Special Report the Value of Dividends

Value of Dividends Over time, dividend income has comprised a significant portion of longterm stock gains. Even better, over the long term, dividend-paying stocks have delivered relatively better total-return performance than non-dividend payers and generally have done so with lower volatility. And in today’s historically lower-yield environment, dividend payouts are all the more attractive. As if this weren’t enough, our recent crunching of the historical numbers reveals that dividend payers have proven the place to be even in a rising rate environment. While not quite the Holy Grail, higher returns, relatively lower risk and generous income make for quite a powerful combination no matter the direction of interest rates.

August 2013 Dividends are not guaranteed. Stock investing involves risk and possible loss of principal.

Dividend Payers: Higher Returns, Lower Risk

S

ome are warning that income-producing stocks are a ‘crowded trade’ as many have been singing the praises of dividend payers. However, such statements

ignore the fact that the 97 non-dividend-paying members of the S&P 500 outperformed the 403 dividend payers in 2012 by a score of 19.2% to 16.1%. The story was the same, at least on a value- (market-cap) weighted basis, per data compiled by Professors Eugene F. Fama and Kenneth R. French. The duo evaluated all NYSE, AMEX and NASDAQ stocks, breaking the list down into non-dividend payers as well as the lowest 30%, the middle 40% and the highest 30% of dividend payers. Believe it or not, the higher the yield in 2012, the weaker the performance as the nondividend payers gained 20.9% compared to 20.8%, 14.2% and 11.8% for the low-30%, mid-40% and high-30%, respectively. Further, the Utilities, Energy and Consumer Staples sectors of the S&P 500 received the least amount of love from investors last year, despite a preponderance of high-yielding members. We suspect that few are complaining, given the outsized returns on equities across the board, but non-dividend payers won the performance derby again over the first seven months of 2013. Despite the excellent returns seen this year and last, the forward (next 12 months) yield on the S&P 500 is now 2.1%, while the Russell 3000 boasts an annual payout rate of 2.0%, so it is easy to see why pundits would continue to extol the virtues of dividends. This is especially true after nonincome-producing and formerly high-flying gold and silver have recently become a lot less precious, while many investors saw more red ink than they might have expected on their bond investments when they opened their June statements.

Figure 1: Equities versus Treasuries

16% 10−Year U.S. Treasury Yield Dividend Yield (LTM) S&P 500

Yields on Treasuries have risen sharply in recent months, but they remain extraordinarily 12%

low by historical standards, while dividend

Yield

payouts have been on the rise.

8%

4%

60

70

80

From 12.31.49 through 06.30.13. SOURCE: Al Frank using data from Bloomberg

2

90

00

10

No doubt, numerous folks today are more concerned with return of principal than return on principal and they are sitting in the safety of cash and cash-like investments. Of course, deciding to place one’s money into the modern-day equivalent of the mattress allows the chance to earn a whopping one basis point (0.01%) on average in taxable money market funds, according to iMoneyNet.com. Growth of capital is obviously not the objective, but it is amusing that at the current money-market rate, cash will double in just 6,932 years! Others are ‘hiding out’ in U.S. Treasuries, where the yield on the 10-year note is currently hovering around 2.6%, the yield on the 20-year bond is near 3.4% and the yield on the 30-year bond is in the 3.7% range. Considering that inflation has averaged 3% per annum over the past eight decades, those willing to accept the current yields on 10-, 20- and 30-year Treasuries are likely to see a reduction in purchasing power or little in the way of real return if they hold to maturity. And should they wish to cash out prior to 2023, 2033 and 2043, respectively, they risk capital losses. Clearly, equity investors must continue to steel their nerves for heightened volatility, as concerns remain about Uncle Sam’s debt levels and potential additional government spending cuts, while the European sovereign debt crisis has not exactly been placed in the rear-view mirror. Also, the strength of the global economy is still very much in question, while question marks have arisen about the patience of the U.S. Federal Reserve, not to mention central bankers around the world, in maintaining their highly-accommodative stances on monetary policy. Nevertheless, relative to Treasuries, dividend yields are as attractive as they’ve been in more than 50 years (see Figure 1). Aside from several months at the height of the ’08-’09 Global Financial Crisis, the last time the yield on the S&P 500 was as close as it is today to the yield on the 10-year Treasury was 1958. And, until the recent spike in interest rates, stocks actually yielded more than the 10-year! What’s more, corporations have actually been boosting their payouts as 348 of the S&P 500 members either raised or initiated a dividend in 2012 and 258 have done the same thus far in 2013. Standard & Poor’s (as of August 7) estimates that operating EPS growth on the S&P 500 will reignite, jumping from $96.44 in 2011 and $96.82 in 2012 to $108.50 in 2013 and $122.38 in 2014. Hard to imagine dividends not rising further were earnings to come close to those projections, especially as corporate balance sheets continue to be loaded with record levels of cash. Value stocks (those trading for lower fundamental valuation metrics) are providing even more generous income streams. Breaking down our benchmark Russell 3000 index into its Value and Growth components, one finds the former sporting a forward yield of 2.3% compared to a 1.6% yield for the latter. The forward yield on the Dow Jones Industrials is actually 2.4%, so the attractive payouts are also available in the most well-known index. It is nice to see the renewed interest in income, as we can’t forget that dividends and their reinvestment have long been a substantial contributor to the total return on equities. As shown in Figure 2, data from Morningstar’s Ibbotson Associates going back to 1927 reveals that through the end of last year, the income component of total return amounted to 42% for Large-Cap Stocks, 36% for Mid-Caps and 31% for Small-Caps.

3

More importantly, numbers we’ve crunched from Fama and French dating back to 1927 find that dividend payers have actually outperformed non-dividend payers over the long term and they have done so with lower overall volatility! Not quite the Holy Grail, but higher returns, relatively lower risk and generous income obviously make for a desirable combination.

Figure 2: Contribution to return Capital Appreciation

12.5%

Income 11.4%

10.9%

Over the past eight decades, dividends and other income have made up a significant

9.8%

10.0%

3.5%

Annualized Return

portion of the annualized return.

3.9% 4.1%

7.5%

5.0% 7.7%

6.9% 5.6%

2.5%

0.0% Large−Cap Stocks

Mid−Cap Stocks

Small−Cap Stocks

As of 12.31.12. Component figures do not sum due to the effects of dividend reinvestment and rounding. SOURCE: Al Frank via Ibbotson Associates

Figure 3: Dividend payer versus non-dividend payer returns since 1927

handsome long-term returns, but dividend payers have won the long-term performance derby...

Hypothetical $100 Invested on 06.30.27

In general, stocks have delivered some

$1m

Top 30% Payers (11.2%) Middle 40% Payers (10.3%) Low 30% Payers (8.9%) Non−Payers (8.4%)

$100k

$10k

$1k

$100

30

40

50

60

70

80

As of 12.31.12. Logarithmic scale. SOURCE: Al Frank using data from Professors Fama and French

4

90

00

10

As Figure 3 shows, annualized returns dating back to 1927 using the valueweighted monthly return series from Fama and French for dividend-paying stocks have ranged between 8.9% (the lowest 30%) and 11.2% (the highest 30%) compared to 8.4% for non-dividend payers. Interestingly, the higher the dividend yield, the higher the long-term return!

Figure 4: Market-capitalization weighted dividend payer versus non-dividend

Hypothetical $100 Invested on 06.30.92

All Non−Dividend Payers (9.4%) All Dividend Payers (8.3%)

payer returns since 1992

$600

...although the horse race has had a different result over the past two decades, with nondividend payers excelling during the Tech

$400

Bubble.

$200

$0 95

00

05

10

From 06.30.92 through 06.30.13. SOURCE: Al Frank using data from Thomson Reuters and Bloomberg

Figure 5:

Hypothetical $100 Invested on 06.30.92

$1,200

Equal-weighted dividend payer versus non-dividend payer returns

All Dividend Payers (12.7%) All Non−Dividend Payers (8.3%)

since 1992

$900

While the findings are similar in the early 90’s, the equal-weighted-return series showed a marked difference in the last decade.

$600

$300

$0 95

00

05

10

From 06.30.92 through 06.30.13. SOURCE: Al Frank using data from Thomson Reuters and Bloomberg

5

Not simply content to take the word of the good Professors, we performed our own calculations looking at returns for the Russell 3000 constituent list since 1992. It is not easy to find accurate historical numbers as companies merge, issue spinoffs and go out of business, but we have done our best to divide the Russell 3000 membership into dividend- and non-dividend-paying groups each year on July 31. We then created two sets of return series, the first consistent with each stock’s weighting in the index and the second utilizing an equal-weighted methodology. Interestingly, we found that on a capitalization-weighted basis, as shown in Figure 4, non-dividend payers returned 9.4% per annum, versus 8.3% for dividend payers. No doubt, the tremendous returns of Internet and other computer-related stocks, most of which did not pay a dividend, during the Tech Bubble accounted for the outperformance, though our research suggests a potential bias around the turn of the Millennium that included and heavily weighted many high-flying non-dividend paying stocks in the Russell while they were rising, but excluded or lightly weighted these companies as they quickly crashed and burned. Of course, few of us invest on a cap-weighted basis. After all, one would have to own eight to ten times as much Apple or ExxonMobil as opposed to Walgreen or Baxter Int’l to match the current weights in the Russell 3000. Indeed, since our founding in 1977, we have worked within an equal-weighting framework for our initial purchases. True, over time a big gain in stock X will mean that it outweighs stock Y which has fallen in price, but we find equal-weighting to be very germane.

Figure 6:

Though volatility spiked during the Global Financial Crisis, dividend payers nearly always have shown lower standard deviation statistics.

Russell Study: Dividend versus Non-Dividend Payers—Risk since 1992

Average Standard Deviation of Trailing 36 Monthly Returns

Dividends and Volatility

35%

Non-Dividend Payers

30%

Dividend Payers

25% 20% 15% 10% 5%

95

00

05

10

Fama-French Study: Dividend versus Non-Dividend Payers—Risk since 1927

Average Standard Deviation of Trailing 36 Monthly Returns

80%

Non-Dividend Payers

70%

Dividend Payers

60% 50% 40% 30% 20% 10% 0%

30

40

50

60

70

80

90

00

10

From 12.31.27 through 12.31.12. Data points are as of July each year. SOURCE: Al Frank using data from data from Russell Investments via Bloomberg (top chart) and Eugene F. Fama & Kenneth R. French (bottom chart)

6

The Russell differences in our equal-weighted study are quite dramatically in favor of dividend-payers. As Figure 5 illustrates, dividend payers have enjoyed a 440 basis point better total return per annum over the last 21 years. The significant long-term performance advantage of the equal weighted numbers over the capweighted illustrates the opportunities available to even average stock pickers! Even more important to some, we also reviewed the annualized standard deviation of the trailing 36-month returns for the cap-weighted Russell and FamaFrench (combining the dividend payers) data sets to determine the spread of the numbers. Standard deviation is the square root of the variance with the variance defined as the average of the squared differences from the mean. In simpler terms, the greater the standard deviation, the more volatile the return and the higher the risk that the return will deviate from the norm. As shown in Figure 6, dividend payers, despite their strong return characteristics, have actually had meaningful lower standard deviation. Hard to argue with the historical evidence that dividend-payers deserve a lion’s share of any equity allocation and we’ve been incorporating dividends into our valuation analytics for a long time now. However, we remain equal opportunity stock pickers and we won’t discriminate against an undervalued company that chooses not to currently pay a dividend. Our long-time holding of Apple, which only last year initiated a payout, provides one such example. We also note that dividend payers do not always outperform non-dividend payers. Figure 7 shows that there have been stretches over the past eight decades when the tables have been turned. Interestingly, the periods of underperformance include three of the last four full calendar years, with a significant gap in the returns during 2009. That said, as contrarians, we don’t mind this recent trend, as the long-term evidence overwhelmingly favors dividend payers. Thus the majority of

Figure 7: 3-year annualized returns since 80%

1927

● ●

●● ● ● ●● ●

Trailing Annualized 3−Year Return

● ●

40%

0%

−40%

● ● ● ●

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They’ve been the best long-term performers, but over several multi-year occasions, dividend payers have lagged behind, including several of the more recent three-year periods.

Non−Dividend Payers Dividend Payers

●

30

40

50

60

70

80

90

00

10

From 06.30.27 through 12.30.12. SOURCE: Al Frank using data from Professors Fama and French

7

our recommendations offer a dividend yield, which we hope provides a little added comfort in a very uncertain geopolitical and economic environment. Of course, it should be stated that we do not favor dividend-paying stocks for their yield alone, especially as the aforementioned historical data reveal that only 30% to 40% of the total returns enjoyed by equities over the past 85 years have come from income. With capital appreciation accounting for the lion’s share of total return, we seek stocks that trade for inexpensive valuations (low multiples of sales, earnings and book value, the historical data showing that these are also excellent indicators of future price appreciation) first and foremost, with dividends always a secondary factor in our analysis. Not surprisingly, this means that we do not simply buy the highest yielding stocks, a strategy that has served us well this year as we have relatively light exposure in our portfolios to some of the industry groups within the Russell 3000 index that are generally associated with large dividend payouts. Indeed, high-yielding Real Estate Investment Trusts (REITs), Telecom Services and Utilities actually were among the weakest performers with respective 2013 returns through July 31 of 5.8%, 11.7% and 15.9%. Of course, given the relatively poor returns of late and the reasonable valuations that have resulted for many stocks in these areas, we are becoming more intrigued by these sorts of companies, and our recommended list reflects this enthusiasm. We also note that we are finding bargains aplenty in the Energy sector, another segment with many big-dividend payers, and our broadly diversified portfolios generally sport yields in excess of the benchmarks. Looking at returns thus far in 2013, the 90+ non-dividend paying stocks in the S&P 500 actually have outperformed the 400+ dividend payers by a score of 28.6% to 21.6% over the first seven months. Interestingly, and reminding us that there is plenty of merit to active investing over passive index strategies, those average (i.e.

Figure 8: S&P 500 Yield versus Fed Funds 20%

Effective Rate

Accommodative monetary policy eventually

Fed Funds Effective Rate S&P 500 Yield Fed Fund Rate Median S&P 500 Yield Median

15%

will change, but it is a long way from near-

Yield

zero today on Fed Funds to the 5.01% median. 10%

5%

0% 60

70

80

90

From 07.31.54 through 06.30.13 SOURCE: Al Frank using data from Bloomberg and Professor Robert J. Shiller

8

00

10

equally weighted) return figures compare very nicely to the 19.6% return of the actual capitalization-weighted S&P 500 index. Many attribute the latest weakness in relative performance for dividend payers to the dramatic rise in interest rates. Incredibly, it was the fear of a ‘Tapering’ in the Federal Reserve Quantitative Easing program ($85 billion in monthly bond purchases) that sent the yield on the 10-year Treasury soaring from 1.6% on May 2 to 2.6% on August 2. All things being equal, one would think that investors would find dividend-paying stocks more attractive when the yield on the S&P 500 exceeds the yield on the 10-year. After all, corporate borrowing costs were lower in Spring 2013. Recall that back in April, Apple issued a record $17 billion in debt, ranging from a three-year note yielding 0.45% to a 30-year bond that yielded 3.85%. The largest piece, $5.5 billion in 10-year notes, yielded 2.4%. The debt offering is helping to fund a portion of the consumer electronic giant’s $60 billion stock buyback plan! As a Standard & Poor’s credit analyst concluded, “It creates better returns for their shareholders. The bond markets are practically begging corporations to issue debt because of how cheap it is to raise money.” And, even those who choose not to buy back stock with their debt offering proceeds can significantly lower their borrowing costs. Barrick Gold repaid $500 million in 6.125% notes by issuing 5-year notes at 2.5%, 10-year notes at 4.1% and 30-

DIVIDENDS & SIMPLE CHANGE IN 10-YEAR TREASURY RATE Long Int. Rate Count

No Divs

Low 30

Mid 40

High 30

All Divs

1-Month Drop 508 9.6% 10.1% 1-Month Rise 506 6.9% 7.3% 3-Month Drop 481 11.3% 11.2% 3-Month Rise 531 5.4% 6.4% 6-Month Drop 484 10.5% 10.5% 6-Month Rise 525 5.9% 6.9% 12-Month Drop 491 8.7% 9.1% 12-Month Rise 512 7.1% 7.8%

12.6% 7.7%

13.7% 8.5%

12.3% 8.0%

13.3% 7.3%

13.9% 8.5%

13.0% 7.5%

12.6% 7.7%

13.3% 8.9%

12.3% 8.0%

10.4% 9.4%

10.8% 10.9%

10.3% 9.5%

From 6.30.27 through 12.31.12. Subsequent 12-month geometric mean. SOURCE: Al Frank using data from Professor. Robert J. Shiller and Profs. Eugene F. Fama & Kenneth R. French

DIVIDENDS & AVERAGE CHANGE IN FED FUNDS EFFECTIVE RATE Fed Funds Rate Count

No Divs

Low 30

Mid 40

High 30

All Divs

< 5.01% 345 8.9% 7.2% > 5.01% 345 8.4% 11.5% 3-Month Drop 307 11.2% 11.1% 3-Month Rise 378 6.3% 7.6% 6-Month Drop 316 8.9% 9.5% 6-Month Rise 363 8.0% 8.6% 12-Month Drop 298 5.8% 6.8% 12-Month Rise 369 10.7% 10.8%

8.3% 13.2%

10.1% 14.5%

8.6% 13.2%

12.8% 8.8%

13.8% 10.7%

12.7% 9.1%

10.4% 10.5%

12.0% 12.0%

10.7% 10.5%

7.5% 12.9%

9.6% 14.1%

8.0% 12.8%

Figure 9: Returns & Rising/Falling Rates

Subsequent 12-month returns have been better when Treasury and Fed Funds rates have declined, but dividend payers beat nondividend payers for all periods, no matter how the data are parsed (e.g. selected month vs. 1,3, 6 and 12 months ago for 10-year Treasury and selected month-end averages for prior 3, 6 and 12 months vs. 3, 6 and 12 month averages for the months ended 3, 6 and 12 months prior for Fed Funds.

From 07.31.54 through 12.31.12. Subsequent 12-month geometric mean. SOURCE: Al Frank using data from Bloomberg and Profs. Eugene F. Fama & Kenneth R. French

9

year notes at 5.75%. Or, they can fund growth initiatives like the foray into oil and gas via the acquisitions of Plains Exploration and McMoRan Exploration at Freeport-McMoRan Copper & Gold, which in the first quarter secured a total of $10.5 billion in senior note and bank term-loan financing at an average rate of just 3.1%. Of course, the movements of the markets are seldom tied to just one factor and a strong case can be made that interest rates are rising due to expectations of stronger economic growth on the horizon. Such an occurrence would certainly be a positive for the health of corporate profits, which in turn would make current valuations appear even more reasonable. And we can’t underestimate that rising rates put in jeopardy the long-time love affair investors have had with bonds, which has undoubtedly vacuumed up money that might have gone into stocks. The fact that Treasuries proved that they are not without risk—the iShares 20+ Year Treasury Bond ETF (TLT) suffered a -13.4% total return over the three months ended August 2—is likely causing folks to rethink allocation strategies in favor of equities! Nevertheless, it is hard to argue with the observation that dividend-paying stocks are in vogue when rates are moving lower and they fall out of favor when rates are moving higher...unless one actually looks at the weight of the historical evidence. While anything can happen in the short run, a review of subsequent 12-month returns when the 10-year Treasury yield and the Fed Funds rate (see Figure 8) have moved higher and lower over 1- 3-, 6- and 12-month periods tells a different long-term story. Believe it or not, the analytics presented in Figure 9 show that on average dividend payers have outperformed non payers. Yes, stocks generally have done better in a declining rate environment, but the odds favor dividend payers even when rates are rising. And it is interesting to see the returns when the Fed Funds rate is high. Of course, none of us want to see Fed Funds above the 5.01% historical median anytime soon!

In Conclusion We at AFAM Capital do not simply accept conventional wisdom—we do our own homework and crunch our own numbers to ensure that what we believe philosophically actually corresponds to what has proven to be successful from a historical perspective. Happily, while we always reserve the right to get smarter and we will never rest on our laurels, our long-time emphasis on undervalued dividend-paying stocks is validated by more than eight decades of market history. Past performance is never a guarantee of future performance, but it is a fact that over the long-term dividend-paying stocks on average have outperformed non-paying stocks, no matter the direction of interest rates, and they have done so with lower volatility!

10

Prudent Speculator Dividend Favorites

W

e’ve put together a diversified listing of 20 of our

gains, we require lower appreciation potential for stocks

most favored undervalued dividend-paying stocks.

that we deem to have more stable earnings streams, more

All trade for significant discounts to our determination of

diversified businesses and stronger balance sheets. The

long-term fair value and/or offer favorable risk/reward pro-

natural corollary is that riskier companies must offer far

files. Note that, while we always seek substantial capital

greater upside to warrant a recommendation.

Symb Company Price AAPL AVX BHP BMR CAT DE E ESV FL GLW HBC MDC MDT MET MOS MSFT NSC PFE PT WMT

Apple AVX BHP Billiton Ltd BioMed Realty Trust Caterpillar Deere & Co Eni SpA Ensco PLC Foot Locker Corning HSBC Holdings PLC MDC Holdings Medtronic MetLife Mosaic Co Microsoft Norfolk Southern Pfizer Portugal Telecom Wal-Mart Stores

454.45 13.13 67.68 19.98 84.51 81.74 45.76 58.85 34.52 15.09 55.25 29.34 55.37 49.77 42.51 32.70 73.98 29.21 4.16 76.90

Target Price Multiples EV/ Debt/ Price EPS S TBV1 EBITDA2 TE3 690.40 16.86 83.94 25.11 112.01 119.54 64.75 86.29 43.82 22.38 66.80 60.25 70.34 67.77 67.20 37.86 104.96 37.88 5.93 92.36

11.3 21.9 11.2 nmf 13.3 10.0 11.7 10.1 13.0 11.6 12.7 13.3 14.7 9.1 10.4 12.2 14.2 13.9 18.1 15.2

2.4 1.5 1.4 nmf 0.9 0.9 0.3 3.0 0.8 2.8 nmf 1.0 3.4 nmf 1.8 3.5 2.1 3.7 0.5 0.5

3.5 1.3 3.0 1.6 7.9 4.4 1.1 1.5 2.3 1.1 1.4 1.3 9.8 1.1 1.6 4.4 2.3 nmf nmf 5.0

5.1 0% 6.2 0% 7.4 41% nmf nmf 6.2 394% 5.5 310% 4.0 34% 8.2 53% 5.6 6% 7.6 17% nmf nmf 17.3 72% 9.7 172% nmf nmf 5.4 9% 6.9 21% 8.0 83% 8.3 nmf 5.4 nmf 8.4 82%

Div Yld 2.7% 2.7% 3.4% 4.7% 2.8% 2.5% 4.9% 3.4% 2.3% 2.7% 4.5% 3.4% 2.0% 2.2% 2.4% 2.8% 2.8% 3.3% 2.1% 2.4%

Mkt Cap 412,866 2,214 172,955 3,839 55,582 31,719 83,150 13,743 5,204 22,037 205,995 1,434 55,780 54,605 18,102 272,326 23,078 207,193 3,729 251,977

Industry Group Technology Hardware Technology Hardware Materials Real Estate Capital Goods Capital Goods Energy Energy Retailing Technology Hardware Banks Consumer Dur & App Health Care Equip/Srvcs Insurance Materials Software & Services Transportation Pharma/Biotech/Life Sci Telecom Services Food & Staples Retailing

As of 08.09.13. N/A=Not applicable. nmf=Not meaningful. 1Tangible book value. 2Enterprise value-to-earnings before interest taxes depreciation and amortization. 3Tangible equity. SOURCE: Al Frank using data from Bloomberg

Apple (AAPL)

refreshed line of premium devices will bolster the bottom

Shares of consumer electronics giant Apple remain

line. AAPL is very much a value investment, given that

far below the $700 level that was pierced last September.

it has a low P/E ratio, a superb balance sheet, a big share

While fiscal Q3 results beat estimates, many are worried

buyback program and a generous 2.7% yield.

that the product cycles have been stretched beyond the time consumers are prepared to wait, particularly with the

AVX (AVX)

iPhone. Also, the company has not refreshed its top-sell-

AVX is a manufacturer and supplier of electronic com-

ing MacBook Pro lineup with Intel’s new energy-efficient

ponents, including ceramic and tantalum capacitors for

Haswell line of processors before the back-to-school rush.

use in products that need to store energy. Approximately

Happily, in the quarterly investor call, the company has

72% of the company is owned by Kyocera of Japan. The

promised a fall launch of a new Mac Pro, OS X Mavericks

company reported solid second quarter earnings per

and iOS 7, in addition to “some amazing new products.”

share, beating analyst estimates ($0.16 vs. $0.15 consen-

Although Apple may see some margin compression dur-

sus) as sales increased by 5% year over year, and its 90-day

ing the transition period, we believe that the introduction

backlog grew 6% since the previous quarter. CEO John

of cheaper entry-level devices like the iPad Mini and a

Gilbertson explained, “One of the advantages of the tablet 11

is that it has a touchscreen...and the bottom line in this

Caterpillar (CAT)

business is capacitors that we sell are basically filters. As

Caterpillar is the world’s leading manufacturer of con-

you put more electronic noise in a circuit with touchpads,

struction and mining equipment, diesel and natural gas

you generally need more of the products we sell. So, a

engines, industrial gas turbines and diesel-electric loco-

touchscreen, which is tablet-oriented, tends to be more

motives. CAT has a dominant share in the U.S. market

positive for us.” We believe that tablet computing demand

and is making headway in emerging economies such as

will continue to build, providing a nice tailwind. Addition-

China, India, Africa and the Middle East. CAT’s exten-

ally, we like that AVX continues to return money to inves-

sive dealer network and reputation for quality products

tors with a buyback program and dividend yield of 2.7%.

provide key competitive advantages. While the near-term

BHP Billiton Ltd (BHP)

outlook remains variable, we like that management is focused on controlling what it can, such as operating effi-

Australian conglomerate BHP is one of the world’s

ciencies, business plan execution, and aftermarket sales

largest miners, with diverse businesses that include alu-

and services. Additionally, we see longer-term benefits

minum, coal, copper, iron ore, mineral sands, oil, gas,

from continuing to migrate production to lower-cost re-

nickel, diamonds, uranium and silver. Though there are

gions. CAT has solid free cash flow generation, which

headwinds, including Australia’s proposed Resource Su-

supports capital allocation strategies that start with

per Profits Tax and economic difficulties in some regions

maintaining its ‘A’ credit rating, followed by investing in

of the global economy, we like that the company has a

growth, steadily raising the dividend (up by 15% this year

low-cost, long-life portfolio of expandable operations that

to a yield of 2.8%), repurchasing shares ($2 billion bought

is robust, diverse and well-suited for long-term growth.

so far in 2013, with another $2.7 billion remaining on the

We remain optimistic on the long-term demand for BHP’s

authorization) and funding the long-term pension plan.

stable of commodities as global economies continue to work through their challenges and either accelerate

Deere & Co (DE)

growth or move into recovery mode, while long-term in-

Deere is the largest manufacturer and distributor of

dustrialization trends continue in China, India and other

agricultural equipment worldwide with leading market

emerging markets. BHP generates attractive free cash

share in large farm-equipment segments. We believe that

flow, supporting a dividend yield of 3.4%.

DE is the best of the best in the agriculture universe. We

BioMed Realty Trust (BMR)

also think that long-term global demand for ag equipment is likely to remain strong as socioeconomic trends

BioMed Realty Trust is a REIT that focuses on owning,

continue to evolve, especially within emerging markets.

leasing, managing and developing commercial spaces for

Deere shares have retreated from January highs, and we

life science tenants. BMR currently has a real estate port-

believe they are offering long-term investors an appealing

folio of approximately 16 million rentable square feet pri-

entry point. While management has tempered near-term

marily in the U.S. and stabilized occupancy rates above

forecasts, they have also affirmed the full-year earnings

90%. The leasing side of the business, we believe, will con-

outlook. DE continues to see strong demand trends for

tinue to benefit from the innovation and growth within

large farm equipment in the U.S., Canada and Brazil, and

the life science industry, as well as the relatively easy ac-

we believe strength will build in emerging economies. We

cess to capital for its clients. The asset development and

believe that undervalued Deere will continue to utilize its

investing side of the business should provide meaning-

strong free cash flow to increase its dividend (the yield is

ful opportunity to expand as it launches new projects and

2.5%) and buy back shares.

partnerships. We also think that the recent merger with Wexford Science & Technology will add important academic research space to the portfolio. Further, we think the solid dividend yield of 4.7% is quite sustainable. 12

Eni SpA (E) Rome-based Eni is a diversified oil major with vertically integrated businesses focusing on international explo-

ration and production (E&P) and European natural gas,

firm sports a strong balance sheet with over $6 of net cash

refining, power generation and chemicals. E shares con-

per share. FL currently yields 2.3%.

tinue to face headwinds as Europe slogs through economic difficulties and some of its more attractive assets are

Corning (GLW)

located in sensitive geopolitical regions. That said, Eni is

Corning is the leading designer and manufacturer of

widely respected for its strong global diplomatic ties and

glass and ceramic substrates found in liquid crystal dis-

its rich, relatively low-cost E&P pipeline of projects. Near-

plays, fiber-optic cables, automobiles and laboratory prod-

term economic and geopolitical risks are offset somewhat

ucts. The company has five primary divisions—display

by Eni’s gas and power business, adding a measure of sta-

technologies, telecommunications, environmental tech-

bility as this segment is less sensitive to volatile commod-

nologies, specialty materials and life sciences. We believe

ity prices. Management has been touting its upstream

that while there may be short-term difficulties to over-

growth potential and its commitment to share the ben-

come, the company is well-positioned to take advantage of

efits of windfall energy prices with its shareholders, the

its market-leading product lines over the long-term. Go-

latter illustrated by the generous 4.9% (net) yield.

rilla Glass, Corning’s ultra-popular mobile device compo-

Ensco PLC (ESV)

nent, has continued to gain traction with manufacturers and consumers, while television panel pricing has been

Ensco is the world’s second largest offshore driller. The

relatively stable and a new endeavor in the automotive

firm operates across six continents with one of the new-

glass space (sunroofs and instrument clusters) is promis-

est jackup and deepwater fleets in the contract drilling

ing. Corning’s inexpensive valuation (P/E ratio less than

industry. In its last few earnings releases, ESV has shown

12) and 2.7% dividend yield are also appealing.

a relatively impressive ability to keep operating expenses in check and generate solid free cash flow. We believe that

HSBC Holdings PLC (HBC)

the outlook for deepwater drilling remains attractive and

Founded in 1865 to finance trade between Asia and

Ensco is well positioned to benefit as newbuilds come on

the West, HSBC is today one of the world’s largest bank-

line and it realizes favorable contract rollovers. ESV has

ing and financial services organizations serving some

a solid balance sheet and future cash use should provide

58 million customers. Headquartered in London, HSBC

another near-term catalyst, coming in the form of addi-

operates through long-established businesses and an in-

tional rig capacity, debt reduction or share buybacks and

ternational network of thousands of offices in more than

dividend increases. ESV shares trade for 9 times forward

80 countries and territories. While HSBC has had to over-

earnings estimates and offer a 3.4% dividend yield.

come challenges from the credit crisis, its true global foot-

Foot Locker (FL)

print gives it unparalleled ability to offer services around the world. We are pleased that management is refocusing

Foot Locker is a leading global retailer of athletic

on core strengths, as well as increasing its presence in

shoes and apparel. The company operates over 3,300

fast-growing emerging markets. Additionally, cost cut-

stores throughout 23 countries and also operates a di-

ting initiatives seem to be having a positive impact and

rect-to-customers business, offering its products to con-

the strengthened balance sheet has left management con-

sumers through its internet, mobile and catalog chan-

structive on increased dividends as well as the potential

nels. Although investors have become a bit jittery over

for future stock buybacks. HBC (note the ticker symbol) is

the choppy mall traffic this summer, we believe that the

trading at 9 times estimated earnings and yielding 4.5%.

athletic cycle is still alive and well, with healthy momentum in higher-priced basketball shoes. We like manage-

MDC Holdings (MDC)

ment’s efforts to more closely collaborate with vendors on

MDC Holdings is a builder and seller of homes in Cali-

products, to develop private label apparel and to remodel

fornia, Colorado, Maryland, Virginia, Arizona and Nevada

stores. Foot Locker generates solid free cash flow and the

under the name Richmond American Homes, and an orig13

inator of mortgage loans for home buyers. We believe that

we were very glad the firm has de-registered as a bank.

the company is well positioned with a strong backlog, a

Having (for the time being) escaped Uncle Sam’s System-

broad geographic footprint, solid net-new-order momen-

atically Important Financial Institution designation, we

tum and improved gross margins. Though interest rates

think that MET will become a bit more aggressive with

have ticked up, the historically low environment should

buybacks and dividend increases. MET boasts a forward

continue to help the company sell to customers that have

P/E multiple below 9 and a dividend yield of 2.2%.

been sitting on the sidelines, waiting for the economic picture to improve. While there might be some lingering

Mosaic Co (MOS)

uncertainty for buyers in the near term, we like that the

Mosaic, the world’s largest integrated producer of

company has continued to actively acquire land in attrac-

phosphate, and the third largest global producer of pot-

tive markets across the country. MDC boasts a solid bal-

ash, markets its North American-based production glob-

ance sheet and a healthy 3.4% dividend yield.

ally via export marketing groups and distribution assets

Medtronic (MDT)

in 11 countries. Following an announcement by the CEO of a major Russian potash producer that his company was

Medtronic is one of the largest healthcare equipment

leaving a decades-old potash cartel and would pursue a

companies in the world, developing and manufacturing

volume-based strategy that could damage global potash

therapeutic medical devices for chronic diseases. Its im-

pricing power industry wide, MOS shares fell by more

plantable products, including pacemakers, defibrillators,

than 20%. Though anything can happen, we note that

heart valves, stents, insulin pumps and spinal fixation

these types of spats in cartels often don’t result in anar-

devices, are marketed to healthcare institutions and phy-

chy, but instead lead to new agreements that evolve over

sicians in the U.S. and overseas, with foreign revenue ac-

time. In the interim, we like that Mosaic has a fortress bal-

counting for more than 40% of total sales. We like that the

ance sheet that includes $6.25 per share of net cash, and

relatively new management team continues to execute on

that the firm generates strong free cash flow, giving man-

its strategy to enhance growth via better R&D productiv-

agement operational flexibility to return capital to share-

ity and we are encouraged by recent global market share

holders via share repurchases and/or dividend increases.

gains and momentum in emerging markets. Additionally,

While the operating environment will be challenging over

we believe the company’s pipeline and newer products

the coming quarters, the firm stands to benefit long term

offer great potential. MDT has a solid balance sheet and

from the positive global macro agriculture trends. Newly

generates strong free cash flow, of which management ex-

inexpensive MOS offers a dividend yield of 2.4%.

pects $25 billion over the next five years, with 50% expected to be returned to holders via buybacks and dividends. MDT shares are attractively valued relative to its peers, not to mention its historic average multiples.

MetLife (MET)

Microsoft (MSFT) Microsoft is the worldwide leader in software, services and solutions that “help people and businesses realize their full potential.” Launched in 2012, sales of the company’s flagship Windows 8 operating system have been slow and

MetLife is a global provider of insurance, annuities

the company desperately needs to launch its 8.1 (“Blue”)

and employee benefit programs, with leading market po-

update, in order to restore some of the legacy functions

sitions in the U.S., Japan, Latin America, Asia, Europe

of the software and win back some of the customer base.

and the Middle East. We are fond of MET’s underwriting

In addition to the Windows 8.1 update, the company has

discipline and its position as the market leader in group

room to improve on its Microsoft Office 2013 suite, which

life insurance. We also like that MET continues to pull

still doesn’t offer a fluid user experience across multiple

back on its variable annuity business, focusing on more

devices like competing products. We believe that straight-

traditional insurance sales. The company has a relatively

forward access to the Cloud is of tremendous importance

strong capital position and, though the process took time,

to all MSFT products and normal teething problems in

14

new interfaces, like integrated touch-screen technology,

to show its commitment to returning capital to sharehold-

are likely to make consumers somewhat slower to adopt

ers. In fact, Pfizer recently announced a new $10 billion

the platforms. We expect enterprise customers will take a

repurchase authorization, adding to the $3.9 billion re-

more serious look at adopting Windows 8.1, though still at

maining from a prior buyback. PFE currently yields 3.3%.

a relatively slow rate. With plenty of bad news priced into the stock, we look favorably upon the company’s growth

Portugal Telecom (PT)

prospects across its business segments, and we are drawn

While turbulence in Europe has not helped and its

to the dividend yield of 2.8% and the modest forward P/E.

25% ownership stake in Brazilian telecom provider Grupo

Norfolk Southern (NSC)

Oi has seen a plunge in value this year, we remain fans of international telecommunications provider Portugal

Norfolk Southern provides rail transportation service

Telecom. The company, which also benefitted in the latest

in the eastern U.S., operating 21,000 miles of route that

quarter from its global asset base (58% and 43% of revenue

spans 22 states and Washington D.C. The rail company

and EBITDA, respectively), continues to invest around

has an extensive intermodal and coal service network and

the world, using cash to acquire 4G network licenses, en-

a significant general freight business, including the larg-

hance residential internet speeds with fiber optic infra-

est automotive shipping business in North America. NSC

structure and build out its TV product. That said, we like

has been one of the best run railroads on the continent,

that even though a significant amount of capital spending

shown by its strong free cash flow generation and attrac-

has been completed, management remains disciplined in

tive operating ratios over the past five years. Norfolk, like

its approach to growth and continues to be proactive in

its counterparts, continues to face headwinds from the be-

shoring up the balance sheet. In sum, we believe that PT’s

leaguered coal market. While we believe this struggle has

geographically diverse revenue stream will contribute

not fully run its course, we see a floor building and believe

positively to earnings stability, while generating the cash

the long-term prospects for export coal are still attractive.

flow needed to keep borrowing costs in check and support

Additionally, we like NSC’s overall growth trends in its

the revised dividend policy (0.10 euros per annum).

intermodal business. With solid business execution, good financial footing, cash flow generation of better than $1 billion in 6 of the last 7 years and a 2.8% dividend yield, the shares offer attractive long-term prospects.

Pfizer (PFE)

Wal-Mart Stores (WMT) Wal-Mart is the world’s largest retailer with a presence in 27 countries, operating supercenters and wholesale warehouse clubs. In addition, the company is rolling out smaller store formats, including exclusive grocery stores,

One of the world’s largest research-based pharmaceu-

in an effort to penetrate historically under-represented

tical firms, Pfizer discovers, develops, manufactures and

urban areas. The company continues to gain momentum

markets medicines for humans and animals. Its products

as it executes its Every Day Low Cost and Price (EDLC

include prescription drugs, non-prescription self-medica-

& EDLP) initiatives across the international segment. We

tions and animal health products such as anti-infective

believe that this unit, along with its growing e-commerce

medicines and vaccines. While recently approved generic

business, gives Wal-Mart attractive long-term growth op-

forms of Lipitor will very likely knock off one of Pfizer’s

portunities. Though there are concerns over the potential

key drugs, the company’s foundation remains solid, with

growth rates of the domestic business, we believe that

a diverse basket of patent-protected drugs and other pop-

there is still a solid sales outlook, supported by a leader-

ular products, an appealing pipeline of new drugs and

ship team focused on such things as increasing the mer-

deep pockets to offer competitive advantages in devel-

chandise assortment at attractive price points and con-

oping new drugs. In addition to the solid balance sheet

tinuing to improve its price-match guarantee programs.

and strong free cash flow, we like that PFE is attractively

With a solid balance sheet, lower-risk Wal-Mart offers a

valued against its peers and that the company continues

reasonable valuation and 2.4% dividend yield. 15

AFAM Capital is committed to assisting our clients build wealth. We are a resource for value-based investor information in the financial community, where we combine our simple philosophy of buying securities that we believe are undervalued for their long-term capital appreciation. We use our experience, hard work and intensive research to give you actionable investment information that can be used by individual investors. For information regarding managed accounts, please call us toll free at 888.994.6827 or visit us at alfrank.com.

Important Information Readers should know we discriminate among potential investments primarily by their relative valuation metrics and our assessments of stock-specific risk. We buy only those stocks we find undervalued along several lines relative to their own trading history, those of their peers or that of the market in general. The prices at which we’ll buy and sell stocks incorporate a range of fundamental risks (e.g. credit, customer and competitive dynamic) that we believe the companies may face over our normal 3-to-5-year investing time horizon. It is important to note that the Russell study period is quite short compared to the history of the market and that the findings from this portion of the study would not necessarily hold over to future periods. To perform the Russell portion of the study from 1992 to present, we constructed a portfolio that mimics the Russell 3000 index. We first utilized a dividend payment series developed with Thomson Reuters and Russell Investments to categorize each member of the Russell 3000 into dividend- and non-dividend-paying groups for each month from July 1992 through June 2013. A stock was considered a dividend payer if it had paid a dividend in the last twelve months. We utilized the last day of each July as, generally speaking, index membership subsequent to that day each year accounts for changes from the annual reconstitution of the index. From those two groups we then generated an equal-weighted portfolio return series, in addition to a capitalization-weighted return series consistent with each stock’s actual weighting in the Russell 3000. Companies in the Russell 3000 without performance history were removed each month, after the companies were broken into the various groups. The resulting returns series, combined with the actual Russell 3000 return series, form the basis of this study. To perform the portion of the study from 1927 to present, we utilized the dividend-weighted portfolio data from Eugene F. Fama and Kenneth R. French. The dataset is broken into four groups: non-dividend paying, top 30% of dividend payers, middle 40% of dividend payers, and bottom 30% of dividend payers. Opinions expressed are those of Al Frank Asset Management, a division of AFAM Capital, Inc., are subject to change without notice and are not intended to be a forecast of future events, a guarantee of future results or investment advice. Past performance may not be indicative of future results. Therefore, you should not assume that the future performance of any specific investment or investment strategy will be profitable or equal to corresponding past performance levels. AFAM Capital, Inc. is registered with the Securities & Exchange Commission, is editor of The Prudent Speculator (TPS) newsletter and is the Investment Advisor to certain no-load proprietary mutual funds and individually managed client accounts. Registration of an investment advisor does not imply any level of skill or training. AFAM adheres to the same investment principles and philosophies in managing value-oriented individual client accounts, its proprietary value mutual funds and in the information that appears in its investment advisory newsletter, which is long-term growth of capital by owning a diversified portfolio of securities that are undervalued and holding them for their long-term potential appreciation. Diversification does not protect against loss in declining markets. As adviser to its own proprietary mutual funds and manager of individual client accounts, AFAM may purchase, sell or hold positions in the securities that appear in this presentation. Also, employees may hold, purchase or sell any of the stocks that appear in this presentation subject to AFAM’s Code of Ethics, Insider Trading, and Personal Trading policies. Al Frank Asset Management, Inc 85 Argonaut, Suite 220 Aliso Viejo, CA 92656 P: 949.499.3215 / 888.994.6827 F: 949.499.3218 A division of: AFAM Capital, Inc. 12117 FM 2244, Bldg. 3, Suite 170 Austin, TX 78738