Around this time last year, geopolitical instability was on the rise with fresh conflicts in the Middle East and Eastern Europe, yet global asset classes were remarkably stable. The old “sell in May and go away” proved to be a poor strategy, as the S&P 500 gained roughly 2% in both May and June. Bond returns were stable, as the 10-year Treasury rate was range bound around 2.5%. Even the normally volatile price of gold was flattish in May and June of last year. As we noted in our Investment Comments, “only the oil market seemed to be showing any effects of rising global instability, outpacing the S&P’s gains noticeably over the past three months.” Of course, we know now that instability in the oil market was about to accelerate, as the price of crude reversed course violently.
As oil was peaking last June, the combination of rising inflation and reduced liquidity in the bond market led the consensus view that bond yields would gradually rise in the second half of the year. A Bloomberg article we referenced in our Investment Comments surveyed 75 economists who, on average, expected the 10-year Treasury yield to rise from 2.58% to 3.07% by the end of the year. Of course, as is typical of economist forecasts, the 10-year yield did the exact opposite, gradually falling to the low 2%’s.
Bond markets have been far less stable this year, thanks to the unprecedented rate environment caused by the ECB’s QE program. 10-year German bund yields reached historic lows near 0.05% in April, leading Bill Gross to proclaim bunds the “short of the century.” At the same time, since they serve as bund alternatives, 10-year US Treasury yields were driven well below 2%. These exceptionally low rates have led to considerable volatility in global bond markets in the last few weeks, as the 10-year bund has made a violent move back near the 1% level, driving the 10-year Treasury back to the 2.4% range.
Once again, the common consensus is for Treasury yields to rise back to the 3% range in anticipation of a Fed rate hike in the back half of the year. However, even if the forecasts are right this time, bonds at these yields still provide a virtually zero real return after inflation, and pose considerable market value risk if interest rates finally do normalize. As a result, we have continued to favor dividend growth stocks for income-oriented investors.
In last June’s IAS, we profiled Praxair Inc (NYSE: PX), the leader in the stable and profitable industrial gas industry, as a potential dividend growth investment. In our view, Praxair offered an attractive combination of quality, stability, and growth. We laid out the investment thesis as follows:
Fueled by its backlog of contracts, we expect Praxair to grow revenue by 10% annually. We also expect the company to continue to gain earnings leverage through efficiency and selected share buybacks. EPS growth could be 14% annually… Adding in the 2.1% dividend yield produces a potential total annual return over 15%.
However, due to significant headwinds, recent results have fallen short of our long-term projections. As a result, Praxair shares have lagged the overall market since we featured them last July. The stock has fallen about 5%, while the S&P 500 has gained 8% on a total return basis. The shares dipped from our initial $130 price tag to the low $120s in the volatile October market of last year. The company announced 3Q14 results during this time that missed Wall Street’s consensus estimates. Q3 sales grew just 4%, while EPS grew 7%. Management also reduced its full year earnings guidance, forecasting flat Q4 growth, as sluggish global industrial output and the surging U.S. dollar were becoming stronger headwinds. Praxair’s strong presence in previously high growth emerging markets like Brazil, China, and Mexico, was now a double whammy on near-term performance as global developing economies were struggling and Praxair’s foreign sales were being translated back into fewer dollars.
Despite the continued strengthening of the U.S. dollar and market rotation out of multinationals, Praxair shares ended 2014 strong after the company reported 10%-15% gas price increases for its customers in the U.S., Canada, and Mexico, effective in 2015. This announcement highlighted the strength of Praxair’s long-term “take or pay” contracts, which allow the company to offset rising input and operating costs by raising prices, thereby maintaining strong profitability in weak economic conditions.
The rally was short-lived however, as Praxair’s international exposure continued to hurt the company’s short-term business and share price performance. Investors sold the stock down ahead of the Q4 earnings release in late January, fearing the continued effects of the surging dollar and instability in its emerging markets. The market’s sentiment was confirmed when the company reported sales fell 1% in Q4, with a 4% negative currency impact, and issued guidance for flat sales and EPS growth for 2015. On an ex-currency basis, growth guidance was not that bad, at 4%-7% for sales, and 5%-11% for EPS, but investors didn’t feel like hanging around for the strong headwinds to die down, and the stock continued its slide to the $120 support level.
The stock went on to track the U.S. dollar closely for the rest of the first quarter. It grinded its way higher when the dollar’s ascent finally stalled in February, before tumbling back towards $120 when the dollar spiked once again amid Greece worries and hawkish Fed speculation in early March. The dollar and emerging market headwinds seem to be priced into the stock in the low $120s at this point. The shares continue to trade sideways at the time of this writing, even after 1Q15 results showed revenue falling 9%, and weak economic conditions led management to lower full year organic EPS growth guidance to 4%-8%.
Because currency impacts will cause actual results to decline year-over-year in 2015, the shares will likely continue to be dead money for now. However, cost control and new-project driven organic growth continue to be above average in an extremely difficult operating environment. When global growth picks up and the U.S. dollar normalizes, patient Praxair shareholders will likely be rewarded. And with a current dividend yield that matches the 10-year Treasury yield, collecting the dividend while waiting for potential double-digit growth to resume appears to be a far better alternative than locking in a fixed bond return below 3%.