miller/Howard's belief that dividends from highly-leveraged companies are not reliable.

As of June 30, 2020.
Source: Eikon; Bloomberg; MHI Research & Analysis.
Bloomberg Screen: All US-traded equities with a market cap >1B and with a dividend yield >0% on 12/31/2019 and were paying a dividend on 3/31/2020. Top/Bottom 5% of outliers are excluded from both cutters/suspenders universe, and all dividend-payers universe. Financials are excluded. Stocks where data is not available are excluded.
* Simple average
** Weighted average

Dividend cuts had a big impact on stock performance. Dividend cutters were down 39% over the first half of the year. On average, the dividend cutters fell 49% prior to announcing the cut, as the market anticipated what was coming. On average the cutters rebounded somewhat following the cut, along with the rest of the market. To answer a common question: no, buying a stock ahead of a dividend cut doesn't lead to a single certain result. Some stocks will continue to plummet while others rally. What's clear is the importance of staying away from companies that could be forced to eliminate their dividend. This remains a pillar of Miller/Howard's approach to active management of dividend equity portfolios.

Read the 2Q20 Quarterly Report  ►

DEFINITIONS

• Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)—A non-GAAP measure used to provide an approximation of a company's profitability. This measure excludes the potential distortion that accounting and financing rules may have on a company's earnings; therefore, EBITDA is a useful tool when comparing companies that incur large amounts of depreciation expense because it excludes these noncash items, which could understate the company's true performance.
• Net Debt to EBITDA—A measure that computes the company's ability to pay off its debt by utilizing the earnings before interest, taxes, depreciation, and amortization (EBITDA).

  

Investors have an opportunity to provide opinions and oversight when a company holds its annual shareholder meeting. The meeting agenda, often available in the proxy statement, features a variety of ballot items (called resolutions or proposals) on which investors are asked to vote. These may include ratification of independent auditors, advisory approval of executive compensation plans (Say-on-Pay), election of directors, and yes or no votes on shareholder proposals. Voting on these is the right of every shareholder.

For each item on the ballot, management will typically issue a voting recommendation. It is widely known that management generally recommends that investors vote FOR whatever resolutions it has put forward, and AGAINST resolutions shareholders have added to the ballot.

Management’s recommendations may very well be sound and fully explained in the proxy statement. Nevertheless, Miller/Howard strives to prioritize investor interests above management’s recommendations. We actively review and vote each item on the ballot according to what we believe best serves our clients.

Accordingly, Miller/Howard finds itself sometimes voting against management recommendations. Many other investment managers vote with management more frequently, as the chart on the following page shows.

• Each annual meeting, investors have an opportunity to provide feedback to management. Investors can rubber-stamp management’s recommendations, or they can vote actively and according to their own interests.
• Miller/Howard reviews each ballot and votes based on our view of what’s in our client’s best interest. In the example above, we voted against an executive pay package (there was a pay/performance disconnect), and for a shareholder proposal that seeks greater transparency around a company’s management of environmental issues, such as emissions and climate change.
• You can see where management told us to vote one way and we voted another, and also that we sometimes vote with management recommendations.

Why Vote against Management?

Here are some examples:

• We believe a report on climate risks would serve the company and its shareholders well. We would then vote for the shareholder proposal, when management suggests we vote against it.
• Insufficient gender diversity on the board, which can speak to the style of governance as well as the company’s approach to competitive recruitment and positioning. We would vote against directors on the nominating and governance committee.
• Pay and performance disconnect. We would vote against the advisory Say-on-Pay proposals, which communicates shareholder opposition to the company’s executive compensation package.

But it’s not just about the vote: A company’s response to the vote can indicate the quality of management. While many, if not all, of the items on a proxy ballot are considered advisory—e.g., information for management but not binding on their actions—we believe that strong corporate governance requires sensitivity to the views of shareholders. If a substantial number of investors vote against the company’s executive compensation program, management should consider this both actionable and material feedback. If a company chooses to ignore such messages, it can serve as a lesson and a warning for investors.

Votes cast at meetings that took place in FY 2019.
Source: Morningstar; Miller/Howard Research & Analysis
*Based on the percentage of proxy votes that were voted contrary to Management’s recommendation, averaged across 50 large fund families, as calculated by Morningstar based on its Proxy Data.

Learn more in our Shareholder Advocacy & Engagement Report

  

Recent market gyrations have brought this dichotomy into stark relief. The S&P 500 Index peaked on February 19th, then fell by roughly a third over the next five weeks. Since then the market has shot up, rising roughly 40% through quarter end. From the standpoint of a short-term barometer, the market swings are easy to explain. Initially, the market's take on the coronavirus was to ignore evidence that a pandemic had started. Panic set in when it became clear that western democracies would partially shut down their economies to control the spread. Markets roared back when both governments and central banks around the world made it clear that there would be a nearly limitless amount of stimulus applied to the ailing economy. The market recognized that the economy would survive, even as the number of COVID-19 cases and deaths trended higher.

While this year's market swings make sense as a gauge of sentiment, these fluctuations are impossible to understand from the standpoint of long-term investing. The coronavirus p­resents an enormous healthcare challenge, but in our opinion its economic impact will be finite and relatively short-term. Either a vaccine will be developed, or the disease will run its course through the population. The latter scenario ended the pandemic a hundred years ago. From a human standpoint, that was a tragic outcome, but it did end after a couple of years. We all hope for a successful vaccine, but in any case, the duration of the pandemic will be limited.

By contrast, equities are truly long-duration assets. Stock prices reflect forecasted earnings far into the future. When a stock trades at a price/earnings (P/E) ratio of 20x, the value of next year's earnings is roughly 5% of the total equity's value. So even if earnings are zeroed out for an entire year, the rational drop in market value would be on the order of 5%—not the wild price swings we have seen.

Even sectors with little change in earnings estimates, such as healthcare, tech and utilities, still endured wide swings. Only the downturn in the airlines makes sense given the possibility of major bankruptcies. Otherwise, we can only conclude that the equity market is highly volatile, far more than could possibly be explained by any sort of rational financial analysis.

Implications of Market Volatility

Even to experienced investors, wild market swings can be unnerving, but volatility also creates opportunity. Over the long-term, volatility is what scares many investors away from equities as an asset class. Bond investors clearly sacrifice long-term returns to avoid equity volatility.

The chart above shows the rolling average returns for high yield stocks, the S&P 500, government bonds and corporate bonds using 10-year holding periods. Equities outperformed bonds in all of these decades, showing the rewards for buy-and-hold equity investing.

What may surprise readers is that high yield equities (Deciles 7-9) outperformed the S&P 500 on average in every one of these decades. Naturally returns can look quite different over shorter periods, as we have seen recently. The outperformance of high-dividend yield stocks over the long-term primarily relates to what a dividend signals about a company and management.

Data are through December 31, 2019. Based on the rolling 10-year annualized total returns, ending each calendar year, averaged by decade.

Source: Miller/Howard Research & Analysis; 2019 Stocks, Bonds, Bills and Inflation ("SBBI Yearbook") and S&P 500 Index data as reported to Morningstar Direct. High Yield Stocks data is provided by Fama/French Research data library (value weighted deciles); Long-term government and corporate bond returns are based on the SBBI Yearbook.

Dividends are a Signal:

• Public companies are run by executives who are strangers to the average investor and should not be trusted blindly. A dividend is a commitment by management to run the firm quarter-after-quarter with shareholder cash return as a priority.
• While management statements should be treated with appropriate skepticism, executives know more about their business than shareholders do. By committing to a regular dividend, management is using more than just words to signal that they expect their business to be resilient, even in a changing environment.

In addition, dividends represent regular cash flow that can be reinvested to compound over time.

In recent years, high-yielding stocks underperformed the broad market. This has largely coincided with the underperformance of value stocks. Dividend investing and value investing are different disciplines, but the universes partially overlap. Many expensive stocks simply cannot afford to pay good dividends. (A company with a P/E of 50x, that pays out half of its earnings, would only yield 1%.)

Value has trailed growth during the last decade primarily for two reasons:

• The run-up of "Winner Take All" growth stocks such as Netflix, Amazon, and Facebook. Investors have rewarded these stocks with fulsome valuations, suggesting that they will maintain high growth rates for decades.
• The increase in bond surrogate stocks, such as some consumer staples and certain utilities, that have reliable dividends but have limited growth potential. Historically low interest rates have enticed some bond investors to buy bond-like equities.

Value investing tends to work best coming out of recessions, following periods in which investors have bid up the prices of stocks offering safety. The relative price of the cheapest 20% of stocks has varied over time, and March 18, 2020 saw a spread so wide it has only been seen two other times in history. Value rallies have typically started during periods of wide valuation spreads. The classic example was the end of the Tech Bubble which led to a sustained rally in value stocks that lasted seven years. Even with valuation spreads narrowing from the recent peak, they are currently just under the level seen at the peak of the Tech Bubble, leaving plenty of room for value to rebound.

In our view, the key catalyst needed for a value rally is for investors to see a clear path to the end to the pandemic. The case count increase in many states is clearly concerning, but we think there will be accommodations to allow the economy to recover. We continue to believe that most jobs can be restructured by social distancing, mask wearing, and temperature checks so that the economy can move forward. A successful vaccine would represent a bright green light, but we would expect the market to trade up strongly on initial news of successful clinical results for any of the hundred plus vaccines under development.

Value rally or not, we expect our dividend strategies to continue to produce reliable income. Over time, dividend income has proven to be an important component of equity returns, and dividends are much less volatile than the overall stock market. A key to dividend investing is avoiding dividend cuts which undermine the premise and the Miller/Howard strategies have largely avoided dividend cuts during this difficult period.

Link to the 2Q20 Quarterly Report  ►

Price-Earnings Ratio (P/E)—The ratio of a company's share price to its earnings per share. The ratio is used as a valuation tool and can help determine whether a company is overvalued or undervalued.
EPS—Earnings Per Share

  

Active Dividends

COVID-19 has ushered in an era of uncertainty for investors, and for now, we can’t be sure if a cure or a second wave is coming around the corner.

We believe dividend investors may be at an advantage in this uncertain environment.

Dividend investors understand that future stock prices are unpredictable, as stock prices can be driven as much by investor sentiment as by fundamentals. They understand that stock prices, historically, are more than six times more volatile than their underlying dividend cash flows (based on the S&P 500 Index from 1957-2019), as sentiment drives short-term prices while fundamentals drive long-term value.

• In the 62 years since the inception of the S&P 500 Index (1957-2019), price return has been negative 18 times with an average negative return of -11.5%.
• Dividend growth, on the other hand, has only been negative 6 times, with 2009 the only time it decreased by more than -3.5%.

Investors typically do not like to see unrealized losses on their statements. However, dividend investors tend to focus on the income line item on their statement instead. As long as the income continues, they can endure the market volatility and wait for stock prices to recover as the pandemic—or other market turbulence—wanes. In addition, during economic downturns, dividend investors may have an opportunity to use the income they receive to purchase additional shares at a discounted price. As we have written before, this can be especially beneficial when combined with the power of compounding dividends.

Periods of market stress often highlight the advantages of active management. This is especially true when managing for dividend stability.

The metrics that drive dividend stability and prospects for growth are more fundamental than sentimental. Active managers may ask:

• What is the company’s dividend obligation—and how committed is management to paying that dividend going forward?
• What is the dividend coverage ratio (i.e., how much is the company making versus the dividend payments)?
• Is the company’s leverage appropriate for the business and the industry?
• What other cash obligations does the company have in the near-term and medium-term?
• What are the company’s revenue and profit projections, and are they realistic? Passive strategies are unable to ask these questions.

Following the Global Financial Crisis, 2009 was a challenging year for dividends. For dividend investors (in particular, investors that rely on dividend income to meet their spending needs), the trauma of 2009 is a fresh memory. S&P 500 dividends declined by -21% in 2009, the largest decline by far throughout the history of the S&P 500.

Such a steep decline in dividend payments was especially jarring to investors that had quietly collected dividend payments and considered them a “safe” part of their portfolio. Investors in passive dividend ETFs quickly learned the shortcomings of an investment strategy that is determined by historical attributes (for example, a history of consistent dividend payments) versus prospects for and commitment to future dividend payments.

Source: Bloomberg; Miller/Howard Research & Analysis

One example, the iShares Select Dividend ETF (Ticker: DVY), which tracks the Dow Jones US Select Dividend Index, saw its dividend decrease by -37% for June 2009 versus June 2008. Making matters worse, the underlying index had its annual rebalance in March 2008, just as dividend suspensions were starting to surge.

Financials were at the center of the Global Financial Crisis. Compounding the pain for dividend investors, financials also made up a significant portion of dividends per share for the S&P 500 in 2008. The share of S&P 500 dividends for the financial sector shrank from 21% in 2007 to 5% in 2009. One condition of participating in the US Treasury’s Troubled Asset Relief Program (TARP) was that banks had to suspend their dividend payments. Not surprisingly, DVY was heavily exposed to financials at the time.

Active managers were able to follow the terms of TARP as it evolved and trade out of financials that were in danger of eliminating their dividends—but many ETFs, with their backward-looking rules, had to continue to hold these stocks. Too, the crisis eventually passed. Many dividend cutters found firmer financial footing and began to increase their payouts again, but certain ETFs couldn’t participate—they required a history of dividend increases that had been broken and reset.

Source: Bloomberg; S&P; and Miller/Howard Research & Analysis

Today’s corollary to TARP might be the CARES Act (Coronavirus Aid, Relief, and Economic Security Act) that also limits the payment of dividends by any company that borrows money from the US government. In many cases, this restriction lasts for one year after the loan is paid back. But unlike TARP, that focused on the financials sector, the CARES Act could restrict dividends for companies across all sectors—though some sectors, such as energy and consumer discretionary, will likely be more impacted than others.

Ultimately, the impacts of COVID-19 are widespread, and simply selecting the ‘right’ sectors or industries may not be enough to protect dividend income.

Past dividends do not guarantee future results.

In our view, investors should, instead, invest in high quality companies with the financial strength to make it through the trough. Bottom-up fundamental research can provide insight into which companies may be over-levered and which firms have strong balance sheets to ride out a period of economic instability. Active management can help to identify the prudent companies that planned for an economic downturn.

Actively managing for dividend stability means finding companies that are best able to continue to pay their dividends, and will be ready for dividend growth when the current storm passes.

The best feature of passive approaches—broad exposure to an investment objective like dividend income—may become a liability during times of stress, when investors want to avoid weaker companies. This has become more of a challenge over the last few years with the 10x growth in the number of passively-managed dividend and low-volatility ETFs.

Recessions and periods of market stress are triggered by a broad range of events. But the factors and company fundamentals that signal a stock’s dividend stability remain consistent during the full market cycle. Throughout our history, we have focused on those signals: high dividend yield, prospects for dividend growth, financial strength, and earnings stability.

Sources: S&P, Robert Shiller (http://www.econ.yale.edu/~shiller/data.htm), and Miller/Howard Research & Analysis

  

We expect the growth of renewable energy to be a multi-year tailwind for utilities companies.

In its Annual Energy Outlook 2020, the US Energy Information Administration (EIA) said it expected electricity generation from renewables to surpass coal in the coming years, and it estimated that nearly 75% of US power generation will be from the combination of cleaner-burning natural gas and renewable power sources by 2050.¹ In fact, the EIA reported that we already saw renewables surpass coal in May 2020.²

EIA expects U.S. electricity generation from renewables to soon surpass nuclear and coal ►

Source: US Energy Information Administration (EIA), Monthly Energy Review May 26, 2020

The coal to natural gas and renewables switch is still in the early innings, and we see a significant growth opportunity for utilities in renewables, in particular.

Notably, the growth trajectory is reinforced by public opinion and regulatory support:

• 26 states have green house gas emissions targets—and 65% of the US population resides in these states
• 29 states have adopted the Renewable Portfolio Standard
• 11 states have a 100% clean energy goal or mandate—these are long-term targets, typically ranging from 2040-2050

While commitment levels and timetables vary, we think, in aggregate, these initiatives will provide a tailwind for the utilities space.

Source: UCLA Luskin Center for Innovation; Center for Climate and Energy Solutions; Miller/Howard Research & Analysis, 2019

Clearly, this transition will require significant capital deployment from utilities companies. Utilities do have to balance capital deployment plans against the impact on consumer bills, but utilities have also stated that they have huge backlogs of potential projects. As a reminder, in the utility model, rate-base growth puts upward pressure on consumer costs, but we believe these prospects for growth put certain utilities in an enviable position today.

Based on Utilities Plus holdings as of May 11, 2020 and last-reported Sustainalytics data for coal power generation.
Source: Sustainalytics; Miller/Howard Research & Analysis

We believe the Miller/Howard Utilities Plus portfolio is poised to capture this opportunity. According to Sustainalytics, 85% of the companies in the portfolio have less than 25% involvement in coal power generation, so we do not have significant concerns about stranded assets as coal plants are retired. Meanwhile, we see the companies in our portfolio focusing their capital deployment on natural gas and renewables projects to position for the future.

Source:
1. https://www.eia.gov/todayinenergy/detail.php?id=42655#:~:text=In%20the%20latest%20long%2Dterm,surpass%20natural%20gas%20in%202045.

2. https://www.eia.gov/todayinenergy/detail.php?id=43895

  

Even with the recent market turbulence, that share has grown. Microsoft and Apple comprised 10.6% of the S&P 500 as of April 22, 2020!

Together, these two stocks are valued higher than all but five of the eleven economic sectors that comprise the S&P 500 on price to trailing earnings. What’s more, the combination of these two stocks represents a higher market capitalization than all but two non-U.S. countries in the MSCI All-Country World Index, an index that includes countries such as France, Saudi Arabia, and the UK. The two stocks dwarf all countries in that index except Japan and China.

To put this another way, if you were rich enough, you could either buy all of Microsoft and Apple—or you could buy all of the Real Estate, Utility, and Materials stocks in the S&P 500…and still have money left over. Oh, and in this Real Estate, Utility, and Materials portfolio, you’d generate nearly 3x the income: 3.39% dividend yield vs. 1.15% for the combination of Microsoft and Apple portfolio.* If you wanted even more income, you could swap out the Materials stocks for Energy stocks to generate a 4.48% dividend yield.

As of April 22, 2020
Source: Bloomberg, S&P, and Miller/Howard Research and Analysis

In a market capitalization-weighted world, Miller/Howard believes it may be time to rebalance your portfolio to reduce concentration risk, and dividend-paying stocks could provide a solution.

* Data as of April 22, 2020
Microsoft and Apple were not held in any Miller/Howard strategies as of April 22, 2020.

  

Energy Macro Environment

So far in 2020, we have seen two oil shocks—one to demand, and one to supply. The current oil price environment is unsustainable. US shale wells are not economic and Saudi Arabia and Russia’s fiscal budgets are stretched. The market remains under severe pressure due to lower demand.

Demand Shock: We estimate oil demand destruction from the COVID-19 containment efforts to be roughly 30 million barrels per day. However, we may be starting to see some light at the end of the tunnel based on improving global trends among daily reported deaths, hospitalizations, and ICU admissions associated with COVID-19. It is unclear, if the trends will continue to improve, but we view these as encouraging data points.

Supply Shock: As the prior OPEC+ oil production cuts agreement was expiring, Russia walked away from the table, and Saudi Arabia retaliated by oversupplying and repricing their oil production. Saudi Arabia decided to essentially trade pricing for increased market share.

On April 12, Saudi Arabia and Russia agreed to slash oil production again after a month of disagreement. The agreement cuts production by 9.7 million barrels a day in May and June, and slowly increases production until April 2022, when the agreement expires. We feel that the re-instatement of the production cut agreement will help support oil prices should demand-pressures start to ease.

Lower oil prices may be a positive for natural gas prices. We view this as supportive for natural gas producers in the Northeast because as oil production goes off-line, there will be less supply of low-cost associated gas coming out of the Permian Basin.

Recent Performance

Beyond the decline of crude, midstream energy investors are taking a hit. Funds are facing margin calls, Fitch Ratings downgraded 10 midstream closed-end funds in March, and fatigued retail investors are contributing to outflows. While funds deleveraging unquestionably put significant pressure on midstream energy share prices, the pricing spreads between higher-quality versus lower-quality companies indicates this pressure may be abating.

Although this does not bring much solace, the midstream sector has outperformed other energy sectors, including those in the oil field services sector (PHLX Oil Service Sector Index), natural gas infrastructure and producers (the ISE-Revere Natural Gas Index), and oil and gas exploration and production companies (S&P Oil & Gas Exploration and Production Index) (as of 3/31/2020).

Our Consistent Focus on Quality Companies

Our selection process across our midstream energy strategies prioritizes financial strength. We typically prefer larger cap names with integrated systems. We believe these firms will weather this storm and eventually grow stronger as the space recovers. As it stands right now, we believe our MLP Strategy owns the highest quality names in the universe.

In the current environment, we continue to stress test the names in our midstream portfolios. We are examining contracts, debt maturities, balance sheets, and cash flow in order to identify potential weaknesses, and evaluate the durability of our holdings. We are also stress testing our models to determine how a prolonged period of depressed oil prices impacts volumes and the commodity-exposed parts of their businesses.

Looking at liquidity and near-term debt maturities for the companies in our MLP Strategy, we believe every holding has enough liquidity to pay down 2020 maturities, and only a few names face limited refinancing difficulty in 2021. For those with tighter liquidity in 2021, we see additional levers for management to pull, such as lowering capex spending. This is assuming sub-$30 per barrel oil prices and the associated financial pressures persist.

When it comes to the resiliency of cash flows, we look at contract structure, in particular. Fee-based contracts are when a Master Limited Partnerships (MLP) earns a predefined rate to ship commodities, but the company does not take ownership of the commodity (i.e., it does not have direct commodity exposure but does have volumetric exposure). Take-or-pay contracts require the upstream shipper to pay a minimum amount to the midstream company whether they ship or not. Specifically looking at the numbers for our MLP Strategy:

• Average fee-based exposure across our holdings is about 95%. This median is fairly consistent with the narrow range of roughly 85%-100% by individual name within the portfolio.
• Average take-or-pay exposure is approximately 58%, Here, looking across portfolio holdings, the range is wider, with the highest name having 83% take-or-pay.

Additionally, we look closely at leverage for our holdings. Prior to the downturn, we already favored companies with below 4x leverage, and we saw positive leverage trends with our companies focusing on financial strength heading into 2020. We believe our high-quality companies are better-situated than other MLPs in the Alerian MLP Index. Looking forward, we believe that if leverage for midstream companies were to improve to be below 3.0x, investors would have more confidence in the space and share/unit price performance would improve.

Midstream Energy Distributions

We have seen several names in our MLP Strategy announce that they are keeping quarter-on-quarter distributions flat, so that has been a good outcome. We saw one holding cut its distribution recently. The company could, conceivably, have continued to pay its existing distribution, but the environment for midstream companies has changed. MLPs are now cognizant of market desires for fiscal discipline and investors have rewarded companies that make financial discipline a priority. We believe this company is now in a better financial position for an eventual recovery.

The space was historically focused on income and growth of income, but that has shifted to financial strength and discipline in recent years—prior to the downturn. Most companies don’t have to cut, but we are assessing willingness and ability to pay current distributions.

MLPs and midstream energy companies generally declare dividends in the months of January, April, July, and October. Companies will start to report earnings in April and lasting into May. We have heard from management teams that 1Q and 2Q earnings will be ugly, but the second half of 2020 is expected to improve if economic activity ramps up again.

For midstream, what if oil did stay below $30/barrel for the next 3 years? We would expect producers to slash their capex budgets, resulting in production declines for the first time in years. On the midstream side, reduced capital spending would help support balance sheets and free cash flow at the expense of future volumes.

Distribution policy is one of the bigger question marks. We suspect midstream companies would take the opportunity to forgo distribution increases and potentially cut distributions in order to maintain debt metrics. Financial strength will be instrumental in attracting a larger group of investors once things return to a more normalized state.

Because we tend to invest in the highest quality midstream companies, we believe our portfolio is well-positioned to withstand the current environment if the supply/demand balance starts to normalize in the second half of 2020. However, if we see a prolonged low commodity price environment, the industry could look different.

Counterparty Risk and Contracts in Midstream Energy

Counterparty risk and contracts are two of the most important items that we monitor. Even before this recent downturn, we had re-assessed exposure to Chesapeake Energy Corporation across our holdings. Because the majority of the companies in the strategy are large and diversified, counterparty risk is spread out.

As far as contracts, this is one of the metrics we use in our proprietary Financial Risk Scorecard during our bottom-up fundamental research process. We look at both the percent of contracts that are fee-based and the percent that are take-or-pay to identify high quality contracts.

Producers that have take-or-pay contracts will have to pay midstream companies, even if they stop producing or cut production. That being said, stressed producers often ask midstream companies for rate relief in exchange for extending the number of years in the contracts. We expect renegotiations to take place again, negatively impacting near-term EBITDA forecasts.

Commodity Storage Constraints

During the month of March and in early-April, storage was in high demand with the crude price curve in contango (i.e., the futures price of oil is higher than the spot price), driving producers to store their products to sell at a higher price in the future. We are aware that storage is filling up quickly. Limited storage would likely lead to forced shut-ins by producers, and we view storage constraints as a near-term risk to monitor. The recent OPEC+ agreement should help alleviate storage constraints but is not a panacea.

For midstream companies with storage, it is a positive, but likely not as much as the market would think. For many companies, storage is already contracted, so there is not much available space. We may see some benefits from midstream energy’s storage business lines during the 1Q and 2Q earnings calls.

What are the Positives in the Midstream Energy Space?

• The oil price environment is unsustainable for all producers, not just for US shale.
• Improved capital discipline and financial positioning was already in place coming into 2020.
• MLPs offer tax-deferred income, with distribution yields well-above many other asset classes.
• Shale production is “short cycle”, so when economic activity eventually picks up, US production will come back and exports will resume.

  

We view an infrastructure stimulus bill as a great opportunity today, with potential benefits of building and repairing infrastructure for the future.

During the period of social distancing and as the world slowly normalizes, we believe outdoor work will remain preferable to indoor work. It’s a great time to build with minimal disruption and lighter traffic patterns. What’s more, warmer weather provides an opportunity for construction to pick up.

The most obvious beneficiaries should be industries within the industrial and materials sectors such as engineering and construction, machinery, road and rail, metals and mining, and construction materials.

We think it is also likely that some spending will be allocated to communications services, mainly 5G technologies. Unlike 4G that was viewed solely as a mobile network, 5G is also described as an Internet of Things (IoT) platform—it’s hard to argue against the importance of communication infrastructure today.

We could also see upgrades and repairs to our aging water and wastewater management infrastructure, as well as grid modernization. There will likely be a push to support renewable energy as well.

Additionally, there could be indirect beneficiaries. For example, spending on roads and highways, airports, and ports could lower shipping costs or improve our ability to compete on a global stage, benefitting transportation and logistics companies.

Learn more about how Miller/Howard’s Infrastructure strategy can provide high and growing income, portfolio diversification, and exposure to macro trends in the infrastructure space:

• Infrastructure presentation
• Infrastructure portfolio pack

We look forward to providing updates on the potential infrastructure stimulus in the near future. Stay tuned!

  

When discussing extreme weather events, you'll frequently hear people joke that 100-year events, say floods or hurricanes, are coming every five or ten years. But in the case of pandemics, extreme outbreaks are truly rare.

One hundred years ago a vicious strain of influenza engulfed the world. Estimates of the death toll vary widely, ranging from 20 to 100 million in a much less populated world. We have better medicine today, but human nature hasn't changed much. Skepticism among politicians and businessmen was rampant: Why shut everything down? What's a little flu? Looking back, it's easy to second-guess those who wanted life to go on as normal. Few events in our experience can unfold as fast as a pandemic.

However, the pandemic will end in a time frame that is short for a long-term investor, and the ultimate value of our investments will be largely unaffected, in our view. This may sound like a throw-away comment, but it's actually very important. If we were investing in sports franchises, this conclusion would not hold. Suppose a basketball team loses its star center. That would put a permanent dent in the value of the franchise. For a large corporation, there is no equivalent. It would be sad if the CEO of one of our holdings was unable to work because of the virus, but a competent CEO should have a succession plan and business should run as usual.

The pandemic will permanently impact some businesses. The most obvious are idiosyncratic—for example, consumers may shy away from cruise ships for years. Most of the long-term economic damage, however, will be associated with problems faced by overly leveraged companies. Getting from the current state of emergency to the other side will involve challenges, including lower revenue, disrupted supply chains, difficulty collecting on debts, and the like. Companies with variable cost structures will likely contract and then expand again with little permanent damage. Highly indebted companies could have trouble, both paying their interest cost as well as finding a willing lender if they need more capital to get through the valley.

In contrast, firms with healthy balance sheets should have the flexibility to survive the crisis and thrive on the other side. Through our process of intensive due diligence and continuous monitoring, we're confident that these qualities predominate in our portfolios relative to their respective categories.

For example, we continue to focus on high current yield, prospects for dividend growth, financial strength, and earnings stability in our Income-Equity strategies. As the charts below show, we believe the companies in our Income-Equity strategies are well-positioned to weather this downturn and poised to return to dividend growth when economic conditions improve.

Source: Bloomberg; S&P 500; Miller/Howard Research & Analysis. The data above is based on representative accounts in our Income-Equity Strategies both with and without MLPs and is subject to change. Dividend yields shown for Miller/Howard portfolios exclude cash. All data is as of year-end, unless otherwise noted.

* Projected Dividend Growth—Miller/Howard Portfolio Team's 3-year annualized projected dividend growth based on data from various sources, adjusted to reflect our view of future economic and market conditions. There is no assurance projections will be realized.
** Bloomberg Dividend per Share 3-year forward estimates.
*** Excludes financials.
† 1Q 2020 projected dividend growth has been removed due to the unreliability of current projections within the current environment. The 1Q 2020 earnings season should provide clarity regarding projections.

Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)—A non-GAAP measure used to provide an approximation of a company's profitability. This measure excludes the potential distortion that accounting and financing rules may have on a company's earnings; therefore, EBITDA is a useful tool when comparing companies that incur large amounts of depreciation expense because it excludes these noncash items, which could understate the company's true performance.

Net Debt to EBITDA—A measure that computes the company's ability to pay off its debt by utilizing the earnings before interest, taxes, depreciation, and amortization (EBITDA).
Price-Earnings Ratio (P/E)—The ratio of a company's share price to its earnings per share. The ratio is used as a valuation tool and can help determine whether a company is overvalued or undervalued.

  

Recent Crises at a Glance

Since the founding of our firm in 1984, there has been an important crisis in the markets every 8–12 years (our founding coincided with the end of the oil-shortage crisis and the end of sharply rising interest rates in response to what had been out-of-control inflation). In 1987 there was a sharp crash that was mainly the result of secular market dynamics and not the real economy (portfolio "insurance" and program trading backfired as exit possibilities could not accommodate the magnitude of fleeing positions). Indeed, the real economy continued to do reasonably well, and markets slowly recovered as investors regained confidence that the system had been repaired. Perhaps that technical crash was also a precognition of the disasters for banks in 1990–91, when rising rates exposed the corruption in savings and loans banks and upended the mortgage market. But that was an economic hiccup, not really crisis.

After relatively smooth sailing during the Clinton-era 1990s, in 2000 the tech bubble of elevated "new economy" valuations collapsed. This was devastating to the portfolios of investors who were even partly invested in technology, but what was plain in real time became even plainer in retrospect. That is, the valuations of that sector bore no relation to sensible business valuations; they were pure emotion. Investment accounts were harmed, but so-called value, or "old economy," stocks began to rise as investors remembered what investing really is. Again, a crisis for investors and the trading marketplace, but not truly a crisis for the real economy. Not long after each of these "crises" the equity markets recovered and went on to make new highs within a reasonable investment time frame.

The year 2008 was a true crisis felt in the markets but also in the society at large. We can recall wondering if our economic system could survive. Banks were hurt worst, but the overall economy ground to a halt and unemployment soared. Would everything be different in the future? It turned out to be a slog, a long slow process that never really became robust. But that wasn't bad at all for investors, for new money at least. A famous investment firm coined the term "new normal," suggesting a poor economy and low future returns, demonstrating that even the most sophisticated investors and analysts can't always know what lies ahead. The "new normal" proclamation came almost to the day of bottoming for the market and the economy, in March of 2009.

The Crisis Right Now

Is this 2008 all over again? 2020 is a time of extremes, and it is uncertain. It isn't 2008 because the financial system has remained intact, and that's what's needed for economic recovery. But it isn't a trivial moment, to be sure.

Volatility is extreme by any measure. One has to go back to the 1930s to find analogs. Volume is equally extreme. Sentiment measures are extreme. Debt levels are extreme, and that's not a good thing in a time of reduced cash flows. But like 2008, the government has gone into action to protect the economy. Observers were skeptical then, but we were skeptical of the skeptics, and expressed a longer-term optimism because the government was "on the case." Yes, it was an anxious time, and we feared for banks as the linchpin of the financial system, but slowly the various financial and fiscal programs gained traction, leading to one of the most durable bull markets of the modern era.

Some Positive Points

There is much we don't know, including the duration of the pandemic (as we write at the end of March it shows no signs of abatement in the US or Europe). However, we have faith in our medical industries to eventually solve this problem—after all, hepatitis C, a virus, has been cured, and HIV, also a virus, has been effectively suppressed. The relevant scientists suggest that either cure or vaccine or both will be available within about a year or less.

The medical crisis will pass. The question is how much damage will it do to the economy during its period of acute infection? That is not something anyone can know at this point, but we suspect its reach will be broader and perhaps deeper than 2008. That doesn't mean it will be worse for investors, since stocks tend to discount a recovery long in advance of reality. And banks, the aforementioned linchpin of the economy, are profoundly sounder than they were in 2008. The tools to restart stability and growth are there.

The President was right that our economy is "not built" to shut down. Americans want to be out there working, producing, and striving. That's all true, but our understanding is that the US economy is "not built" to withstand periods of zero revenue. That will deal a body blow to retail-facing industries such as the stores and restaurants that are closed as we write, and all who supply and service them, as well as the debt financers who enable the whole chain of commerce.

A glass-half-empty view posits that the economy has suffered a disruptive body blow, the microbial equivalent of a hurricane that flattens a town. However, a glass-half-full view asserts that the town has been flattened before, and it has rebuilt before, with better and new buildings that are hurricane proof. Over 250 years the system and the people within it have shown resilience, tenacity, determination, and imagination—and have always come back. We don't see why this will be any different, though the human toll in terms of mortality as well as economic disruption will be great.

The Short-Term Fallout

Like many things, however, the doing will be harder than the envisioning. There will be personal tragedies and business tragedies. The government will be poorer and deeper in debt, and taxes will eventually have to rise. Interest rates may not be as benign as they were after 2008—recall that the vast consensus of observers then predicted higher interest rates, though that was wrong because so much liquidity overwhelmed the demand for money. And there will be changes in society as well as the economy as a result of the pandemic.

On the downside, we think the universe of retailers and restaurants will substantially shrink, as will the population of workers in those industries (roughly 20 million before COVID-19 hit—about 100 times the average new claims for unemployment for 20191). Landlords will share the pain, both for commercial tenants and individual renters. Companies with substantial debt will find themselves unable to cover their monthly payments. In a restrained economy there is less need for resources, including energy and minerals, and for the tools and equipment of extraction and processing.

The Upside for Investors, as We See It

On the upside, life in the cloud has proven itself. Work from home will gain new traction, and 5G services will meet accelerated and increased acceptance. Everything cloud acquires new urgency. Much will go on as before, especially for the healthcare industries serving an aging population. Technology was a kind of savior after 2008, and its efficiency and productivity mean it will continue to play that role. And of course you have to turn on the lights, and run that technology, so utilities need to remain an important factor in an investor's landscape.

Secular market factors are very positive, and if not for the uncertainties of the pandemic they would suggest the best opportunity to invest in equities in at least a generation. Volume has not been so high since 2008, and high volume typically marks the end of a decline. Prices have declined sharply. Enough to discount the harder road ahead? That's unknown, but the further prices decline, the more they discount negative prospects. Sentiment has swung from an extreme of bullishness (which is bearish) to an extreme of bearishness (which is bullish). Stocks are oversold by quantitative measures, a reasonably expectable bounce at the end March notwithstanding. Rates remain low and will likely stay that way for years, at least at the short end.

The Fed is ready to do "whatever it takes," and the previous episode of this posture worked out well for equity investors—there will be no shortage of money, which may overcome inevitable low velocity. Because bonds rose this year and equities declined sharply, large institutions (including pension funds and sovereign wealth funds) around the world with an equity/bond mix will need to rebalance in favor of equities, and that is a huge source of funds for the equity market. A record-breaking flow of funds into money markets and short-dated credit will want a new home before too long, as returns of less than 1% get tiresome when you have a mid-single-digit or higher return assumption for your funds. Private equity is loaded with cash to purchase whole companies.

Will the two themes—economic damage and uncertainty as to duration versus a classic setup laying the groundwork for a new bull market—balance out? No one can know without more data and information, but the environment is not all one-sided.

A Future for Dividends

Importantly for us, we are well aware that dividends are not guaranteed. Companies whose cash flow has disappeared are not going to have the funds to pay dividends (which should always be an evidence of prosperity in any event), and we will see many reductions and cuts in the broad market, just like 2008–09 (1 out of 3 S&P 500 companies cut in 2008–9, though aggregate levels were restored by about 3 years out). Some companies will take action out of a feeling of prudence due to uncertainty, even if they can in fact afford to keep paying.

All of our strategies have high dividend yields—typically in excess of four times the yield on government bonds—and we want to keep it that way. We've focused for decades on companies with reliable cash flows and strong balance sheets that can ride out a period of softness, and these special times alert us to increase our vigilance even further. Of note, the many dividend-oriented "products" or "indexes" that have arisen in recent years are driven by formulas relating to past dividends, but pay little heed to balance sheet strength or current conditions that may impact the dividend. In other words, those portfolios are carrying lots of securities that met the criteria in 2019, as of the last index rebalance, but may enter the ranks of nonpayers in 2020. Our efforts are dedicated to distinguishing our portfolio from those passive approaches and keeping the income high.

It is our philosophy that long-term investment success depends on reliable income, and for us, nothing has changed. We will always adapt to current circumstances when necessary, but our foundation remains the same. Now more than ever, a long-term view gives us comfort in the resilience of the real economy.

  

Miller/Howard wants to help you navigate through rough markets.

Our first priority at Miller/Howard is making sure that we are in a position to steward your assets through all markets, including this one. We have navigated challenging markets for 30 years, and we will navigate this one. Past challenges have prepared us from an operational and technological standpoint to continue to serve our clients seamlessly while doing our part to social distance. To that end, our portfolio managers have been working diligently to navigate choppy markets, our marketing team is grounded and available for client calls, and our traders and staff are prepared to continue to care for the assets you have entrusted to us without interruption.  We are doing our best to be part of the solution, without compromising client care or fiduciary responsibility.

At its core though, this is a human event. We know that this has an emotional and economic impact on you and your clients. We have designed our strategies in an effort to endure challenging economic times, and our portfolios were already positioned in healthy companies and those providing essential services with enduring business models. Many of the companies that we own are businesses that you write checks to every month; companies that, themselves, have endured and thrived during other challenging times.

Near-term price volatility is unavoidable, but what we seek to deliver is a stable income stream from dividends. Every market cycle will have unanticipated events that need to be evaluated. Portfolio changes will be made when warranted. What is unchanging is our commitment to our clients.

We are here to serve you, and we are committed to doing the best work we can to protect income. Please don’t hesitate to reach out.

We earnestly hope that you and your family stay healthy.

Be well,
The Miller/Howard Team