Market Collision affecting Dividend Investors – Part I

In the last post, I presented El-Erian’s major themes that are significantly affecting the financial markets. Taking these themes as a framework, the author presents the asset allocation model that was used under his stewardship at Harvard Endowment Fund. The asset allocation model can be found here and here.

The discussion of the asset allocation in this book should be viewed as reflection of author’s understanding of the world of finance. It is the result of author’s belief and conviction on how financial markets are evolving. I do not interpret this as a guideline, framework, or a model that I should follow. With the investment vehicles in this model, how can I?

Among others, one of the key characteristics of dividend-based investing is:

  • Management’s sincere conviction that shareholders have stake in the business and earnings must be shared with them;

Now let us compare this characteristics with one of El-Erian’s world colliding themes i.e. use of derivates and lack of financial infrastructure.

It is highly likely that dividend investors (DI) may not invest in funds, companies, and/or institutions that only do business in derivatives domain. Only because they do not have any background history associated with it. DI’s are looking for companies with dividend history and sincere managements. So in 2008 what went wrong with financial companies? Weren’t they good? Some of them had 20+ years of history and dividend growths. It can be argued that at hindsight, it is very easy to say considering what happened in 2008. Quite a few well-known financial institutions imploded due to these derivates. However, when we really put this in perspective, we can see that, in last few years these companies transitioned to greed and excessive use of derivates. Management did not know or understand how to access risk (lack of infrastructure!!). Perhaps, it also failed to communicate to shareholders that their business model has transitioned and they have highly leveraged balanced sheets. In my opinion, I believe management knew about this, but did not communicate due to their short term gains. I believe these folks are smart enough to understand these issues (did anyone make losses?) and were sincere to their own self. They had tight agreements in places to fill their own pockets irrespective of company performance. For example, Citibank CEO Chuck Prince’s famous words on front pages of Financial Times, “when the music stops it will be messy, but as long as it’s playing he’s on the dance floor….” What message was he trying to communicate? Companies such as JPM, USB, WFC, BBT, BAC, etc. also used derivates and got affected by this implosion. These companies are able to digest the loss (and not face extinction) because they managed it as per their risk-appetite. Isn’t that what we call management sincerity towards the company and its stakeholders? Where was risk management?

The author does not comment on whether to use or not use derivatives. All he is trying to bring out is derivatives and their risk management is not supported by existing financial infrastructure and governing mechanism.

In that case, I interpret this as it is acceptable for companies to use derivatives to an extent where risk of loss is understood and manageable. In other words, use it but do not over expose; one of the basic tenets of portfolio managements. So as a dividend investor, it would be acceptable to invest in somewhat riskier groups as long as I understand the downside and its implication on my overall portfolio.

Since the post is becoming long, I will discuss the theme of emerging markets in next post tomorrow.

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