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Dividend Investing Weekly: Fed Provides a Fresh Appetite for Yield

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Dividend Investing Weekly
Dividend Investing Weekly Cash Machine Premium Income Quick Income Trader
09/28/2015
Fed Provides a Fresh Appetite for Yield

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At the most recent Federal Open Market Committee (FOMC) meeting, the Fed announced that it would keep its target band for the Fed funds rate at 0.00-0.25%. In its policy statement, the Committee said that “recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.” This is “Fed speak” for how the slowdown in China, and its impact on other emerging markets through the steep decline of commodity prices, will keep inflation low through 2015.

Despite the jawboning of the Fed’s desire to hike rates, the FOMC’s decision may well have been the right one given that price indices and inflation expectations have remained stubbornly low since the recovery began. Businesses cautious about raising capital spending are holding cash at record levels, and consumers are putting more disposable income into savings and retirement accounts instead of freely spending, as was the pattern before the post-2007 recession.

After the Fed ended quantitative easing back in November 2014, the stock market carried higher for a while but it has since hit headwinds due to the absence of the tens of billions of dollars that were being printed out of thin air by the Fed, much of it finding its way into the equity markets. Now the Fed is taking significant criticism for holding interest rates too low for too long and it is short on tools to stimulate the economy if the slowdown in China and emerging markets begins to weigh on U.S. growth.

The role of the fed is two-fold: to control inflation and achieve full employment. If the domestic economy is not destabilized by the global economic slowdown and payrolls continue to add 200k jobs per month, at some point, wage inflation, and thus purchasing power, will improve. But the Fed will want to be careful not to preempt that scenario to normalize policy rates until corporations show they are willing to pay up for more labor, especially with the current labor participation at a record 62.6 low reading as of the end of August.

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This puts the real picture of actual unemployment at 10.3%, 2x the published unemployment rate of 5.1% but still the lowest level since topping out at 17.1% in October 2009. Looking at the real employment picture, the labor market has a long way to go before any statements like “full recovery” can be declared -- or even suggested. So if the Fed’s dual mandate is full employment and modest inflation of 2%, they are well short on both goals. And though Fed Chair Janet Yellen voiced her support for a rate hike by year-end, it will be interesting to see how she and the rest of the Fed justify any such move when the resultant effect will cause a rally in the dollar and put more pressure on exports, thereby making it harder for Fortune 500 companies to hire new workers, much less raise wages.

One area of the market that should continue to benefit from this backdrop is the Business Development Company (BDC) sector. All the hype about the Fed embarking on a new cycle of higher interest rates put undeserved downside pressure on BDC stocks, many of which are enjoying solid returns on their loan portfolios structured around private small- to medium-sized businesses. Yet the best-positioned BDCs that have invested in defensive industries have been discounted and offer attractive entry points.

Take, for instance, New Mountain Finance (NMFC), a BDC with a market cap of $830 million (a small-cap by definition), which is forecast to grow top-line revenues by 13% to $152 million for 2015 and 12% to $172 million for 2016, with earnings per share set to advance from $1.38 to $1.48 per share during the next year. The company posted Q2 earnings of $0.35, beating estimates by a penny while declaring a $0.34 per share quarterly dividend.

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This past week, New Mountain priced a 5,000,000 share secondary stock offering at a price of $14.14 per share. Steven Klinsky, chairman of the company’s board of directors, purchased 500,000 shares of the offering at the public offering price. This $7 million open market purchase is, in my view, a very vocal vote of confidence for shareholders.

A couple observations come to mind regarding NMFC. The stock has been trading in a one-point range, $14-$15, for the past year -- very tight and very stable by any measure, especially when taking into account the elevated level of volatility. At its current price of $14.00, the stock is trading near the low end of the range and also trading above the secondary offering price, having digested the offering within the worst market downturn going back to October 2014.

With a current dividend yield of 9.54% where the dividend payout is 100% covered by earned income, I consider New Mountain Finance a stock for income investors seeking outsized income in alternative asset classes that are uniquely well positioned to benefit from a low-interest-rate environment, where 100% of investments are applied in U.S. dollars in U.S.-based companies and where management is one of the largest open market buyers of the stock.

In case you missed it, I encourage you to read my e-letter column from last week about why the Fed's decision is bullish for high-yield investors. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.

 

Sincerely, 

Bryan Perry
Editor, Cash Machine
Editor, Premium Income

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