As part of work done for Investing Daily’s Utility Forecaster, where I am a senior analyst, I developed an Early Warning System for the utility sector to ascertain threats to the dividend and identify investment opportunities. 

The model also works well with all types of income investments in addition to utilities, such as the REITs, banks, and telecoms. That’s why I regularly use the Early Warning System to monitor Global Income Edge portfolio companies.

In the subscriber section, we’ll share the results of the model and discuss which companies, if any, have shown weakness or strength, and what actions we might take as a result. 

This Early Warning System deconstructs a company’s return on equity (ROE) into its individual components, which allows for greater ease in analyzing what’s actually driving growth.

In addition to identifying promising investments, this system alerts us to declining margins and rising leverage. The System’s red and green flash alerts notify us when trends in percentage changes in ROE exceed or fall short of preset criteria. The system then displays customized breakdowns of each company’s fundamentals, offering a snapshot of a firm’s true financial health.

The System, also referred to as the DuPont Hybrid Model, originates from the original DuPont model that was developed in 1919 by a finance executive at EI du Pont de Nemours and Co, and was then used by many other companies to evaluate the critical components that contribute to ROE and so shareholder value. ROE is still considered a key measure when comparing companies against their peers and is used by many of the world’s top investors, including Warren Buffett.

According to a study conducted by Charles Schwab, ROE also appears closely correlated with the safety and sustainability of a company’s payout. Schwab reviewed the characteristics of dividend payers among the top 3,200 stocks by market capitalization, over the period from 1990 through February 2009, and found that companies with higher ROEs were less likely to have cut their dividend.

Furthermore, many utilities’ cash flows are cyclical in nature, as they’re highly sensitive to weather-related events, as are many other businesses in the GIE portfolios. A precipitous, short-term drop in ROE in one quarter may not necessarily indicate that a company’s financials are unraveling. As such, the early-warning system will evaluate trends in ROE across multiple quarters prior to recommending any action with regard to an existing holding or a new opportunity.

The most surprising result of running the early warning system on Global Income Edge portfolios was in what great shape our Real Estate Investment Trust holdings are in. This confirms suspicions that the recent selloff in the sector has been more investor overreaction to a possible rate increase by the Federal Reserve than on the fundamentals. 

And we have long argued that income investments such as REITs will remain competitive with Treasuries for some time as Fed rate increases are expected to be gradual.

The majority of REITs in our portfolio maintained their previous quarter’s return on equity (ROE) levels, one increased its ROE and profitability, while two companies showed potential weakness. We highlight them here, though two negative ROE quarters are required before we would make a ratings change.      

WEEKLY INCOME TRIVIA QUESTION

Q: What is the origin of the word “Bank?”

The answer will be provided in next week’s issue.

Last week’s question was: What is the name of the major ethnic group that makes up 96% of the population of Beijing, China?

The answer: The Han. With 1.3 billion people, the Han make up 19% of the global population and are the largest ethnic group in the world.

The name Han comes from the Han Dynasty, which was first established in 206 BC. Much of the long cultural legacy for this people group is preserved in Beijing.

Beijing is home to one of our newest picks in energy. It’s a power plant utility company that pays a 4.45% dividend and has a double-digit upside. Best of all, this pick is super-safe with long-term contracts.

Safe dividends like this are part of our strategy to make income we call the “safest in the world” – click here to read about income that you won’t find anywhere else.