RETHINKING MONEY MARKETS

By Eric Uhlfelder, Investing Across Borders

For the Financial Times, 4 December, 2001

Nearly two years of declining stock markets sent many investors fleeing to the sidelines. The result has been a boon for money market funds. For this year through October, net cash flow into US money market funds soared $341 billion versus $87 billion for the same period last year, according to the mutual fund industry group the Investment Company Institute.

While the appeal of such funds is security of prinicipal, these days they offer little more. Peter Crane, managing editor of iMoneyNet, a money markets data tracking firm, reports that the average compounded annual yield of US taxable money market funds at the end of November was only 1.93 percent. Even with no additional interest rate cuts, which is unlikely, that average annual return will drop further as the latest Fed cut filters into fund portfolios. "Money market yields are at their lowest point over the past 30 years," observes Crane, "and some funds may soon consider waiving expenses to maintain positive yields."

While money markets are the most convenient place to park cash that will be needed over the next 12 to 18 months, for investors waiting for equities to rebound, there is an alternative: Going back into the stock market.

While that sounds somewhat perverse, there are some great solid stocks out there that are yielding up to twice as much as what money market funds are paying. Their dividends are secure and are not likely to decline, a prospect which is nearly inevitable for money market funds given the likelihood of further rate cuts by the Fed.

For example, oil giant Exxon is paying 2.4 percent and BP 3.0 percent. Global insurer AXA is yielding 3.8 percent, and Britain’s largest bank, HSBC, is paying out 4.4 percent.

There are foreign exchange risks when investing in non-US equities. It doesn’t take much of a currency shift to wipe out today’s modest yields. But conversely, a weakening dollar would enhance returns.

The largest caveat is risk to principal. If the recession deepens and industry profits collapse even further, there’s no telling how much more stocks could fall. However, equity prices have already declined substantially, and if one believes the current recession is close to its nadir, additional downside for industry bellwethers may be limited.

According to Bart Dowling, Director of Global Asset Allocation at Merrill Lynch in New York, "Looking at the current economic cycle, we may be approaching the time in which it may make sense for individual investors to shift a portion of their investable capital into big, safe, friendly companies for their yield." Dowling looks to the most recent slowdowns of the mid-1980s and early 1990s for guidance to what may make sense in today’s economic environment. And if his assumptions are correct, dividend-seeking investors could be doubly rewarded with capital appreciation in the not too distant future.

However, investors should not simply look for large brand name companies offering attractive yields. British Airways is a case in point. The company’s commitment to a progressively increasing dividend simply didn’t square with the reality of its business. While BA was able to sustain a dividend of more than 7 percent during the late 1990s when the company was losing money for the first time since privatization, its dividend coverage or payout ratio had actually exceeded 100 percent. This meant that the company was paying out more than it was earning. The collapse of air travel after September 11^th quickly put an end to this fiscally challenging practice.

Therefore, it’s incumbent upon investors seeking to replace safe money market yields with corporate dividends to discern how secure this payout actually is. There are several essential measurements for doing this: transparency of income and earnings (especially during recession), history of a strong balance sheet, and a dividend payout ratio that’s sustainable.

Exxon, for instance, has a record of expanding revenues and earnings. Between 1992 and the most recent four quarters, EPS has increased from $0.95 to $2.57. Its products and services are essential, and because the company is in both production and sales, Exxon is reasonably sheltered from falling oil prices. At the same time, the company has been slowly increasing its dividend by more than 20 percent from $0.71 to $0.90 per share over the past 10 years, while its payout ratio has erratically declined from 75 percent to 35 percent, suggesting a fairly secure dividend.

HSBC offers a slightly different picture. It's a venerable global banking leader with a long proven track record. Earnings have increased from $0.31 per share in 1992 to $0.74 over the most recent four quarters. The dividend has grown substantially from $0.096 to $0.375 over the same time. However, the payout ratio has climbed from 39 percent to 66 percent. While most analysts believe that the bank should be able to maintain its current dividend during the recession, it may be more at risk than Exxon’s.

Payout ratios can fluctuate substantially with market conditions, and what analysts deem adequate coverage will vary from industry to industry. A temporary rise in the ratio doesn’t automatically mean the dividend is at risk. Investors must observe the trend of this ratio over time to assess the security of the dividend.

In addition, investors can take analysis of dividend stability a step further by looking at cash flow. "When we invest in a company in part for yield," explains Thomas Barr, managing director of the money management firm Munn Bernhard & Associates in New York, "we need to be sure there’s adequate cash flow to cover it, and just as important, that there are prospects for long-term growth."

SELECT LARGE-CAP STOCKS WITH ATTRACTIVE DIVIDENDS